SUPPLY &SUPPLY &DEMANDDEMAND

1.0 PATTERN-SEEKING, STORYTELLING1.0 PATTERN-SEEKING, STORYTELLING1.1 PATTERN-SEEKING1.1 PATTERN-SEEKING1.2 STORYTELLING1.2 STORYTELLING1.3 PICTURES, WORDS & NUMBERS1.3 PICTURES, WORDS & NUMBERS1.4 MATH AS A LANGUAGE1.4 MATH AS A LANGUAGE1.5 FUNCTIONS1.5 FUNCTIONS2.0 RETURNS TO SCALE2.0 RETURNS TO SCALE3.0 SUPPLY & DEMAND BASICS3.0 SUPPLY & DEMAND BASICS3.1 DEMAND CURVES3.1 DEMAND CURVES3.2 SUPPLY CURVES3.2 SUPPLY CURVES3.3 KINKED CURVES3.3 KINKED CURVES4.0 VARIANTS OF SUPPLY & DEMAND4.0 VARIANTS OF SUPPLY & DEMAND5.0 AUCTIONEER MODEL5.0 AUCTIONEER MODEL5.1 THE MODEL APPLIED5.1 THE MODEL APPLIED5.2 PROBLEMS5.2 PROBLEMS6.0 THE ROCKING-HORSE MODEL6.0 THE ROCKING-HORSE MODEL6.1 THE MODEL APPLIED6.1 THE MODEL APPLIED6.2 PROBLEMS6.2 PROBLEMS7.0 THE DISCO MODEL & SEARCH EQUILIBRIUM7.0 THE DISCO MODEL & SEARCH EQUILIBRIUM7.1.1 THE MODEL APPLIED I: LABOR MARKETS7.1.1 THE MODEL APPLIED I: LABOR MARKETS7.1.2 THE MODEL APPLIED II: COLLEGE SEARCH7.1.2 THE MODEL APPLIED II: COLLEGE SEARCH7.1.3 THE MODEL APPLIED III: HEALTH 7.1.3 THE MODEL APPLIED III: HEALTH INSURANCEINSURANCE7.1.4 THE MODEL APPLIED IV: PREDATOR-PREY7.1.4 THE MODEL APPLIED IV: PREDATOR-PREY7.2 PROBLEMS7.2 PROBLEMS

8.0 THE CORRIDOR MODEL8.0 THE CORRIDOR MODEL8.1 PRICES & PHYSICS8.1 PRICES & PHYSICS8.2 THE MODEL APPLIED8.2 THE MODEL APPLIED9.0 THE COBWEB MODEL9.0 THE COBWEB MODEL9.1 ELASTICITY9.1 ELASTICITY9.2.1 INELASTIC SUPPLY & DEMAND9.2.1 INELASTIC SUPPLY & DEMAND9.2.2 ELASTIC SUPPLY & DEMAND9.2.2 ELASTIC SUPPLY & DEMAND9.3 GIFFEN GOODS & CONSPICUOUS 9.3 GIFFEN GOODS & CONSPICUOUS CONSUMPTIONCONSUMPTION10.0 AREAS10.0 AREAS

This chapter examines the core economic mechanism of supply and demand. Although sometimes presentedas a “Law,” how supply and demand operate varies from one type of market to another. In addition, marketsinteract and so we think not simply about the partial equilibrium of a single market, but the generalequilibrium that results from the balancing of all markets. Charting supply and demand is a simple method ofdescribing the structure and pattern (the “what”) of economic activity that enables us to “tell stories” (the“why” and “what if ”) about the causes and likely consequences of different choices. Therefore, imperfect asthey may be factually, they can still act as models and guides to help us think through the causes andconsequences of economic activity. This chapter will present five models of supply and demand and explainconstituent concepts such as elasticity, returns to scale, and consumer and producer surpluses.

1.0 PATTERN-SEEKING, STORYTELLING ANIMALS1.0 PATTERN-SEEKING, STORYTELLING ANIMALS

The economist Edward Leamer recently observed that humans are “pattern seeking, storytelling” animals.Leamer meant ot emphasize that when we look at human behavior or environments, we seek impose order onthe flow of events, actions and circumstance sin which we find ourselves; we look for a pattern to give itmeaning. For example, if I think that studying improves performances on tests, I might look at two things: thenumber of hours studied and the test grade and plot them on x-y axes to determine the pattern. If studyingimproves performance, I should see the observations cluster along a northeasterly vector from the origin (y =x). If I think that studying decreases performance, the dots should cluster in a southeasterly direction, fromNorth to East (y = -x + c). If I think there is no relationship, then we should observe a random “buckshot” spraypattern. We can collect data and discover which pattern best fits the observational data.

1.1 PATTERN-SEEKING1.1 PATTERN-SEEKING

However, due to the disposition to seek patterns, we tend to impose structure andpatterns that may not be there. Most are familiar with projective psychological testslike the Rorschach test. Individuals are asked to see patterns in a random inkblot likethe one on the right. Even though there is no real pattern, each person can "see"something in the blots just like people see shapes in clouds. The pattern we see maysay more about the observer than the object. The same is true of information we getfrom our social and natural world. For healthcare providers, physical symptoms canbe elements of a larger syndrome, or not. For teachers, a correct choice "A" on amultiple choice test may demonstrate knowledge or just a really lucky guess.

Simply finding a pattern does not tell us how or why the pattern exists. “Correlation does not equal causation”is the frequent refrain in criticisms of social research. For example, the winner -- AFC or NFC -- of the SuperBowl is a near perfect predictor of the stock the following Monday. As a teacher, I witness a miraculous patternevery day, where every 45 minutes a bell rings and students show up in my classroom. I may conclude fromthis pattern that the bell caused the students’ arrival. Another pattern is that hospitals have much higherconcentrations of sick and ill individuals than average. One could conclude that hospitals make people sick.In the 1980s, it was famously observed that trees cause climate change because they are the largest source ofatmospheric CO2. To make sense of patterns, we must have narratives that puts patterns in their proper context.In the case of hospitals, the simple narrative is that patients are brought to hospitals to heal. In the case of theSuper Bowl, NFC teams tend to be located in larger cities, which has a disproportionate impact on the post-game euphoria. The carbon cycle is the scientific narrative that explains the relationship between plants andatmospheric carbon and the desire to graduate is probably the real cause of the students’ attendance, not thebell. In short, facts do not “speak for themselves,” and most common error is not seeing the wrong pattern, butseeing a pattern where none exists.

SUPPLY & DEMANDSUPPLY & DEMAND

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1.2 STORYTELLING1.2 STORYTELLING

Humans also tell stories or "narratives." Stories gives actions and events context and meaning. Take thefollowing sentence. Jack killed Jill. By itself, this simple sentence does not tell us a lot. Immediately, you maythink Jack is pretty bad because killing is bad, but we don't know about the context, the motivations, thesetting to inform us about making a judgment. Perhaps Jill is a terrorist and Jack (Bauer?) is a soldier, thenperhaps Jack is a hero. Or, Jill is suffering from a terminal disease and Jack is an anguished spouse who, againsthis own wishes, does what Jill asks. Or, like Othello & Desdemona, Jack killed Jill because he was tricked intobelieving Jill was unfaithful and he “loved not wisely but too well." Or, Jack is sent from the future to stop Jillthe scientist from inventing a technology that will lead to the end of the human race. Each of these narrativesprovides a different context and interpretation, but all are consistent with the simple factual observation. Ashumans, we not only construct narratives in fiction, but also create self-narratives that explain our own actionsand those of others.

In economics, there are many narratives embedded in the basic models. The shape of the supply and demandcurves depend on what factors an observer believes influences supply and demand. Liberals tend to focus onquantity movements (ex. employment, GDP, income distribution) in supply and demand dynamics, whileConservatives emphasize price movements (ex. inflation, tax rates, incentives) even when describing the samedata pattern. “Just So” stories about the origins of money often reflect how we think money operates in thehere and now. Narratives about how economic institutions and processes operate help us put data in contextand provide the framework to make cause-and-effect inferences. While pattern-seeking and storytelling canlead to self-deception and self-subversion, it also provides us distinct advantages. Identifying patterns allows usto perceive reality and use language in a way unlike any species. Telling stories allows us to learn overgenerations that has made humans today much more advanced than a human 10,000 years ago, while achimpanzee today is probably just as advanced as a chimpanzee from 10,000 years ago.

1.3 PICTURES, WORDS & NUMBERS1.3 PICTURES, WORDS & NUMBERS

There are three basic modes of communication and thought: pictures, words, and numbers. Economics uses allthree. The supply and demand diagram is a visual representation (picture) of systems of equations (numbers)that operationalize verbal descriptions of economic processes and institutions. One can express any economicidea or concept using any mode, but some modes are better suited to certain tasks than others and certainindividuals are more comfortable using certain modes than others. This chapter will try to express each modelof supply and demand in each mode.

Generally speaking, pictures are the best mode for communication of information, while numbers are the bestformat for analysis. Using numbers ensures the logical consistency and describe phenomena that are hard tovisual like multidimensional variables. Pictures, including graphs, diagrams and charts, require the least ofaudience and can show the interrelation of several phenomena, like the intersection of supply and demandcurves and provide good first approximations of economic dynamics. Words occupy the middle ground:neither logically precise or transparently communicative. Economic insight lies at the intersection of the three.

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1.4 MATH AS A LANGUAGE1.4 MATH AS A LANGUAGE

Math is a language with its own vocabulary, grammar, and style. Since the “marginal revolution” in the late19th century, economics has been a discipline largely written in mathematical formulae and identities anddisplayed in its counterpart: Cartesian-grid diagrams. As a result, much of economics is applied physics andcalculus and math literacy and numeracy is necessary to grasp much of economics.

1.5 FUNCTIONS1.5 FUNCTIONS

A statistic is a single measurement like your height at age 18 or the average grade in geometry. A variable avector of individual statistics such your height at ages 1, 2, 3, . . . or average grades in geometry across highschools in Westchester and Putnam counties. Key thing: Variables vary, statistics do not. Statistics arephotographs, variables are movies. Functions define the mathematical relationship between two variables, xand y. For our purposes let's say that x is the hours students studied for a test and y is their grade on that test.We can hypothesize two relationships:

1) Studying more will increase your grade on the test or y = x2) Studying more will decrease your grade on the test or y = -x

These two functions are linear, meaning that for every in the value ofx, the value of y increases a constant amount. Examples of linearfunctions are y = 3x or y = -5x. Functions can also be non-linear. Ineconomics, non-linear functions include patterns includingincreasing returns to scale, diminishing returns to scale, anddiminishing marginal utility. Increasing returns to scale are usuallywritten as exponential or power functions such as y = x2 or y = 102x -1. Adam Smith's idea of the Division of Labor is an example returnsto scale. When one organizes work in a division of labor theproductivity of individual workers increase exponentially as moreworkers are added to the process. Logarithmic functions such as y =ln x or y = 10 log x express decreasing returns to scale. For example,my demand for pizza may be linear, but if consumption hasdecreasing returns to scale, this can be expressed by taking the naturallogarithm of the linear function.

Interaction effects produce non-linear functional forms. Studying a foreign language helps one learn to read,write, and understand English and vice versa. If this is true, that means that one hour studying both Englishand Japanese could have a positive non-linear effect on my English grade. Conversely, studying while listeningto your I-Pod Nano may have a negative non-linear effect on the relationship between hours studied and yourgrade. Some students claim -- erroneously -- that listening to music makes them work better, but what theymay really is that they can study longer while listening to music. This does not mean they are studying moreeffectively. The slope of the function tells you how effectively you are studying -- how much your gradeimproves for each hour studied -- while the number of hours studied tells you what the x-value (hours studied)for an individual student. A good comparison is the economies of China and the USA, the second largest andlargest economies in the world respectively. In total, the economies are both large, but China has 4 to 5 timesthe population of the United States. Obviously, if you have 5 times the number of people, you should be 5 timesmore work. However, if you looked at the economy in per capita terms, the average Chinese earns about $5000per year, while the average American earns $30,000 to $40,000 per year. Political units come in all shapes andsizes, and therefore, aggregate comparisons sometimes only tell you that a country is bigger.

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2.0 RETURNS TO SCALE2.0 RETURNS TO SCALE

The basic competitive model of the market economy assumes constant returns to scale (linear functionalform). Constant returns are implicit in economic arguments for free trade and the efficacy of the “invisiblehand” of the market. When constant returns cannot be assumed, many of the general conclusions abouteconomic relationships break down. Unfortunately, there are many known examples of economies anddiseconomies of scale in economics. The tension between constant returns and increasing/decreasing returnsto scale lie in the origins of economic thought. Adam Smith’s Wealth of Nations presents two basic pillars ofmodern capitalist economies: the “invisible hand” of competitive markets -- an example of constant returns-- and the division of labor of industrial organization -- an example of increasing returns. Understandingwhen increasing (or decreasing) returns matter is a good key to grasping the exceptions to conventionaleconomic theories and why markets often do not work in practice even when they should work in theory.

Increasing returns to scale are primarily applied to productionfunctions. For every unit of input of a factor of production (i.e., land,labor, and capital), output increases more than one unit. The divisionof labor shows how the organization of the production process canproduce increasing returns. However, increasing returns can shapeother types of economic behavior. Positive externalities, such asnetwork effects, can make a networked good disproportionatelyvaluable to a prospective entrant. Mobile phone or social networkingproducts become more valuable as they add users. Environments thatpromote more interactions may be more valuable than isolatedcounterparts. Education is another example. One’s existing stock ofknowledge facilitate the flow of new knowledge. Positive feedbackloops such as global warming and compound interest can produce greater output as stocks accumulate.

The most common example of decreasing returns is the diminishing marginal utility of consumption. Evenfor desirable goods, the consumption of the second unit producesless satisfaction than the first, the third less than the second, and soforth. Congestion and crowding effects, where enjoyment decreasesas more participate, such as fashion trends, road traffic, or aroundtable discussion are examples. Bureaucratization,professionalization or micro-management can reduce the efficiencyof labor; one boss is helpful, two bosses is not twice as helpful.Professions -- law, medicine, education -- and service occupationsmore generally, have constant returns, but compensation costs givethem decreasing returns. Most natural resources have decliningreturns due to the tendency to use the easiest to extract mineral or

most productive land first. Knowledge can have decreasing returns if prior knowledge makes one closed-minded. Drug resistance is another example of decreasing returns where constant doses yield a smaller effect.

The other reason that non-linear returns to scale are important is thatthey raise the possibility of multiple equilibria. When supply anddemand have constant (linear) returns, there is only one uniqueequilibrium. However, if one or both of the curves are non-linear,there can be two or more intersections, which means that there can besub-optimal equilibrium traps that prevent the economy fromreaching full employment. In addition, feedback loops -- multipliereffects -- can accentuate booms and busts during the business cycle.

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3.0 SUPPLY & DEMAND BASICS3.0 SUPPLY & DEMAND BASICS

The basic supply and demand chart consists of four elements: asupply curve, a demand curve, an equilibrium at the intersection ofthese two curves, and vertical and horizontal axes labeled “price” and“quantity” respectively. The supply and demand curves intersectwhere the marginal cost of producing an additional unit to producersequals the marginal value of consuming an additional unit toconsumers. Movements along the supply the demand curves reflectchanges in price or quantity, while shifts of the supply and demandcurves reflect changing conditions of supply and demand unrelated toprice, such as the adoption of new technologies, increases inpopulation, or changes in tastes. The standard supply and demanddiagram, pictured to your right, only shows supply and demand inone isolated market. However, since supply and demand in one goodor service can affect supply and demand in related markets (inputs,substitutes, complements), a more complete description would require a general equilibrium result.

3.1 DEMAND CURVES3.1 DEMAND CURVES

Ordinarily, demand curves slope downward, reflecting theopportunity cost tradeoff between money (price) and the goodpurchased (quantity). In most cases, the higher the price, thelower the quantity of a good or service will be demanded; thelower the price, the more will be demanded. The chart to the leftpictures the intuition behind the downward-sloping demandcurve. At a high price, only one ice cream cone is demanded, butas the price drops, more ice cream cones will be demanded. Thefunctional form of the demand curve is influenced by thepresence of substitutes, wealth of buyers, the extent of themarket, and diminishing marginal utility of consumption.

3.2 SUPPLY CURVES3.2 SUPPLY CURVES

In most cases, sUPply curves slope upward reflecting theopportunity cost tradeoff between the money spent (quantity)and the revenue earned from sale of a product (price). Ordinarily,the higher price, the more willing producers are to make a largerquantity of a good or service. The chart to your right shows theresults of an “applause auction” where students “bid” on $1 and$5 dollar mystery prizes. Some students were willing to “supply”more minutes of applause for the same payoff. The slope of theirsupply curves reflects their individual willingness to trade timefor money. Assuming constant returns, it is assumed that theywill produce 5x the quantity of applause for a $5 prize comparedto a $1 prize. The functional form of the supply curve is shaped by the scarcity of factors, the technology ofproduction, substitutes, the size of the producing sector, other costs to bring the product to market, and thepresence of economies and diseconomies of scale. In the short-run, supply curves have unit elasticities, butlong-run supply curves are thought to be inelastic due to the finite supply of natural resources.

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3.3 KINKED CURVES3.3 KINKED CURVES

Ordinarily, supply and demand curves are thought to be continuous and differentiable. However, in marketsfor certain goods, these conditions may not hold. If a good or service is not divisible, then its supply anddemand curve should not be continuous. A good example is the supply and demand for grades. There two basicways to record grades are: numeric (100, 99, 97 . . .) and alphabetic (A, B-, C+ . . .). Numeric grades arecontinuous and can be represented with the basic supply and demand because both student effort/ability andthe grading scheme are continuous variables. However, this is not true for alphabetic grading schemes.

The chart to your left shows the supply and demand curves for analphabetic grading framework. The “quantity” supplied is the grade andthe “price” paid is the student’s effort and ability. The student’s demandfor grades is represented by the red diagonal; the blue stepped supplycurve shows the teacher’s supply of grades. The supply and demandcurves intersect at the “C” plateau, but just short of the threshold ofbecoming a “B.” Suppose a teacher seeks to elicit more effort fromstudents by using grades as an incentive system and resolves to evaluatestudent assignments 5% more rigorously. This is equivalent to a smallhorizontal shift of the supply curve to the left (makes high grades scarce).

According to this chart, even a small change in grading standards should evoke a greater effort from studentsdue to the vertical (inelastic) segment of the curve. However, a greater laxity -- 10% -- in grading rigor wouldhave no effect on student effort due to the horizontal (elastic) segment of the “C” plateau. In the conventionalsupply and demand framework, a 5% decrease or a 10% increase in the quantity supplied would yield aproportionate movement in price. This was not the case in alphabetic framework because grades were no longerdivisible (continuous) goods. Perhaps the starkest example of the alphabetic grading system is the “pass/fail”thresholds for high-stakes tests or the minimum attendance to graduate. In essence, this reduces the gradingsystem to two steps: “pass” and “fail.” This explains, in part, the common student question of what is theminimum level of acceptable work, instead of questions of how to improve their performance.

The other situation that encounters kinked supply curves are industriesthat have high fixed and low variable costs. The classic examples of thisis energy generation. The large fixed cost for an energy company is theconstruction of the plant or simply having online or offline. Once aplant is online, the variable costs of its operation are minor bycomparison. As a result, the supply of energy is basically elastic --whether one uses ten or ten hundred kilowatts, the unit charge is thesame -- because of the low variable costs of producing energy. The costscome with the necessity of putting another plant online and thereforethere are sharp price spikes at peak energy use times to discourageaggregate energy use that would break this threshold. This is also whyone could extract windfall profits by selectively taking plants “offline” during peak demand times as Enron didduring the California Electricity Crisis of 2000 and 2001. It is also why energy use at the margin by theconsumer has little effect on the level of energy production. Marginal tax rates and oligopolistic kinkeddemand curves are also examples of discontinuous supply and demand curves and will be described in moredetail in the chapters on taxation and imperfect competition respectively.

4.0 VARIANTS OF SUPPLY & DEMAND4.0 VARIANTS OF SUPPLY & DEMAND

In the following sections, five different models of supply and demand will be covered in detail. They can beremembered by the acronym ACCORD for Auctioneer, Cobweb, COrrider, Rocking horse, and Disco.

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5.0 AUCTIONEER5.0 AUCTIONEER

The inspiration for supply and demand is AdamSmith’s “invisible hand,” but Smith did notspecify the mechanism through which theinvisible hand generated prices. One of the first,and most successful, attempts was by Swisseconomist Leon Walras. Walras is best knownfor reworking the insights of the Classicaleconomists into mathematical format. Forsupply and demand, he suggested the process oftatonnement, the French word for “groping” or“trial-and-error.” Walras imagined an auctionwith a fixed set of goods to be sold. Theauctioneer would announce prices and thentake bids from all the buyers regarding thequantity they want at that price. If thequantities demanded exceed the stock of goods, the auctioneer announces a new higher price; if the quantitiesare less than the stock of goods, the auctioneer announces a second lower price. The process continues until allthe goods are distributed. The market clears. The auction can simultaneously engage both buyers and sellerswith each side announcing the amount they would and buy at given prices. The price that equalizes thequantities of good demanded and goods supplied is the market equilibrium price.

Mathematically, this process can be represented as the solutionto series of simultaneous equations. In Walras’ example, thesolution process was simply plugging in numbers (prices) untilthe equations were solved. However, the more efficient way is touse algebra to solve the unique solution to the system ofequations as shown in the box to the right. This framework isuseful because it allows the economist to identify the equationsfor component processes, such as the consumption andproduction function of demand and supply respectively.

5.1 THE MODEL APPLIED5.1 THE MODEL APPLIED

The diagram above can illustrate how this may work. Suppose that Charlie Brown is a “good” in dating marketand he wants to recoup the full worth for his quantity of prom date. To simplify, assume that there are onlythree qualities that prospective “buyers” care about: “outer” beauty (parameter A), “inner” beauty (parameter

B), and cash on hand (parameter C) and there is an objective number thatcan be assigned to each of these parameters. Each buyer offers a bid on thegood, represented in the diagram in the cloud bubbles. However, each bidis simply the result of each buyer’s “demand function” shown in the yellowbubble in the diagram. Each buyer puts a different weight, represented bythe equation coefficients and their demand functions can be solved byplugging in the good’s parameters (A, B, & C). Using matrix algebra, theWalrasian auctioneer can sum all the buyers demand functions into a singledemand function. A parallel process can be accomplished on the supplyside. The market equilibrium can be determined by setting the supply anddemand matrix equal to each other solving for quantity and price.

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5.2 PROBLEMS5.2 PROBLEMS

The auctioneer model illustrate the “Law of One Price” that holds that all identical goods must have the sameprice in a market. The auctioneer model produces a single, unique and deterministic equilibrium. However, itmakes several large assumptions to do so. First, it assumes there are no transaction costs; the auctioneer worksfor free. However, in the real world, transactions are not costless and in most exchanges there is a broker whogains compensation from identifying buyers and sellers and facilitating the transaction. Second, it assumesperfect information on the part of the auctioneer -- the auctioneer knows all the information necessary toconduct the calculation -- and the market participants -- buyers and sellers know perfectly their own utility,market prices and goods and services available for sale. These are fairly heroic assumptions given what isknown about economic agents and real world markets. In addition, the model is static. Once the market is inequilibrium, there is no reason for prices or quantities to change. However, in real markets we know that pricesare constantly fluctuating. The Auctioneer Model has little to offer to understand how supply and demandchange over time. However, the biggest problem with the auctioneer model is that it is just as consistent with“market socialism” as it is with a free-enterprise, competitive market economy. The calculations of theauctioneer could be the result of a central government planner or the product of market processes.

6.0 THE ROCKING-HORSE MODEL6.0 THE ROCKING-HORSE MODEL

The second model of supply and demand is the “rocking-horse” model developed by economists Ragnar Frischand Jan Tinbergen, the first recipients of the Nobel Prize in Economics. The Rocking-Horse Model addressesthe problem of dynamic change and fluctuating prices and economic activity. The model starts from theobservation that there are observable business cycles that show swings of increased and depressed economicactivity that cannot be explained by the Auctioneer Model. The movements of the key elements of both thesupply and demand curves do not conform to observable economic activity. In addition, there are manyinstances of seemingly random or irrational movements in markets, such as several hundred point swing upand down of the stock market on successive days. In short, the economic system does not appear to be one inequilibrium. In addition, there seems to be little connection between cause and effect -- in both sequence andmagnitude -- between exogenous forces in the real economy and supply and demand equilibria in markets.

The Rocking-Horse Model creates an analogy between the economy andthe movements of rocking horse or pendulum. The rocking horse, sittingon its skids, has an internal equilibrium if not disturbed. However, if itsequilibrium is disturbed by an outside force, it will rock back and forthbefore returning to its equilibrium. The key insight of Frisch andTinbergen was to separate the impulse (outside shock) from thepropagation mechanism (internal adjustment). They anticipate“disequilibrium” approaches to supply and demand that do not assumethat economic markets are in equilibrium and the process of returning toequilibrium is not simple or eventual. However, they do advance thenotion that the market is a cybernetic mechanism that serves as a shock absorber for various supply an demandshocks that buffet the economy. Although the market is never in equilibrium at rest it is in dynamicequilibrium because it oscillates around the equilibrium just as a pendulum swings around its pivot.

One way to visualize the model is to think of marble (price-quantity)sitting at the bottom of a bowl. If the bowl is undisturbed, the marblewill sit at the bottom in equilibrium. If disturbed, the marble will rockback and forth inside the bowl as shown by the double-sided arrow.However, the equilibrating forces of the bowl’s sides will eventuallyreturn the marble to the at-rest equilibrium at the bowl’s bottom.

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6.1 THE MODEL APPLIED6.1 THE MODEL APPLIED

Exogenous impulses can be either demandor supply shocks. Demand shocks includecredit collapses due to mass bankruptcy orbank closures, collapses in asset prices,government policy or seasonality. As thegraph to your right shows, there areidentifiable seasonal demand oscillations inemployment and sales in retail everyDecember. As a result, most publiceconomic data is seasonally adjusted to take into account the natural oscillations in the economy. Supplyshocks include changes in core technologies, changes in the structure of the economy (i.e., shift fromagriculture to manufacturing) and boycotts, embargoes, and shortages, such as the 1973 Oil Embargo.However, the propagation mechanism need not simply be an equilibrating and proportionate translation ofthe original impulse, but can have cancelling or reinforcing dynamics leading to distortion and disorientationof supply and demand signals in the market. An example of this would be a vehicle without shock absorbers.Reinforcing vibrations may not only make it difficult, but impossible, to control. This has implications for theability of policymakers to “fine-tune” economic activity. Perhaps the greatest example is the 1973 Oil Embargowhich delivered a supply-side shock to the economies of the developed world by raising energy prices thatlasted long after the embargo was lifted and affected more than just energy prices.

6.2 PROBLEMS6.2 PROBLEMS

One problem with the application of the Rocking-Horse Model is thateconomies, especially monetary economies, are not constructed like a singlependulum, with discrete impulses and single, passive equilibratingmechanisms. Instead, they may resemble a double pendulum becauseindividuals are actively, but incompletely, trying to stabilize the supply anddemand movements in the economy. The picture to the right shows themotion path of a double pendulum (a pendulum suspended from anotherpendulum). As can be seen, the adjustment path is chaotic and there is notendency toward equilibrium.

Another problem is that not all prices are equally flexible in practice, creating at least two sets of interactingmarkets governed by “flex-prices” and “fix-prices” respectively. The adjustment of supply and demand canoccur through a change in quantity or a change in price. Some economists, usually of a conservative (Classical)persuasion, assuming that supplies are finite and quantities fixed argue that adjustment should occur primarilythrough price changes. This is the world of flex-prices. Others, typically of a progressive (Keynesian)perspective, argue that prices are “sticky” or “fixed” and the adjustment will occur through quantitymovements. This is the world of fix-prices. Some markets, usually ones with decreasing marginal returns, are

characterized by flex prices. Examples include gasoline, fresh produce anddairy (milk / eggs), and financial markets where prices fluctuate on a day-to-day, even minute-to-minute, basis. Other markets, particularly labor markets(nominal wage rigidity) and markets for manufactured goods display inertia.Prices are not set in competitive markets, but as a mark-up on productioncosts. The chart to the left shows changes in wages during the recent (2008-)economic crisis. Despite high unemployment (quantity), there was littledownward movement in wages (price). This may be why movements in theminimum wage have little impact on the level of employment as predicted.

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7.0 THE DISCO MODEL & SEARCH EQUILIBRIUM7.0 THE DISCO MODEL & SEARCH EQUILIBRIUM

The third model of supply and demand are search equilibrium models developed initially by recent NobelLaureate Peter Diamond. In the previous two models, there is an implicit assumption that all buyers and sellersare present at the Walrasian auction or riding Frisch-Tinbergen’s rocking horse. As the aphorism goes, “half oflife is showing up,” but there is no guarantee that a market will exist even if there exists ready buyers and sellersbecause they do not “show up.” In this formulation of supply and demand, the process is principally one ofmatching. However, the process of matching is not costless. Firms expend significant resources marketing theirproducts and buyers spend time shopping to identify the best purchase. It is possible that individual buyersand sellers, discouraged by the cost of looking, give up the search or settle (“satisfice”) on a sub-optimal choicerather than expend more resources. While some goods and services are transacted in complete and liquidmarkets, most purchases are webs of ad hoc local contracts made for convenience, not optimality.

One can illustrate the process of search equilibrium bythinking of a disco or nightclub as a “dating market” thatworks through matching single individuals. Theattractiveness of a particular nightclub is the presence ofpotential dates. If there are more women, the club will bemore attractive to men and if there are more men, moreattractive to women. The scarcer gender will command ahigher price from the more plentiful one. One can comparethis to a “predator-prey” ecological model, where a largersupply of prey attracts a greater number of predators, buthaving killed off its food supply, the number of predatorsdeclines, giving rise to the population of prey. The problemthis model uncovers is that there is no need for everyone tostay in the market. For example, if the club patrons are 2/3male and 1/3 female, the female patrons may be happy, but half of the male patrons may find that their chancesof a successful search are low and decide to leave, changing the attractiveness of the club to the women as theydo, causing more women to leave. The same dynamic exists if the shares are reversed. If the shares are uneven,there is a pressure for the club to become 100% male or 100% female, extinguishing the dating market. Thissuggests at least three possible equilibria: a unstable, optimal equilibrium when the composition of the marketis 50-50 and two stable, sub-optimal equilibria where the composition is either 100% buyers or 100% sellers. In the later two cases, no market is formed, despite the desire to buy and sell.

The key is finding a way to keep market participants frombailing when their chances of a successful search decline.“Ladies’ Night” promotions are an example of thisdynamic. Clubs offer free drinks to women to raise the shareof their female clientele to attract more men, who are thengouged for overpriced drinks. Since the club owner makesmoney off volume, he is willing to subsidize the “datingmarket” at the club, keeping the shares of women and menproportional. Another example is the practice by casinos ofcomping “high-rollers” to encourage them to keep bettingeven when they face unlucky streaks. The existence of realestate brokers, job “headhunters” and college counselors --not to mention the entire marketing and advertisingindustries -- all suggest that there are lucrative

opportunities to be had simply by assisting the supposedly automatic processes of market.

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Another way to visualize this model is to return to the marbleand bowl example used in the previous section. However, thistime, the bowl is open face down, as shown by the diagramto the right, and the marble is perched on top. Theequilibrium that maximizes aggregate social welfare is themarble perched on top of the bowl, but it is unstable, becauseeven the slighted perturbation chances knocking it off itsspot and trapping it in a stable (difficult to escape) sub-optimal equilibria as the market becomes dominated byeither buyers or sellers. The previous models of supply anddemand assumed that the stable equilibrium (naturallyoccurring and sustainable was also the optimal (mostdesirable) one. The “disco” search equilibrium model showshow markets can stay depressed for extended periods of time.

7.1.1 THE MODEL APPLIED I: LABOR MARKETS7.1.1 THE MODEL APPLIED I: LABOR MARKETS

Many key economic markets are characterized by search and matching, perhaps none is as important as thelabor market. Employers -- especially in the service sectors -- do not buy labor by the hogshead based onprevailing wages, but seek to fill specific positions with specific workers. Similarly, workers are not looking forany job, but a job that promises them compensation and work requirements they desire. As a result, the labormarket is not simply matching an aggregate quantity with the aggregate price level. To effect this match, bothworkers and employers invest resources just to identify the ideal individual and job. Workers polish resumes,purchase interview clothing, research firms, and look through want ads. Employers also expend resources todetermine job requirements, advertise for applicants, interview candidates, and, for high-skilled workers, “sell”their firm to potential employees. These are significant expenses which are undertaken even if the idealcandidate or job manifests. As a result, both employers and workers use employment agencies and headhuntersto reduce the cost of a search. Willingness to bear these costs is related to the probability of a successful search.

What makes a successful search more probable? One factor isprevailing economic conditions. When the unemployment rate is low,employers must work harder to find suitable employees because mostworkers are already employed. When unemployment is high, theunemployed must work harder because more applicants compete for asmaller pool of jobs. The relationship between job vacancies (demandfor workers) and the unemployment rate (demand for jobs) is knownas the Beveridge Curve and is shown on the left. Vacancies andunemployment are inversely related and movements along the curveoccur as the economy booms and busts. Shifts inward or outward fromthe origin reflect the match (or mismatch) of skills to the jobs availableand suggest a growth or reduction of structural (supply-side)

unemployment instead cyclical (demand-side) unemployment. Matches between job vacancies and workers areeasier when they are more compatible (i.e., skills supplied = skills demanded).

However, the search may become so onerous that either or both employers and workers may give up the search.Workers can become “discouraged” from looking for work after prolonged stints of unemployment andemployers may train within for positions for which good applicant are scarce. While both employers andworkers benefit from a successful match, they would prefer that their counterpart bear the cost of the search.The ability to shift costs depends on the state of the labor market. Practices such as signing bonuses exist forscarce high-skilled workers as a means of defraying the cost for workers (and high employer-specific benefits

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to prevent valued employees from leaving). This sharedburden also arises in discussions about “who is to blame?”for current unemployment. From the employers’ side, theblame is put on applicants who either are not applying forthe jobs available or do not have the skills to meet the jobrequirements. If the unemployed only worked harder -- anddid not have “cushy” unemployment benefits --unemployment would disappear. The data tells a differentstory. The first chart to the right shows the job-filling rateand the intensity (effort) of recruiting by employers. Sincethe onset of the last recession, it is clear that the job-fillingrate rose before falling again, while the intensity ofrecruiting has fallen and stayed low. This data is consistentwith the theory that employers are taking advantage of poorlabor market conditions and economizing on recruiting.However, even with low levels of recruiting by firms, therecould still be a structural employment problem of a skill-jobsmismatch in the labor market. This argument often goeshand-in-hand with arguments that schools do not providestudents with the requisite skills for 21st century workforceor that they do not graduate “career and college ready.” This,too, is a nice story, but is not supported by the availableevidence. As the graph to the right shows, the level ofmismatch rose temporarily during the height of the recession(2009), but has returned to previous levels whileunemployment has continued to stay at elevated levels. Asone scholar noted, the problem is that employers are lookingfor “purple squirrels” and are having problems because they create unreasonable and utopian job requirementsthat cannot possibly be filled.

The second dimension to search equilibrium in labor marketis the size of the “labor wedge.” The wedge is the ratiobetween the marginal rate of substitution of work for leisureand the marginal product of labor. In other words, the ratiobetween the “use-value” workers put on their time and the“exchange-value” that their labor commands in the labormarket. The labor wedge acts as a tax on work, discouragingworkers from seeking employment because they cannot findadequate compensation for their time (paid less than theirvalue). The lower the labor wedge, the higher the penalty forworking. As the chart to the left shows, the labor wedge hasfalls in times of recession (because firms have less use ofworkers without demand for their products) and has

dropped precipitously in the last recession. A lower labor wedge implies a higher cost of searching for work. Ifthe costs of searching for work exceed the compensation of the job that search produces, a worker mayrationally decide to stop searching even at high penalties to income.

7.1.2 THE MODEL APPLIED II: COLLEGE SEARCH7.1.2 THE MODEL APPLIED II: COLLEGE SEARCH

Another application of search equilibrium theories is the college search. A college education is not a good that

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can simply be bought on the market; there is an admissions process thatseeks to determine whether the student is a “good fit” for the collegeand whether the college is a “good fit” for the student. In short, it is amatching process. If colleges were a simple supply and demandproposition, the best colleges would experience higher demand andthey could raise tuition (price) until they had the desired class size(quantity). Worse colleges would lower tuitions to fill their seats andinstitutions that had to lower prices below costs would close. Clearly,this is not the world we live in. Both colleges and students (and parents and teachers) invest a large amount ofresources to make the right match. The chart above shows the cost of the college search for one NJ parent forone child. None of these costs guarantees acceptance or even that one will make the correct math.

Colleges also invest in finding applicants, and, if you are a high school senior, you have probably been delugedby a flood of glossy brochures from colleges you never knew existed during the past year. In addition, travellingcollege representatives, college admissions offices (which are as much marketing as evaluation agencies),alumni relations departments, interscholastic sports programs and merchandising, etc. are all expenditures toattract applicants and have little to do with the quality or quantity of the core goods and services transacted.Also not negligible is the cost expended by K-12 institutions by keeping student records, writingrecommendation letters, offering “advanced placement” course options, and assisting students to choose the“right” college. Given the substantial cost of the college search and application process, it is little wonder thatmany students (and some colleges) forego the entire search process and simply attend local universities andcommunity colleges. As a result, it is likely that most students do not attend the best matching college for theirabilities, preferences, and resources, in many cases because they never know or never apply.

7.1.3 THE MODEL APPLIED III: HEALTH INSURANCE7.1.3 THE MODEL APPLIED III: HEALTH INSURANCE

In modern societies, most do not purchase healthcare directly,they buy insurance to defray the costs of healthcare. Purchasinginsurance is the classic case of a “market for lemons,” or itsmore technical name, adverse selection. If you are a high-medical risk, the cost of insuring you would be above thepolicy’s cost, while if you are low-medical risk, the cost ofinsuring you would be below the policy’s cost. Knowing this,why would any insurance company sell a policy to a high-medical risk and why would any low-medical risk personpurchase insurance?

In the market for insurance, there are two competing searches:one by insurance companies looking for healthy individuals to

insure and a second by sick people looking for companies that will insure them. It is highly unlikely that thismarket will form because both buyers and sellers must deceive their counterparty about the real cost of theirpurchase. Insurance policies in the US were first offered through employers because, in part, workers -- asdemonstrated by their ability to work -- were probably a healthier segment of the population than thepopulation as a whole. In parallel, the largest pool of uninsured are young adults who generally have thelowest-medical risk profile in the population. If the insurer only offers the average policy, the low-medical riskswould refuse to purchase and only high-medical risks would purchase the policy. This would lead the insurerto raise the premium, making it moderate-medical risks refuse to purchase. Eventually, only the highest-medical risks would purchase a policy and the insurer would go bankrupt, extinguishing the insurance market.The only optimal equilibrium is one where everyone purchases insurance and everyone is insured, but thisequilibrium is unstable, because if insurers begin to discriminate or individuals refuse to pay, the insurance

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market becomes unsustainable. It either becomes a market will all buyers, no sellers or all sellers, no buyers.

A similar dynamic may be at play in the choice of two coursesof treatment. Imagine two courses of treatment: one relying ondrugs and the other focusing on physical therapy. The physicaltherapy is more effective, but is less likely to done correctly. Thedrug therapy is less effective, but is easily understood. If aphysician cannot know whether the patient can carry out themore complicated therapy, he may prescribe the treatment forthe average patient. Eventually, the simpler, but less effective,therapy becomes dominant and the more effective isabandoned. Likewise, if there are two therapies, one effectiveone that requires a highly-skilled (but scarce) professional anda second, less effective alternative that can be accomplished byminimally competent (but plentiful) professional, the standardof care may gravitate toward the simpler procedure. There is some evidence that this is how caesarean sectionsreplaced forceps delivery.

7.1.4 THE MODEL APPLIED IV: PREDATOR-PREY MODEL7.1.4 THE MODEL APPLIED IV: PREDATOR-PREY MODEL

A relative to the search equilibrium theories in economics is thepredator-prey (P-P) model in ecology. The P-P model is used tomodel the interaction of two species in an ecosystem where the sizeof one population depends on the size of its counterpart. Predatorspecies depend on prey species for food, so their size is limited by thesize of the prey species population. However, the size of the preyspecies population depends on the size of the predator population.As the predator population grows, they feed on more prey species,reducing their number. This makes the predator species sizeunsustainable, decreasing its size and giving new rise to the preyspecies. If the size of the predator and prey are plotted on x and yaxes respectively, it draws a circular path over time as shown by the

graph above. Plotted over time, the predator-prey model produces harmonic oscillations, similar to boom-bustcycles of the business cycle as shown by the graph below.

The P-P model has three basic states: steady-state equilibrium (unstable, butsustainable) where the populations are in balance and two stable, butunsustainable equilibria, that consists of all predator or all prey species. If theequilibrium is not found, the ecosystem collapses, just as a market would notform. Predator-prey models have been used to model the growth of gangterritory and the spatial distribution of gang violence and have been used ineconomics to model the activity of business competitors in the same sectorcompeting over market share. However, the core intuition the searchequilibrium family of models and applications emphasize the key role playedby coordination and cooperation, rather than competition, distinguishes itfrom other models of supply and demand.

7.2 PROBLEMS7.2 PROBLEMS

The main problem with search equilibrium models is that they imply that reaching equilibrium is difficult if

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not impossible. However, most of the time, economic agents seem to manage to overcome these dilemmas. Inaddition, not all markets are about matching. Many transparent and liquid markets do exist and the insightsof search theories are not particularly helpful. In addition, they are more helpful at identifying ways thatmarket equilibrium break down than providing guidance for how to restore equilibrium.

8.0 THE CORRIDOR MODEL8.0 THE CORRIDOR MODEL

Corridor models, associated with the work of RobertClower and Axel Leijonhufvud, are a hybrid of theRocking-Horse and Disco Models presented in theprevious sections. The key innovation of this approach isto identify in what circumstances supply and demandbehave in the self-equilibrating and stabilizing manner ofthe Rocking-Horse and Auctioneer Models and when ithas the destabilizing and disequilibrating propertiessuggested by the Disco Model. In the previous models,there is an implicit assumption that all transactions occurat the market equilibrium price and quantity. Althoughthe Auctioneer model “finds” the market price through aprocess of trial-and-error, no goods are exchanged until the market-clearing price is found. While the DiscoModel suggests that prices and quantities can diverge from an optimal equilibrium, it argues that marketsquickly evaporate if they cannot maintain that position.

The common assumption is that the supply and demand curves move simultaneously and instantaneously, likethe two blades of a scissors, from one position to another. In contrast, the Corridor Model views the process ofsupply and demand as sequences of moves and the sequence order matters. In most supply and demand models,it is implicit that prices change first and quantities second. This ensures that all quantities in the market arecleared and each agent has the maximum purchasing power possible. However, if quantities adjust first, sellersmay not have “cash-in-advance” to buy the goods supplied to others, who now have less purchasing power tobuy the goods of still others, and so forth. This is a destabilizing and disequilibrating spiral akin to the DiscoModel. Deprived of the ability to earn money to finance purchases, the market falls apart. The Corridor Modelspecifies a zone -- the “Corridor” -- where the normal laws of supply and demand appear to be in force, butoutside the corridor, price and quantity signals produce disequilibrating dynamics -- vicious cycles -- thatimpair the ability of buyers and sellers to coordinate their decisions. The “Corridor” is defined by the abilityto liquidate one’s goods and services (or use them as collateral for credit), an ability that is undermined whenprices are rising or falling too fast for individuals to coordinate their actions. In short, the real damage ofinflation and deflation is not the appreciation or depreciation in the value of money as a commodity, but itsirrelevancy as a numeraire, a unit of account.

The diagram above sketches out the basic shape of the Corridor theory. In the zone of the corridor -- roughlyinflation levels between 2% - 10% or unemployment levels between 5% - 10% -- the surface is concave or bowl-shaped. Like the Rocking-Horse model, prices, left to their own devices, will tend toward the bottom of thebowl and find a stable equilibrium. Outside the corridor, however, the model takes on the form of the DiscoModel, with steep drops into sub-optimal equilibria of inflationary and deflationary traps. A key feature arethe “speed bumps” or “guard rails” that border the Corridor. These speed bumps are policies that keep self-reinforcing processes from reaching their full power such as central bank’s monetary policies, “automaticstabilizers” such as unemployment insurance, food stamps and Medicaid (which restore purchasing power tothose who cannot sell their goods and services), deposit insurance, agricultural price supports, and bankruptcyand courts of equity. It is necessarily difficult to enter an inflationary or deflationary spiral as a result, and onlya substantial supply or demand “shock” should be able to knock the market out of the Corridor.

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8.1 PRICES & PHYSICS8.1 PRICES & PHYSICS

Economics grew out of the application of physical and naturallaws to social phenomena using math as the grammar andvocabulary of this enterprise. Not surprisingly, many of theconcepts (equilibrium, inertia) of Newton’s Laws of Motion,calculus (marginal analysis), and gravity are distributedthroughout economic analysis. Economic incentives work likegravitational forces upon behavior and Say’s Law seems like aneconomic version of the conservation of energy and matter. Thevisual analogies used here to illustrate different models -- marblesmoving along bowl-shaped surfaces -- can be compared toEinstein’s concept of gravity in the time-space continuum,

pictured to the right. Mass creates depressions in surface that warp the time-spacesurface. Just as these depressions create the gravitational paths that draw or repelobjects, incentives create their own push and pull effects. In the visual analogies, themarble is the price-quantity equilibrium and as it travels over the warped surfacescreated by “incentive-depressions” it moves from one area to another. The corridormodel emphasizes the warp and woof of the surface to identify when incentives willbe equilibrating (stabilizing) or disequilibrating (destabilizing). In stabilizing areas(depressions), market incentives have a centripetal force, but outside, they can havecentrifugal forces that are destabilizing.

8.2 THE MODEL APPLIED8.2 THE MODEL APPLIED

As a hybrid of the Rocking-Horse and Disco Models, the applicationsof the Corridor Model can be seen as a general model that decomposesinto its component models depending on the economic context. Insidethe Corridor, it is the Rocking-Horse model; outside the Corridor, it isthe Disco Model. The key difference is the presence or absence ofinflation or deflation. Since inflation and deflation will be discussed ingreater detail elsewhere, only a quick presentation of real examples ofinflation and deflation will be presented here to illustrate how supplyand demand can break down. The graph to your right shows theexchange rates (relative to $US) for the former Yugoslavia, Zimbabwe,Argentina and Brazil since the early 1980s The foreign exchange ratetracks the domestic level in inflation in these countries (inflation = slope of the rise in exchange rates). As canbe seen, these countries experienced inflation rate in the thousands, even millions, percent in a short period oftime. Anyone who knows the economic history of these countries understand how destabilizing inflation levels

of this magnitude can be. The period of the greatest rise -- the 1980s -- isknown in Latin America as the “Lost Decade.” Markets -- supply anddemand -- break down because prices become unreliable. On the otherend of the spectrum is the approaching two “lost decades” of Japan sincethe bursting of its stock market and real estate bubbles in the early 1990s.The chart to your left shows the trend of disinflation for Japan (blue)during the 1990s and the US in the 2000s (red). The correlation of thetrends does not bode well for the next decade of the American economy.Japan was able to cushion internal deflation by running trade surpluses,the United States does not have this advantage. Many experts see Japan’s1990s as a portent of what lies ahead for the US.

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9.0 THE COBWEB MODEL9.0 THE COBWEB MODEL

Like the Corridor Model, the Cobweb Model is principally concerned withpotential disequilibrating forces related to supply and demand. However,while the Corridor Model holds that within the Corridor, supply and demandfunction normally and is only affected by substantial direction changes inprice (up = inflation; down = deflation), the Cobweb Model notes problemswithin the supply and demand framework itself and is more concerned withprice volatility than price levels or the rate of price changes. The Cobwebkernelizes the insight of the Corridor Model that quantity adjustments mayoccur before price adjustments, by examining the relative elasticities (slopes)of the supply and demand curves. It is known as the “cobweb” model becauseof the spiral paths of price-quantity adjustments around the supply anddemand curves resemble the shape of a spider web and its primary applicationare markets where the costs and benefits are temporally segregated. In otherwords, when the costs are incurred upfront, but the benefits materialize in thefuture. In between, the material conditions undergirding the production ofsupply may change, causing the market equilibrium to reset.

One example is agriculture where farmer must undertake the costs productionbefore they know the demand for their product. Another is shortages of high-skilled workers, such as nurses (2000s), engineers (1970s) or IT workers(1990s). A shortage may cause a rise in compensation to attract individuals tothese occupations, but there is a lag because one cannot train a nurse or

engineer immediately. During the lag, the shortage may be remedied, leadingto lower compensation when newly trained professionals are ready to enterthe market. Finally, stock markets and venture capital (especially intechnology and pharmaceuticals) are also structured with high upfront costsand uncertain and delayed revenues. As a result, many individuals in thesesituations seek to stabilize prices either through futures contracts (inagriculture and equity markets) or by contracts that reward investments ineducation (independent of ability), signing bonuses, salaried compensationor tenure contracts.

In general, the cost-benefit time problem is not an issue because deviation-dampening adjustments would make current price-quantities a time-path torisk-adjusted future price-quantity equilibria in competitive markets. As newinformation about the probable future becomes available, the informationwould become “baked in” the current market price. However, if the slope ofsupply is less (more elastic) than the slope of demand (more inelastic), thenquantity changes in supply will induce a disproportionate larger movement inprice, resulting in deviation amplifying adjustments in price as shown by thegraphs to the left. The graphs to the right show the conventional convergenceon the market equilibrium price for the same supply changes with a differentstructure of supply and demand. The deviation-dampening pattern is thesame as found in the Rocking-Horse Model. The deviation-amplifying

pattern has the same oscillation axis, but the deviations (volatility) grow over time, making it increasinglydifficult to base decision based on price movements. This different than high or low prices, but the acceleratingpace of price changes, both high and low around the presumed market equilibrium.

9.1 ELASTICITY9.1 ELASTICITY

Elasticity is the sensitivity of prices changes to changes in quantity. It is similar, but not thesame, as the slope of the supply and demand curves. While slope is the simple ratio of “rise overrun,” elasticity is the percent change in the in the change quantity over changes in price. Whileelasticity has many applications in economics, three levels of elasticity concern us for themoment: perfect elasticity, unit elasticity, and inelasticity. An inelastic supply or demand curveis a vertical curve perpendicular to the x-axis (quantity). It can be remembered because itposition forms an “I” on the supply and demand graph as shown below. A perfectly elastic curve is a horizontal

curve perpendicular to the y-axis (price). One can remember it by the “E” shapeit makes on the graph of supply and demand. A unit elastic curve is one thatforms a 45-degree angle, indicating there is a “one-to-one” relationship betweenquantity and price changes. When a curve is inelastic it mean the quantitydemanded or supplied does not vary with price. When a curve is perfectly elastic,it mean the price will not change no matter what quantity is supplied ordemanded. These situations are important “special cases” in economics because

when supply or demand has elastic or inelastic properties the commonsense operation of supply and demanddo not apply.

9.2.1 INELASTIC SUPPLY & DEMAND 9.2.1 INELASTIC SUPPLY & DEMAND

In the long-run, supply is thought to be inelastic because there is a finite supply of resources. At some point,the supply curve is vertical. A vertical (inelastic) supply curve suggests a technological or resource constraint.Supply curves should become more and more inelastic as resources become exhausted over time. Technologicalconstraints also create vertical supply curves: the supply of time machines, no matter how great the demand, isfirmly fixed at quantity = 0. However, technological change can shift an inelastic supply curve outward byusing resources more efficiently, recycling resources, or finding new uses for unused resources.

Inelastic demand reflects “addictive” behavior. Consumersdemand a certain quantity regardless of price. One may think ofa “junkie” given their first drug free that creates an addiction.Once addicted, they will pay any price -- and not just monetarycosts -- to service their addiction. The dealer can raise the priceconfident that the junkie will continue to demand the same fix.This behavior can be found in smaller addictions as well:gambling, fandom of sports teams, or alcoholism. Another typeof inelastic demand can be found in monogamous humanrelationships. We want a partner; two is not better than one; zerois unacceptable. The practices of “playing hard to get” is a way ofraising value by restricting supply knowing that invariantdemand will not change. However, the economically most seriousexample of inelastic demand may be the market for healthcare. We are all, understandably, “addicted” to ourown lives: we need one; we cannot have two, we will probably spend anything to prevent ourselves (and thosewe care for) from having zero. The most direct “market” for this is healthcare, which allows us to have a longerand higher quality life. However, at any given time, the quantity of “sickness” -- the demand for healthcareservices -- is fixed.* People do not demand a second heart transplant or an extra tetanus shot because a clinicoffers a “two for one” special. The main factor driving healthcare costs is supply. One way to raise prices is torestrict supply of medical professionals -- a main reason why medical and nursing schools are hard, another isto rise of drug patents (and restricting generics). The second way is to shift demand outward by creating “new”

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Inelastic Curve Elastic Curve

*Dentistry and elective/cosmetic surgery may be an exception to this generalization, which is probably the reason that these procedures are not covered by general insurance. In addition, diet and fitness may not have inelastic demand curves.

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diagnoses that find new diseases and illnesses that require treatment -- treatment provided by medicalprofessionals. Some have argued that Americans have become “overmedicated” as mood and behavior disordershave become medicalized. Medical writer and physician Atul Gawande observed that two Texas towns with thesame level of health and sickness, but different levels of medical spending.

9.2.2 ELASTIC SUPPLY & DEMAND9.2.2 ELASTIC SUPPLY & DEMAND

The price of “free” is probably the best example of perfectly elastic demand. This can be seen in the case ofHalloween candy (has anyone met a child who thought they had enough candy?), “all you can eat” specials,water at restaurants, or subsidized healthcare. In addition, when “utilities are included” in the price of rent,individuals have virtually no limit to their use of electricity, hot water, or heat. However, if the price was raisedeven slightly (charging children 1¢ for each piece of Halloween candy or restaurant patrons for beveragerefills), the demand might disappear. Perfectly substitutable goods, like paper clips or No.2 pencils, also haveperfectly elastic demand. Consumers are willing to pay a certain price, but, in general, will completely abandona product that has a slightly higher price. This is the logic of “dollar stores” (or, in an earlier age, Five andDimes): people will buy more if they know the price is fixed.

Goods and services that have uniform cost and characteristics --commodities -- and manufactured goods that have high fixed andlow variable costs tend to have elastic supplies. As noted above,electricity tends to have elastic supply since flow of the power gridmust be maintained regardless of incremental use. Grades, becausethey have no natural scarcity, can have elastic supplies (teachers cangive an infinite number of “A” at a fixed price [grade]), and menuitems have an effective elastic supply. However, the economicallymost critical example of perfectly elastic supply is money. In aliquidity trap, discussed in the chapter on money, there is effectivelyan endless supply of fiat money. The elasticity of the overall price level is a major difference between Classicaland Keynesian economists. Classical economists, with their emphasis on scarcity, tend to see the elasticity ofsupply in the long-run as vertical (inelastic), while economists of Keynesian bent tend to see the elasticity ofsupply as more nearly horizontal. In an essay, “The Economic Possibilities of our Grandchildren,” Keynesconcluded that we too often sacrifice important values because of a supposed, but imaginary, “economicproblem,”: “do not let us overestimate the importance of the economic problem, or sacrifice to its supposednecessities other matters of greater and more permanent significance.” As a result, they see money supply aseffectively elastic.

9.3 GIFFEN GOODS & CONSPICUOUS CONSUMPTION9.3 GIFFEN GOODS & CONSPICUOUS CONSUMPTION

Ordinarily, when the price of an item rises, the demand for that item decreases. However, certain goods seemto defy this logic. Two types of these good are Giffen goods and Veblen goods, named after the economists whofirst identified the respective phenomena. In both cases,they have price elasticities of demand that are positive(they slop upward). This may because they are“backward bending” demand curves (they have both apositive and negative elasticity), but the upward-slopingdemand curve presents a strange phenomenon: thehigher the price, the greater the quantity demanded!Giffen goods are inferior goods that are usually discardedwhen incomes rise: they are only bought because they are

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all that can be afforded, like bad microwave dinners. If they rose inprice, the expectation would be that consumers would demand less.However, contrary to conventional economic wisdom, they demandmore. Veblen goods are (mainly useless) luxury items that increase invalue (the quantity demanded) when their prices rise. They have “snobvalue” as the economist Thorstein Veblen documented in his famousstudy, The Theory of the Leisure Class. Perhaps the best illustrated is thePeanuts characters Lucy and Charlie Brown. Lucy dares Charlie Brownto kick a football, only to pull the football away at the last moment.The more Lucy does this (raises the price), the more Charlie Brownwants to kick it. This type of behavior can only be seen as masochistic.

In the case of Giffen Goods, the question is why would consumers prefer an clearly inferior good at a higherprice? The original example was the consumption of bread by Irish peasants. The price of bread was rising,consuming more of their budgets and curtailing their consumption of higher calorie and protein food items.Not only did they not reduce their share of bread, they increased their consumption. Examples of individualsin relationships who seem to be more enthralled with their counterpart the worse they are treated (especiallywhen they have alternatives) would also qualify as Giffen good behavior. There are individuals who insist onusing earlier software versions -- and are willing to pay more to do so -- than use upgrades -- even at reducedprices.

Perhaps less rare of Veblen goods. The purpose of purchasing Veblen goods is a) their “snob value” or b)conspicuous consumption. The consumption of certain goods and services confers status. For example, goingto see the opera because you think it will make you seem sophisticated, even though you dislike opera, payingmore for brand-name merchandise even though there is no quality difference, or paying more for a “name”private school because others will think you are smart are all examples of Veblen goods. Another exampleoccurs is the choice of physician. Many people want the “best” physician -- and pay a premium for it -- eventhough the quality of service is probably as good with the “2nd best” physician. The payment of exorbitantsums for sports memorabilia or original art are also examples of status goods that confer snob value. In short,the broad spectrum of phenomena that may be considered “materialistic” fall under the rubric of Veblen goods.Karl Marx’s notion of “commodity fetishism” from the concepts of “use values” and “exchange values” providesanother explanation. Instead of determining price from one’s “use value” of a good or service, one would usethe price to infer its value. In short, in a money economy, consumers would assume that something that ishigher priced must ipso facto be of better quality. However, Veblen attributed the dynamic to conspicuousconsumption. We do not buy these items for our own consumption, but for others. We consume them to beseen by others consuming them. Wedding gifts, perfume, or “flowers and chocolates” are mainly bought fortheir value to others. For example, one would be likely offended, not pleased, if one received a gift of flowersonly to be told that they were purchased at a 50% discount.

10.0 AREAS 10.0 AREAS

The supply and demand chart is not only useful for determining theprice-quantity market equilibrium, but can be used to determine thewelfare effects of different supply and demand schedules. The mostbasic of these is the producer and consumer surpluses. As the chart tothe left shows, the consumer and producer surpluses can be derivedfrom bisecting the eastern quadrant formed by the supply anddemand curves at the level of the equilibrium price. The consumersurplus is the utility of the good purchased minus the price paid forthe good. The producer surplus is the price of the good sold minus

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the cost of producing the good. A more commonname for the producer surplus is profit. Anotherway to conceptualize this is to split the supply anddemand chart vertically so that only the left side ofthe chart remains. The total expenditure in themarket is equivalent to the price x quantity and thetotal revenue in the market is also the price xquantity. These price-quantity squares can be foundin the upper left and lower left quadrants of thesupply and demand chart. They are split by thedemand and supply curves respectively. Althoughnot monetized, the consumer surplus reflects thewelfare gain to the consumer for purchasing a good or service at a price below its value to the consumer. Inother words, the consumer would have paid more, but fortunately did not. In a competitive market, both theconsumer and producer surplus should be competed away as producers try to sell their products at the highestprice possible and consumers try to purchase goods at the lowest cost possible. In short, this means that in acompetitive market economy, there should be no long-term profits.

The areas can also be used to estimate the amount of welfareloss that occurs from taxes and tariffs. Taxes and tariffs addto the market price of goods and services. As a result,transactions that would occur without the tax do not occur.This raises prices and reduces quantities transacted. The boxformed between the consumer and producer surpluses isequivalent to the revenue gained by governments in taxes,however, the “Harberger Triangle” or deadweight lossremains as the triangle formed to the right of the tax revenuerectangle.