Microeconomics Textbook PDF - Free Introductory Textbook

Microeconomics A free introductory textbook with linked videos Richard Friberg Beta Version: February 2024  1 Beta version This is the pre-launch version of a micro...

Microeconomics A free introductory textbook with linked videos Richard Friberg Beta Version: February 2024  1 Beta version This is the pre-launch version of a microeconomics textbook. The book is ready for classroom use, but the occasional typo may still be there. Comments are invited at [email protected]. The book is available for free download at https://sites.google.com/view/freemicro/ startsida where also exercises and powerpoint slides are available. Version: 0.2 © Richard Friberg.1 Users may copy and distribute the material in unadapted form only, and only so long as attribution is given to the copyright holder. No derivatives or adaptations of the work are permitted without permission of the copyright holder. 1 Stockholm School of Economics, P.O. Box 6501, 113 83 Stockholm, Sweden. Email:[email protected]. Also affiliated with Norwegian School of Economics and CEPR.  2 What is this book? This is a textbook suited for a first or second course in microeconomics at the university level. I have been teaching such a course at the Stockholm School of Economics for about 20 years and the book is an outgrowth of the notes and examples that I have found work well during these years. There are a large number of books that target the same audience and let me highlight a few distinguishing features: ˆ Many of us find it easier to understand a graph if it is drawn live, as we are following with some commentary, rather than just presented as a ready-made figure. For this reason I have posted short videos of many of the key figures on Youtube, and they are linked from within the book. ˆ I’ve surveyed many, and taught from several, microeconomics textbooks. The basic material of perfectly competitive markets (Chapters 2-8) is covered in very similar ways and I’m mostly happy with these treatments. When it comes to the issues where markets run into problems however, what we cover from Chapter 9 and onwards, I find that many textbooks get into a rather bewildering array of cases with surprisingly little thought on how best to convey the central ideas and link them to practice and empirical evidence. I hope that my ambition to do better here has been successful. ˆ I’ve included some topics that are becoming increasingly important but are tra- ditionally left out in microeconomic textbooks: in particular Chapter 9 includes models of competitive selection when firms have different marginal costs and Chap- ter 15 examines topics of importance for digital markets: platforms and auctions. ˆ It is free. ˆ It tries to be succinct. A pedagogical adage is that “What is worth learning is worth learning well.” Therefore, rather than present a very large number of different cases and applications, we focus on the key concepts in each topic. If you understand these well, you are well set to apply the concepts to other issues. ˆ Many of the key insights in microeconomics compares the costs and benefits of changing a variable - be it consumption, production or a tax. Many textbooks shy away from using mathematics and try to describe effects verbally, and via rules of  3 thumb. In my experience most of us find it easier to instead understand these con- cepts using calculus, taking derivatives of functions. This is how we think of these concepts as professional economists and it reflects how the tools were developed. We therefore rely on calculus in the book. We use the same limited set of tools over and over again in different situations, whilst explaining clearly what is going on. I have found this to work well. Some notes for faculty thinking of assigning the book. You might worry that if a book is free it is of low quality - particularly so if you’re a professor and consider assigning the book as reading for your course. A few words of background may therefore be useful. The Stockholm School of Economics is a highly selective institution and is arguably been the most prestigious university education for students going into business and public administration in Sweden. Cohorts of 300 entering students have made their first university acquaintance with economics with the course in microeconomics from which this book has developed. This background is reflected in the book. We assume no prior knowledge of economics but move faster and deeper than what is common in an introductory text. I have been selected teacher of the year by the students twice so I must have been doing something right. As to my background, I first taught microeconomics at university as a TA using Hal Varian’s marvelously clear books in both undergraduate and PhD-level courses in the early 1990s. During my PhD studies I spent one year as a visiting Fulbright student at MIT with an all star cast of teachers including Holmström, Dornbusch and Solow. In particular the latter made a great impression on me – in his hands a single equation could say so much and his pedagogical style has been my role model ever since. Not surprisingly my research is focused on topics in microeconomics, in particular empirical industrial organization. My interests are broad however and I’ve published in both general interest journals such as American Economic Review and top journals in closely related fields such as Journal of Finance and Marketing Science. Widely dispersed reserch interests might not be the best strategy for maximizing professional impact but for a textbook author it may have its benefits, seeing questions from different angles. The book relies more on mathematical arguments and calculus than what is common for introductory, and to some extent, intermediate textbooks in microeconomics. A concept can be understood by students at different levels – ranging from an intuitive “that sounds reasonable” when someone else explains it to students having the ability  4 to confidently work with problems. In his advice for how to build a model (and write a textbook) Hal Varian highlights a tip given to him (Varian, 2016, p. 89): “Get together the problems that you want your students to be able to solve after they’ve read your book – and then write the book that will teach them how to solve them.” This book is written very much in that spirit. While problems are the key part of the learning process (my students have graded hand-in problem sets every week) including the problems in the book itself makes it a bit unwieldy. A set of problems are therefore available at the book’s homepage2. In a perhaps useful analogy the problems ensure that we are not just talking about riding a bike, students are learning to actually ride the bike. The book contains frequent references to empirical work and surveys. These may be valuable to students that are particularly interested in a certain topic but are also meant to help faculty that want to refresh their background in an area to be able to provide more color and context in lectures. Slides for the book are available for download at the same homepage as exercises and the full book. Clearly, since the book is free it may also be useful if you only want to use it as a basis for one or a few lectures on a particular topic. Acknowledgements Unless stated the illustrative figures and paintings have been created using Dall-E’s AI based tools. I’m grateful for valuable comments from Tommy Andersson, Emil Bustos, Anna Dreber Almenberg, Tore Ellingsen, Mark Sanctuary, Björn Tyrefors and Robert Östling. I’m also grateful to Björn Ericsson and Ute Harris for helping me navigate the world of open access textbooks. [your name can be here:)] 2 https://sites.google.com/view/freemicro/startsida Contents 1 INTRODUCTION 11 1.1 An example to get our minds primed about the role of economics.... 11 1.2 Economics – The Wealth of Nations..................... 13 1.3 Scarcity – An underlying assumption.................... 14 1.4 On the use of models in microeconomics.................. 15 1.5 What we do in the book - and what we don’t do.............. 18 2 SUPPLY AND DEMAND 19 2.1 Supply and demand – An Introduction................... 19 2.2 Demand.................................... 22 2.2.1 Effect on demand of changes in..................... 23 2.2.2 Demand functions – Some additional aspects............ 29 2.3 Supply..................................... 31 2.3.1 Effect of Changes on the Supply Curve............... 32 2.4 Combining supply and demand to find the market equilibrium...... 33 2.4.1 Both demand and supply matter for the equilibrium price and quan- tity................................... 38 2.5 Shifts in the equilibrium........................... 38 2.5.1 The slope of supply and demand curves and the effects of shocks. 45 I WHERE DOES SUPPLY COME FROM? 47 3 FROM TECHNOLOGY TO COSTS 49 3.1 Setting the stage............................... 49 3.2 Defining some key concepts......................... 50 3.3 The production function........................... 51 5 CONTENTS 6 3.3.1 Varying one input while keeping other inputs fixed........ 53 3.3.2 Different ways of producing the same volume of output: Describing the technology............................. 56 3.3.3 Production function and isoquants: A numerical example..... 63 3.4 Productivity.................................. 64 3.5 From technology to costs........................... 69 3.5.1 Cost minimization and isocosts, some additional results...... 73 3.6 From cost minimization to a cost function................. 76 3.6.1 Average costs and marginal costs.................. 77 3.7 Additional aspects of cost functions..................... 80 3.7.1 Costs in the long and short run................... 80 3.7.2 Economies of scale.......................... 82 4 SUPPLY BY PRICE TAKING FIRMS 85 4.1 Maximizing profit – an introduction..................... 85 4.2 The supply of a price taking firm: How much should be produced?.... 89 4.3 The supply of a price taking firm: Should the good be produced at all?. 95 4.4 Profits: Positive, negative or zero?...................... 97 4.5 From firm supply to the market supply................... 100 4.6 Free entry and profits............................. 102 4.7 What do we mean by zero profit?...................... 106 4.7.1 Opportunity cost........................... 106 4.8 Supply in the long run............................ 108 II WHERE DOES DEMAND COME FROM? 110 5 CONSUMER CHOICE 112 5.1 How can we model choice?.......................... 112 5.2 Preferences.................................. 113 5.2.1 Utility................................. 118 5.3 Budget constraints.............................. 121 5.4 Maximization of utility subject to constraints............... 122 5.4.1 Example of optimal choices under different prices......... 124 5.5 Discussion of assumptions and framework.................. 126 5.5.1 Where are the limits of the framework outlined above?...... 126 CONTENTS 7 5.6 Behavioral Economics............................ 129 5.6.1 Social preferences........................... 130 5.6.2 Behavioral biases........................... 131 5.6.3 Lack of self-control.......................... 132 5.6.4 Cognitive limitations and biased information processing...... 134 5.6.5 Final words.............................. 136 5.7 Appendix – Solving for the optimal consumption basket.......... 137 6 DEMAND CURVES AND ELASTICITIES 140 6.1 From constrained optimization to demand curves............. 140 6.1.1 An example of the usefulness of linking preferences to demand.. 144 6.2 Effect of changes in income on demand................... 146 6.3 From individual to market level demand.................. 148 6.4 Elasticities................................... 150 6.4.1 Own price elasticity of demand................... 150 6.4.2 Cross-price elasticities of demand.................. 155 6.4.3 Income elasticity of demand..................... 156 6.4.4 Elasticities: A simple example.................... 157 6.5 Appendix – Income and substitution effects................ 158 III EFFICIENCY AND EQUITY IN A COMPETITIVE MAR- KET 164 7 EFFICIENCY IN PARTIAL EQUILIBRIUM 166 7.1 Efficiency of a competitive market...................... 166 7.2 Consumer surplus............................... 167 7.2.1 Changes in consumer surplus.................... 169 7.2.2 Diamonds and water again...................... 169 7.3 Producer surplus............................... 171 7.4 Putting CS and PS together: Efficiency in partial equilibrium...... 172 7.5 Policy and deadweight loss.......................... 175 7.5.1 Price cap............................... 175 7.5.2 Unit tax................................ 176 7.5.3 Subsidies................................ 179 CONTENTS 8 8 EFFICIENCY IN GENERAL EQUILIBRIUM 183 8.1 How resources are allocated in an economy................. 183 8.2 Efficiency in consumption.......................... 188 8.3 Efficient use of inputs............................. 199 8.4 Efficient combination of goods........................ 202 8.5 Comparing different allocations: Equity................... 206 8.5.1 Normative and positive economics.................. 208 8.5.2 Social welfare functions........................ 209 8.6 Final words.................................. 212 IV IMPERFECT COMPETITION 214 9 MONOPOLY AND MONOPOLISTIC COMPETITION 217 9.1 Quantity set by a monopolist........................ 217 9.1.1 Profit maximization for a monopolist – A numerical example... 219 9.1.2 Deadweight loss of a monopoly................... 222 9.1.3 Profit maximization for a monopolist – The general case..... 224 9.2 Why do monopolies exist?.......................... 227 9.3 Monopolistic competition........................... 230 9.3.1 Monopolistic competition when firms differ in productivity.... 232 9.4 Appendix................................... 242 10 OLIGOPOLY 243 10.1 Overview of oligopoly markets........................ 243 10.2 Oligopoly with homogeneous products................... 244 10.2.1 Quantity competition: Cournot................... 244 10.2.2 Price competition: Bertrand..................... 255 10.3 Oligopoly with differentiated products................... 259 10.3.1 Price competition with differentiated products........... 260 11 GAMES AND STRATEGIES 267 11.1 Overview.................................... 267 11.2 Simultaneous games............................. 269 11.3 Repeated games................................ 277 11.4 Sequential games............................... 283 CONTENTS 9 11.5 Game theory – Some concluding thoughts................. 292 12 MORE SOPHISTICATED PRICING STRATEGIES 294 12.1 Price discrimination.............................. 294 12.1.1 Perfect price discrimination..................... 296 12.1.2 Different prices to different customer groups based on observable criteria................................. 298 12.1.3 Price discrimination under self-selection constraints........ 303 V MARKET FAILURES: EXTERNALITIES AND ASYM- METRIC INFORMATION 312 13 EXTERNALITIES 314 13.1 Externalities.................................. 314 13.1.1 Too much is produced when there is strong competition and nega- tive externalities........................... 316 13.1.2 Public policy to deal with externalities............... 320 13.1.3 Property rights and bargaining as a solution to externalities... 327 13.2 Different types of goods........................... 331 13.2.1 Common resource........................... 333 13.2.2 Public goods............................. 338 13.2.3 Club goods.............................. 342 14 ASYMMETRIC INFORMATION 343 14.1 Different forms of asymmetric information................. 343 14.2 Adverse selection............................... 345 14.2.1 Examples of situations with scope for adverse selection...... 348 14.2.2 Ways of limiting effects of adverse selection............. 351 14.3 Moral hazard................................. 357 14.3.1 Further examples of moral hazard.................. 360 14.3.2 How to limit consequences of moral hazard............. 367 14.4 Concluding discussion............................ 368 CONTENTS 10 VI APPLICATIONS 372 15 TOPICS IN DIGITAL MARKETS 374 15.1 Digitalization................................. 374 15.2 Platform markets............................... 375 15.2.1 Issues when designing a platform.................. 377 15.2.2 Competition issues raised by platforms............... 382 15.3 Auctions.................................... 384 15.3.1 Valuations and bids.......................... 385 15.3.2 Various auction formats....................... 386 15.3.3 Evaluating the different auction formats.............. 388 15.4 Appendix – Further details on profit maximization on a platform.... 391 15.5 Appendix – The revenue equivalence theorem............... 392 16 INTERNATIONAL TRADE 395 16.1 International trade – Some background................... 395 16.2 The mechanisms that drive trade – three classes of models........ 396 16.2.1 Comparative advantage and the gains from trade - an example.. 396 16.2.2 Trade under perfect competition with specific factors....... 400 16.2.3 Trade with monopolistic competition................ 406 16.3 Trade policy.................................. 409 16.3.1 Partial equilibrium analysis of trade policy............. 412 16.4 Empirical evidence on trade - its impact and determinants........ 416 16.4.1 The importance of trade has varied with technology and with policy 416 16.4.2 A large share of trade is with countries that are relatively close and there is much exporting and importing of the same goods..... 418 16.4.3 The goods that countries export and import reflect their technolo- gies and natural endowments.................... 420 16.4.4 The welfare effects from trade integration - an overview of the evi- dence.................................. 421 17 MATHEMATICAL APPENDIX 424 Chapter 1 INTRODUCTION “Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world.” John May- nard Keynes in a letter to Roy Harrod, July 4, 1938. In this chapter we give a brief background on microeconomics as a topic of study and the scope of the present book. 1.1 An example to get our minds primed about the role of economics If you’re reading this you are presumably taking part in a university education. It is an example of a type of good or service that we are interested in studying in economics. 11 CHAPTER 1. INTRODUCTION 12 Who should get to study what topic at what university? How should educational spots be financed? We can imagine a large number of different ways to solve this issue. First consider a number of different selection mechanisms that are not directly linked to funding of the education:1 ˆ Selection by aptitude tests, interviews and references. ˆ Selection by grades from secondary education. ˆ Education is open to everyone but popular educations will be oversubscribed, dif- ficult exams limit the number of students that continue on. ˆ Selection by waiting lists. For really popular educations your parents would have rushed to place you on the list while you were still just a toddler. ˆ Selection by queue. Like with tickets for a popular concert some might be waiting for several days or weeks even – camping on the sidewalk to be one of the first 300 through the door. How many weeks would you be willing to camp on the sidewalk to get into Harvard? ˆ Selection by lottery. ˆ Selection by social class or what university that your parents attended. The examples above share the feature that financing of the education is not directly linked to the selection of who gets to study what. Alternatively, educational spots can be sold in different ways, thereby determining who gets to study what partly by who is willing and able to pay the price: ˆ All students pay the same yearly fee. Prices set high enough that not more students want to study than what the number of places available are. ˆ Educational spots are auctioned off sequentially – the highest bidders get to study. The mechanisms above have all been used in some circumstances and in many cases several selection mechanisms are combined – many US universities for instance are largely financed by tuition fees but also select students based on aptitude tests and interviews. 1 These mechanisms are especially relevant in cases where university education is financed via taxes or donations. Indeed, the Stockholm School of Economics is mainly financed via donations which allow us to be a private university with no tuition for students from within the EU. CHAPTER 1. INTRODUCTION 13 In addition we may note that historically many resources have been allocated by violence, or threat of violence. The different ways of allocating educational spots have different implications for who gets to study. They thereby have important ramifications for equality - and the extent to which they decouple selection from parents’ incomes. They also differ in the incentives that they give to work hard on developing valuable skills. Some provide strong incentives to study hard in secondary school whereas others do not. They also differ in their ability to generate revenue for the university. We may want to provide a systematic analysis of how the educational slots are allocated – what are the pros and cons of different ways of allocating slots? Microeconomics provides the tools to conduct a systematic analysis of questions regarding how to allocate a scarce resource, such as university education. Much of microeconomics examines the case where prices are used to allocate goods – hence reflecting individual choices that depend on the interaction of prices and incomes. The example of university education is nevertheless useful in highlighting that many other ways are also used to allocate goods or services and that the tools of economics are useful in studying such cases as well. 1.2 Economics – The Wealth of Nations Who gets what, and the rules that govern how goods and services are created and divided, has clearly been given serious thought since the dawn of history. Nevertheless we often emphasize the Scottish economist Adam Smith, and his book Wealth of Nations, first published in 1776, as the beginning of economics as a field of analysis. The timing is no coincidence. Europe in the 1700s in earnest saw the shift away from largely self-sufficient farming communities to people interacting more widely via markets. Understanding how those markets worked became ever more important. Also today the title of his book, Wealth of Nations, is useful in describing the aims and goals of economics. As we look around the globe the conditions under which people work and live are vastly different and it is natural to ask what we can do to allow people to live happier and healthier lives. An understanding of economics and how interactions take place in markets is so pervasive to our lives that it is easy to take the functioning of markets for granted. None of my breakfast is grown by myself or those close to me – instead I have bought all the items in a store, relying on being able to purchase tea from Sri Lanka, orange juice from Spain and bread and cheese from more nearby. I sell my services as an economist and purchase what I need from markets. Those markets are kept functioning by a huge CHAPTER 1. INTRODUCTION 14 number of different people working within firms and government indirectly interacting in markets. These markets are partly supported by laws and public policy, and partly by norms, ways of conduct and trust that have developed over time. Economics studies how this whole system works and can be made to work even better. Within a first textbook in microeconomics we take most of those laws and public policies as given and focus largely on the role of prices in directing resources in this system. This is not because it is the only question of great interest, but it sufficiently important and nontrivial that it will keep us busy for the next 15 chapters.2 1.3 Scarcity – An underlying assumption One useful starting point for understanding the scope of economics is the following: “Economics can be defined in a few different ways. It’s the study of scarcity, the study of how people use resources and respond to incentives, or the study of decision-making. It often involves topics like wealth and finance, but it’s not all about money. Economics is a broad discipline that helps us understand historical trends, interpret today’s headlines, and make predictions about the coming years.”3 Scarcity is indeed often taken as a foundation for the study of economics. By scarcity we mean that resources are limited and we need to make choices about how to use them. It may be useful to start with an example that is not scarce – air for breathing.4 If we are in a room, I’m not thinking that if you’re taking more breaths I need to take fewer breaths. I don’t think about taking fewer breaths now to be able to take more breaths later. Simply put, how many breaths of air to take in a minute is not an economic question. In contrast, many resources are in limited supply, we need to make decisions on how to use them. This is true both for individuals, firms, countries and the world as a whole. Time is an example of a scarce resource from the perspective of an individual. A day has 24 hours and if you live a relatively long life you may experience some 30,000 2 I’m sometimes asked about suggested readings for such broader topics. New and good books appear continuously but the following three are personal favorites that are profound and thought-provoking yet easy enough reads to keep your attention also on the beach: McMillan (2003), Rodrik (2015), Seabright (2010). 3 The quote is taken from the website of the American Economic Association, one of the key societies that organize economists, organizing conferences and publishing academic journals. Their website also has some resources targeted at students, for instance the following one where the quote was taken from on March 15 2023: https://www.aeaweb.org/resources/students/what-is-economics. 4 Pollution can be seen as leading to an exception to this rule, but we hold off on that discussion until Chapter 13. CHAPTER 1. INTRODUCTION 15 days. How should you spend those? For every minute that you’re doing something, there is something else that you’re not doing. You can study microeconomics, work, hang out with new friends, old friends, play video games, binge-watch fantasy movies, play badminton, or practice your slackline skills. Time is limited and how you choose to spend it is an economic question. Similarly, for most of us income is limited in that if we’re buying more of one good or service, that implies buying less of something else. As we cover in Chapter 4, one implication of scarcity is that there is an opportunity cost of everything that we do, the cost of doing something can be seen as what we are giving up by not spending that time and those resources on an alternative use. This is sometimes summarized under the saying “there’s no such thing as a free lunch.” Resources are scarce also at the more aggregate level. Electricity for instance can be used for heating and cooling houses, for fueling manufacturing plants, for mining bitcoins, for fueling electrical vehicles and for lighting up the garden with reindeers and santas in the run-up to Christmas. More electricity spent on one use typically means less spent on other uses. More resources spent on military defense means less resources spent on other uses. Again, economics provides a structured way to analyze how those resources are best spent given the goals of an individual, firm or state. 1.4 On the use of models in microeconomics If we want to compare different ways of allocating goods and services, like education, we can make different assumptions about how people choose. Do people follow “what is expected of them” based on social class and background only? Or are choices mainly reflecting chance? The microeconomic approach to this question is to assume that people make deliberate choices and we then aggregate from the ground up. For instance, the total number of applicants to a university reflects the deliberate choices of a large number of potential students that try to be as well off as possible given the constraints that they face. Of course there will be some mistakes and some people will just mindlessly follow what is expected of them, but the microeconomic starting point is that choices are deliberate. This allows us to in a natural way examine the effect of factors that we may expect make university education more or less attractive: higher wages for university educated students, student housing and student loans are all potentially important factors. When we say that people make deliberate choices we need to operationalize that in some way. In the following chapters we examine the baseline type of model that we use in economics – individuals maximize utility given the prices that they face, the income they CHAPTER 1. INTRODUCTION 16 have and their preferences. Similarly, we assume that firms strive to maximize profits given the technology that they use and the prices of inputs. We use models, simplified versions of decision problems that firms, states and individuals face, to make predictions and understand the trade-offs faced. The models are useful in that they allow us to check that our arguments are logically sound and allow us to examine various counterfactual scenarios. An old analogy states that a model is like a map. To be useful a map needs to simplify – a map on the scale of 1:1 is hardly helpful. In a saying, sometimes attributed to Albert Einstein, we say that “a model should be as simple as possible, but not simpler than that.” A useful model simplifies enough that we can work efficiently with it, but is still rich enough to provide insights and predict well with regard to the key problems that we want to solve. Figure 1.1: A Polynesian stick chart Source: https://commons.wikimedia.org/wiki/File:Polynesian navigation device showing directions of winds, waves and islands.jpg. To me the history of how Polynesians populated the Pacific Ocean is one of the more fascinating of human history. Paying close attention to winds, stars, currents, and wave patterns, they were able to successfully navigate across the huge expanses of the Pacific Ocean, long before the advent of modern navigational tools. In some areas, such as the Marshall Islands, stick charts like the one depicted in Figure 1.1 were also used. Small shells were used to represent islands and sticks were used to represent wave patterns, which reflect off of islands and are discernible to the initiated also from far away. To a CHAPTER 1. INTRODUCTION 17 trained mind stick charts were a useful navigational tool. They do not provide a detailed image of the Pacific – they provide a highly stylized representation that was useful for navigation. Similarly I like to think of models in economics as stick charts – useful simplifications. As noted in the introductory quote by John Maynard Keynes,5 the models assure us that our thinking is sound. But it is often not obvious which model is applicable in what situation. In micro we typically use the same basic model (maximization of utility under constraints) but assumptions need to reflect key aspects of how a particular market works (regarding e.g. number of sellers, information och product differentiation). Compare for instance demand for potatoes, education, addictive drugs and human kidneys for donation. Demand for potatoes is likely to be importantly determined by price and be relatively straightforward – many producers grow potatoes and we can relatively easily judge the quality. In cases where there is school choice, demand for a particular school is likely to be more complicated. In many countries prices are low, or education is free, such that price is not a key factor. On the other hand quality may be hard to judge and highly dependent on who the other students are. Price is then relatively unimportant for demand and understanding of educational markets will need to focus on other aspects than study of markets for potatoes. Turning to our third example, addictive drugs present hard questions about the limits of what people should be allowed to do, hurting themselves and others. And as to our final example, humans have two kidneys and can donate one to others which may save the life of the recipient. People may donate for altruistic reasons, typically to close family, but in almost all countries the sale of kidneys is illegal, reflecting commonly held moral views on what kind of goods and services that should be acceptable to exchange in return for money. One can come to different conclusions regarding the correct type of regulation, but clearly a serious analysis needs to reflect that trade in heroin or human kidneys poses very different questions than trade in potatoes.6 5 Keynes is one of the more impressive economists ever. His main contribution is in helping us under- stand the forces that shape business cycles (Keynes (1936)) but he also made profound contributions to our understanding of uncertainty (e.g. Keynes (1921)), made remarkably prescient observations regard- ing the dangers of the harsh conditions imposed on Germany in the post World War 1 peace (Keynes (1920)) and was a dominant force is creating the framework for international cooperation in the after- math of World War II. He actively engaged with artists, writers and leading philosophers of his time. Out of many biographies, the one by Skidelsky (2009) is particularly comprehensive and readable. 6 One constraint on altruism as a source of human kidneys is that there may be no good match within a family – I may be willing to donate to you but you may not be able to medically receive my kidney. Setting up donor chains – I give to your family and your family gives to mine – can then be a way of realizing gains from trade and save lives also when prices are not used, see Roth (2007) for an overview. CHAPTER 1. INTRODUCTION 18 1.5 What we do in the book - and what we don’t do This book, as is common for courses in microeconomics, focuses on models. In practice no question in economics should be decided on theory alone. All of the key classes of models that we examine have been used to understand how markets and individuals operate. The next chapter will open with an example from global rice markets for instance and any policy recommendation needs to be cognizant of the empirical work. A single textbook can’t cover everything however and in keeping with how microeconomics is typically taught, this book focuses on theory. Theory gives us the indication of what data that empirical analysis should examine and provides hypotheses to guide the work. The chapters in this book follow a standard curriculum of what is taught in microe- conomics. Microeconomics studies how prices and quantities are set on markets, often focusing on one market at a time (e.g. the market for rice). It examines how markets work when they work as well as possible and some especially important cases when they run into problems, market failures. Microeconomics is not only important in its own right, the tools that we learn in microeconomics are also used in other applications in economics. Macroeconomics is the other main building block of an economics curriculum. In macroeconomics we focus on the economy as a whole, how the economy grows and on business cycles. Monetary (e.g. how should the central bank act) and fiscal (e.g. should governments stimulate the economy to counter a recession) policy are key areas of interest. Similarly, many specialized courses are given at a more advanced level – for instance public economics (focusing on the role of government), labor economics and international economics. These typically rely on the type of framework that we study in microeconomics but dive deeper and relate the models to institutional details and data. Thus – microeconomics really is the foundation of further studies in economics. Chapter 2 SUPPLY AND DEMAND 2.1 Supply and demand – An Introduction Figure 2.1 shows an index of the price of rice on global markets.1 As typical of many agricultural products and minerals, prices exhibit large changes over time. A standout feature of the graph is the increase, and subsequent drop, in price in 2008. Rice is a key food for billions of people and when prices more than double in a short period this clearly has great repercussions for many poor across Asia in particular but the price surge also led to riots in for instance Haiti. What causes such price changes? How can 1 The data are from a website maintained by the International Monetary Fund, https://www.imf. org/en/Research/commodity-prices. This a convenient and free source of data on prices of agricultural products and other commodities, such as metals. 19 CHAPTER 2. SUPPLY AND DEMAND 20 we understand them? How can we think of counterfactual scenarios? In this chapter we will learn how the tools of Supply and Demand can be used to determine how prices and quantities are decided on markets. These are simple tools that are extremely powerful in thinking about markets. We will see how prices and quantities respond to changing conditions. In the case of rice markets this clearly matters if we are producers of rice – what should we plan for – as well as if we are policy makers, investors or any other interested party whose well-being is somehow tied to the price of rice. Figure 2.1: World market price of rice Source: https://www.imf.org/en/Research/commodity-prices. We will also use the example of supply and demand to show how models are key to our ability to make sense of the world. For instance, it seems natural that price says something about value – a painting by Vincent Van Gogh sold for hundreds of millions is seen as more valuable than a painting by myself that probably would carry a price of 0. But then consider what is sometimes known as the diamond-water puzzle: How can it be that water, which is so central to our life, typically has a very low price, whereas diamonds, that we can easily live without, typically have a very high price? We shall see that in terms of a supply and demand analysis there is no puzzle at all - it is a natural outcome of such an analysis.2 2 Often this puzzle is presented as one that philosophers from Aristotle and Plato onwards, via Coper- nicus and Adam Smith, struggled with, and that only with the development of supply and demand analysis in the 1800s did this question become resolved. I have a lot of sympathy with this view but CHAPTER 2. SUPPLY AND DEMAND 21 When studying how prices and quantities are determined on a market we first need to specify what mean by a market. A market is a collection of buyers and sellers of a good or service. It is defined both by geography and by the product. The market for haircuts in Wellington New Zealand is a different market from the market for haircuts in Lima, Peru. In addition the market for watermelons in Lima is different from the market for haircuts in Lima.3 Strictly speaking a number of assumptions are needed for us to be able to describe a market price and quantity as the outcome of a meeting of a supply curve and a demand curve. We will return with a discussion of these assumptions when we discuss how markets allocate resources and whether that allocation is “efficient” in Chapter 8. For now note that the key assumptions for being able to analyze a market with supply and demand curves are the following: ˆ We assume that we can treat the product in question as a homogeneous product: The products from different suppliers are seen as equal in all dimensions. As a buyer I do not care about which wheat farmer that produced my wheat. In large centralized markets for commodities this holds true, as I can buy for instance 1 ton of wheat for delivery in a month which will bundle wheat grains from many different farmers. The quality of the wheat is determined by various standards but individual producers are not kept track of. Goods traded on exchanges – in particular between large professional parties – can often be thought of in this way. Later on in the book we will consider the case where different producers sell differentiated products, where, for instance, I as a consumer can choose between buying a bicycle with certain characteristics from one producer and buying one with slightly different characteristics from another producer.4 a substantial literature goes to great depths to try to determine exactly in what sense that the ancient thinkers thought of it as a puzzle or paradox (see for instance Ekelund Jr and Thornton (2011)). Thus, for the purposes of this text-book, take it as a puzzle whose answer is not immediately obvious but that has a very simple answer and interpretation in the model that we are about to learn. 3 Time is another dimension that is relevant in defining a market. For a typical consumption good the time is typically “now”, but in for instance commodity markets the price of a commodity delivered in one years time can be seen as different market than the same commodity delivered tomorrow. 4 An aspect that sometimes confuses students is that similar physical goods can exist in both homo- geneous and differentiated versions. The vast majority of wheat traded on global markets can be seen as homogeneous products. This does not necessarily conflict with that an individual wheat farmer can sell boutique wheat from her farm at premium prices, where the location and story of the production help make it into a differentiated product. Similarly tap water can be seen as a homogeneous product which does not hinder some premium producers to successfully market some high-priced bottled waters. We return to the distinction between homogeneous and differentiated products in Chapter 10. CHAPTER 2. SUPPLY AND DEMAND 22 ˆ There are many buyers and sellers, that each acts as if they have no impact on the market price – that is they act as price takers. As an individual wheat farmer I’m faced with many decisions, but when deciding how much wheat to plant I do not take into account that if I plant more I will affect the world market price of wheat. 2.2 Demand We use a demand function to pin down the quantity that buyers of the good or service want to purchase at different prices. Use QD denote the total quantity demanded and p to denote price. Quantity is in some measure of units such as kilos of rice or number of rickshaw rides taken. The corresponding price is in some currency, such as 2 euros per kilo of rice or 50 rupees for a rickshaw ride of a particular duration. As we shall see later, market level demand is the sum of demand from all buyers in the market. To take a specific example, consider the market for strawberries in a small town. Assume that there are 10 people in the town and their willingness to pay is such that one person is willing to pay at most 9 euros for a liter of strawberries, one person is willing to pay at most 8 euros for one liter, one at most 7 euros and so forth. To make our setting even simpler assume that each person buys at most one liter. Thus, for instance, if the price is 8 euros, 2 liters will be demanded and if the price is 7 euros, 3 liters will be demanded. We plot the relation in Figure 2.2. While demand in this case is discrete, that is, only whole liters will be sold, we typically simplify the analysis and assume that quantity is a continuous function of price such that for instance 2.586 liters can be bought. The relation between quantity and price can then in this case be described by the function CHAPTER 2. SUPPLY AND DEMAND 23 QD = 10 − p. Figure 2.2: Demand – A simple example Price in euros 10 9 8 7 Demand function 1 2 3 Liters of strawberries If we for instance plug in the price 7 euros, the demand function indicates that 3 liters will be sold. For the purposes of drawing demand we typically rewrite the demand function so that it is stated with price as the dependent variable, on the left-hand side, as indeed drawn in Figure 2.2. We term this the inverse demand function. Thus in this case it is p = 10 − QD. Applied to the current setting, a function is a mathematical relation between price and quantity. Give me a quantity and the function gives me a price. Equivalently give me a price and the function gives me a quantity.5 2.2.1 Effect on demand of changes in... One use of supply and demand analysis is to determine how price and quantity respond to various changes in the environment. Below we present a list of some of the most common 5 For another example, consider the demand function QD = 10 − 2p. The inverse demand function is again simply found by solving for p, yielding p = 5−QD /2. Two ways of expressing the same relationship. CHAPTER 2. SUPPLY AND DEMAND 24 changes of interest. The list is not exhaustive, and depending on the market in question, other variables may also be of interest. Changes in the price of the good What is the effect of a change in the price of the good on the quantity demanded for the same good? The answer to this is given by the demand curve, which relates the quantity demanded of a product to the price of that same product. We move along the demand curve, as illustrated in Figure 2.3. For the example given above, QD = 10 − p. Plugging in different values of prices in this relation we for instance find that quantity increases from 3 to 4 if price decreases from 7 to 6. Figure 2.3: Demand: Movement along the demand curve Price 7 A change in price is associated with a 6 movement along the curve Demand 3 4 Quantity Typically we expect demand curves to slope downwards, the lower the price the higher quantities are demanded. While in principle they can slope upwards, a little introspection points to that this is likely to be a very unusual situation - it is a rare situation in which you demand more as prices go up.6 6 Goods with an upward sloping demand curve are termed Giffen goods, after British journalist Robert Giffen who allegedly made the observation that such a pattern held for demand for potatoes during the great famine in Ireland in the mid-1800s. Whether the demand curve for potatoes in Ireland during the famine were indeed upward-sloping remains a debated issue, but such Giffen behavior has been documented for instance for rice among poor Chinese households, see Jensen and Miller (2008). In the appendix to Chapter 5 we examine Giffen goods in some detail. In simple terms, when the price of potatoes goes up poor consumers forego whatever other foodstuffs that could enrich the diet and CHAPTER 2. SUPPLY AND DEMAND 25 Let us also point out a misunderstanding that sometimes appears. People might for instance make the observation that a branded t-shirt sells a lot of units whereas a cheaper generic t-shirt sells much fewer units. Isn’t this evidence that a higher price is associated with a higher demand in some cases? No. Remember that an assumption underlying the analysis is that we are examining homogeneous products, comparing apples to apples rather than apples to oranges. When Gucci lower price of their t-shirts during a temporary sale, they expect to sell more rather than less.7 Changes in income How much of a good that is demanded depends not only on price but also on a number of other variables. Are the group demanding the strawberries impoverished or are we examining demand in a spot where billionaires thrive? Clearly, income does not explicitly figure in the equation QD = 10 − p but is subsumed in the intercept 10. For many goods we expect higher incomes to be associated with higher demand, something which characterizes what we call normal goods. As my income increases I will demand more strawberries. How do we illustrate this in a diagram? The simplest way to think of it is the following: At a given price, will consumers demand more or less if income increases? If they demand more, demand will be given by a point further out in the diagram for that particular price. The same applies for any price when income increases for a normal good. We thus say that the demand curve shifts outwards as illustrated in Figure 2.4. Another possible pattern is that demand shifts inward if income increases. Such goods are termed inferior goods. Low priced food items are common examples of such products, if incomes go up we buy less of instant noodles, as we can better afford more attractive alternatives. Figure 2.5 provides an illustration. purchase more potatoes. 7 This is not to deny that in the long run demand for a particular type of product can be shaped by perceptions of quality and social status associated with use of the product. Price can play a role there but we have then left the standard analysis of the slope of demand curves way behind us. CHAPTER 2. SUPPLY AND DEMAND 26 Figure 2.4: An outward shift in the demand curve as income increases (normal goods) Price Demand Curve at Higher Income for a Normal Good Initial Demand Curve Quantity Figure 2.5: An inward shift in the demand curve as income increases (inferior goods) Price Initial Demand Demand Curve Curve at Higher Income for an Inferior Good Quantity Changes in the price of other goods We examine the demand for one good but clearly the prices of many other goods have the potential to affect demand as well. As I’m standing in the store thinking of buying strawberries, there may be raspberries stacked up right next to the strawberries. In a lot CHAPTER 2. SUPPLY AND DEMAND 27 of cases I might envision consuming either strawberries or raspberries – on a cake or with some sugar and cream for desert. Again, the effect of the price of raspberries on demand for strawberries is subsumed in the intercept and a change in the price of raspberries would be associated with a shift in the demand curve for strawberries. Again we perform the simple thought experiment: At a given price, will consumers demand more or less if the price of another good increases? If the price of raspberries goes up, and consumers view raspberries as an alternative, demand for strawberries shifts outward. The formal term is that goods are substitutes if demand for good 1 increases if price of good 2 increases. The substitute product just got more expensive, which implies that at least some consumers will opt for strawberries rather than raspberries, as illustrated in Figure 2.6. Figure 2.6: An outward shift in the demand curve as the price of a substitute product increases Price of Straw- berries Demand Curve for Strawberries at a Higher Price of Raspberries (Substitute Product) Initial Demand Curve Quantity of Strawberries There may also be inward shifts in demand as the price of another product increases. The formal term is that goods are complements if demand for good 1 decreases if price of good 2 increases. A typical example is products that are consumed together such as milk and ready-to-eat cereal such as Corn Flakes. We can think of the two products as a joint bundle and if the price of one of the products just went up, that joint bundle just became less attractive to buy, at given price of strawberries, fewer strawberries will be demanded if the price of the complement just went up. Many like the combination of vanilla ice cream and strawberries, and let us assume that the two goods are complements. So, if CHAPTER 2. SUPPLY AND DEMAND 28 the price of vanilla ice cream just went up, fewer strawberries will be demanded and the demand curve shifts inwards, as illustrated in Figure 2.7. Figure 2.7: An inward shift in the demand curve as the price of a complement product increases Price of Straw- berries Demand Curve for Strawberries at a Higher Price Initial Demand of Vanilla Ice Cream (Complement) Curve Quantity of Strawberries Other factors that shift demand functions A host of other variables can shift demand curves. At some level a list of such variables can become almost metaphysical and as the American saying goes, “anything but the kitchen sink” could have an effect. Of course an analysis were we considered hundreds of variables would become unwieldy and in typical applications we focus on a few variables that we expect to be particularly important. What those other variables are will be specific to the product and partly determined by applications of common sense, possibly complemented by statistical analysis. For instance demand for ice cream will likely be affected by temperatures and demand for ski passes at a snow resort will be affected by the snow cover. Expectations are another important variable in some markets. A standout example was in the early days of the Covid pandemic when expectations that toilet paper would run out (a really odd expectation by the way) led to stockpiling in a lot of countries, demand shifting out for a time period. CHAPTER 2. SUPPLY AND DEMAND 29 2.2.2 Demand functions – Some additional aspects In the example above the demand function was linear. Simply put it is a straight line and when we shifted the demand curve we simply stated that demand should shift in some direction. In the following section we expand somewhat beyond those simplifying assumptions. Demand: General form vs specific form Above we showed a simple demand curve. We gave it a specific form, for every increase in price by 1 euro, 1 liter of strawberries less were demanded. We can also express the demand function in general form, just noting that quantity demanded of strawberries depends in some way on the price of strawberries. As discussed, in principle many different circumstances could also affect the demand for strawberries: temperature (if its a warm day a strawberry dessert may be more attractive), prices of a substitute like raspberries, as well as incomes of the demanders in the market. Using T to denote temperature, pr to denote the price of raspberries and I to denote income, we can then express demand for strawberries in general form as QD = f (p, T, pr , I). Thus quantity demanded of strawberries depends in some way, as specified by a func- tion that we denote by f , on the 4 variables p, T, pr and I. In principle we could think of a very long list of potential variables that affect demand for strawberries. In practice we limit ourselves to what we believe to be the main variables that have an impact. In specific form, that is saying that the function takes a particular form, the relationship may for instance be expressed as QD = 1 − p + T × 0.25 + pr × 0.75 + I × 0.5. The demand function QD = 10 − p that we described above can then be seen as the relation between quantity demanded and price for specific other values of the other variables. Thus for T =20 degrees, pr =2 euros and income I (in thousands) equal to 5 euros, the relation becomes QD = 1 − p + |{z} 20 ×0.25 + |{z} 2 ×0.75 + |{z} 5 ×0.5 = 10 − p. T pr I CHAPTER 2. SUPPLY AND DEMAND 30 Demand: Different shapes Economists typically estimate demand functions based on observations of prices and quantities from markets. Covering how to do that would take us to far afield and is left for courses in statistics and econometrics. Let us nevertheless for illustration consider a case where we observe quantities purchased in a market at various prices. Assume that these different prices have been shifted because of changes in costs, rather than in response to developments in demand. Figure 2.8 presents a simple example where each black dot represents an observed combination of price and quantity. There is some randomness so that the dots do not perfectly line up on a single curve, but clearly a fitted line such as the red curve would provide a reasonable representation of the demand curve in a case such as this. Demand curves with this kind of curvature, where the lines becomes increasingly flat at lower prices are common in economics.8 Note however that a linear demand curve provides a reasonable application at prices in the ”middle”. In practice it is not uncommon to believe that a linear demand curve gives reasonable ballpark answers at middling observations but special care is needed if we are to make inferences about what happens as either the number of units goes to 0 or as the price goes to 0. Figure 2.8: Demand: Different shapes Price Quantity Similarly, above we illustrated shifts in the demand curve as perfectly parallel shifts. 8 A particularly common formulation are what are known as constant elastic demand curves, for 1 instance expressed as p = Q ϵ where the parameter ϵ determines the curvature of the inverse demand function. CHAPTER 2. SUPPLY AND DEMAND 31 In many applications we could think of demand shifting more at certain price levels so that the demand curve e.g. both shifts and becomes flatter. 2.3 Supply Similarly, the supply of a good is the amount of the good that sellers are willing to sell at different prices. The supply curve typically slopes upward: At higher prices suppliers are willing to supply more. While demand curves are typically a straightforward concept it is not uncommon to find supply curves more complex and perhaps confusing. The key point to remember here firms whose decisions can be described by a supply curve are not setting price, they are price takers. They determine how many strawberries to pick and bring to the market, they don’t determine the price itself. If this still appears somewhat puzzling worry not, we will provide a thorough walk-through of the supply curve in later chapters. Many of the aspects that we discussed in connection to demand curves apply also to supply curves. They may be linear, but may also have other shapes, for instance increase at an increasing rate. Similarly we can express them in general form, such as QS = f (p) or in specific form such as QS = −2 + p. (2.1) We also typically draw the inverse supply curve (p as a function of Q) rather than Q as a function of p. Thus, rewriting supply from Equation (2.1) to have p as the dependent variable yields p = 2 + QS. (2.2) The supply intercept of -2 in the supply function may look a bit puzzling in Equation 2.1 but is more intuitive when we express the supply relation as the inverse supply curve, as we do in Equation (2.2) and Figure 2.9. Price needs to be well above 0 before any producer is willing to supply the good. CHAPTER 2. SUPPLY AND DEMAND 32 Figure 2.9: Supply curve: An example Price of Straw- berries Supply Curve 2 Quantity of Strawberries 2.3.1 Effect of Changes on the Supply Curve Changes in the Price Just as with the demand curve, the effect of changes in price on quantities supplied are given by the supply curve. As price changes we move along the supply curve. With a supply curve given by QS = −2 + p, the many firms that jointly make up supply are willing to supply 1 liter of strawberries if the price is equal to 3 euros and 2 liters as the price increases to 4 euros.9 Changes in the price of inputs In Chapter 4 we will formalize the idea that how much firms are willing to supply depends on their costs, which in turn depend on the price of the inputs that are used in production. For now note that it is intuitive that if costs increase firms will want a higher price to supply the same quantity. Or, another way to say the same thing, for a given price, a lower quantity will be supplied if cost increases. If wages or costs of transporting the strawberries to the market increase, this will lead to an inward shift in the supply curve as illustrated in Figure 2.10. Similarly, if input costs decrease, the supply shifts outwards, 9 You may find it unconvincing that many suppliers together only supply a handful of liters. I agree, but have chosen to opt for simple numbers rather than realism in this dimension. If you want you can think of quantity as thousands of liters, which solves the conundrum. CHAPTER 2. SUPPLY AND DEMAND 33 firms are willing to supply a greater quantity for the same price. Or, another way to say the same thing, firms are willing to supply the same quantity at a lower price. Figure 2.10: Supply churve: The effect of higher input prices Price of Straw- Supply Curve For berries Strawberries at Higher Cost of Inputs Supply Curve 2 Quantity of Strawberries Other factors that shift supply functions Just as with demand functions, many other factors can affect supply, and again the question is if supply will increase or decrease at a given price. For instance, if a formerly closed local market opens up to foreign suppliers, this will shift the supply curve outwards. Disruptions where some production units close because of accidents, extreme weather or strikes are other prominent examples that would cause supply curves to shift inwards. 2.4 Combining supply and demand to find the mar- ket equilibrium We now combine supply and demand to establish how prices and quantities are deter- mined on a market. We say that the market is in equilibrium when the price is such that quantity demanded equals the quantity supplied. Buyers buy all that they want at this prevailing market price, and sellers are able to sell all that they want at this price. We sometimes refer to the equilibrium price as the market clearing price, as the market CHAPTER 2. SUPPLY AND DEMAND 34 “clears”, sellers are not left with large piles of unsold stock and buyers are able to buy as much as they want at the prevailing prices. We can analyze the equilibrium price graphically, as the price at which the supply and demand curves intersect. We can also solve for the equilibrium price using explicit functional forms for the supply and demand equations. Using the expressions from above we have that QD = 10 − p and QS = −2 + p. At the equilibrium price, quantity demanded is the same as the quantity supplied and hence we can set QD = QS. In this case it implies that the equilibrium price is given by solving 10 − p = −2 + p for p: 10 − p = −2 + p | {z } | {z } QD QS 12 = 2p p = 6. Figure 2.11 illustrates and we see that the point of intersection happens at the price of 6 euros. To find the associated equilibrium quantity, we insert price into either the demand or the supply equation (they give the same answer) and find that Q = 10 − 6 = 4 liters. CHAPTER 2. SUPPLY AND DEMAND 35 Figure 2.11: Market equilibrium Price of Straw- Supply berries Curve 10 6 2 Demand Curve 4 Quantity of Strawberries Video link for table: https://youtu.be/7_00TFu9RBc. What are the mechanisms that lead to the equilibrium price being established on a well functioning market? First let us consider what would happen if price were below the equilibrium, as illustrated in Figure 2.12. For a moment assume that the price was 4 euros. If we draw a line at this level in Figure 2.12, we find the quantity supplied at this price by reading off quantity at the point at which this price line intersects supply and the quantity demanded at this price from the intersection of the price line with the demand curve. We can also calculate these by simply inserting the price 4 into supply and demand functions to determine how much is supplied and demanded at this price. Thus QS = −2 + 4 = 2 liters of strawberries are supplied and QD = 10 − 4 = 6 liters of strawberries are demanded if p = 4. Thus, at this price more is demanded than what is supplied and we say that there is excess demand. In this particular case there is excess demand of 4 liters (the difference between quantity demanded (6) and quantity supplied (2)). We can think of excess demand as a situation where there are lines building up as people struggle to purchase the good. People are milling about looking for an opportunity to buy at these prices. At this price there are many buyers who are willing to purchase at this, or even a higher price, but that are not able to get their hands on any units of the good. If the price is low because of a regulation, such as a price cap, we might expect CHAPTER 2. SUPPLY AND DEMAND 36 a second-hand market where some of the lucky few that have been able to purchase some units resell at a higher price. In a well functioning market we would instead expect at least some sellers faced with this situation to sell for a higher price. At a slightly higher price than p = 4 there is no problem to find buyers, also at a price of 5 euros for instance there is unmet demand. We thus expect upward pressure on prices as long as price is below the equilibrium.10 Figure 2.12: A price below the market equilibrium: Upward pricing pressure Price of Straw- Supply berries Curve 10 A Price Below the Equilibrium will Imply an Upward Tendency for Price 4 2 Demand Curve 2 6 Quantity of Strawberries Excess Demand Video link for table: https://youtu.be/2NcdivUfDzw. In contrast, if price were to for some reason be above the equilibrium we expect a 10 While this is intuitive we should note that there could be seen to be some contradiction between the upward price pressure, which implies that at least some firms set price and the assumption that all firms are price takers. In theory, equilibrium is assumed to reached by an agent who takes up information about supply and demand curves from all buyers and sellers and then proposes an equilibrium price, a “Walrasian auctioneer” (after Léon Walras, a French economist who in the 1800s made large contributions to the study of market equilibrium). In the early 1960s later Nobel laureate Vernon Smith was dissatisfied with this state of affairs and created a set of experiments where participants in the experiment where given valuations of a good, an identity as a seller or buyer and then allowed to trade. The experiments consistently showed that the equilibrium price was relatively quickly reached, a finding that has been confirmed in many subsequent studies. Smith (1962) is the original reference and an accessible discussion of the results is found in e.g. the motivation for the 2002 Economics prize in honor of Alfred Nobel found at the Nobel foundation’s website https://www.nobelprize.org/uploads/ 2018/06/advanced-economicsciences2002.pdf. Thus while theory relies on somewhat of a “trick” to establish the equilibrium price, the predictions seem to work well in the “laboratory” and ample evidence from real world market shows how price are established and respond to new information in line with predictions of the supply and demand model. CHAPTER 2. SUPPLY AND DEMAND 37 downward pressure on price. Figure 2.13 illustrates a case where the price for some reason is equal to 8 euros, and hence above the equilibrium price of 6 euros. Again we trace out a path at the level of the price and first hit the demand curve, the point of contact being associated with a demanded quantity of 2 liters of strawberries (QD = 10 − 8 = 2). Continuing rightward we eventually reach the supply curve and the point of contact is associated with a willingness to supply 6 liters (QS = −2 + 8 = 6). There is thus an excess supply of 4 liters (the difference between supply of 6 and demand of 2). Here we can visually think of a situation where sellers on a village market are sitting in their stalls behind large piles of unsold strawberries. At least some of those will choose to sell for a lower price. Since goods are homogeneous such a seller will have no problem attracting buyers and will diminish her pile of unsold strawberries. There will thus be a downward pressure on prices as long as price is above equilibrium. Figure 2.13: A price above the market equilibrium: Downward pricing pressure Price of Straw- berries Supply Curve 10 A Price Above the Equilibrium will Imply a Downward Tendency for Price 8 2 Demand Curve 2 6 Quantity of Strawberries Excess Supply Video link for figure: https://youtu.be/2NcdivUfDzw. One confusion that I sometimes meet in students is the following: How can there be excess demand or excess supply? Clearly not more goods can be bought than what are sold, so are demand and supply not always equal? The key to understand why supply curves and demand curves might not equate is that they determine how much buyers want to buy at a given price and how much sellers want to sell at a given price. For a price that is below the market price for some reason (as because of a price cap or because CHAPTER 2. SUPPLY AND DEMAND 38 concert tickets for some reason are sold below the market clearing price) it is true that not more goods can be bought than are offered. But at the actual price, buyers would want to buy much more – and the concept of excess demand is useful to understand why there is an upward pressure on price and to understand a second-hand market where for instance concert tickets are resold. 2.4.1 Both demand and supply matter for the equilibrium price and quantity Cambridge economist Alfred Marshall produced a path breaking textbook in economics, and his “Principles of Economics”, (Marshall (1890)), noted that we might as well argue about whether it is the upper or the lower blade of a pair of scissors that cuts a piece of paper, as whether the equilibrium is determined by demand or supply. This is a key point. Assume for instance that in our numerical example above supply was more responsive to price and given by QS = −2 + 2p instead of QS = −2 + p. The equilibrium price would then fall to 4 euros (from solving for the price at which 10 − p = −2 + 2p) and quantity would increase to 6 liters. Similarly if supply is as this more responsive level (QS = −2 + 2p => p = 10 − Q/2) but demand increases such that each individual wants to buy two liters of strawberries at their maximum price (QD = 20 − 2p.) The price would in this case fall to 5.5 (from solving for the price at which 20 − 2p = −2 + 2p) and a full 9 liters would be demanded (since 20 − 2 × 5.5 = 9). Figure 2.14 illustrates. With these insights we can also easily see why the puzzle “why is the price of diamonds, which we can live perfectly without, so high whereas the price of water, which we need for survival, so low?” There are several layers to this question, and we will return to it, but for now note that the simple answer is that price is determined not only by demand but also by supply. If diamonds were as plentiful as water rest assured that their price would be low, or even negative, we’d pay to get rid of them. 2.5 Shifts in the equilibrium An important use for supply and demand analysis is to examine how changes affects markets. As with the case of rice that we used at the start of the chapter, there are many cases that may be of interest to firms, investors, consumers or governments. With the price of rice as an example, governments have been toppled for less and high prices may mean starvation for large groups of people. CHAPTER 2. SUPPLY AND DEMAND 39 Figure 2.14: Demand and supply jointly determine price and quantity Price of Straw- Price of Straw- berries berries Supply Curve (p=2+Q) 10 10 Supply Supply Curve (p=2+Q/2) Curve (p=2+Q/2) 5.5 4 Demand Curve Demand Curve (p=10-Q/2) Demand Curve 2 (p=10-2Q) (p=10-Q) 6 Quantity of 9 Quantity of Strawberries Strawberries The supply and demand analysis that we developed above, and that we will explore additionally in coming chapters, is a theoretical construct. Starting from a set of as- sumptions (for instance price taking behavior by all agents in a market) a set of results follow by application of logic. Back in the real world things are typically more messy than in the rarefied air of economic theorists but for more than a hundred years market participants, firms, journalists and governments have found supply and demand analysis useful in analyzing market outcomes. As discussed at length later, we would not try to analyze the competitive situation in a market that is clearly dominated by a few firms or by firms that produce differentiated products in this way. But many agricultural products (such as cocoa, rice, wheat, potatoes), metals and fuels are produced by many producers and the products of different producers are more or less perfect substitutes. Such goods, often known as “commodities” are often traded on organized exchanges and prices move by the day or sometimes by the minute and supply and demand analysis is routinely used to analyze developments.11 An example of such a commodity is the metal Palladium and Figure 2.15 shows the development of price over a particularly eventful period. Palladium has a number of industrial uses, for instance in catalytic converters to lower emissions from cars, as well as in fuel cells, batteries and electronics. 11 We might note that quality certification goes into the assignment of products as homogeneous. A trader can go to an organized exchange and purchase 1 ton of grade A quality of a particular good. CHAPTER 2. SUPPLY AND DEMAND 40 Figure 2.15: An example of price movements for a commodity Source: https://www.imf.org/en/Research/commodity-prices What is driving these price developments? A simple answer would be “shocks to supply and demand”. Figure 2.16 presents one analysis by a consultancy firm (SFA Oxford), linking price developments for Palladium to what we can broadly think of as factors that affect either demand or supply. We see that factors that plausibly can be thought of as affecting both supply and demand are mentioned - for instance supply disruptions in South Africa, and regulations affecting demand for catalytic converters as well as replacement of platinum with pala- dium in catalytic converters. In the following we present an analysis of how to analyze the impact of shocks on the market equilibrium. CHAPTER 2. SUPPLY AND DEMAND 41 Figure 2.16: An example of supply and demand shocks for a commodity: Palladium Source: https://www.sfa-oxford.com/platinum-group-metals/palladium-market-and-palladium-price-drivers Let us highlight a few important guidelines for analyzing the effect of shocks on the market equilibrium: ˆ First and foremost: Is primarily demand or primarily supply affected? In my experience a beginner is likely to bring too many effects into the analysis and thinking in various ways through which there could be an effect. While there are cases where both supply and demand are affected we would typically find that the major impact is on either supply or demand. Are incomes of consumers falling? This should be expected to primarily affect demand. Similarly, are prices of close substitutes changing? This should be expected to primarily affect demand. Some technology or regulatory changes can also be expected to affect demand, as in the case of palladium. Closings and disruptions at producers are shocks that primarily affect supply. Similarly, changes in the cost of inputs used in production primarily affect supply. The textbook by Alfred Marshall that we mentioned above was important for driv- ing home the usefulness of this approach, focusing on what we believe to be the CHAPTER 2. SUPPLY AND DEMAND 42 major impact of a change and disregarding secondary effects. Any major change is also likely to appear at the same time as other changes happen. Trying to analyze all possible changes at the same time will tend to produce a muddle. Following in the footsteps of Marshall12 we therefore focus on the main effect, keeping “other things equal”. We might return to those other things, but in the type of supply and demand analysis that we perform in the following, we look at one or two changes at a time. As economists we often add this qualifier, if A happens I expect the price of B to increase, other things equal. The latin version of “other things equal”, ceteris paribus, is also frequently used. ˆ To see the direction of change in supply or demand it is useful to use the way of thinking that we introduced above: At a given price, do we expect a particular change to lead to higher or lower demand? At a given price, do we expect a particular change to lead to higher or lower supply? ˆ Also, don’t jump directly to thinking “what happens to price and quantity?” Keep the first stage, is it primarily supply or demand that is affected, and if so in what direction? This in turn will give predictions for price and quantity. As you become used to this kind of analysis, your mind will probably jump to the price and quantity effects directly, but at the start this is likely to confuse rather than clarify. Thus let us exemplify how the analysis can be used and consider a shock in the form of tighter emissions regulations that lead to catalytic converters being installed in more cars. What is the effect of this on the market for palladium? First, is demand likely to be affected? Yes. At a given price of palladium more catalytic converters would be installed, demand will be affected and shifted outward. Is there a direct effect on supply? No. In the long run one could imagine new mines opening, additional efforts being directed at recycling and so forth, but on impact we expect the main impact to be an outward shift in demand. Figure 2.17 illustrates. For shorthand we use D0 and S0 to denote the initial demand and supply curves and the associated equilibrium price p0 and quantity Q0. Higher demand for palladium, because of more use of catalytic converters, shifts the demand curve outwards to D1 and we reach a new equilibrium where price is p1 and quantity Q1. The producers respond to the increased demand by producing more. How much more? Well, that is given by the supply curve. 12 He did walk a lot. Summers were largely spent on foot, criss-crossing the Alps as discussed in Keynes (1924). CHAPTER 2. SUPPLY AND DEMAND 43 Figure 2.17: Change in equilibrium: An increase in demand Price of S0 Palladium p1 p0 D1 D0 Q0 Q1 Quantity of Palladium Before we move on let me note that students sometimes find a comparison of the type in Figure 2.17 confusing. We compare two cases: one with a higher price and higher quantity and one with a lower price and lower quantity. Doesn’t this go against our expectation that demand curves slope down so that lower prices are associated with a higher quantity? No. The fundamental thing to remember is that if demand curves shift we are not moving along the demand curve. The assumption of “other things equal” does not preclude us from examining several changes at the same time - we just need to be clear about what changes that we are examining. Thus, in addition to the demand shock above, consider that at the same time a number of palladium mines are closed to flooding. This is clearly something that affects supply. At a given price, the exit of some producers should lead to lower quantities being supplied, thus supply shift inwards. Figure 2.18 shows how we can analyze the joint effect of these two shocks where we have included the shift in the supply curve S0 to S2. The outward demand shift and inward supply shift both contribute to raise prices which rise from p0 to p2 in the new equilibrium, given by the intersection of the new supply and demand curves. In the case illustrated, quantity in the new equilibrium, Q2 is higher than in the original equilibrium, Q0. From visual inspection it should be clear that while the effect of increasing prices from outward shifts in demand and inward shifts in supply are unambiguous, the effect on equilibrium quantities depend on the relative magnitude of the shifts. For instance, if supply had shifted more, we could end up in a situation CHAPTER 2. SUPPLY AND DEMAND 44 where quantity was lower. Figure 2.18: Change in equilibrium: An increase in demand and a decrease in supply Price of S2 Palladium S0 p2 p0 D1 D0 Q0 Q2 Quantity of Palladium Video link for figure: https://youtu.be/YmZ175cTCyw. Let us also tie back to the introductory example with sharp increases in the price of rice in 2008-2009. How can those be explained? Economists that have looked closely at the events (e.g. Dawe and Slayton (2010)) see a combination of supply and demand shocks as responsible for the sharp increase in price. A number of important exporters, starting with India in late 2007, imposed restrictions on the export of rice. From the perspective of world markets this clearly lowers supply.13 As noted, expectations can also affect demand and a fear that export restrictions would spread and lead to even higher future prices prompted several importers like the Phillipines, Malaysia and Nigeria to stockpile, “buy now because tomorrow it will be even more expensive, or even difficult to purchase at any price”. This is associated with an outward shift in demand, just as in the palladium example we thus have two movements that combine to drive prices higher. Concerted efforts to reassure importing countries that markets would be open and a signaling of willingness to sell some stockpiles of rice in e.g. Japan to keep prices down helped lower the prices in the later part of 2008. The financial crisis of 2008, which can be thought of as a negative demand shock further contributed to lowering price levels. 13 On the other hand, within an exporting country that suddenly imposes a ban on exports, domestic supply of rice will increase, tending to keep price down, which is a typical motivation for such export bans. CHAPTER 2. SUPPLY AND DEMAND 45 2.5.1 The slope of supply and demand curves and the effects of shocks Visual inspection of the figures above indicate that two aspects are central for the quan- titative impact of a demand shock on equilibrium prices and quantities: the size of the shift in demand and the slope of the supply curve. Likewise, the size of the shift in supply and the slope of the demand curve determine the quantitative impact of shocks to supply. Let us exemplify with a demand shock. First consider the case of avocados and assume that a host of trends and new information that avocados are healthy shift demand outwards. Assume that the supply curve of avocados is relatively steep, at least in the short run as illustrated in Figure 2.19. It takes several years from the planting of an avocado tree until it bears avocados so in the short run the set of trees is fixed. Yield among existing trees can be increased by for instance having more pickers, taking greater care that fewer avocados are damaged in picking and transport, pampering the trees more etc. These factors imply that the supply curve is less than vertical, such that higher prices are associated with higher supply. The supply curve is nevertheless likely to be quite steep. The steepness ensures that large movements along the vertical price axis are associated with relatively small movements along the horizontal quantity axis. In a case such as this, an outward demand shock generates a large increase in price but only a limited expansion of quantity, since it is difficult to expand production. Figure 2.19: Change in equilibrium: A shift in demand when the supply curve is steep Price of S Avocados p1 p0 D1 D0 Q0 Q1 Quantity of Avocados CHAPTER 2. SUPPLY AND DEMAND 46 Contrast the case of avocados with one where the supply curve is rather flat. I write this in Sweden, a country where pine trees abound. Now consider the case where pine needles are used to make tea. Supply can come from any person that simply goes out and collects pine needles in the forest and just a few pinches of pine needles are sufficient to generate a nice cup of pine-needle tea. At present there is next to no harvesting of pine needles so that many potential needle pickers are likely to find an abundance of needles just within a short walk from their place of residence. A situation such as this suggests that if price of pine needles were to increase, it could generate a large supply response – the supply curve is relatively flat as illustrated in Figure 2.20. Here supply easily expands to meet the shift in demand, in consequence prices do not rise much and quantity increases. Figure 2.20: Change in equilibrium: A shift in demand when the supply curve is relatively flat Price of Pine Needles S p1 p0 D1 D0 Q0 Q1 Quantity of Pine Needles  Part I WHERE DOES SUPPLY COME FROM? 47  48 In the next two chapters we will see where the supply curve comes from. Why does it have the slope that it does? Why does it differ across products? What precisely is the reason for why supply curves shift when the price of inputs change? These are some of the questions that motivate us. We will also introduce a set of tools that we will apply again when we examine the determinants of demand in subsequent chapters. Broadly speaking we assume that supply comes from firms that want to make as much profit as possible given the constraints that they face. Getting from this broad charac- terization to a supply curve requires a number of steps and assumptions as we describe in the following. We first describe technology and costs in Chapter 3 – how do firms decide on the way to produce and what are the costs that result from this? These tools are relevant for any firm, not just the firms that are faced with strong competition that we analyze in this first part of the book but can also be used to analyze for instance the relation between demand for labor and the increased capacities of artificial intelligence. Differences in cost structure are also a useful way to understand differences in the way that firms compete in different markets. Understand the cost structure of a market and you are well onto the path of understanding that market. In Chapter 4 we move from the costs to the supply of a firm faced by strong compe- tition. This is directly applicapable to many markets, ranging from mineral extraction to container shipping. Again the tools that we learn here are going to be useful also for understanding how for instance a monopolist sets prices later in the book. Chapter 3 FROM TECHNOLOGY TO COSTS 3.1 Setting the stage If I were writing this in Florence in the 1300s I’d be writing with a goose pen and for you to have your own copy you would need to manually copy the book.1 The invention of the printing pres