John Merrifield
BASIC ECONOMIC TOOLS
December
17, 2002
Chapter one
THE
TOOLS
Key Concepts:
1.) Opportunity costs
2.) Marginal analysis - the
Economic Golden Rule
a. Marginal benefits
b. Marginal costs
3.) Supply and Demand Analysis
a. Individuals vs
markets
b.
Shifters
c.
Equilibrium
d.
Gains from trade
consumer
surplus
producer
surplus
Because
of limited resources, individuals and societies cannot have all they want. Resource scarcity challenges everyone with
numerous difficult choices. Scarcity
also makes choicemaking an interesting study topic. The scarcity problem is especially evident to students who have
to earn enough money for school and meager living expenses, and have enough
time left over to study, sleep, and socialize a bit. A few high priority items consume the available resources,
largely time and money. So, in effect,
the highest priority items pre-empted or crowded out the lower priority
items. In other words, you sacrifice
the lower priority items for the higher priority items. Sacrifice is another word for cost. That brings us to our first analysis tool.
Tool #1: The
Opportunity Cost Principle
Everything
has a cost, or as economists have become famous for saying; there’s no such
thing as a free lunch. Every decision
eliminates other opportunities. Because
economists constantly point that out, they are quite unpopular in many
policymaking arenas and election campaigns where only glowing promises of
benefits without costs are welcome.
The
true, full cost of any given choice is the resulting lost opportunities, or
opportunity costs. For example, if you
decide to get a haircut, the opportunity cost is what you sacrifice, namely the
chance to spend the time it will take, and the money it will cost, on other
things. The value to you of those
‘other things’ is the true cost or opportunity cost of the haircut. We can use the haircut example to
demonstrate some key general economic facts: a.) Opportunity costs are true,
full costs, and they are hardly ever zero.
Even gifts are costly. ‘Free’
things still have handling and storage costs.
b.) For identical items, the opportunity cost still varies from one
person to the next because of differences in storage, handling, and time costs,
and differences in the 2nd best uses of the time and money. c.) Sometimes, opportunity costs - true,
full costs - are not the same for individuals and society. A decision’s impact on society will
sometimes differ from the impact on the decisionmaker. d.) The true cost of a decision is the
undesirable changes that it causes.
Making any decision changes your ability to do other things. For example, a decision to get a haircut
lowers the amount of time you have for other things; an undesirable
change. Now suppose your favorite
barber is next door to someone you had to visit anyway. You plan a haircut to coincide with the
other visit you had to make anyway. By
killing two birds with one stone, you lower the time cost of the haircut. There is less of a change in your ability to
do other things.
Lets
look at another example of the key points above. In most places, the local government charges a flat monthly fee
for periodically hauling away homeowners’ trash. A monthly flat fee means that changes in homeowner Jones’ trash
volume will not change what the government bills Jones to haul it
away. The government’s hauling and
disposal costs (point d. – the true costs, all the undesirable changes) depend
on how much trash they have to pick up, but Jones’ payment for the service (the
flat fee) stays the same. Jones’
decisions change society’s disposal costs, but except for the changed
physical effort to put the trash out for pick-up, and Jones’ tiny share of
societal costs, trash generation decisions do not change Jones’ trash
disposal costs. That's point c. in the
previous paragraph. Society's costs for
extra trash are greater than Jones’ costs.
People throw away more trash when extra trash doesn’t change
their personal disposal costs. It's the
result of 'marginal analysis'; the subject of the next section.
Tool #2: Marginal Analysis and The Economic Golden Rule
Marginal
analysis is the identification and evaluation of the changes associated
with particular decisions. It is the
second basic economic analysis tool.
People instinctively implement marginal analysis. They evaluate most of their own choices
according to what would change. Every
time you’ve thought ‘it’ (what you were thinking about) is or is
not ‘worth it’, you just completed a marginal analysis. Through a detailed examination of the
process I aim to transform your instinctive behavior into a critical thinking
skill. Economists named it marginal
analysis because most decisions impact existing conditions marginally; that is
only by a small amount.
For
every decision, the incremental (one unit at a time) changes in opportunity
costs are the likely undesirable changes in the current conditions. Economists often call them MARGINAL
COSTS. Identifying MARGINAL COSTS means
determining undesirable changes in the way things would otherwise be. It is in capital letters because you will
see and hear it a lot!!! It is
essential that you master this concept quickly. That means practice using the MARGINAL COST concept, or one of
its many equivalents, such as incremental costs, or additional costs, or extra
costs. It will be well worth the
opportunity cost (what you give up) of getting comfortable with it. Practice recognizing the MARGINAL COST
calculations that are part of most decisions you make. In rare, but important cases like the trash
disposal example, marginal social costs (MSC = all of the undesirable changes)
are greater than the marginal private costs (MPC = the undesirable changes
that impact only the decisionmaker).
Benefits
are desirable changes in a decisionmaker’s current circumstances. Economists often use the term MARGINAL
BENEFITS. Again, in rare, but important
cases like parents' chance to get their kids immunized against a contagious
disease, marginal social benefits (MSB = all of the desirable changes)
are greater than marginal private benefits (MPB = only the desirable changes
that impact the vaccine recipient). In
the immunization example, marginal social benefits exceed marginal private
benefits (MSB > MPB) because by reducing the spread of the virus, each
immunization helps people other than the vaccine user.
To
begin the process of mastering marginal analysis, return now to the trash
pick-up example. There is usually a
flat monthly trash disposal fee, so if Jones throws away more trash it will not
change what the government bills him for picking it up? Even if Jones goes on vacation for an entire
month and puts out no trash, he pays the same monthly fee. Since the fee does not depend on how much
trash Jones asks the government to haul away, the size of the fee is not
relevant to Jones’ choice of how much trash to put out for pick-up. To Jones, the only undesirable change,
or opportunity cost of additional trash, is the physical effort to take the
trash to the curb or other pick-up point; a marginal cost to Jones of nearly
zero. Jones will use trash pick-up
service as long as the desirable changes (Marginal Benefits = increased
convenience in this example) are worth more than the nearly zero marginal
private cost.
The
points of the trash pick-up example generalize. Marginal analysis tells us that decision makers pursue an option
until the next increment produces greater undesirable than desirable changes
for them; that is until marginal costs exceed marginal benefits. Common sense, right? If someone sees more good than harm in
something they will do it. Indeed,
everyone uses marginal analysis all the time, usually without even thinking
about it.
The new
terms may temporarily obscure that marginal analysis is common sense. Don’t get discouraged by that. New languages are difficult at first, and
then they become second nature. This
application of common sense is quite powerful because it has a very insightful
bottom line. For any decision, the best
amount is where the marginal benefits equal the marginal costs.
For ease
of reference throughout the book, I will call that key result of marginal
analysis the Economic Golden Rule. The best amount of anything is the amount
where the marginal benefits equal the marginal costs. That amount maximizes net benefits (total benefit minus total
cost), such as the profit earned from selling a product. Make sure you do not confuse total benefits
(TB) and marginal benefits (MB = the change in TB), and total costs (TC) and
marginal costs (MC = the change in TC).
When MB and MC differ as little as possible, TB and TC differ as much as
possible. Following the Economic Golden
Rule maximizes net benefits because it makes us keep going when net benefits
are rising, and stops us just before net benefits begin to shrink.
The
Economic Golden Rule also tells us that incentives matter. The behavior of some people and societal
outcomes will change (whether we want them to or not) anytime the MB or
MC associated with a decision change.
When the perceived MB of an activity rises, that activity
increases. When the marginal costs (MC)
of an activity appear to rise, that activity decreases. A recent, unexpected confirmation that
incentives matter came a few years after the 1986 Federal Tax Reform Act
lowered the cost of raising children.
Sure enough, economists were able to attribute part of a subsequent rise
in the birthrate to the change in the federal tax laws.
A Numerical Example to Illustrate Opportunity
Cost and Marginal Analysis
It
is very difficult to learn anything without practice. Limited examples like the haircut and trash generation decisions
are a good start, but they are not enough.
The hypothetical numbers in Table 1.1 will help you practice thinking
about opportunity costs, and marginal analysis. Farmer Smith compiled the data to decide what mix of oats and
barley to grow. The numbers indicate
Smith’s seven production possibilities (choices) when the available resources
(labor, machinery, chemicals, seeds) are used efficiently in the technical or
engineering sense (with the best farming methods).
Table 1.1: Total Production (tons/year) by Farmer Smith
Choice # 1 2
3 4 5 6
7
Oats 0 1
2 3 4 5
6
Barley
30.1 30 28 24
18 10 0
Whenever
information arrives in a table, or in the form of a graph, take the time to
interpret what the numbers say. For
example, the numbers indicate that if all available resources efficiently
produce barley, Smith will produce 30.1 tons of barley per year (Choice
#1). If Smith devotes all available
resources to oats production, Smith will produce six tons of oats per year
(Choice #7).
Which of
Jones’ seven technically efficient options is best? In other words, what is the best (smartest) allocation of resources
to oats and barley production? In this
example, as in most real-world situations, there are several technically
efficient options. One is best, or
allocatively efficient (smartest).
For
simplicity, assume that total production expenses (chemicals, machinery
depreciation, fuel, labor, seeds) are the same for each of the seven production
possibilities. In other words, assume
each of the seven choices use up all of Smith’s resources. Compare choices #1 and #2. If Smith wants to produce a ton of oats, he
can only produce 30 tons of barley. In
other words, if Smith increases oats production from zero to one ton per year,
it will only cut barley production from 30.1 to 30 tons per year. So the incremental opportunity cost, or
marginal cost, of the first ton of oats is 0.1 tons of barley. Apparently some of Smith’s land that is
reasonably well suited for oats production is not very well suited to barley
production. After all, Smith only has
to give up 0.1 tons of barley to produce one ton of oats. Notice that marginal costs or benefits result
from incremental changes, and that computations always involve
subtraction.
Is it
smart to make that change; to give up 0.1 ton of barley to gain one ton of
oats? It depends on the prices of oats
and barley. Unless the price of barley
is at least ten times the price of oats, marginal benefits (one more ton of
oats) exceed marginal costs (0.1 ton less of barley), and choice #2 is better
than choice #1.
To
practice computing marginal benefits and marginal costs in dollars, and
practice determining the best choice, let’s use the following prices:
Smith
can sell oats for $25/ton and barley sells for $12/ton.
Then the marginal cost of
changing from choice #1 to #2 is $1.20 (0.1 tons of barley times $12), and the
marginal benefit is $25 (1 ton of oats times $25). Choice #2 is clearly superior to #1. However, the Economic Golden Rule, which says that the best
amount is where marginal benefits equal marginal costs, tells us that choice #2
is probably not the best choice. With choice #2, the marginal benefits of oats
production are still far ahead of the marginal costs. Therefore, we should compare choice #2 to choice #3. The opportunity cost of the second ton of
oats is two tons of barley (30 minus 28), for a marginal cost of $24 (2
fewer tons of barley x $12/ton), and the marginal benefit is $25 (1 more ton of
oats times $25/ton). Choice #3 is just
barely better than choice #2, and according to the Economic Golden Rule,
probably the best choice. The marginal
benefit is almost exactly the same as the marginal cost. Note that there are times when the best possible
choice will not have exactly equal marginal benefits and costs. Therefore, a more precise statement of the
Economic Golden Rule is that the decisionmaker’s best amount of anything is
where the marginal benefits equal the marginal costs, or come as close as
possible with the marginal benefits being the larger number.
Increasing Opportunity Costs
To be sure that choice #3 is the best possible choice, we should compare it to choice #4. The opportunity cost of the third ton of oats is four tons of barley (28 minus 24), for a marginal cost (MC) of $48; much greater than the marginal benefit (MB) of $25. Choice #3 is the best. It is barely better than choice #2, and much better than choice #4.
How
can we be sure that choice #3 is also better than #5, #6, and #7 without
directly making the comparisons? As is
the case with our made-up numbers, real world marginal costs rise. As we pursue any activity, the incremental
opportunity costs grow for each additional unit of that activity. Once the marginal costs exceed marginal
benefits, we can generally be confident that they will continue to do so,
usually by a larger margin. For
practice, confirm that feature of the example.
The opportunity cost of the fourth ton of oats is $72 (24 tons of barley
minus 18 = 6; $12/ton x 6 = $72), $96 for the fifth ton of oats, and $120 for
the sixth ton of oats.
An
example may help you understand increasing opportunity costs. It’s Christmas, and you’ve decided to send
many of the people on your long Christmas card list a nice $5 desk calendar
along with a card. Assume that everyone
on your list will appreciate them equally.
How many calendars should you send out?
The constant $5 per calendar does not translate into a constant
opportunity cost (what you must give up to pay for them). You can buy a small number of calendars by
giving up a night out on the town, or by substituting some video rentals for
trips to the theater to see new movies; a modest sacrifice. To send out a large number of calendars, you
have to sacrifice that, plus things of even greater importance to you. As you spend more on something, what you
have to sacrifice to free up the money to do it becomes more and more
important. People typically sacrifice
the least important purchases first, and the most important things last, so
opportunity costs rise as any activity increases.
Diminishing
Incremental Benefits
The same reasoning explains why marginal benefits (MB) usually drop as any activity rises. You take care of the highest priority uses first. No matter how many calendars you buy, you will send them to the people on your list whose increased happiness means the most to you. Each additional calendar matters less to you than the preceding calendar because it is sent to a person lower on your list. That’s what decreasing MB means.
Applying Opportunity Cost and Marginal
Analysis With Graphs
This book uses many graphs, so lets practice using them right away. Production possibilities, such as the Table 1.1 data, plot into a graph like Figure 1.1. Combine Table 1.1 and the prices of $12/ton and $25/ton for barley and oats, respectively, and you get Figure 1.2; the marginal costs and benefits of oats production. The line in Figure 1.1 is called a production possibilities frontier (PPF). It is called a frontier because it defines the current limit of our production abilities. The numbers associated with any point on or below the PPF are feasible production levels.
Before you can use a graph, you must begin by practicing interpreting it. For example, point A indicates that one of the production possibilities during the upcoming year is one ton of oats and 30 tons of barley. Clearly then, it would be inefficient, but certainly possible, to produce one ton of oats and less than 30 tons of barley (point B). Every point in the area ‘inside’ (below and left) of the PPF is a feasible, but inefficient production level. Point B represents an inefficient output combination because more was possible with the available resources. Likewise, since points on the frontier indicate the production possibilities when all available resources are put to use with the best known methods (technology), the numbers associated with a point in the space ‘outside’ (above and right of the PPF) the frontier are currently infeasible production levels. For example, it is not currently possible to produce 30 tons of barley and 2 tons of oats (point C). It takes all the available resources to produce 30 tons of barley and just one ton of oats.
Four
Critical Steps
Graph
interpretation entails four critical steps.
Like we just did, always begin practicing the use of any
graph by interpreting at least two points on each line. Write out what they ‘say’. The line’s leftmost point should usually be
one of your picks. A second key part of
efforts to practice using a graph is to write down a summary of what each line,
based on its starting point (left end), shape, and slope says about the
subject of the graph. Third, make sure
the summary interpretation of every line on the graph makes sense to you. For example, the outward-bulging,
downward-sloping production possibilities frontier (PPF) says that as Smith
raises the production of either crop he will experience rising opportunity
costs, which means larger and larger declines in the production of the other
crop. Because some resources are better
suited to one crop than the other, that summary interpretation of a PPF line
does make sense. Fourth, identify the
factors that the location of the line depends on. Such factors are often simply called ‘shifters’ because when
one of them changes, the line shifts to the left or the right. The production possibility issues that
determine the location of the PPF (shift it left or right) are resource
availability and production technologies.
So, with better farming methods (better technology) or more resources
(like more tools, land, or workers), Smith’s production possibilities
improve. The PPF changes from PPF0
to PPF1 (see Figure 1.3).
The 0 and 1 subscripts denote time periods. Some output levels that were unattainable in time period 0, are
feasible in time period 1. For any
given oats production level, the efficient barley production level is greater
in time period 1 than it was during time period 0.
Opportunity
Costs and Growth
Societies
have PPFs for every combination of a particular good (like concrete) and other
goods (Figure 1.4). To produce more
concrete, resources must be diverted from the production of other goods. The rate at which society’s PPF line shifts
outward (that means up and to the right) is the economy’s growth rate. Growth means improved production
possibilities. The growth rate depends
on how fast new resources become available and the rate of technology
improvement. Business and government
investments in research and capital equipment can influence how fast production
possibilities improve.
Let’s
look at how human decisions could influence resource availability and
technology advancement. The three
basic economic resources are land, labor, and capital. Enterprise, a special type of labor,
is often listed as a fourth resource.
Enterprise is the organizational, managerial, and risk-taking skills
that are especially important to predominantly market-based economic
systems. Capital is physical
infrastructure and hardware (not money) like buildings, machines, tools, ships,
roads, bridges, and railroads. Land is
a traditional, but imprecise term for natural resources like land surface,
soil, minerals, plants, and animals.
Past biological and geological processes determined the availability of
land, and the size of the labor force.
But people decide the availability of capital, the quality of the labor
force, and the level of effort devoted to improving technologies through
research. Therefore, we can accelerate
production possibility improvement by investing in education, research, or
increased production of capital. Of
course there are opportunity costs. ‘Investment’
means to divert resources away from the production of current consumption goods
(CC) to the production of capital (K) and research. Current consumption goods are consumer goods like food and
clothing. Figure 1.5 depicts the
production possibility trade-offs between CC and K.
The Trade-Offs
Moving
time period 0’s production choice to the left along the PPF (like from
production possibility A to production possibility B in Figure 1.5) will raise
the economy’s growth rate. That means larger rightward PPF shifts over
time. The opportunity cost of the
improvement in future production possibilities and living standards is the
decline in the ability to produce goods for immediate consumption. And that reduces current living standards
(less CC). Selecting point B instead of
point A reduces the production of goods and services available for current
consumption (CC) during time period 0 by 10 units per year. Return to this part of Chapter 1 whenever
you want to refresh your grasp of opportunity cost and PPF fundamentals.
Using a Graph to Apply the
ECONOMIC GOLDEN RULE
Return
to Figure 1.2. The best amount, two
tons of oats, is at, or just to the left of where the two lines meet. Two tons of oats is the optimum, because the
2nd ton is the last ton that raises net benefits (total benefits minus total
costs). Pick a few points and interpret
them. For example, point A indicates
that changing oats output from two to three tons per year raises the
opportunity cost (= the true total cost) of oats production by $48, and point B
indicates that changing oats production from two to three tons per year raises
the total revenue earned from the oats crop by $25. Points A and B indicate that three tons of oats per year is too
many.
The MC
line shifters are factors that affect opportunity costs like prices of labor,
capital, and materials like seeds and chemicals, technology, and the prices of
alternate crops like barley. Since
Smith is just one of many oats producers, he can earn $25 for each extra ton of
oats produced. A decision by Smith to
produce more oats doesn’t change the scarcity of oats significantly. The horizontal MB line in Figure 1.2
indicates that Smith gains a constant additional $25 for each additional ton of
oats produced. The market price of oats
is the only MB shifter.
The
calendar example implied that most real world MB lines aren’t like the
horizontal line in Figure 1.2. The
highly simplified Farmer Smith example yielded the unusual result. Indeed, most of the MB lines in this text,
and the MB lines implied by real world situations, slope downward from left to
right. It means that as a good becomes
less scarce, extra units become less valuable.
For example, though some water is worth a lot, it is still usually cheap
because it is relatively abundant. Now
think about some of your favorite things!
You still eventually get tired of them.
That’s why ‘variety is the spice of life’. It means that total benefits rise at a decreasing rate. In other words, the change in total
benefits (MB) gets smaller the larger the quantity already owned. Marginal benefits can even become negative
if people begin behaving irrationally.
Many of us have experienced falling and negative MB at a party. You arrive sober and thirsty. That first drink is really appreciated; that
means the MB is high. Since the host of
the party doesn’t usually charge for drinks, the MC to guests is zero. After the first one, you’re not that thirsty
any more, so you enjoy subsequent drinks less than the first (declining MB). Soon you’re just sipping a little every now
and then to be sociable (MB near zero).
The alcohol may make you irrational enough so that you continue to drink
when you would otherwise stop. Even if
you were smart enough to have a designated driver, the nausea later that
evening, or the hangover the next morning, tells you that you had too
many. Because the alcohol impaired your
critical thinking skills, you drank until the MB of alcohol to you became
negative. Let’s move to fundamental
Tool #3.
Tool #3: Supply and Demand Analysis
What
prompts a consumer to make a purchase, and what factors affect such
decisions? Like other decisions, people
evaluate a purchase by comparing attractive changes (MB) and undesirable
changes (MC). They demand more
of a good whenever they think the MB to them tops the opportunity cost of the
purchase (MC). From a buyer's
perspective, MC is the price tag plus handling and storage requirements. For example, an 80-pound bag of concrete
costs about $3. But the MC also includes
the struggle to load and unload the heavy bags, and then mix them with
water. The final step in handling is
getting the wet concrete into the space to be filled. Between purchase and mixing, they take up storage space. For most users, the $3 purchase price is a
relatively small fraction of the opportunity cost (MC) per bag.
Demand Lines and Schedules
Lets
look at each of the factors that affect an individual consumer’s perception of
MB and MC. To do that, lets first
establish some key terms. If we note
the amount that a consumer buys at each price, we have what economists call a
demand schedule. The demand schedule
reveals the MB schedule. The numerical
example in Table 1.2 will help illustrate why that is the case. Since concrete examples are usually best,
we’ll discuss a hypothetical demand for concrete. For this simple example, assume there are 100 identical concrete
buyers. If we plot the data for the
market demand schedule (P and QD) in a graph (Figure 1.6), the
downward-sloping result is a demand line.
Figure 1.6’s five labeled points correspond to Table 1.2’s five labeled
rows. Demand lines are sometimes
curved, because for some goods it takes an astronomical price to reduce
purchases to zero (point Z in Figure 1.7).
But for the sake of simplicity, all of the book’s many, many remaining
demand lines are straight.
Table
1.2 indicates that Clark will not buy two tons of concrete per week until the
price per ton falls to $8. That means
the second ton of concrete is just barely worth (=marginal benefit) the
sacrifice of $8 plus handling and storage costs. Since each buyer behaves similarly – the last unit they buy is
just barely worth what they must pay for it - we can safely assume that the
market price is a good approximation of the good’s marginal benefit. For the sake of simplicity, I will not
mention the handling and storage costs.
We’ll hold that component of the buyer’s MC constant and just concentrate
on the effect of changes in the purchase price.
Table 1.2: Clark's Demand Schedule for
Concrete, and the Market Demand Schedule
P qD QD P =
Price of Concrete in $$/ton
A $10 0
0
B $9 1
100
$8 2
200 QD =
Total Concrete Demanded in tons per week.
$7 3
300
$6 4 400 qD = quantity
demanded just by Clark.
$5 5 500
$4 6 600
$3 7 700
C $2 8
800
F $1 9
900
G $0 10 1000
Notice
the complete absence of the word 'NEED'; a strong term that implies that, short
of astronomical, price doesn’t matter.
But price nearly always affects the total amount purchased. Except in very rare exceptions, 'NEED'
overstates the situation of buyers.
Words have meaning, and we must protect our analytical skills from mind-numbing,
thought-distorting terms. Try to avoid
saying ‘NEED’, but especially avoid thinking ‘NEED’. Truth in labeling is a critical principle in life, especially in
the study and application of economic principles. Most things are 'goods' that many consumers WANT if the price is low enough, and the lower the price the more
they WANT. When you use the word 'NEED' you imply something that is probably
not true; that everyone buys the same amount no matter what price they must
pay. If you were to represent that kind
of behavior with a line on a graph, you would have a vertical demand line; a
very rare situation. Medicine that your
life depends on is one of the rare examples of a genuine 'NEED'. Except for those kinds of situations, do not
use or think the word 'NEED'. Use words
like 'WANT', 'desire', or 'demand'
instead.
Supply Lines and Schedules
Also for the sake of simplicity, we’ll assume there
are 100 identical concrete producers.
Notice from Table 1.3 that the amount offered for sale rises as the
selling price rises, an indication of rising opportunity costs in the short-run. In other words, the cost per ton will rise
in the short- run as Portland tries to squeeze more and more output from his
existing capital stock (factory and
Table 1.3: The Market Demand Schedule, Portland’s Supply Schedule, and the
Market
Supply Schedule for Concrete.
P QD qS QS P = Price of Concrete in
$$/ton
$10 0
9 900
$9 100 8 800
$8 200 7 700 QD
= Total Concrete Demanded in tons per week.
$7 300 6 600 H
$6 400 5 500
qS = quantity supplied just by the business firm, Portland.
$5 500 4 400
$4 600 3 300
I
$3 700 2 200
QS = Total Quantity Supplied (offered for sale) by Portland
$2 800 1 100 in tons per week.
$1 900 0 0
J
$0 1000 0 0
office buildings, tools, and
machines). A firm's capital stock is
not readily changeable. But given
sufficient time to install more capital, additional output may be forthcoming
without a price increase. We'll focus
on the short-run first.
If we
graph the supply line (P on the vertical axis and QS on the
horizontal axis), we get an upward-sloping line (Figure 1.8). The three labeled points in Figure 1.8
correspond to the three labeled rows in Table 1.3 (H, I, and J).
Note
from Figure 1.8 that the amount offered for sale is zero until the price rises
above $1 per ton (point J). That means
that even the most efficient concrete firm can't produce any concrete for less
than $1.01 per ton. Nearly every market
has a minimum price for any production to occur. Nature produces most of the exceptions; things like water, blood,
and transplantable organs. For example,
nature produces water, but not as much and at the right times and places as we
want. If you run outside when it’s
raining, you get a ‘free’ drink and shower.
But we want to drink and cook more often than it rains, and we want to
bathe in private, so we build pumps, pipes, and reservoirs, and we pay a
monthly water bill. Note again that we
only ‘NEED’ a small amount of water.
Most water uses are WANTs.
To see
the link between supply schedules and the marginal cost (MC) of production,
note from Table 1.3 that Portland won’t offer five tons/week until the price
rises to $6/ton. Portland will offer
four tons/week at $5/ton, but not five tons.
Apparently, the MC or opportunity cost of the fifth ton per week was
more than $5/ton, but less than or equal to $6. Higher prices cause the amount offered for sale to rise because
producers will only produce as much as can be made for less than or equal to
the amount they will earn when it is sold.
With a price of $5/ton, it would not make sense to produce more than
four tons per week. With a market price
of $5/ton, the fifth ton per week would raise Portland's costs more than the $5
earned by selling it, and thus lower profits.
The ‘p’ symbol
will denote profit. p = total
revenue minus total cost.
Market Equilibrium
If
we combine the market demand and supply schedules (see Figure 1.9), we have a
basic market model. In the graph and
the numbers in Table 1.3, we can see that there will be a shortage or a surplus
of concrete at any price other than $5.50/ton.
For example at $6/ton, the buyers want 400 tons per week, while the
sellers are willing to sell them 500 tons per week; a surplus of 100 tons per
week. Clearly, such a situation is not
stable. The sellers will not keep
producing more than they can sell.
Sellers will compete for customers by cutting prices until the buyers
want to buy the same amount the sellers want to sell; 450 tons per week at
$5.50/ton. Since that's a stable
situation, it is typically called the 'Market Equilibrium' (point E). It’s stable because at the equilibrium
price, the buyers want to buy the same amount the sellers want to sell. At $5/ton, the buyers want 500 tons per
week, while the sellers are willing to sell them only 400 tons per week; a
shortage of 100 tons per week. Again,
such a situation is not stable. Sellers
are always eager to raise prices, and buyers hate empty shelves, so prices will
rise. The price hike raises the amount
sellers will offer. At the same time,
it will cause some potential buyers to do without, and others will switch to
substitutes. The amount available rises
and planned purchases fall until once again, the buyers want to buy the same
amount the sellers want to sell.
Reactions to surpluses and shortages push the price toward the 'Market
Equilibrium' of 450 tons per week at $5.50/ton.
Demand and Supply Shifters
Actually,
the market equilibrium is only relatively stable. Many factors affect what buyers want, and what sellers are
willing to sell, at a certain price.
Those factors are called SHIFTERS because they cause demand
and supply lines to shift in a market model like Figure 1.9. By definition, 'SHIFTERS' change the
amount that corresponds to each price.
In other words, they change, or shift, the relationship between price
and quantity. Coincidentally, there are
six possible demand shifters and six possible supply shifters. The number is smaller when the weather or
time of year does not affect use or production of a good. And not all goods have both kinds
(production and consumption) of substitutes and compliments. They may have neither. Here are the complete lists followed by an
introductory discussion of each.
A Demand Shifter is something that affects the amount that
can be sold at any given price. THE SIX DEMAND SHIFTERS are:
1.
Consumers’ Income:
Unless a good is ‘inferior’, extra income raises the amount purchased.
Even
before college students learn about inferior goods through a course, they
understand the concept intuitively better than most people. Students' extra lean budgets prompt them to
buy things they wouldn't buy if they had more money. Generic soda and fast food are inferior goods for many college
students. They’d buy less generic soda
and fast food if they had more money.
Since
inferior goods are unusual, the vast majority of goods and services are called
'normal' goods. Since pay raises reduce
the opportunity cost of each purchase, extra income usually prompts people to
buy more. On a graph, it means a
rightward demand shift for pay raises (D0®D1
in Figure 1.10), and leftward demand shift for lower income (D0®D1
in Figure 1.11).
2.
Tastes and Preferences:
this is one of the major reasons why businesses advertise.
Advertising
aims to provide information, but it also aims to change consumers' priorities.
Consumers can only buy more of
the advertised good if they divert money from other uses. Advertising isn't the only thing that
changes tastes and preferences, but changes in tastes and preferences always
'shift' demand by changing consumers' priorities.
3.
Number of Buyers
The assumption of 100 identical buyers underlies the data in Tables 1.2 and 1.3. A change in the number of buyers would proportionately impact the purchases at each price.
4. Expectations
about the future availability (including price) of a good or service.
Like tastes and preferences, expectations influence consumers' priorities. For example, if consumers hear rumors that it will become difficult to buy something, say toilet paper, stockpiling it will suddenly become a high priority. Expectations of reduced availability, including concerns that prices will be significantly higher in the future, will increase current demand. Notice that widely held expectations often become self-fulfilling prophecies. For example, some previous rushes to stockpile toilet paper have ‘wiped out’ grocery store and producer inventories.
5. The
weather or season is a factor in the use of goods and services like clothing,
umbrellas, certain foods, and particular types of vacations.
6. Characteristics
of consumption substitutes and consumption complements.
Consumption
substitutes are alternatives that satisfy similar desires. In other words, one alternative can be used
in place of the other. When one
alternative becomes less attractive (higher price for example), the demand for
the other rises. For example, when
Toyota cars get more expensive, people buy more Fords and Chevrolets.
Consumption
complements are goods that are often used together; for example, peanut butter,
bread, and jelly. When one becomes less
attractive, it also reduces the demand for the things used with it. For example, if concerns about the sugar
content of jelly make it less attractive to some consumers, the demand for
peanut butter and bread will fall.
A Supply Shifter is something that affects the amount that
producers are willing to sell at any given price. THE SIX SUPPLY SHIFTERS
are:
1.
Input prices: The
price of the resources that are used to make the good or service.
Resources
include labor, capital, and raw materials.
Since the government supplies businesses with critical inputs like
streets, courts, and police and fire protection, taxes are input prices.
If
it costs more to make something, say because of higher labor costs, it will
take a higher price to get sellers to offer the same amount as before. In other words, higher input prices shift
the Supply line to the left (S0®S1 in Figure 1.12). Note in the graph that the opportunity cost per ton (marginal
cost: MC) is $1 higher. Now it takes
$2.01/ton rather than $1.01/ton to initiate production of concrete. Before the shift, concrete makers would supply
100 tons per week at $2/ton. Because of
the input price hike, the opportunity cost of the 5th ton is $7,
rather than $6.
2.
Technology.
The
efficiency of the production methods available for making products determines
how costly they are to make. Technology
changes shift the supply line for most goods steadily rightward by improving
the efficiency of production processes.
The only exceptions are production processes altered by government
intervention. Regulations can prohibit
the use of some processes and or discourage innovation that would have led to
cost-cutting improvements.
3. Number of
Sellers.
The
assumption of 100 identical sellers underlies the data in Table 1.3. A change in the
number of sellers would
proportionately impact the availability of the good at each price.
4. Expectations
about future demand (including selling price).
Again,
widely held expectations usually become self-fulfilling prophecies, at least
for awhile. If sellers believe that
buyers will become less interested in their product, they will try to sell what
they have on hand more quickly. The
result is a rightward shift in supply (S0®S1
in Figure 1.14).
5.
The weather or season affects the production of some
goods.
Weather
is a major factor in the supply of farm products, as well as other items made
outdoors or seasonally. Bad weather
creates the same effect as higher input prices (S0®S1
in Figure 1.12).
6. Characteristics
of production substitutes and production complements.
Production
substitutes are production alternatives.
Production alternatives are different things made mostly from the same
resources. Production substitutes are
most easily understood by looking at the situation of farmers. Their land, tools, skills, and climate can
usually produce many different crops.
For example, many farmers can grow oats or barley. That was the basis for the opportunity cost
example a few pages ago. A few years
ago, the oat bran craze drove up the price of oats. Because farmers responded by growing more oats, there was a large
drop in the supply of barley (S0®S1 in Figure 1.12). Be very careful thinking about production substitutes. Production substitutes and consumption
substitutes sound similar, and you’re much more familiar with consumption
substitutes, so there is a tendency to confuse them. They are very different concepts. If oats and barley were consumption substitutes, the rise in the
price of oats would increase the demand for barley. Instead, what happened as a result of the oat bran craze was a
reduction in the supply of barley. Oats
and barley are production substitutes, NOT consumption
substitutes. Only very rarely are two
goods both production substitutes and consumption substitutes.
Some
goods have production complements.
Goods are production complements when they are automatically made
together. That is why production
complements are often called joint products or byproducts. When ranchers produce beef, manure for
fertilizer and hides that can be made into leather goods are byproducts. Beef, manure, and leather are production
complements because they are made together.
When people lose interest in eating beef they raise the price of manure
and leather goods by increasing their scarcity.
Many of
the festivals held annually in San Antonio, Texas illustrate the concept of
production complements. Many of the
food booths sell turkey drumsticks.
Farmers can’t produce turkey drumsticks without producing breasts,
thighs, and wings, so during and after each festival, I tell my wife to be on
the lookout for bargains on legless turkeys.
After all, the increased demand for turkey drumsticks (D0®D1
in Figure 1.13a) should increase the quantity supplied (Q0®Q1),
and that should increase the supply of legless turkeys (S0®S1
in Figure 1.13b). And sure enough,
inexpensive, legless turkeys began appearing in local supermarkets.
Forest
products are another example of production complements. Several products result from cutting down a
tree; bark for landscaping, resin for chemicals, and wood for construction and
furniture. A rise in the demand for any
of them raises the supply of the others (S0®S1
in Figure 1.14). Again, be very
cautious about production complements.
Consumption complements and production complements also sound very
similar, and you’re also much more used to thinking about consumption
complements. But, again, they are very
different concepts. Consumption
complements like peanut butter and jelly are used together. Production complements like beef and leather
are not used together. But beef and
leather are produced at the same time.
I can’t think of any goods that are production complements and
consumption complements.
Shifts and Price Change - the Market Mechanism
Supply and demand shifts create surpluses or shortages. Price change – a critical element of the
market mechanism – eliminates them.
Consider, for example, the forest products scenario described
above. A rise in the demand for
construction lumber increases the supply of wood byproducts (production
complements) like bark chips for landscaping (Figure 1.15). The supply shift of bark chips (S0®S1) creates a surplus (QB
minus QA) that is then eliminated by a decline in the equilibrium
price from PA to PC.
Price and quantity move in the opposite direction when supply shifts are
dominant. For example, the only way to
see a simultaneous rise in price and drop in quantity sold is if a leftward
supply shift (reduced supply) dominates shifts in demand. The supply shift in Figure 1.15
simultaneously reduces the price and increases the quantity sold.
Now let’s closely examine a specific demand increase. Price and quantity sold change in the same
direction. Both rise, or both
fall. Figure 1.16 reflects the data in
Table 1.3, and a 100 tons per week rise in demand (D1 = D0
+ 100). A 100 ton/week rise in
demand? What exactly does that
mean? It means that the total amount
consumers want to buy at any price is 100 tons/week more than before. So, at the original $5.50/ton equilibrium
price, the demand increase would mean that buyers want 550 tons/week (point B)
instead of the original equilibrium quantity of 450 tons/week (point A). Since the supply line didn't shift, the
amount available at $5.50/ton is still 450 tons/week, and a 100 ton/week
shortage exists (the difference between points A and B). Sellers must raise prices to keep from
running out before they can get more.
Sellers' inability to keep up with the demand at $5.50/ton also tells
the sellers that, at least for awhile, they can get away with higher
prices. They raise prices enough to
eliminate the shortage. Sellers quickly
respond to the market signal to raise prices, because they can still sell all
they have available, and at a higher price.
Since the price hike enhances the concrete producers' ability to compete
for the resources that it will take to make more concrete, the quantity sold rises
from A to C along the supply line.
Simultaneously, the price hike reduces the quantity demanded from B to C
along the new demand line, D1.
Through price change, shortages and surpluses self-destruct. They can survive only if the government
curbs price change. For practice, draw
a graph like Figure 1.16 without D1, and then examine the process of
adjusting to a supply increase. It will
create a surplus that is then erased by a price decrease.
In Figure 1.16, and in your
graph, note the following. The
change in the equilibrium is less than the shift. That is true whether the shift is defined in
terms of price or quantity. For
example, in Figure 1.16, the demand shift of 100 tons/week only raised the
equilibrium by 50 tons/week; from 450 to 500 tons/week. The change in the equilibrium was less than
the shift because of price change. The
price hike eliminated some of the initial surge in purchases.
If
the opportunity costs were to rise, say $1/ton, the new supply line would be a
dollar above the original supply line.
Get out your graph paper and try it.
Note that the new equilibrium price will be less than $1/ton above the
original equilibrium. The
change in the equilibrium is less than the shift because consumers will
buy less when goods cost more.
When
demand and supply shifts of comparable magnitude occur simultaneously, either
price or quantity will change little.
For example, if you observe market expansion at stable prices, you know
that supply increases match demand growth.
But, what if you observe higher prices with stable sales? It means demand is increasing while supply
is decreasing. Use your graph paper to
try the other two possibilities (D¯ with S and D¯ with S¯).
Gains from Trade
Finally,
from a basic market model, we can derive the gain from trade (GFT). It is the sum of the buyers’ gain and the
sellers’ gain from trade. The buyers'
share of the gain from trade is called the consumer surplus (CS). The sellers' share of the gain from trade is
called the producer surplus (PS). GFT =
CS + PS.
Consumer
surplus is the difference between what the buyers were willing to pay and the
market price they did pay. For example,
recall from a few pages ago, that marginal benefit (MB) is above price except
for the last unit each consumer buys. A
gain from trade results because all but the last purchase is worth more to the
purchaser than the market price they pay.
The quantity at which MB is equal to or near price determines the amount
purchased. Recall from Table 1.2 that
at a price of $9/ton, Clark would buy one ton per week. One ton is worth $9, but consumers of
concrete only have to pay the equilibrium price of $5.50/ton. Clark's first ton per week is worth
$3.50/ton more ($9 - $5.50) than Clark must pay. The next ton is worth $2.50/ton more - the $8/ton value minus the
$5.50 market price - than what Clark must pay.
Clark's total gain from trade at the $5.50 market equilibrium is $8 =
$3.50 (for ton #1) + $2.50 (for ton #2) + $1.50 (for ton #3) + 50¢ (for ton
#4). The four tons per week Clark buys
at $5.50 per ton - total spending by Clark of $22 per week (4 x $5.50) - is worth $30 ($9 for the first ton + $8
for the second ton + $7 for the third ton + $6 for the fourth ton). The $8 difference ($30 minus $22) is Clark’s
gain from trade; his share of the consumer surplus for the entire market.
Figuring the consumer surplus for the entire market is not as tedious a process as the Clark example implies. We don't have to subtract $5.50 from the value (MB) for each of the 450 tons sold each week at $5.50 per ton. We can use Figure 1.9. Since the demand line depicts the value of each amount (for example, 100 tons per week are worth $9 per ton), the area of the triangle between the demand line and the market price of $5.50 per ton (triangle AKE) provides a very good estimate of the total consumer surplus of all 100 buyers. The length of the 'base' of the triangle (line segment KE) is 450 tons per week, and the 'height' of the triangle (line segment AK) is $10 per ton minus $5.50 per ton, equals $4.50 per ton. The area of the triangle AKE is the Base times the Height, divided by two, so we multiply 450 tons per week times $4.50 per ton, divide by two - the 'tons' cancel - and get $1012.5 in gains to buyers of concrete per week.
(450 tons/week x
$4.50/ton) ÷ 2 = $1012.50/week
Concrete consumers together gain
$1012.50/week from the opportunity to buy concrete for $5.50/ton. Always take the time to interpret the final
result of calculations. Otherwise,
calculations become pointless.
The
basis of producer surplus, the sellers' share of the gains from trade, is
similar. For each seller, only the last
unit produced cost as much, or nearly as much, as it was sold for. The price of $5.50/ton is larger than
opportunity cost for every ton sold but the last one sold each week. For example, Table 1.3 indicates that
Portland would only offer one ton per week if the price were $2/ton. Since the market price is $5.50 per ton,
Portland gains $3.50 on the first ton sold.
Portland's total gain from trade at the $5.50 market equilibrium is $8 =
$3.50 ($5.50 minus $2 for ton #1) + $2.50 ($5.50 minus $3 for ton #2) + $1.50
($5.50 minus $4 for ton #3) + 50¢ ($5.50 minus $5 for ton #4). Since the Supply line indicates the combined
opportunity costs of all 100 concrete producers, the area of the triangle
(triangle BCE) between the market price of $5.50/ton and the Supply Line is a
good estimate of the combined gains from trade of all 100 concrete
producers. Just by coincidence,
Portland’s gain is the same as Clark’s gain, and the combined gain for all the
concrete producers is the same as the consumer surplus. The base of the triangle is still line
segment KE, and the height (line segment KJ) is $5.50 minus $1, equals
$4.50/ton.
(450
tons/week x $4.50/ton) ÷ 2 = $1012.50/week
The concrete producers gain
$1012.50/week from the opportunity to sell concrete for $5.50/ton.
GFT, CS,
and PS are not just additional economic concepts to understand. They are useful policy analysis tools. CS, PS, and GFT calculations allow us to
determine whether policies that benefit producers, but hurt consumers (and vice
versa), produce net benefits or net losses.
For example, a government policy that raises the price of something will
probably increase the sellers’ gain from trade, the producer surplus (PS). But the price increase will also lower the
consumer surplus (CS). If the CS drop
exceeds the PS rise, the government policy is inefficient. It reduces the GFT; the wealth generated by
a particular market. A drop in GFT is
called a deadweight loss (DWL) to society.
DWL calculations arise throughout this book.
SUMMARY
This
chapter introduced the three basic economic analysis tools - opportunity costs,
marginal analysis, and demand and supply analysis - and it demonstrated that
they are closely related.
The
scarcity of time and money forces people to make choices. The consequences of each decision (the
changes it causes) define its costs (opportunities sacrificed) and
benefits. The incremental or marginal
costs connected to production decisions determine the amount that sellers will
offer to sell for a particular price.
The incremental or marginal benefits connected to consumption decisions
determine the amount buyers will want to buy for a particular price.
Think of
this chapter like the army's basic training.
It's rough, scary, and it introduces a lot of new things. You won't master the tools introduced in
this chapter without a lot of practice.
That's what the rest of this book is for. Refer back to this chapter from time to time as you encounter the three
basic tools in new policy issue contexts.