Hill – Mankiw 9th Edn Chapter 4: The Market Forces of Supply and Demand
Mankiw, N. G. (2021) Principles of macroeconomics (9th ed.)
Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
Chapter 4 – The Market Forces of Supply and Demand
Here are some things to consider when reading this chapter.
- Market models, time, and fairness
(a) Demand, supply, and time
This model consists of a demand and a supply curve, describing the quantities demanded and supplied over some (often unspecified) length of time at all possible market prices, all else constant. Mankiw typically labels the horizontal axis with a quantity (e.g., Quantity of Labouré) not a quantity per unit of time (e.g., Hours of work per week). The vague treatment of time here holds for other models of markets as well.
What is the appropriate period of time for the analysis? If demand or supply fluctuates in some predictable way during the day or during the week or seasonally, should the analysis take that into account or not? How frequently do or should prices change in response to changes in demand and supply? These questions are rarely addressed.
(ii) Fairness and changing prices as demand and supply change
In some markets predictable variations in demand are accompanied by socially accepted variations in price (e.g., airline and vacation package prices during holiday periods), while in others price changes are not socially acceptable. In 1999, the CEO of Coke got the idea of raising the price of Coke in vending machines on hot days when demand would be higher and selling it more cheaply on cooler days. Coke had to retreat in humiliation in the face of consumer anger (Leonhardt 1999).
Mankiw’s case study “Price Increases after Disasters” asks: should businesses raise prices during temporary shortages following natural disasters? The evidence he presents suggests that his ‘Economic Experts Panel’ thinks that it’s okay if businesses charge “unconscionably excessive” prices during “a severe weather event emergency” (p. 81). Behavioural economist Richard Thaler calls this theory-induced blindness, the result of believing that businesses should behave in the simplistic profit maximizing way that economic theory assumes they do (2015, p. 128). This should serve as a warning to students that they shouldn’t confuse the assumptions textbook theory makes about people’s behaviour with prescriptions about how people should behave. Fortunately, established businesses do not suffer from this blindness and don’t raise prices during natural disasters; some even lower them, investing in reputation and future profits (Mohammed 2017).
.2. The characteristics of perfectly competitive markets
Mankiw describes two characteristics required for perfectly competitive markets: (1) all sellers sell identical products and (2) there are so many buyers and sellers that no one has any influence over the market price – everyone is a price taker (p. 62).
He doesn’t mention a third characteristic: both buyers and sellers must have perfect information about all relevant aspects of the market. Only then can there be a single market price: all sellers must charge the same price because buyers have perfect information about selling prices and always buy at the lowest price. Texts like Mankiw’s that don’t mention the requirement of perfect information widen the apparent applicability of the perfectly competitive model to real world markets.
What if information is not quite perfect? Does that have a negligible effect on the predictions of model? The answer is important in determining the domain of applicability of this model, as discussed in the Commentary for Chapter 2.
As Joseph Stiglitz explained in his 2001 Nobel Memorial Prize lecture, even an “epsilon” [i.e. arbitrarily small] cost to a potential buyer to find out another seller’s price has a large effect:
Then any firm which charged half an epsilon more would lose no customers and thus would choose to increase its price. Similarly, it would pay all other firms to increase their prices. But at the higher price, it would again pay each to increase price, and so on until the price charged at every firm is the monopoly price, even though search costs are small. (Stiglitz 2002, p. 477).
The conclusion? The perfectly competitive model only applies to a situation of perfect and therefore costless information. As part 4 below also notes, this effectively means that sellers must be in exactly the same place if search costs are zero.
- Are there any actual markets that are perfectly competitive?
Mankiw says that there are, giving an example: “There are some markets in which the assumption of perfect competition applies perfectly. In the wheat market, for example, there are thousands of farmers who sell wheat and millions of consumers who use wheat and wheat products. Because no single buyer or seller can influence the price of wheat, each takes the market price as given” (p. 62).
But this is an incorrect description of the wheat market. Farmers do not sell wheat directly to consumers. They sell their wheat to firms that mill the grain and produce flour. What does that market look like? A study by two American economists concluded that three large companies have a dominating presence in the US industry. Instead of being price takers, the milling firms set prices on a take it or leave it basis for farmers (Goodhue and Russo, 2012).
This kind of market, where a few buyers have a lot of power over the price, is called an oligopsony and is not discussed in any standard principles text. Yet it’s common in agricultural markets, particularly where distance is important. For example, cattle, hogs, and chickens cannot be transported long distances for slaughter, giving slaughterhouses and processing plants considerable power over producers. In general, oligopsony is relevant in any markets with a few large buyers and many sellers.
In fact, as some texts acknowledge, there are very few, if any, markets which meet the requirements of perfect competition.
- Is the assumption of perfect competition a reasonable approximation to analyse markets that have different characteristics?
Mankiw clearly thinks so. The central example in this chapter starts by describing a market for ice cream cones in a town. “The sellers of ice cream are in different locations and offer somewhat different products… Each seller posts a price for an ice-cream cone, and each buyer decides how many cones to buy at each store.” (p. 61).
This is a good example of a more realistic market structure called monopolistic competition, which is introduced in Chapter 16. Yet Mankiw transforms this into a story of perfect competition in which each seller must charge a ‘market price’. This can only happen if all ice cream sellers are selling identical ice cream cones at exactly the same location. Recall Stiglitz’s explanation about the costs of searching out another seller. If the distance between sellers is zero, it costs nothing to see what price another seller is asking.
Mankiw assumes that the ice cream cone market, which lacks the characteristics of a perfectly competitive market, can be analysed as if it is perfectly competitive. It’s true that for certain simple questions the perfectly competitive model gives the same predictions as other models of markets that will be introduced later in the book. For example, the model predicts that prices increase if producers’ costs increase. If demand decreases, less will be sold. But all market models make the same predictions, so this gives the perfectly competitive model no particular primacy. Nor is the model simpler than, for example the model of a monopoly, introduced in Chapter 15.
The perfectly competitive model cannot address more interesting questions such as ‘What price should a particular ice cream seller charge?’ or ‘Where is the most profitable location to establish a new ice cream shop?’. There is no escaping the need to have a variety of different models of markets and to choose the most appropriate one in any given situation. There are no one-size-fits-all models in economics.
- What happens if the market is not in equilibrium?
Market equilibrium means that the plans of the buyers and sellers are realized during the period of time in question. If their plans aren’t realized, then there is a disequilibrium; one or both sides of the market have an incentive to change their behaviour.
How does the market reach equilibrium? Mankiw explains that the actions of the buyers and sellers “naturally move markets toward the equilibrium”. If the current price is above the equilibrium price, ice cream sellers “respond to the surplus by cutting their prices” (p. 74), moving the market towards equilibrium. Sellers are said to raise prices if there is a shortage, again moving the price towards its equilibrium level.
But how can they do this do this if no one has any influence over the market price and every seller is a price taker, as emphasized earlier? Now the story has changed, and sellers have become price makers, at least until equilibrium is restored.
The answer to this apparent paradox is that the theory has no adequate explanation of what happens in disequilibrium. Perfect competition prevails only in equilibrium.
When this theory of a market economy was developed in the 19th century by French economist Léon Walras, an ‘auctioneer’ was imagined, calling out prices, comparing demand and supply in each market, and revising the prices until equilibrium in all markets was reached. Only then could trades take place.
If buying and selling occurs in disequilibrium (as is apparently the case in the textbook story), buyers will have spent some of their budget. This would leave them unable to buy what they otherwise would have bought at what would have been the new equilibrium price. The model would have no unique equilibrium.
Mankiw’s explanation, found in all standard textbooks, is a superficially plausible story of price adjustment to make the theory seem realistic and more applicable to actual markets.
An alternative account of how the market reaches equilibrium was set out in 1890 in Alfred Marshall’s influential text, Principles of Economics. In Marshall’s story, producers adjust the quantity they supply in response to the perceived profitability of doing so. For example, if there is a shortage in the market, suppliers realize that there are potential buyers willing to pay a higher price than the suppliers require to produce their product. (This is seen in the vertical gap between the demand and supply curves at the current quantity supplied.) As a result, they expand production, moving up the supply curve. The market price increases until the shortage is eliminated. There is then no gap between what the last buyer is willing to pay and the price that suppliers need to produce the last unit of the good or service. Perhaps for ease of exposition, the texts have chosen to tell the price adjustment story instead of the quantity adjustment story, although one is no better than the other.
- The supply and demand model of perfect competition is treated as a generic model that can be used as a typical market in a market economy
Mankiw begins the chapter by writing: “Supply and demand are the forces that make market economies work. They determine the quantity of each good produced and the price at which it is sold. If you want to know how any event or policy will affect the economy, you must think first about how it will affect supply and demand. This chapter … shows how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources” (p. 61, my emphasis).
The chapter concludes on the same note: “Our discussion has centered on the market for ice cream, but the lessons learned here apply to most other markets as well… Because supply and demand are such pervasive economic phenomena, the model of supply and demand is a powerful tool for analysis. We use this model repeatedly in the following chapters” (p. 80, my emphasis).
Two things are worth noting. First, it only becomes apparent in Chapters 15 that the supply curve only exists in a perfectly competitive market where sellers are price takers, not price makers as in every other model of a market. If virtually all real-world markets have sellers who set prices, then ‘supply and demand’ do not determine the prices or quantities of anything.
Second, the analysis of public policy that follows uses only the supply and demand model. It will be important to consider whether any other models of the market would lead to different conclusions. Then, in line with the methodology set out in Chapter 2, we could ask which model is more consistent with the evidence.
Goodhue, R., and C. Russo (2012) ‘Modeling processor market power and the incidence of agricultural policy: A nonparametric approach’, in G. Zivin, S. Joshua and J. Perloff (eds), The Intended and Unintended Effects of US Agricultural and Biotechnology Policies, University of Chicago Press, pp. 51–81.
Leonhardt, D. (2005) ‘Why variable pricing fails at the vending machine’, New York Times, 27 June.
Mohammed, Rafi (2017) ‘Why Businesses Should Lower Prices During Natural Disasters’, Harvard Business Review, September 11.
Stiglitz, Joseph E. (2002) ‘Information and the change in the paradigm in economics’, American Economic Review, 92(3): 460–501.
Thaler, Richard (2015) Misbehaving: The Making of Behavioral Economics, W. W. Norton.
Stuart Birks, “Supply and demand models – the impact of framing”, real-world economics review 67.