From the Lectern: Week 2

This week we introduced the primary tool economists use for developing intuitions about markets: supply and demand. Although there is a lot more to understanding markets than just supply and demand, economic intuitions will pretty much always start by what we can get from competitive markets. In fact, the first two-thirds of the course revolve around thoroughly understanding all their implications, with the last third focused on what happens when markets fall short of perfect competition.

To facilitate our study, it's usually easier to have a specific market in mind as a source of  examples. I thought I'd pick a memorable one, so this week we talked about the market for Pet Care Rapture Insurance. Although Wikipedia can explain the rapture more fully than I intend to do here, many evangelical Christians believe that the rapture is a coming event in which Christians will suddenly disappear from the earth because they have been taken up in anticipation of the return of Jesus to the earth. Now, for some Christians who believe this but are also animal lovers, this leaves in question how their pets will be cared for when they are no longer present. The insurance, which is offered by non-Christians, says that in the event of the rapture, the insurance agency will pay to have an agent go to your home and care for your animals. A couple of firms in the market are Eternal Earthbound Pets and Jesus Pets.

With that information as background, lets consider the market for this insurance itself. There are two groups of people interacting in this (and any other) market, the buyers and the sellers. In order to describe the behavior in the market, we need to describe these two groups. Let's look at buyers first.

What might influence the amount of pet care rapture insurance people want to buy? Well, first and foremost is going to be the price of the insurance. If it means giving up twice the cost of your house, it seems unlikely even the most pet-loving person in the world is going to buy it. If it's only a few dollars up front, it might be attractive to anyone who owns pets and believes there's even the slightest chance of the rapture happening. For $20 total up front, why not hedge your bets? We can see this relationship graphically in the demand curve.



In order to make sure what we are looking at is just the relationship between price and quantity, we have to impose the condition 'everything else held constant,' or ceteris paribus if you want to impress your friends with some Latin. If anything that might affect this relationship changes, we have to draw a new demand curve by shifting the curve either to the left or to the right.

Other things that could shift a demand curve fall into four broad categories: (1) other prices, such as the price of a substitute good like extra pampering for your pets now or the price of a complement good (perhaps buyers of rapture insurance also buy services that will email friends to help them understand what just happened); (2) income; (3) expectations about what will happen to prices or incomes in the future; and (4) individual preferences and tastes (if people who believe in the rapture start to like pets more, they'll probably buy more insurance). The number of buyers also affects the market demand curve, since market demand is just adding up all the quantities individuals are willing and able to buy at each price.

Notice that a couple things you might expect to change the relationship between price and quantity demanded are not on the list.  Availability (or supply) isn't on there; you can pretty much always get a product you want (assuming it exists) if you're willing to pay enough for it, so availability changes the price itself, rather than the relationship between price and quantity. Need also isn't on there. Do people need pet care rapture insurance? We might be inclined to say no, but do we really get to start telling people what is and isn't needful for them? Do you want a bunch of economics students telling you what you do or don't need? Does the market even care what you need? Yeah. That's what I thought.

On the other side of the market we have sellers. So what affects seller behavior? You guessed it, the price, which gives us (ceteris paribus) the supply curve. Generally, the more money per item sellers can make, the more they'll want to put the time and effort into producing and selling their wares.

So what are we holding constant with the supply curve? Again there are a couple of categories: (1) related prices, such as the prices of other goods sold by the same firm (If the same employees can take care of post-rapture pets and post-rapture houses, a higher price for the latter will make the firm want to provide more of the former; if they have to pick one, the opposite will occur) and firms' expectations about future prices; and (2) things that affect the costs of production, which may either be prices of inputs (how much do we have to pay employees to take care of pets in a post-rapture world) or technology (how many people do we need to cover a certain area? Fewer people means lower costs, regardless of what we pay per person). Again, the number of sellers also matters to the market, although not to the individual firms.

What doesn't make it to the list? Demand. You can sell whatever you want if it's cheap enough, so demand affects the price, but not the relationship between price and quantity.

So what happens when these two sides of the market come together? Suppose sellers quote a high price and are willing to provide a lot of policies at that price. However, buyers don't want to buy that many policies at a high price. So the sellers will find that some of them can't sell as much as they are willing to at this price. For goods, this usually takes the form of a growing inventory of the good, or a surplus of the good. Sellers have an incentive, then, to lower their prices and steal customers away from those who would be selling at a high price. Sellers essentially bid the price down. If sellers quote a low price, though, they won't want to sell many policies, and some buyers will instead be willing to buy more than they can at this price; we usually call this a shortage. Buyers then have an incentive to offer more so that sellers will insure them, and they bid the price up. This bidding up and down only stops when nobody involved has any incentive to do things differently: at this point we say the market is in equilibrium (or, alternatively, that the markets 'clear,' so there are no lasting surpluses or shortages). If either supply or demand (or sometimes both!) shift, then we will have a new equilibrium to go with the new curves.

With the supply and demand graph, we can see what will happen to prices and quantities exchanged whenever some incentive changes the behavior of those in the market. In the graph above, dog treats (substitute) got really expensive, leading more people to buy the insurance instead. Amazingly enough, the price went up.

Why do we care so much what happens to prices and quantities? First of all, gains from trade. Notice that demand curves tell us not only how much people will buy at any price, but for any particular unit sold, it tells us how much the buyer would pay to get it. Willingness-to-pay essentially tells us how much a buyer values the good in terms of other things they could do with the money. Most buyers don't have to pay as much as they would be willing to, meaning there's surplus value that they get to keep. Similarly, the supply curve represents the opportunity cost of producing and selling each extra unit, but most units produced bring in more extra revenue (the price) than it took to make them. Firms then get surplus value that they get to keep, too. This consumer surplus and producer surplus represent the total gains from trade, or total surplus. We can even see the consumer and producer surplus, and thus the gains from trade, on the graph. It's the area below the demand curve (the benefit of the product) and above the supply curve (the opportunity cost of the product) for all units that get exchanged in the market.

In the context of the market, bidding the price up or down until it reaches equilibrium guarantees some very good things when it comes to gains from trade. First and foremost, market price guarantees that buyers and sellers will exchange every unit (in our example, every policy) that creates gains from trade, because every unit where the demand curve is above the supply curve gets produced and sold. Even better, the market price guarantees that no wasted trades take place, since none of the units where the opportunity cost (supply curve) is above the benefits (demand curve) gets produced.

Prices also contain valuable information for people thinking about getting into this market. Market prices can tell firms whether they should provide pet care rapture insurance policies (if your costs are lower than the price, sell it), and they can tell buyers whether they should use some of their limited wealth on this product or save it for something else (if you're willing to pay more than the price, buy it). In this way, the firms that produce the good are those with the lowest costs, and the buyers that get the goods are those who value the good the most (relative to other things you can buy, anyway).

In economics, when all these things happen we say that a market is efficient. Efficiency is good, because it gets us all the gains from trade we can get, and frees up as many resources as possible to do other, more useful things like create gains from trade elsewhere. One of the best -- and most important -- features of competitive markets is that, as long as the government keeps its fingers out of things, the market will and must be efficient. Hurray!

"I'm so glad there are markets!"