Hahnel ABCs of Political Economy Modern Primer

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units sellers want to sell. In terms of the supply and demand graph in Figure 4.1, the micro law of supply and demand says that the market will settle at the price across from where the market supply and demand curves cross, and at the quantity bought and sold beneath where the supply and demand curves cross. This price and this quantity bought and sold are called the equilibrium price and equilibrium quantity, so another way of stating the micro law of supply and demand is: markets will settle at their equilibrium prices, and if left to the free market the quantity of any good that will be produced and consumed will be the equilibrium quantity.

The rationale for the micro law of supply and demand is as follows: Suppose the going market price, P(1), is higher than the equilibrium price, P(e). In this case if we read across from this price to find out how much buyers are willing to buy, QD(1), as compared to how much suppliers are willing to sell, QS(1), we discover from the market demand curve and market supply curve that buyers are not willing to buy all that sellers are willing to sell at this price, QD(1) < QS(1). In other words, at this price there will be excess supply in the market for the good. What can we expect sellers to do? In conditions of excess supply sellers fall into two groups: those who are happily succeeding in selling their goods at P(1) and those who cannot sell all they want and are therefore frustrated. Those who are not able to sell their goods have an incentive to lower their asking price below the going market price in order to move from the group of frustrated sellers to the group of successful sellers, thereby driving the market price down in the direction of the equilibrium price. Buyers also have an incentive to only agree to buy at a price below the going market price when they notice there is excess supply in the market since they know that there are some frustrated sellers out there who should be willing to accept less than the going market price, providing another reason why market price should start to fall in the direction of the equilibrium price.

On the other hand, suppose the going market price, P(2), is lower than the equilibrium price, P(e). If we read across from this price to find out how much buyers are willing to buy, QD(2), as compared to how much suppliers are willing to sell, QS(2), we discover from the market demand curve and market supply curve that sellers are not willing to sell all that buyers are willing to buy at this price, QS(2) < QD(2). In other words, at this price there will be excess demand in the market for the good. What can we expect buyers to do? In conditions of excess demand buyers fall into two groups: those who

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are happily able to buy all the good they want at P(2), and those who are not able to buy all they want and are therefore frustrated. Those who are not able to buy all they want have an incentive to raise their offer price above the going market price in order to move from the group of frustrated buyers to the group of successful buyers, thereby driving the market price up in the direction of the equilibrium price. Sellers also have an incentive to only agree to sell at a price above the going market price when they notice there is excess demand in the market since they know that there are some frustrated buyers who should be willing to pay more than the going market price, providing another reason why market price should rise in the direction of the equilibrium price.

So for actual market prices above the equilibrium price there are incentives for frustrated sellers to cut their asking price and buyers to offer a lower price, driving the market price down toward the equilibrium price. And as the market price drops the amount of the excess supply will decrease since the law of supply says that supply decreases as price falls and the law of demand says that demand increases as price falls. And for market prices below the equilibrium price there are incentives for frustrated buyers to raise their offer price and for sellers to raise their asking price, driving the market price up toward the equilibrium price. And as the market price rises the excess demand will decrease since the law of demand says that demand decreases as price rises, and the law of supply says that supply increases as price rises. So according to the micro law of supply and demand, the only stable price will be the equilibrium price because self-interested behavior of frustrated sellers or buyers will lead to changes in price under conditions of both excess supply and excess demand, and only at the equilibrium price is there neither excess supply nor excess demand. This particular kind of selfinterested behavior of buyers and sellers – individually rational responses to finding oneself unable to sell or buy all one wants at the going market price – can be thought of as “equilibrating forces” that economists expect to operate in markets. So the micro law of supply and demand can be thought of as a “law” explaining why there should be equilibrating forces at work in markets. We will discover below that market enthusiasts and critics disagree about how strong these “equilibrating forces” are compared to “disequilibrating forces” the micro law of supply and demand does not alert us to that sometimes operate alongside equilibrating forces.

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There are a few things worth noting at this point:

1.There are different senses in which buyers or sellers are “satisfied.” All buyers would always like to pay a lower price, and all sellers would always like to receive a higher price. So in that sense, neither buyers nor sellers are ever “satisfied” no matter what the going price. But when the market price is above the equilibrium price, while successful sellers will be pleased, there will be unsuccessful sellers who will be displeased. Moreover, there is something the non-sellers can do about their frustrations: they can offer to sell at a lower price. Similarly, when the market price is below the equilibrium price, while successful buyers will be pleased, there will be unsuccessful buyers who will be displeased. And what the non-buyers can do about their frustrations is to offer to pay a higher price.

2.It is always the case that the quantity bought will be equal to the quantity sold – whether the market is in equilibrium or not. This follows because every unit that was bought was sold and every unit that was sold was bought! But that is not the same as saying that the quantity demanders want to buy is equal to the quantity suppliers want to sell. There is only one price at which the quantity demanded will equal the quantity supplied – the equilibrium price. At all other prices there will be either excess supply or excess demand.

3.Since not all markets are always in equilibrium, how much will be bought and sold when a market is out of equilibrium? This is where the assumption of non-coercion in our definition of a market enters in: buyers cannot be forced to buy if they don’t want to and sellers can’t be forced to sell if they don’t want to. When there is excess supply the sellers would like to sell more than the buyers want to buy at the going price. So under conditions of excess supply it is the buyers who have the upper hand, in a sense, and they will determine how much is going to be bought, and therefore sold. In Figure 4.1 when market price is P(1) and there is excess supply buyers will only buy QD(1) and therefore, that is all sellers, will be able to sell. When there is excess demand the buyers would like to buy more than the sellers want to sell. So under conditions of excess demand it is the sellers who have the upper hand and will determine how much is going to be sold, and therefore bought. In Figure 4.1 when market price is P(2) and there is excess demand sellers will only sell QS(2) and therefore, that is all buyers will be able to buy.

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Elasticity of supply and demand

The law of demand just says that as price rises we expect the quantity demanded to fall. It doesn’t say whether demand will fall a lot or a little. If a 1% increase in price leads to more than a 1% fall in quantity demanded, we say that market demand is elastic. If a 1% increase in price leads to less than a 1% fall in quantity demanded, we say that market demand is inelastic. Similarly, the law of supply just says that as price rises we expect the quantity supplied to rise; it doesn’t say whether supply will rise a lot or a little. If a 1% increase in price leads to more than a 1% rise in quantity supplied, we say that market supply is elastic. If a 1% increase in price leads to less than a 1% rise in quantity supplied, we say that market supply is inelastic.

The elasticity of supply and demand allows us to predict how much the supply and demand for goods will change when their price changes. Elasticity also holds the key to how revenues of sellers will be affected by changes in supply. For example, the demand for corn is usually elastic. So when a drought hits the corn belt the price will rise and the equilibrium quantity bought and sold will fall. But the percentage fall in sales will be greater than the percentage increase in price because demand for corn is elastic. Since the revenue of corn farmers is simply equal to the market price times the quantity sold, the fact that sales drop by a greater percent than the increase in price means revenues must fall. On the other hand, the demand for oil is usually inelastic. So if war breaks out in the Middle East and a country such as Iraq, Kuwait, Iran, Libya, or Saudi Arabia is temporarily eliminated as a potential supplier the price will rise and the equilibrium quantity bought and sold will fall as before. But because demand for oil is inelastic the percentage fall in sales will be less than the percentage increase in price. In this case the revenue of oil suppliers will increase because the rise in price outweighs the drop in sales when supply decreases.

You can use your understanding of elasticity to predict whether more or less unemployment will result from minimum wage laws, and whether more or fewer shortages will result from price controls. Draw a labor market diagram with one “flat” (elastic) labor demand curve and one “steep” (inelastic) labor demand curve where both demand curves cross the labor supply curve at the same point. Where both demand curves cross the supply curve determines the equilibrium wage rate and the equilibrium level of employment. Now draw in a minimum wage above the equilibrium wage and see

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what happens to employment as buyers (employers) determine the quantity that will be bought and sold in a market with excess supply. Notice that the drop in employment is greater if the demand for labor is more elastic, and smaller if the demand for labor is more inelastic. Draw a diagram for the steel market with one “flat” or elastic supply curve and one “steep” or inelastic supply curve where both supply curves cross the demand curve for steel at the same point. Where both supply curves cross the demand curve determines the equilibrium price of steel and the equilibrium quantity of steel production. Now draw a price ceiling below the equilibrium price and see what happens to production when suppliers determine the amount that will be sold and bought in a market with excess demand. Notice that the drop in production and shortage is greater if the supply of steel is more elastic and smaller if the supply of steel is more inelastic.

The principal factors that determine the elasticity of market demand are the availability and closeness of substitutes for the good, and the organization and bargaining power of potential buyers. The principal factors that determine the elasticity of market supply are the mobility of productive factors into and out of the industry and the organization and bargaining power of potential sellers.

THE DREAM OF A BENEFICENT INVISIBLE HAND

Adam Smith noticed something strange but wonderful about free markets. He saw competitive markets as a kind of beneficent, “invisible hand” that guided “the private interests and passions of men” in the direction “which is most agreeable to the interest of the whole society.” Smith expressed this view, in perhaps the most widely quoted passage in all of economics in The Wealth of Nations published in 1776:

Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than

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Or, suppose agronomists develop a new strain of apple that can be grown with less land between trees than before. This is a technical change that reduces the amount of scarce productive resources it takes to grow apples compared to the past. An omniscient, beneficent God would have consumers buy more apples and fewer oranges now that apples are less socially costly. What will free markets do? The cost-reducing change in apple growing technology will shift the market supply curve for apples out to the right because now apple growers can cover the cost of growing more apples than before at each and every price – producing an excess supply of apples at the old equilibrium price. The micro law of supply and demand will lower apple prices until the excess supply is eliminated and we reach the new equilibrium in the apple market. And the law of demand tells us that consumers will buy more apples at the lower price. Meanwhile, over in the orange market, the fall in the price of apples leads some fruit buyers to substitute apples for oranges which shifts the demand curve for oranges back to the left indicating that fewer oranges will be demanded at each and every price of oranges now that the price of apples is lower – creating excess supply in the orange market. This will lead to a fall in the price of oranges and lower levels of orange production. Bingo! The free market will bring about an increase in apple production and consumption and a decrease in orange production and consumption when the social cost of producing apples decreases relative to the social cost of producing oranges – just what we would have wanted to happen.

We can combine Figure 2.2: The Efficiency Criterion (p. 33) and Figure 4.1: Supply and Demand (p. 73) to see what Smith’s conclusion that markets harness individually rational behavior to yield socially rational outcomes amounts to. According to the micro law of supply and demand, the market outcome will be the equilibrium outcome, and the number of apples produced and consumed can be found directly below where the market supply curve crosses the market demand curve. According to the efficiency criterion the optimal number of apples to produce and consume can be found directly below where the marginal social cost curve crosses the marginal social benefit curve. So the market outcome will yield the socially efficient outcome if and only if the market supply curve coincides with the MSC curve and the market demand curve coincides with the MSB curve. Another way to put it is that if and only if market supply closely approximates marginal social cost and

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market demand closely approximates marginal social benefits will free market outcomes be socially efficient outcomes.

But do market supply and demand reasonably express marginal social costs and benefits? That is one way to see the debate between those who see market allocations as being guided by an invisible hand versus those who see them as being misguided by an invisible foot. If market supply and demand closely approximate true marginal social costs and benefits then the individually rational behavior of buyers and sellers and the workings of the micro law of supply and demand would be working in the social interest because they would be driving production and consumption of goods and services toward socially efficient levels. Moreover, whenever conditions changed social costs or benefits these equilibrating forces would move us to the new socially efficient outcome. In other words, markets would yield efficient allocations of scarce productive resources. On the other hand, if there are significant discrepancies between market supply and marginal social costs and/or market demand and marginal social benefits, individually rational behavior of buyers and sellers and the micro law of supply and demand work against the social interest by driving us to produce too little of some goods and too much of others. In other words, by relying on market forces we would consistently get inefficient allocations of productive resources.

Mainstream and political economists agree on one part of the answer before parting company. They agree that what market supply captures and represents are the costs born by the actual sellers of goods and services; and what market demand represents are the benefits enjoyed by the actual buyers of goods and services. We call these “private costs” and “private benefits.” A rational buyer will keep buying a good as long as the private benefit to her of an additional unit is at least as great as the price she must pay for it. In other words, her marginal private benefit curve is her individual demand curve. Since the market demand curve is simply the summation of all individual demand curves, the market demand curve is simply the sum of all marginal private benefit curves. A rational seller will keep selling as long as the cost to her of producing another unit of output is no greater than the price she will get from selling it. In other words, her marginal private cost curve is her individual supply curve. Since market supply is simply the summation of all individual supply curves, the market supply curve is simply the sum of all marginal private cost curves. So the question becomes: When do private costs and benefits differ from social costs and benefits?

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In fairness to Adam Smith, the distinction between private and social costs and benefits was not clear in his lifetime. Smith, and “classical economists” who lived and wrote after him as well, conflated social and private costs and benefits and never asked if anyone other than the seller bore part of the cost of increased production, or anyone other than the buyer enjoyed part of the benefit of increased consumption of different kinds of goods and services. The modern terminology for differences between social and private costs of production is “a production externality.” And the name for the difference between social and private benefits from consumption is “a consumption externality.” These “external effects” can be negative if someone other than the seller suffers a cost associated with production so social costs exceed private costs, or if someone other than the buyer is adversely affected by the buyer’s consumption so private benefits exceed social benefits. Or external effects can be positive if the private costs of production exceed the social costs or social benefits of consumption exceed private benefits. Adam Smith’s vision of the market as a mechanism that successfully harnesses individual desires to the social purpose of using scarce productive resources efficiently hinges on the assumption that external effects are insignificant. And, indeed, this is precisely the un-emphasized assumption that lies behind the mainstream conclusion that markets are remarkable efficiency machines that require little social effort on our part. In fact, the mainstream view today is a strident echo of Adam Smith’s conclusion that the only “effort” required is the “effort” to resist the temptation to tamper with the free market place and simply: “laissez faire.”

THE NIGHTMARE OF A MALEVOLENT INVISIBLE FOOT

Mainstream economic theory teaches that the problem with externalities is that the buyer or seller has no incentive to take the external cost or benefit for others into account when deciding how much of something to supply or demand. And Mainstream theory teaches that the “problem” with public goods is that nobody can be excluded from benefitting from a public good once anyone buys it, and therefore everyone has an incentive to “ride for free” on the purchases of others rather than revealing their true willingness to pay for public goods by purchasing them in the market place. In other words, mainstream economics concedes that the laws of the market place will lead to inefficient allocations of scarce productive

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resources when public goods and externalities come into play because important benefits or costs go unaccounted for in the market decision making process. If anyone cares to listen, standard economic theory predicts that market forces will lead us to produce too much of goods whose production and/or consumption entail negative externalities, too little of goods whose production and/or consumption entail positive externalities, and much too little, if any, public goods. We can see the problem of negative externalities by looking at the automobile industry, and the problem of public goods by considering pollution reduction.

Externalities: the auto industry

The micro law of supply and demand tells us how many cars will be produced and consumed if we leave the decision to the free market. The price of cars will adjust until there is neither excess supply nor excess demand at which point the “equilibrium” number of cars will be produced and consumed. The question is whether or not this is more, less, or the same number of cars that is socially efficient, or optimal to produce and consume. As we saw, the socially efficient level of auto production and consumption is where the MSB curve crosses the MSC curve. If the market supply curve for cars coincides with the MSC curve for cars, and if the market demand curve for cars coincides with the MSB curve for cars, the market outcome will be the efficient outcome. Otherwise, it will not.

Let us assume that the market supply curve for cars does a reasonably good job of approximating the marginal private costs the makers and sellers of cars incur. That is, we will assume that if car manufacturers can get a price for a car that is something above what it costs them to make it, they will produce and sell the car. In this case the market supply curve, S, closely approximates the marginal private cost (MPC) curve for making cars: S = MPC. But if there are costs to external parties above and beyond the costs of inputs car makers must pay for, there is no reason to expect the car makers to take them into account. So if the corporations making cars in Detroit also pollute the air in ways that cause acid rain, the costs that take the form of lost benefits to those who own, use, or enjoy forests and lakes in Eastern Canada and the United States will not be taken into account by those who make the decisions about how many cars to produce. Nevertheless, along with the cost of steel, rubber and labor needed to make a car – which are costs borne by car manufacturers

– the costs of acid rain are part of the social costs of making cars even