Economic Analysis for Policy Makers Paul R. Gregory Professor of Economics University of Houston December 1998
Part I: Supply and Demand Analysis for Policy Makers
The oldest joke about economics is that you can make a parrot a good economist simply by training it to say “supply and demand.” Indeed economists do use supply and demand as their basic tools, but we use them in powerful and subtle ways to analyze a wide variety of policy problems.
The Law of Demand
Economists have relatively few economic “laws” (maybe three to four), but the most powerful economic law is the “law of demand.” It is a “law” because it works in the real world under almost all circumstances. The law of demand says that more physical units of a particular good or service will be demanded (bought) by consumers at a lower price than at a higher price, all other things remaining the same. Why this is true is easy to understand. If the price rises, and everything else remains the same, this good has become more expensive relative to other goods, and consumers will buy less. No one is obligated to buy anything and all goods have substitutes. The law of demand is illustrated by the demand curve which shows what physical quantities the participants in the market are prepared to buy at different prices, all other things remaining the same:
Price q
Demand
q
q’
The demand curve (solid line) shows that consumers are prepared to buy more at low prices than at higher prices. There are limits. At some point
the price becomes so high that no one wishes to buy anything. Also when the price is zero (it is given away) people usually don’t want an infinite amount. Consider what happens when there is a finite amount of production (denoted by the vertical line). Not everyone who wants it (q’ versus q) can get it; so there must be a “rationing” system. Consider the options: a) the government could decide who gets what, or b) it could be rationed by willingness to pay. The major advantage of the ability-to-pay system is that only those people who place a high value will get the good. DISCUSSION QUESTIONS: 1. Commercial space along Kreschatik Avenue is limited; what is best way to allocate it? 2. What would happen if licenses for Kyiv cellular telephone franchises were awarded by free lottery tickets? 3. How about a monopoly? Let us assume that the monopolist (the sole supplier of a good which has few substitutes) produce at absolutely no cost (Ukraine owns a natural gas pipeline to Europe that has very low operating and maintenance costs). What price would the monopolist charge if its demand curve were as follows? Price Quantity Demanded 10 30 20 20 30 15 40 10 50 5 60 1 4. How would these numbers change if two alternate gas pipelines to Europe were opened through another country? What does this tell you about monopoly pricing?
EQUILIBRIUM
There is no “law of supply,” but most businesses will want to sell more of its product at a higher price than at a lower price because the higher price makes its production a better choice than other products it can produce (cars
versus trucks). Therefore the supply curve has a positive slope; producers want to sell more the higher the price. When we combine supply and demand curves, we get:
Price P’’
high transaction costs
low transaction costs p p’
q’’
q
q’ quantity
Look first at the solid lines; they show the demand and supply curves together. Using only the solid curves, try to answer the following questions: QUESTIONS: 1. What would be the result if the government decided that because people “need” this product (say it is children’s food) the price should be no higher than p’? 2. Let’s say that it costs producers p to produce one unit of children’s food. Who should pay the difference? 3. If the price were set at p’, do you see an opportunity to make a speculative profit? Do you see an opportunity for official corruption? 4. If the government decree that set the price at p’ were withdrawn, what would happen? 5. What would producers do, if the price were for some reason to rise to p’’? Do you think they could hold the price at p’’? Your answers illustrate two concepts: disequilibrium pricing and equilibrium (or market) pricing. If there is no government intervention and a number of other conditions are met (discussed below), the price should settle at p – the only price at which the quantity demanded equaled the quantity supplied. No government direction is required; this will happen by itself. This is called an equilibrium because there is no
reason (as long as these conditions prevail) for anyone to change their decisions. All who want to buy can buy and all who want to sell can sell. This is what Adam Smith called the invisible hand. THE BALANCE MENTALITY: WHY UKRAINIANS DON’T BELIEVE THE MARKET WILL WORK? Why don’t Ukrainian citizens and policy makers trust the market? The invisible hand states that we don’t have to worry about whether there will be “enough” to go around. Buyers pursue their own interest in the market place; sellers just want to make a profit. They come together in the market place, and all who want to buy can; all who want to sell can sell. That this invisible hand works can be seen in the fact that once market reforms began in Ukraine and most prices were freed, queues for products disappeared. Now, if you want to buy something as a consumer and have the money you can. Earlier this was not the case. On the other hand, most policy makers and citizens fear that if things are left to the market, there will not be a balance of supply and demand. In winter, there won’t be enough fuel! There won’t be enough grain! In advanced industrialized countries, we don’t worry about these things because we have had centuries of experience knowing that markets take care of us. Looking back at the equilibrium price and quantity (p and q), we must recognize the INSTITUTIONS that make this system work. The buyer must know that the seller will indeed deliver the quantity purchased as promised; the seller must know that the buyer will pay; if the purchase is large financial institutions such as banks may have to provide credit to the buyer. Buyers and sellers have done business together for a long time and know that they can trust each other. Taxes on transactions are not prohibitive. No buyer or seller has to make a payment to a mafia organization. There must be an organized market in which buyers and sellers can come together in a free manner. If the buyer or seller violate the contract, there must be a legal system for reliable contract enforcement. Do these conditions exist in the Ukraine? In retail markets, where transactions are in cash, start up costs are not high, goods are delivered immediately, and so on, most of these conditions are met approximately. In wholesale markets, however, things become more complicated. Sellers do not know if the buyer will pay. Buyers do not know if the seller will honor the terms of the contract. Buyers and sellers do not know each others reputations. Commercial credit is not available from financial
institutions. National and local governments may impose complex taxes on transactions or withdraw licenses at will. Also, in advanced market economies, we can safely assume that most businesses will have as their goal profit maximization – not maintaining their staff of labor or receiving government subsidies. The above diagram shows the effects of all these obstacles, which are called generally transaction costs. These extra costs of arranging transactions raise the cost of doing business. With the extra transaction costs, business now are willing to supply less at each price – the dotted line. This causes the price to rise to p’’ and often these transaction costs are collected in the form of commissions or fees; so that a third party now receives a portion of the price. QUESTIONS: 1. Can you identify transaction costs associated with doing business in the Ukraine? Do you think they are high? 2. What happens to the market if transaction costs are so high that the dotted line intersects the vertical axis above p’’? 3. In Ukrainian stock markets and stock markets elsewhere, there are two prices – a bid and ask price. Explain why there is a different price for buyers and sellers. WHY A MARKET ECONOMY ALWAYS CHANGES The equilibrium price does not change as long as the supply and demand curves do not change. In the real world of market economies, supply and demand change constantly. Demand curves will shift (an increase is a shift to the right, a decrease is a shift to the left) when: 1. consumer tastes change 2. purchasing power changes 3. prices of related products change 4. the number of buyers increases or decreases The supply curve shifts whenever: 1. technology changes 2. input prices change 3. prices of related products change 4. the number of sellers changes The next figure shows what happens when two things happen: consumers increase their preferences for the good on the left and technology deteriorates for the product on the right.
P’ P
P’ P
q
q’
q’
q
QUESTIONS: 1. What happens to the distribution of the labor force? 2. What happens to relative prices? 3. What would happen to relative prices and the distribution of the labor force if demand for the product on the right decreased (instead of a deterioration of technology)? RELEVANCE FOR UKRAINE Look at the following table of the distribution of the U.S. labor force in 1960 and 1998:
agric govt Industry trans trade mining Services 1960 9.5 13.7 33.6 6.8 18.9 1.2 16.3 1998 2.9 16.4 19.6 5 23.1 0.5 32.5
As a consequence of transition, the Ukrainian economy has been subject to enormous shifts in supply and demand. There however has been a desire to preserve jobs in the same branches of the economy as under Soviet times. This has been done by subsidies and the underutilization of labor in traditional jobs. The lesson of market economies is that the economy will decline if it does not constantly change. Let us look at the results for the Ukraine over the period 1991 to 1998. For an economy undergoing such dramatic change, the change in the distribution of the labor force is relatively minor. This suggests that there has been resistance to changes in supply and demand that have occurred during this period of time.
agric industry constr transport trade services
1992 21 31 8 7 7 26
1997 25 25 6 6 6 32
APPLICATIONS OF SUPPLY AND DEMAND 1. SUCCESSFUL SPECULATION IS GOOD FOR THE ECONOMY! Successful speculators buy low in one market and sell high in another, or they buy low at one time and sell high at another time. Speculators are the risk takers in an economy. We are speaking about speculators that do not make their profits on the basis of influence, licenses, or privileges, but make their profits by “outsmarting” the market. The following diagram shows what would happen to prices and quantities of wheat in two years, where year 1 is a good harvest and year 2 is a bad harvest. The solid supply and demand curves show what prices and quantities would have been without speculation. On the basis of these curves, try to answer the following questions: 1. What “bet” should speculators make in year 1? 2. How do they affect the supply curves in both periods? What exactly have they done? 3. Would you conclude that speculators have helped or hurt the economy?
Year 1 year 2
2. CURRENCY DEVALUATION EFFECTS ON DOMESTIC PRICES The Ukrainian currency recently depreciated and may continue to depreciate. The next diagram explains the effect on prices of imported goods of a currency devaluation. To understand the diagram, you must realize that depreciation raises the cost to the importer by the amount of the currency devaluation. The supplier is therefore no longer willing to supply the same amount as before. The supply curve shifts to the left (along the dotted line). If the currency depreciates by 20%, the supply curve shifts up by 20%. The analysis shows that the importer cannot pass all of the cost increase along to the consumer. How much he can pass on depends on the consumer’s reaction to price increases. The diagram uses two types of demand curves. On the basis of these two curves, answer the following questions: 1. What does the slope of each demand curve tell you about the way consumers react to higher prices? In which case do domestic prices of imported goods rise more? Why? 2. What effect should the currency depreciation have on the prices of domestically produced consumer goods? 3. If instead of a currency devaluation, the state placed a 20% sales tax on the product (either imported or domestic) what would be the effect on prices?
P’’ P’ P