AM02 S&D Models

AM02: Supply & Demand Model   [supplementary materials on Google webpage for AM02]

Lectures on Advanced Microeconomics I at PIDE, 14 Sep 2017, by  Dr. Asad Zaman, VC PIDE

This lecture is taken from pages 46-66 of Hill, Rod, and Tony Myatt. The economics anti-textbook: a critical thinker’s guide to microeconomics. Zed Books Ltd., 2010. The textbook starts by reviewing the classical Supply and Demand model which is exposited as the central tool of microeconomic analysis in conventional textbooks. It draws out several policy implications which textbooks present on the basis of this analysis. After the review, the Anti-Textbook explodes the bombshell.

Even though Supply and Demand models are presented as being universally applicable to all types of markets, they work only in perfectly competitive markets. This means that all agents — firms and consumers — must be price takers. In fact, empirical evidence (Blinder survey) shows that more than 90% of firms set prices, and hence are price makers. Thus supply curves do not exist in vast majority of markets, and therefore S&D analysis fails to be valid.

Some analysis is provided, both theoretical and empirical, of the policy conclusions and recommendations textbooks make on the basis of S&D models, and it is shown that these are also not valid, and do not provide a good guide to empirical realities in real world markets. A 90 minute video lecture is linked below. A more detail 3000 word outline of the lecture is also given below.

3000 word outline of lecture.

1      S&D Applies Only to Perfectly Competitive Markets

‘The supply and demand model, which we introduced in Chapter 3  and have used repeatedly since then, is a model of a perfectly  competitive market.’ Krugman and Wells (2005: 207)

‘Perfect competition is rarely, if ever, found in practice.’ Baumol and Blinder (2006: 194)

1.1     The conflict between economics and Reality

“Needed: A New Empiricism” by Barbara Bergmann: Article states that: Biologists made discoveries about dolphins by studying them. Economists do not spend any time studying actual firms. Textbook theories and research publications study imaginary worlds.

BEHAVIORAL ECONOMISTS started studying real world behavior of human beings and firms. They found many contradictions. Economists IGNORE findings of Behavioral economists, AND CONSIDER them IRRELEVANT. They study rational behavior. If people don’t behave rationally, then tough! They should learn to be rational

Behavioral Economists predicted GFC 2007, Conventional Economists did NOT. Nonetheless, BE is an ODDITY, PERIPHERAL, NOT REAL ECONOMICS according to economists. It studies REAL WORLD

1.2     Maximization and Equilibrium: Core Principles of Economics

I am open-minded … , but I am basically a maximization-and-equilibrium kind of guy. Indeed, I am quite fanatical about … standard economic models  – Paul Krugman

Quote from 1st chapter of Varian: Intermediate Microeconomics:

Whenever we try to explain the behavior of human beings we need to have a framework on which our analysis can be based. In much of economics we use a framework built on the following two simple principles.

The optimization principle: People try to choose the best patterns of consumption that they can afford.

The equilibrium principle: Prices adjust until the amount that people demand of something is equal to the amount that is supplied

1.3     Axioms triumph over Reality

In his General Theory, John Maynard Keynes stated that classical economists ‘resemble Euclidean Geometers in a non Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight—as the only remedy for the unfortunate collisions which are occurring. Yet in truth there is no remedy except to throw over the axiom of parallels and to work out a non Euclidean geometry. Something similar is required today in economics.

1.4     What is wrong with Maximization?

Strong Empirical Evidence (behavioral) against maximization – Offer people $10 versus $9 and around 10% will choose $9 – not BOTHERING to calculate. SATISFICING is more logical, defensible. Complexity of the situations (faced by) imaginary agents  (requires models of) behavior by ad hoc rules rather than as  a maximum problem – We will illustrate in OLIGOPOLY situations – Maximization is IMPOSSIBLE.

1.5     What is wrong with EQUILIBRIUM

Study of Dynamic Systems shows that they rarely converge to equilibrium. Often have multiple equilibria. There are many types of equilibria – stable, unstable, attractors, repellors, etc. We CANNOT learn system behaviors/dynamics from the equilibria.

Typically, economists believe in unique equilibria – BUT, theorems prove that in MOST situations there will be MULTIPLE equilibria. Almost any REASONABLE model will have multiple equilibria. In these situations, ECONOMIC THEORY is completely useless. The key to understanding a complex system is to understand what happens in DISEQUILIBRIUM. It is ONLY from studying this that we can understand whether or not the system  will converge to equilibrium and how long it will take in doing so. We will give many examples to show how disequilibrium behavior can completely change the properties of the system. By refusing to study dis-equilibrium, economists refuse to understand the complex economic system that we see in the world around us. Equilibrium theories are incapable of helping us to understand the global financial crisis, which is an evidence example of dis-equilibrium.

1.6     Illustration: Predator-Prey Models

This is to illustrate the idea of how we cannot understand a dynamic system by studying its equilibrium. In the sheeps and grass model, grass is plentiful and sheep are scarce. So sheep start to grow and grass grows scarce. When grass becomes sparse and sheep plentiful, sheep start dying off due to lack of food, and so grass gets a chance to grow. This cycle keeps repeating, and NEVER reaches any equilibrium. If we look for equilibrium, there is ONLY ONE – all sheep dead, ONLY grass left. But this does not tell us anything about how the system behaves. This is exactly like the economists study of equilibrium. We do not learn anything about the world from this study, because the world is NEVER in equilibrium. For a video illustration of a Sheep and Grass model, see: https://www.youtube.com/watch?v=jM9iiyzCav8

1.7     Evolutionary Economics

There are many ways to study worlds in which there is no equilibrium, or where there are multiple equilibria. One of them is evolutionary economics, which we will study to some extent in this course.  The calculations required for this are done by Agent Based Modelling. We will teach some of this in this course. Studying economics in this way leads to ENTIRELY different results from standard economic theory.

ECONOMISTS ARGUE using evolutionary arguments BUT DO NOT TAKE THEM SERIOUSLY. They say if firm does not maximize profits than it will not survive. To ASSESS this requires an evolutionary model, which leads to OTHER results.  In particular, we will see that Perfect Competition, the darling of economists, is almost Impossible to achieve in realistic models. It can come about only using highly unrealistic assumptions:

  1. All agents are PRICE TAKERS – they CANNOT compete.
  2. Conditions, perfect information, zero transaction costs,
  3. No externalities, etc. etc. etc.

LONG LIST OF IMPOSSIBLE DEMANDS required to create perfect competition. Small deviations cause COMPLETE FAILURE of theorems and theory of Perfect Competition. Stiglitz gives many examples.

There is Strong Empirical Evidence AGAINST perfect competition – size distribution of firms – heterogeneity – principal-agent problems, etc. etc. Most firms are price makers, not price takers.

 

2      Review of Textbook S&D Equilibrium

To understand what textbooks are trying to do (meta-economics), we must understand that the goal of the conventional textbooks is to brainwash students into believing the benefits of free markets, and the harms of government regulations, and any kind of interference with free market mechanisms. Unfortunately, even in purely theoretical, textbook models, with no contact with reality, this result is very hard to achieve. As a typical example, most micro textbooks discuss rent control along the following general lines:

Policy Conclusions from S&D Models: All interference with free markets is harmful. Governments often try to control market prices using price ceilings and price floors. Rent control (an example of a price ceiling) is an attempt to help low-income families afford the cost of accommodation. However, these controls provide benefits to a small number of people, while depriving a larger number of poor families from access to good quality housing. Similarly, minimum wage laws attempt to help workers, but end up hurting them.  Textbooks emphasize that attempts to overrule market forces always lead to unintended effects that usually hurt the very group the government is intending to help.

2.1     H&M Anti-Textbook lists Five Problems with Rent Controls

Summarized arguments found in conventional textbooks against rent control. These arguments are based on the use of the Supply and Demand Model:

  1. Excess Demand, price is below equilibrium, Shortage of Supply of Houses. People cannot find houses.
  2. Inefficient Distribution – People locked into existing apts, cannot bid more for more desirable apt.
  3. Wasted time/effort on UNSUCCESSFUL search for houses.
  4. Low Quality of Housing – Landlords cannot afford to provide good housing services, due to low rent
  5. Illegal activities – emergence of black markets, people bribe to get rent=controlled apts.

2.2     H&M Anti-Textbook lists problems with Minimum Wage Laws:

Similarly, conventional textbooks use the S&D model to establish the case against minimum wage laws.

  1. Wage is above equilibrium
  2. Excess Supply of Labor.
  3. People want to work, but cannot find jobs.
  4. If Min Wage was lower, more jobs would be created and more would be able too find jobs.
  5. Surplus (wage above equilibrium) is distributed among a small class of people. A large class of people gets ZERO wage because they are now unemployed.
  6. LABOR UNIONS are harmful to public interest.

 

2.3     Textbooks apply S&D theory to study Incidence of Tax:

Similarly, the S&D model is used to analyze the effect of taxation. H&M show that this fall on producers and consumers in proportion to elasticity of supply and demand. In fact this analysis holds ONLY in perfectly competitive markets, but students are not informed about this restriction.

3      Economics as RHETORIC

Economic theory uses many subtle tricks to PERSUADE students of validity of theories which are either false, or there is no empirical evidence. Without doing any study of firms, economists prove to students certain properties of firms. Imagine biologists who have never observed dolphins making up theories about dolphin behavior. Economists are very good at the art of persuasion:

  1. Students are told that FREE MARKETS work well
  2. Well-Meaning People want to help those who are hurt by market outcomes (like extreme inequality and poverty)
  3. However, when they interfere with markets, the result is even worse.
  4. They HURT the people that they want to help.
  5. Students are persuaded WITHOUT ANY EMPIRICAL EVIDENCE, any history of places with rent controls, any studies of what has been happening in New York, Montreal, other major cities with rent control

Why do economics textbooks want to persuade students to believe in false theories? Why not teach them the TRUTH instead?

4      Soft Power necessary for enslavement of masses

Marx also stresses the ideological component of this process, by which the labourer comes to believe in the necessity of his own enslavement to work. Wealth concentrates in the hands of a minority, while the masses must sell their labour to survive. “The advance of capitalist production develops a working class which by education, tradition and habit looks upon the requirements of that mode of production as self-evident natural laws” (Marx, 1977: 899–900).

One of the MAJOR LIES that Textbooks teach is that the S&D model is universally applicable. A KEY contribution of the Hill and Myatt Anti-Textbook is the demonstration that  S&D is a model of extremely limited applicability, which works under extreme assumptions, rarely satisfied in reality. Thus ALL policy implications drawn by textbooks (as listed above) are wrong in typical markets where S&D theory does not apply.

5       Limitations of the S&D Model

What are the rhetorical strategies used by textbooks to convince students that S&D is universally applicable, when in fact S&D is a VERY limited and restricted model, which applies to a very small set of markets?

H&M write that: The range of these applications, the position of these chapters near the front of the text, and the immediately preceding methodological discussion that plays down realism of assumptions, all suggest that the supply and demand framework is a generic tool that can be applied to all markets. Colander et al. (2006: 72) are explicit here, saying supply and demand provides ‘a good off-the-cuff answer for any economic question’.

5.1     TRUTH: S&D theory ONLY works with PERFECT COMPETITION

Event though textbooks sometimes explain this in footnotes. This admission of limitation of S&D comes late, or never:

Krugman and Wells state in their Chapter 9: ‘The supply and demand model, which we introduced in Chapter 3 and have used repeatedly since then, is a model of a perfectly competitive market’

Varian introduced Monopoly on page 450 in Chapter 25, and mentions that S&D does not apply to monopoly.  However, throughout the book, he has been applying it to all markets, without considering whether the market is competitive or monopolistics. Textbooks provide NO ANALYSIS available of what happens in the same situations if market is not competitive. What happens if we put on rent controls when landlords have some market power. What if firms have market power in hiring, allowing them to set wages, and we combat it using minimum wage laws? These questions are not considered by textbooks.

H&M Anti-Textbook explains that S&D MODEL  is the same as Assumption of Perfect Competition
To differentiate between monopoly and competition, consider the concept of Price-Takers vs Price Makers. S&D model requires all agents, consumers and producers, to be price takers. Supply Curve ONLY EXISTS if firms are price takers. Supply Curve DOES NOT exist if firms are price makers.

Large Scale Survey of Firms by Blinder et. al. shows that more than 90% of firms SET PRICES for their products and reviewed the price structure every three months (on the average). If there is no supply curve (as in monopoly), then S&D analysis is not valid. Textbooks ignore, de-emphasize, importance of assumptions:
Perfect Information, Zero Transaction Costs. In the next lecture, we will later show how important these assumptions are, and how they can never be actually satisfied in real world market settings.

SO: Which Markets satisfy Perfect Competition?

H&M Anti-Textbook writes that even though in reality, we might be able to apply the model to about 2-3% of the US market, actual textbooks apply it to all markets, and create the impression that S&D is universally valid model. The only markets where this might work is Agriculture and Raw Materials. In USA, this is about 2-3% of the economy

When this model is so limited, why do textbooks make this the central model?

  1. BECAUSE we want to prove free markets work, and governments should not interfere with them.
  2. THIS IS THE ONLY CASE WHERE THEORY CAN BE DEVELOPED TO SUPPORT THIS IDEA.

IN other words, this is a RHETORICAL strategy.

Strong Empirical Evidence exists AGAINST the idea of perfect competition.  Blinder survey of firm behavior cited earlier shows that:

First, the evidence gathered in this study emphatically supports the mainstream view that sticky prices are the rule, not the exception, in American industry. According to our respondents, the median number of price changes for a typical product in a typical year is just 1.4, and almost half of all prices change no more often than annually. Among firms reporting regular price reviews, annual reviews are by far the most common. At the other end of the spectrum, only about 10 percent of all prices change as often as once a week, and about 7 percent of all firms schedule price reviews at least weekly.

5.2     Is Perfect Competition A Useful Approximation?

Since empirical evidence strongly rejects the model, some Textbooks take the position that perfect competition is a useful approximation. Oligopoly models are complex, and simpler PC analysis provides useful and valid approximation. Most textbooks simple IGNORE the issue, and simply do not consider whether S&D can be applied to all markets or not.

To check whether Perfect Competition provides a useful approximation to reality, we cross-check model results against some studies of what happens in the real world.

Let us look at the predictions and policy implications of Perfect Competition, and see if they match real world

PREDICTION OF S&D: Minimum Wage will reduce Employment

See my lecture (previous semester) on 80 years of Economists failure to understand the Labor Market.

Convincing empirical evidence produced by Card and Krueger that increasing minimum wage led to INCREASED employment.  H&M show that these results have convinced many economists, with the result that consensus on S&D in labor market has silently decreased. Very interestingly, they use data cited by a conventional textbook to prove this point, and show how the textbook mis-interprets the data to try to show students that all economists agree on S&D analysis. Again this is a rhetorical strategy; when the textbook theory is not convincing, cite the authority of the collected wisdom of economists to prove the point, and fudge the statistics in the process.

5.3     Empirical Evidence on Rent Controls: Study by Arnott

The impact of these other factors is likely to be significantly greater than any effect due to controls. Trying to discern the effects of rent control in such a situation is akin to trying to hear a whispered conversation across a street of roaring traffic’ (1995: 112). He suggests that with the exception of New York City (which retained its first-generation controls) and perhaps Toronto (which had poorly designed second-generation controls) the effects of rent control in North America have been almost imperceptible.

 

6      Meta-Theory: Why are textbooks hostile to Rent Control?

Two Reasons discussed by Arnott:

IDEOLOGICAL: A primary battle-ground between free- markets proponents and opponents. Landlords versus Renters.

METHODOLOGICAL: Is Supply and Demand a useful analytical tool?

whether the competitive model is good enough as a generic approximation to most markets. The housing market has many non-competitive elements: apartments are heterogeneous and tastes diosyncratic, which renders the market thin; search costs are substantial (as evidenced by agents’ fees), as are moving costs; and there is a lack of information about who’s a good landlord and who’s a good tenant.

Arnott’s conclusions

‘Perhaps a majority, at least among the younger generation, would agree with the statement that a well-designed rent control program can be beneficial’ (ibid.: 99)

Yet this research seems to have had no impact on the principles textbooks

6.1     Failure of Textbook Predictions concerning the incidence of taxation

If the evidence presented for the effects of minimum wages and for rent controls is weak, things are even worse when it comes to the incidence of sales taxes: the textbooks present no evidence at all.

WHY is no EMPIRICAL EVIDENCE presented about incidence of taxation? Because IT CANNOT EXIST in markets where there is no supply curve. The incidence is split across produced and consumer in proportion to elasticities of supply and demand. We will show in next lecture how supply curves do not exist when markets are not competitive.

Next Lecture: AM03 – Monopoly (no supply curve, opposite policy conclusions from S&D models)

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