You just can’t make this stuff up
My post on supply and demand produced a lot of good comments, but none better than this one from Michael:
I can relate to this. I’m getting my Ph.D. in economics I feel that with every passing year I am even less confident about answering seemingly simple questions.
I also find that this specific topic makes it incredibly frustrating as a TA to grade work for intro undergrad courses. Some professors expect it to be “obvious” that if the price is lower, quantity has gone up due to the law of demand, and this is the answer they judge to be correct, whereas others are trying to weed out the students who understand that you cannot make a statement about quantity solely based on an observed change in the market price. Quantity could’ve gone up, down, or stayed the same.
I find myself explaining to students, “well, the answer for THIS professor is …” Students do not find professor-specific explanations to be very satisfactory.
Not very satisfactory? What’s wrong with the young these days, do they expect everything to be handed to them on a silver platter? I mulled over everything I learned in econ, and then accepted or rejected it on the basis of whether it made sense to me. But I guess if you’ve been reading my blog you already noticed that.
Seriously, I propose an emergency meeting of the AEA to resolve this issue once and for all. We should not wait for the January meetings in Atlanta, as by then a whole new group of EC101 students will have been mis-educated in the fall semester.
Some readers thought I was mocking students in my post. Actually I was serious; S&D is incredibly confusing, perhaps as difficult as quantum mechanics. Consider how Steven Landsburg commented on the Mankiw quotation I provided:
“Suppose that the price of frozen yogurt falls. The law of demand says that you will buy more frozen yogurt. At the same time you will probably buy less ice cream.”
This is entirely correct.
If a health scare reduces the demand for frozen yogurt,
then you will probably buy less as a result of the health
scare. If, as a result of the health scare, the price falls, then you will probably more as a result of the price
drop. At the same time, you’ll buy more ice cream as a
result of the yogurt health scare, and less ice cream as a
result of the yogurt price drop. By shifting supply and
demand curves, you can easily see which effects are dominant.Of course you knew all that already. But that’s how I
explain it to my students (and essentially how I explain it
in my textbook) and it seems to me to be the best way to
make the issues clear.
I still think it is incorrect. Steven seems to interpret Mankiw’s statement as saying that a reduction in price would cause an increase in quantity demanded (which would be correct.) I interpreted the second sentence as saying that a reduction in price would lead to an increase in the equilibrium quantity, which would be incorrect. I consider myself pretty knowledgeable about economics, and Steven knows even more than I do (I know this because I sat behind him in grad school.) Even two well-informed people can interpret a simple question differently.
Obviously my dispute with Steven is over semantics, we agree on what the theory says. But one of my colleagues at Bentley mentioned that he thought graduate education in economics is now too technical, and doesn’t spend enough time teaching economic intuition. When I studied at Chicago in the late 1970s economic intuition was almost all I learned. I learned little or no math and econometrics. My I/O prelim had seven questions, all story problems. I passed without writing down a single number, graph or equation. My other prelim in public finance was almost as non-technical. BTW, I did not concentrate on money/macro in grad school, as I wasn’t interested in the new classical model then being taught.
I also recall reading that Steven Levitt’s success with Freakonomics has made economic intuition trendy again with younger grad students. Let’s hope so.
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6. August 2009 at 05:47
Hi Scott,
I agree with your sentiments on the confusion of supply and demand and with your thoughts on the “Yogurt” example. Although, I still think the example may be not entirely true, the good economics answer being; it depends. This is the way I like to think about the question…. Say the price of yogurt declines as a result of a health scare, as in the example, but what if the health scare means someone who eats the tainted yogurt will die. The price could go to one penny and I would not think that quantity demanded would increase…..in fact I would think demand would go to zero and everyone would just buy ice cream instead. Let me know if my example is too hypothetical.
Thanks,
Joe
6. August 2009 at 06:56
I am a graduate of Bentley ’08, and took classes with snyder and clarke. I too do not understand the second section of that excerpt. If there is a health scare related to yogurt and I switch to ice cream, which then in turn causes yogurt prices to drop I still will not want to consume yogurt. My health trumps the price drop of yogurt. This reminds me of the peanut butter scare we had in the past year. I wonder what the overall effects of demand for peanut butter and the substitutes were?
6. August 2009 at 07:44
joe, perhaps i am wrong, but in your health scare example, arent u saying the demand curve becomes perfectly inelastic AND shifts to the left? that is, no change in price will elicit a noticeable change in demand?
6. August 2009 at 08:53
Scott, this is on a bit of a tangent from the topic of this post but I’m curious how you reconcile your defense of the efficient market hypothesis with the recent news about Goldman Sachs’ trading profits for the last quarter: http://ftalphaville.ft.com/blog/2009/08/06/65616/goldman-has-record-trading-days/ . It seems such results would be highly unlikely if EMH were true. Is this evidence against EMH or is it evidence that Goldman are cheating the system in some way?
6. August 2009 at 09:25
Van,
Yes that sounds correct.
6. August 2009 at 09:55
To Mike and Joe,
It is my understanding (feel free to yell at me if I am wrong), but even though you guys would switch and not buy the dangerous yogurt, other people who were not already buying yogurt would switch to yogurt due to the price drop. For example. if before the health scare there were 10 people that consumed yogurt and 15 that consumed ice cream. After the scare 5 of the people switched to ice cream (with Y=5 and I=20 now). The price decrease could cause 7 (or more than 5) people who were consuming ice cream originally to now switch to yogurt: they would accept the risk for the decrease in price. This would result in the quantity demanded for yogurt equaling 12 and the demand for ice cream equaling 13.
Obviously, it would depend on the severity of the scare, but I think that is the overall point.
And if this example is blantantly obvious and not even worth mentioning, forgive me, I am really tired today.
6. August 2009 at 10:05
Paul,
My example was definitely a worst case scenario but I see your point. Thats why I think in reality, a more realistic health scare, the demand curve would probably not be completely inelastic, but more inelastic than it was before the scare.
This is why I like ecoonomics, we can take virtually anything, analyze it and discuss it for days.
6. August 2009 at 10:14
That’s actually a great point. I remember learning in school what shifts demand and supply curves, but I don’t ever think we went over what changes the elasticity of supply and demand curves (other than the fact that elasticity changes on different points on the curves). You would think that would be something important that might be taught at an intermediary level.
6. August 2009 at 11:01
Joe, I think that’s right. I’d like to clarify one point however. When I said that one problem had a clear answer, it was the movie example. And even that was only clear because of the way it was asked. I asked “do these facts disprove S&D.” And since either S or D can shift, the answer was no. With yogurt, I agree that Q could go in either direction.
Mike, Good to hear from a Bentley grad. I think you are right–that is a definite possibility.
Van, Yes it would be completely flat, and also fall right down to the X-axis.
Matt, I know it looks that way, but I’d need a bit more info. Here’s why. I made a huge percentage gain in Q2, partly because the markets went much higher, and partly because I was titled toward HK/Asia, which greatly outperformed Wall Street. So big gains alone aren’t enough. I think you are referring to the ratio of 46 big gains, lots of small gains, and two losses. That can’t be due to chance. But . . . What if they calculate trading profits as follows; the accounting profits are not the daily gain in the portfolio, but rather the difference between price sold and price paid. Also assume that GS tends to hold stocks for at least a few weeks. The market low was March 9. So as you got into Q2, where prices were rising rapidly, almost everything they sold would have been sold at a profit. The analogy is that if I bought a lot of stocks in Q1, and sold off 1/90th of my portfolio in each day of Q2, it is possible that virtually every day would show a profit. But because the time periods overlap there is serial correlation, which drastically reduces the statistical significance.
I don’t want to be dogmatic about this. I have always argued that the EMH is a good approximation of reality. If I had to guess, and my life depended on it, I’d guess GS is slightly better than the market. But I don’t think they are 46-2 better, I think there is at least some serial correlation in there somewhere.
Joe and Paul, It is interesting that you mention that possibility. I was also wondering if that could occur with the coffee–tea example I used. My intuition was that tea demand would rise, but I saw at least a small theoretical chance it would fall. You need:
1. Coffee drinkers not liking tea
2. Tea drinkers being low income, and also liking coffee almost as much as tea.
3. The health scare not being too bad.
In that case the lower price of coffee due to falling demand would bring in some tea drinkers, but very few coffee drinkers would switch to tea. That’s a lot of “ifs” but I think Paul’s case is theoretically possible.
6. August 2009 at 11:04
Steven Lansburg said:
“If a health scare reduces the demand for frozen yogurt,
then you will probably buy less as a result of the health
scare. If, as a result of the health scare, the price falls, then you will probably [buy] more as a result of the price
drop.”
I agree completely with this statement. Although I wouldn’t agree that economics is as hard as quantum mechanics, I do think that the physics approach is the right one … i.e., one way to analyze the situation is to consider the relative effects of different forces. The health scare causes a shift in the demand curve. So fewer people buy yogurt. Since fewer people buy yogurt, the price of yogurt drops, and more people buy yogurt, which reflects movement along the demand curve (a shift in the supply curve). As Steven said, these effects are combined to see which are dominant.
One possible analogy to physics would be: drop an object near the earth. Gravity will accelerate that object at ~9.8 meters per second, per second. However, as the velocity increases, wind resistance will “push back,” decreasing the object’s acceleration. At the “terminal velocity” the effect of wind resistance completely mitigates the effect of gravity, and the object stops accelerating. This doesn’t mean that the force of gravity has vanished; it just means the force of the wind resistance must also be considered, and the two together create a new equilibrium in the object’s velocity.
In this example, letting go of the object represents a shift in the demand; the wind resistance mitigates this effect, similar to how the demand curve mitigates the drop in price; and the new equilibrium velocity is like the new equilibrium price of yogurt.
Well, I’m not sure if that really clarifies it. But I think a lot of people tend to confuse a tendency (more people buy yogurt as the price drops) with an absolute change (yogurt sales go up). Sure, a decrease in the price of yogurt drives up sales … but this doesn’t overcome the dominant effect of the health scare. So even though a lower price pushes up sales, overall sales of yogurt drops due to a changing demand curve.
Hope this helps.
6. August 2009 at 11:34
Scott, it seems that Goldman holds many of its stocks not for a few weeks but for a few milliseconds: http://zerohedge.blogspot.com/2009/07/nyse-issues-correction-goldman-pt.html – recently program / high frequency trading has accounted for nearly 50% of daily volume on the NYSE and Goldman for around 1/3 of that volume, meaning Goldman’s high frequency trades (80% of which complete in less than 400 microseconds: http://ftalphaville.ft.com/blog/2009/07/08/60761/the-cold-war-in-high-frequency-trading/) account for perhaps 1/6 of total daily volume on the NYSE. Buy and hold this is not.
6. August 2009 at 11:35
joe/scott: in any of the examples, can we conceivably be dealing with a demand curve with diff elasticities at different points along the curve? reason i ask is bec it would seem too simplistic to assume supply or demand curves as wholly linear always…no? and therefore, i guess diff points on teh curve will give us diff outcomes to the analysis…
6. August 2009 at 11:50
Try using profit instead of price. The supply of a good will increase if the profit for its sale increases. The sales price is formed by comparing the good with a substitute, and complicates the discussion.
6. August 2009 at 11:50
Ok, just thought of something that might be helpful, let me know what you guys think:
Ok,so, so far we have all been thinking about individual demand curves it seems like. ie if their is a health scare then my demand curve shifts left. The health scare causes the price to drop which increases my purchasing power(or real income), this causes a shift in the demand curve right.
However, the overall market demand will be the aggregate of all the left and right shifts and the resulting demand curve will shift whichever way the sum is greater. And that is the end of it. No other movement or shifting of other curves.
In the overall market equillibrium there is not a “first demand shifts so people buy less, then people buy more because the price drops”; The market takes all this into account simulatenously and the result is that people will either buy less or more overall, not less first then more.
It sounded great in my head and a little bit less great typed. But let me know if that makes any sense.
6. August 2009 at 12:01
Van, almost all demand and supply curves have changing elasticities along different points on the curves. Constant elasticity curves are the only ones that do not and look bent and are not linear.
Linear demand curves always having changing elasticities except for perfectly inelastic or perfectly elastic curves (? is that correct, I should remember this but I am having a brain slip)
6. August 2009 at 13:25
Ted, You said:
“Steven Landsburg said:
“If a health scare reduces the demand for frozen yogurt,
then you will probably buy less as a result of the health
scare. If, as a result of the health scare, the price falls, then you will probably [buy] more as a result of the price
drop.”
I agree completely with this statement.”
So do I. There is no doubt that Steven Landsburg understands S&D better than I do. But I still think Mankiw’s wording is technically wrong. Steven understands the concept, and so does Mankiw, but I think Mankiw expressed this idea poorly.
But I may well be wrong–let the debate continue.
Matt, But that proves too much. Profits from that sort of activity should not be affected at all by the direction of the market. The market shows almost no trend over a millisecond. But GS lost 2 billion in the 4th quarter, made 1.8 billion in the first quarter, and made 3.4 billion in Q@. That tells me that while most of their trades are as you describe, most of their profits are from longer term investments. They may be providing some sort of market service with these quick trades, say adding liquidity. That’s just a guess, but it clearly doesn’t explain the huge swings in profits, with in fact correlate with the medium term movements in the markets (medium term being months).
van, Yes the elasticity could vary, and indeed it even varies along a linear demand curve.
mattyoung, you can use profit, but then it isn’t a supply curve. I’d have to think about that.
Paul, Yes, I agree that in reality (in a competitive market) all of these things are simultaneous.
6. August 2009 at 14:29
I don’t know much about the slope of demand curves but my ignorance hasn’t stopped me from throwing my 2 cents in on any debate yet, so:
To me this is obvious. The yogurt health scare is announced. Few people go out and buy yogurt the next day. The price drops. More people go out and buy yogurt than they did immediately after the health scare announcement, because the tainted yogurt is at least cheaper tainted yogurt. But of course they are buying less than before the announcement, otherwise the price wouldn’t have dropped. So people would buy MORE ice cream not less, if you assume the two are substitutes.
The language of supply & demand is the problem. The term “quantity demanded” is entirely imaginary and intentionally misleading, because the word “demand” changes meanings from when it is used to mean demand.
6. August 2009 at 15:03
Re GS: another theory out there is that since there are a lot fewer professional traders than last year, the market has more inefficiencies in it for GS to exploit.
My question is: if the EMH is correct, why does GS pay its traders so much? Even if you agree that some traders are better than others but the EMH mostly holds true, that wouldn’t justify how much they pay for those traders, would it? I suppose you are going to say it does. But if it does, these traders are performing on a completely different level than mutual fund managers, because mutual fund managers surely don’t, as a group, earn their dough.
But mutual funds don’t make their money by beating the market: they make their money through marketing! Open up a bunch of funds, close the losing ones, let the winners ride and after a few years you have a few funds that look like they are well managed. So those studying the EMH should not look to mutual fund performance as their guide. Their incentive is to spend money on marketing, not R&D.
GS, on the other hand, spends a lot on R&D.
6. August 2009 at 16:00
At Caltech, we couldn’t be more different. Intuition is seriously in short supply. The focus is heavily on mathematical analysis. Quite a few actively sneer at the lack of mathematical rigor at other schools. Back during in the gleam of my salad days, I found this all quite becoming. Now, I feel rather differently. Most of the work being done is completely fatuous–artificial in its supposed exactitude, it is thin on insight and rich in gruel.
Calculus, as a system, was developed to solve physical problems. Needless to say it handles those problems very well, but you can see the strains. i.e., in quantum mechanics the tools of calculus are suddenly very unwieldy and alternative systems of notation have arisen to hold down the complexity.
I find the application of calculus to macro-economic problems even worse, and so inevitably out trot the toy models. Business cycle modeling that reaches the journals seems to be shockingly ignorant of relevant parallels to machine learning and optimization. Reported convergence, divergence, and similarities to real data demonstrate only that people ‘optimize’.
Based on my hedge fund experiences, the best ‘models’ are black-box–ones that are merely fitting data and doing optimization–where the author understands that that’s what counts. Computational finance clearly works, but it doesn’t really explain why things ‘are’.
Lest I leave too bad an impression, econometrics is the bright-light. Statistical analysis–awareness of auto-correlation, data-mining, etc–is absolutely top-notch in economics and our brethren in the physical sciences would often do well to take a few notes.
6. August 2009 at 17:29
I hope that mathematical virtuosity and intuition are not incompatible. I see myself as a mathematician before an economist, but economic intuition is critical to know how to do good mathematics in this field. Not to mention the huge efficiency gains from intuition, because it saves you a ton of math work if you can figure out the answer by actually understanding things.
Anyway: here is what my intuition says about this.
The yogurt health scare has no direct effect on price (this is part of Scott’s original point). Its immediate effect is to shift the demand curve leftwards.
And surely, given an upward-sloping supply curve and monotonic demand curve (assume it’s downward-sloping for simplicity, as a monotonically increasing demand curve would be pretty bizarre), it is IMPOSSIBLE for the quantity traded to increase when the demand curve shifts leftward. It’s not a matter of examining the elasticity of the curve at different points, or weighing up the strength of two different factors. It’s IMPOSSIBLE.
Rob’s intuitive view seems almost right, though I think he still slightly conflates the causality of prices, quantities and preferences.
If I don’t rely on finding the crossing points of graphs, and try to explain this intuitively, I would suggest the following step-by-step view:
– Imagine the price of yogurt is $2
– Let’s say there are 1000 buyers who are willing to buy yogurt at $2
– Then the health scare.
– 500 of the buyers are no longer willing to buy yogurt at $2 (perhaps they won’t buy it at any price – it doesn’t matter)
– Suppliers are now producing too much yogurt to sell at $2
– They reduce the price to $1.90 see if they can sell more
– At $1.90 a few suppliers drop out of the market and only 800 pots are produced
– Let’s be extreme to illustrate the point. At $1.90 there are 10,000 people willing to buy yogurt who would not have been interested at $2. These people don’t care about their health – they just want to stuff that lovely yogurt in their mouth. It happens that most of them used to eat Big Macs at $1.94 and were just waiting for a better offer. So at $1.90 there are now 10,500 willing buyers.
– All 800 pots are, of course, snapped up.
– The suppliers realise they can increase prices a bit, because at $1.90 they have more willing buyers than pots available.
– They bump the price to $1.95, and one supplier comes back into the market, raising the quantity produced to 900
– Some of the buyers drop out of the market and go back to eating Big Macs, leaving the 500 original people (who were still willing to buy at $2, so they’re quite happy at $1.95) and 400 of the new entrants
The effect of demand elasticity is to determine how quickly those 10,000 people move in or out of the market. But they will move in and out. Remember that they were not interested in buying at $2, so you can be sure most of them will still not be interested at $1.99. Somewhere along the line an equilibrium will be reached.
I think what people are missing is the underlined point above: the quantity traded is not just a function of demand. It arises equally from supply. No matter if there are 10,000 people ready to buy at $1.90, the suppliers are not going to suddenly supply more than they were willing to do at $2.
Remember the point that, at equilibrium, the “amount demanded” is the same as the “amount supplied” and should instead be called the “amount traded”.
Can it be true that Greg Mankiw and Steven Landsburg understand demand perfectly, but have forgotten about supply? Maybe they need to talk to some, ahem, supply-side economists.
I think if you want to understand things intuitively, it’s worth working through all of the steps in how people change their behaviour in response to events. Is this what Leijonhufvud called a cybernetic model? Or could one say it’s simply behavioural – though rational – microeconomics?
6. August 2009 at 19:01
Your blog is quite enriching and has gives keen Economics students a different take on Monetary Economics. I am a Management graduate from India and currently work at a Consulting firm in Bangalore.
With regards to a national level examination, I am required to do self-study of courses on International Economics, Monetary Economics & Public Finance. While the articles on your blog has helped me a lot, I have been struggling with getting real-world examples and strong arguments supporting/contradicting theories for the other subjects. I would be extremely obliged if you could help me with some freely downloadable online links/blogs etc… which deal with the subjects of Public Finance & International Economics.
Sorry for the trouble,
Thanks & Regards,
Kailash.N
09341665899
6. August 2009 at 19:21
Leigh, no offense but it isnt plausible that a decrease in price DUE TO a decrease in demand could lead to an increase in quantity traded, although i do like your term “quantity traded”. (i guess the only drawback in that term is the implication we have moved beyond theory)
My background is mathematics although working in the business world has caused me to forget most of it. My real world experience in negotiating contracts the last six months is that i have had to continually reduce prices due to falling demand (which from my POV means falling revenue) . It seems ludicrous i would reduce prices to a point at which im selling a greater quantity than before i started reducing prices, because i would have stopped reducing before i reached that point or i would be out of business. but then again, maybe that is the yogurt health scare point. if i had a fire sale perhaps i would sell more in order to liquidate. but that is taking things to extremes. now i dont know what to believe.
6. August 2009 at 20:23
I think the introduction of the health scare is a red herring, and what Mankiw was trying to say is that a fall in the price of frozen yogurt will increase demand, and that since ice cream is a substitute good (unstated but arguably obvious), holding utility constant with more yogurt results in less ice cream.
6. August 2009 at 20:24
Rob: I agree, that’s my point. I could have been clearer about the final step in the derivation, but the quantity traded has fallen in my example from 1000 to 900.
My conclusion is precisely the same as yours: a fall in demand could not lead to an increase in quantities.
The geometrical intuition for this is: the demand curve has moved to the left, and the supply curve stays where it was, so how could the equilibrium point move to the right?
6. August 2009 at 20:48
Hi, rob. Let me take a stab at it, if you don’t mind.
In Leigh’s scenario, there are buyers willing to buy 1000 units of yogurt at $2.00; there are also sellers willing to sell 1000 units at $2.00. Some of these sellers are perfectly willing or able to sell for less than $2.00; there are also other buyers willing and able to pay $1.95, but not $2.00. In other words, when supply or demand shifts as in this example, sellers leave the market and buyers enter the market until a new equilibrium price is reached.
What Leigh is describing is a step-by-step process of reaching this new equilibrium. Even if you aren’t willing to cut your price, other sellers will, in order to keep selling yogurt.
Now the situation where there is a dramatic increase in buyers at a slightly lower price probably represents lack of information in the market place. (This happens a lot in the real world, and Leigh’s example explores how the information – the equilibrium price point – is reached.) I say ‘probably’ because I am assuming there are some suppliers willing and able to supply as much yogurt as the market needs at $1.90, even if others are not. Note that in Leigh’s example, this isn’t true … supply at that price point is limited to 800 units, which is far below demand, so the price inches back up to $1.95.
Remember Sam Walton (of Wal-Mart) made his fortune because he would rather make $1.00 per pair of socks selling 10,000 pairs than sell only 1,000 and make $5.00 per pair … selling 10x the quantity for twice the profit. Other people might have been willing to do this, too … but they didn’t have perfect information about the marketplace – they didn’t know it could be done. Walton made a big, bold bet and won by discovering that information. (He also helped ensure his profit margin by getting quantity discounts, leveraging economies of scale, and building huge stores on cheap land, but that’s just what allowed him to reach $1.00 per unit. He could have been wrong and lost his shirt.)
These scenarios usually assume perfect competition or perfect information, and so the new equilibrium price is reached immediately. But – as Leigh points out – in the real world this process isn’t so smooth.
6. August 2009 at 20:55
Scott: off topic but just read your How many Tylers are there post.
Tyler is brilliant but your writing voice is far superior. Also, you may be a slower reader but I doubt he appreciates Borges as much.
BTW, all us commenters have a side bet on how long you can keep responding to every comment.
6. August 2009 at 21:54
I am bemused to learn that the EMH is “a good approxomation of reality,” (and therefore true?) but Newton’s laws are “wrong.”
The health scare is a demand shock. Is an S&D chart analysis useful in a disequilbrium state? Will the scare last long enough for prices to adjust? The demand curve moves left, as Leigh said, but what happens to the supply curve when the tainted yogurt is pulled from stores and destroyed? If the scare is long lasting and demand stabilizes at a reduced level, supply would also adjust and the price would find a level determined by the new factors of production.
7. August 2009 at 05:26
Rob, Yes, your explanation sounds plausible. And I agree that the terminology is confusing.
Rob#2; You said;
“My question is: if the EMH is correct, why does GS pay its traders so much? Even if you agree that some traders are better than others but the EMH mostly holds true, that wouldn’t justify how much they pay for those traders, would it?”
I don’t know enough about these millisecond trades to have an intelligent opinion. But I don’t think what you said is correct. I believe a highly leveraged firm like GS could take advantage of even slight deviations from the EMH. Suppose a 29 year bond persistently traded at a slightly higher yield than 30 year bonds. Then GS could make money arbitraging this difference (selling the 30 and buying the 29) and by doing so they would make the market even more efficient. So these highly paid traders may be spotting slight inefficiencies and pushing the market back toward the efficient position. Obviously someone must do that, or else the market wouldn’t have been efficient in the first place.
Jon, Thanks for those insights. They sound about right to me.
Leigh, I agree that math and economic intuition are not incompatible. Skeldelsky has a piece in the FT criticizing the technical slant of modern econ. But he also shows appalling ignorance of the nontechnical side of econ, for instance he argues that the fact that the crisis wasn’t predicted counts against the Chicago efficient markets view (whereas the opposite is true.) So those who criticize the use of math, often have much worse intuition than those who use a lot of math.
You explanation of the yogurt health scare is exactly right. If the cause of the lower price is a yogurt health scare, then yogurt consumption will definitely fall. Ice cream consumption will probably increase, but one cannot be sure.
But Mankiw and Landsburg clearly understand this. Rather the dispute is over semantics. Is Mankiw merely saying quantity demanded rose or is he also saying equilibrium quantity rose? I think it is the latter.
Kailash, I haven’t had time to investigate many other blogs, but perhaps one of my commenters can answer your question.
Rob, I think Leigh agrees.
David, No he is not trying to say it would increase demand (everyone agrees price doesn’t affect demand) he is trying to say it would increase quantity demanded. But he actually says it would increase equilibrium quantity, which is very different.
Ted, Yes, I also think Leigh is right.
Rob, You said;
“BTW, all us commenters have a side bet on how long you can keep responding to every comment.”
Can I bet with someone? Seriously, I may have to start doing responses like my former professor at Chicago, Robert Lucas. Someone would ask him a really long question, and his response would sometimes be “Yeah.”
I appreciate the compliments on my writing, but I still think Tyler is a better writer. He actually knows how to write, whereas all I do is once and a while put down an amusing internal monologue in my head.
My taste in literature is narrow, he is able to appreciate a much wider range. A lot of literature goes right over my head.
David, Earlier I said that I was using “wrong” in a deliberative provocative way. I think the two theories are very compatible. My point was that most other people come on here and tell me the EMH is “wrong” because some anomaly is found. Well there are also anomalies in Newton’s laws, so if the EMH is wrong, then so are Newton’s laws. That was my point.
But you are right, there was a seeming contradiction there, I should have been clearer.
7. August 2009 at 07:11
Scott,
Yes, when I wrote “increase demand” what I meant was increase quantity demanded. I should have been more precise. You seem to be saying that a lower price for yogurt will increase quantity demanded but there will not necessarily be a new equilibrium at the lower price. Fair enough; as I said I think in the case of a health scare there would be disequilibrium. Maybe this is a concept an S&D chart cannot convey adequately?
7. August 2009 at 08:28
As I said in the earlier thread, we’re talking about different products. Yogurt that can be consumed (and enjoyed) safely is an entirely different thing than yogurt that can make you sick or kill you. The former is a ‘good’, and the latter is a ‘bad’.
7. August 2009 at 09:41
wondering if we can move the discussion of disequilibrium from the hypothetical yogurt example, to the current loanable funds market. since 2007, have money markets been in disequilibrium due to a “health scare”?
8. August 2009 at 04:57
David, You can show disequilibrium on a supply and demand chart, but unless you have price controls that prevent the price from falling, I’m not sure why you would end up with disequilibrium.
Patrick, I agree, but in this case it wasn’t the product that changed, but rather the perception of the product. Demand shifts often change because the perception of a product changes–for instance when clothes go in and out of style.
van, I don’t see why credit markets would be out of equilibrium. The interest rate adjusts to reflect changes in the perceived risk.
8. August 2009 at 07:12
Scott, I was seeing a health scare as a temporary event, like a tainted batch that can be destroyed. I don’t think you “end up” with a disequilibrium, I think you have a disequilibrium state while the event passes, then supply, demand, and price return to normal.
If your health scare is a permanent shift in the perception of yogurt but the product remains saleable, then retailers see slower sales, order less, and supply adjusts along with price to a new equilibrium.
By writing “if the price of frozen yogurt falls,” we are implying that you have a constant utility function for frozen treats and discover lower prices you will buy more. By writing “a health scare changes the demand for yogurt,” we are implying that your utility function for yogurt decreases. That makes it two different problems. I think.
8. August 2009 at 07:20
I find myself explaining to students, “well, the answer for THIS professor is …” Students do not find professor-specific explanations to be very satisfactory.
As a non-economist, I do not understand how you can just dismiss this comment with a couple of jokes. It also amazes me that there can be such widespread disagreement within a discipline that claims, at least sometimes, to be a science.
Here’s an article that says it better than I can:
http://www.ritholtz.com/blog/2009/08/six-impossible-things-before-breakfast/
Here’s a quote from that article:
“Rob Arnott tells a lovely story of a speech he was giving to some 200 finance professors. He asked how many of them taught EMH – pretty much everyone’s hand was up. Then he asked how many of them believed it. Only two hands stayed up!”
9. August 2009 at 05:04
David, Of course you can have disequilibrium in any market if the price doesn’t move to the point that equates supply and demand. I just wasn’t able to see the connection to yogurt and health scares. Why that shock would cause disequilibrium.
In your last point, I agree that a fall in price, and a fall in utility from consuming yogurt are two different things.
lxm, I suppose my joking was black humor. Part of the problem is that I am not 100% sure this commenter was correct. I think he was likely correct, but as we saw with the dispute between me and Steven Landsburg two economists can understand the model of S&D in exactly the same way, but interpret wording slightly differently.
Again, my hunch is that the commenter was correct; I so often see economists misuse S&D that I found it very plausible.
Sometimes humor can make a point more effectively than outrage. No one likes to be criticized, but they especially don’t like to be ridiculed. So if my ridicule makes economists rethink this issue, so much the better.
Regarding you comment about economics being a science, my view is that economists understand the technical aspects of the models pretty well, but they have trouble applying them to the real world.
I was also interested in your EMH example for two reasons:
1. I don’t teach models that I don’t believe in, although I do mention points of view that I don’t believe in.
2. I do think the EMH is a useful model.
So the response of those professors seems pretty pathetic. On the other hand, there may be more there than meets the eye. It is possible that most of the finance professors think the EMH model is useful, even if not precisely true. Indeed this is the perspective of most finance professors that I talk to. In that case they are completely justified in teaching the model. But I can’t speak for them, you’d have to ask them yourself.
9. August 2009 at 05:09
lxm, I just read the article you attached, and I think he gets things exactly backward. Finance professors follow up on teaching the EMH by showing all sorts of “anomalies” that supposedly show it is wrong. Student go out into the world thinking they will discover these anomalies and get rich. When they do so you get LTCM, and Bernie Madoff.
9. August 2009 at 07:15
Scott, I thought the paradox of EMH was that only the collective action of individuals working counter to EMH create the efficient market. People need to be motivated by the belief their information is better. And with a little brains, effort, or luck your information will be better…occasionally.
We might agree it’s folly to think you can consistently have better information than the market. But on the other hand, the EMH is not a sufficient argument against action in those instances when you do believe you have better information.
9. August 2009 at 07:22
On the disequilibrium thing, my thoughts are probably colored by real world experience. If there was a tainted batch of frozen yogurt there would be a recall. It’s possible the price of frozen yogurt would increase, as the same demand for edible yogurt met a smaller supply.
“Health scare” is a vague idea that could play out a number of different ways, which might be why it’s difficult to conclude the discussion.
10. August 2009 at 05:49
David, You said:
“Scott, I thought the paradox of EMH was that only the collective action of individuals working counter to EMH create the efficient market. People need to be motivated by the belief their information is better. And with a little brains, effort, or luck your information will be better occasionally.
We might agree it’s folly to think you can consistently have better information than the market. But on the other hand, the EMH is not a sufficient argument against action in those instances when you do believe you have better information.”
I agree, but that is if you have real information, not a statistical hunt for anomalies that is based on the premise that markets are not efficient. So Madoff had double digit returns every year? That’s a horrible reason to invest in Madoff if you believe in the EMH, but a great reason to invest in Madoff if you believe in anomalies.
Investors should go out and find real information, like Warren Buffet supposedly does. He doesn’t look at reams of data looking for anomalies, he looks for companies with good fundamentals.
David#2, You may be right about recalls, but now we are drifting far away from the question.
18. August 2009 at 09:32
so it wasn’t obvious in 2005 that house prices went down because more of them were being built?
19. August 2009 at 02:53
q, The theory of S&D doesn’t say prices should go down just becasue more are built. It could be that quantity supplied is responding to higher prices caused by more demand. 2005 looks like an obvious mistake in retrospect, but at the time many people didn’t expect prices to fall.
20. August 2009 at 06:12
(blush) i was being sarcastic — guess that wasn’t clear.
20. August 2009 at 08:59
I was trained as a physicist. What I cannot understand is why we bother modeling supply and demand. Why not simply observe and model the flow of consumption or production directly?
Is it that data was too hard to get before the Internet? Is it that neoclassical models are so beautiful in some aesthetic sense? What’s the deal?
23. August 2009 at 23:07
q, Sorry. I get burnout answering comments, and often miss the humor. And I think I was also thrown off by the year, did you mean 2007?
Michael, We also try to explain output, but the S&D model gives us an understanding of the forces shifting output, which can help public policymakers design more effective policies.
24. August 2009 at 01:13
Michael F. Martin,
The flows of consumption and production don’t tell us much.
The most effective weapon in the economists toolbox is consideration of the local situation of actors. Supply and demand arise from this.
Attempts to “model” production and consumption without understanding how they come about through the decisions of economic actors are doomed to failure. Hayek rightly called them scientism.
26. August 2009 at 14:22
Thank you Scott and Current, but these answers don’t necessarily help.
Scott’s answer seems to be an acknowledgment that understanding the dynamics of output are the goal, and an explanation that S&D provide a useful tool for modeling dynamics of output. Fine. But isn’t the point of this series of posts that in practice, S&D models obscure some details? Why not measured and model output dynamics directly?
Current’s answer sort of gets at this. It seems that Hayek (in what text?) was skeptical of such attempts. Can I suggest that this might have been because there was no empirical data to test such models when Hayek was working? Today we have datasets that show us the stream of consumption of thousands of individuals. Many large companies can test models of the flow of consumption against real data easily. Models of supply and demand were fine when changes in patterns of consumption and production were relatively slow, or when dynamics were close to equilibrium. We do not live in that world anymore.
In physics, we make the transition from microdynamics to macrodynamics through renormalization group. This means taking the set of dynamical variables for each of N microscopic units (such as subatomic particles, atoms, or molecules) and “coarse-graining” them by rescaling them up to larger and larger scales. By doing this systematically, one can identify a handful of dynamical variables that determine the statistical behavior of the entire system of N units. In physics, these are temperature, pressure, volume, and mass, for example. A whole new set of equations applies to the dynamics of the system, which are nontrivial (in fact, impossible) to drive from the equations governing microscopic dynamics.
With the data now available, it is not completely crazy to think that a similar process could be carried out in testing equations from macroeconomics.
27. August 2009 at 02:32
Martin, It seems to me that you are referring to less than perfectly competitive markets. S&D is set up for perfect competition, like some of the commodity markets, but is only an approximation for consumer goods, which are typically sold in monopolistically competitive markets. You may be right that the data we have know allows us to model these market more effectively. I believe Walmart keeps track of everything they sell each day, and at what price. If so, then we might be able to estimate the demand curve more effectively than before. There is no supply curve for a monopolistically competitive firm, and I think this is what you hint at with your “disequilibrium” comment. Micro isn’t my area, so I don’t know what sort of research is currently being done with this sort of high frequency data. Some of my colleagues have looked at internet markets which allow for some interesting tests of pricing models, so I know some work is being done.
27. August 2009 at 03:25
Michael F. Martin,
I see what you mean about Thermodynamics, I learnt about that myself a few years ago. However, Economics isn’t like Thermodynamics.
Ludvig Von Mises wrote about this in “Theory and History” http://mises.org/th.asp . I think Mises is unreasonable about epistemology in places, but I think he is quite right in the parts I quote below.
The methods used by economics and by physics are different because the subjects studied are different.
A good example of this problem is given by the recent history of the P/E ratio on the stock market and the rate of interest on bonds. To quote an old newspaper article from 1998.
When Ed Keon said this there were decades of evidence showing it to be correct, many financial economists agreed with him. However the model is generally wrong. Over other long periods of time the relationship has been different. The present day inverse relationship began in ~1966.
Coming back to supply and demand, Supply and demand arise from marginalism. They have underpinnings in the basic facts of human action, and some fairly permanent institutional factors. We can be quite sure that they will always work.
Consumption though is driven by marginal decisions. They act through supply and demand. Any shortcut that correlates consumption against some other variable infers a model of marginal decisions and supply & demand.
Note that economies have probably never been “close to equilibrium” in the sense of general equilibrium. However, contrary to popular belief, price theory doesn’t require general equilibrium. It is a description of how a market comes closer to equilibrium.
27. August 2009 at 03:25
Here is a graph with a longer time period http://brian-krassenstein.blogspot.com/2009/06/historic-pe-ratios-compared-to-interest.html .
27. August 2009 at 12:12
Scott,
Thanks for the explanation and suggestion for follow up with micro folks. Very helpful.
Current,
Clearly human behavior is a more complex phenomenon than the phenomena of atoms and molecules. The question is always what models and approximations may give insight into the phenomena that is not intuitive from the mess of data that assaults our senses. I do not think there is a difference in kind between the natural and social sciences in this regard, and indeed have argued that theoretical techniques from the natural sciences may be applied fruitfully to improving our understanding of group behavior.
More specifically, I would say that there is a good chance that people could be grouped dynamically into patterns of consumption based on the frequency distribution of their activities. Here’s an example of a toy model motivated by that type of thinking:
http://brokensymmetry.typepad.com/broken_symmetry/2009/08/a-systems-theory-of-animal-spirits-an-application-of-the-1d-ising-model.html
Will such models give us a perfect description? No. Mises always wins on that point. But we have to find ways of muddling through, and marginal improvements in theory are better than none.
I am not as familiar with Mises as I would like, but my sense is that he was more strongly motivated than other Austrian economists to reach the conclusion that regulatory interventions were wrong. He makes good arguments, but there are good responses to nearly all of them. Today there is consensus that free markets are an efficient mechanism for allocating scarce resources AND a consensus that certain failure inhibit market freedom or prohibit or impair markets entirely. It’s the latter set of theoretical questions that interests me.
27. August 2009 at 13:54
I think you will agree that human beings are much more complicated than molecules. You are making light of what is a very serious problem.
As for “models” giving us “insights”. This isn’t the natural sciences. In physics we often observe complex large scale phenomena and we induce what is occuring on the smaller scale from that. That is how our models provide us with insights. They simplify the thinking about the constitutents parts we can’t see.
Economics is in exactly the opposite situation. Each of us are one of the fundamental building blocks. We don’t really need the “insight” of models. The “mess of [market] data” that assaults our senses is something that we already interpret. What is needed is a structure for the apparently adhoc way we do that, that is what marginalism is all about. The challenge is rather to put the insights of our situation into the models. And to find realistic simplifications if they are needed.
I’ll reply to the rest later.
31. August 2009 at 03:28
I read your website where you propose to use a variant of the Ising model. I don’t think that such a model could provide results that are useful in the long term, I doubt it could even do so in the short term.
Consider what the actual motivations between saving and consumption are. We must start from preferences. Each person has preferences, one service X will be prioritized versus another Y. If the person has enough money for both he will buy both, if not he will buy only X. I mention services here, but it could be a good too, or a future good.
Now, obviously people will prioritize the near-term over the long-term. As the wealth (or expected future wealth) of a person increases they are able to make longer term plans. However, this doesn’t translate directly into consumption and saving behaviour (not in the normal use of those terms anyway).
Consider buying a car for example, what sort of purchase is that? This isn’t a simple question. Clearly a car is a consumer good. It provides a consumption service from the first day it is bought, but, it continues to provide that service for many years afterwards. So, it involves an element of investment.
Then there is the question of expectations. A person who expects to be poor in the future is going to make different decisions to someone who expects to be rich. This too affects the amount spent on consumption and that saved. As Keynes was noting those expectations of the future cannot be entirely based on calculated probabilities.
I’ve only scratched the surface of the problems with your model, there are many more.
If you are not familiar with Mises then how can you argue he was wrong? What are the good responses to his arguments? and by what magic do you know them?
Well, that’s your opinion, and a common one. I don’t think that policy is directly important in the debate about methods.
8. September 2009 at 06:58
I will give Mises another look. Some of my good friends are gaga for Mises.
I do have misgivings about the logic of an argument that seems to go like this: scientific models of human behavior are flawed because human behavior is not deterministic. Therefore, we will use non-scientific models of human behavior. Besides that, if we look for historical tests of Mises’s principles, they are mixed in result. Like price changes and the identification problem, the historical record cannot resolve any debates in favor of Mises.
Thanks for your comments on the post on the Ising Model. It’s a toy model, and says nothing about the expectations or time horizons of individuals. What is does show, however, is that *regardless* of these other effects, IF there is even a weak interdependence in decisonmaking by individuals (I.e., even a slight influence of others’ decisions to consume or save on my own decision) then under conditions of low interest rates and money supply, individual decisionmaking will spontaneously correlate. I think it an obvious fact subject to anybody’s observation that we are influenced by others (because of our “animal spirits”). Indeed there is evidence from biology and psychology of the same. Yet this simple result is not part of the repertoire for macro theorists, even if policymakers grasp it dimly.