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Macroeconomics
Economics and the Economy
by Timothy Taylor
Managing Editor:
The Journal of Economic Perspectives
Macalester College
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Macroeconomics
Side 2
Endorsement: ―Tim is also an award-winning teacher and a highly sought-after editor. The characteristics that
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-John Karl Scholz; Professor; UW-Madison
About the author/book: Tim Taylor’s career has been devoted to making complex economic ideas clear to students, policy makers and other professional economists. Taylor is the founding and only managing editor of the
American Economic Association’s Journal of Economic Perspectives, which for more than 20 years has been an
accessible source for state-of-the art economic thinking. Tim has won numerous teaching awards from his teaching stints at institutions like Stanford, the University of Minnesota and Macalester College.
More about Tim Taylor’s Principles of Economics (and Macro/Micro splits):
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Demand
and Supply
W
hen people talk about prices, the discussion often takes a judgmental
tone. A bidder in an auction pays thousands of dollars for a dress once
worn by Diana, Princess of Wales. A collector spends thousands of
dollars for some drawings by John Lennon of the Beatles. Mouths gape. Surely such
purchases are a waste of money? But when economists talk about prices, they are
less interested in making judgments than in gaining a practical understanding of
what determines prices and why prices change. In 1933, the great British economist
Joan Robinson (1903–1983) explained how economists perceive price:
The point may be put like this: You see two men, one of whom is giving
a banana to the other, and is taking a penny from him. You ask, How is it
that a banana costs a penny rather than any other sum? The most obvious
line of attack on this question is to break it up into two fresh questions:
How does it happen that the one man will take a penny for a banana? and:
How does it happen that the other man will give a penny for a banana?
In short, the natural thing is to divide up the problem under two heads:
Supply and Demand.
As a contemporary example, consider a price often listed on large signs beside
well-traveled roads: the price of a gallon of gasoline. Why was the average price of
gasoline in the United States $2.21 per gallon in January 2006? Why did the price
for gasoline rise to $2.81 per gallon six months later by June 2006? To explain
why prices are at a certain level and why that level changes over time, economic
analysis focuses on the determinants of what gasoline buyers are willing to pay
and what gasoline sellers are willing to accept. For example, the price of a gallon
of gasoline in June of a given year is nearly always higher than the price in January
of that year; over recent decades, gasoline prices in midsummer have averaged
61
62
Chapter 4
Demand and Supply
about 10 cents per gallon more than their midwinter low. The likely reason is that people
want to drive more in the summer, and thus they are willing to pay more for gas at that
time. However, in 2006, gasoline prices rose by much more than the average winter-tosummer rise, which suggests that other factors related to those who buy gasoline and
firms that sell it changed during those six months, too.
This chapter introduces the economic model of demand and supply. The discussion
begins by examining how demand and supply determine the price and the quantity sold in
markets for goods and services, and how changes in demand and supply lead to changes
in prices and quantities. Then in Chapter 5, the very same demand and supply model
is applied to markets for labor and financial capital. In Chapter 6, the same supply and
demand model is applied to international trade. In situation after situation, in different
places around the world, across different cultures, even reaching back into history, the
demand and supply model offers a useful framework for thinking about what determines
the prices and quantities of what is bought and sold.
Demand, Supply, and Equilibrium in Markets
for Goods and Services
Markets for goods and services include everything from accounting services, air travel,
and apples to zinc, zinfandel wine, and zucchini. Let’s first focus on what economists
mean by demand, what they mean by supply, and then how demand and supply interact
in an economic model of the market.
demand: A relationship
between price and the quantity
demanded of a certain good
or service.
quantity demanded: The
total number of units of a good
or service purchased at a
certain price.
law of demand: The
common relationship that a
higher price leads to a lower
quantity demanded of a
certain good or service.
demand schedule: A table
that shows a range of prices
for a certain good or service
and the quantity demanded at
each price.
demand curve: A line
that shows the relationship
between price and quantity
demanded of a certain good
or service on a graph, with
quantity on the horizontal axis
and the price on the vertical
axis.
Demand for Goods and Services
Economists use the term demand to refer to a relationship between price and the
quantity demanded. Price is what a buyer pays (or the seller receives) for a unit of the
specific good or service. Quantity demanded refers to the total number of units that
are purchased at that price. A rise in price of a good or service almost always decreases
the quantity demanded of that good or service; conversely, a fall in price will increase
the quantity demanded. When the price of a gallon of gasoline goes up, for example,
people look for ways to reduce their purchases of gasoline by combining several errands,
commuting by carpool or mass transit, or taking weekend or vacation trips by car close
to home. Economists refer to the relationship that a higher price leads to a lower quantity
demanded as the law of demand.
Exhibit 4-1 gives an example in the market for gasoline. The table which shows
the quantity demanded at each price is called a demand schedule. Price in this case
is measured per gallon of gasoline. The quantity demanded is measured in millions
of gallons over some time period (for example, per day or per year) and over some
geographic area (like a state or a country). A demand curve shows the relationship
between price and quantity demanded on a graph, with quantity on the horizontal axis
and the price per gallon on the vertical axis. The demand schedule shown by the table and
the demand curve shown on the graph are two ways of describing the same relationship
between price and quantity demanded.
Each individual good or service needs to be graphed on its own demand curve,
because it wouldn’t make sense to graph the quantity of apples and the quantity of
oranges on the same diagram. Demand curves will appear somewhat different for each
product; for example, they may appear relatively steep or flat, or they may be straight or
Chapter 4
Demand and Supply
In economic terminology, demand is not the same as quantity demanded. When economists
refer to demand, they mean the relationship between a range of prices and the quantities
demanded at those prices, as illustrated by a demand curve or a demand schedule. When
economists refer to quantity demanded, they often mean only a certain point on the demand
curve, or perhaps the horizontal axis of the demand curve or one column of the demand
schedule.
63
Clearing It Up
Demand Is Not Quantity
Demanded
Exhibit 4-1 A Demand
Curve for Gasoline
D
Price ($ per gallon)
$2.20
($2.20 per gallon, 420 million gallons)
($2.00 per gallon, 460 million gallons)
$2.00
($1.80 per gallon, 500 million gallons)
$1.80
($1.60 per gallon, 550 million gallons)
$1.60
($1.40 per gallon, 600 million gallons)
($1.20 per gallon, 700 million gallons)
$1.40
$1.20
($1.00 per gallon, 800 million gallons)
$1.00
300
400
500
600
700
800
900
Quantity of Gasoline (millions of gallons)
Price (per gallon)
Quantity demanded (in millions of gallons)
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
800
700
600
550
500
460
420
The table that shows quantity
demanded of gasoline at
each price is called a demand
schedule. The demand schedule
shows that as price rises,
quantity demanded decreases.
These points are then graphed
on the figure, and the line
connecting them is the demand
curve D. The downward slope
of the demand curve again
illustrates the pattern that as
price rises, quantity demanded
decreases. This pattern is called
the law of demand.
curved. But nearly all demand curves share the fundamental similarity that they slope
down from left to right. In this way, demand curves embody the law of demand; as the
price increases, the quantity demanded decreases, and conversely, as the price decreases,
the quantity demanded increases.
Supply of Goods and Services
When economists talk about supply, they are referring to a relationship between price
received for each unit sold and the quantity supplied, which is the total number of
units sold in the market at a certain price. A rise in price of a good or service almost
always leads to an increase in the quantity supplied of that good or service, while a
fall in price will decrease the quantity supplied. When the price of gasoline rises, for
example, profit-seeking firms are encouraged to expand exploration for oil reserves;
to carry out additional drilling for oil; to make new investments in pipelines and oil
tankers to bring the oil to plants where it can be refined into gasoline; to build new oil
supply: A relationship
between price and the
quantity supplied of a certain
good or service.
quantity supplied: The
total number of units of a
good or service sold at a
certain price.
Chapter 4
64
Clearing It Up
Supply Is Not the Same
as Quantity Supplied
Demand and Supply
In economic terminology, supply is not the same as quantity supplied. When economists
refer to supply, they mean the relationship between a range of prices and the quantities
supplied at those prices, a relationship that can be illustrated with a supply curve or a supply
schedule. When economists refer to quantity supplied, they often mean only a certain point
on the supply curve, or sometimes, they are referring to the horizontal axis of the supply
curve or one column of the supply schedule.
Exhibit 4-2 A Supply
Curve for Gasoline
law of supply: The common
relationship that a higher price
is associated with a greater
quantity supplied.
supply schedule: A table
that shows a range of prices
for a good or service and
the quantity supplied at each
price.
supply curve: A line
that shows the relationship
between price and quantity
supplied on a graph, with
quantity supplied on the
horizontal axis and price on
the vertical axis.
($2.20 per gallon, 720 million gallons)
$2.20
Price ($ per gallon)
The supply schedule is the table
that shows quantity supplied
of gasoline at each price. As
price rises, quantity supplied
also increases. The supply curve
S is created by graphing the
points from the supply schedule
and then connecting them. The
upward slope of the supply
curve illustrates the pattern that
a higher price leads to a higher
quantity supplied—a pattern
that is common enough to be
called the law of supply.
($2.00 per gallon, 700 million gallons)
$2.00
($1.80 per gallon, 680 million gallons)
$1.80
($1.60 per gallon, 640 million gallons)
$1.60
$1.40
($1.40 per gallon, 600 million gallons)
($1.20 per gallon, 550 million gallons)
$1.20
($1.00 per gallon, 500 million gallons)
$1.00
300
400
500
600
700
800
900
Quantity of Gasoline (millions of gallons)
Price (per gallon)
Quantity supplied (millions of gallons)
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
500
550
600
640
680
700
720
refineries; to purchase additional pipelines and trucks to ship the gasoline to gas stations;
and to open more gas stations or to keep existing gas stations open longer hours. The
pattern that a higher price is associated with a greater quantity supplied is so common
that economists have named it the law of supply.
Exhibit 4-2 illustrates the law of supply, again using the market for gasoline as an
example. A supply schedule is a table that shows the quantity supplied at a range of
different prices. Again, price is measured per gallon of gasoline and quantity demanded
is measured in millions of gallons. A supply curve is a graphical illustration of the
relationship between price, shown on the vertical axis, and quantity, shown on the
horizontal axis. The supply schedule and the supply curve are just two different ways
of showing the same information. Notice that the horizontal and vertical axes on the
graph for the supply curve are the same as for the demand curve.
Just as each product has its own demand curve, each product has its own supply
curve. The shape of supply curves will vary somewhat according to the product: steeper,
flatter, straighter, or curved. But nearly all supply curves share a basic similarity: they
Chapter 4
Demand and Supply
65
slope up from left to right. In that way, the supply curve illustrates the law of supply:
as the price rises, the quantity supplied increases, and conversely, as the price falls, the
quantity supplied decreases.
Equilibrium—Where Demand and Supply Cross
Because the graphs for demand and supply curves both have price on the vertical axis
and quantity on the horizontal axis, the demand curve and supply curve for a particular
good or service can appear on the same graph. Together, demand and supply determine
the price and the quantity that will be bought and sold in a market.
Exhibit 4-3 illustrates the interaction of demand and supply in the market for
gasoline. The demand curve D is identical to Exhibit 4-1. The supply curve S is identical
to Exhibit 4–2. When one curve slopes down, like demand, and another curve slopes
up, like supply, the curves intersect at some point.
In every economics course you will ever take, when two lines on a diagram cross,
this intersection means something! The point where the supply curve S and the demand
curve D cross, designated by point E in Exhibit 4-3, is called the equilibrium. The
equilibrium price is defined as the price where quantity demanded is equal to quantity
supplied. The equilibrium quantity is the quantity where quantity demanded and
quantity supplied are equal at a certain price. In Exhibit 4-3, the equilibrium price is
$1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you
had only the demand and supply schedules, and not the graph, it would be easy to find
the equilibrium by looking for the price level on the tables where the quantity demanded
and the quantity supplied are equal.
equilibrium price:
The price where quantity
demanded is equal to quantity
supplied.
equilibrium quantity: The
quantity at which quantity
demanded and quantity
supplied are equal at a
certain price.
Exhibit 4-3 Demand
and Supply for Gasoline
Excess supply
or surplus
P ($ per gallon)
$2.20
$1.80
S
An above-equilibrium price
E
$1.40
$1.20
$1.00
Equilibrium price
A below-equilibrium price
Excess demand
or shortage
D
$0.60
300 400 500 600 700 800 900
Quantity of Gasoline (millions of gallons)
Price (per gallon)
Quantity demanded
Quantity demanded
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
800
700
600
550
500
460
420
500
550
600
640
680
700
720
The demand curve D and the
supply curve S intersect at the
equilibrium point E, with a price
of $1.40 and a quantity of 600.
The equilibrium is the only price
where quantity demanded is
equal to quantity supplied.
At a price above equilibrium
like $1.80, quantity supplied
of 680 exceeds the quantity
demanded of 500, so there is
excess supply or a surplus. At a
price below equilibrium such as
$1.20, quantity demanded of
700 exceeds quantity supplied
of 550, so there is excess
demand or a shortage.
66
Chapter 4
equilibrium: The
combination of price and
quantity where there is no
economic pressure from
surpluses or shortages that
would cause price or quantity
to shift.
The word equilibrium means “balance.” If a market is balanced at its equilibrium
price and quantity, then it has no reason to move away from that point. However, if a
market is not balanced at equilibrium, then economic pressures arise to move toward
the equilibrium price and the equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above the
equilibrium price; that is, instead of $1.40 per gallon, the price is $1.80 per gallon.
This above-equilibrium price is illustrated by the dashed horizontal line at the price of
$1.80 in Exhibit 4-3. At this higher price of $1.80, the quantity demanded drops from
the equilibrium quantity of 600 to 500. This decline in quantity reflects how people
and businesses react to the higher price by seeking out ways to use less gasoline, like
sharing rides to work, taking mass transit, and avoiding faraway vacation destinations.
Moreover, at this higher price of $1.80, the quantity supplied of gasoline rises from the
600 to 680, as the higher price provides incentives for gasoline producers to expand
their output. At this above-equilibrium price, there is excess supply, or a surplus;
that is, the quantity supplied exceeds the quantity demanded at the given price. With a
surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil
refineries. This accumulation puts pressure on gasoline sellers. If a surplus of gasoline
remains unsold, those firms involved in making and selling gasoline are not receiving
enough cash to pay their workers and to cover their expenses. In this situation, at least
some gasoline producers and sellers will be tempted to cut prices, because it’s better
to sell at a lower price than not to sell at all. Once some sellers start cutting gasoline
prices, others will follow so that they won’t lose sales to the earlier price-cutters. These
price reductions in turn will stimulate a higher quantity demanded. Thus, if the price
is above the equilibrium level, incentives built into the structure of demand and supply
will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as
shown by the dashed horizontal line at this price in Exhibit 4-3. At this lower price, the
quantity demanded increases from 600 to 700 as drivers take longer trips, spend more
minutes warming up their car in the driveway in wintertime, stop sharing rides to work,
and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium
price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity
supplied of gasoline falls from 600 to 550. When the price is below equilibrium, there
is excess demand, or a shortage; that is, at the given price the quantity demanded,
which has been stimulated by the lower price, now exceeds the quantity supplied, which
had been depressed by the lower price. In this situation, eager gasoline buyers mob
the gas stations, only to find many stations running short of fuel. Oil companies and
gas stations recognize that they have an opportunity to make higher profits by selling
what gasoline they have at a higher price. As a result, the price increases toward the
equilibrium level.
excess supply: When at
the existing price, quantity
supplied exceeds the quantity
demanded; also called a
“surplus.”
surplus: When at the
existing price, quantity
supplied exceeds the quantity
demanded; also called
“excess supply.”
excess demand: At the
existing price, the quantity
demanded exceeds the
quantity supplied, also called
“shortage.”
shortage: At the existing
price, the quantity demanded
exceeds the quantity supplied,
also called “excess demand.”
Demand and Supply
Shifts in Demand and Supply for Goods
and Services
A demand curve shows how quantity demanded changes as the price rises or falls.
A supply curve shows how quantity supplied changes as the price rises or falls. But
what happens when factors other than price influence quantity demanded and quantity
supplied? For example, what if demand for, say, vegetarian food becomes popular
with more consumers? Or what if the supply of, say, diamonds rises not because of
Chapter 4
Demand and Supply
67
any change in price, but because companies discover several new diamond mines? A
change in price leads to a different point on a specific demand curve or a supply curve,
but a shift in some economic factor other than price can cause the entire demand curve
or supply curve to shift.
The Ceteris Paribus Assumption
A demand curve or a supply curve is a relationship between two and only two variables:
quantity on the horizontal axis and price on the vertical axis. Thus, the implicit
assumption behind a demand curve or a supply curve is that no other relevant economic
factors are changing. Economists refer to this assumption as ceteris paribus, a Latin
phrase meaning “other things being equal.” Any given demand or supply curve is based
on the ceteris paribus assumption that all else is held equal. If all else is not held equal,
then the demand or supply curve itself can shift.
ceteris paribus: Other
things being equal.
An Example of a Shifting Demand Curve
The original demand curve D0 in Exhibit 4-4 shows at point Q that at a price of $20,000
per car, the quantity of cars demanded would be 18 million. The original demand curve
D0 also shows how the quantity of cars demanded would change as a result of a higher
or lower price; for example, if the price of a car rose to $22,000, the quantity demanded
would decrease to 17 million, as at point R.
Exhibit 4-4 Shifts in
Demand: A Car Example
$28,000
Increased demand means
that at every given price, the
quantity demanded is higher,
so that the demand curve shifts
to the right from D 0 to D 1 .
Decreased demand means
that at every given price, the
quantity demand is lower, so
that the demand curve shifts to
the left from D0 to D2.
$26,000
$24,000
R
Price
$22,000
p = 20,000
q = 14.4 million
$20,000
T
p = 20,000
q = 18 million
S
p = 20,000
q = 20 million
Q
$18,000
$16,000
D2
D0
D0
$14,000
$12,000
$10,000
8
13 14.4
17 18
20
23
28
Quantity
Price
$16,000
$18,000
$20,000
$22,000
$24,000
$26,000
Decrease
to D2
17.6
16.0
14.4
13.6
13.2
12.8
million
million
million
million
million
million
Original Quantity
Demanded D0
22.0
20.0
18.0
17.0
16.5
16.0
million
million
million
million
million
million
Increase
to D1
24.0
22.0
20.0
19.0
18.5
18.0
million
million
million
million
million
million
68
shift in demand: When
a change in some economic
factor related to demand
causes a different quantity to
be demanded at every price.
normal goods: Goods
where the quantity demanded
rises as income rises.
inferior goods: Goods
where the quantity demanded
falls as income rises.
Chapter 4
Demand and Supply
The original demand curve D0, like every demand curve, is based on the ceteris
paribus assumption that no other economically relevant factors change. But now imagine
that the economy expands in a way that raises the incomes of many people. As a result of
the higher income levels, a shift in demand occurs, which means that compared to the
original demand curve D0, a different quantity of cars will now be demanded at every
price. On the original demand curve, a price of $20,000 means a quantity demanded of
18 million, but after higher incomes cause an increase in demand, a price of $20,000
leads to a quantity demanded of 20 million, at point S. Exhibit 4-4 illustrates the shift in
demand as a result of higher income levels with the shift of the original demand curve
D0 to the right to the new demand curve D1.
This logic works in reverse, too. Imagine that the economy slows down so that many
people lose their jobs or work fewer hours and thus suffer reductions in income. In this
case, the shift in demand would lead to a lower quantity of cars demanded at every given
price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2
represents a decrease in demand; that is, at any given price level, the quantity demanded
is now lower. In this example, a price of $20,000 means 18 million cars sold along the
original demand curve, but only 14.4 million cars sold after demand has decreased.
When a demand curve shifts, it does not mean that the quantity demanded by every
individual buyer changes by the same amount. In this example, not everyone would
have higher or lower income and not everyone would buy or not buy an additional car.
Instead, a shift in a demand captures an overall pattern for the market as a whole.
Factors That Shift Demand Curves
A change in any one of the underlying factors that determine what quantity people are
willing to buy at a given price will cause a shift in demand. Graphically, the new demand
curve lies either to the right or to the left of the original demand curve. Various factors
may cause a demand curve to shift: changes in income, change in population, changes
in taste, changes in expectations, and changes in the prices of closely related goods.
Let’s consider these factors in turn.
A change in income will often move demand curves. A household with a higher
income level will tend to demand a greater quantity of goods at every price than a
household with a lower income level. For some luxury goods and services, such as
expensive cars, exotic spa vacations, and fine jewelry, the effect of a rise in income
can be especially pronounced. However, a few exceptions to this pattern do exist. As
incomes rise, many people will buy fewer popsicles and more ice cream, less chicken
and more steak, they will be less likely to rent an apartment and more likely to own a
home, and so on. Normal goods are defined as those where the quantity demanded rises
as income rises, which is the most common case; inferior goods are defined as those
where the quantity demanded falls as income rises.
Changes in the composition of the population can also shift demand curves for
certain goods and services. The proportion of elderly citizens in the U.S. population
is rising from 9.8% in 1970, to 12.6% in 2000, and to a projected (by the U.S. Census
Bureau) 20% of the population by 2030. A society with relatively more children, like
the United States in the 1960s, will have greater demand for goods and services like
tricycles and day care facilities. A society with relatively more elderly persons, as the
United States is projected to have by 2030, has a higher demand for nursing homes and
hearing aids.
Changing tastes can also shift demand curves. In demand for music, for example,
50% of sound recordings sold in 1990 were in the rock or pop music categories.
Chapter 4
Demand and Supply
By 2004, rock and pop had fallen to less than 40% of the total, while sales of rap/
hip-hop, religious, and country categories had increased. Tastes in food and drink have
changed, too. From 1980 to 2004, the per person consumption of chicken by Americans
rose from 33 pounds per year to 60 pounds per year, and consumption of cheese rose
from 17 pounds per year to 31 pounds per year. Changes like these are largely due to
movements in taste, which change the quantity of a good demanded at every price: that
is, they shift the demand curve for that good.
Changes in expectations about future conditions and prices can also shift the demand
curve for a good or service. For example, if people hear that a hurricane is coming, they
may rush to the store to buy flashlight batteries and bottled water. If people learn that
the price of a good like coffee is likely to rise in the future, they may head for the store
to stock up on coffee now.
The demand curve for one good or service can be affected by changes in the prices
of related goods. Some goods and services are substitutes for others, which means that
they can replace the other good to some extent. For example, if the price of cotton rises,
driving up the price of clothing, sheets, and other items made from cotton, then some
people will shift to comparable goods made from other fabrics like wool, silk, linen,
and polyester. A higher price for a substitute good shifts the demand curve to the right;
for example, a higher price for tea encourages buying more coffee. Conversely, a lower
price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning that the goods are often
used together, so that consumption of one good tends to increase consumption of the
other. Examples include breakfast cereal and milk; golf balls and golf clubs; gasoline
and sports utility vehicles; and the five-way combination of bacon, lettuce, tomato,
mayonnaise, and bread. If the price of golf clubs rises, demand for a complement good
like golf balls decreases. A higher price for skis would shifts the demand curve for a
complement good like ski resort trips to the left, while a lower price for a complement
has the reverse effect.
Summing Up Factors That Change Demand
Six factors that can shift demand curves are summarized in Exhibit 4-5. The direction of
the arrows indicates whether the demand curve shifts represent an increase in demand or
a decrease in demand based on the six factors we just considered. Notice that a change
in the price of the good or service itself is not listed among the factors that can shift a
demand curve. A change in the price of a good or service causes a movement along a
specific demand curve, and it typically leads to some change in the quantity demanded,
but it doesn’t shift the demand curve. Notice also that in these diagrams, the demand
curves are drawn without numerical quantities and prices on the horizontal and vertical
axes. The demand and supply model can often be a useful conceptual tool even without
attaching specific numbers.
When a demand curve shifts, it will then intersect with a given supply curve at a
different equilibrium price and quantity. But we are getting ahead of our story. Before
discussing how changes in demand can affect equilibrium price and quantity, we first
need to discuss shifts in supply curves.
An Example of a Shift in a Supply Curve
A supply curve shows how quantity supplied will change as the price rises and falls,
based on the ceteris paribus assumption that no other economically relevant factors are
changing. But if other factors relevant to supply do change, then the entire supply curve
69
substitutes: Goods that
can replace each other to
some extent, so that greater
consumption of one good can
mean less of the other.
complements: Goods that
are often used together, so
that consumption of one good
tends to increase consumption
of the other.
Chapter 4
70
Demand and Supply
Exhibit 4-5 Some Factors That Shift Demand Curves
(a) A list of factors that can cause an increase in demand from D0 to D1.
Taste shift to greater popularity
Population likely to buy rises
Income rises (for a normal good)
Price of substitutes rises
Price of complements falls
Future expectations
encourage buying
Price
Price
(b) How the same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1. For example, greater
popularity of a good or service increases demand, causing a shift in the demand curve to the right, while lesser popularity of a
good or service reduces demand, causing a shift of the demand curve to the left.
Taste shift to lesser popularity
Population likely to buy drops
Income drops (for a normal good)
Price of substitutes falls
Price of complements rises
Future expectations
discourage buying
D1
D0
D0
Quantity
(a) Factors that increase demand
shift in supply: When a
change in some economic
factor related to supply causes
a quantity to be supplied at
every price.
D1
Quantity
(b) Factors that decrease demand
can shift. Just as a shift in demand is represented by a change in the quantity demanded
at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember the basic motivation of firms:
to earn profits. If a firm faces lower costs of production, while the prices for the output
the firm produces remain unchanged, a firm’s profits will increase. Thus, when costs of
production fall, a firm will supply a higher quantity at any given price for its output, and
the supply curve will shift to the right. Conversely, if a firm faces an increased cost of
production, then it will earn lower profits at any given selling price for its products. As
a result, a higher cost of production typically causes a firm to supply a smaller quantity
at any given price. In this case, the supply curve shifts to the left.
As an example, imagine that supply in the market for cars is represented by S0 in
Exhibit 4-6. The original supply curve, S0, includes a point with a price of $20,000 and
a quantity supplied of 18 million cars, labeled as point J, which represents the current
market equilibrium price and quantity. If the price rises to $22,000 per car, ceteris
paribus, the quantity supplied will rise to 20 million cars, as shown by point K on the
S0 curve.
Now imagine that the price of steel, an important ingredient in manufacturing cars,
rises, so that producing a car has now become more expensive. At any given price for
selling cars, car manufacturers will react by supplying a lower quantity. The shift of
supply from S0 to S1 shows that at any given prices, the quantity supplied decreases.
In this example, at a price of $20,000, the quantity supplied decreases from 18 million
on the original supply curve S0 to 16.5 million on the supply curve S1, which is labeled
as point L.
Conversely, imagine that the price of steel decreases, so that producing a car becomes
less expensive. At any given price for selling cars, car manufacturers can now expect
to earn higher profits and so will supply a higher quantity. The shift of supply to the
right from S0 to S2 means that at all prices, the quantity supplied has increased. In this
example, at a price of $20,000, the quantity supplied increases from 18 million on the
original supply curve S0 to 19.8 million on the supply curve S2, which is labeled M.
Chapter 4
Demand and Supply
Exhibit 4-6 Shifts in
Supply: A Car Example
$28,000
S1
$26,000
S2
p = 20,000
q = 18 million
K
$22,000
Price
S0
p = 20,000
q = 19.8 million
$24,000
p = 20,000
q = 16.5 million
L
J
M
16.5
18
19.8
$20,000
$18,000
$16,000
$14,000
$12,000
$10,000
8
13
23
Quantity
Price
$16,000
$18,000
$20,000
$22,000
$24,000
$26,000
71
Decrease
to S1
10.5
13.5
16.5
18.5
19.5
20.5
million
million
million
million
million
million
Original Quantity
Supplied S0
12.0
15.0
18.0
20.0
21.0
22.0
million
million
million
million
million
million
Increase
to S2
13.2
16.5
19.8
22.0
23.1
24.2
million
million
million
million
million
million
Factors That Shift Supply Curves
A change in any factor that determines what quantity firms are willing to buy at a given
price will cause a change in supply. Some factors that can cause a supply to shift include:
changes in natural conditions, altered prices for inputs to production, new technologies
for production, and government policies that affect production costs.
The cost of production for many agricultural products will be affected by changes
in natural conditions. For example, a substantial area of Central America suffered a
devastating drought during summer 2001. Guatemala, for example, received 60% less
rain than usual. In the areas hardest hit by drought, harvests of declined by half or more.
A drought decreases the supply of agricultural products, which means that at any given
price a lower quantity will be supplied; conversely, especially good weather would shift
the supply curve to the right.
Goods and services are produced using combinations of labor, materials, and
machinery. When the price of a key input to production changes, the supply curve is
affected. For example, a messenger company that delivers packages around a city will
find that buying gasoline is one of its main costs. If the price of gasoline falls, then
in the market for messenger services, a higher quantity will be supplied at any given
price per delivery. Conversely, a higher price for key inputs will cause supply to shift
to the left.
Increased supply means that at
every given price, the quantity
supplied is higher, so that the
supply curve shifts to the right
from S0 to S2. Decreased supply
means that at every given price,
quantity supplied of cars is
lower, so that the supply curve
shifts to the left from S0 to S1.
Chapter 4
72
Demand and Supply
When a firm discovers a new technology, so that it can produce at a lower cost,
the supply curve will shift as well. For example, in the 1960s a major scientific effort
nicknamed the Green Revolution focused on breeding improved seeds for basic crops
like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice
in low income countries around the world was grown with these Green Revolution
seeds—and the harvest was twice as high per acre. A technological improvement that
reduces costs of production will shift supply to the right, so that a greater quantity will
be produced at any given price.
Government policies can affect the cost of production and the supply curve through
taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on
alcoholic beverages that collects about $8 billion per year from producers. There is a
wide array of government regulations that require firms to spend money to provide a
cleaner environment or a safer workplace. A government subsidy, on the other hand,
occurs when the government sends money to a firm directly or when the government
reduces the firm’s taxes if the firm carries out certain actions. For example, the U.S.
government pays about $20 billion per year directly to firms to support research and
development. From the perspective of a firm, taxes or regulations are an additional cost
of production that shifts supply to the left, leading the firm to produce a lower quantity
at every given price. However, government subsidies reduce the cost of production and
increase supply.
Summing Up Factors That Change Supply
Natural disasters, changes in the cost of inputs, new technologies, and the impact of
government decisions all affect the cost of production for firms. In turn, these factors
affect firms’ willingness to supply at a given price. Exhibit 4-7 summarizes factors that
change the supply of goods and services. Notice that a change in the price of the product
itself is not among the factors that shift the supply curve. Although a change in price of
a good or service typically causes a change in quantity supplied along the supply curve
for that specific good or service, it does not cause the supply curve itself to shift.
Exhibit 4-7 Some Factors That Shift Supply Curves
(a) A list of factors that can cause an increase in supply from S0 to S1.
(b) How the same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1. For example, favorable
natural conditions for production will increase supply, causing the supply curve to shift to the right, while poor natural conditions
for production reduce supply, causing the supply curve to shift to the left.
Favorable natural conditions for
production
S0
S1
Improved technology
Lower product
taxes/ less costly
regulations
Quantity
(a) Factors that increase supply
Price
Price
A fall in input prices
Poor natural conditions for
production
A rise in input prices
A decline in technology
(not common)
Higher product taxes/
more costly
regulations
Quantity
(b) Factors that decrease supply
S1
S0
Chapter 4
Demand and Supply
Because demand and supply curves appear on a two-dimensional diagram with only
price and quantity on the axes, an unwary visitor to the land of economics might be
fooled into believing that economics is only about four topics: demand, supply, price, and
quantity. However, demand and supply are really “umbrella” concepts: demand covers all
of the factors that affect demand, and supply covers all of the factors that affect supply. The
factors other than price that affect demand and supply are included by using shifts in the
demand or the supply curve. In this way, the two-dimensional demand and supply model
becomes a powerful tool for analyzing a wide range of economic circumstances.
Shifts in Equilibrium Price and Quantity:
The Four-Step Process
Let’s begin with a single economic event. It might be an event that affects demand,
like a change in income, population, tastes, prices of substitutes or complements, or
expectations about future prices. It might be an event that affects supply, like a change
in natural conditions, input prices, or technology, or government policies that affect
production. How does this economic event affect equilibrium price and quantity? We
can analyze this question using a four-step process.
Step 1: Think about what the demand and supply curves in this market looked like
before the economic change occurred. Sketch the curves.
Step 2: Decide whether the economic change being analyzed affects demand or
supply.
Step 3: Decide whether the effect on demand or supply causes the curve to shift to
the right or to the left, and sketch the new demand or supply curve on the
diagram.
Step 4: Compare the original equilibrium price and quantity to the new equilibrium
price and quantity.
To make this process concrete, let’s consider one example that involves a shift in supply
and one that involves a shift in demand.
Good Weather for Salmon Fishing
In summer 2000, weather conditions were excellent for commercial salmon fishing
off the California coast. Heavy rains meant higher than normal levels of water in the
rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated
growth of plankton, the microscopic organisms at the bottom of the ocean food chain,
thus providing everything in the ocean with a hearty food supply. The ocean stayed
calm during fishing season, so commercial fishing operations didn’t lose many days to
bad weather. How did these weather conditions affect the quantity and price of salmon?
Exhibit 4-8 uses the four-step approach to work through this problem.
1. Draw a demand and supply diagram to show what the market for salmon looked like
before the good weather arrived. The original equilibrium E0 was $3.25 per pound
and the original equilibrium quantity was 250,000 fish. (This price per pound is what
commercial buyers pay at the fishing docks; what consumers pay at the grocery is
higher.)
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74
Chapter 4
Demand and Supply
Exhibit 4-8 Good
Weather for Salmon
Fishing: The Four-Step
Process
$4.00
Step 1: Draw a demand and
supply diagram to illustrate
what the market for salmon
looked like in the year before
the good weather arrived.
The demand cur ve D 0 and
the supply curve S0 show that
the original equilibrium price
is $3.25 per pound and the
original equilibrium quantity is
250,000 fish.
St ep 2 : Will t h e ch a ng e
described affect supply or
demand? Good weather is an
example of a natural condition
that affects supply.
Step 3: Will the effect on supply
be an increase or decrease?
Good weather is a change in
natural conditions that increases
the quantity supplied at any
given price. The supply curve
shifts to the right, moving from
the original supply curve S0 to
the new supply curve S1, which
is shown in both the schedule
and the figure.
Step 4: Compare the new
equilibrium price and quantity
to the original equilibrium.
At the new equilibrium E 1 ,
the equilibrium price falls
from $3.25 to $2.50, but the
equilibrium quantity increases
from 250,000 to 550,000
salmon.
S1
S0
$3.50
E0 (p = 3.25, q = 250)
Price ($ per pound)
$3.00
E1 (p = 2.50, q = 550)
$2.50
$2.00
D0
$1.50
$1.00
$0.50
$0.00
0
200
400
600
800
Quantity (thousands of fish)
1,000
Price
per Pound
Quantity Supplied
in 1999
Quantity Supplied
in 2000
Quantity
Demanded
$2.00
$2.25
$2.50
$2.75
$3.00
$3.25
$3.50
80
120
160
200
230
250
270
400
480
550
600
640
670
700
840
680
550
450
350
250
200
2. Did the economic event affect supply or demand? Good weather is a natural condition
that affects supply.
3. Was the effect on supply an increase or a decrease? Good weather increases the
quantity that will be supplied at any given price. The supply curve shifts to the right
from the S0 to S1.
4. Compare the new equilibrium price and quantity to the original equilibrium. At
the new equilibrium, E1, the equilibrium price fell from $3.25 to $2.50, but the
equilibrium quantity increased from 250,000 salmon to 550,000 fish. Notice that
the equilibrium quantity demanded increased, even though the demand curve did
not move.
In short, good weather conditions increased supply for the California commercial
salmon fishing industry. The result was a higher equilibrium quantity of salmon bought
and sold in the market at a lower price.
Seal Hunting and New Drugs
As the catch of whales dwindled, Canada’s seal industry had become the only remaining
large-scale hunt for marine mammals. In the late 1990s, about 280,000 Canadian seals
were killed each year. In 2000, the number dropped to 90,000 seals. What happened?
Chapter 4
Demand and Supply
Price
One common mistake in applying the demand and supply framework is to confuse the
Clearing It Up
shift of a demand or a supply curve with the movement along a demand or supply curve.
Shifts of Demand
As an example, consider a problem that asks whether a drought will increase or decrease
the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory
or Supply versus
economics class, might reason:
Movements along a
“Well, it’s clear that a drought reduces supply, so I’ll shift back the supply curve, as in
Demand or Supply
the shift from the original supply curve S0 to S1 shown on the diagram (call this Shift 1). So
Curve
the equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium
price is higher. Then, a higher price makes farmers more likely to supply the good, so the
supply curve shifts right, as shown by the shift from S1 to S2 on the diagram (shown as
Shift 2), so that the equilibrium now moves from E1 to E2. But the higher price also reduces
demand and so causes demand to shift back, like the shift from the original demand curve
D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves
S1
from E2 to E3.”
At about this point, Lee suspects that this answer is headed down
S2
the wrong path. Think about what might be wrong with Lee’s logic,
Shift 1
S0
and then read the answer that follows.
E1
Answer: Lee’s first step is correct: that is, a drought shifts back the
E2
supply curve of wheat and leads to a prediction of a lower equilibrium
Shift 2
quantity and a higher equilibrium price. The rest of Lee’s argument is
E0
wrong, because it mixes up shifts in supply with quantity supplied, and
shifts demand with quantity demanded. A higher or lower price never
Shift 3
shifts the supply curve, as suggested by the shift in supply from S1 to
S2. Instead, a price change leads to a movement along a given supply
D0
curve. Similarly, a higher or lower price never shifts a demand curve,
as suggested in the shifts from D0 to D1. Instead, a price change leads
to a movement along a given demand curve. Remember, a change
D1
in the price of a good never causes the demand or supply curve for
Quantity
that good to shift.
One major use of seals was that some of their body parts were used as ingredients in
traditional medications in China and other Asian nations that promised to treat male
impotence. However, pharmaceutical companies—led by Pfizer Inc., which invented
the drug Viagra—developed some alternative and medically proven treatments for male
impotence. How would the invention of Viagra, and other drugs to treat mail impotence,
affect the harvest of seals? Exhibit 4-9 illustrates the four-step analysis.
1. Draw a demand and supply diagram to illustrate what the market for seals looked
like in the year before the invention of Viagra. In Exhibit 4-9, the demand curve D0
and the supply curve S0 show the original relationships. In this case, the analysis is
performed without specific numbers on the price and quantity axes. (Not surprisingly,
detailed annual data on quantities and prices of seals body parts are not readily
available.)
2. Did the change described affect supply or demand? A newly available substitute
good, like Viagra, will affect demand for the original product, seal body parts.
3. Was the effect on demand an increase or a decrease? An effective substitute product
for male impotence, means a lower quantity demanded of the original product at
every given price, causing the demand curve for seals to shift left to the new demand
curve D1.
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Chapter 4
Demand and Supply
Selling Human Kidneys? How Far Should Markets Go?
In June 1998, a group of surgeons and philosophers
published “The case for allowing kidney sales” in the
prestigious medical journal The Lancet. While the authors
admitted that the idea of selling kidneys brings “feelings
of outrage and disgust,” they also argued that there are
advantages for those in need of a kidney.
About 45,000 people are on the waiting list for a kidney
transplant in the United States, and about 2,300 of them die
each year while waiting. A kidney that is surgically removed
from a living person is much more likely to be transplanted
successfully, and to last longer, than a kidney that is, say,
retrieved after death from a victim of a motorcycle accident.
If the lives saved and extended are not enough reason to
justify the selling of kidneys, dialysis treatment for those
with failing kidneys costs about $40,000 per year. Given
this expense, kidney transplants will pay for themselves in
saved medical costs.
A natural concern is that the poor and minorities will
be disproportionately tempted to sell a kidney. But is it such
a terrible thing that a poor person should have a choice
to receive perhaps $50,000 for a kidney? Donating a
kidney is a medically safe procedure and carries no more
risk to the life of an average person then, say, taking a job
in the construction industry or driving a delivery van. Also
consider that those on the waiting list for kidney donations
are disproportionately minorities, too; nearly half are black
or Hispanic.
A market in kidneys may seem an ugly idea. But so is
the reality of thousands of people suffering and dying each
year for lack of a kidney transplant.
Exhibit 4-9 The Seal
Market: A Four-Step
Analysis
St ep 2 : Will t h e ch a ng e
described affect supply or
demand? A newly available
substitute good, like Viagra, will
affect demand for the original
product, seals.
Step 3: Will the effect on
demand be positive or negative?
A less expensive substitute
product will tend to mean a
lower quantity demanded of
the original product, seal, at
every given price, causing the
demand curve for seal to shift
to the left from D0 to D1.
Step 4: Compare the new
equilibrium price and quantity
to the original equilibrium price.
The new equilibrium E1 occurs
at a lower quantity and a
lower price than the original
equilibrium E0.
S0
Price
Step 1: Draw a demand and
supply diagram to illustrate what
the market for seals looked like
in the year before the invention
of Viagra. The demand curve D0
and the supply curve S0 show
the original relationships.
E0
p0
p1
E1
D1
q1
D0
q0
Quantity
4. Compare the new equilibrium price and quantity at E1 to the original equilibrium
price and quantity at E0. The new equilibrium E1 occurs at a lower quantity and a
lower price than the original equilibrium E0.
The extremely sharp decline in the number of Canadian seals killed in the late 1990s,
together with anecdotal evidence that the price of seal body parts dropped sharply at
this time, suggests that the invention of drugs to treat male impotence helped reduce the
number of seals killed. In fact, some environmentalists are hoping that such drugs may
reduce demand for other common ingredients for traditional male potency medicines,
including tiger bones and monkey heads.
Chapter 4
Demand and Supply
77
The Interconnections and Speed of Adjustment in Real Markets
In the real world, many factors that affect demand and supply change all at once. For
example, the demand for cars might increase because of rising incomes and population,
and it might decrease because of rising gasoline prices (a complementary good).
Likewise, the supply of cars might increase because of innovative new technologies that
reduce the cost of car production, and it might decrease as a result of new government
regulations requiring the installation of costly pollution-control technology. Moreover,
rising incomes and population or changes in gasoline prices will affect many markets,
not just cars. How can an economist sort out all of these interconnected events? The
answer lies in the ceteris paribus assumption. Look at how each economic event affects
each market, one event at a time, holding all else constant.
In the four-step analysis of how economic events affect equilibrium price and
quantity, the movement from the old to the new equilibrium seems immediate. But
as a practical matter, prices and quantities often do not zoom straight to equilibrium.
More realistically, when an economic event causes demand or supply to shift, prices
and quantities set off in the general direction of equilibrium. Indeed, even as they are
moving toward one new equilibrium, prices are often then pushed by another change
in demand or supply toward another equilibrium.
Price Ceilings and Price Floors in Markets
for Goods and Services
Controversy often surrounds the prices and quantities that are established by demand
and supply. After all, every time you buy a gallon of gasoline, pay the rent for your
apartment, or pay the interest charges on your credit card, it’s natural to wish that the
price had been at least a little lower. Every time a restaurant sells a meal, a department
store sells a sweater, or a farmer sells a bushel of wheat, it’s natural for the profit-seeking
seller to wish that the price had been higher. In some cases, discontent over prices turns
into public pressure on politicians, who may then pass legislation to prevent a certain
price from climbing “too high” or falling “too low.” The demand and supply model
shows how people and firms will react to the incentives provided by these laws to control
prices, in ways that will often lead to undesirable costs and consequences. Alternative
policy tools can often achieve the desired goals of price control laws, while avoiding at
least some of the costs and trade-offs of such laws.
Price Ceilings
Price controls are laws that the government enacts to regulate prices. Price controls
come in two flavors. A price ceiling keeps a price from rising above a certain level,
while a price floor keeps a price from falling below a certain level. This section uses
the demand and supply framework to analyze price ceilings; the next section turns to
price floors.
In many markets for goods and services, demanders outnumber suppliers. There
are more people who buy bread than companies that make bread; more people who rent
apartments than landlords; more people who purchase prescription drugs than companies
that manufacture such drugs; more people who buy gasoline than companies that refine
and sell gasoline. Consumers, who are also potential voters, sometimes unite behind a
political proposal to hold down a certain price. In some cities, for example, renters have
price controls: Government
laws to regulate prices.
price ceiling: A law that
prevents a price from rising
above a certain level.
price floor: A law that
prevents a price from falling
below a certain level.
78
Chapter 4
Demand and Supply
Price (dollars in monthly rent)
Exhibit 4-10 A Price
Ceiling Example—Rent
Control
The original intersection of
demand and supply occurs
at E0. Demand shifts from D0
to D 1. The new equilibrium
would be at E1—except that
a price ceiling prevents the
price from rising. Because
the price doesn’t change, the
quantity supplied remains at
15,000. However, after the
change in demand, the quantity
demanded rises to 19,000.
There is excess demand, also
called a shortage.
$900
$800
D0
D1
S0
$700
E1
$600
E0
$500
Price ceiling
set here
$400
Excess demand
or shortage
from price ceiling
$300
$200
$100
0
10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Quantity (thousands of rental units)
Price
Original Quantity
Supplied
Original Quantity
Demanded
New Quantity
Demanded
$400
$500
$600
$700
$800
12,000
15,000
17,000
19,000
20,000
18,000
15,000
13,000
11,000
10,000
23,000
19,000
17,000
15,000
14,000
pressed political leaders to pass rent control laws, a form of price ceiling that usually works
by stating that rents can only be raised by a certain maximum percentage each year.
Rent control can become a politically hot topic when rents begin to rise rapidly.
Rents might rise for many reasons. Perhaps a change in tastes makes a certain suburb
or town a more popular place to live. Perhaps locally based businesses expand, bringing
higher incomes and more people into the area. Changes of this sort can cause a change
in the demand for rental housing, as illustrated in Exhibit 4-10. The original equilibrium
E0 lies at the intersection of supply curve S0 and demand curve D0, corresponding to an
equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing.
The effect of greater income or a change in tastes is to shift the demand curve for rental
housing to the right, as shown by the data in the table and the shift from D0 to D1 on the
graph. In this market, at the new equilibrium E1, the price of a rental unit would rise to
$600 and the equilibrium quantity would increase to 17,000 units.
Long-time apartment dwellers will dislike these price increases. They may argue,
“Why should our rents rise because a lot of newcomers want to move in?” The current
apartment-dwellers are also voters, and they may elect local politicians who pass a price
ceiling law that limits how much rents can rise.
For simplicity, let’s assume that a rent control law is passed to keep the price at the
original equilibrium of $500 for a typical apartment. In Exhibit 4-10, the horizontal
line at the price of $500 shows the legally fixed maximum price set by the rent control
law. However, the underlying forces that shifted the demand curve to the right have not
vanished. At that price ceiling, the quantity demanded exceeds the quantity supplied:
that is, at a price of $500 the quantity supplied remains at the same 15,000 rental units,
but the quantity demanded is 19,000 rental units. Thus, people who would like to rent in
this area are knocking on the doors of landlords, searching for apartments. A situation
of excess demand, also called a shortage, results when people are willing to pay the
market price but cannot purchase (or in this case rent) what they desire.
Chapter 4
Demand and Supply
Rent control has been especially popular in wartime and during times of high
inflation. New York City, the most prominent U.S. city that has imposed rent control laws
for a long period, put rent control in place as a “temporary” measure during World War II.
Rent control was also especially popular during the 1970s, when all prices in the U.S.
economy were rising rapidly as part of an overall process of inflation. By the mid-1980s,
more than 200 American cities, with about 20% of the nation’s population, had rent
control laws. But in the last two decades, the political pendulum began swinging against
rent control. Thirty-one states adopted laws or constitutional amendments banning rent
control outright. Cambridge, Massachusetts, a city with a large college-age population
where rent control had been popular, repealed its rent control laws. In many cities that
kept some form of rent control, the focus of the law shifted from trying to hold rents
below the equilibrium price to offering ways for resolving disputes between tenants and
landlords, like disagreements about maintenance, pets, and noise. But in New York City,
relatively strict rent controls have persisted into the 2000s.
Although the effect of rent control laws in the United States has faded in recent years,
price ceilings are often proposed for other products. For example, price ceilings to limit
what producers can charge have been proposed in recent years for prescription drugs, on
doctor and hospital fees, the charges made by some automatic teller bank machines, and
auto insurance rates. Many low-income countries around the world, including nations in
Africa and Asia, have also imposed price ceilings on basic items like bread. In the early
2000s, the government of the African country of Zimbabwe tried to help its ordinary
citizens by placing ceilings on the prices of ordinary household items like bread, wheat,
and cooking oil. But many producers of these items, faced with the low prices, went out
of business. The goal of the price ceiling had been to keep necessities affordable to all,
but the result was that the quantity of the products declined and shortages occurred.
Price ceilings are enacted in an attempt to keep prices low for those who demand
the product. But when the market price is not allowed to rise to the equilibrium level,
quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who
manage to purchase the product at the lower price given by the price ceiling will benefit,
but sellers of the product will suffer, along with those who are not able to purchase the
product at all.
Price Floors
Price floors are enacted when discontented sellers, feeling that prices are too low, appeal
to legislators to keep prices from falling. A price floor is the lowest legal price that can
be paid in markets for goods and services, labor, and financial capital. Price floors are
sometimes called “price supports,” because they support a price by preventing it from
falling below a certain level.
Around the world, many countries have passed laws to keep farm prices higher than
they otherwise would be. In the annual budget of the European Union, roughly half of
all spending in the mid-2000s—about $50 billion per year—is used to keep prices high
for Europe’s farmers. Thanks to this policy, the prices received by European farmers for
such agricultural staples as wheat, barley, rice, milk, and beef have typically been 50%
or more above the price prevailing in the world market for several decades.
Exhibit 4-11 illustrates the effects of a government program that assures a price
above the equilibrium by focusing on the market for wheat in Europe. In the absence
of government intervention, the price would adjust so that the quantity supplied would
equal the quantity demanded at the equilibrium point E0, with price p0 and quantity q0.
However, policies to keep prices high for farmers keeps the price above what would
have been the market equilibrium level—the price pf shown by the dashed horizontal
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80
Clearing It Up
Price Ceilings and
Floors Do Not Change
Demand or Supply
Clearing It Up
When Floors Are Higher
Than Ceilings
Demand and Supply
Neither price ceilings nor price floors cause demand or supply to change. Indeed, changes
in price don’t cause demand or supply to change. Price ceilings and price floors can cause a
different choice of quantity demanded along a demand curve, but they don’t move demand
curve. Price controls can cause a different choice of quantity supplied along a supply curve,
but they don’t shift the supply curve.
In economics, (price) ceilings are graphically lower than (price) floors. The reason is that
binding price ceilings are below the equilibrium level, stopping the price from rising, and
binding price floors are above the equilibrium level, stopping the price from falling. So
above-equilibrium price floors are higher than below-equilibrium price ceilings.
Exhibit 4-11 The
European Wheat Prices: A
Price Floor Example
Excess supply
or surplus
pf
Price
The intersection of demand D
and supply S would be at the
equilibrium point E0. However,
a price floor set at pf holds the
price above E0 and prevents it
from falling. The result of the
price floor is that the quantity
supplied Qs exceeds the quantity
demanded Qd. There is excess
supply, also called a surplus.
S
D
Price floor set here
E0
p0
Qd
Q0
QS
Quantity
line in the diagram. The result is a quantity supplied of QS in excess of the quantity
demanded QD. When quantity supply exceeds quantity demanded, then a situation of
excess supply exists, also called a surplus. The high-income countries of the world,
including the United States, Europe and Japan, spend a total of about $1 billion per day
in supporting their farmers. If the government is willing to purchase the excess supply
(or to provide payments for others to purchase it), then farmers will benefit from the
price floor but taxpayers and consumers of food will pay the costs. Numerous proposals
have been offered for reducing farm subsidies. But in many countries, political support
for subsidies for farmers—and indirectly, for the rural way of life—remains strong.
Responses to Price Controls: Many Margins for Action
Although a government can set price floors or price ceilings, it cannot control how
households and firms react to these price controls. Attempts to control prices often have
unintended consequences. The focus of the discussion so far has been on reactions that take
Chapter 4
Demand and Supply
81
Price Controls of 1776
During the American Revolution, a number of states imposed
price ceilings on many goods. After Rhode Island passed
price control laws in 1776, the city of Providence reported
on the effects to the state legislature in 1777:
[The effect] is so intricate, variable, and
complicated, that it cannot remain any time equitable…
It was made to cheapen the articles of life, but it has
in fact raised their prices, by producing an artificial
and in some respects a real scarcity. It was made to
unite us in good agreement respecting prices; but hath
produced animosity, and ill will between town and
country, and between buyers and sellers in general. It
was made to bring us up to some equitable standard
of honesty . . . but hath produced a sharping set of
mushroom peddlars, who adulterate their commodities,
and take every advantage to evade the . . . act, by
quibbles and lies.
Price control laws are often popular in the short run, because
they look like an easy fix, but they become less popular over
time as shortages occur, social tensions arise, and efforts
to evade the laws gain force. The problems noted by the
citizens of Providence, Rhode Island, in 1775 apply today
as they did more than 200 years ago.
the form of changes in quantity demanded or quantity supplied, and thus on understanding
why price ceilings commonly lead to shortages and price floors lead to surpluses. However,
buyers and sellers in real-world markets have many other ways in which they can react
to price controls. The ability of households and firms to react in a variety of ways to
government rules is called the problem of “many margins for action.”
One alternative reaction occurs when buyers and seller decide to break the
government rules on prices or sales, which is referred to as black market. Consider a
landlord who owns rent-controlled property. Suppose that although the law dictates the
cap on the rent that the landlord can charge, a potential tenant is willing to pay more
than the rent control law allows to live in the apartment. If this “extra rent” is paid in
cash, then who will know?
A second margin for action is “side payments,” which are additional payments that
are made along with the actual price paid. In New York City, with its long history of
rent control, landlords have devised innovative charges like a “nonrefundable cleaning
deposit” and a “nonrefundable key deposit,” or they may require several months’ rent
in advance. These charges can have the effect of making the tenant pay more than the
actual rent.
A third margin for action involves quality adjustment. In the case of rent control,
a landlord may keep the rent low but put off maintenance or installing new appliances.
The result is a lower-priced apartment—but also a lower-quality apartment.
A fourth margin for action involves shifting who is involved in the transaction. In
cities with rent control, it isn’t unusual for a tenant living in a rent-controlled apartment
not to move out officially; instead, the tenant sublets the apartment to someone else. In
this case, the original tenant pays the rent-controlled rate but charges the market rate to
the new renter and pockets the difference.
Those who favor price floors and price ceilings are often quite aware of the actions
that can circumvent the underlying purpose of price controls. Thus, supporters of
price controls also favor rules that will include penalties for black markets, make side
payments illegal, require certain quality levels, and prohibit shifts in who is involved in
the transaction. However, establishing rules or laws that will limit all of the alternative
margins for action is like trying to block a flowing stream with your fingers. The
government cannot monitor the details of every market transaction. Shutting down the
many margins for action by which citizens and firms respond to price controls is much
easier said than done.
black market: An illegal
market that breaks government
rules on prices or sales.
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Chapter 4
Demand and Supply
The original equilibrium is the
intersection of demand D0 and
supply S 0 at the equilibrium
E0. Providing subsidies to lowincome buyers of housing will
shift the demand curve from
D 0 to D 1, leading to a new
equilibrium at E2. Alternatively,
a policy of providing subsidies
to builders of affordable housing
would shift the supply curve
from S0 to S1, leading to a new
equilibrium at E1. Undertaking
both demand-side and supplyside policies would move the
market to equilibrium E3, at the
intersection of the new demand
curve D1 and the new supply
curve S1. As drawn here, both
of these policies will increase
the equilibrium quantity of
affordable housing. An increase
in demand will also raise the
price of affordable housing, but
as long as the subsidy received
by buyers is larger than the
higher price, buyers will not
be adversely affected by the
higher price that occurs from
an increase in demand.
Price (dollars per housing unit)
Exhibit 4-12 Policies
for Affordable Housing:
Alternatives to Rent Control
S0
S1
E2
p2
p3
E3
p0
E0
p1
E1
D1
D0
q0
q1 q2
q3
Quantity (housing units)
Policy Alternatives to Price Ceilings and Price Floors
The economic analysis of how price ceilings can create shortages and price floors create
surpluses can be disheartening. If you want to pursue a policy goal of assuring that
people have a sufficient quantity of affordable housing, but rent controls are just price
ceilings that cause housing shortages, what alternative policy can you advocate? If you
want to pursue a policy goal of supporting farmers, but farm price supports lead to
storehouses of surplus grain rotting at high cost to taxpayers and consumers, then what
alternative policy can you advocate? The same demand and supply model that shows
that price ceilings and price floors often have unintended, undesirable consequences of
creating surpluses and shortages, can also suggest alternate public policies that do not
have these same trade-offs.
Let’s return to the issue of rent control. If the goal is to have an expanded supply of
affordable housing, then a rightward shift in a demand curve, a supply curve, or both
as shown in Exhibit 4-12, can accomplish this goal. A shift to the right in the supply of
affordable housing from S0 to S1, for example, might be achieved if a government grants
subsidies to builders who construct apartment buildings that include have relatively
smaller rental units, which will have a more affordable price in the market. This step
taken alone would cause a shift to the right from the original equilibrium, E0, to the new
equilibrium, E1, and would increase the quantity of housing from q0 to q1. A shift to
the right in the demand curve from D0 to D1 might be achieved by giving a subsidy to
low-income renters, perhaps in the form of cash or of a voucher that the renters could
use to pay some of the rent, so that low-income renters could then have more to spend
on housing. This step taken alone would cause a shift to the right from the original
equilibrium, E0, to the new equilibrium, E2, and would increase the quantity of affordable
housing from q0 to q2. Instituting both sets of policies would shift supply from S0 to S1,
demand from D0 to D1, the equilibrium from the original E0 to E3, and the quantity of
affordable housing from q0 to q3.
Any combination of these policies is likely to be more useful in expanding affordable
housing than rent control, because these policies tend to increase the quantity of
affordable housing, whereas rent control tends to decrease it. Moreover, these alternative
Chapter 4
Demand and Supply
policies sidestep many of the problems that arise when suppliers and demanders react
to price controls.
Similarly, there are a number of alternative policies to support farmers or rural
areas that do not involve setting price floors for crops. For example, the government
could provide income directly to farmers, especially to those with lower incomes.
The government might also assist rural economies in many other ways: establishing
new branches of state colleges and universities in agricultural areas, creating parks or
nature preserves that might attract tourists, supporting research into new methods of
producing and using local crops to help the local farmers stay ahead, helping to build
transportation links to rural areas, and subsidizing high-speed Internet cable connections
across rural areas or wireless phone service. All of these alternative policies would help
rural communities while avoiding the problem of price floors, because these alternative
policies don’t encourage farmers to produce an excess supply of surplus food.
With alternative policies like these readily available, why do governments enact
price floors and price ceilings? One reason is that in public policy debates over price
controls, people often don’t take into account the unintended but predictable tradeoffs. Another reason is that government sometimes views laws about price floors and
ceilings as having zero cost, while giving subsidies to demanders or suppliers requires
a government to collect taxes and spend money. The point here is not to endorse every
proposal for using targeted subsidies or tax breaks to change demand and supply. Each
policy proposal must be evaluated according to its own costs and benefits. But before
reaching for the seemingly easy policy tool of price controls, with all of their undesired
if predictable consequences and trade-offs, it is wise to consider alternative policies to
shift demand and supply so as to achieve the desired new market equilibrium.
Supply, Demand, and Efficiency
In the market equilibrium, where the quantity demanded equals quantity supplied,
nothing is wasted. No excess supply sits unsold, gathering dust in warehouses. No
shortages exist that cause people to stand in long lines or rely on political connections
to acquire goods—alternatives that involve wastes of time and energy. All those who
wish to purchase or sell goods at the equilibrium market price are able to purchase or
sell the quantity that they desire, as movements of the equilibrium price bring quantity
demanded and supplied into balance.
The familiar demand and supply diagram holds within it the concept of economic
efficiency, which was introduced in Chapter 2. To economists, an efficient outcome is
one where it is impossible to improve the situation of one party without imposing a cost
on someone else. Conversely, if a situation is inefficient, it becomes possible to benefit
at least one party without imposing costs on others. Thus, the definition of productive
efficiency in Chapter 2 was that economy was producing without waste, and getting all
it could out of its scarce resources, in the sense that it was impossible to get more of
good A without a reduction in good B. Efficiency in the demand and supply model has
the same basic meaning: the economy is getting as much benefit as possible from its
scarce resources and all the possible gains from trade have been achieved.
Consumer Surplus, Producer Surplus, Social Surplus
Consider the example of a market for portable CD players shown in Exhibit 4-13. The
equilibrium price is $80 and the equilibrium quantity is 28 million. To see the benefits
83
84
Chapter 4
Demand and Supply
Figure 4-13 Consumer
and Producer Surplus
consumer surplus: The
benefit consumers receive
from buying a good or
service, measured by what
the individuals would have
been willing to pay minus
the amount that they actually
paid.
producer surplus: The
benefit producers receive from
selling a good or service,
measured by the price
producer actually received
minus the price the producer
would have been willing to
accept.
social surplus: The sum of
consumer surplus and producer
surplus.
S
$120
Price
The triangular area labeled by
F shows the area of consumer
surplus, which shows that the
equilibrium price in the market
was less than what many of
the consumers were willing to
pay. For example, point J on
the demand curve shows that
even at the price of $100,
consumers would have been
willing to purchase a quantity
of 20. But those consumers only
needed to pay the equilibrium
price of $80. The triangular
area labeled by G shows the
area of producer surplus, which
shows that the equilibrium price
received in the market was more
than what many of the producers
were willing to accept for their
products. For example, point K
on the supply curve shows that
at a price of $40, firms would
have been willing to supply a
quantity of 14. However, in
this market those firms could
receive a price of $80 for
their production. The sum of
consumer surplus and producer
surplus—that is, F + G—is
called social surplus.
$100
$90
$80
$60
$40
F
J
Consumer surplus
Producer surplus
E
D
G
K
$20
10 14
20
28 30
Quantity
received by consumers, look at the segment of the demand curve above the equilibrium
point and to the left. This portion of the demand curve shows that at least some demanders
would have been willing to pay more than $80 for a portable CD player. For example,
point J shows that if the price was $100, the quantity demanded of CD players would
have been 20 million. Those consumers who would have been willing to pay $100 for a
CD player based on the utility they expect to receive from it, but who were able to pay the
equilibrium price of $80, clearly received a benefit. Remember, the demand curve traces
out the willingness to pay for different quantities. The amount that individuals would
have been willing to pay minus the amount that they actually paid is called consumer
surplus. Consumer surplus is the area labeled F—that is, the area between the market
price and the segment of the demand curve above equilibrium.
The equilibrium price also benefits producers. The supply curve shows the quantity
that firms are willing to supply at each price. For example, point K on Exhibit 4-13
illustrates that at an equilibrium price of $40, firms would still have been willing to
supply a quantity of 14 million. Those producers who would have been willing to supply
portable CD players at a price of $40, but who were instead able to charge the equilibrium
price of $80, clearly received a benefit. Producer surplus is the amount that a seller
is paid for a good minus the seller’s actual cost. In Exhibit 4-13, producer surplus is
the area labeled G—that is, the area between the market price and the segment of the
supply curve below the equilibrium.
Social surplus is the sum of consumer surplus and producer surplus. In Exhibit 4-13,
social surplus would thus be shown as the area F + G. Social surplus is larger at
equilibrium quantity and price than it would be at any other quantity. At the efficient
level of output, it is impossible to produce greater consumer surplus without reducing
producer surplus, and it is impossible to produce greater producer surplus without
reducing consumer surplus.
Inefficiency of Price Floors and Price Ceilings
The imposition of a price floor or a price ceiling will prevent a market from adjusting
to its equilibrium price and quantity, and thus will create an inefficient outcome. But
Chapter 4
Demand and Supply
S
S
G
$12
T
U
P $600
V
P
Price
ceiling
W
$400
H
$8
I
X
Price
floor
J
K
D
D
15,000 20,000
Q
(a) Reduced social surplus from a price ceiling
1,400
1,800
Q
(b) Reduced social surplus from a price floor
there is an additional twist here. Along with creating and inefficiency, price floors and
ceilings will also transfer some consumer surplus to producers, or some producer surplus
to consumers. Let’s consider a price ceiling and a price floor in turn.
Imagine that several firms develop a promising but expensive new drug for treating
back pain. If this therapy is left to the market, the equilibrium price will be $600 per
month and 200,000 people will use the drug, as shown in Exhibit 4-14a. The original
level of consumer surplus is the T + U and producer surplus is V + W + X. However, the
government decides to impose a price ceiling of $400 to make the drug more affordable.
At this price ceiling, firms in the market now produce only a quantity of 150,000. As a
result, two changes occur. First, an inefficient outcome occurs and the total surplus of
society is reduced. Deadweight loss is the name for the loss in social surplus that occurs
when the economy produces at an inefficient quantity. In Exhibit 4-14a, the deadweight
loss is the area U + W. When deadweight loss exists, it is possible for both consumer
and producer surplus to increase, in this case because the price control is blocking some
suppliers and demanders from transactions that they would both be willing to make. A
second change from the price ceiling is that some of the producer surplus is transferred to
consumers. After the price ceiling is imposed, the new consumer surplus is T + V, while
the new producer surplus is X. In other words, the price ceiling transfers the area of
surplus V from producers to consumers.
For the case of a price floor shown in Exhibit 4-14b, envision a situation where a city
with several movie theaters that are all losing money. The current equilibrium is a price
of $8 per movie, with 18,000 people attending movies. The original consumer surplus
is G + H + J, and producer surplus is I + K. The city government is worried that movie
theaters will go out of business, thus reducing the entertainment options available to
citizens, so it decides to impose a price floor of $12 per ticket. As a result, the quantity
demanded of movie tickets falls to 1,400. The new consumer surplus is G, and the new
producer surplus is H + I. In effect, the price floor causes the area H to be transferred
from consumer to producer surplus, but also causes a deadweight loss of J + K.
This analysis shows that a price ceiling, like a law establishing rent controls, will
transfer some producer surplus to consumers—which explains why consumers often
favor them. Conversely, a price floor like a guarantee that farmers will receive a certain
price for their crops will transfer some consumer surplus to producers, which explains
85
Figure 4-14 Efficiency
and Price Floors and
Ceilings
(a) The original equilibrium
price is $600 with a quantity
of 20,000. Consumer surplus
is T + U, and producer surplus
is V + W + X. A price ceiling
is imposed at $400, so firms in
the market now produce only a
quantity of 15,000. As a result,
the new consumer surplus is
T + V, while the new producer
surplus is X. In effect, the price
ceiling transfers the surplus V
from producers to consumers,
but also causes deadweight loss
in social surplus of U + W.
(b) The original equilibrium
is $8 at a quantity of 1,800.
Consumer surplus is G + H + J,
and producer surplus is I + K.
A price floor is imposed at
$12, which means that quantity
demanded falls to 1,400. As a
result, the new consumer surplus
is G, and the new producer
surplus is H + I. In effect, the
price floor causes the area H
to be transferred from consumer
to producer surplus, but also
causes a deadweight loss in
social surplus of J + K.
deadweight loss: The loss
in social surplus that occurs
when a market produces an
inefficient quantity.
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Chapter 4
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why producers often favor them. However, both price floors and price ceilings block
some transactions that buyers and sellers would have been willing to make, and create
deadweight loss. Removing such barriers so that prices and quantities can adjust to their
equilibrium level will increase the economy’s social surplus.
Demand and Supply as a Social
Adjustment Mechanism
The demand and supply model emphasizes that prices are not set only by demand or
only by supply, but by the interaction between the two. In 1890, the famous economist
Alfred Marshall wrote that asking whether supply or demand determined a price was
like arguing “whether it is the upper or the under blade of a pair of scissors that cuts a
piece of paper.” The answer is that both blades of the demand and supply scissors are
always involved.
The adjustments of equilibrium price and quantity in a market-oriented economy
often occur without much government direction or oversight. If the coffee crop in Brazil
suffers a terrible frost, then the supply curve of coffee shifts to the left and the price of
coffee rises. Some people—call them the coffee addicts—continue to drink coffee and
pay the higher price. Others switch to tea or soft drinks. No government commission is
needed to figure out how to adjust coffee prices; or which companies will be allowed
to process the remaining supply; or which supermarkets in which cities will get how
much coffee to sell; or which consumers will ultimately be allowed to drink the brew.
Such adjustments in response to price changes happen all the time in a market economy,
often so smoothly and rapidly that we barely notice them. Think for a moment of all
the seasonal foods that are available and inexpensive at certain times of the year, like
fresh corn in midsummer, but more expensive at other times of the year. People alter
their diets and restaurants alter their menus in response to these fluctuations in prices
without fuss or fanfare. For both the U.S. economy and the world economy as a whole,
demand and supply is the primary social mechanism for answering the basic questions
about what is produced, how it is produced, and for whom it is produced.
Key Concepts and Summary
1. A demand schedule is a table that shows the quantity demanded at different prices
in the market. A demand curve shows the relationship between quantity demanded
and price in a given market on a graph. The law of demand points out that a higher
price typically leads to a lower quantity demanded.
2. A supply schedule is a table that shows the quantity supplied at different prices in
the market. A supply curve shows the relationship between quantity supplied and
price on a graph. The law of supply points out that a higher price typically leads
to a higher quantity supplied.
3. The equilibrium price and equilibrium quantity occur where the supply and
demand curves cross. The equilibrium occurs where the quantity demanded is
equal to the quantity supplied.
Chapter 4
Demand and Supply
4. If the price is below the equilibrium level, then the quantity demanded will exceed
the quantity supplied. Excess demand or a shortage will exist. If the price is below
the equilibrium level, then the quantity supplied will exceed the quantity demanded.
Excess supply or a surplus will exist. In either case, economic pressures will push
the price toward the equilibrium level.
5. Economists often use the ceteris paribus or “other things equal” assumption,
that while examining the economic impact of one event, all other factors remain
unchanged for the purpose of the analysis.
6. Factors that can shift the demand curve for goods and services, causing a different
quantity to be demanded at any given price, include changes in tastes, population,
income, prices of substitute or complement goods, and expectations about future
conditions and prices.
7. Factors that can shift the supply curve for goods and services, causing a different
quantity to be supplied at any given price, include natural conditions, input prices,
changes in technology, and government taxes, regulations, or subsidies.
8. When using the supply and demand framework to think about how an event will
affect the equilibrium price and quantity, proceed through four steps: (a) Sketch a
supply and demand diagram to think about what the market looked like before the
event; (b) decide whether the event will affect supply or demand; (c) decide whether
the effect on supply or demand is negative or positive, and draw the appropriate
shifted supply or demand curve; (d) compare the new equilibrium price and quantity
to the original ones.
9. Price ceilings prevent a price from rising above a certain level. When a price
ceiling is set below the equilibrium price, quantity demanded will exceed quantity
supplied, and excess demand or shortages will result. Price floors prevent a price
from falling below as certain level. When a price floor is set above the equilibrium
price, quantity supplied will exceed quantity demanded, and excess supply or
surpluses will result.
10. Price floors and price ceilings often lead to unintended consequences, because
buyers and sellers have many margins for action. These margins include black
markets, side payments, quality adjustments, and shifts in who is involved in the
transaction.
11. Policies that shift supply and demand explicitly, through targeted subsidies or taxes,
are often preferable to policies that attempt to set prices, because they avoid the
shortages, surpluses, and other unintended consequences that price ceilings and
floors typically produce.
12. Consumer surplus is the gap between the price that consumers are willing to pay,
based on their preferences, and the market equilibrium price. Producer surplus is
the gap between the price for which producers are willing to sell a product, based on
their costs, and the market equilibrium price. Social surplus is the sum of consumer
surplus and producer surplus. Total surplus is larger at the equilibrium quantity and
price than it will be at any other quantity and price. Deadweight loss is loss in total
surplus that occurs when the economy produces at an inefficient quantity.
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Chapter 4
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Review Questions
1. In the economic view, what determines the level of
prices?
2. What does a downward-sloping demand curve mean
about how buyers in a market will react to a higher
price?
3. Will demand curves have the same exact shape in all
markets?
4. What does an upward-sloping supply curve mean
about how sellers in a market will react to a higher
price?
5. Will supply curves have the same shape in all
markets?
6. What is the relationship between quantity demanded
and quantity supplied at equilibrium?
7. How can you locate the equilibrium point on a demand
and supply graph?
8. When analyzing a market, how do economists deal
with the problem that many factors that affect the
market are changing at the same time?
9. If the price is above the equilibrium level, would you
predict excess supply or excess demand? If the price
is below the equilibrium level, would you predict a
shortage or a surplus?
10. Explain why a price that is above the equilibrium level
will tend to fall toward equilibrium. Explain why a
price that is below the equilibrium level will tend to
rise toward the equilibrium.
11. Name some factors that can cause a shift in the
demand curve in markets for goods and services.
12. Does a price ceiling attempt to make a price higher
or lower?
13. How does a price ceiling set below the equilibrium level
affect quantity demanded and quantity supplied?
14. Does a price floor attempt to make a price higher or
lower?
15. How does a price floor set above the equilibrium level
affect quantity demanded and quantity supplied?
16. Make a list of ways that buyers and sellers may
respond to price ceilings and price floors, other than
changes in quantity.
17. Why might economists commonly prefer public
policies that shift demand and/or supply rather than
imposing price ceilings or price floors?
18. What’s the difference between demand and quantity
demanded?
19. Name some factors that can cause a shift in the supply
curve in markets for goods and services.
20. Is supply the same thing as quantity supplied?
Explain.
21. What is consumer surplus? How is it illustrated on a
demand and supply diagram?
22. What is producer surplus? How is it illustrated on a
demand and supply diagram?
23. What is total surplus? How is it illustrated on a
demand and supply diagram?
24. What is the relationship between total surplus and
economic efficiency?
25. What is deadweight loss?
The Macroeconomic
Perspective
M
acroeconomics and microeconomics are two different perspectives on
the subject of economics. What seems sensible from a microeconomic
point of view can have unexpected or counterproductive results at the
macroeconomic level. For example, imagine that you are sitting at an event with
a large audience, like a live concert or a basketball game. A few people decide
that they want a better view, and so they stand up. However, when these people
stand up, they block the view for some other people, and the others need to stand
up as well if they wish to see. Eventually, nearly everyone is standing up, and as a
result, no one can see much better than before. The individually rational decision
of some individuals at the micro level—stand up to see better—ended up being
self-defeating at the macro level.
Or consider the case of a farmer who п¬Ѓnds out that the long-range weather
forecast is for an especially п¬Ѓne growing season. The farmer decides to plant
extra acreage to take advantage of the п¬Ѓne weather. However, if all farmers see
the same forecast, and all decide to plant extra, then the result will be a shift out
to the right of the supply curve that depresses the equilibrium market price for all
farmers. In this case, the microeconomic rational behavior of individual farmers
who are seeking higher profits ends up with an outcome—low prices—that none
of them desired.
Finally, consider the case of a country in which many foreign individuals and
п¬Ѓrms are making п¬Ѓnancial investments. A rumor circulates that the economy of
this country may be weakening, and that some of its leading companies may go
bankrupt. The foreign investors become worried. They start selling their assets in
the country and declining to make any new investments. But when many foreign
investors react in this way, the country’s economy actually does become much
weaker from a lack of loans and п¬Ѓnancial investment capital, and many leading
companies go bankrupt as a result. Again, individually rational, cautious decisions
387
388
Chapter 21
The Macroeconomic Perspective
by investors—in this case, reducing the amount invested in the country—leads to a selffulfilling prophecy that their investments turn out poorly.
These stories have a common theme: Individually rational motivations help
economic agents coordinate their behavior in some ways, but in some cases they
can also lead to undesired outcomes. In such cases, society may wish to create other
coordinating mechanisms. In the case of people in a crowd trying to see better, for
example, the coordinating mechanism is often social pressure: that is, the group
accepts that people will stand up in moments of excitement, but if someone stands at
other times, then others in the audience yell at them to sit down. In macroeconomic
settings, government may in certain situations be able to play a coordinating role to
avoid unwanted outcomes.
This chapter begins the discussion of macroeconomics by focusing on the single
most common measure of the size of the macro economy: gross domestic product or
GDP. Since the macro economy involves all the buying and selling transactions that
occur, GDP can be measured in two ways: by looking at the overall demand for goods
and services, or by looking at what is produced. The chapter will discuss comparing
GDP across countries, patterns of GDP in the long run and the short run, and the extent
to which GDP captures or does not capture the broader concept of a society’s standard
of living.
The chapters that follow will п¬Ѓrst discuss macroeconomic goals, then frameworks
for analysis, and п¬Ѓnally policy tools. Exhibit 21-1 illustrates the structure. In thinking
about the overall health of a macro economy, it is useful to consider four goals. Economic
growth, which can be approximated by the growth of gross domestic product, ultimately
determines the prevailing standard of living in a country. Unemployment, the situation
in which people want to work but can’t find a job, is not only potentially devastating for
individuals and families—but society as a whole loses the value of the output that could
have been produced. Inflation refers to a rise in the overall level of prices. The difficulty
arises because not all prices rise at the same time. For example, if many people face a
situation where the prices that they pay for food, shelter, and health care are rising much
faster than the wages they receive for their labor, there will be widespread unhappiness.
Finally, a sustainable balance of trade refers to the flows of goods and financial capital
back and forth between countries. Although the gains from trade in the global economy
can produce economic gains for all nations, trade imbalances can also be a source of
macroeconomic disruption and instability. One or more of these statistics are in the new
almost every day. The next four chapters—from Ch. 22–25—will explore and explain
these four goals.
None of these macroeconomic goals is straightforward to analyze from a
microeconomic perspective. For example, microeconomic analysis of supply and demand
can explain why equilibrium quantity might increase in a single market for a good or a
service, but it does not offer a simple method for explaining overall growth in the entire
macro economy. Microeconomic analysis can explain why a п¬Ѓrm or an industry might
hire more or fewer workers, but it does not offer a simple method for explaining why
many or most п¬Ѓrms might become unwilling to hire at the same time, thus creating the
macroeconomic problem of unemployment. Microeconomic analysis can explain why
the price might rise or fall for a particular product, but it doesn’t offer any simple way
of discussing why most prices might all rise by about the same amount at the same time
in a process of inflation. Finally, microeconomic analysis can explain why a firm might
have success selling its goods abroad and why consumers might want to buy goods from
abroad, but it offers no easy framework for discussing the implications of the overall
balance of exports and imports—that is, the balance of trade.
Chapter 21
The Macroeconomic Perspective
Goals
Framework
Policy Tools
Economic growth
Low unemployment
Low inflation
Sustainable balance
of trade
Aggregate demand/
Aggregate supply
Keynesian model
Neoclassical model
Monetary policy
Fiscal policy
Several different analytical frameworks exist for thinking about how these four
macroeconomic goals relate to each other, and how pursuing one goal may in some
cases or over the short run or the long run involve tradeoffs with other goals. These
frameworks have names like “aggregate supply and aggregate demand models,” “sticky
price Keynesian models,” and “flexible price neoclassical models.” At this point, these
names are just empty words, but they will be explained from Chapters 26–28.
With the goals and frameworks in mind, the stage is set to discuss how the
macroeconomic policy tools available to government, working through the analytical
frameworks, will affect the ultimate policy goals. Monetary policy includes policies
that affect money, banking, interest rates, and exchange rates, and these policies are
discussed in Chapters 29–31.
Fiscal policy means policies that involve government taxes or spending, and
applications of fiscal policy are discussed in Chapters 32–33. Chapter 34, the final
chapter of the macroeconomic section, offers overall lessons of macroeconomics in a
global context.
389
Exhibit 21-1
Macroeconomic Goals,
Framework, and Policies
The discussion of macroeconomics in the chapters that
follow will discuss four goals
of macroeconomics, present
several analytical frameworks for
thinking about how these goals
may interact and conflict, and
finally, discuss two broad sets of
macroeconomic policies.
Measuring the Size of the Economy: Gross
Domestic Product
The size of a nation’s overall economy is typically measured by its gross domestic
product or GDP, which is the value of the output of all goods and services produced
within a country. The measurement of GDP thus involves counting up millions of
different goods and services—cars, haircuts, computers, steel, bananas, college
educations, and everything else—and summing them into a total value. As a conceptual
matter, this task is straightforward: take the quantity of everything produced, multiply
it by the price that everything for which everything sold, and add up the total. In 2005,
the U.S. GDP totaled $12.4 trillion.
Each of the market transactions that enter into GDP must involve both a buyer and
a seller. Thus, the GDP of an economy can be measured either by the total of what is
demanded in the economy, or by the total of what is produced in the economy.
GDP Measured by Components of Demand
GDP as measured by demand is commonly divided into п¬Ѓve parts: consumption,
investment, government, exports, and imports. Exhibit 21-2 shows how these п¬Ѓve factors
add up to the GDP in 2005. Exhibit 21-3a shows the levels of consumption, investment
and government consumption over time, expressed as a percentage of GDP, while Exhibit
21-3b shows the levels of exports and imports as a percentage of GDP over time. A few
patterns about each of these components are worth noticing.
gross domestic product
(GDP): The value of the
output of all goods and
services produced within a
country.
Chapter 21
390
Exhibit 21-2
Components of GDP in
2005: From the Demand
Site
The Macroeconomic Perspective
Consumption
Investment
Government
Exports
Imports
Total
From the Demand Site
GDP (in trillions of dollars)
$8.7
$2.1
$2.3
$1.3
–$2.0
$12.4
Percentage of Total
70.2%
16.5%
19.0%
10.5%
–16.2%
100%
Exhibit 21-3 Components of GDP on the Demand Site
(a) Consumption is about two-thirds of GDP, but it moves relatively little over time. Investment hovers around 15% of GDP, but it
increases and declines more than consumption. Government spending on goods and services used to be a little more than 20%
of GDP, but it has trended down a little over time.
(b) Exports are added to total demand for goods and services, while imports are subtracted from total demand. Thus, if exports are
equal to imports, international trade as a whole has no impact on the size of GDP. If exports exceed imports, as in most of the 1960s
and 1970s in the U.S. economy, a trade surplus exists. If imports exceed exports, as in recent years, than a trade deficit exists.
80
18
16
70
Exports
14
60
Percentage of GDP
Percentage of GDP
Consumption
50
40
30
Government
20
10
12
10
8
6
Imports
4
Investment
2
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Year
(a) Demand from consumption, investment, and government
0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Year
(b) Imports and exports
Consumption (C) by households is the largest component of GDP, accounting for
about two-thirds of the GDP in any year. However, consumption is a gentle elephant:
when viewed over time, it doesn’t jump around too much.
Investment (I) by businesses refers to real purchases of physical plant and
equipment by businesses. Investment demand is far smaller than consumption
demand, typically accounting for only about 15–20% of GDP. However, it moves up
and down more noticeably than consumption. Investment is a cat in a bag: it jumps
around unexpectedly.
Government (G) demand in the United States appears relatively small, at about 20%
of GDP. This proportion may seem too low. Indeed, government in the United States
(including the federal, state and local levels) collects about one-third of GDP in taxes.
However, much of that money is passed directly to citizens, through programs like
Chapter 21
The Macroeconomic Perspective
391
How Statisticians Measure GDP
Economists have an old, sad joke that there are two things you
never want to watch being made: sausages and economic
statistics. The joke comes to mind in considering the task
of the government economists at the Bureau of Economic
Analysis, within the U.S. Department of Commerce, who
piece together estimates of GDP from a variety of sources.
Once every five years, in the second and seventh year
of each decade, the Bureau of the Census carries out a
detailed census of businesses throughout the United States.
In between, the Census bureau carries out a monthly survey
of retail sales. These figures are adjusted with foreign trade
data, to account for exports that are produced in the United
States and sold abroad and for imports that are produced
abroad and sold here. Once every 10 years, the Census
Bureau does a comprehensive survey of housing and
residential finance. Together, these sources provide the main
basis for figuring what is produced for consumers.
For investment, the Census Bureau does a monthly
survey of construction and an annual survey of expenditures
on physical capital equipment.
For what is purchased by the federal government, the
statisticians rely on the U.S. Department of the Treasury.
An annual Census of Governments gathers information on
state and local governments. Because a lot of government
spending at all levels is involves hiring people to provide
services, a large portion of government spending can
also be tracked through payroll records collected by state
governments and by the Social Security Administration.
With regard to foreign trade, the Census Bureau
compiles a monthly record of all import and export
documents. Additional surveys cover transportation and
travel, and adjustment needs to be made for financial
services that are produced in the United States for foreign
customers.
Many other sources contribute to the estimates of GDP.
Information on energy comes from the U.S. Department
of Transportation and Department of Energy. Information
on health care is collected by the Health Care Financing
Administration. Surveys of landlords find out about rent. The
Department of Agriculture collects statistics on farming.
All of these bits and pieces of information arrive in
different forms, at different time intervals. The Bureau
of Economic Analysis melds them together to produce
estimates of GDP on a quarterly basis (that is, every three
months). These estimates are then updated and revised. The
“advance” estimate of GDP for a certain quarter is released
one month after a quarter. The “preliminary” estimate
comes out one month after that. The “final” estimate is
published one month later, but it isn’t actually final. In July,
roughly, updated estimates for the previous calendar year
are released. Then, once every five years, after the results
of the latest detailed five-year business census have been
processed, the BEA revises all of the past estimates of GDP
according to the newest methods and data, going all the
way back to 1929.
When you read newspaper reports of recent GDP
announcements, be aware that the “advance,” “preliminary
and “final” announcements of quarterly GDP during a year
usually don’t change much. However, the annual revisions
released each summer can be substantial; enough to make
GDP growth appear quite different than the quarterly reports
released earlier for that year.
Social Security, welfare payments to the poor, or interest payments on past government
borrowing. In these cases, the money that passes through government hands is counted
as part of consumption. The only part of government spending counted in demand
is—returning to the basic definition of GDP—government purchases of goods or services
produced in the economy. Examples would include when the government buys a new
п¬Ѓghter jet for the Air Force or when it pays workers who deliver government services.
When thinking about the demand for domestically produced goods in a global
economy, it is important to count demand for exports (X)—that is, domestically made
goods that are sold abroad. However, if one is going to add in the extra demand generated
by foreign buyers, one must also subtract out imports (M)—that is, goods produced in
other countries that are purchased in this country. The gap between exports and imports
is called the trade balance. If a country’s exports are larger than its imports, then a
country is said to have a trade surplus. In the United States, exports typically exceeded
imports in the 1960s and 1970s, as shown in Exhibit 21-3b. But since the early 1980s,
imports have typically exceeded exports, and so the United States has experienced a
trade deficit in most years. Indeed, the trade deficit grew quite large in the late 1990s
and п¬Ѓrst half of the 2000s. Exhibit 21-3 also shows that imports and exports have both
risen substantially in recent decades, illustrating the process of globalization. If exports
trade balance: Gap
between exports and imports.
trade surplus: When
exports exceed imports.
trade deficit: When imports
exceed exports.
392
Chapter 21
The Macroeconomic Perspective
and imports are equal, then foreign trade no effect on the total GDP of the economy.
However, even if exports and imports are balanced overall, foreign trade might still
have powerful effects on particular industries and workers by causing nations to shift
workers and physical capital investment toward specializing in one industry rather than
another.
Based on these п¬Ѓve components of demand, GDP can be measured as:
GDP = Consumption + Investment + Government + Trade balance
GDP = C + I + G + (X–M).
Remember this definition. It will prove important for analyzing connections in the macro
economy and for thinking about macroeconomic policy tools.
durable goods: Longlasting goods like cars and
refrigerators.
nondurable goods: Shortlived goods like food and
clothing.
inventories: Goods that
have been produced, but not
yet been sold.
GDP Measured by What Is Produced
Everything that is purchased with components of demand must also be produced.
Exhibit 21-4 breaks down what is produced into п¬Ѓve categories: durable goods,
nondurable goods, services, structures, and the change in inventories. Before going
into detail about these categories, notice that total GDP measured according to what is
produced is exactly the same as the GDP measured by looking at the п¬Ѓve components of
demand. Since every market transaction must have both a buyer and a seller, GDP must
be the same whether measured by what is demanded or what is produced. Exhibit 21-5
shows these components of what is produced, expressed as a percentage of GDP, since
1960. Again, a few patterns stand out.
In thinking about what is produced in the economy, many non-economists
immediately focus on solid, long-lasting goods, like cars and computers. But by far the
largest part of GDP is services rather than goods. Moreover, services have been a growing
share of GDP over time. A detailed breakdown of the leading service industries would
include health care, education, law, and п¬Ѓnancial services. It has been decades since most
of the U.S. economy involved making solid objects. Instead, the most common jobs in a
modern economy involves a worker looking at pieces of paper; meeting with co-workers,
customers or suppliers; making phone calls; or looking at a computer screen.
Even within the overall category of goods, long-lasting durable goods like cars and
refrigerators are a smaller proportion of the economy than short-lived nondurable goods
like food and clothing. The category of structures includes everything from homes, to
office buildings, shopping malls, and factories. Inventories is a small category that refers
to the goods that have been produced by one business but have not yet been sold to
Exhibit 21-4
Components of GDP in
2005: Supply
GDP (in trillions of dollars)
Goods
Durable goods
Nondurable goods
Services
Structures
Change in inventories
Total
$1.7
$2.1
$7.2
$1.4
$0.04
$12.4
Percentage of Total
22.2%
54.6%
15.5%
7.4%
0.3%
100%
Chapter 21
The Macroeconomic Perspective
Exhibit 21-5
Components of Supply
70
Percentage of GDP
60
Services
50
40
30
Nondurable
goods
Durable goods
Structures
20
10
0
1960
393
1965
1970
1975
1980 1985
Year
1990
1995
2000
Services are the largest single
component of aggregate
supply, representing over half
of GDP. Nondurable goods
used to be larger than durable
goods, but in recent years, both
categories are about 20% of
GDP. Structures hover around
10% of GDP. The change in
inventories, the final component
of aggregate supply, is not
shown here; it is typically less
than 1% of GDP.
2005
consumers, and are still sitting in warehouses and on shelves. The amount of inventories
sitting on shelves will tend to decline if business is better than expected, or to rise if
business is worse than expected.
The Problem of Double Counting
One danger for the statisticians who calculate GDP is to avoid the mistake of double
counting, in which output is counted two or more times as it travels through the stages
of production. This problem arises because in an economy with a division of labor, most
products must work through an interconnected network of producers. For example,
imagine what would happen if the government statisticians who calculate GDP п¬Ѓrst
counted the value of mining iron ore, and then counted the value of the steel that used
that iron ore, and then counted the value of the car that used that steel. In this example,
the value of the original iron ore would have been counted three times—once at each
stage of production.
To avoid this problem, which could overstate the size of the economy considerably,
government statisticians count just the final goods and services in the chain of
production that are sold for consumption, investment, government, and trade purposes.
This need to avoid double counting (or triple counting, or worse) explains why neither
the method of measuring GDP—what is demanded or what is produced—includes the
many intermediate goods and services that businesses provide to other businesses. The
value of what businesses provide to other businesses is captured in the п¬Ѓnal products
at the end of the production chain. Similarly, the value of people’s work is included in
the price of the goods and services that are eventually produced.
The concept of GDP is fairly straightforward: it’s just the value of all final goods
and services bought and sold in the economy everything. But in a decentralized,
market-oriented economy, actually calculating the more-than $12 trillion dollar U.S.
GDP—along with how it is changing every few months—is a full-time job for a brigade
of government statisticians.
double counting:
A potential mistake to be
avoided in measuring GDP,
in which output is counted
two or more times as it
travels through the stages of
production.
final goods and services:
Output used directly for
consumption, investment,
government, and trade
purposes; contrast with
“intermediate goods.”
intermediate goods
and services: Output
provided to other businesses
at an intermediate stage of
production, not for final users;
contrast with “final goods and
services.”
394
Chapter 21
The Macroeconomic Perspective
Cousins of GDP
In the world of economic statistics, too much is never enough.
There are several different but closely related ways of
measuring the size of the economy other than GDP.
One of the closest cousins of GDP is GNP, or gross
national product. GDP includes only what is produced
by labor and capital located within a country’s borders.
However, GNP adds what is produced by a nation’s labor
and capital that are located in the rest of the world, and
subtracts out any payments sent home to other countries by
foreign labor and capital located in the United States. In other
words, GNP is based more on production of citizens and
firms from a country, wherever they are located, and GDP is
based on what happens within the geographic boundaries
of a certain country. For the United States, the gap between
GDP and GNP is relatively small; in recent years, only about
0.2%. But for small nations, which may have a substantial
share of their population working abroad and sending money
back home, the difference can be substantial.
Net national product, or NNP, is calculated by taking
GNP and then subtracting the value of how much physical
capital is worn out, or reduced in value because of aging,
over the course of a year. The process by which capital ages
and loses value is called “depreciation.” The NNP can be
further subdivided into national income, which includes all
income to businesses and individuals, and personal income,
which includes only income to people.
For practical purposes, it isn’t vital to memorize these
definitions. However, it is important be aware that these
differences exist and to know what statistic you are looking
at, so that you don’t accidentally compare, say, GDP in one
year or for one country with GNP or NNP in another year
or another country.
Comparing GDP among Countries
When comparing the GDP of different countries, two issues immediately arise. First, the
GDP of a country is measured in its own currency: the United States uses the U.S. dollar;
Canada, the Canadian dollar; most countries of western Europe, the euro; Japan, the
yen; Mexico, the peso; and so on. Thus, comparing GDP between two countries requires
converting from one currency to another. A second problem is that countries have very
different numbers of people. For instance, the United States has a much larger economy
than Mexico or Canada, but it also has roughly three times as many people as Mexico and
nine times as many people as Canada. Thus, comparing GDP across countries requires
a way of adjusting for different currencies and for different population levels.
exchange rate: The
rate at which one currency
exchanges for another.
Converting Currencies with Exchange Rates
To compare the GDP of two different countries with different currencies, it is necessary
to use an exchange rate, which is the rate at which one currency exchanges for another.
Exchange rates can always be expressed either as the units of country A currency that
need to be traded for a single unit of country B currency, or units of country B currency
that need to traded for a single unit of country A currency. For example, the exchange rate
between the Mexican peso and the U.S. dollar can be expressed either as approximately
11 Mexican pesos per 1 U.S. dollar; or to put it the other way, it takes 1/11of a U.S.
dollar (about 9 cents) to buy a peso. It is equally accurate to express the exchange rate
in either way, so you can choose whichever measure is more convenient.
Exchange rates are published each day in the “Business” section of major newspapers
and are available at banks and many websites. An illustrative list of exchange rates from
late 2006 appears in Exhibit 21-6. Each exchange rate is expressed in two ways: the
foreign currency per one U.S. dollar, and the amount in U.S. dollars to buy a unit of
foreign currency. These two measures are the reciprocals of each other; in mathematical
terms, multiplying the currency per U.S. dollar exchange rate times the U.S. dollars per
foreign currency exchange rate will always equal 1.
Using the exchange rate to convert GDP from one currency to another is
straightforward. Say that the task is to compare Japan’s GDP of 500 trillion yen with
Chapter 21
The Macroeconomic Perspective
The most common mistake that students make when using exchange rates to convert between
currencies is to put the exchange rate upside down: for example, they might use the U.S.
dollars per euro exchange rate when they meant to use the euros per U.S. dollar exchange
rate. To avoid this error, write out the currency units when doing these calculations. Then,
you will notice that that the currency units that you are converting away from cancel out in
the numerator and denominator of the multiplication calculation, as shown in the conversion
of U.S. and Japanese GDP in the text, leaving behind the currency units into which you
are converting.
Country (Currency)
Currency per U.S. Dollar
Brazil (real)
Britain (pound)
Canada (dollar)
China (yuan)
Egypt (pound)
Euro
India (rupee)
Indonesia (rupiah)
Japan (yen)
Mexico (peso)
Nigeria (naira)
Russia (ruble)
South Africa (rand)
United States (dollar)
U.S. Dollar Equivalent
2.134
0.530
1.125
7.895
5.692
0.789
45.190
9132.420
118.620
10.733
122.697
26.809
7.510
1.000
0.469
1.888
0.889
0.127
0.176
1.267
0.022
0.000
0.008
0.093
0.008
0.037
0.133
1.000
the U.S GDP of $12 trillion. The exchange rate is 120 yen = $1. (These numbers are
realistic, but rounded off to simplify the calculations.) To convert Japan’s GDP into
U.S. dollars, multiply:
Japan's GDP in yen Г—
500 trillion yen Г—
$
exchange
yen
$1
yen = $4,167 billion dollars
120
Of course, it is equally possible to convert the U.S. GDP into yen:
U.S. GDP in $ Г—
yen
= U.S. GDP in yen
$ exchange rate
$12 trillion Г—
120 yen
=1,440 trillion yen
$1
In either case, GDP in the United States is more than double that of GDP in Japan.
To compare the size of several economies, you must convert all of the different
measures of GDP into a common currency. The second column of Exhibit 21-7 shows
the size of each country’s GDP, measured in billions of units of its own currency. The
395
Clearing It Up
Write Out the Exchange
Rate Units
Exhibit 21-6 Some
Exchange Rates in Late
2006
Chapter 21
396
The Macroeconomic Perspective
Exhibit 21-7 Exchange Rates and Gross Domestic Product (GDP), 2005
The second column shows the size of each country’s GDP, measured in billions of units of its own currency in 2005. The third
column shows the exchange rate, measured in terms of how many units of domestic currency to each U.S. dollar. The fourth
column takes the GDP in the nation’s own currency, multiplies by 1/exchange rate in the third column, and thus calculates the
country’s GDP in U.S. dollars.
Country
Brazil
Canada
China
Egypt
Germany
India
Indonesia
Japan
Mexico
Nigeria
Russia
South Africa
United Kingdom
United States
GDP in Domestic Currency
1,691 billion reals
1,260 billion (Canadian) dollars
17,587 billion renminbi
506 billion pounds
2,114 billion euros
35,519 billion rupees
2,620,884 billion rupiah
531,708 billion yens
8,241 billion pesos
12,078 billion nairas
1,976 billion rubles
1,803 billion rand
1,162 billion pounds
12,455 billion dollars
Domestic Currency/
U.S. Dollars
2.13
1.13
7.89
5.69
0.76
45.19
9,132
118
10.73
122
26
7.51
0.53
1
GDP in Billions
of U.S. Dollars
794
1,115
2,229
89
2,782
786
287
4,506
768
99
764
240
2,193
12,455
third column shows the exchange rate, measured in U.S. dollars per unit of foreign
currency. The fourth column takes the GDP in each country’s own currency, multiplies
by 1/exchange rate in the third column, and thus expresses the GDP for each country
in U.S. dollars.
per capita GDP: GDP
divided by the population.
Converting to Per Capita GDP
The U.S. economy has the largest GDP in the world, by a considerable amount. But
the United States is also a populous country; in fact, it is the third-largest country by
population in the world, although well behind China and India. So is the U.S. economy
larger than other countries just because the United States has more people than most
other countries, or because the U.S. economy is actually larger on a per-person basis?
This question can be answered by calculating a country’s per capita GDP; that is, the
GDP divided by the population.
The second column of Exhibit 21-8 lists the GDP of the same selection of countries
that appeared in the previous two exhibits, showing their GDP as converted into U.S.
dollars. The third column gives the population for each country. The fourth column lists
the per capita GDP, which is calculated by dividing the second column by the third.
Exhibit 21-8 illustrates that a country with a small population can have a smaller
GDP, but a larger per capita GDP, than a country with a larger population. For example,
the GDP of China is much larger than that of Mexico, but the per capita GDP of Mexico
is much larger than China. Looking ahead several decades, it is quite possible that
economic growth in China will cause China to have the largest overall economy in the
world—while still having a much lower per capita GDP than the United States. After
all, since China has roughly п¬Ѓve times as many people as the United States, its per
Chapter 21
Country
Brazil
Canada
China
Egypt
Germany
India
Indonesia
Japan
Mexico
Nigeria
Russia
South Africa
United Kingdom
United States
The Macroeconomic Perspective
GDP (in billions
of U.S. dollars)
Population
(in millions)
Per Capita GDP
(U.S. dollars)
794
1,115
2,229
89
2,782
786
287
4,506
768
99
764
240
2,193
12,455
188
32
1,316
79
82
1,118
233
127
108
132
141
44
60
98
4,223
34,844
1,694
1,126
33,926
703
1,232
35,480
7,111
750
5,418
5,455
36,550
41,795
397
Exhibit 21-8 Per
Capita GDP in 2005
capita GDP needs only to be more than one-п¬Ѓfth as large as the U.S. per capita GDP
for China’s total GDP to exceed that of the United States.
The high-income nations of the world—including the United States and Canada, the
western European countries and Japan—typically have per capita GDP in the range of
$20,000 to $50,000. Middle-income countries, which include much of Latin America,
Eastern Europe, and some countries in East Asia, have per capita GDP in the range of
$6,000 to $12,000. The low-income countries in the world, many of them located in
Africa and Asia, often have per capita GDP of less than $2,000 per year, and in some
cases even less than $1,000 per year.
The Pattern of GDP over Time
For most high-income countries of the world, the long-term pattern of GDP looks
generally similar. GDP rises gradually over time, but the road can be bumpy.
Exhibit 21-9 illustrates this general pattern with data on U.S. GDP. These GDP data
are presented after adjusting for inflation. As the discussion of inflation in Chapter 24 will
explore in detail, GDP can rise either because a greater quantity of goods and services
are being produced, or because the prices of goods and services are higher as a result of
inflation. By stripping out the effects of inflation, the remaining rise in GDP shown in
the exhibits represents only an increase in the quantity of goods and services produced.
Chapter 24 will also discuss just how this adjustment for inflation is performed.
Exhibit 21-9a shows the pattern of total U.S. GDP since 1900. The generally upward
long-term path of GDP has been regularly interrupted by short-term declines in GDP.
A significant decline in national output is called a recession. An especially lengthy and
deep recession is called a depression. The severe drop in GDP that occurred during
the Great Depression of the 1930s is clearly visible. The most significant human
problem associated with recessions (and their larger, uglier cousins, depressions) is
that a slowdown in production means that many п¬Ѓrms will need to hire fewer people,
recession: A significant
decline in national output.
depression: An especially
lengthy and deep decline in
output.
Chapter 21
398
The Macroeconomic Perspective
Exhibit 21-9 U.S. GDP, 1900–2005
(a) GDP in the United States in 2005 was about $12 trillion. After adjusting to remove the effects of inflation, this represents a
roughly 20-fold increase in the economy’s production of goods and services since the start of the twentieth century. (b) Per capita
GDP in the United States in 2005 exceeded $40,000. This represents an almost eight-fold increase, even after adjusting for the
effects of inflation, since the start of the twentieth century.
$45,000
$14
$40,000
Real GDP per Capita
GDP (in trillions of dollars)
$12
$10
$8
$6
$4
$35,000
$30,000
$25,000
$20,000
$15,000
$10,000
$2
$0
1900
$5,000
1920
1940
(a)
peak: During the business
cycle, the highest point of
output before a recession
begins.
trough: During the business
cycle, the lowest point of
output in a recession, before a
recovery begins.
business cycle: The
relatively short-term movement
of the economy in and out of
recession.
1960
Year
1980
$0
1900
2000
1920
1940
1960
Year
1980
2000
(b)
or even to lay off or п¬Ѓre some of the workers that they have. Losing a job imposes
painful п¬Ѓnancial and personal costs on the worker, and often on their extended family
as well. In addition, even those who keep their jobs are likely to п¬Ѓnd that wage raises
are scanty at best—or they may even be asked to take pay cuts. Exhibit 21-9b shows
the corresponding rise in per capita GDP (again adjusted for inflation). Even though
the U.S. population nearly quadrupled over the twentieth century, GDP on a per capita
basis has multiplied almost eight-fold since 1900. The per capita growth rate of GDP
over the twentieth century averaged about 2% per year.
Exhibit 21-10 lists the pattern of recessions and expansions in the U.S. economy
since 1900. The highest point of the economy, before the recession begins, is called the
peak; conversely, the lowest point of a recession, before a recovery begins, is called
the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs
from trough to peak. The movement of the economy from peak to trough and trough to
peak is called the business cycle. It is intriguing to notice that the three longest troughto-peak expansions of the twentieth century have happened since 1960, and that the
peak-to-trough recessions during this time have been relatively short (the longest is 16
months). Recessions have by no means disappeared, but they do seem to be arriving
less frequently and not lingering as long.
These patterns of GDP growth suggest that the health of the macroeconomy, as
measured by GDP, poses two main issues: economic growth and recessions. The time
frame for worrying about economic growth is over the long term; the time frame for
worrying about recessions is the short term. This long-term/short-term approach to
thinking about GDP will play a central role in macroeconomic analysis.
Chapter 21
Trough
December 1900
August 1904
June 1908
January 1912
December 1914
March 1919
July 1921
July 1924
November 1927
March 1993
June 1938
October 1945
October 1949
May 1954
April 1958
February 1961
November 1970
March 1975
July 1980
November 1982
March 1991
November 2001
Peak
September 1902
May 1907
January 1910
January 1913
August 1918
January 1920
May 1923
October 1926
August 1929
May 1937
February 1945
November 1948
July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
March 2001
––
The Macroeconomic Perspective
Contraction
18
23
13
24
23
7
18
14
13
43
13
8
11
10
8
10
11
16
6
16
8
8
Expansion
21
33
19
12
44
10
22
27
21
50
80
37
45
39
24
106
36
58
12
92
120
––
How Well Does GDP Measure the Well-Being
of Society?
The level of per capita GDP clearly captures some element of what is meant by the
phrase “standard of living.” Most of the migration in the world, for example, involves
people who are moving from countries with relatively low per capita GDP to countries
with relatively high per capita GDP. Similarly, it is not common to п¬Ѓnd many people
in a high-income country who choose to deny themselves the benefits of electricity,
plumbing, modern medicine, automobile and plane travel, and choose instead to live
only with the income levels and technologies that were available 50 or 100 years ago
in high-income countries—or with the technologies that are still in common use in
low-income countries.
However, “standard of living” is a broader term than GDP. GDP focuses on
production that is bought and sold in markets. Standard of living includes all elements
that affect people’s happiness, whether they are bought and sold in the market or not.
To illuminate the gap between GDP and standard of living, it’s useful to spell out some
things that GDP does not cover that are clearly relevant to standard of living.
Some Differences between GDP and Standard of Living
GDP includes spending on recreation and travel, but it does not cover leisure time.
Clearly, however, there is a substantial difference between an economy that is large
399
Exhibit 21-10 Dates of
U.S. Business Cycles since
1900
400
Chapter 21
The Macroeconomic Perspective
because people work long hours, and an economy that grows because people work the
same number of hours but are more productive with their time. For example, the per capita
GDP of the U.S. economy is about 20% larger than the per capita GDP of Germany, as
was shown in Exhibit 21-8, but it’s also true that the average U.S. worker is on the job
about 360 hours per year more than the average German worker. The calculation of GDP
doesn’t take the German worker’s nine extra weeks of leisure into account.
GDP includes what is spent on environmental protection, health care, and education,
but it does not include actual levels of environmental cleanliness, health, and learning.
Thus, GDP includes the cost of buying pollution-control equipment, but it does not
address whether the air and water are actually cleaner or dirtier. GDP includes spending
on medical care, but does not address whether life expectancy or infant mortality have
risen or fallen. Similarly, it counts spending on education, but doesn’t address directly
how much of the population can read, write, or do basic mathematics.
GDP includes production that is exchanged in the market, but it does not cover
production that is not exchanged in the market. For example, hiring someone to mow
your lawn or clean your house is part of GDP, but doing these tasks yourself is not
part of GDP. One remarkable change in the U.S. economy in recent decades is that as
of 1970, only about 42% of women participated in the paid labor force. By the early
2000s, about 60% of women participated in the paid labor force. As women have
entered the labor force, many of the services that they used to produce in the nonmarket economy like food preparation and child care have shifted to some extent into
the market economy, which makes the GDP appear larger even if more services are not
actually being consumed.
GDP includes newly produced goods and services, but does not count the buying
and selling of previously existing assets. For example, a house built this year is counted
in GDP, but a house built in the past that is sold this year is not part of GDP—because
nothing new was produced this year. Although the price of the old house is not part of
GDP, the amount paid to a realtor for the service of assisting with the transaction is
counted in this year’s GDP.
GDP has nothing to say about the level of inequality in society. Per capita GDP
is only an average. When per capita GDP rises by 5%, it could mean that everyone in
the society has risen by 5%, or that some groups have risen by more while others have
risen by less—or even declined. GDP has nothing in particular to say about the amount
of variety available. If a family buys 100 loaves of bread in a year, GDP doesn’t care
whether they are all white bread, or whether the family can choose from wheat, rye,
pumpernickel and many others—it just looks at the total amount spent on bread is the
same.
GDP has nothing much to say about what technology and products are available.
The standard of living in, say 1950 or 1900 wasn’t affected only by how much money
people had—it was also affected by what they could buy. No matter how much money
you had in 1950, you could not buy a CD player or a portable phone.
In certain cases, it isn’t clear that a rise in GDP is even a good thing. If a city
is wrecked by a hurricane, and then experiences a surge of rebuilding construction
activity, it would be peculiar to claim that the destruction of the hurricane was therefore
economically beneficial. If people are led by a rising fear of crime to pay for installation
of bars and burglar alarms on all their windows, it is hard to believe that this increase in
GDP has made them better off. Some people would argue that sales of certain goods,
like pornography or extremely violent movies, do not represent a gain to society’s
standard of living.
Chapter 21
The Macroeconomic Perspective
401
The Human Development Index
Economists have long recognized that GDP is not a complete
measure of social well-being. In 1990, an economist
named Mahbud ul Haq at the United Nations Development
Programme decided to do something about it. The UNDP
began publishing an annual Human Development Report.
Each year, along with a discussion of economic and social
issues affecting low-income countries, the Report includes
a Human Development Index, which ranks countries in
three broad areas: health, as measured by life expectancy;
education, as measured by school enrollment and adult
literacy; and material standard of living, as measured by
per capita GDP.
By blending per capita GDP with measures of health
and education, countries with good levels of health and
education may rank higher in the Human Development Index
than other countries that have greater per capita GDP. For
example, in the rankings published in 2006, the U.S. per
capita GDP was 31% higher than that of Australia. However,
life expectancy in Australia was three years greater than in
the United States and a higher proportion of Australians
are enrolled in school (including college) than in the United
States. Thus, in the HDI rankings, Australia ranked above
the United States.
To choose a more extreme example, the per capita GDP
of Turkey is about 70% above that of the Philippines. But the
Philippines has a life expectancy of 70.7 years and an adult
literacy rate of 93%, while in Turkey life expectancy is 68.9
years and only 87% of adults are literate. In the 2006 HDI
rankings, the Philippines rank ahead of Turkey.
The HDI rankings are controversial. Are these factors,
measured in these specific ways, the right ones to include?
What about making additional adjustments for gender
or racial equality, the level of poverty, or environmental
quality? Are the three factors weighted properly, or is, say,
adult literacy getting too much weight and per capita GDP
too little weight? The UNDP readily acknowledges: “The
concept of human development is much deeper and richer
than what can be captured in any composite index or even
by a detailed set of statistical indicators.”
Does a Rise in GDP Overstate or Understate the Rise
in the Standard of Living?
The fact that per capita GDP does not fully capture the broader idea of standard of
living has led to a concern that the increases in GDP over time are illusory. It is at least
theoretically possible that while the measured GDP is rising, the standard of living
could be falling if human health, environmental cleanliness, and other factors that aren’t
included in GDP are worsening. Fortunately, this fear appears to be overstated.
In some ways, the rise in GDP understates the actual rise in the standard of living.
For example, the typical workweek for a U.S. worker has fallen over the last century
from about 60 hours per week to less than 40 hours per week. Life expectancy and health
have risen dramatically, and so has the average level of education. Since 1970, the air and
water in the United States have generally (with some exceptions) been getting cleaner.
New technologies have been developed for many functions, including entertainment,
travel, information, and health. A much wider variety of basic products like food and
clothing is available today than several decades ago. Because GDP does not capture
leisure, health, a cleaner environmental, the possibilities created by new technology, or
an increase in variety, the actual rise in the standard of living for Americans in recent
decades has exceeded the rise in GDP.
On the other side, rates of crime, levels of traffic congestion, and inequality of
incomes are higher in the United States now than they were in the 1960s. Moreover, a
substantial number of services that used to be provided, primarily by women, in the nonmarket economy are now part of the market economy that is counted by GDP. By ignoring
these factors, GDP would tend to overstate the true rise in the standard of living.
The positive factors ignored by GDP are probably larger than the negative factors
ignored by GDP, in which case GDP over time would understate the true rise in the
standard of living. But that judgment is a controversial one.
402
Chapter 21
The Macroeconomic Perspective
GDP Is Rough, but Useful
It would be foolish and blinkered to believe that a high level of GDP should be the only
goal of macroeconomic policy or government policy more broadly. But even though
GDP does not measure broader standard of living with great precision, it still reveals
something important about the standard of living. In most countries, a significantly
higher per capita GDP occurs hand in hand with other improvements in everyday life
along many dimensions like education, health, environmental protection.
No single number can capture all the elements of a term as broad as “standard
of living.” Per capita GDP has real limitations, which must always be kept in mind.
Nonetheless, per capita GDP is a reasonable, rough-and-ready measure of the standard
of living.
Conclusion
There is sometimes a tendency to speak as if certain parts of the economy deserve more
emphasis than others: for example, that high-technology industries are more important
to the economy than established industries, like making paper, or service jobs in areas,
like tourism. Even within the high-tech industries, certain hot new firms—perhaps
those involved in the Internet or in biotechnology—are sometimes claimed to be more
important than older established п¬Ѓrms.
This desire to treat certain industries like favorite children is often misguided,
because an economy is not like a country’s Olympic team. In the Olympics, a country
can celebrate if a few of its top athletes perform well. In the Olympics, it doesn’t matter
if the rest of the people in the country, watching on television, are fat and lazy and out of
shape. But in an economy, every business counts. For an economy as a whole, it doesn’t
work especially well to have a few wonderful, world-class companies, while the rest of
the economy is flabby and inefficient. After all, people work everywhere in the economy
and buy goods from everywhere in the economy. Everyone throughout the economy
needs good products, good jobs, good pay, and a generally rising standard of living.
Key Concepts and Summary
1. In a number of cases, behavior that seems rational at the microeconomic level for
individuals and п¬Ѓrms can end up leading to unexpected or even counterproductive
outcomes at the macroeconomic level.
2. The size of a nation’s economy is commonly measured by its gross domestic
product or GDP, which measures the value of the output of all goods and services
produced within the country. GDP is measured by taking the quantities of all goods
and services produced, multiplying them by their prices, and summing the total.
3. Since GDP measures what is bought and sold in the economy, it can be measured
either by the sum of what is demanded in the economy or what is produced. Demand
can be divided into consumption, investment, government, exports, and imports.
What is produced in the economy can be divided into durable goods, nondurable
goods, services, structures, and inventories.
Chapter 21
The Macroeconomic Perspective
403
4. To avoid double-counting, GDP counts only п¬Ѓnal output of goods and services,
not the production of intermediate goods or the value of labor in the chain of
production.
5. In comparing GDP п¬Ѓgures between countries, it is necessary to useful to convert to
a common currency using exchange rates and to divide by population to calculate
per capita GDP.
6. In the long term, the key issue concerning GDP is real per capita growth. In the short
run, the key issue concerning GDP is shortening or reducing the size of recessions
and depressions—or avoiding them completely.
7. GDP is an indicator of a society’s standard of living, but it is only a rough indicator.
GDP does not directly take account of leisure, environmental quality, levels of health
and education, activities conducted outside the market, changes in inequality of
income, increases in variety, increases in technology, or the (positive or negative)
value that society may place on certain types of output.
Review Questions
1. What are the main components of measuring GDP
with what is demanded?
2. What are the main components of measuring GDP
with what is produced?
3. Would you usually expect GDP as measured by what
is demanded to be greater than GDP measured by
what is supplied, or the reverse?
4. Why is double counting a danger when measuring
GDP?
5. What are the two main difficulties that arise in
comparing the GDP of different countries?
6. What are the typical patterns of GDP for a highincome economy like the United State’s in the longrun and the short-run?
7. List some of the reasons why GDP should not be
considered a precise measure of the standard of living
in a country.

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