Lectures following Rüdiger Dornbusch’ works (1)
Macroeconomics, McGraw-Hill, New York, 1990 (with S. Fischer) 5th ed.
International Economic Policy: Theory and Evidence, Johns Hopkins University Press, (edited with J. A. Frenkel.)
Open Economy Macroeconomics, Basic Books, New York, 1980.
PART 1 INTRODUCTION
The basic questions in economics-What should be produced? How? and For whom?-have to be decided by society in some way. One way of making these decisions is through the use of markets and the price system. Buyers and sellers in markets, each responding to prices, effectively decide among themselves what gets produced, how, and for whom.
In this chapter we will define markets and see how the responses of buyers and sellers to prices determine what goods are produced, how, and for whom. The framework of analysis is a very general one that can be applied to the markets for cars, labor, and nu#clear reactors as well as the markets for banana splits, haircuts, and baseball players. In each case the interplay between demand (the behavior of buyers) and supply (the behavior of sellers) determines the price and the amount of output produced and sold.
The U.S. economy and most other economies rely heavily on markets to allocate resources. To take only two examples: the quantity of cars produced and their prices
are determined in the market for cars, and the wages of labor are determined in the market for labor. Because of the heavy reliance on markets and prices, the information contained in this chapter is a basic element of economics and a vital tool for the analysis of economic issues. It has to be mastered by anyone who wants to understand the economies in which we live.
1 THE MARKET
At the center of the analysis of the allocation of resources through the price system is the notion of a market. We can readily think of a market as a place where people get together to buy and sell, haggling over the prices of goods such as food, clothing, or jewels. But the term “market” has a broader meaning. A market is a set of arrangements by which buyers and sellers of a good are in contact to trade that good.
Here are some examples. The market for used cars operates with dealers and private sellers on the selling side. Buyers come into contact with sellers by reading newspaper advertisements, by visiting dealers, by looking at notices on bulletin boards, and by hearing from friends about people who want to sell. Some markets, such as the New York Stock Exchange, operate through intermediaries or traders.
Lectures following Rüdiger Dornbusch’ works (2)
Buyers and sellers call in their orders from all over the country and can have the orders carried out within minutes or even seconds. The markets for internationally traded commodities such as wheat or copper work largely over the telephone, with potential buyers and sellers talking to each other from anyplace in the world. Still other examples are auctions, where buyers compete against each other, and supermarkets, where the sellers flll the shelves and post the prices at which the buyers do the shopping.
These situations all describe different setups by which buyers and sellers get together and by which the price and amount to be traded are determined. An auction, where people bid for a good, is clearly dif ferent from a supermarket checkout counter, where prices are read off the boxes, jars, and cans. But once we look beyond the features of a particular market, we will see that all markets have a common, basic economic core. All help determine the answers to the what, how, and for whom questions. They determine why a box of cornflakes costs $2 rather than 20 cents or $20, who will supply cornflakes, and who will buy them. They determine why it is possible for top baseball players to receive over a million dollars a year and top football players much less.
To understand how prices are determined and resources allocated, we have to build up a model of the market. Such a model will enable us to identify the factors that matter in a market-for determining both price and the quantities bought and sold-and the precise way in which they affect price and quantity. Demand and supply are the basic ideas. By “demand” we mean the behavior of buyers. By “supply” we mean the behavior of sellers. This behavior is summarized by the amounts of goods buyers want to buy at each price and sellers sell at each price. We will now set out the determinants of demand and supply.
2 DEMAND, SUPPLY, AND EQUILIBRIUM
Demand is the amount of a good buyer want to purchase at different prices. Thus demand is not a particular quantity, say, three six-packs of beer, but rather a description of the amount of beer the buyer would want to buy at different prices for six-pack. In Table 3-1 we take the hypothetical example of fish. The first column shows a range of prices, from $0 (when fish is free) to $7 per pound of fish. The second column shows the quantities demanded by buyers at the different prices. For each price there is a corresponding quantity of fish demanded. When fish is free, the quantity demanded is 50 million pounds. At $4 a pound, the quantity demanded is only one million pounds. The first and second columns together describe demand.
Supply is the amount of a good sellers want to sell at different prices. Supply, too, is not a particular quantity. Rather it is a complete description of the amount sellers would want to sell at different prices. In the third column of Table 3.2 we show the quantities suppliers in the fish market want to sell at the different prices of fish. For each price there is a corresponding quantity of fish supplied. When fish is free the quantity supplied is zero. When the price of fish is $5 per pound, the quantity supplied is 40 million pounds. The first and third columns together describe supply.
There is an important distinction between demand and quantity demanded. Demand describes consumer behavior at different prices. But at any given price, like $2, there is a particular quantity demnanded. Thus the term “quantity demanded” makes sense only in relation to a particular price. The term “demand” describes consumer behavior- the entire relationship between quantity demanded and price-rather than a particular quantity of goods at a particular price.