ECO LECTURE SEVEN 1 TODAY WE WANT TO TALK ABOUT SUPPLY AND DEMAND. IF YOU'LL REMEMBER, WHAT WE WERE TALKING ABOUT LAST TIME WAS THE

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1 ECO LECTURE SEVEN 1 TODAY WE WANT TO TALK ABOUT SUPPLY AND DEMAND. IF YOU'LL REMEMBER, WHAT WE WERE TALKING ABOUT LAST TIME WAS THE PRODUCTION POSSIBILITIES FRONTIER AND I ENDED THAT DISCUSSION BY TALKING ABOUT THESE QUESTIONS THAT EVERY SOCIETY MUST ANSWER: WHAT GOODS WILL BE PRODUCED, HOW WILL THOSE GOODS BE PRODUCED, AND FOR WHOM WILL THE GOODS BE PRODUCED? WHO GETS THE THINGS THAT WE'RE PRODUCING? AND IN THE UNITED STATES, MOST OF THE ANSWERS TO THOSE QUESTIONS ARE -- WELL, WE DON'T HAVE A NATIONAL ANSWER. WE LEAVE THAT UP TO EACH PERSON. AND SO IN THE UNITED STATES THOSE DECISIONS ABOUT WHAT WILL BE PRODUCED AND HOW WILL IT BE PRODUCED AND WHO WILL RECEIVE IT, WE JUST LEAVE THAT UP TO THE MARKETPLACE. AND BY THE MARKETPLACE, WE REALLY JUST MEAN PEOPLE, BUYERS AND SELLERS, JUST COMING TOGETHER AND INTERACTING WITH EACH OTHER. THAT'S THE POLICY IN THE UNITED STATES FOR THE MOST PART. THERE'S SOME GOVERNMENT PRODUCTION. THERE'S SOME NON-MARKET DECISIONS THAT ARE MADE, OF COURSE, AND THE GOVERNMENT PART OF THE ECONOMY IS MADE ON THE ORDER OF -- IT DEPENDS ON HOW YOU MEASURE THIS STUFF, BUT ON THE ORDER OF TWENTY, THIRTY, FORTY -- NOT FORTY PERCENT -- TWENTY, THIRTY, THIRTY-FIVE PERCENT. OKAY. ANYWAY, SO WE LET CONSUMERS DECIDE WHAT GOODS WILL BE PRODUCED, RIGHT? WELL, THE PRODUCERS MAKE THE DECISION WHAT TO

2 ECO LECTURE SEVEN 2 PRODUCE. THEY PRODUCE FOR THE BENEFIT OF CONSUMERS. WE LET THOSE BUSINESS MANAGERS DECIDE HOW WILL THE GOODS BE PRODUCED. THEY CAN PRODUCE IT WITH LABOR OR CAPITOL OR HOWEVER THEY WOULD LIKE. AND THEN WHO WILL RECEIVE THE GOODS? THAT'S JUST A MATTER OF WHO'S WILLING TO PAY THE MOST FOR 'EM. SO IN THE UNITED STATES ECONOMY, THOSE DECISIONS ARE ANSWERED THAT WAY IN THE MARKETPLACE. WHAT DO WE MEAN BY A MARKET? FIRST OF ALL, LET ME TELL YOU WHAT A MARKET IS NOT -- OR WHAT I DO NOT MEAN WHEN I SAY MARKET. I DO NOT MEAN SOME SORT OF SQUARE DOWNTOWN WHERE EVERYBODY COMES TO BUY AND SELL THINGS. I DON'T MEAN A SHOPPING MALL OR SOME CENTRAL LOCATION. I DON'T MEAN THAT AT ALL. I MEAN, BY A MARKET, IT'S ALL BUYERS AND SELLERS OF A PARTICULAR GOOD OR SERVICE. A MARKET IS -- IT'S REALLY A COLLECTION OF PEOPLE AND THE COLLECTION OF PEOPLE -- SOME PEOPLE ARE BUYING AND SOME PEOPLE ARE SELLING, BUT THE MARKET IS MADE UP OF THOSE PEOPLE. SO WHERE ARE THEY LOCATED? AND THE ANSWER IS I DON'T KNOW. THEY COULD BE LOCATED ANYWHERE. IN THIS ROOM THERE'S A MARKET MEETING TAKING PLACE RIGHT NOW. THERE'S SOMEBODY SELLING ECONOMICS AND THERE'S SOME PEOPLE BUYING ECONOMICS, SO WE'RE RIGHT HERE. BUT THE MARKET FOR ECONOMICS EXTENDS BEYOND THIS ROOM. THERE'S AN ECONOMICS CLASS MEETING NEXT DOOR AND THERE ARE ECONOMICS CLASSES MEETING IN THE COLLEGE ACROSS TOWN AND

3 ECO LECTURE SEVEN 3 ECONOMICS CLASSES MEETING IN DIFFERENT TOWNS. AND SO THE MARKET FOR ECONOMICS IS NOT JUST CONFINED TO THIS SPECIFIC LOCATION, OKAY? SO DON'T THINK OF IT AS A PLACE; THINK OF IT AS PEOPLE. AND IF YOU DECIDE NOT TO BUY YOUR ECONOMICS HERE, THEN YOU CAN PICK UP AND GO NEXT DOOR. AND I'M NOT INVITING YOU TO; I'M JUST SAYING THE MARKET ENCOMPASSES YOU GOING NEXT DOOR OR YOU GOING TO ANOTHER COLLEGE, AND SO FORTH. OKAY. MARKET EXCHANGES ARE VOLUNTARY SO PEOPLE TRADE IN THE MARKETPLACE BECAUSE THEY WANT TO. YOU MAY NOT BE HAPPY ABOUT THE DEAL YOU'RE GETTING, BUT YOU CAN ALWAYS JUST SAY, "NO, I DON'T WANT THAT DEAL," IF YOU DON'T LIKE IT, YOU KNOW. THAT'S ALWAYS ONE OF THE CHOICES YOU HAVE. AND THAT BEING THE CASE, BY BEING -- BY HAVING THESE EXCHANGES VOLUNTARY, BY GIVING YOU THE RIGHT TO ALWAYS SAY "NO, I DON'T WANT TO TRADE," THEN WHAT YOU CAN DO IS YOU CAN PREVENT YOURSELF FROM GETTING INTO THOSE TRADES THAT ACTUALLY HURT YOU, RIGHT? THESE ARE POSITIVE SUM EXCHANGES, BY WHICH I MEAN BOTH SIDES EXPECT TO GAIN. THIS TERM IS MAYBE A LITTLE BIT NEW TO YOU AND THAT'S PART OF THE REASON I WROTE IT UP HERE WAS TO INTRODUCE YOU TO THIS TERM, POSITIVE SUM. THINK ABOUT A CARD GAME FOR JUST A SECOND. MAYBE WE'RE PLAYING POKER. FOUR OF US SIT DOWN AT A TABLE, MAYBE EACH ONE OF US STARTS OFF WITH TEN DOLLARS, AND THEN WE START PLAYING CARDS. AND WE START OFF, EACH ONE OF US WITH TEN

4 ECO LECTURE SEVEN 4 DOLLARS, THERE'S FOUR OF US, THERE'S FORTY DOLLARS AT THE TABLE. NOW, WE START PLAYING CARDS AND BASICALLY WHAT HAPPENS IS THAT FORTY DOLLARS JUST SHIFTS ACROSS THE TABLE, BACK AND FORTH, AS THE CARD GAME GOES ON. THAT WOULD BE CALLED A ZERO SUM GAME. ONE PERSON'S GAINS EQUAL ANOTHER PERSON'S LOSSES. AND SINCE THE GAINS AND THE LOSSES ARE OFFSET BY EACH OTHER, THEN OVERALL THERE'S NO MONEY BEING SORT OF ADDED TO THE TABLE AND THERE'S NOTHING BEING LOST. THE POSITIVE AND THE NEGATIVES, THE GAINS AND THE LOSSES OFFSET, THAT WOULD BE A ZERO SUM GAME. A NEGATIVE SUM GAME WOULD BE ONE IF WE WERE PLAYING A GAME AND LET'S SAY EVERY HOUR A DOLLAR EVAPORATED INTO THE AIR. WE START OFF THE EVENING PLAYING CARDS AND THERE'S FORTY DOLLARS AT THE TABLE, AND EVERY HOUR A DOLLAR EVAPORATES. WE DON'T SEE IT GO; IT JUST GOES. AND AT THE END OF THE EVENING MAYBE THERE'S ONLY THIRTY-FIVE DOLLARS AT THE TABLE. AND IF THAT WERE THE CASE -- AND I KNOW IT'S NOT, BUT IF THAT WERE THAT WOULD BE A NEGATIVE SUM GAME. THE TRANSACTION, THE INTERACTION BETWEEN US IS SOMETHING THAT IN THE END WE ALL LOSE, ONE WAY OR ANOTHER. BUT WITH A POSITIVE SUM GAME, WHAT HAPPENS -- OR A POSITIVE SUM TRANSACTION -- IS THAT IT'S SORT OF LIKE ONE PLUS ONE EQUALS THREE. AND TRADE IS A POSITIVE SUM EXCHANGE OR TRADING WITH PEOPLE IS A POSITIVE SUM EXPERIENCE, BECAUSE WHAT HAPPENS IS BOTH PARTIES EXPECT TO BENEFIT. YOU START OFF WITH A CERTAIN AMOUNT OF,

5 ECO LECTURE SEVEN 5 LET'S SAY, SATISFACTION OR WEALTH OR WHATEVER AND BY THE END OF THE TRADE, YOU HAVE MORE THAN BEFORE. LET ME GIVE YOU AN EXAMPLE. I THINK I MAYBE MENTIONED IT BEFORE, BUT JUST TO GIVE YOU AN EXAMPLE. LET'S SAY THAT I HAVE A TV SET I WANTED TO TRADE AND YOU MOW LAWNS FOR PEOPLE. AND I SAY TO YOU, "HEY, IF YOU'LL COME AND MOW MY LAWN FOR TWO MONTHS, I'LL GIVE YOU MY TV SET." AND YOU SAY, "YEAH, I'D LIKE TO HAVE A TV SET. I'VE JUST GOT THIS CRUMMY ONE; IT DOESN'T DO A GOOD JOB; IT'S BLACK AND WHITE, NOT COLOR. AND SO THAT'D BE GREAT." SO WE DO A DEAL HERE. WE SHAKE HANDS ON IT. YOU MOW MY LAWN FOR TWO MONTHS, JUST LIKE YOU SAID YOU WOULD; I GIVE YOU THE TV SET, JUST LIKE I SAID I WOULD. IS THIS A ZERO SUM GAME? IS IT A NEGATIVE SUM GAME? I SAY IT'S A POSITIVE SUM GAME AND HERE'S WHY. I VOLUNTARILY GAVE UP MY TV SET TO HAVE THE YARD MOWED FOR TWO MONTHS. I WANTED TO DO THAT. NOBODY FORCED ME TO DO IT. I WAS THINKING IN MY OWN HEAD, "HEY, HAVING THE YARD MOWED FOR TWO MONTHS, THAT'S MORE VALUABLE TO ME THAN HAVING THIS TV SET. I'VE GOT AN EXTRA TV SET I WAS JUST GONNA SELL IN MY GARAGE SALE OR SOMETHING. I DON'T NEED IT VERY MUCH. AND SO TO GET MY YARD MOWED FOR TWO MONTHS, THAT'S A WONDERFUL THING. I'M HAPPY. I'M BETTER OFF THAN I STARTED." ON YOUR SIDE OF THE TRANSACTION, WHAT YOU'RE THINKING IS, "WELL, YOU KNOW, I MOW YARDS ALL DAY LONG. IT'S NO BIG DEAL. I COME OVER AND MOW THIS GUY'S YARD, IT TAKES ME A HALF HOUR, I DO IT FOR A

6 ECO LECTURE SEVEN 6 COUPLE OF MONTHS, HE GIVES ME A TV SET. IT'S A GOOD TV SET, IT'S A COLOR TV, IT'S GOT A GOOD PICTURE AND SO FORTH. THIS IS A GOOD THING. I CAME OUT AHEAD ON THIS DEAL." IN A VOLUNTARY TRADE, YOU CAN ALWAYS BACK OUT IF YOU THINK IT'S NOT GONNA HELP YOU. YOU WOULDN'T SAY, "AHHH, I DON'T WANT THAT TV SET BUT I'LL DO IT." IF YOU DON'T WANT THE TV SET WHAT YOU SAY IS, "I WON'T DO IT." SO IN THIS KIND OF A DEAL WHERE I BENEFIT, YOU BENEFIT, IT'S A POSITIVE SUM GAME. WE BOTH -- AS A RESULT OF THIS TRANSACTION BETWEEN US, WE BOTH COME OUT AHEAD AND SOCIETY IS BETTER OFF FOR IT. NOW, I'M TELLING YOU THAT THAT'S WHAT HAPPENS IN EVERY MARKET TRANSACTION, IS PEOPLE -- WE'LL NEED TO BE CAREFUL HERE. THE WORD "EXPECT" IS THERE. PEOPLE EXPECT TO BENEFIT FROM EVERY MARKET TRANSACTION THEY'RE INVOLVED IN. NOW, SOMETIMES WE GET SOMETHING WE DON'T EXPECT. MAYBE YOU GET THIS TV SET FROM ME, AND YOU GET HOME AND YOU PLUG IT IN AND IT DOESN'T WORK. OKAY. COURSE YOU OUGHT TO FIND OUT ABOUT THAT PRETTY EARLY ON AND STOP MOWING MY YARD. BUT THE POINT IS, THAT COULD HAPPEN AND I MIGHT BE A BAD GUY AND JUST SAY, "WELL, THAT'S TOO BAD FOR YOU. YOU STILL OWE ME TWO MONTHS OF MOWING MY LAWN." NOW, YOU MAY NOT DO IT. I DON'T KNOW WHETHER YOU WILL OR NOT. BUT THE POINT IS, THAT CAN HAPPEN. OR I COULD BE A FRAUD. I COULD JUST GIVE YOU THIS BOX THAT LOOKS LIKE A

7 ECO LECTURE SEVEN 7 TV SET AND IT COULD BE EMPTY INSIDE. OR YOU COULD BE KIND OF BAD ON YOUR END OF THE DEAL, TOO. YOU COULD COME OVER AND ACT LIKE YOU'RE MOWING THE YARD, BUT JUST SORT OF DO IT IN A HAPHAZARD WAY AND JUST BE GONE IN A FEW MINUTES AND I'M NOT SATISFIED. THAT CAN HAPPEN. BUT THE POINT IS THAT GOING INTO EVERY SINGLE TRANSACTION, EVERYONE, BOTH PARTIES EXPECT TO COME OUT AHEAD. AND USUALLY THEY DO. THINK ABOUT THIS. IT IS POSSIBLE TO HAVE SOME FRAUD OR DECEPTION, OR WHATEVER, CREEP INTO THE TRANSACTION. BUT MOST TRANSACTIONS THAT WE SEE -- OR I SHOULDN'T SAY MOST. A LOT OF TRANSACTIONS ARE REPEAT PURCHASES. FOR EXAMPLE, I BUY A PEPSI TODAY, I BUY A PEPSI TOMORROW, I BUY A PEPSI THE NEXT DAY AND THE NEXT DAY AND THE NEXT DAY. THESE ARE REPEAT PURCHASES. IF THERE WAS SOMETHING ABOUT PEPSI WHERE THEY TRICKED ME, I THOUGHT THIS WAS GONNA BE SOME MAGICAL ELIXIR THAT WAS GONNA PROLONG MY LIFE AND MAKE ME GOOD-LOOKING AND SO FORTH, BUT IT DIDN'T DO THAT, THEN I WOULDN'T BUY IT THE NEXT DAY. YOU'RE THINKING I NEED SOME OF THAT PEPSI, AREN'T YOU? I WAS THINKING I NEEDED SOME, TOO. ANYWAY, WE WOULDN'T GO BACK THE NEXT DAY. IF YOU GO TO FAMOUS-BARR AND YOU BUY SOME CLOTHES FROM THEM, AND THEN YOU GET HOME AND JUST -- YOU KNOW, THE FIRST TIME YOU PUT 'EM IN THE WASHING MACHINE THEY JUST FALL INTO THREADS ON

8 ECO LECTURE SEVEN 8 THE FLOOR AND THEY'RE NOT DURABLE, THEN YOU DON'T GO BACK TO FAMOUS-BARR. AND SO THE POINT IS IS THAT WE CAN BE TRICKED. BUT WHAT HAPPENS IS WE DO A LOT OF OUR BUSINESS WITH THE SAME PEOPLE WE DID BUSINESS WITH YESTERDAY AND THE DAY BEFORE THAT AND THE DAY BEFORE THAT. AND SO USUALLY WHAT HAPPENS IS WE'RE NOT TRICKED. WE'RE PRETTY FAMILIAR WITH WHAT WE'RE GETTING AND WE'RE HAPPY WITH IT. NOW, THE REASON I MAKE A BIG DEAL ABOUT THIS, THE VOLUNTARY NATURE OF THE TRANSACTIONS MEANS THAT WE'RE INVOLVED IN A POSITIVE SUM EXPERIENCE OR A POSITIVE SUM TRANSACTION WHERE BOTH PARTIES' BENEFIT. THINK FOR JUST ONE MOMENT HOW MANY TRANSACTIONS THERE ARE IN THE UNITED STATES, RIGHT? BECAUSE, I MEAN, IN ONE DAY YOU MIGHT DO SOMETHING LIKE BUY SOME CLOTHES, BUY SOME SUPPLIES FOR SCHOOL, BUY A LITTLE BIT OF GASOLINE FOR YOUR CAR -- AH, I'VE GOT SOMETHING IN MY EYE. RENT A MOVIE FROM BLOCKBUSTER, GO TO THE STORE AND DO A LITTLE BIT OF SHOPPING FOR GROCERIES. I MEAN, IN ONE DAY YOU MAY EASILY DO TEN OR TWENTY TRANSACTIONS. MULTIPLY THAT BY THE NUMBER OF PEOPLE IN THE UNITED STATES. HUNDREDS OF MILLIONS. WHAT, TWO HUNDRED AND SEVENTY MILLION PEOPLE? SO ALL THESE TRANSACTIONS BY ALL THOSE PEOPLE, AND WE'RE THINKING THAT MOST ALL OF 'EM CREATE VALUE, EACH ONE OF THESE TRANSACTIONS. WE START OFF WITH A TV SET BEING HELD BY SOMEBODY THAT DOESN'T EVEN APPRECIATE IT AND AT THE END OF THE TRANSACTION

9 ECO LECTURE SEVEN 9 WE'VE GOT A TV SET BY SOMEBODY THAT APPRECIATES IT A LOT MORE. THAT'S A BENEFIT. SOCIETY BECAME WEALTHIER, AND I'M SAYING THAT HAPPENS HUNDREDS OF MILLIONS OF TIMES A DAY. THAT'S A WONDERFUL THING. WE'VE GOT AN ECONOMY THAT CAN PRODUCE VALUE JUST SEEMINGLY FROM NOWHERE. WHEN WE'RE TALKING ABOUT MARKETS, WE PUT EVERYBODY INTO THREE CATEGORIES: THEY'RE EITHER BUYERS, THEY'RE SELLERS, OR THEY'RE NEITHER. AND IF THEY'RE NEITHER, WE IGNORE 'EM. EVERYBODY IN A MARKET IS EITHER A BUYER OR A SELLER OR NEITHER ONE, WHICH REALLY MEANS THEY'RE NOT IN THE MARKET. THEY'RE JUST INCIDENTAL. WHO CARES? OKAY. SO THE MARKET IS MADE UP OF THOSE TWO SIDES TO THE MARKETPLACE. THE BEHAVIOR OF BUYERS WE'LL TALK ABOUT FIRST. THEIR BEHAVIOR IS DESCRIBED BY SOMETHING CALLED THE LAW OF DEMAND. THE BEHAVIOR OF BUYERS IS DESCRIBED BY THE LAW OF DEMAND. I THINK I'VE ALREADY TALKED ABOUT THIS BEFORE, TOO. LAW OF DEMAND. THE LAW OF DEMAND SAYS THIS: AS THE PRICE OF A GOOD GOES UP -- LET'S SAY RISES, THE QUANTITY OF THAT GOOD DEMANDED BY -- LET ME SAY THIS SLIGHTLY DIFFERENT -- THE QUANTITY DEMANDED OF THAT GOOD DECLINES. AND VICE VERSA. WHAT WE'RE DEALING WITH HERE IS REALLY SORT OF A CAUSE AND EFFECT. IF THE PRICE CHANGES, THAT'S OUR CAUSE -- IF THE PRICE OF THE GOOD CHANGES, THEN THE EFFECT OF THAT WILL BE ON QUANTITY

10 ECO LECTURE SEVEN 10 DEMANDED. A HIGHER PRICE, A LOWER QUANTITY DEMANDED. AND IT SAYS HERE VICE VERSA. BY VICE VERSA, IF THE PRICE OF THE GOOD WENT DOWN, PEOPLE WOULD BUY MORE OF IT. QUANTITY DEMANDED WOULD INCREASE, OKAY? SO THERE IS A LAW OF DEMAND. THIS IS REALLY -- IT'S NOT A UNIVERSAL TRUTH. WHAT THIS IS, THIS IS A THEORY THAT -- ECONOMISTS DEVELOPED THIS THEORY AND THEN WENT OUT AND STARTED LOOKING FOR EVIDENCE. AND THE EVIDENCE THEY FOUND TIME AFTER TIME AFTER TIME, DIFFERENT COUNTRIES, DIFFERENT PEOPLE, DIFFERENT GOODS. WHAT THEY FOUND OUT OVER AND OVER WAS THAT THIS THEORY GETS THE SUPPORT OF ACTUAL EXPERIENCE. PEOPLE DO BEHAVE THIS WAY TIME AFTER TIME. AND AFTER PEOPLE BEHAVE THAT WAY ENOUGH AND WE GOT ENOUGH EVIDENCE OF IT, THEN ALL OF A SUDDEN THIS THEORY JUST GOT CALLED A LAW. LIKE IT'S GOTTA BE THIS WAY. IT DOESN'T REALLY HAVE TO BE THAT WAY, BUT IT ALMOST ALWAYS IS. AND IT'S SORT OF LIKE GRAVITY, YOU KNOW. IF YOU GET INTO OUTER SPACE AND YOU DROP SOMETHING, IT WON'T NECESSARILY GO DOWN. IT MAY GO UP OR TO THE SIDE. AND SO GRAVITY ISN'T A UNIVERSAL TRUTH; IT'S JUST NORMALLY THAT'S THE WAY THE WORLD WORKS. WELL, NORMALLY THE WORLD WORKS THIS WAY AS THE LAW OF DEMAND SAYS. THIS THEORY OF DEMAND IS GENERALLY GONNA BE ACCURATE. OKAY. HIGHER PRICE, SMALLER QUANTITY DEMANDED. IF TUITION AT SMS WERE DOUBLED, THERE WOULD BE FEWER PEOPLE IN THIS ROOM. THE LAW

11 ECO LECTURE SEVEN 11 OF DEMAND TELLS ME SO. I DON'T HAVE TO GO AROUND AND DO A SURVEY. THE LAW OF DEMAND WORKS IN TIME AFTER TIME AFTER TIME. THAT BEING THE CASE, I PREDICT IT'S GONNA WORK WITH THIS CLASS. IF WE WOULD DOUBLE THE PRICE OF TAKING THIS CLASS, THERE'D BE FEWER PEOPLE IN THIS ROOM. MAYBE NOBODY IN THE ROOM. BUT THE POINT IS, THERE'D BE FEWER. IF THE PRICE OF ICE CREAM WENT UP FROM A DOLLAR A SCOOP TO TWO DOLLARS A SCOOP, PEOPLE WOULD BUY LESS ICE CREAM. AND SO ON ALL THE WAY DOWN THE LIST. AND VICE VERSA. LET'S DRAW A DIAGRAM OR A GRAPH TO SHOW THIS RELATIONSHIP. WE'LL TALK ABOUT SOME MYTHICAL GOOD, GOOD X, AND WE'LL PUT THE PRICE OF GOOD X ON THE VERTICAL AXIS OF MY DIAGRAM AND WE'LL PUT THE QUANTITY OF GOOD X ON THE HORIZONTAL AXIS. AND THIS DOWNWARD SLOPING LINE THAT I'VE JUST DRAWN, WE'LL CALL THAT A DEMAND CURVE. NOW, SO FOR A DEMAND CURVE WE'LL HAVE SOMETHING LIKE THIS. LET'S SAY THE PRICE OF A GOOD STARTS OFF AT ONE DOLLAR PER UNIT. WE'LL START AT THAT ONE DOLLAR, WE'LL COME OVER TO THE CURVE AND DOWN, AND SAY, "OH, LOOK. PEOPLE WILL BUY FIFTY UNITS." WHATEVER THESE UNITS ARE OF GOOD X. LET'S SAY THAT WE START OFF AT THAT POINT -- I'LL CALL IT POINT A JUST FOR CONVENIENCE. I'M SAYING WITH THE LAW OF DEMAND -- IF THE PRICE OF THIS GOOD GOES UP TO A DOLLAR FIFTY, THE LAW OF DEMAND SAYS PEOPLE WILL BUY LESS. AND THERE'S A POINT B ON THE DEMAND CURVE WHERE WE SHOW THAT. IN THIS PARTICULAR CASE, IF THE PRICE GOES UP FROM A DOLLAR TO A DOLLAR FIFTY, THE QUANTITY

12 ECO LECTURE SEVEN 12 DEMANDED OF X GOES DOWN FROM FIFTY TO TWENTY. SO QUANTITY DEMANDED DECLINES FROM PRICE INCREASES, AND VICE VERSA. IT WOULD GO THE OTHER DIRECTION, TOO. IF WE STARTED OFF WITH A DOLLAR AND HALF PRICE AND PEOPLE WERE BUYING TWENTY, THE PRICE GOES DOWN, PEOPLE WILL BUY MORE UNITS. QUESTIONS ABOUT THIS? IT'S PRETTY STRAIGHTFORWARD. I THINK IT DESCRIBES SOMETHING YOU'VE ALL EXPERIENCED. I MEAN, I KNOW WHEN I'M AT THE STORE OR SOMETHING LIKE THAT I SAY, "HOW MUCH?" AND IF THEY SAY A NUMBER THAT IS A LITTLE BIT DISTASTEFUL TO ME, THEN I SAY, "AH, I'LL JUST KIND OF PASS ON THAT." AND IF WE'VE ALL EXPERIENCED THAT, AND I THINK WE HAVE, THEN WE'VE ALL EXPERIENCED THIS LAW OF DEMAND. MAYBE WEREN'T THINKING ABOUT PUTTING A NAME ON IT, BUT THAT'S THE BEHAVIOR THAT PEOPLE DO. NOW, WHY WOULD PEOPLE BEHAVE THIS WAY? AND THE ANSWER IS, SELF-INTEREST. JUST SELF-INTEREST, THAT'S ALL. IF -- LET'S SAY THAT THE PRICE OF SOMETHING STARTS OFF -- LET ME USE A DIFFERENT EXAMPLE, NOT JUST THIS GOOD X. BUT LET'S SAY THAT YOU'RE LOOKING AT A CAR TO BUY AND THAT CAR COSTS TWENTY THOUSAND DOLLARS. AND YOU MIGHT SAY, "OH, MAN. TWENTY THOUSAND DOLLARS. I DON'T KNOW. I'M JUST AT THE POINT WHERE I'M WILLING TO BUY, BUT THAT'S A LITTLE BIT MORE THAN I WANT TO SPEND. I DON'T KNOW. I JUST CAN'T DECIDE." LET'S SAY YOU START OFF THAT WAY. AND THEN THEY COME ALONG AND THEY SAY, "OKAY. I'LL SELL YOU

13 ECO LECTURE SEVEN 13 THIS CAR FOR EIGHTEEN THOUSAND DOLLARS." NOW, HERE'S WHAT YOU'RE THINKING: "HUH. A MOMENT AGO IT WAS GONNA COST ME TWENTY THOUSAND DOLLARS, AND NOT JUST THE MONEY BUT IT'S THE THINGS I COULD'VE BOUGHT WITH THAT MONEY." THAT'S ITS OPPORTUNITY COST. "BUT I WAS THINKING ABOUT HANDING OVER TWENTY THOUSAND DOLLARS TO GET THIS CAR AND I JUST COULDN'T DECIDE. BUT NOW, FOR THAT SAME TWENTY THOUSAND DOLLARS, I CAN GET THE CAR PLUS TWO THOUSAND DOLLARS WORTH OF OTHER STUFF." CAUSE THEY'RE GONNA BASICALLY NOT CHARGE YOU TWENTY THOUSAND. NOW THEY'RE ONLY GONNA CHARGE EIGHTEEN THOUSAND. YOU'VE GOT TWO THOUSAND DOLLARS LEFT OVER TO GET SOMETHING ELSE. AND SO THE POINT IS, IS THAT WHEN THE PRICE WENT DOWN, YOU FIND OUT THAT YOU CAN BUY MORE STUFF NOW. YOUR PURCHASING POWER IS GREATER. AND SO YOU'VE GOT AN INCENTIVE TO GO AHEAD AND BUY MORE THE LOWER THAT PRICE IS BECAUSE YOU GET MORE FOR YOUR MONEY. THE VALUE THAT YOU'RE GETTING FOR YOUR DOLLAR IS GOING UP SO WE BUY MORE IF THE PRICE GOES DOWN. IF THE PRICE GOES UP, THE SACRIFICE YOU'D HAVE TO MAKE, THE MORE THE OTHER GOODS AND SERVICES YOU HAVE TO DO WITHOUT -- THAT'S GOING UP IF THE PRICE RISES. AND SO YOU HAVE AN INCENTIVE, "AH, I DON'T THINK THAT THAT NEW CAR IS WORTH THAT TO ME. I HAVE TO GIVE UP TOO MANY THINGS FOR IT." THERE'S SOMETHING CALLED THE SUBSTITUTION EFFECT. THE SUBSTITUTION EFFECT OF A PRICE INCREASE. HERE'S WHAT THE

14 ECO LECTURE SEVEN 14 SUBSTITUTION EFFECT SAYS: IT SAYS IF THE PRICE OF A GOOD GOES UP, CONSUMERS TEND TO BUY LESS OF THAT GOOD AND SUBSTITUTE IN ITS PLACE OTHER GOODS. IF THE PRICE OF A GOOD GOES UP, PEOPLE TEND TO BUY LESS OF THAT GOOD AND SUBSTITUTE OTHER GOODS IN ITS PLACE. SO, FOR EXAMPLE, LET'S SAY THAT A HAMBURGER COSTS A DOLLAR AND YOU'RE BUYING, I DON'T KNOW, THREE HAMBURGERS A WEEK. AND ALL OF A SUDDEN THE PRICE OF A HAMBURGER GOES UP TO A DOLLAR AND A HALF. YOU MIGHT SAY, "NO MORE HAMBURGERS FOR ME. NOW I'M GONNA EAT CASHEW CHICKEN." IF THE PRICE OF A GOOD GOES UP, YOU BUY LESS OF THAT GOOD. YOU SUBSTITUTE OTHER GOODS IN ITS PLACE. NOW, ARE THERE GOODS THAT DON'T HAVE SUBSTITUTES? NOT VERY MANY. I MEAN, IT'S HARD TO COME UP WITH A GOOD THAT DOESN'T HAVE A SUBSTITUTE. CERTAINLY, YOU KNOW, HAMBURGERS. YOU CAN SUBSTITUTE FOR THOSE. CARS YOU CAN SUBSTITUTE. YOU KNOW, A MOTORCYCLE WILL SUBSTITUTE FOR A CAR OR A, WHAT, RAPID TRANSIT, A BUS OR A SUBWAY OR AN AIRPLANE. THERE'S SUBSTITUTES FOR JUST ABOUT EVERYTHING. AND SO THE SUBSTITUTION EFFECT IS TELLING US, "MAN, IF THE PRICE GOES UP I'LL DO WITHOUT IT. I'LL TAKE SOMETHING ELSE IN ITS PLACE." OKAY. SO ANYWAY, HERE'S OUR LAW OF DEMAND. LET'S TALK ABOUT THE LAW OF SUPPLY. THIS IS OUR DESCRIPTION OF HOW SELLERS BEHAVE. AS THE PRICE OF A GOOD RISES, THE QUANTITY SUPPLIED OF THAT GOOD INCREASES. AND VICE VERSA. AND AGAIN, WE'RE DEALING WITH A CAUSE AND EFFECT RELATIONSHIP HERE. PRICE CHANGES,

15 ECO LECTURE SEVEN 15 THAT'S THE CAUSE. AND THEN THE EFFECT IS PEOPLE REACT TO THAT, SUPPLIERS REACT TO THAT. IF THE PRICE CHANGES, IT CAUSES SUPPLIERS TO REACT. AND WE'VE GOT, WHAT, A HIGHER PRICE? AN INCREASE IN QUANTITY SUPPLIED. AND, BY THE WAY, I DIDN'T USE THE TERM BEFORE. LET ME JUST KIND OF ADD THAT TO THE DISCUSSION. HERE WHAT WE HAVE IS A POSITIVE OR DIRECT RELATIONSHIP BETWEEN PRICE AND QUANTITY. THAT IS TO SAY, A HIGHER PRICE CAUSES QUANTITY SUPPLIED TO GO UP. IN OUR PREVIOUS CASE, WHAT WE HAD IS A NEGATIVE -- I SAY "OUR PREVIOUS CASE," THE LAW OF DEMAND -- OR INVERSE RELATIONSHIP. AND I'M ONLY TELLING YOU THAT TO GET THE TERMINOLOGY STRAIGHT. AND WHAT WE SAID THERE IS IF PRICE GOES UP, QUANTITY DEMANDED WENT DOWN. SO THOSE TWO VARIABLES MOVE IN OPPOSITE DIRECTIONS. OKAY. ARE YOU COMFORTABLE WITH THAT TERMINOLOGY? CAUSE AND EFFECT. PRICE CHANGES. SUPPLIERS REACT. YOU MAY NOT THINK OF THINGS TOO MUCH THIS WAY. MOSTLY, MOST OF US ARE BUYERS, YOU KNOW. MOST OF US, MOST OF THE TIME, BUY RATHER THAN SELL THINGS. AND THAT BEING THE CASE, AND IT'S KIND OF EASY TO IDENTIFY WITH THIS, I THINK THAT A LOT OF PEOPLE HAVE A DIFFERENT OPINION, THOUGH, ABOUT SUPPLIERS. THEY'RE THINKING ABOUT -- LET'S THINK ABOUT A GROCERY STORE AS A SUPPLIER. I THINK MOST PEOPLE ARE THINKING, "THAT GROCERY STORE, THEY JUST SET THE PRICE, WHATEVER PRICE THEY WANT." AND SO OUR VIEW OF SUPPLIERS MAY BE

16 ECO LECTURE SEVEN 16 MORE IN TERMS OF "THEY FIX PRICES" RATHER THAN "WELL, THEY ARE JUST AT THE MERCY OF PRICES. PRICES GO UP AND DOWN AND THEY HAVE TO JUST REACT TO THAT." MAYBE WE DON'T SEE THAT SO MUCH. THEY SEE IT THAT WAY, THE SUPPLIERS OF THINGS. THEY'RE ALWAYS THINKING ABOUT, "OH, MAN. THE MARKET'S GOING AGAINST ME HERE AND THE PRICE IS GOING DOWN, SO WHAT AM I GONNA DO?" THEY SEE THEIR OWN LIFE IN THOSE TERMS BUT MAYBE WE DON'T. ANYWAY, AGAIN WE'RE ASSUMING THAT PEOPLE ARE SELF- INTERESTED. THAT'S WHAT I SAID BEFORE. WHY DO PEOPLE BEHAVE THE WAY THE LAW OF DEMAND SAYS? SELF-INTEREST. WELL, WHY DO PEOPLE BEHAVE THE WAY THE LAW OF SUPPLY SAYS? AND THE ANSWER AGAIN IS SELF-INTEREST. IF YOU CAN MAKE A DOLLAR PROFIT FROM DOING SOMETHING, MAYBE YOU'LL DO THAT. BUT WHAT IF YOU CAN MAKE TWO DOLLARS PROFIT FROM DOING THE SAME THING? WELL, YOU'LL FOR SURE DO IT NOW. AND MAYBE EVEN MORE. AND WHAT IF YOU'RE GONNA MAKE THREE DOLLARS PROFIT FROM THAT SAME ACTIVITY? WELL, MAYBE YOU'D DO EVEN MORE OF IT. LET'S DRAW A DIAGRAM. AH, I'VE GOT A LITTLE ROOM HERE. QUANTITY OF X, PRICE OF X. HERE'S OUR SUPPLY CURVE AS A POSITIVELY SLOPED CURVE. IT'S GOING UP TO THE RIGHT. NOW, WHAT THIS IS TELLING US IS, IF THE PRICE RISES -- LET'S START OFF WITH A PRICE OF, I DON'T KNOW, WELL, ONE DOLLAR IS GOOD ENOUGH. AND MAYBE THIS SUPPLIER PRODUCES THIRTY UNITS OF THE GOOD AT ONE DOLLAR. IF THE PRICE GOES UP, LET'S

17 ECO LECTURE SEVEN 17 SAY, TO TWO DOLLARS, MAYBE THE SUPPLIER SELLS OR OFFERS FOR SALE SEVENTY UNITS OF THE GOOD. WE'VE GOT THIS LIKE AS BEFORE, POINT A AND B. THERE'S A POSITIVE RELATIONSHIP BETWEEN THESE VARIABLES. HIGHER PRICES ASSOCIATED WITH THE GREATER QUANTITY SUPPLIED. AGAIN, IT'S SELF-INTEREST. THE SUPPLIER IS THINKING, "HUH. THIS IS IN MY INTEREST. NOW THAT THE PRICE HAS GONE UP, IT'S IN MY INTEREST TO PRODUCE MORE OF THIS." MAYBE YOU'VE GOT A -- MAYBE YOU OWN A FARM AND YOU'VE GOT A WHEAT FIELD OUT HERE AND YOU'RE GROWING A CERTAIN AMOUNT OF WHEAT. BUT THE PRICE IS NOT GREAT; IT'S JUST OKAY. SO YOU GO OUT THERE AND GROW THE WHEAT. BUT MAYBE THE PRICE OF WHEAT DOUBLES. THEN YOU START THINKING ABOUT, "WOW, I COULD GET IN AN EARLY CROP OF WHEAT -- YOU KNOW, SOME WINTER WHEAT. AND THEN IF I WORK PRETTY GOOD DURING THE MIDDLE OF THE SUMMER, I CAN HARVEST THAT" -- NOT SUMMER SO MUCH AS SPRING, LATE SPRING -- "I CAN HARVEST THAT AND I CAN GET SOME MORE SEED IN THE GROUND AND I CAN HAVE A SECOND CROP." OR "I CAN PUT A LITTLE FERTILIZER OUT ON THIS AND GET ME A LITTLE BIT BETTER CROP," OR "I CAN DO WHATEVER." AS SOON AS THE PRICE STARTS GOING UP, WE'VE STARTED THINKING ABOUT, "HOW CAN I CASH IN ON THIS SITUATION? THE PRICE IS GOING UP. I DON'T WANT TO JUST KEEP ON ACTING THE SAME WAY. NOW I WANT TO WORK EVEN HARDER, NOW THAT I'M MAKING A BIGGER PROFIT ON EACH UNIT." SO THERE'S AN INCENTIVE THERE -- AND I DON'T THINK I'VE USED THAT TERM BEFORE. BUT PRICE IS AN INCENTIVE OR A REWARD FOR BEHAVING IN

18 ECO LECTURE SEVEN 18 CERTAIN WAYS. AND HERE FOR THIS SUPPLIER, PRICE IS A POSITIVE INCENTIVE. IT SAYS DO MORE; DO MORE OF THIS. IT'S MORE REWARDING NOW. AND SO PEOPLE DO MORE. IN THE CASE BEFORE, PRICE WAS AN INCENTIVE TO DO LESS AND PRICE WAS THE COST OF CONSUMING A GOOD, AND THE INCENTIVE WAS, "MAN, DON'T BUY AS MUCH OF THAT STUFF WHEN THE PRICE GOES UP." YOU HAVE TO SACRIFICE MORE IN ORDER TO GET THE GOOD. GEE, I WONDER WHAT YOU WOULD GET IF YOU BROUGHT THIS DEMAND CURVE TOGETHER WITH THE SUPPLY CURVE? I KNOW WHAT YOU'D GET. YOU'D GET SUPPLY AND DEMAND. AND, BY THE WAY, THIS IS THE TOTAL MARKET SUPPLY WHICH IS EQUAL TO THE SUPPLY OF ALL SELLERS. THIS IS NOT JUST THE SUPPLY BY ONE PERSON BUT THE SUPPLY BY EVERYBODY. AND THE DEMAND, THIS IS THE TOTAL MARKET DEMAND, EQUALS THE DEMAND OF ALL BUYERS. WE ADD THOSE TOGETHER. NOW WE'VE GOT THESE TWO CURVES DRAWN. WHAT WE WANT TO DO IS JUST PICK A PRICE AND WHY DON'T YOU PICK ONE LIKE I AM HERE. PICK A PRICE THAT'S KIND OF HIGH, KIND OF HIGH UP IN YOUR DIAGRAM. SAY THE PRICE OF THE GOOD IS, I DON'T KNOW, TWO DOLLARS. WHAT WE'LL DO IS WE'LL COME ACROSS HERE FROM THIS TWO DOLLARS AND WE'LL ASK ABOUT THE BEHAVIOR OF THESE TWO GROUPS OF PEOPLE. IF THE PRICE IS TWO DOLLARS, THE DEMAND CURVE TELLS US HOW MUCH BUYERS WANT TO BUY. THE DEMAND CURVE SAYS, "GOSH, I'D LIKE TO BUY, I DON'T KNOW, TEN UNITS." AND THESE QUANTITIES ARE JUST HYPOTHETICAL AND THE PRICES

19 ECO LECTURE SEVEN 19 ARE, TOO, SO DON'T WORRY ABOUT THE NUMBER OF UNITS. BUT THE BUYER SAYS, "I WANT TO BUY A CERTAIN NUMBER OF UNITS AT A PRICE OF TWO DOLLARS." WE STARTED OFF WITH THE TWO DOLLAR PRICE THEN WENT ACROSS TO THE DEMAND CURVE AND DOWN, DOWN TO HERE. BUT AT A PRICE OF TWO DOLLARS, THE SUPPLIER SAYS, "I'D LIKE TO SELL, I DON'T KNOW, SEVENTY UNITS." SO AT THIS PRICE OF TWO DOLLARS, WE HAVE A SURPLUS. THE SURPLUS IS SIXTY UNITS, ISN'T IT? SEVENTY UNITS BEING OFFERED FOR SALE, TEN UNITS BEING PURCHASED AND CONSUMED, WE HAVE A SURPLUS OF THIS GOOD. WHAT HAPPENS WHEN STORES HAVE A SURPLUS? ABOUT ANYTHING. THEY HAVE A SALE, RIGHT? I ALWAYS LIKE TO BUY THINGS ON SALE. I DON'T ALWAYS, BUT I TRY TO. SO I TRY TO BUY THINGS THAT ARE OUT OF FAVOR, THAT NOBODY WANTS. IT'S HOW I GOT THESE CLOTHES. SURPLUS. YOU KNOW, IF OUT AT THE FAMOUS-BARR THEY'VE GOT MORE SHOES ON SALE THAN PEOPLE WANT TO BUY, THEY JUST SAY, "MAN, WE'VE HAD THESE SHOES HERE FOR MONTHS. THERE'S NOBODY BUYING 'EM." THEY SAY, "LET'S PUT UP A SIGN THAT SAYS TWENTY-FIVE PERCENT OFF." AND THAT TWENTY-FIVE PERCENT OFF, THEY LOWER THE PRICE. SO IF WE START OFF AT A PRICE IN THIS EXAMPLE OF TWO DOLLARS AND WE END UP OBSERVING A SURPLUS, WE DON'T KNOW IF WE'RE GONNA GET A SURPLUS GOING INTO THIS. HERE'S THE THING IS, WE IN THIS CLASS, WE ECONOMISTS, WE KNOW ABOUT SUPPLY AND DEMAND. BUT OUT IN THE REAL WORLD, ALL YOU'VE GOT IS LIKE SHOES. AND YOU'RE TRYING TO SELL

20 ECO LECTURE SEVEN 20 SHOES AND YOU DON'T KNOW WHERE THESE SUPPLY AND DEMAND CURVES ARE. MAYBE YOU KNOW THAT THEY ARE OUT THERE SOMEWHERE BUT YOU DON'T KNOW WHERE THEY TOUCH EACH OTHER, INTERSECT. YOU DON'T KNOW WHAT THEIR SHAPE IS. ALL YOU KNOW IS, "HEY, I'VE BEEN TRYING TO SELL SOMETHING FOR A CERTAIN PRICE AND I CAN'T SELL IT. I GOT A SURPLUS." SO YOU PUT IT ON SALE. AND THE PRICE STARTS GOING DOWN. AND IF THE PRICE GOES DOWN TO, LET'S SAY, RIGHT HERE, JUST A LITTLE BIT, WHAT WE OBSERVE IS, "WELL, YOU KNOW, THERE'S A SMALLER SURPLUS BUT THERE'S STILL A SURPLUS. QUANTITY SUPPLIED IS STILL GREATER THAN QUANTITY DEMANDED." AND SO TIME TO HAVE ANOTHER SALE. TWENTY-FIVE PERCENT OFF WASN'T ENOUGH. AND WE LOWER THE PRICE AGAIN AND AGAIN AND AGAIN. WHAT WE'RE TRYING TO DO -- WE DON'T KNOW ABOUT THESE CURVES. WE DON'T KNOW WHERE THEY ARE. WE DON'T KNOW IF THEY EXIST. BUT HERE'S WHAT WE KNOW IS THAT AS LONG AS WE'VE GOT A SURPLUS, THE PRICE IS TOO HIGH. THAT'S WHAT THE SELLER KNOWS. IF THE PRICE IS TOO HIGH, I'LL LOWER THE PRICE. AND FINALLY THAT SELLER LOWERS THE PRICE DOWN TO RIGHT HERE, LET'S SAY A DOLLAR AND TWENTY-SEVEN CENTS. AND AT A DOLLAR TWENTY-SEVEN, BUYERS WOULD LIKE TO BUY -- I'LL JUST PICK OUT A NUMBER OF UNITS HERE -- FIFTY-FOUR UNITS. THE DEMAND CURVE TELLS US THAT AT A PRICE OF A DOLLAR TWENTY-SEVEN, BUYERS WOULD LIKE TO BUY FIFTY-FOUR UNITS. THE SUPPLY CURVE TELLS US THAT AT THAT PRICE OF A DOLLAR

21 ECO LECTURE SEVEN 21 TWENTY-SEVEN, SELLERS WOULD LIKE TO SELL FIFTY-FOUR UNITS. SO WHAT WE HAVE AT THIS SITUATION IS, QUANTITY DEMANDED EQUALS QUANTITY SUPPLIED. WE'LL COME BACK AND TALK ABOUT IT MORE, BUT I WANT TO MAKE IT REAL CLEAR TO YOU WHAT I DID NOT SAY HERE. I DID NOT SAY DEMAND EQUALS SUPPLY. THE WAY I'M USING THIS SPECIFIC TERM HERE, QUANTITY DEMANDED AND QUANTITY SUPPLIED. AND I'LL COME BACK AND WE'LL TALK ABOUT WHY THAT IS LATER ON, BUT THAT'S THE TERMINOLOGY WE'RE USING. QUANTITY DEMANDED EQUALS QUANTITY SUPPLIED. AND WHAT WE SAY IS, THE MARKET -- WELL, LET ME NOT PUT IT THAT WAY. LET ME SAY THIS: THIS IS THE EQUILIBRIUM PRICE. THE EQUILIBRIUM PRICE IS THE PRICE WHERE QUANTITY SUPPLIED EQUALS QUANTITY DEMANDED. THIS PRICE OF TWO DOLLARS, THESE PRICES ABOVE A DOLLAR TWENTY-SEVEN, ANY OF 'EM, THOSE WERE NOT AT EQUILIBRIUM PRICE. HERE'S WHAT I MEAN BY AN EQUILIBRIUM. ONCE YOU GET TO THAT PRICE, THE PRICE DOESN'T HAVE ANY TENDENCY TO CHANGE AWAY FROM THERE. BUT WHEN WE GET TO A PRICE OF TWO DOLLARS TO BEGIN WITH, THAT WAS NOT AN EQUILIBRIUM. THERE WAS A TENDENCY FOR PRICE TO CHANGE. WHEN WE GOT A PRICE UP TWO DOLLARS, THERE WAS A SURPLUS AND THE TENDENCY WAS FOR THE SELLERS TO LOWER THE PRICE. AND SO THIS CAN'T BE AN EQUILIBRIUM. AND NO PRICE CAN BE AN EQUILIBRIUM IF QUANTITY SUPPLIED AND QUANTITY DEMANDED AREN'T EQUAL. SO IT'S WHEN THESE TWO THINGS ARE BROUGHT INTO EQUALITY THAT

22 ECO LECTURE SEVEN 22 WE SAY THERE'S AN EQUILIBRIUM. THIS PRICE COULD LAST. IF IT'S A DOLLAR TWENTY-SEVEN, IS THERE A REASON FOR THE PRICE TO GO UP? I DON'T THINK SO. WHAT WOULD IT BE? BUYERS WANT TO BUY FIFTY-FOUR UNITS; SELLERS WANT TO SELL FIFTY-FOUR UNITS. THE BEHAVIOR OF ONE GROUP IS CONSISTENT WITH THE BEHAVIOR OF THE OTHER GROUP. THIS IS AN EQUILIBRIUM FOR THE MARKET. WE COULD'VE DONE EXACTLY THE SAME THING -- LET ME ERASE A FEW OF THESE LINES OUT OF HERE. WE COULD'VE DONE THE SAME THING IF WE STARTED OFF AT A LOWER PRICE. LET'S START OUR EXAMPLE OFF AT SOME PRICE OF ONE DOLLAR. AND I'LL LEAVE A DOLLAR TWENTY-SEVEN THERE. WE'LL BE BACK. ONE DOLLAR PRICE. WHAT WE OBSERVE NOW IS QUANTITY DEMANDED IS LARGE, EIGHTY-ONE UNITS. QUANTITY SUPPLIED IS SMALL, NINETEEN UNITS. WHAT DO WE HAVE NOW? QUANTITY DEMANDED IS GREATER THAN QUANTITY SUPPLIED. WHAT DO YOU THINK WE CALL THIS? SHORTAGE. THAT'S RIGHT. PEOPLE WANT TO BUY A LOT AND THERE'S JUST NOT ENOUGH AVAILABLE. QUANTITY DEMANDED IS GREATER THAN QUANTITY SUPPLIED AT THAT PRICE. OKAY. NOW, PUT YOURSELF IN THE POSITION OF YOU'RE A STORE MANAGER. YOU'RE SELLING SOME PRODUCT. YOU PUT A PRICE OF A DOLLAR ON IT AND THERE'S JUST PEOPLE STANDING IN LINE TO GET IT. YOU SAY, "ONE DOLLAR. HOW MUCH DO YOU WANT? WE GOT TWENTY-SEVEN UNITS" -- NO, WHAT WOULD IT BE -- "WE GOT NINETEEN UNITS FOR SALE," AND THERE'S EIGHTY-ONE PEOPLE STANDING IN LINE. WHAT YOU HAVE

23 ECO LECTURE SEVEN 23 THERE, OF COURSE, IS A SHORTAGE. BUT WHAT WOULD YOU DO IF YOU WERE THE STORE OWNER? YOU SAY, "MAN, I GOT EIGHTY-ONE PEOPLE STANDING IN A LINE TO BUY NINETEEN UNITS. HMMM. ALL I'VE GOT IS NINETEEN UNITS. I THINK I COULD SELL ALL NINETEEN OF THOSE EVEN IF I WAS CHARGING A DOLLAR TEN." SO YOU RAISE THE PRICE A LITTLE BIT. AND AT THE HIGHER PRICE, SURE ENOUGH, PEOPLE DON'T WANT TO BUY AS MANY, BUT THEY STILL WANT TO BUY MORE THAN YOU'RE OFFERING FOR SALE, YOU AND THE OTHER SUPPLIERS. BUT THE SHORTAGE IS A LITTLE BIT SMALLER AT THIS HIGHER PRICE. AND SO THEN YOU SAY, "BUT THERE'S STILL A SHORTAGE. WHY DON'T I RAISE THE PRICE AGAIN?" AND AGAIN AND AGAIN. AND FINALLY YOU RAISE IT TO THE POINT WHERE IT'S A DOLLAR TWENTY-SEVEN. AND NOW QUANTITY SUPPLIED EQUALS QUANTITY DEMANDED. WE HAVE REACHED AN EQUILIBRIUM. NOW, HERE'S WHAT WE HAVE SEEN AT THIS POINT. I'M NOT PRETENDING FOR ONE MOMENT THAT ANYBODY KNOWS WHERE THESE DIAGRAMS ARE FOR -- OR THE SUPPLY AND DEMAND CURVES ARE FOR GOOD X. I'M NOT SAYING ANYBODY'S GOT TO KNOW. I'M SAYING IN COMPLETE IGNORANCE OF THIS, IF SOMEBODY LIKE JUST PICKS A PRICE -- YOU KNOW, THEY'RE NOT LOOKING AT THE DIAGRAM, THEY PICK A PRICE. AND IF THAT HAPPENED NOT TO BE THE EQUILIBRIUM PRICE, THEY'LL FIND OUT THAT THERE'S EITHER A SHORTAGE OR A SURPLUS. AND THAT SHORTAGE OR SURPLUS WILL MAKE ITSELF OBVIOUS TO

24 ECO LECTURE SEVEN 24 EVERYBODY WHO WATCHES. I SAY "OBVIOUS." IF YOU'RE THERE MANAGING THAT STORE, IT'S SUPPOSED TO BE OBVIOUS TO YOU. THAT'S WHAT YOU'RE SUPPOSED TO BE PAYING ATTENTION TO. YOU'RE SUPPOSED TO SAY, "OH, MAN. I PUT THAT PRICE OUT THERE AND, YOU KNOW, WE'RE NOT SELLING VERY MUCH. I WAS KIND OF DISAPPOINTED." AND THEN YOU'RE SUPPOSED TO THINK, "WHAT CAN I DO TO GET RID OF THAT SURPLUS? I'LL LOWER THE PRICE A LITTLE BIT." IF YOU'RE THE MANAGER OF THE STORE AND YOU PUT OUT NINETEEN ITEMS, AND THERE'S EIGHTY-ONE PEOPLE STANDING IN LINE, YOU'RE SUPPOSED TO BE THINKING, "YOU KNOW, WE COULD ALL BE DOING BETTER HERE." "WE" ON THE SUPPLIER SIDE OF THE MARKET. "WE COULD BE DOING BETTER. WHY DON'T WE RAISE OUR PRICE A LITTLE BIT? WE'RE JUST GIVING THIS STUFF AWAY." AND SO YOU RAISE THE PRICE. SO WHAT I'M SAYING IS, IN COMPLETE IGNORANCE OF WHERE THE EQUILIBRIUM IS, IF YOU PICK A PRICE THAT'S NOT AN EQUILIBRIUM AND THEN YOU JUST DO THE OBVIOUS THING -- IF YOU'VE GOT A SURPLUS, LOWER THE PRICE; IF YOU'VE GOT A SHORTAGE, RAISE IT -- YOU WILL AUTOMATICALLY WORK YOUR WAY TO A DOLLAR TWENTY-SEVEN WITHOUT EVEN KNOWING THAT A DOLLAR TWENTY-SEVEN IS THE EQUILIBRIUM PRICE. YOU JUST FIND YOUR WAY THERE. AND I'M MAKING THIS WHERE IT'S, YOU KNOW, SORT OF REAL SIMPLE AND EASY, AND MAYBE IN REALITY IT'S DIFFICULT TO KNOW IF THE EQUILIBRIUM PRICE IS A DOLLAR THIRTY OR A DOLLAR TWENTY-FIVE, OR WHATEVER. BUT I'M SAYING THAT YOU'RE GONNA WORK YOUR PRICE --

25 ECO LECTURE SEVEN 25 WORK THE PRICE UP IN THE DIRECTION OF THE EQUILIBRIUM. YOU KNOW, THIS IS KIND OF A NEAT DEAL. AND YOU MAY NOT THINK OF IT IN THESE TERMS, BUT I DO. I'M NOT THINKING SO MUCH AS A PARTICIPANT, A PERSON WHO'S BUYING AND SELLING, AS SOMEBODY WHO STANDS BACK AND OBSERVES. AND I FIND THIS KIND OF AN INTERESTING THING. WE'VE GOT TWO DIFFERENT GROUPS HERE. WE'VE GOT BUYERS AND WE'VE GOT SELLERS, AND THEY'RE JUST TOTALLY DIFFERENT PEOPLE WITH TOTALLY DIFFERENT INTERESTS; DON'T REALLY CARE ANYTHING ABOUT THE OTHER ONE. MAYBE THEY DO, MAYBE THEY DON'T, BUT THERE'S NO REQUIREMENT HERE THAT THEY CARE ABOUT THE OTHER ONE. THEY'RE JUST LOOKING OUT FOR THEMSELVES. AND WHAT HAPPENED WAS THAT THE BEHAVIOR OF THESE TWO INDIVIDUALS, THESE TWO GROUPS, THE BEHAVIOR OF THOSE TWO GROUPS ARE BROUGHT INTO SOME SORT OF CONSISTENCY IN THE MARKETPLACE. WHAT THE SUPPLIERS WANT TO SELL IS EQUAL TO WHAT THE BUYERS WANT TO BUY. AND YOU MIGHT THINK, "WELL, THESE PEOPLE -- THEY'VE GOT TOTALLY DIFFERENT INTERESTS. THEY'RE GOING OFF IN DIFFERENT DIRECTIONS. WE'LL NEVER FIND ANY WAY OF GETTING AGREEMENT BETWEEN THEM." BUT THEY AGREED ON A DOLLAR TWENTY-SEVEN. THEY AGREED ON THIS QUANTITY THAT GETS TRADED. AND WE DIDN'T EVEN TALK ABOUT THAT QUANTITY, BUT THAT EQUILIBRIUM QUANTITY. THEY BOTH AGREED ON THAT QUANTITY. WHAT WE'VE GOT HERE IS THIS MARKETPLACE WHERE THERE'S

26 ECO LECTURE SEVEN 26 VOLUNTARY BUYING AND SELLING. WE FOUND A WAY TO BRING THE BEHAVIOR OF DIFFERENT GROUPS SORT OF INTO SOME CONSISTENCY WHERE THERE'S AGREEMENT RATHER THAN CONFLICT ABOUT WHAT'S GOING ON IN THE MARKETPLACE, ABOUT THE PRODUCTION AND ALLOCATION OF THESE GOODS. OKAY. ANY QUESTIONS ABOUT THIS? THIS IS REALLY A BIG DEAL -- BIG DEAL -- UNDERSTANDING THIS IDEA OF EQUILIBRIUM IN THE MARKETPLACE. I'VE GOT THIS PICTURE SORT OF IN MY MIND -- I'M NOT ALWAYS LOOKING AT THE PICTURE, BUT I'VE GOT THIS IN MY MIND WHEN I'M THINKING ABOUT HOW MARKETS OPERATE. SUPPLY AND DEMAND IS REALLY -- WAS DEVELOPED TO HELP US UNDERSTAND PRICING, HOW PRICES OCCUR IN OUR ECONOMY. I HAD A NEPHEW SEVERAL YEARS BACK AND HE WAS VISITING MY PARENTS, AND I WAS SITTING OUT ON THE FRONT PORCH WITH HIM ONE DAY AND I THOUGHT, "I'M GONNA SEE IF I CAN TEACH THIS KID SUPPLY AND DEMAND." AND HE WAS LIKE SIX YEARS OLD, SEVEN YEARS OLD, BUT NOT VERY OLD. AND SO I JUST SAT THERE AND STARTED ASKING HIM QUESTIONS, YOU KNOW? "WOULD YOU BUY MORE ICE CREAM OR LESS ICE CREAM IF THE PRICE WENT UP?" AND THIS KIND OF STUFF. AND EVERY TIME HE WOULD GIVE ME THE RIGHT ANSWER, I'D GIVE HIM A QUARTER. THIS WAS KIND OF EXPENSIVE ON ME BEFORE ALL WAS SAID AND DONE. BUT -- BECAUSE I GAVE HIM A LOT OF QUARTERS. BUT I WOULD SORT OF TALK TO HIM THERE AND THEN I'D ASK HIM A QUESTION, AND THEN IF HE WAS RIGHT I GAVE HIM A QUARTER. AND THEN IF

27 ECO LECTURE SEVEN 27 HE WAS RIGHT I GAVE HIM ANOTHER QUARTER. AND, YOU KNOW, HE'S PRETTY SMART TO BEGIN WITH, BUT FOR ALL THESE QUARTERS THEN HE WAS EVEN SMARTER. AND AFTER AWHILE THEN WE SWITCHED OVER TO THE SUPPLY SIDE OF THE MARKET AND I DREW HIM A LITTLE GRAPH, YOU KNOW, AND, YEAH, HE COULD FIGURE OUT THAT GRAPH. NOT RIGHT AWAY, BUT HE COULD WITH THE QUARTERS COMING. AND I WAS TALKING ABOUT IT AND AFTER AWHILE I GOT THE SUPPLY AND DEMAND CURVES TOGETHER AND THEN WE GOT THIS EQUILIBRIUM PRICE. HE CAUGHT ON TO IT GREAT. BUT, YOU KNOW, FOR A LONG TIME IN HISTORY, ECONOMISTS DID NOT UNDERSTAND -- NOT ONLY ECONOMISTS, BUT ANYBODY ELSE -- DID NOT UNDERSTAND WHAT'S DETERMINING THE PRICE OF SOMETHING. AND SO THAT IS THE CONFUSION ABOUT THE PRICING THAT CAUSED PEOPLE TO THINK ABOUT THIS AND CAUSED 'EM TO DEVELOP THESE ECONOMIC MODELS, AND THEN BEFORE YOU KNOW IT WE GOT SOME ANSWERS. LET ME JUST MENTION TO YOU ONE OR TWO THINGS THAT PEOPLE HAVE SAID IN HISTORY. KARL MARX, WHO YOU MAY OR MAY NOT KNOW MUCH ABOUT -- BUT KARL MARX, WHO WROTE ABOUT SOCIALISM AND COMMUNISM, HE -- AMONG OTHER PEOPLE, HE BELIEVED IN SOMETHING CALLED THE LABOR THEORY OF VALUE. HE SAID, "YOU KNOW, SOMETHING'S GOT VALUE BECAUSE IT WAS PRODUCED BY LABOR." NOW, I DON'T AGREE WITH THIS AND THE THINGS I PUT UP HERE DON'T AGREE WITH IT. BUT KARL MARX, I'M SAYING, WAS WORRIED ABOUT OR INTERESTED IN THE SAME THING THAT WE ARE RIGHT HERE. HE WAS TRYING

28 ECO LECTURE SEVEN 28 TO FIGURE OUT WHAT IS IT THAT DETERMINES THE VALUE OF SOMETHING? I'VE TOLD YOU HERE WHAT DETERMINES THE VALUE OF SOMETHING: SUPPLY AND DEMAND. BUT KARL MARX SAID -- AND AGAIN, SOME OTHER ECONOMISTS SAID THE SAME THING -- HE SAID, "THE VALUE OF SOMETHING IS DETERMINED BY THE LABOR THAT GOES INTO IT. IF YOU'VE GOT TWO DIFFERENT THINGS AND THE ONE THING IT TAKES ONE HOUR TO PRODUCE, ONE HOUR OF WORKING, AND THIS THING TAKES TWO HOURS TO PRODUCE, TWO HOURS OF WORKING, THEN THE THING THAT TAKES TWO HOURS TO PRODUCE IS TWICE AS VALUABLE AS THE THING THAT TAKES ONE HOUR TO PRODUCE." THERE'S -- THE THEORY OF VALUE I'M WORKING WITH IS, IT'S BASED ON LABOR. OKAY. NOW, LATER ON THERE WERE SOME OTHER GUYS -- AND WE WON'T GET INTO THEIR NAMES AND SO FORTH BECAUSE THIS IS NOT A CLASS INTO THE HISTORY OF ECONOMIC THEORY. BUT THERE WERE SOME OTHER PEOPLE THAT CAME ALONG AND THEY SAID, "OH, HERE'S WHAT I THINK. I THINK HOW USEFUL SOMETHING IS, THAT'S WHAT DETERMINES ITS VALUE." THEY SAID SOMETHING LIKE THIS: "LOOK" -- WE DON'T REALLY HAVE TIME TO GET INTO THESE LONG STORIES. THEY THOUGHT THAT THE VALUE OF SOMETHING -- SORRY, I WON'T GET INTO THAT STORY. THEY THOUGHT THE VALUE OF SOMETHING WAS BASED ON ITS USEFULNESS, THOUGH. OR OUR DESIRE FOR IT. OR OUR DEMAND FOR IT. AND SO WHAT YOU'VE GOT IS SOME PEOPLE THAT ARE SORT OF ARGUING IT'S THE AMOUNT OF LABOR OR EFFORT OR WHATEVER THAT GOES

29 ECO LECTURE SEVEN 29 INTO PRODUCING IT, THAT'S WHAT DETERMINES THE VALUE. SOMEBODY ELSE SAYS IT'S HOW DESIRABLE WE FIND THIS. THAT'S WHAT DETERMINES VALUE. AND THEN A GUY CAME ALONG NAMED ALFRED MARSHALL AND I DON'T KNOW WHAT YEAR HE SAID THIS, BUT ABOUT I'M GONNA SAY 1908, MORE OR LESS. I'M NOT EXACTLY SURE. BUT SOMETIME AT ABOUT THERE HE CAME ONTO THE SCENE AND HE HAD SEEN WHAT THESE OTHER PEOPLE WERE SAYING, AND THE KARL MARX APPROACH AND THIS OTHER APPROACH THAT SAYS THE VALUE OF SOMETHING IS DETERMINED BY HOW MUCH WE DESIRE IT, THE STRENGTH OF OUR DESIRE OR THE USEFULNESS OF THE GOOD. ALFRED MARSHALL CAME ALONG AND SAID, "LOOK, THIS IS REALLY JUST -- YOU'RE BOTH WRONG AND YOU'RE BOTH RIGHT. THERE'S SOME OF YOU WHO THINK THE VALUE'S DETERMINED BY THE LABOR THAT GOES INTO IT. THERE'S OTHER PEOPLE WHO" -- AND, BY THE WAY, THAT REALLY JUST COMES BACK TO THE SUPPLY CURVE, THE DIFFICULTY OF PRODUCING OR SUPPLYING THE GOOD. "THERE'S OTHERS WHO THINK IT'S BASED ON THE USEFULNESS OF THE PRODUCT OR DEMAND FOR IT. IT'S NOT EITHER ONE. IT'S BOTH PUT TOGETHER. THERE IS A SUPPLY SIDE OF THE STORY, THE AMOUNT OF LABOR THAT GOES INTO IT AND OTHER RESOURCES, BUT THERE'S ALSO A DEMAND SIDE TO THE STORY." AND HE SAID, "YOU KNOW, IMAGINE IF SOMEBODY ASKED YOU -- SAID, 'WHAT BLADE OF THE SCISSORS CUTS PAPER?' IF YOU'VE GOT PAPER, YOU KNOW, YOU CAN CUT THAT WITH

30 ECO LECTURE SEVEN 30 SCISSORS. WHICH BLADE OF THE SCISSORS DOES THE CUTTING? IS IT THE TOP BLADE OR IS IT THE BOTTOM ONE?" AND ALFRED MARSHALL SAID, "IT'S NEITHER ONE. IT'S THE TWO BLADES TOGETHER." AND SO HE SAID IN THE SAME WAY, "IF YOU WANT TO KNOW WHAT DETERMINES THE PRICE OF A PRODUCT, IT'S NOT THE SUPPLY OF THE PRODUCT; IT'S NOT JUST SUPPLY KIND OF THINGS LIKE THE AMOUNT OF LABOR THAT WENT INTO THE GOOD." AND HE SAID, "IT'S NOT JUST THE DEMAND FOR THE GOOD, EITHER, OR THE USEFULNESS OF THE GOOD. IT'S THOSE TWO BLADES OF THE SCISSORS WORKING TOGETHER. BOTH SUPPLY AND DEMAND DETERMINE THE MARKET PRICE, IN COMBINATION." FINALLY, HERE'S WHAT WE'RE GONNA TALK ABOUT NEXT TIME. WE'RE GONNA TALK ABOUT WHAT COULD CAUSE THAT PRICE TO GO UP OR GO DOWN. WE SEE SUPPLY AND DEMAND HERE. BUT WILL THE PRICE EVER CHANGE? AND THE ANSWER IS, THE PRICE WILL CHANGE IF THESE CURVES MOVE. AND WHAT WE'RE GONNA TALK ABOUT NEXT TIME, THE SHIFTS IN SUPPLY OR IN DEMAND. I'LL SEE YOU THEN.