Category: demand

A Debate on Market Failures

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December 1, 2024

by Stephen Stofka

This is part of a continuing series of debates on economic and political issues. Substack users can find the past two debates here and here. WordPress and other  users can visit my web site innocentinvestor.com here. Hope everyone had a good Thanksgiving.

This week’s letter focuses on market failures, continuing an ongoing series of debates on economic and political issues. Investopedia describes market failure as “the inefficient allocation of resources that occurs when individuals acting in rational self-interest produce a sub-optimal outcome.” In an idealized market, prices act as signals to consumers and producers, who alter their behavior in response. Those actions affect prices, producing a feedback loop that moves supply and demand toward an equilibrium that maximizes the benefits or minimizes the costs to both consumers and producers (Pindyck & Rubinfeld, 2017, p. 312).

Market failures occur when that equilibrium-seeking process is prevented. Failures occur in markets where:
1) a company has monopoly power,
2) buyers or sellers have incomplete information,
3) there are externalities where the effects of consumption do not fall entirely on the buyer of the product or service. Pollution is a common example,
4) public goods where a good or service benefits the group as a whole but the dynamics of the market result in an undersupply.

Abel began the conversation, “Last week we left off with the housing market in New York City being a prime example of a market failure.”

Cain replied, “That’s right. I said that behind every market failure is a policy failure. The idealized ‘free market’ conveniently excludes political alliances and policy. In that idealized framework, prices coordinate supply and demand. The reality is that policymakers nudge both the supply and demand curves, adopting laws that favor suppliers or consumers.”

Abel said, “So you admit that the unregulated free market model misrepresents reality. Why is your group such a champion of markets with as little regulation as possible?”

Cain responded, “In a representative democracy, policymakers try to maximize their power and influence within the political system. They want to get reelected so the choices they make benefit their constituents.”

Abel interjected, “Yes, but not all of their constituents. Just the most influential, the most powerful.”

Cain nodded. “True enough. Naturally, that interferes with the price system. The political ‘market’ is entirely different than the market for goods and services. The political system has an entirely different cost and benefit structure. Policymakers are rewarded when they conform to the strategies of party leaders, or they bear the cost of being marginalized in committees where policymaking happens.”

Abel countered, “Yes, but its not realistic to analyze the economic system without the influence of the political system. Policymakers grant patents and copyrights, enact bankruptcy laws and thousands of measures that affect property rights. Those rights are the foundation of the economic system.”

Cain argued, “I’ll grant you that. But any assignment of property rights should be done to minimize further political involvement. Let private agents working within the price system make adjustments to circumstances.”

Abel said, “In a 2012 interview Ronald Coase (1910 – 2013) pointed out the price system is expensive because buyers and sellers need to know a lot to reach a bargain. Your group says that policymakers should step in once, make a rule and let buyers and sellers take that rule into account as they negotiate transactions. Those ongoing transaction costs are more expensive than the ongoing cost of regulating the market.”

Cain shook his head. “Our group disagrees. Remember, people don’t obey the letter of the regulations. They are always trying to minimize their costs or maximize their gain within that regulatory framework. Our group favors a system with minimal ongoing political regulation. Let the individuals within the market police themselves.”

Abel asked, “How are people living next to a dry cleaners supposed to police the owners of the dry cleaners? The solvent they use is perchloroethylene, commonly called ‘perc,’ and it’s a toxic air pollutant. The neighbors don’t have the expertise to monitor the equipment at the dry cleaners, to make sure that there are no leaks, and that filtration is installed and adequately maintained.”

Cain responded, “Policymakers can assign responsibility. In a 2013 podcast, economist Don Boudreaux noted that lawmakers usually decide that the person responsible for a harm is the party that has the lowest cost in avoiding or preventing that harm. In this case, the owners of the dry cleaners have a much lower cost than the surrounding neighbors.”

Abel argued, “That establishes the dry cleaners as the responsible party. Some regulatory agency must regularly inspect the establishment to make sure they are in compliance with the law. The price system cannot reach some idealistic equilibrium of perc because the equilibrium point is zero. The supply and demand model is an appropriate tool to analyze a market for goods and services where there is some distribution of benefits and costs. In the case of the dry cleaners, the benefit of using perc is concentrated in the owners of the business. It is a critical component of the service they offer. The costs are widely distributed to the surrounding neighborhood.”

Cain countered, “The use of dry-cleaning chemicals benefits the customers who get their clothes dry-cleaned. The owners of the business are just a distribution point of those benefits. If the benefits were entirely concentrated in the business, there would be no dry-cleaning businesses. There would be no political support for those businesses and lawmakers would ban them. This only proves the point that market failures are a result of policy decisions. In this case it is zoning regulations. Dry cleaners serve a public demand and operate in the vicinity of their customers because the public wants the convenience.”

Abel interjected, “That convenience impacts the health of the people surrounding the dry cleaners whether they get their clothes dry-cleaned or not. Those health consequences are a negative externality that the customers don’t pay for. The price system can’t handle a situation like that.”

Cain objected, “There could be a ‘perc’ charge for every piece of clothing dry-cleaned. That would reduce the volume of business.”

Abel argued, “But there is no way for the business owners to recompense the neighbors for the extra risk of living close to a dry cleaners.”

Cain responded, “In a free market system, residents would pay lower rents and house prices as long as the risks were made public. That would be an indirect benefit.”

Abel replied, “Why must poorer people pay the price of pollution? Who gets the ‘perc’ charge that is added on? The city or state? Certainly not the people affected by it. The price system only accounts for the benefits and costs of the parties to a transaction. The price system simply doesn’t respond to externalities like pollution. What about monopolists? Unlike suppliers in a competitive market monopolists maximize their profits by selling fewer goods at a higher price.”

Cain’s voice was resolute. “That only proves the point that behind every market failure is a policy failure. Companies become monopolists through some set of policies that grants them some exclusive property right. If an industry is profitable, it will attract competitors.”

Abel scoffed. “That’s textbook economics – not the real world. A business may become a leader in an industry because it builds a better widget. Then it buys up its competitors and uses economies of scale to rule an industry. Google and Facebook are good examples.”

Cain argued, “They became monopolists because they bought political influence to systematically eliminate any threats to their dominance. Section 230 gave Google and Facebook immunity from liability for user posts. Lawmakers had good intentions. The internet was new,  and lawmakers wanted to encourage growth. By removing legal constraints, they inadvertently created the ideal environment for monopolists. It’s a recurrent pattern. I’ll adapt Milton Friedman’s remark on inflation and say, ‘Market failures are always and everywhere policy failures.’ Monopolists lobby for laws that enable then protect their market power. Unlike prices, laws are rigid and don’t respond to the changing circumstances of supply and demand.”

Abel said, “Let’s explore more of monopoly power next week. I’m thinking of Joan Robinson’s innovative thinking about monopsony, where there is one buyer and a lot of sellers.”

Cain responded, “And public goods. Let’s not forget those. See you next week.”

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Photo by Elena Mozhvilo on Unsplash

Birch, S. (2018). Demand-based models and market failure in health care: Projecting shortages and surpluses in doctors and nurses. Health Economics, Policy and Law, 14(2), 291–294. https://doi.org/10.1017/s1744133118000336

Pindyck, R. S., & Rubinfeld, D. L. (2017). Microeconomics. New York, NY: Pearson Education Limited.

Stern, N., & Stiglitz, J. E. (2021). The social cost of carbon, risk, distribution, market failures: An alternative approach. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3785806

Friedman’s more repeated quote is “Inflation is always and everywhere a monetary phenomenon.” Less well-known is his remark that “Inflation is the one form of taxation that can be imposed without legislation.” https://en.wikiquote.org/wiki/Milton_Friedman

Cause and Effect

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May 26, 2024

by Stephen Stofka

This week’s letter is about the causes of inflation. Inflation can be easily described as a mismatch between supply and demand but that is a tautology that does not explain how the mismatch occurred. For hundreds of years, scholars and academics have identified various components of inflation’s causal web but identifying a primary cause has inspired enthusiastic debate. In the past century, economists have built sophisticated mathematical models which failed to predict a subsequent episode of inflation or predicted an inflation that did not occur. Economic models predicted that large government support during the financial crisis fifteen years ago would lead to higher inflation. It did not. Some economists were surprised at the extent and strength of the inflationary surge following the pandemic. In hindsight, turning off the world’s economic supply engine for even a short time was likely to have a strong effect on prices.

In The Power of Gold, Peter Bernstein (2000) recounts the causes that sixteenth century scholars gave for the persistent inflation in Europe during the 1500s. Those factors included “the decline of agriculture, ruinous taxation, depopulation, market manipulation, high labor costs, vagrancy, luxury and the machination of businessmen” (p. 191). Five hundred years later, most factors are relevant today in an altered form. With more sophisticated analytical tools, economists have developed a better understanding of these causal influences but that understanding has not led to better inflation forecasting. These factors can be grouped into those that affect supply or demand. Missing from that list was war, a common cause of inflation that distorts both supply and demand.

Prior to the severe cooling of the Little Ice Age in the 1600s, England and northwest Europe experienced a cooler climate that affected harvests. In an economy that relied mostly on agriculture, a poor harvest, or decline in agriculture was a supply constraint that pushed up prices. The demand / supply relationship is a fraction that helps explain a change in price. A lower supply, the denominator in that fraction, equals a higher price. Repeated waves of the plague and other general pandemics led to a depopulation that reduced the work force and pushed up the subsistence wages paid to workers. Employment in the U.K. has still not recovered from pre-pandemic levels, contributing to slightly higher inflation in the U.K. compared to the U.S.

High labor costs are the essence of a cost-push theory of inflation. When there is not enough supply of labor, workers are able to command higher wages. In many businesses, labor is an employer’s highest cost. Because employers markup all production costs, that markup increases the rise in prices. If employees get an extra $1 wage and the employer marks it up 50% to cover operating expenses, required taxes, fixed investment and profit, then the price will rise $1.50. The additional wage income will increase demand, resulting in a wage-price spiral that further exacerbates inflation. Any policy that reduces the supply of labor can be included in a cost-push theory of inflation.

Vagrancy, or homelessness, was a new phenomenon in the 16th century as Europe emerged from the feudal system in which workers were bound to the properties they cultivated. Policies that tolerated idleness of any sort reduced the work force and gave workers more bargaining power. Scholars of that century would be puzzled by modern day unemployment insurance which “rewards” workers for idleness. The mathematics of probability and risk that makes any insurance program feasible was barely in its infancy. By the late 17th century, Blaise Pascal and Pierre de Fermat had developed probability analysis, giving pools of underwriters gathered in coffee houses near London’s Royal Exchange the mathematical tools to sell insurance policies on many risky events (Bernstein, 1996, 63, 90).

Ruinous taxation consisted of import taxes and the debasement of hard metal currencies by the sovereign as a substitute for taxation. Import taxes on necessary commodities increased production costs, creating a cost-push effect. To repay debts incurred during war campaigns, rulers debased the currency by mixing base metals with gold or silver. In the 4th century B.C., Dionysius of Syracuse in Sicily had all the coins in his kingdom restamped to double their value so he could pay his debts (Bernstein, 2000, 48). Monetarists claim that an excess supply of money is the root cause of inflation. The economist Milton Friedman, never one to equivocate, stated flatly that inflation was “always and everywhere a monetary phenomenon.” In the Wealth of Nations, Smith (1776; 2009) noted that gold discoveries in the Americas had driven prices higher in England. A higher supply of money of any form will increase demand so this root cause is a subset of demand-pull theories of inflation.

Popular and scholarly opinion often points an accusing finger at the business class, whose conspiratorial machinations are thought to be responsible for rising prices. Historian Barbara Tuchman (1978, 163-165) described the power that merchants had acquired as the Third Estate under feudalism in 14th century France. Because many merchants were free citizens of a town and not subject to the rule of a noble, they enjoyed wealth and privileges like that of nobles, and at the expense of the workers who regarded them with scorn and envy. In Part 1, Chapter 10 of the Wealth of Nations, Smith wrote “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” Responding to the global inflation following the Covid-19 pandemic, some op-ed writers and Twitter threads were convinced that collusion by business interests was the primary cause of the inflation.

The reasoning and analysis by thinkers of centuries past did not include the role of expectations in fostering and feeding inflation. Expectations are a key part of some prominent models because supply and demand operate on different time scales. The companies that make up the supply chain must anticipate the level of demand for a product or service before the demand manifests. Each year, the risk of being wrong increases in an economy marked by technological change and rapidly evolving tastes. Inflationary expectations needs a bit more space and will have to wait until next week. Have a good holiday weekend!

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Photo by Elias Kauerhof on Unsplash

Keywords: expectations, money, taxation, unemployment, supply, demand, cost-push, demand-pull

Bernstein, P. L. (1998). Against the Gods, the Remarkable Story of Risk. John Wiley & Sons.

Smith, A. (2009). Wealth of Nations. Classic House Books.

Tuchman, B. W. (1978). A Distant Mirror: The calamitous 14th Century. Alfred A. Knopf.

Price Consensus

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August 20, 2023

by Stephen Stofka

This week’s letter is about the formation of a price consensus between buyers and sellers. I’ll introduce a different perspective that might help us understand broad price changes. Visually oriented readers familiar with economics and statistics can listen to this letter and mentally picture these ideas as they walk the dog. However, I’ll present several graphs to illustrate the perspective.

Anyone who has taken an Economic course has been introduced to a supply demand diagram. Quantity is on the x-axis and Price is on the y-axis. The lines may be curved or straight. The intersection of the demand and supply lines is the equilibrium price, the long term average. A capitalist economy promotes change and the supply-demand diagram is a visual aid to understand how price and quantity respond to shifting conditions. Students learn how the supply-demand curves respond to changes in income, to better production technology, to price changes in other kinds of goods. That simple diagram demonstrates responses to government policies like taxes, transfer programs, price controls like apartment rents, and agricultural price supports.

The dotted line represents demand after a period of time, the one component missing from this 2-dimensional graph. While it pictures the formation of an equlibrium price it does not emphasize the broad price consensus that forms between buyers and sellers. To picture that let’s draw a probability distribution of sales at various prices and quantities. I’ll exchange the quantity and price axes so that price is on the horizontal x-axis and quantity is on the vertical y-axis.

I’ll redraw the chart, setting the average price to $0 with a short range of prices above and below that average. The equilibrium price is just the average long term price. The chart below highlights the narrow consensus over price between consumers (blue line) and suppliers (orange line). Rising prices induce more suppliers to enter the market. Declining prices attract more buyers. The supply and demand lines are curved, representing the number of sales taking place at each price level. The total number of units sold is 10,000.

Let’s consider a garden tool whose average price is $30. We will see some customers willing to pay $34, or $4 above that average price, but there are few of them. Likewise, there are few suppliers willing to sell at a price of $26, a price that is $4 below the average price.

To show price and quantity dynamics, the normal distribution graph is not as flexible or as simple as the conventional supply-demand diagram. The normal distribution chart can be viewed as a spread of prices over time, the third dimension. Just imagine that wedge of blue is a piece of pie so many weeks or months thick. Seeing price as a probability distribution does reflect a buyer’s reality in the sense that we prefer to shop with approximate prices in mind. Monthly surveys conducted by the BLS tell us that the prices of two categories – food and energy – are volatile, making it difficult for us to anchor a price expectation. These are the prices we encounter frequently when we fill up our cars, pay our utility bills and shop at the grocery store.

The graph is similar to a 2-dimensional triangle and is missing a critical component – time. The depth of a slice of pie can represent time periods. Demand operates on a shorter time scale than supply, an idea central to the analysis of Alfred Marshall, the economist who developed the supply-demand graph we use today. It’s a thinner wedge of pie.

Imagine that the average of a weekly tank of gas is $40. The blue pie of the normal distribution in the graph is sliced into a 100 vertical strips that statisticians call “bins.” Imagine that every one of those bins is a week and the center, the zero point, is an average of gas prices over two years. That is the time scale of demand. The time scale of supply is thicker, perhaps four times as long in some industries. The chart below shows the 2-year (demand) and 4-year (supply) averages of weekly gas prices for the past 25 years. Current 2-year average prices are at a historical peak. These prices are not adjusted for inflation. Adjusted for inflation, gas prices have declined in the past 40 years. After adjusting for fuel efficiency, gas prices are comparable to those in the 1950s.

The supply chain, including the banks that fund them, must look far into the future. Each one of the bins in the normal distribution chart could represent a month, not a week, forming an eight year average. No one could have foreseen a pandemic that interrupted global production. Coming out of the pandemic, businesses responded to low interest rates and anticipated a surge in demand. In an 18-month period from the fall of 2020 to the spring of 2022, private investment increased by 22%. The inflation that erupted in the spring of 2022 was a combination of growth in short term demand and long term supply investment. As soon as the Fed began raising interest rates, the surge in private investment ended and leveled out.

The normal distribution chart helps us see price as a probability distribution dispersed over time. Any chart that reminds us of pie is a useful and welcome analytical tool.

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Photo by Michael Dziedzic on Unsplash

Keywords: probability distribution, supply, demand, price