Advanced Macroeconomics; Lecture 1
S1: Review of Basics of Supply and Demand Models, according to classical and neoclassical economic theory.
NOTE: Keynesian Macroeconomics is BASED on the observation that supply and demand did not work in the labor market after the Great Depression.
GOAL of this part is just to REVIEW the basic supply and demand model, and HIGHLIGHT some assumptions made in deriving the model and its results.
We review the basics of standard supply and demand models. Read Varian Chap 1 p1-8 attached below to refresh your memory. The basic idea is very simple. First there is a good -- which must be uniform (the same good). Varian treats the model for housing near campus. There is a supply of apartments, and there is demand by students. Varian assumes that all houses are identical, so that there is only one good. The second crucial assumption is that there is only one price, which is the same for all goods. This means that all houses rent at the same price.
Now consider a thought experiment: What will the market price be? If the market price is low, then suppliers will not want to supply, while demand for the good will be large -- there will be excess demand. As the price rises, more suppliers will want to supply the good, and the demand will also decrease. For very high price, there will be excess supply, when everybody wants to sell but very few want to buy. In the middle somewhere as the price rises from low to high, and excess demand changes to excess supply, there will be an EQUILIBRIUM POINT. A point at which the demand is exactly the same as the supply. According to standard economic theory, this point is the price which will prevail in the market.
In this basic supply and demand story, many many assumptions have been made without mention. As we will see, in reality, many of these assumptions are false. As a result, the supply and demand theory does not actually work in the real world.
CRUCIAL METHODOLOGICAL POINT: The main difference between the way we will teach this economics course, and the conventional course being taught all over the world today, is that we will compare theories to the real world, and modify the theories if they do not match reality. This is exactly what is called the "scientific method". For more details on how economists use a methodology which is not scientific, see "Economists Confuse Greek Methodology with Science".
Some of the problems are as follows:
The same good sells in the same market for different prices. So the "law of one price" does not hold.
The assumption is that everyone knows all the prices, so everyone will automatically go to the lowest price seller. When the lowest price seller sees excess demand, he will raise prices. No one will come to higher price sellers so they will lower prices. Ultimately, only one price can prevail. However, this process of convergence to equilibrium can work only under very special conditions, which do not normally hold in usual marketplaces.
Some other problematic assumptions are listed below:
Varian introduces what might be called the fundamental methodological commitment made by modern economic theory:
The optimization principle: People try to choose the best patterns of consumption that they can afford.
(This) is almost tautological. If people are free to choose their actions, it is reasonable to assume that they try to choose things they want rather than things they don’t want. Of course there are exceptions to this general principle, but they typically lie outside the domain of economic behavior.(p3)
The second principle introduced by Varian is also part of the core methodological commitments of modern economic theory:
The equilibrium principle: Prices adjust until the amount that people demand of something is equal to the amount that is supplied.
The second notion is a bit more problematic. It is at least conceivable that at any given time peoples’ demands and supplies are not compatible, and hence something must be changing. These changes may take a long time to work themselves out, and, even worse, they may induce other changes that might “destabilize” the whole system. This kind of thing can happen . . . but it usually doesn’t. In the case of apartments, we typically see a fairly stable rental price from month to month. It is this equilibrium price that we are interested in, not in how the market gets to this equilibrium or how it might change over long periods of time. (p3)
For commentary on these principles, see Comments on Varian.