If you use your economics, then no matter how complex the supply-chain problems might appear, they can be solved using the price system. The price system may or may not be able to call forth more supply, but it certainly can ration demand, and it can do so more efficiently than is being done at present. Everywhere the supply chain is “broken,” higher prices can ensure that scarce goods are allocated to the highest-priority uses.
Category Archives: Introductory Economics
Are the laws of supply and demand broken?
Everywhere, one hears about shortages. Not enough trucks to pick up goods at ports. Six-month waits for appliances. Car dealers with empty lots. Grocery shelves with missing goods. Book releases postponed because of lack of paper and printing facilities.
None of that is supposed to happen. When you have an adverse supply shock, prices are supposed to rise to clear markets. Even if a higher price does not summon more supply, it serves to ration demand. A shortage, where people have to wait or the quantity is rationed, only takes place when the price is artificially held down.
Why are markets not clearing? More remarkably, why aren’t economists talking about it?
The best explanation this economist can offer is that firms do not want to raise prices because they are afraid of blame. If you walk into a store and the price has gone way up, you blame the owners and managers, because the store has discretion over the price. But if the store runs out the stuff, a typical customer will think, “They couldn’t help it. It’s a supply shortage.”
Of course, if you had internalized freshman econ, you would not blame the store for high prices, because the the price comes from market supply and demand conditions. And you would blame the store for being out of stuff and thereby making you wait or else run all over town trying to find stuff. They are just as responsible for setting their price too low. But because most customers have not internalized freshman econ, stores think they will have better customer relations if they run out of stuff than if they raise prices.
If this is the explanation, then I think that the price stickiness will not last forever. Over time, firms will gradually raise prices. I believe that what we are seeing right now is a considerable amount of repressed inflation, and it won’t stay repressed for much longer. By the end of next year, I predict that “shortages” will have been replaced by higher prices.
December 1978
Going through some old letters I wrote to my father, which he saved. An excerpt from December 4, 1978, when I had been a section leader for the first-year econ course at Harvard.
My exam really separated the men from the women. The four worst grades in the class were all from women, and a woman tied for the fifth worst. My class is a sample of students in which sex-based differences in upbringing are apparent. The women are not math and science oriented, whereas the men have some background in math and science.
The exam was not mathematical, but like all economics exams stressed applications to problems rather than knowledge of facts or formulas. I felt that the results, with a few exceptions, represented what people knew about the course.
One sad comment on my teaching is that the student who got the best grade is the one who comes to class least often.
Today, I would say that my teaching was a perfect example of the Null Hypothesis.
Being a teaching assistant at Harvard was eye-opening. It was scary how many weak students were in my section. I remember teaching a simple consumption function, C = a + bY and five of my students independently came up to me afterward because they did not understand what a and b were supposed to mean. They had been too uncomfortable with 8th-grade algebra to understand the concept of line with a slope and an intercept but too ego-protective to ask the question publicly in class.
By the way, if I had to bet, I would wager that Harvard students today are much better at 8th-grade algebra but are even more ego-sensitive. And I would wager that the male–female difference in ability to handle a course with simple applied math has narrowed or even reversed.
The next year, I was a teaching assistant at MIT. That was a completely different experience. There, when I was trying to explain the concept of “rational expectations,” (a concept typically not taught to first-year students in those days) one student piped up skeptically, “That’s like saying that the batter knows what the pitcher is going to throw before he throws it.” That was a darn good analogy.
Ken Rogoff told his first-year students at MIT that he would give an A to anyone who could help him prove a mathematical conjecture (this was for his Ph.D thesis). He ended up getting two different correct proofs.
MIT undergrads were scary that way.
There is No Labor Shortage
I reprint an essay I first posted almost a quarter century ago.
Although most economists would share my confidence that the market can take care of a labor shortage, there is much that we do not know. We do not know how far away the current wage rate is from the one that is consistent with no excess demand for labor. We do not know if the process of wage adjustment will be inflationary (nominal wages rising) or deflationary (prices falling relative to wages). We do not know how long the process may take.
That was in 1997. In today’s environment, I would bet that the upward adjustment of wages will take place in the context of inflation. As I write this, prices are going up faster than wages, which exacerbates the appearance of a “labor shortage.” Market forces are likely to drive wages higher, and we will see history repeated. Not like 1997. More like 1977.
The recent evolution of central banking in the U.S.
when I was teaching big classes in the late 1980s and into the 1990s, the textbooks all discussed three tools for conducting monetary policy: open market operations, changing the reserve requirement, or changing the discount rate.
Somewhat disconcertingly, when my son took AP economics in high school last year, he was still learning this lesson–even though it does not describe what the Fed has actually been doing for more than a decade since the Great Recession. Perhaps even more disconcertingly, when Ihrig and Wolla looked the latest revision of some prominent intro econ textbooks with publication dates 2021, like the widely used texts by Mankiw and by McConnell, Brue and Flynn, and found that they are still emphasizing open market operations as the main tool of Fed monetary policy.
I recommend the whole post. I think this is an important issue.
The way I see it, central bank practices moved away from the textbook story at least 40 years ago. There were three important steps.
1. Intervention via the market for repurchase agreements, commonly called the repo market.
2. The use of risk-based capital requirements (RBC) to steer the banking sector.
3. The expansion of bank reserves and the payment of interest on reserves (IOR).
I will discuss these in turn. Continue reading
Five books on macroeconomics
In response to a list of five conventional macroeconomics textbooks, I compiled my own list of books to read on macroeconomics. They won’t necessarily cover what’s on the exam in a typical course, but they will help you become learned on the topic.
An excerpt from my short essay:
The late Charles Kindleberger was an economic historian, and I believe a historian’s perspective is crucial for looking at macroeconomics. After all, there are no repeatable experiments in macroeconomics, only historical episodes. Kindleberger looks at the most dramatic episodes in history, using the framework of financial instability developed by Hyman Minsky. Kindleberger is a better expositor than Minsky. Also, Kindleberger emphasizes the phenomenon of “displacement,” in which a sudden change in world conditions, brought about by a major new discovery or the outcome of a war, triggers a dangerous mania. My own thinking about macroeconomics is a combination of Kindleberger-Minsky and Fischer Black (below).
Competition and market structures
My take on competition and market structures, for college economic topics. It has always bothered me that the most-discussed market structures, monopoly and perfect competition, are those least found in the real world, where monopolistic competition and oligopoly prevail.
Aggregate Supply
My take on aggregate supply, for college economics topics.
Aggregate demand
My take on aggregate demand, for college economic topics.
Accounting for stimulus checks
April saw by far the largest increase in personal income ever seen in America. That’s not normal for a month that is likely to end up being the absolute trough of the 2020 depression. And saying it’s “not normal” during a depression is an epic understatement.
In freshman macroeconomics, the letter Y often is used to stand for GDP and for national income, interchangeably. In the national income accounts, they are arrived at separately. Nominal GDP is measured as the purchases of goods and services at market prices. Nominal income is the payments received by workers and investors. Any difference between these two measured is labeled as a statistical discrepancy.
Personal income includes transfer payments, which are checks written by the government–Social Security, or unemployment compensation, or this year’s stimulus checks. Transfer payments are not part of national income, because they are not earned from the sale of goods and services. If you counted transfer payments in national income, the “statistical discrepancy” would get out of hand.
All of these flows are measured at annual rates. If you get a $1000 stimulus check in April, then at an annual rate that is $12,000. And some of us did not even get our checks until May. So the second quarter (April, May, and June) is going to see a whopping increase in personal income.
Some households will spend their stimulus checks right away, but many households will not. There’s only so much spending you can do with all the stores closed. In the national income accounts, there will be a big increase in personal savings. This will not be matched by investment; instead it will be matched by government dis-saving, a larger government deficit.
Suppose that households were to spend all of their income in the second quarter. Meanwhile, 20 percent are unemployed, so output should be down by a lot. Nominal spending up and real output down means that prices have to rise.
As I see it, the price rise was delayed by the fact that households did a lot of saving. Eventually, as they spend their stimulus checks, we will see the impact on prices.
Consider an extreme case. Suppose that textbook Y is $1. That is, we produce $1 of output and receive $1 in income. Next, the government writes a total of $99 in stimulus checks to households. Now households have $100 in personal income, and the government has a $99 deficit. When households spend their $100 on the output, the price of output will go up. Income will also go up, which means people can spend still more. The process only stops when the government engages in saving by running a surplus. That surplus cuts into personal income, reducing spending.