eco2013 lecture notes 1_5_10

Gator Tutoring Concept Note ® ECO2013 Spring 2010 1/05 Lecture Notes

We begin by talking a bit about supply and demand. A supply curve is a line (locus of

points) that shows different quantities of a good that a firm is willing to supply at different prices. The Law of Supply says that supply curves slope up. This means that as the price of a good rises, a seller of that good wants to sell more. This should make sense – the more money a firm gets per unit, the more units it will be able to produce.

We’re going to be discussing the market for tulips, specifically the market for tulips in Holland in the 1620s; this is because a significant macroeconomic event happened here, and we’ll see what it is in a bit. Let’s say Palin Farm is just one supplier of tulips in this market, and that it sells 100 tulips/year at $1/tulip (note that quantity here is a flow variable, because it has a time dimension [per year]; this is opposed to a stock variable, which doesn’t).

When the price goes up to $2/tulip, it would now want to sell more than 100 tulips/year (again, by the Law of Supply). Let’s say it sells 200/year. The upward‐sloping supply curve for Palin Farm will look like the graph to the right.

Now, let’s find the supply curve for the entire tulip industry. Suppose there are 1,000 identical tulip farmers, and all of them have the same individual supply curve as Palin Farm. To find industry supply, we add these individual supply curves horizontally – that is, at any given price, we add up the quantity supplied of each individual firm. So, at a price of $1, industry quantity is 100 *1,000 = 100,000 ; at a price of $2, industry quantity is 200 *1,000 = 200,000 ; and so on.

Ultimately, we’re looking for a way to determine whether the entire market is in

equilibrium. To do this, we need to add demand to the story. A demand curve shows different quantities of a good that a consumer is willing to buy at different prices; it is the consumer‐side mirror of supply curve. The Law of Demand says that demand curves slope down. This means that as the price of a good rises, a buyer of that good wants to buy less. This is pretty intuitive – at higher prices, consumers tend to buy less goods than they would at lower prices.

There are two reasons for the Law of Demand: the substitution effect, and the income effect.

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‐ The Substitution Effect: This component of the Law of Demand is the larger of

the two. It states that if the price of a good rises, people tend to buy less of it, because substitutes exist for that good. For example, if the price of hamburgers increases, I may buy more hotdogs, because hotdogs can function as a substitute for hamburgers.

‐ The Income Effect: This component of the Law of Demand is the smaller of the two. It states that as a consumer’s income falls, he can buy fewer units of a good than he was able to before. So, if the price of hamburgers increases, a consumer will be less able to afford the original amount of hamburgers he was consuming. Conversely, if the price decreases, he will be able to afford more, and will increase his consumption. (Note: this is true for a normal good. For an inferior good, a decrease in price actually yields to a decrease in quantity demanded. An inferior good is something like bus travel or spam, which are consumed less and less as people get richer and richer)

Now suppose Tiger is an individual consumer of tulips, and his demand curve looks like the graph to the right. We can see that at a price of $1/tulip, he will buy 300 tulips, and at a price of $2/tulip, he will buy 200 tulips, etc.

We again want to find the industry demand for the entire market, so assuming there are 1,000 identical customers, we add the individual demand curves horizontally. So, at a price of $1, all 1,000 customers want to buy 300 *1,000 = 100,000 tulips; at a price of $2, industry demand is 200 *1,000 = 200,000 tulips; and so on.

Now that we have industry supply and demand, we can put them on the same graph to determine equilibrium price and quantity.

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We can see that the equilibrium price is $2, and the equilibrium quantity is 200,000 tulips per year, because this is where the demand and supply curves cross. Now, we’ve developed this graph in order to discuss the Tulip Mania, which occurred in Holland in the 1630’s. The Tulip Mania is the earliest economic bubble that we have significant historical documentation on. An economic bubble is a market where prices are unsustainably high. How do bubbles come about?

First, let’s talk about the conditions that are necessary for a market to be in equilibrium. There are two of them:

1. QD = QS : the quantity demanded in the market must equal the quantity supplied

2. PC = PF : the price paid by the consumers must equal the price received by the farmers

So, if the price of tulips were $1, the quantity supplied would be 100,000, and the quantity demanded would be 300,000. Then our market would be out of equilibrium:


When a market is out of equilibrium, one of two things can occur: a shortage or a

surplus. A shortage occurs when the quantity demanded is greater than the quantity supplied, as in the above graph. This happens when the price is below the equilibrium price. The actual value of shortage simply equals the difference between the higher quantity demanded and the lower quantity supplied; in our example, the shortage is 300,000 −100,000 = 200,000 .

A surplus occurs when the quantity demanded is less than the quantity supplied. This happens when the price is above the equilibrium price. A surplus would occur if the price in the above graph were $3. In this case, the quantity demanded would be 100,000 and the quantity supplied would be 300,000. The value of the surplus is the different between these two numbers, or 200,000.

During either a shortage or a surplus, the short side of the market determines the quantity that is actually transacted. This means that since there is a disparity between quantity supplied and quantity demanded, the lower of the two quantities will determine what is bought and sold. In the graph, when the price is $1, consumers demand 300,000 tulips, but suppliers only produce 100,000. Thus, the quantity transacted is 100,000. If the price were $3, the quantity demanded would be 100,000, the quantity supplied would be 300,000, and so since the consumers only demand 100,00, the quantity transacted would be 100,000. Whenever a market is out of equilibrium, there is pressure on prices to move

toward equilibrium. If price is below equilibrium (i.e. there is a shortage), consumers will be willing to pay higher prices to obtain more goods; so, prices will tend upward. If price is above equilibrium (i.e. there is a surplus), firms will have excess inventory and will lower price to sell more; so, prices will tend down. In either case, prices that are unstable will move toward the equilibrium price, which is stable. This is called the Law of Demand and Supply.


So, if markets tend toward stable equilibrium prices, how can economic bubbles

form, like the Tulip Bubble in 1630? Something must have caused a change in the market. On February 2nd, 1630, Anne of Austria (the Queen of France) celebrated her birthday at the Palace of Versailles, adorning the palace with tulips. Being the Queen, her actions tend to set trends. Thus, her endorsement of the tulip causes their popularity to increase, sending the demand for tulips way up. This shifts the demand curve for tulips to the right.

However, this itself is not enough to cause the market to be unstable. We know this by the Law of Demand and Supply. A rightward shift in demand, such as that shown in the graph to the right, will initially cause a shortage. But firms will respond to this shortage, either by producing more tulips than they were before, or entirely new firms will enter the market to meet the new, higher demand. In fact, at this time Rembrandt moved to Amsterdam to begin selling tulips to fund his endeavors as a painter.

Now we’ve seen that a change in tastes can have an effect on demand. Something that also impacts demand is market expectations. There are two kinds of expectations: rational (or fundamental) expectations, which are based on the fundamentals of supply and demand; and adaptive expectations, in which some variable will continue with its current value. Rational expectations cannot explain a bubble; however, adaptive expectations may help to. Suppose that the percentage change in price (denoted %ΔP ) is the variable that continues with its current value. This means that after the initial increase in price, as a result of Anne of Austria’s use of tulips during her birthday, some people in the market developed adaptive expectations that the price of tulips would continue to increase at the same rate (i.e. the %ΔP would remain constant).

In 1633, halfway through the 30 Years’ War, there was a celebration that caused another increase in the demand for tulips. However, at this point, the effect of the adaptive expectations becomes stronger, and people simply expect that prices will continue to rise,

even in the absence of any fundamental reason for believing so. This causes the demand curve to keep shifting right, which raises the price even more. Now given these expectations for price, we can construct an expectations demand curve. Instead of showing different quantities that consumers would buy at various prices, this demand curve shows different quantities that consumers with different expectations of the future would buy. Those consumers at the prices above the current price of P1 expect the price to go up; those consumers at the prices below the current price of P1 expect the price to go down. A good example of this

phenomenon is the recent housing boom. When prices of houses were extremely high in 2005, some consumers continued to buy them. These consumers must have thought that the prices were going to continue to rise, or else they wouldn’t have bought them at their already‐high levels.


In the recent financial episode, many people developed adaptive expectations about

the market for housing and thought that the price of housing was going to keep rising. The development of sub‐prime mortgages (also called NINJA mortgages, an acronym for No Income, No Job or Assets) allowed people who had these expectations but traditionally were unable to afford housing to get into the market. This shifted the demand for housing even further to the right, pushing prices up.

A similar situation developed in the Tulip Mania bubble. In 1636, firms began to allow people to buy on the margin. This means that a consumer could put, say, 10% of his own money down toward the purchase of tulips, and borrow the rest of the money. When a consumer buys on the margin, we say he becomes leveraged. This means that by buying on the margin, the consumer is not only responsible for what happens to his money, but also what happens to the money that he is borrowing from someone else. It is risky if you become leveraged, because if the price of tulips goes down, it will be difficult to pay back the money you borrowed. Thus, the consumers that were buying on the margin in 1636 believed that the price of tulips would continue to rise – just as the consumers in 2005 who bought houses on the margin (sometimes with not a cent of their own money) believed that the price of houses would continue to rise.

As a result of these events, the demand for tulips continued to shift right, which drove the price up way beyond what the fundamentals dictated the price ought to be. It came to a point where the price of a single tulip was worth a team of oxen; a particularly valuable tulip may have sole for the value of an entire merchant ship. People were selling their houses and farms in order to buy tulips and gain access to this speculative market.

As a side note, both of these markets (tulips and housing) have something in common – the products are durable. This means that they last for a significant period of time. It is obvious why houses are durable; in the tulip market, it was the tulip bulb that was actually bought and sold. So, buyers of tulip bulbs could store their bulbs and plant them to be sold the following year. Things like haircuts are not durable. You cannot go out and buy 1,000 haircuts and sell them in the future. So, asset bubbles will typically not form around goods that are not durable.

How does the Tulip Mania end? The bubble burst in 1637 when Anne of Austria again celebrated her birthday; only this time, she didn’t use tulips to decorate her palace. This shifted the demand for tulips way down, which brought down the price, and everyone who bought in to the speculative tulip market and who thought they were going to get rich instead became poor.

eco2013 lecture notes 1_5_10

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