The term “market” is a controversial one—indeed, one of the most divisive terms there is.

And it means very different things to different people.

In the coming lessons, we will try to look at the topic objectively, with as few biases and
prior assumptions as possible. We will see that many of the descriptions that people ascribe
to markets do, in fact, describe certain properties of markets very well. But these
descriptions can’t also be relevant all the time, so we have to learn to look carefully at
what’s really going on in any particular market.

Let’s consider the demand and supply curves for a particular product or service, say the
market for lawyers. More specifically, we’ll consider the market for the services of newly
graduated lawyers. (Around 40,000-50,000 law school students graduate every year in the
US!) The demand curve indicates the willingness to pay by each law firm, and the supply
curve represents the willingness to sell (their services) for law graduates.

The graph below shows the demand and supply curves for this market. As you should
recognize, the downward sloping blue line is the demand curve, and the upward sloping red
line is the supply curve. Imagine that firms “bid” to hire new law graduates as they enter the
labor force every year. (We’ll also assume, for simplicity, that law graduates are similar in
ability and quality—a heroic assumption, of course, but one that simplifies the analysis while
still illustrating the important points.)
Even if you’ve never seen demand and supply curves together on the same graph until now,
a very intuitive answer—and, indeed, the right answer—is that the market wage for lawyers
is found where the demand and supply curves intersect. This intersection also tells you
what the quantity demanded or supplied of lawyers will be at that price and it is often
referred to as the market outcome.

But Why?

What’s so natural or special about the intersection of the demand and supply curves? After
all, it’s just one point on the entire graph, just one outcome of many, many possible ones.

Why should we expect the quantity transacted in the market to be (even close to) what the
demand-supply intersection predicts? And why should we expect the market price to be
close to what the demand-supply intersection predicts? One thing that is notable about the
intersection of the demand and supply curves is that, at that outcome, the quantity
demanded by buyers (law firms in this case) will exactly equal the quantity produced by
sellers (law graduates in this case). Now that’s nice, because it says that, at the market
price, there are no “unsold law services” that law graduates wanted to sell but couldn't and
there are no law firms with unspent money they wanted to spend on new law graduates but
couldn't.

Let's explore this a bit further. Specifically, let’s ask what would happen if the market wage
were something other than the wage at the intersection of the curves?

Suppose the “market salary” were $80,000 rather than the $160,000 that corresponds to the
intersection. What would happen then?

4.1.3 The Concept of Market

Equilibrium
The only stable outcome—where there are no buyers who are willing to pay for the product
but can’t get it and no sellers who produce the product but can’t sell it—is the intersection of
the demand and supply curves. At that outcome, there is neither excess demand nor
excess supply. As a result, there’s no incentive to raise or lower prices further.

The dynamic process described here is often referred to, colloquially, as the “cobweb”
model of adjustment (simply because the arrows resemble a cobweb—it’s not that
imaginative of a term).

Now, the story described here—of how prices adjust to reach the market outcome—was
very stylized: it’s a bit like imagining that there's a marketplace for lawyers where everyone
(lawyers and law firms) meets every year and looks for someone else to transact with and
where prices are bid up or down. Of course, we don’t really see this precise mechanism in
every real market—other than a bazaar or marketplace. (Indeed, in many markets, firms set
prices directly rather than there being an auction or marketplace or bazaar.)

But regardless of what the actual process looks like in real markets (and how they might
differ from this one), what we’ve described here is a fairly good description of the forces at
play that bring markets to rest. And that’s the important thing to remember.

By the way, this resting point is also referred to as the market equilibrium. (As in other
contexts, the term equilibrium indicates a balance between opposing forces—in this case,
the forces that might raise or lower prices.)

The Process of Market Adjustments

To summarize: if there’s excess demand or excess supply at any particular price, there are
strong incentives for either buyers or sellers to change their behavior and move the market
away from that outcome.

When there are shortages in a market, prices typically rise. When there are surpluses,
prices fall. Prices adjust in order to correct or eliminate excess supply and demand. And
they do so by creating incentives for firms to produce more or less of the good and for
buyers to demand more or less of the good, depending on the circumstance.

And here is a critical point: in our story above, adjustments in price caused the market to
self-correct, when it was out of equilibrium. One didn’t need any outside intervention or
any authority to step in and allocate products to the right buyers or sellers. Prices did the
trick.

Markets and Surplus

So we’ve seen one attractive property of market outcomes: at the market equilibrium,
there’s neither excess demand nor excess supply. And prices are stable.

But there’s another interesting property of market equilibrium that’s useful to mention.
Remember our earlier definitions of consumer and producer surplus in Module 3? That’s
simply the value captured by buyers and sellers. Let’s examine total surplus in a market
and who captures what.

In our graph below, the gray-shaded upper triangle or trapezoid represents the total
surplus to consumers. It is just the difference between consumer willingness to pay and
price, added up for all consumers who get to transact in the market. For example, if the
price were $60, then quantity demanded is 40 units and quantity supplied is 60 units, so the
amount traded is determined by the demand curve (40 units). And even though every
consumer who transacts pays the same price ($60), some end up better off than others—
since they had a higher WTP for the product. So a consumer whose willingness to pay was
$80 ends up with a surplus of $20.

Similarly, the blue-shaded lower triangle or trapezoid represents the total surplus to
producers. It's just the difference between price and supplier marginal cost (or variable
cost), added up for all suppliers who transact in the market. In this case, a firm that was
willing to sell the good for $30 can now sell it for $60—and earn $30 in surplus (or profit).

Together, the two areas represent the total social surplus—or the total value created by
buyers and sellers interacting through the market. It’s simply the consumer surplus and
producer surplus combined.

Why is total surplus maximized at the market equilibrium?

One way to see this is to remember that every point on the demand curve can be thought of
as some consumer’s WTP and every point on the supply curve represents some firm’s
variable cost (or willingness to sell). Now, do you notice what happens if prices were to end
up anywhere other than the market equilibrium? In that case, there is at least one
transaction between a buyer and seller that didn’t occur, but should have—since the
willingness to pay of some buyer that’s “left out” is greater than the willingness to sell of
some firm that’s “left out” as well.

When prices are at the demand-supply intersection, there is no buyer or seller who would
have liked to transact at that price, but couldn’t.
 1. If a market is not at its equilibrium, and there is excess supply, what is likely
to happen to the market over time?
a. Price will decrease to the point at which quantity supplied is equal to quantity
demanded.
i. Price will return to equilibrium as producers adjust their price and
quantity to match demand.

2. At the current price of $1.50 per dozen, producers are willing to produce 1 million
pencils, and consumers want to purchase 1.2 million. What will happen to the market
for pencils over time?
a. Producers will raise their prices until the point at which quantity supplied is
equal to quantity demanded.
i. $1.50 is below the equilibrium price for a dozen pencils, and market
forces will raise the price until the market is in equilibrium.

What’s interesting about this (very stylized) story of market adjustment is that one doesn’t
actually need a real person or an organization whose job it is to coordinate buyers and
sellers. Instead, prices contain information that coordinates—and incentivizes—both
sides. For example, if prices are too low, buyers who are willing to pay more than that price
will search for (and reach) sellers who are willing to sell to them at a higher price—putting
upward pressure on prices. If prices are very high, some sellers will be stuck with goods
that no one is willing to purchase—and they’ll reduce prices to attract more buyers.

In other words, prices can be thought of as serving a coordinating role for the market.

So, as Professor Kohlberg describes, the simple idea of “price as coordinator” generalizes
beyond a single market to thinking about multiple related markets. Indeed, the price system
can be thought of as coordinating the activities of the entire economy.

Prices versus Command-and-Control

Professor Kohlberg describes the “magic” by which prices coordinate activities within and
across markets. But prices are surely not the only way to coordinate activities and markets.
We are familiar with others: notably, the attempts of command-and-control economies to
coordinate activities in an economy.

The Economist, invoking the economist Friedrich Hayek, described the primary challenges
of a central planning approach—in comparison with the price system:
Most amateur critics of communism limit their criticism to the incentive problem: why should
people work hard, if they are provided basic needs without working?... The real problem of
central planning is not the incentive problem, but the information problem: central planners
have no better method than prices for aggregating information.

But what’s the difficulty? Why, over the decades, have some nations found it so hard to
manage markets through a centralized approach?

4.1.5 Equilibrium: Short-Run vs. Long-

Run
Few markets have benefited as much from the Internet boom as consumer videos. And
between 2001 and 2011, no company grew faster in this market than Netflix, a firm founded
by entrepreneur Reed Hastings in 1997.

On June 3rd, 2011, Netflix’s stock price had risen to $274—far higher than cable giants
Time Warner Cable or Comcast—and its market capitalization was $14 billion.

Until 2007, Netflix had been primarily an online renter of physical DVDs. Since then,
demand for streaming video services had been rapidly increasing.

There were other benefits too. The costs of running an online streaming business were far
lower than the costs of operating a rental business. For example, Netflix had built 44
distribution centers across the entire US market (costing millions of dollars) to serve its DVD
customers; none of these were required for a streaming service. (Indeed, the cost savings
from going digital were similar to those we saw earlier for book publishers.)

On the face of it, streaming would increase demand and reduce cost.

But there were concerns, too. To begin with, Netflix had grown its DVD rental business over
the prior decade in an impressive fashion to become the undisputed market leader. Now the
growth of streaming threatened to cannibalize DVD rentals—and Netflix had the most to
lose.
On top of that, there was the prospect of increased competition. Unlike DVD rentals—where
large investments in distribution centers created entry barriers—the investment costs for
operating a streaming business were far lower. As a result, many more players had entered
the market, creating the prospect of greater rivalry. As analyst Tony Wible pointed out,
"Amazon, Google, Dish Network, HBO, Wal-Mart, Best Buy, Facebook, Coinstar and others
are looking to take advantage of the lower barriers to entry in digital distribution.... Ratings
erosion is inevitable."

And finally, there was a question of cost. Some analysts predicted that content providers—
like Starz, Disney, Sony, and others—would increase the costs of content for streaming
providers by raising prices. (The reason it was different from rentals was because of an
obscure rule called “first-sale” doctrine that only applied to DVDs, not to streaming.) Other
analysts predicted that Internet access providers (such as cable operators)—on whom the
streaming services critically depended on—would have the last laugh since they could
charge users for bandwidth; in effect, forcing streaming providers like Netflix to raise
their prices to customers which, in turn, would lower demand.

Not everyone agreed on these predictions. But the more important point is that Netflix’s past
success had little bearing on its future performance. For that, one had to predict what would
happen to customer demand, cost, rivalry, and entry.

In effect, one had to predict what would happen to the demand and supply
curves confronting Netflix.
Sustaining Corporate Performance
But how can one predict future performance? One reasonable approach is to rely on current
measures of a firm's success. After all, what better indicator than how a company is doing
today? Success today seems likely to translate into success tomorrow. Conversely, poor
performance today is more likely to result in failure tomorrow.

Here are the results from a study that looked at precisely this question. Specifically, the
study tracked all firms in the US during the 1971-1982 period. It started by breaking up the
firms that existed in 1971 into three groups: the highest performing one-third, the middle
third of performers, and the lowest-performing one-third. The chart below indicates the
performance of each group in 1971.

And here were the results of the study:

The results were dramatic—and sobering. They indicate a fairly strong “reversion to the
mean” in performance over time. If anything, today’s high performers are likely to do far
worse tomorrow; the opposite is the case for poor performers.

And the results are not just limited to that time period. Here are the results from a more
recent study that tracked the performance of the most successful firms in three different
markets: Brazil, South Korea, and the US.

Sustaining performance is hard for firms—even for the most successful ones. And that’s
why short-run indicators may not be good predictors of long-run outcomes.
Network effects, scale, regulation, patents, and innovative capabilities are all examples of
factors that slow or even reverse the dynamics of perfect competition. For this reason,
they’re often termed “frictions” in markets – since they can slow, or even reverse, the
apparent inexorable dynamic of perfect competition. And that’s the basic tension that
Warren Buffett refers to: firms are engaged in a continual effort to create or exploit such
frictions, while market forces tend to work against them.

“Perfect competition” is an image rather than an everyday occurrence. But it’s an image that
is powerful enough - and sobering enough - for even the most successful firms.

1. Equilibrium price and quantity will both increase.

a. This would occur as a result of an increase in demand.

2. Equilibrium price will increase and equilibrium quantity will decrease.

a. This would occur as a result of an decrease in supply.

3. Equilibrium price will decrease and equilibrium quantity will increase.

a. This would occur as a result of an increase in supply.

4. Equilibrium price and quantity will both decrease.

a. Demand has decreased, so the market outcome will be at a lower price and
quantity than before.

1. A mining company has discovered huge silver deposits in a previously unmined

region. What impact will this have on the market for silver?

a. Price will decrease and quantity will increase.

i. The new discovery increases the supply of silver, which leads to a

higher quantity and a lower price.

2. Manufacturers of a type of cable used to charge electronic devices have improved

the production process, reducing their costs. Meanwhile, a popular new e-reader that
is compatible with the charger has been released. What is the effect on the market
for the chargers?

a. Quantity increases, and the effect on price cannot be determined.

i. The new manufacturing process increases the supply of the chargers,

but the new e-reader increases the demand. Quantity will certainly
 increase, but the effect on price will depend on the magnitude of these
two changes.

A Hint: How to Answer These Questions

Assessing the impact of any “intervention” on a market—a change in technology, the effect
of new substitutes or complements, the impact of a policy change, etc.—is a very common
and useful exercise.

When you are analyzing the impact of any event or intervention like these on the market
equilibrium price and quantity, you want to ask two simple questions:

1. Has demand changed? If the event affects consumers' WTP, the demand curve will shift.

2. Has supply changed? If the event affects suppliers’ costs, the supply curve will shift.

In question 3 above, both supply and demand increase. That is, both curves shift to the
right. In the interactive graph below, try moving the demand and supply curves to see how
they affect equilibrium price and quantity.

Resolving Shortages via Lottery

To avoid this outcome, suppose that Springsteen decides to have concert tickets allocated
by a lottery to all those who wish to purchase the lower-price tickets. Of course, the lottery
winners would still have to pay for their tickets—but at least they get to go to the concert.
Lottery losers are out of luck.

Incidentally, the idea of allocating tickets—or other goods—via lottery is not uncommon.
This is what is done every year with a portion of the tickets for the Super Bowl, the annual
championship game of the National Football League (NFL) and the second-most
popular annual sporting event in the world (after the UEFA Champions League final in
soccer). Because of its popularity, getting tickets to the game is a very difficult mission that
can require large sums of money: in 2013, the average ticket was sold for $3,521.44, and in
2014 the most expensive ticket cost around $19,200, with a viewing suite for 30 persons
costing around $950,000!

The NFL conducts a lottery each year as a way to sell “less expensive” tickets directly to the
public. Lottery winners have a chance to buy a ticket for the “face value”—around $500.
Only around 500 persons win those tickets—roughly 1% of the stadium’s capacity. The
other tickets are distributed between the playing teams (35%), the hosting team (around
5%), the remaining 29 teams (around 1% each), and the NFL’s media partners and
sponsors (around 25%). In some cases, tickets distributed to teams are also sold via lottery
to their own fans.
If the lottery successfully placed concert tickets in the hands of Springsteen’s desired
attendees, he might think he’d achieved his goal. But not so fast! Remember the ticket
resellers like Ace Ticket, StubHub, and eBay? They might create attractive opportunities for
a fan—even a loyal Springsteen fan—to resell his or her ticket to another person who's
willing to pay a higher price!

Say you’ve just purchased a ticket to your favorite concert—but someone offers you a
higher price for it. At how much more than what you bought the ticket for would you be
willing to sell it instead?

This outcome reflects a frequent—and unintended—consequence of price ceilings: side

markets spring up to resolve the market shortage that was created by the price ceiling. If
there are consumers who are willing to pay more, someone will probably find out a way to
enable them to do that.

Incidentally, this is exactly what happened to Springsteen concert prices. The resale market
simply became more vibrant and active and effective concert prices went up. As a New York
Times article noted recently:

By leaving money on the table, Springsteen and his ilk might be doing their fans an
inadvertent disservice. … The president of Ticketmaster North America told me that
the artists who charge the least tend to see the most scalping. Springsteen and others
have angrily denounced scalping at their shows, but their prices are guaranteeing the very
existence of that secondary market. One of the surest ways to eliminate scalping is to
charge a more accurate price in the first place.

But Springsteen was not done. In response, he requested Ticketmaster (the original
distributor) to issue nontransferable paperless tickets that could not be resold. Buyers would
need to present a photo ID at the event and swipe the same credit card they had used to
purchase the ticket. Not surprisingly, this launched another confrontation:

On one side is Ticketmaster, acting as a proxy for Springsteen, arguing that non-
transferable tickets are meant to foil scalpers who scoop up tickets en masse and resell
them at astronomical prices. On the other are ticket resellers who oppose paperless tickets,
saying they restrict the consumer right to do what they want with tickets they purchase. Both
sides argue that they speak for fans.

One article was wryly headlined: “Ticket resellers show Bruce Springsteen fans who's really
The Boss.”

The questions you just answered are ones that have not only raged on for decades in
market economies, they are also accompanied by extreme polarization of views. And they
are hard to resolve.
Part of the reason for the debate is a practical one: for example, what’s a fair wage? A
related question is whether there’s good reason to believe that market forces, left to
themselves, would result in wages that were “too low”? Indeed, even if one believed that
any individual firm would prefer to pay the lowest wage possible to its workers, competition
between firms would drive wages up. After all, if a firm paid a wage lower than what a
worker’s true productivity merited, other firms could draw away those workers by paying
them slightly more and still retaining some surplus. On top of that, the argument goes, since
markets tend to maximize value or surplus (as we saw earlier), any intervention had better
have sound cause. Otherwise, there’s a real possibility of reducing the total value created
for society as a whole.

What these arguments highlight is the tension between the dual objectives of maximizing
value versus guaranteeing a fair division of value. This tension is central to many debates
around markets today. It’s also a tension that is inherent in several questions in business
strategy. For example, consider an alliance, a joint venture, or a merger between two firms:
even though such business arrangements might be value-maximizing for a given pair of
companies in many settings, any one party may be entirely unwilling to enter into such a
partnership because it gets less out of it than the other.

This is a tension, in other words, that has to do with creating value versus capturing
value. And part of the reason this tension is hard to resolve is that even if one believes that
markets are the best allocative mechanism at creating more value, there’s no guarantee
that market outcomes result in a division of value that most will consider fair.

The Labor Market

But let’s return to the minimum wage and examine its effects through our simple demand-
supply framework.

First, let’s think about the demand for labor. Where does it come from? The demand
comes from firms hiring labor. And applying our concept of a demand curve
straightforwardly to this setting, one can think of the demand curve for labor as simply
representing firms’ willingness to pay for labor.

But, what is their willingness to pay for labor? It’s just the incremental revenue a worker can
generate for the firm. (This is also termed a worker’s marginal revenue product.)

So a firm should be willing to pay its workers any amount up to this marginal revenue
product. Pay less, and the firm gets to keep some revenues; pay more, and the firm loses
money.

Now, what about the supply of labor? Well, let’s figure out where this comes from and what
it looks like.

Think back to your first job during freshman year in college. The job could have been any of
a number of different ones: delivering newspapers, working in the college cafeteria,
cleaning dorms, being a security guard, shelving books in the library, working as a research
assistant, or distributing flyers on campus. (If you never had to work in one of these jobs, or
found a “better” job than any of these—well, let’s just imagine that you weren’t so lucky and,
for the sake of argument, pick your favorite job among the ones listed here.)

Of course, this is a very crude way of estimating the elasticity of your labor supply - but you
get the point. It might have been high—indicating that a small increase in wages would lead
you to work far more. Or, it might have been very low—probably because you just couldn’t
work more hours, since it would take away from your studies (and CORe :)).

It might even be negative. If, for example, you were just looking to earn a certain amount of
income, then as your wages increased, you’d be able to earn that amount by working fewer
hours.

In practice, studies that estimate labor-supply elasticity calculate it for a broad range of
workers, wages, and professions. Aggregate estimates of labor-supply elasticity range from
0.1 all the way to 3 (for some industries), but 0.5 is a fairly plausible number—implying a
fairly inelastic curve.

Now, given the demand and supply of labor, what’s the “equilibrium” wage rate? It’s the
wage at which there’s no excess demand or supply: a wage of w* in the figure below. And
that summarizes the basic market for labor.

The Effects of a Minimum Wage

Now, what’s the effect of imposing a minimum wage?

Notice that if the wage were below w*, it wouldn’t have any effect at all—firms would have
paid workers more than that anyway. We sometimes refer to any minimum wage below w*
as “non-binding.” The more relevant case is when the wage is above w*. What happens
then?
And that’s the problem. At a wage above w*, workers are willing to work some more—labor
supply increases. But at the higher wage, firms are likely to hire fewer workers. A firm’s
willingness to pay for the “marginal worker” L* is w*, which is lower than the minimum wage
wm. So that worker (and other workers with similar productivity) are now unprofitable for the
firm to hire.

The result of a minimum wage? A surplus of labor—or, “unemployment.”

On the face of it, it would seem that mandating a minimum wage for workers is one of those
“no-brainer” policies. Who wouldn’t be in favor of it? But the analysis of its effects turns out
to be very similar to our earlier analysis of concert price ceilings. In each case, a seemingly
desirable intervention had unintended consequences, since market forces undid the effects
of the intervention.

It turns out that whether or not a minimum wage increases unemployment is one of the
most researched questions in labor economics. Some economists have suggested factors
that might make the effects of a minimum wage more complicated than the simple analysis
described above. For example, the supply-demand logic above assumes that firms compete
in hiring labor. (It’s a reasonable assumption in many settings.) Suppose, however, that a
firm doesn’t face much competition when hiring workers: then, it might in fact set wages
below employees’ true productivity. In these cases, requiring firms to raise wages via a price
floor is less likely to raise unemployment.

Labor economists have been trying to nail down the effects of a minimum wage for over two
decades. (For some of the most creative studies, look at the work of Berkeley’s David Card,
Princeton’s Alan Krueger, or MIT’s Joshua Angrist.) And the evidence so far does appear to
indicate that raising the minimum wage—at least from current levels—might have minimal
effects on employment.

But the debate continues to rage on.

By the way, here's some data from the past 75 years on the minimum wage in the US and
how it’s kept up (or not) with the rate of inflation.
1. A minimum wage is more likely to increase unemployment if the labor supply is:
a. Elastic
i. An elastic labor supply would mean employees would want to work
many more hours if wages increased slightly. This would make a price
floor more likely to lead to a surplus of labor.
 An inelastic supply of labor means that changing wages will not have much effect on
the number of hours worked.

2. Under which of the following circumstances would a minimum wage be least likely to
lead to unemployment?
a. There is only one employer in the market
i. If one firm is the only employer in a market, it may be capable of
paying lower wages than its top "willingness to pay," since there are no
other firms competing with it for employees. A minimum wage might
increase wages while keeping them below the firms WTP, in which
case it might not decrease the quantity of labor demanded.
4.2.4 Measuring Fairness
Let’s return to our simple supply and demand analysis of a market (below) and evaluate
how fair the outcomes are.

Is the market outcome “fair”—or, what might lead you to argue it’s unfair?

You've probably already noticed something interesting in your answers to these questions.
Even though the framework we’ve developed around markets appears fairly agnostic about
where demand and supply curves come from—indeed, all that matters for market outcomes
is where the two curves intersect—our notions of fairness are deeply influenced
by where these curves come from.

The fact that firm C captures more value than firm D appears fair: after all, that’s a result of
firm C being more cost-efficient than D. However, the fact that consumer A captures
substantially more value than B doesn’t appear quite so fair—since his high willingness to
pay might simply reflect, in large part, his higher income (or, as economists like to refer to it
somewhat inelegantly, his “initial endowment”).

What factor determines how value or surplus is distributed among different

economic actors in a market?

As we’ve seen in this and earlier modules, each of these factors plays a role in
determining who captures how much value.

Consumers' “initial endowments” (or, their initial distribution of wealth) matter, as we’ve just
seen, since higher incomes usually mean higher willingness to pay, and therefore greater
consumer surplus. Similarly, a firm’s innovativeness will determine how productive its
technology is relative to that of other firms, which in turn affects their relative costs, and
therefore their producer surplus. On top of that, the allocation mechanism matters: as we
saw earlier in this module, pricing and queuing are just two of many different mechanisms
for allocating products in an economy, but they have different implications for whether or not
there’s excess demand or supply, and for who benefits by how much.

And last, the slopes of demand and supply curves obviously matter in determining the
division of value. A relatively inelastic supply curve implies that small demand shocks will
result in large swings in prices for firms. But it also implies that the most efficient firms
capture a lot of surplus, while others capture very little. Conversely, a relatively inelastic
demand curve will result in large swings in prices with small changes in supply, but will also
mean that some high-WTP buyers capture a lot of surplus.

This entire discussion centers around two aspects (or measures) of fairness: first, how
is value distributed between the buyers and sellers that participate in the market.
Second, there’s the pesky question of those who don’t get to transact at all in the market
– those who are way down on the demand curve (like consumer B) or way up on the supply
curve (like firm D). Here, again, our notions of fairness matter greatly, and depend on the
context. Shutting out inefficient firms—or even consumers who can’t afford concert tickets—
is one thing. Shutting out buyers who can't afford food or health care due to high prices is
another.

Springsteen Redux

So who should get seats to Springsteen concerts—the most loyal Springsteen fans, or
those who can most easily afford the seats? How should gasoline be rationed during a
hurricane—to those who are willing to wait the longest time in lines, or to everyone in some
equal allocation? How much should workers get paid—based on market forces that drive
wages up or down, or based on some other notion of fairness?

These questions around fairness arise in nearly every market. And they are very similar to
the questions on which you just offered your views for a “standard” market.

And the reason these questions arouse tension, often times, is the core tension between
the notions of efficiency (that’s concerned with value maximization) and equity (that’s
concerned with value division).

Indeed, we saw this same tension in Springsteen’s battle to reduce concert prices.

Springsteen’s intended effect in setting a concert price ceiling is to reduce concert revenues
and consumer surplus. But he’s fine with that—as long as fans “lower down the demand
curve” get access.
Unintended Consequences of Market
Interventions
By the way, there is something else in these stories that’s useful to remember about
markets: they work through the price mechanism. Indeed, the “force” of prices incentives is
so strong, as we saw, that even when we try to allocate products through non-price means
(as with Springsteen’s concert prices, minimum wage laws, or lotteries), secondary markets
often arise that undo the designed intervention.

That’s exactly the story of black markets as well—when and why they arise and the
debates around how to resolve their problems. Think of the market for marijuana: for a long
time, efforts to intervene or regulate consumption of this substance were based on the
premise that one should try to limit supply. But that had an unintended effect: secondary
markets emerged and drove the price of marijuana (way) up. More recently, efforts to
regulate the market have been centered around the idea that it’s better to increase
competition—thereby driving prices down and driving undesirable elements out of the
market. Now those are two very different approaches to regulating the same market—one’s
based on an effort to limit the force of the market, the other is based on an effort to embrace
it. Whether or not the recent approach works remains to be seen.

4.2.5 The Distribution of Surplus

Returns to Capital versus Returns to Labor
You just explored various measures of fairness: value division between consumers and
firms, value division across consumers, and value division across firms.

Beyond these measures of fairness, there’s another important aspect of value division that
is central to debates regarding inequality and income distribution: the distinction between
labor and capital.

Let's return to our simple demand and supply curves (below), and let’s say they illustrate the
market for smartphones.
The lower, blue, triangle represents the surplus to firms like Apple, Samsung, HTC, etc.

What fraction of this surplus is captured by shareholders (capital) versus workers (labor) in
these firms?

This one is relatively straightforward: remember, the cost of labor is already included in the
supply curve! So producer surplus represents the returns to capital.

Many debates regarding inequality center on the question of the appropriate returns to
suppliers of capital versus suppliers of labor. (And, it’s not just Karl Marx and his
treatise, Das Kapital. Even recent studies—including the celebrated work of French
economist Thomas Piketty in his 2014 book, Capital in the Twenty-First Century—center
their analysis, and much of their evidence, around this very distinction.)

Before examining the “returns to capital” or the “returns to labor,” however, it’s useful to first
understand what exactly is capital and what’s labor.

This is a list of plausible trends that might occur in an economy. As it turns out, however,
this is hardly a random list. They represent the central theses of some of the most influential
economists during the last 200 years or so.

In 1798, Malthus warned about the dire effects of population growth then being witnessed
across Europe. In 1817, David Ricardo described the effect of population growth and
economic development on rents to landowners. The result, Ricardo noted, was a simple
illustration of relative elasticities: since land was inelastic in supply (and therefore scarce),
economy-wide growth would ultimately result in a disproportionate increase in land prices
relative to the prices of other assets.
In 1867, Marx described the possibility of capital returns outstripping the economy for long
periods of time, and leading to its ultimate demise (resulting, he predicted, from labor
uprisings). And in 1971, Simon Kuznets described the effects of technical progress: "Mass
application of technological innovations, which constitutes much of the distinctive substance
of modern economic growth, is closely connected with the further progress of science, in its
turn the basis for additional advance in technology."

Each story was, in effect, a particular economist's prediction of what would happen to their
national economies. Each prediction centered around a particular phenomenon central to
their times: population growth, land scarcity, and innovation. And each story was, ultimately,
a simple story of supply and demand.

Long-Run Trends in Relative Returns

So far, we’ve looked at questions of fairness in the context of a single market—and a more
or less static picture. How today’s market outcomes affect tomorrow’s is not a question
we’ve really considered. But these dynamics—and descriptions of the longer-run trends in
an economy—are often central to questions of fairness and inequality, as these stories
illustrate.

And here's some data on the returns to capital and labor, and how they've changed over
long periods of time. (The data are from Piketty's recent book, Capital.)

A note: The capital-income ratio is measured as the ratio of a nation’s wealth to its income.
"Wealth" and "capital" are used somewhat interchangeably in the book since they both
comprise the various assets in an economy. Not surprisingly, the recent (fifty-year) upward
spike in returns to capital relative to labor – and the causes of it – have sparked fierce
debate.

To summarize:
  Debates over the attractiveness of markets often center around two different
objectives: efficiency and equity. Markets—and market prices—are often an efficient
way of allocating resources. But efficiency may have very little to do with equity or
fairness.
 On top of that, fairness considerations have a lot to do with personal beliefs:
reasonable people can disagree.
 Regardless of personal beliefs, it can be useful to make explicit one’s assumptions,
clarify the relevant measures, and understand the empirical data in any debates
around the “fairness of markets.”
 Even in our very simple framework, "fairness" has multiple dimensions to consider:
firm surplus versus consumer surplus, market participants versus market non-
participants, and capital versus labor.
 Notwithstanding fairness considerations, part of the reason the “efficiency” criterion
is attractive is that it maximizes the total pie available to all parties. So, even if
there’s some other outcome where consumers or producers are individually better
off, the market outcome may still be preferred to all parties - since the incremental
pie obtained from the market outcome can be redistributed appropriately so as to
make everyone better off (or at least no one worse off).
 Lastly, part of the force of markets arises from their "self-correcting" properties: even
seemingly desirable interventions can sometimes have undesirable outcomes—as
we saw in our analysis of price floors and price ceilings.

4.3.1 Online Advertising

Economists love to talk about “widgets.” Nobody knows what a widget is, but we do know
that they are physical objects and they are homogeneous. And that makes them an ideal
candidate for applying the standard framework of supply and demand.

But the supply-and-demand framework can be applied to a far broader range of markets,
yielding further interesting insights. In this section, we’ll apply the supply-and-demand
framework to several phenomena—advertising, exchange rates, and taxation—that aren’t
very widget-like at all. These “products” are not physical objects that you can buy and take
home and they are certainly not homogenous.

In each case, it will be helpful to answer three questions when analyzing the market in
terms of supply and demand:

1. What are the sources of supply and demand in this market—who’s buying
and who’s selling?
2. What drives the shape (or elasticity) of the supply and demand curves? That
is, how sensitive is each side of the market to changes in price and what
factors drive this sensitivity?
3. What forces could shift supply and demand in this market?
 As we saw earlier in Module 2, firms buy advertising space to try to increase the
demand for their products or services. (It’s not only firms that purchase advertising
space—think of campaign advertising, for example—but the logic is similar in those
cases, too.) In 2012, the world’s biggest advertiser was Procter & Gamble (P&G).

Let’s think about what factors influence P&G's willingness to pay for advertising
space. (In Module 2, we were looking at the demand for a firm’s product by
consumers. Here, we are looking at a different demand curve: the demand for
advertising by firms.)

Ultimately, a firm’s willingness to pay for an advertisement is influenced by the

advertisement’s impact on sales and profits. And that’s usually driven by three key metrics:

 The total number of viewers of the advertisement

 The share of “relevant” viewers (that is, those who would potentially buy the
product). For a firm like Procter & Gamble, relevant viewers might be consumers
who are in the market for products like diapers, hair color, laundry
detergent, and beauty products. (You can immediately see why the number of
“relevant viewers” is so large!). Similarly, for General Motors, relevant viewers are
those people looking to purchase a car.
 The probability that the advertisement convinces the relevant viewer to actually buy
the product. This, of course, depends on the effectiveness of the advertisement.

Let’s observe this in the context of a simple example.

Let’s say that Procter and Gamble’s average profit from a Pampers baby diaper is $1. Now,
suppose that it’s considering whether to place an advertisement on a TV program that
reaches 1 million viewers, of whom 30% are new parents, and that the probability of the
advertisement actually convincing a target consumer to purchase a Pampers diaper—
someone who wouldn’t have purchased it in the absence of the ad and instead might have
bought a different brand—is 3%.

Given this information, what’s P&G’s willingness to pay for this advertisement?

The willingness to pay for the advertisement can be calculated simply as:

Average profit*expected increase in quantity demanded

where the increase in quantity demanded is just the number of relevant viewers who would
be more likely to purchase a Pampers diaper as a result of the advertisement (300,000*0.03
= 9,000).

Why does the demand for advertising slope downward?

Now, the first advertisement that P&G airs might be very effective. As viewers see the
fourth, fifth, or sixth ad, the effectiveness of the advertising drops—for example, the
additional ads are not reaching new customers, or existing customers might be getting
annoyed by seeing so many ads. Those are reasons why P&G’s willingness to pay plausibly
decreases for each additional ad.

So that’s the demand side. Let’s now turn to the supply of advertising.

Who supplies advertising space? It’s the media publishers, of course: for example, TV
channels, newspapers, radio stations, and websites that provide “shelf space” to firms for
advertising. In fact, several media firms even explicitly state nowadays that they are in the
business of providing shelf space for advertisers rather than content for viewers. (Ugh!)

What is the cost of supplying advertising space? And why does the supply curve for
advertising slope upward?

The space a media publisher devotes to advertising typically comes at the expense of
space for content (for which consumers pay attention). Advertise more, and you’re likely to
irritate viewers or even turn them away. So an important cost of supplying advertising is
the opportunity cost of lost viewers. Increase the price of advertising, however, and a
media publisher would be willing to supply more advertising space—resulting in an upward-
sloping supply curve.

With an understanding of both sides of the market for advertising, we can understand the
forces that affect the (equilibrium) quantity and price for advertising.

Online Advertising
Let’s now consider the forces that might shift the supply and demand curves: that is, the
reasons that the advertising market could evolve over time.

Consider the major change in the advertising industry during the last 20 years: the advent of
online advertising. Put yourself in the shoes of an advertising industry analyst in the early
2000s, trying to predict how the growth of online ad opportunities would affect the industry’s
size and the price of advertising.

How is an advertiser’s demand curve for online advertising different from the demand curve
for traditional advertising?

Remember the factors that influence an advertiser’s willingness to pay for an

advertisement? Suppose we’re comparing a website that reaches 1 million viewers to a
newspaper that reaches the same number. What’s different, of course, is that online
advertisements can be targeted to precisely the right people—the “relevant” viewers—rather
than just indiscriminately broadcast to everyone.

In our earlier example, P&G’s willingness to pay for a TV advertisement was $9,000. Now
suppose in that example that the TV program drew in another 100,000 viewers—none of
whom were “relevant” for P&G’s product.

In both of these scenarios, P&G's willingness to pay would be unchanged. In other words,
an advertiser’s WTP for an advertisement is only driven by the number of relevant viewers.
Another way to say this is that the ads are “wasted” on all viewers who are not relevant.

And that’s where the promise of online advertising lay: in principle, an advertiser could
more precisely target every viewer on a website with a different advertisement. (Indeed, if
two people go to any given website, chances are they’ll each see a different ad.) Better
targeting implies a higher WTP, resulting in an outward shift in the demand curve and
therefore in a higher price per advertisement (as well as more advertisements).

On top of this, there was another beneficial effect: better measurement. With traditional
advertising, one really didn’t have good measures for whether a viewer did in fact purchase
the product and whether that was linked to the ad exposure. Online, one could in principle
track both advertising exposures and e-commerce purchases far more accurately—making
advertisers more confident in what they were buying.

You can start to see why, everything else being equal, online advertising was supposed to
be the “holy grail” for advertisers and publishers.

Unfortunately, something else happened along the way: online advertising prices (measured
as “cost per thousand” viewers – or "CPM") actually decreased over time. In 2009, an
AdAge article noted that “the pricing appears to be getting worse, not better” as CPM’s were
dropping by as much as 50% year-over-year ( "Online CPM Prices Take Tumble,” by
Abbey Klaassen, January 26, 2009).

So what happened here?

A key effect of the Internet was to dramatically increase the amount of advertising space.
“Everyone is a publisher now” is the refrain on the Web, as any small retailer or individual
blogger could sell advertising space as well. (This was further enabled by advertising
networks that bought ad inventory, aggregated it, and sold it to advertisers—thereby
undermining the claims of major publishers to be differentiated on “broad reach.”) The
result was a nearly infinite supply of advertising space and therefore a rightward shift in the
supply curve.

At the same time, the opportunity cost of advertising was very low for many publishers,
making the supply curve flatter as well.
The net result? Though the quantity of online advertising kept growing over time, the
supply shifts threatened to undo virtually all the benefits of superior targeting and
measurability on online advertising prices.

4.3.2 Cigarette Taxes

On May 23, 1994, Mississippi attorney general Mike Moore filed a lawsuit against the major
US tobacco corporations and affiliated companies, seeking reimbursement for tobacco-
related health expenditures (Evans, Ringel & Stech, 1999). By the fall of 1998, the legal
effort had grown into one of the largest in US history, as more than 40 other states filed
similar suits. The four largest US tobacco companies, nervous about a potentially
devastating trial outcome, were signaling their interest in a settlement, floating numbers that
would make this the largest civil settlement in US history.

One of the settlement issues actively under discussion was a quantity-adjusted fine,
effectively an excise tax on cigarettes. The rationale behind such a tax was stated
succinctly by Mike Moore: “[The] lawsuit is premised on a simple notion: you caused the
health crisis; you pay for it.”

Moore’s logic has intuitive appeal. But as we saw in our previous analyses of concert prices,
minimum wages, and online advertising, the effects of an intervention depend on both the
supply and demand effects. Specifically, we need to understand both in order to understand
the effects of an excise tax on equilibrium prices and firms’ revenues.

Let’s return to our simple supply and demand analysis. The supply curve is simply the firms'
marginal cost of producing cigarettes.

The effect on supply is straightforward: for any pack produced, a firm’s costs increase by $1
now—the amount of the tax.
But we’re not home free. For that, we need to bring in the demand curve so that we can
examine the effect a $1/pack excise tax has on equilibrium price and quantity.

Here’s what the demand curve for cigarettes looks like:

Although the tax reduced industry revenues, the reduction was far smaller than the total
amount of the tax. But how can this be? The reason is that most of the tax was simply
“passed through” to consumers in the form of higher prices. In other words, although all of
the tax revenues are collected from the tobacco companies, in reality the tax burden falls
on consumers through higher prices.

This notion of the “true burden” of a tax is known as the “economic incidence” of a tax. In
the instance above, the incidence of the cigarette tax falls primarily on consumers, not
firms.

But is that always the case? What determines the incidence of a tax? Let’s go back to our
model and examine it further.

What determines the true incidence of any tax is just the elasticity of the demand and
supply curves! Look at the graphs below, in which the same tax is imposed on markets with
two different demand curves:
Much more of the tax is paid by consumers in the graph on the right, where demand is
more inelastic.
As you can see, the same tax will have different effects depending on whether demand is
relatively elastic or inelastic. When demand is relatively elastic, the tax burden falls on
producers. Consumers are more easily able to substitute away from the product as prices
rise, so firms bear the tax cost. When demand is relatively inelastic, the tax—even when
“imposed” on producers—is mostly passed on to consumers through higher prices (since
they cannot as easily substitute away from the product), so consumers bear the brunt of the
tax.

4.3.4 The China Growth Miracle

China has the second-largest GDP in the world, having grown at an astonishing rate of over
10% for much of the 1980s and 1990s. Let’s take a look at the evolution of China’s pro-
growth investment policies over the years through our demand-and-supply lens.

Here’s a very simplified version of the story, and how it started. (For more details, refer to
this paper by Dani Rodrik.)

During the 1970s, industrial progress was beginning to take hold in Chinese cities, making
urban Chinese workers more productive and pushing up their wages.

As urban wages increase, what type of response would you expect in the labor market?

Normally, as we saw earlier in this module, one might expect a self-correcting response to a
change in price: as urban wages increase, urban migration should be expected to increase
in response, which would in turn reduce the wage hikes by increasing the supply of labor.
This did not happen, however—and a main reason was the tight restrictions at that time on
the ability of workers to relocate, so that labor supply was fairly insensitive to this increase
in wages.

In 1979, however, internal migration restrictions were scaled back. Not surprisingly, the
period thereafter saw a large influx of rural workers seeking those higher urban wages. And
with a large share of labor being reallocated to more productive jobs, China’s economic
growth accelerated.

This pattern of urbanization and economic growth was not lost on Chinese leadership. In an
effort to speed up economic development further, the government looked to implement
industrial policies to accelerate the rise of urban wages and the corresponding labor
migration.

But how to do this? In order to be successful, such policies needed to raise demand for
labor among industrial firms in Chinese cities. One key tool was China’s massive state-run
banking system, which exercised a degree of control over which firms received capital and
at what interest rates.

A primary pro-growth policy in late-1980s China was to provide very-low-interest loans to

urban firms. “Cheap urban capital” was intended to realize the objective of faster economic
growth. How?

Since capital is generally a complement to labor in the production process, subsidizing it

increases the gains from hiring additional workers. (Imagine a textiles factory that can
suddenly invest in sewing machines more cheaply…it’s time to hire more tailors!)
Pro-industrial policies continued through the 1990s. And so did China’s growth. Between
1980 and 1995, China experienced growth rates nearly unprecedented in emerging
economies.

But in 1986, China took part in the Uruguay Round of talks on The General Agreement on
Tariffs and Trade (GATT), a multilateral agreement on trade regulation that would eventually
form the basis for the establishment of The World Trade Organization (WTO).

And with a seat at the table of GATT (and eventual WTO membership), China faced a
challenge. Among the restrictions imposed by the WTO is a prohibition against policies
subsidizing domestic industries, such as loans at artificially low interest rates. This created a
conundrum for Chinese leadership: how to sustain the urban growth momentum without
violating the WTO’s restrictions against subsidizing domestic investment?

Module 4
Markets describe relations between buyers and sellers – or, what happens when demand
curves and supply curves come together. Module 4 examined certain properties of markets,
the sense in which markets “perform well,” and some challenges with intervening in
markets.

Equilibrium

The price and quantity designated by the intersection of demand and supply curves is
usually referred to as the “market outcome” or “market equilibrium.”

When prices exceed the equilibrium price, quantity supplied exceeds quantity demanded,
resulting in excess supply of the product. When prices are lower than the equilibrium price,
quantity demanded exceeds quantity supplied, resulting in excess demand for the product.
Situations of excess demand or excess supply typically result in price adjustments until
market equilibrium is reached.

At market equilibrium, consumer surplus + producer surplus (also known as the “total
welfare” or “total surplus”) is maximized: this is the property of efficiency. That is, there is no
dead-weight loss, or a loss in value from trades between buyers and sellers that could have
occurred but did not.
Market equilibrium need not ensure an equal or “fair” distribution of surplus between
consumers and producers, however, or across consumers or producers. (This is the
principle of equity). The distribution of consumer versus producer surplus depends on the
elasticity of demand and supply curves, among other things.

Factors that shift demand and supply curves also result in changes in the market
equilibrium. Predicting how demand and supply curves might shift in the future is important
in understanding how a firm’s profits, or consumer surplus, might change.

A firm that is making substantial profits in the short-run may return to zero profits in the long-
run. Some reasons that allow firms to sustain profits in the long-run include government
regulation, economies of scale, network effects, sustained innovation, or other “barriers to
entry.”

Market Interventions

Interventions in markets (by governments or other actors) are often undertaken in an effort
to achieve “fairer” outcomes. Common forms of intervention involve price ceilings or price
floors.

A price ceiling sets a maximum price that can be charged for a product. If the maximum
price is above the market outcome, the price ceiling will have no effect. If the ceiling is lower
than the market outcome, more consumers will want to purchase the good than producers
will want to sell it, resulting in “excess demand” or a shortage.

A price floor sets a minimum price that can be charged for a product (e.g., a minimum wage
mandate). Price floors result in excess supply, or surpluses. (In the case of a minimum
wage, a surplus would be unemployment).

Such interventions in markets (that lead to excess demand or supply) can often result
in informal side markets where prices adjust to eliminate the shortage or surplus.

The Analysis of Market Interventions

The analysis of any market intervention typically requires analyzing (a) what happens
to both demand and supply curves, and (b) how these changes affect market equilibrium.
An important application is taxes. A tax levied on a firm or producer will, in effect, increase
the cost of producing the good – and shift the supply curve upward (or to the left). A tax
levied on consumers will, in effect, reduce (or shift leftward) the demand curve that firms
face. A tax will have the same impact on market equilibrium whether it is explicitly (or
“statutorily”) charged to the producer or the consumer: the economic incidence of a tax is
unrelated to its statutory incidence.

Whether consumers or producers “pay” a higher portion of the tax will depend on the
elasticity of demand and supply curves: consumers bear most of the tax cost if the demand
curve is steeper (or “inelastic”). Likewise, producers bear most of the tax cost if the supply
curve is steeper. Taxes, like price ceilings and price floors, decrease the total surplus
captured in a market (resulting in dead-weight loss).

Creating Markets

Markets can be created in environments where they may not previously have existed, by
assigning ownership of a good to individuals, or by creating a forum in which individuals can
trade. One interesting application of markets is prediction markets, in which buyers and
sellers purchase “securities” whose value depends on future events. The probability of
these future events occurring can be inferred from the price set on the securities.