Got Lobster?

It’s a good thing I don’t have to watch my cholesterol, because after moving to the Maine seacoast last July, I simply cannot get enough lobster. Though I haven’t had to worry about the health cost of consuming lobster, I have been paying attention to changes in the dollar cost over the course of the season. Monitoring prices doesn’t get any easier for this lobster-loving Mainer because every day on the way to my son’s school, I drive by a sign advertising the current price.

The start of the lobster season coincides with an increase in the demand for lobster as summer vacationers head to the Maine beaches. In York, Maine, alone, the population triples during peak season then drops back down again once the school year begins. An increase in demand means upward pressure on price, while an increase in supply means downward pressure on price.

As lobster season came to a close in the summer of 2012, however, word on the street was that there was a surplus of lobsters. With quantity supplied larger than quantity demanded, downward pressure dropped lobster prices to an astonishingly low $2.99/pound for chix (lobsters weighing between 1 and 1.24 pounds), making lobster in southern Maine cheaper than a good steak at the time.

As lobster season ended and the bitter winter set in, the per-pound price of lobster started to tick upward. This is consistent with the basic model of supply and demand—once lobster season was over, supply decreased which put upward pressure on prices and demand decreased which put downward pressure on prices . Over the last year, it appears that supply changes have been more drastic than demand ones, thus the same good that had cost roughly $3 per pound in the summer cost nearly $10 per pound by March 2013 simply because of changes in supply and demand.

Between summer and winter, supply changes outweighed demand effects in the market for Maine lobsters (as evident in the large increase in price), so I am hopeful that lobster prices will drop in the coming months as supply increases so that I can enjoy my favorite butter conduit once more!

Discussion Questions

1. Using a supply and demand diagram, illustrate the shifts in demand and supply after the lobster season ends. Be sure to pay attention to the magnitudes of your shifts so that the equilibrium price rises as described in the article.

2. If  lobster fishermen have a bad catch this summer, what would you expect to happen to the price of lobster in Maine in July?

3. How do fluctuations in the market price for lobster affect other markets for food products such as steak and chicken?

How Much Does It Cost To Make Cookies?

“Buyers know what goods cost.” Some version of that assumption comes up in the very first weeks of just about every introductory econ course. It becomes one of the few assumptions that we make to build the model of consumer demand. But every once in a while, life gets in the way and asks “Is that something you really can assume?”

I had to test that assumption recently. I just moved and after unpacking, I was in the mood to make dessert for myself. Of course, I hadn't brought many kitchen supplies with me, so that quickly posed a problem. To make cookies, I needed to buy some wooden spoons, measuring cups, and a cooling rack. None of those are hard items to find, and I happened to live just minutes away from a shopping center that had a regional grocery store, a Wal-Mart, a Target, and a regional department store. I knew that all four stores should have what I want, so the question of where to go really came down to where it would cost the least. And that’s when I realized that one of the most basic assumptions of microeconomics didn't hold true. I didn't know which store would be the cheapest, or even what the prices of the goods should be!

I had some free time on a Saturday and a strong enough curiosity that I wanted to sample prices from each store. Here’s what I found:

STORE	WOODEN SPOON (Dollars per spoon)	COOLING RACK (Dollars per rack)	MEASURING CUPS (Dollars per cup)
GROCERY STORE	$1.50	$4.50	$1.22
WAL-MART	$2.97	$2.99	$1.32
TARGET	$2.03	$3.67	$4.97
DEPARTMENT STORE	$12.00	$7.00	$7.50

I was also shocked by the spread in prices. While I did expect to see some markup at higher-end stores, the range was wider than I expected. I was also surprised that there wasn't one store that had the cheapest prices, across-the-board, for all the goods.

When economists create models, the goal is to make a few assumptions about the world to describe the “typical” human response and show how that response leads to a “general” outcome. My behavior in this case is not what economists would call “typical.” (My friends might even call it weird!) But even for the typical consumer, are the assumptions of the supply and demand model always appropriate?

In a lot of cases, the classic supply and demand model does gives accurate results, but sometimes the assumption that consumers know the distribution of prices isn't appropriate. In those cases, it’s important to understand how behavior will change if an assumption is violated. The classic model does not involve consumers looking for prices, they just know them. As economists, we often say we are assuming “complete information.” When consumers don’t have complete information the market price typically doesn't match the equilibrium price the model predicts. Most of the time the market will be inefficient (contrary to what the model suggests) and both producer and consumer surplus will be lost.

Throughout economics, every conclusion that we draw from a model depends on the assumptions that are used to build that model. Whenever I learn about a new model, I always list the assumptions made and focus on how the results change if the assumption would be removed. Understanding the relationship between assumptions and results is the critical step to applying what we learn from theory and using it to understand what happens in the real world.

DISCUSSION QUESTIONS: 

1. When I was getting my information I found that stores rarely carry the exact same goods. (Even if they are the same brand, the packaging might be different. It’s why I calculated my information in per unit prices.) Since I was able to find the goods in multiple locations, but they were not identical, which market structure is the most appropriate to describe kitchen supplies: Monopoly, Oligopoly, Monopolistic Competition, or Perfect competition? Why?

2. While my shopping behavior was a bit different than most people for kitchen supplies, people do “search” when they buy certain goods. Name some items where the supply and demand model isn't as appropriate as a consumer search model would be. Why is it more appropriate to think about consumers searching for these goods?

3. An important part of search theory talks about the cost of searching. Suppose I didn't live near a shopping center and the stores were all 20 minute drives apart. How do you think that distance (and the opportunity cost associated with traveling between them) would change my behavior when I search? How would it change the pricing behavior of the stores?

Assumption Corruption

A famous economics joke says it best: A physicist, a chemist and an economist are stranded on an island, with nothing to eat. A can of soup washes ashore. The physicist says, "Let’s smash the can open with a rock." The chemist says, "Let’s build a fire and heat the can first." The economist says, "Let’s assume that we have a can-opener..."

Though the above example is meant to be extreme, all economic models are based on underlying assumptions. They may pertain to variety of things such as the market structure, pricing mechanism, location, time lags, frictions, mathematical properties, etc., and they are used to simplify economic relationships.  An important assumption that drives many popular economic models is that of perfect information. In particular, models rely on the assumption that the prices of all goods and services are known.

As I was recently perusing the latest status updates of my Facebook friends, I noticed the following post: “How much do you pay a 14-year-old high school freshman as a mother’s helper a few days a week?”

As an economist, one might be inclined to quickly answer “whatever the market price is for that service!” However, it is clear from this post that that information is not actually known to the buyer.

While the internet has clearly helped to alleviate this information gap, it can still take time to gather all the relevant information necessary to make an informed decision. Sometimes, the cost of obtaining this information becomes so high that consumers decide not to research at all. For example, if you want to buy a hair dryer, a quick internet search may result in the same model offered at different stores for different prices, so you still wouldn’t know the relevant price for your needs without more digging.  

Even though the famous supply and demand model does not completely reflect the real world (since it assumes, among other things, that prices are known), this is not meant to imply that economic models are worthless. It would be impossible to model every detail of the “real world”; rather, it's important to make sure the assumptions are appropriate for what you are trying to analyze. For example, if you’re trying to model the effects of an increase in fuel price on consumers’ demand for SUVs, assuming perfect information for prices does not invalidate the results that it will decrease the demand for this good; it merely simplifies the model into something tractable. But in general, you’ll want to ask yourself the following questions when you examine an economic model: Are the assumptions of this model reasonable? Would changing the assumptions affect the result in a drastic way?

In short, be careful not to become a victim of assumption corruption, but don’t let fear of assumptions keep you away from using models at all either!

Discussion Questions

1. Another popular assumption is that agents act rationally and are utility-maximizers. How can this assumption still be valid in the presence of people volunteering their time or donating money?

2. Consider some other assumptions for the supply and demand model, such as price-taking behavior or the competitive hypothesis. How would relaxing those assumptions change the results of the model, if at all?

3. Why do we study economic models that don’t perfectly match our experience in the real world?

4. What are some other markets where the assumption of perfect information does not hold true in the real world?

Kicking through the Ceiling

In the sports world, it has become cliché for people to say that every second counts. However, we expect that phrase to apply on the field, not to the teams trying to get there. Recently, a friend of mine wanted to register his team for a local kickball league. The registration was online only, starting at noon. He had a problem with his credit card that slowed him down, and by 12:02, all the spots in the league were taken and his team was shut out.

Rather than seeing his misfortune as a sign of kickball’s growing popularity, or the quick typing skills of other kickball managers, the first thing that came to my mind was that the market for league entries must be distorted. The league uses public fields that also need to accommodate other sports and high schools, so time on the fields is limited. Since the kickball league will only have a fixed number of hours on the fields, and since the season needs to accommodate a set number of games, it’s fair to think about the supply of league space as fixed, or perfectly inelastic. Most importantly, even at very high market prices, there is no way to add additional teams to the league.

If limited space were the only constraint on the market, then we could find the equilibrium for the market at the intersection of supply and demand, and thus know the equilibrium price where there are exactly as many teams willing to pay as there are spaces in the league. However, since the league filled up so fast, and teams (like my friend’s) that are willing to pay more than the $500 entry fee are unable to join, it appears that there is an artificial price ceiling in this market. Since the league is publicly run, it is likely that someone decided on a “fair” price to charge, so that entries in the league would be open to people of varying incomes. Unfortunately, price ceilings create shortages, that is, they force some people who desperately want the good to go without it. When goods do not sell for the unrestricted equilibrium price, people who value the entries the most do not necessarily receive them. Thus, the shortage caused by a binding price ceiling will end up lowering society’s total welfare.

Can economic theory suggest a solution that would still offer entries at the “fair” price, but also make sure the entries go to the teams that value them the most? Suppose that the league entries were still given out the same way, but once initially purchased by a team manager, an entry could be resold to a team that did not sign up fast enough, if both parties agree. Teams that got entries and value them at least as much as the equilibrium price will hold on to their entries, but teams that were too slow to purchase them initially will be able to buy them from teams who value them less than the equilibrium price. In terms of the final price and quantity of entries, making the league entries tradable will achieve the same result as removing the price ceiling altogether: the market price for the tradable entries will rise to the unrestricted equilibrium price, and the teams that value them the most will end up in the league. However, setting a lower price initially allows some teams the opportunity to buy that otherwise wouldn’t be able to get them. Society’s total welfare is maximized by either making the entries tradable or removing the price ceiling, the only difference is who earns the surplus. As you can see, there are different ways to maximize society’s welfare. Some can be more complicated than others, but they can accommodate different concerns about fairness.

DISCUSSION QUESTIONS:

1) Currently, the market mechanism used to allocate kickball league entries is first-come-first-served. What behaviors does this sort of mechanism encourage?

2) If league entries are tradable and originally given on a first-come-first-served basis, who would attempt to get the initial entries? Is there a chance people who do not want to have a kickball team might apply for a slot? Under a tradable permit system, does the way the entries are initially allocated affect who receives the most welfare?

3) The Coase Theorem is a public economics result that applies to markets where governments want to reduce pollution. It says that the most efficient way to reduce pollution to any desired level is to give firms in an industry permits to pollute the desired amount, and then allow the firms to trade the permits. Consider the similarities between a fixed number of kickball league entries and a fixed amount of pollution by an industry. What results would you expect to see in the market for pollution permits? What effect would creating that market have on society’s welfare?

Low Carbs, High Fat…High Prices?

"One box will cost you $740, but if you don’t like it, you could try your luck with the Russian smuggler down the street." There are plenty of goods that might be sold based on discussions like that, but would you ever expect to hear that said about butter? Residents in Norway are currently facing a market like that, according to recent reports.

A recent diet craze emphasizing high fat and low carbs has caused a change in Norwegian consumer preferences. Fads and trends will change the equilibrium price and quantity observed in a market by shifting the demand curve. In this case, the popular new diet increased the demand for butter (shifting the demand curve to the right), while leaving the supply curve unchanged. The standard supply and demand model says a rightward shift of the demand curve leads to an increase in the equilibrium price and quantity consumed. Both of those were observed in real life, as well.

Nonetheless, changes in tastes rarely result in price fluctuations of this magnitude, so how do economists explain why the cost of butter went so high? We see increases (and decreases) in demand every day, but prices rarely swing so wildly. A closer look at the details sheds some light on the source: the government is preventing the free market from doing its work. As the Swedish Dairy Association (Svensk Mjölk) noted, Norway has “very restrictive trading policies, borderline protectionist.” That means that the Norwegian government’s policies make it very difficult (or even impossible) for foreign goods to enter the domestic market.

Though the government does this in an effort to protect Norwegian producers, protective policies like those block markets from working efficiently. When a “shock” to supply or demand occurs (in this case, an increase in demand), protectionist policies prevent foreign producers from entering the market to capture new profits. Because the trend hit quickly, and the production time for agricultural goods isn’t exactly short (you can’t just go out and rent an extra 200 cows overnight), the Norwegian market for butter appears to be relatively inelastic in the short run (that is, even a small percentage change in the quantity supplied is associated with a large percentage change in price). If this trend in preferences continues, prices will remain high until producers have time to react by expanding their farms to accommodate more livestock, hire more workers, and install more processing equipment.

Does that mean that Norwegian consumers are going to continue facing these brutal prices for the coming months? Only time will tell, but if prices persist, it would be a testament to a population stubborn enough (or wealthy enough) to stick to the latest trendy diet, and a government dedicated to hard-line international policies, even at the cost of its own citizens’ welfare.

DISCUSSION QUESTIONS:

1) A change in preferences isn’t the only way that the demand for a good can change. What are some other factors that could cause the demand for butter to increase?

2) Rather than demand returning to where it was (the end of interest in the fad diet), the equilibrium price of butter could also decrease if supply shifts. Which direction would the supply curve need to shift for that to happen? What would happen to the equilibrium quantity? What are some ways that the supply could shift in that direction?

3) Suppose the Norwegian government feels pressure to help lower butter prices. Propose a policy that would help lower prices in the market. Is there a policy that the government could use to generate revenue for itself while lowering the price of butter?

Revisiting the Reach of the BP Oil Spill

A year ago, cleanup efforts to recover from the Gulf oil spill were just beginning, but the effects of the spill were already finding their way into markets. While the debates and projections attempt to forecast how far the oil will spread, economists understand that the effects of the spill will reach further than the oil itself ever could. While many initial discussions focused on the local impact of the disaster, applications of the basic supply and demand model shed light on how a regional disaster can spread to national and global markets.

Soon after the disaster, the Associated Press reported that the price of shrimp started to climb in response to the spill. To begin to understand why, consider the direct effect of the spill on the supply of shrimp caught in the Gulf. The graph to the left reflects the market for Gulf-coast shrimp. As shown on the graph the oil spill reduces the supply of locally caught shrimp in the gulf as fishermen have been prevented from conducting much of their normal business. In response to the reduced supply, the equilibrium price rises, while the amount of shrimp sold falls.

Assume that shrimp caught in the Gulf and shrimp caught elsewhere are separate goods, though the markets for each are clearly related. Aside from the environmental problems associated with catching shrimp in the gulf, there may be variations in quality or style between shrimp caught in different locations. That said, shrimp are still shrimp, so even if consumers have a slight preference for one type or another, shrimp from other locations can be considered substitutes. When two goods are substitutes, an increase in the price of one of the goods causes an increase in demand for the other, all else held constant. When the market price for Gulf-caught shrimp rises (along with concerns that shrimp caught in the gulf may be contaminated) many buyers will look to purchase shrimp from other regions, like North Carolina, South Carolina, Georgia, and Texas. The second graph to the left illustrates how an increase in the price of a one good (Gulf shrimp) causes an increase in the demand for a substitute good (non-Gulf shrimp). The result here matches the reports by the AP: An increase in the equilibrium price and quantity of non-Gulf shrimp due to the effects of the oil spill.

Interestingly, the effects of the oil spill will also be felt by companies that have nothing to do with catching anything from the sea. For example, consider the market for tartar sauce. Many people like putting tartar sauce on their shrimp when they eat it, but have no desire to eat tartar sauce on its own. Economists would call tartar sauce a compliment to shrimp. When two goods are compliments, an increase in the price of one of the goods causes a decrease in demand for the other, all else held constant. On the final graph below, you can see the effect that higher equilibrium prices of shrimp have on the tartar sauce market. When the market price goes up, consumers will purchase less shrimp, and if less shrimp is consumed, consumers have less of a need for tartar sauce. This decreases the demand for tartar sauce, resulting in a decrease in the equilibrium price and quantity of tartar sauce.

There is still too much uncertainty about how much damage has been caused and the extent of the long-term effect on the environment for economists to reliably give exact figures on how these markets will change. However, the basic supply and demand confirms that the effects of this spill can be seen far beyond the Gulf region.

Discussion Questions:

1) How will the elasticity of supply and the elasticity of demand for non-Gulf shrimp affect the magnitude of the change in equilibrium price and quantity? How do economists describe the magnitude of a change in demand for one good in response to a change in the price of another?

2) What other markets do you expect to be affected by a change in the price of shrimp? What will happen to the equilibrium price and quantity in each of these markets? Are these goods compliments or substitutes?

3) Suppose that instead of an oil spill earlier this year, weather patterns had changed to make the shrimp season in the Gulf abnormally productive. If it were easier to catch shrimp in the gulf, what would you expect to happen to demand for shrimp caught in other regions? What about the demand for complementary goods like tartar sauce?

4) If you wanted to work on a shrimp fishing boat, all else held constant, which labor market do you think would be more favorable to join, one in the Gulf coast or one in South Carolina? Why?

5) Suppose the fishing industry is monopolistically competitive. Do you expect firms to enter or exit the market in the Gulf right now? In the long-run, assuming that fishing conditions return to their pre-spill levels, what can you say about the firms that will be in the market? Is it possible that any existing firms will be better off now than they were before the spill? If so, how?