McConnell Economics, Chapter 3
McConnell Economics, Chapter 3
Discussion of the curriculum McConnell, Brue, Flynn Economics text, chapter3.
Re: McConnell Economics, Chapter 3
This chapter is a heavy hitter. The market model is what I'd say is the basis for all of economics. The classic model is a graph with price on the Y-axis, quantity on the X-axis a downward sloping line representing demand and an upward sloping line representing supply. Where the two lines cross is where supply and demand are equal, which tells us the price and quantity of the good.
A confusing math point: Supply and demand functions are usually written as quantity being a function of price. When price is written as a function of quantity, the function is referred to as the "inverse supply/ demand" function. However, the graph of the classic model shows price as a function of quantity (following the mathematical convention of putting the dependent variable on the vertical or "Y" axis). If you don't know what I'm talking about don't worry about it, but this was confusing as fuck to me for at least a year.
I'm going to write a short summary of what I feel were the most important topics covered in this chapter:
(Consumer) Demand: Demand, represented in table, graph or functional form shows the quantity demanded of a specific good or service at different price levels.
As price falls, if everything else remains the same, consumers will demand more of a certain good. Thus demand curves are downward sloping.
To move from individual to market demand, sum all individual demand curves.
(Producer) Supply: Supply, represented in table, graph or functional form shows the quantity of a specific good or service supplied at different price levels.
As price falls, if everything else remains the same, producers will supply more of a certain good. Thus supply curves are upward sloping.
Shifts in Demand and Supply:
The model captures only the effect of price on quantity. If an outside ("exogenous") change occurs the curves will shift. An outside supply (demand) change will cause producers (consumers) to supply (demand) a different quantity of goods at each price.
The book lists some likely reasons for demand shifts: A change in consumer preferences; a change in the number of consumers in the market; a change in consumers' income; a change in price of related goods; a change in consumer expectations about the future.
And supply shifts: A change in resource (input) prices; a change in technology; a change in taxes or subsidies; a change in the price of other goods; a change in future price expectations; a change in the number of sellers in the market.
The market is in equilibrium when the supply and demand functions meet. This determines the quantity exchanged in the market and the price of exchange.
The rest of the chapter covers what happens in specific cases of supply and demand shifts. It's useful to read about these and think through them, but I'm not going to include each of them in this summary.
The supply and demand model is strangely beautiful when you understand it. This is why capitalists and libertarians get on their high horse about market efficiency. When it's working, the market will distribute resources in a Pareto efficient manner, without any outside management. This is the "invisible hand."
The tragedy is a misunderstanding of the assumptions that are required to make this work, which we talked about briefly in the discussion on Chapters 1 & 2.
A confusing math point: Supply and demand functions are usually written as quantity being a function of price. When price is written as a function of quantity, the function is referred to as the "inverse supply/ demand" function. However, the graph of the classic model shows price as a function of quantity (following the mathematical convention of putting the dependent variable on the vertical or "Y" axis). If you don't know what I'm talking about don't worry about it, but this was confusing as fuck to me for at least a year.
I'm going to write a short summary of what I feel were the most important topics covered in this chapter:
(Consumer) Demand: Demand, represented in table, graph or functional form shows the quantity demanded of a specific good or service at different price levels.
As price falls, if everything else remains the same, consumers will demand more of a certain good. Thus demand curves are downward sloping.
To move from individual to market demand, sum all individual demand curves.
(Producer) Supply: Supply, represented in table, graph or functional form shows the quantity of a specific good or service supplied at different price levels.
As price falls, if everything else remains the same, producers will supply more of a certain good. Thus supply curves are upward sloping.
Shifts in Demand and Supply:
The model captures only the effect of price on quantity. If an outside ("exogenous") change occurs the curves will shift. An outside supply (demand) change will cause producers (consumers) to supply (demand) a different quantity of goods at each price.
The book lists some likely reasons for demand shifts: A change in consumer preferences; a change in the number of consumers in the market; a change in consumers' income; a change in price of related goods; a change in consumer expectations about the future.
And supply shifts: A change in resource (input) prices; a change in technology; a change in taxes or subsidies; a change in the price of other goods; a change in future price expectations; a change in the number of sellers in the market.
The market is in equilibrium when the supply and demand functions meet. This determines the quantity exchanged in the market and the price of exchange.
The rest of the chapter covers what happens in specific cases of supply and demand shifts. It's useful to read about these and think through them, but I'm not going to include each of them in this summary.
The supply and demand model is strangely beautiful when you understand it. This is why capitalists and libertarians get on their high horse about market efficiency. When it's working, the market will distribute resources in a Pareto efficient manner, without any outside management. This is the "invisible hand."
The tragedy is a misunderstanding of the assumptions that are required to make this work, which we talked about briefly in the discussion on Chapters 1 & 2.
-
jacob
- Site Admin
- Posts: 16001
- Joined: Fri Jun 28, 2013 8:38 pm
- Location: USA, Zone 5b, Koppen Dfa, Elev. 620ft, Walkscore 77
- Contact:
Re: McConnell Economics, Chapter 3
It's interesting to me how much clout the supply and demand curves get in economic thinking given that they're invisible and only exist by postulation to serve as a model framework. Mathematically speaking, they're only known locally at the point of the clearing price. It's very hard to know the curves further away because you'd literally have to poll all the consumers in the market about how much more quantity they'd like if the price was this or that much lower. And ditto all producers on the other side.
In [investment] practice, this means you have a lot of freedom in terms of how you imagine those actual demand curves. They all become linear (and discontinuous) locally, but what's relevant [for alpha profit] is how they look further away.
If you have access to so-called Level 2 data (google it) you can actually see a bit more of the supply/demand curves to see what I mean. The order book will show quantity and prices on both demand (bids) and supply (asks). Lets have a look at http://markets.cboe.com/us/equities/ (only works when the US markets are open)
So GE might look like this
...
sell 11000 shares at 11.93
sell 9661 shares at 11.92
sell 1400 shares at 11.91
buy 18000 shares at 11.90
buy 38000 shares at 11.89
...
The bid-ask is thus 11.90-11.91. The spread is 0.01 (the difference). A market order is a "taker" order and is considered aggressive because it crosses the spread. For example, a market buy above would happen at 11.91 ... if you market bought 2000 shares, 1400 would clear at 11.91 and 600 at 11.92. Sells are similar but on the order side. Note the curves are actually discreet in practice.
A market is considered "efficient" when the spreads are low. Compare to AAPL which is less efficient.
BTW if you draw the supply and demand curves like this, you can actually predict (with 60-70% accuracy) what the next price is going to be. For example, here the next trade is likely to happen at 11.91 because there are "more buyers than sellers". Now you should also understand what professionals mean when they say that. It's implied that "there are more buyers than sellers FOR A GIVEN PRICE" because each trade of course has exactly one buyer and one seller. Understanding the curves also means that on a day where there were "more buyers than sellers" => the price likely went up.
This is why volume is highly relevant and about as relevant as price in real world investing.
What's interesting in this real world example is that you only see the demand curve up to the price point where sellers cut half of it off. You'll never know how many would be willing to pay 11.95 because right now sellers are already filling at 11.91.
What supply and demand curve thinking does is to ignore the game theory and negotiation that's actually going on in the market place. It's a theoretical construct that in some ways is more bizarre than the postulation of fundamental particles. We never seen them directly, but the world acts as if they exist.
If you want to know more about [the mechanics] this, look into "market microstructure"
In [investment] practice, this means you have a lot of freedom in terms of how you imagine those actual demand curves. They all become linear (and discontinuous) locally, but what's relevant [for alpha profit] is how they look further away.
If you have access to so-called Level 2 data (google it) you can actually see a bit more of the supply/demand curves to see what I mean. The order book will show quantity and prices on both demand (bids) and supply (asks). Lets have a look at http://markets.cboe.com/us/equities/ (only works when the US markets are open)
So GE might look like this
...
sell 11000 shares at 11.93
sell 9661 shares at 11.92
sell 1400 shares at 11.91
buy 18000 shares at 11.90
buy 38000 shares at 11.89
...
The bid-ask is thus 11.90-11.91. The spread is 0.01 (the difference). A market order is a "taker" order and is considered aggressive because it crosses the spread. For example, a market buy above would happen at 11.91 ... if you market bought 2000 shares, 1400 would clear at 11.91 and 600 at 11.92. Sells are similar but on the order side. Note the curves are actually discreet in practice.
A market is considered "efficient" when the spreads are low. Compare to AAPL which is less efficient.
BTW if you draw the supply and demand curves like this, you can actually predict (with 60-70% accuracy) what the next price is going to be. For example, here the next trade is likely to happen at 11.91 because there are "more buyers than sellers". Now you should also understand what professionals mean when they say that. It's implied that "there are more buyers than sellers FOR A GIVEN PRICE" because each trade of course has exactly one buyer and one seller. Understanding the curves also means that on a day where there were "more buyers than sellers" => the price likely went up.
This is why volume is highly relevant and about as relevant as price in real world investing.
What's interesting in this real world example is that you only see the demand curve up to the price point where sellers cut half of it off. You'll never know how many would be willing to pay 11.95 because right now sellers are already filling at 11.91.
What supply and demand curve thinking does is to ignore the game theory and negotiation that's actually going on in the market place. It's a theoretical construct that in some ways is more bizarre than the postulation of fundamental particles. We never seen them directly, but the world acts as if they exist.
If you want to know more about [the mechanics] this, look into "market microstructure"
-
Riggerjack
- Posts: 3191
- Joined: Thu Jul 14, 2011 3:09 am
Re: McConnell Economics, Chapter 3
Yes, in passive investment markets. But most markets don't operate this way. Most markets don't allow nearly the same price for one item or a million. This is what I always thought of as market efficiency, the difference between wholesale and retail pricing.It's very hard to know the curves further away because you'd literally have to poll all the consumers in the market about how much more quantity they'd like if the price was this or that much lower. And ditto all producers on the other side.
In most markets, there are wholesale and retail pricing, and supply increases or decreases in response to pricing. So there are many prices at different quantities, all the time.
If the price of GE goes up, more sellers will appear, but the quantity of GE stock doesn't change (general rule, obviously, GE could release more shares to public markets, but that effects multiple factors).
But I should read the chapter...
Re: McConnell Economics, Chapter 3
This is because Alfred Marshal who first developed the S_D model did it this way so we kept at it. In math, the convention is to put the independent variable on the x-axis - but sometimes price/money is the independent variable, sometimes it's the dependent variable. Ditto quantity.Jin+Guice wrote: ↑Thu Jan 09, 2020 11:24 am
A confusing math point: Supply and demand functions are usually written as quantity being a function of price. When price is written as a function of quantity, the function is referred to as the "inverse supply/ demand" function. However, the graph of the classic model shows price as a function of quantity (following the mathematical convention of putting the dependent variable on the vertical or "Y" axis). If you don't know what I'm talking about don't worry about it, but this was confusing as fuck to me for at least a year.
For instance, price is an independent variable to a consumer. They observe the price and make a purchasing decision, or, in the labor supply model, observe the wage and make a labor decision. To a firm, on the other hand, price is sometimes a dependent variable, e.g. a firm with pricing power / monopoly power is modeled as affecting price whereas a small firm which is too insignificant compared to the market doesn't - so price is an independent variable to a perfectly competitive firm but a dependent variable to a monopoly or an oligopoly.
What definitely is a dependent variable, though, is the cost of production - this depends on how many Qs you make (no company's cost is completely independent of the amount of output). + Price of output and cost of production often need to go on the same "money" axis in later models.
tl;dr: much easier and more consistent to agree that "money always goes on the y-axis" than to flip your graphs every time you make them depending on whether price or quantity is the dependent variable in this case - which doesn't even account for the case where price is dependent w.r.t one actor, e.g. a monopoly, and independent w.r.t. the other actor, the atomic consumer.
Re: McConnell Economics, Chapter 3
@jacob: Interesting, I've only learned about this stuff in theory, never from an actual practitioner who needs to use it (like an investor). Estimating demand curves was never my area of research but I believe there is a fairly standard econometric way to do it?
It always bothered me how economists act like this shit they basically made up is some universal law. There is a lot of dick swinging, jargon, mathematics, and smoke and mirrors to make it seem more complicated and unreachable than it actually is. Economics seems like it should be a "learn the rules so you can break them" field, but everybody forgot the last step.
@RJ: I'm not 100% sure this is what you're saying, but markets need to have enough buyers and sellers that each are "price takers" and not "price makers" in order to be efficient. This is coming from the theoretical economic side, not the experienced trader side.
@ertyu: Good notes, thanks for adding depth to my statement. I remembered their being a historical reason for the graph convention, but I couldn't remember what it was, thanks for the addition. The way I learned it, saying "demand function" implies quantity is the dependent variable and "inverse demand function" implies price is the dependent variable, ditto for supply. I'm not sure if this holds across institutions/ schools, but it held across professors and, IIRC, the textbooks we used.
Anyway, minor note that I found confusing for awhile. Anyone who doesn't know wtf we're talking about feel free to ignore it at this stage.
It always bothered me how economists act like this shit they basically made up is some universal law. There is a lot of dick swinging, jargon, mathematics, and smoke and mirrors to make it seem more complicated and unreachable than it actually is. Economics seems like it should be a "learn the rules so you can break them" field, but everybody forgot the last step.
@RJ: I'm not 100% sure this is what you're saying, but markets need to have enough buyers and sellers that each are "price takers" and not "price makers" in order to be efficient. This is coming from the theoretical economic side, not the experienced trader side.
@ertyu: Good notes, thanks for adding depth to my statement. I remembered their being a historical reason for the graph convention, but I couldn't remember what it was, thanks for the addition. The way I learned it, saying "demand function" implies quantity is the dependent variable and "inverse demand function" implies price is the dependent variable, ditto for supply. I'm not sure if this holds across institutions/ schools, but it held across professors and, IIRC, the textbooks we used.
Anyway, minor note that I found confusing for awhile. Anyone who doesn't know wtf we're talking about feel free to ignore it at this stage.
-
Riggerjack
- Posts: 3191
- Joined: Thu Jul 14, 2011 3:09 am
Re: McConnell Economics, Chapter 3
@ j&g
The point I was trying to make is that in most markets, there are several different price/quantity points at all times.
For instance, the price of no. 2 diesel is one price by the gallon, another by the truckload, still another by the shipload. Same product, different prices. No need to poll all buyers and sellers, just look at the current prices. And those prices are moving, often in different directions.
The market efficiency is the spread between those prices. A market where individual units cost X but a crate of 144 units costs 48x is not very efficient. If the crate cost 120x, it would be far more efficient.
So, the market for gold bullion is efficient, compared to, say diamonds. In that gold will have a minimal price differential from the spot price. Whereas the price of diamonds is very dependent on the quantity/quality and matching with the right buyers, in the right places. Inefficient markets have more room for profit, and local knowledge is far more valuable.
Amazon is raising market efficiency across the board. And driving out the businesses that depend on those inefficiencies for their profit margins. This can be both good and bad, but on the whole, seems very positive.
Did I make myself any clearer?
The point I was trying to make is that in most markets, there are several different price/quantity points at all times.
For instance, the price of no. 2 diesel is one price by the gallon, another by the truckload, still another by the shipload. Same product, different prices. No need to poll all buyers and sellers, just look at the current prices. And those prices are moving, often in different directions.
The market efficiency is the spread between those prices. A market where individual units cost X but a crate of 144 units costs 48x is not very efficient. If the crate cost 120x, it would be far more efficient.
So, the market for gold bullion is efficient, compared to, say diamonds. In that gold will have a minimal price differential from the spot price. Whereas the price of diamonds is very dependent on the quantity/quality and matching with the right buyers, in the right places. Inefficient markets have more room for profit, and local knowledge is far more valuable.
Amazon is raising market efficiency across the board. And driving out the businesses that depend on those inefficiencies for their profit margins. This can be both good and bad, but on the whole, seems very positive.
Did I make myself any clearer?
-
white belt
- Posts: 1457
- Joined: Sat May 21, 2011 12:15 am
Re: McConnell Economics, Chapter 3
I agree with J+G's and Jacob's point that supply and demand curves only exist to serve as a model. While reading through the chapter, I found myself thinking of all the situations left out by the inherent assumptions like "all things equal." Additionally, I think the factors that shift demand and supply can just be used as an easy cop-out when it appears the supply/demand model isn't working as predicted. With any supply/demand curve there are countless factors influencing it and it's unlikely that one person will have complete information at any one time.
-
guitarplayer
- Posts: 1349
- Joined: Thu Feb 27, 2020 6:43 pm
- Location: Scotland
Re: McConnell Economics, Chapter 3
My notes or thoughts for this chapter below.
Markets are arenas of exchange. If we say that money is purely medium of exchange i.e. medium of the market, then 'price paid' is 'utility'. Is then price equal to value, I don't know.
Demand schedule is then a schedule of diminishing utility for each additional 'something'. Seems to me here the utility if function of quantity. The law of demand is that the more I have of something, the less useful each additional bit of it is for me - diminishing marginal utility.
NB: I can imagine this gets potentially complicated when I need exactly x amount of something, then I will value this x amount more than either less or more of it.
The income effect is that the less of stuff I have is required to get what I find useful (per unit), theoretically the more of it I will get (maybe stock up for later). The opportunity cost of other things that I find useful is then comparatively higher so I will forgo other stuff in order to 'stock up' - this is the substitution effect.
The demand schedule can be depicted as a curve and individual demands summed up to give a market demand curve. Determinants of demand are to be seen in the context of partial derivatives as mentioned by @ertyu in one of the earlier chapters.
The curve shifts left or rights at the whims of
fashion (taste),
interest (number of buyers - reminds me of a discussion here I think where someone mentioned how pension funds shifting to investing their portfolio in stocks some years back created the wave that lifted many boats - lucky boomers),
income (normal goods and inferior goods - this can be exploited),
price of related goods: mention of substitute goods (pepsi and coke) and complementary goods (pipe and tobacco),
consumer expectations.
Change in demand - move the curve
Change in quantity demanded - move along the curve.
Supply schedule is a schedule of increasing utility for others for each additional 'something' I have. Seems to me here the quantity is function of utility. The law of supply is that the more utility something holds for others, the more of it I am happy to get for them, despite the fact that it costs me increasingly more to get it - increasing marginal cost.
The supply schedule can be depicted as a curve and individual supply curves summed up to give a market supply curve. Determinants of supply are to be seen in the context of partial derivatives as mentioned by @ertyu in one of the earlier chapters.
The curve shifts to the left or right according to
resource prices (a supplier is a demander in terms of pulling resources)
technology
taxes and subsidies
prices of other goods
producer expectations
number of sellers.
Change in supply - move the curve
Change in quantity supplied - move along the curve.
Equilibrium price and quantity is this impossible point where the demander says 'this bit more would be yet less useful to me' and supplier says 'if only this was more useful to you, I would get you more'.
Productive efficiency is that the cost of getting an amount of something on the market is at its minimum.
Allocative efficiency is that the most useful stuff gets on the market.
When the demand and / or supply curves move, this changes where the equilibrium point is.
Price ceiling (that is below the equilibrium point) makes it look for the demander like the opportunity cost of alternatives is higher than how it is seen by the supplier. For the supplier, the inverted opportunity cost (that it the opportunity cost of not engaging in something else) is higher. The supplier proceeds to engage in other activities while the demander is left with no stuff to get for a good price, which results in a shortage. This can result in rationing problem and in black markets.
Price floor (that is above the equilibrium point) creates an illusion for the supplier that the 'something' they supply holds more utility for the demanders than they see it. But since for suppliers quantity is the function of utility, they proceed to get a lot of stuff on the market, more than demanders are happy to clear. The result is surplus.
Markets are arenas of exchange. If we say that money is purely medium of exchange i.e. medium of the market, then 'price paid' is 'utility'. Is then price equal to value, I don't know.
Demand schedule is then a schedule of diminishing utility for each additional 'something'. Seems to me here the utility if function of quantity. The law of demand is that the more I have of something, the less useful each additional bit of it is for me - diminishing marginal utility.
NB: I can imagine this gets potentially complicated when I need exactly x amount of something, then I will value this x amount more than either less or more of it.
The income effect is that the less of stuff I have is required to get what I find useful (per unit), theoretically the more of it I will get (maybe stock up for later). The opportunity cost of other things that I find useful is then comparatively higher so I will forgo other stuff in order to 'stock up' - this is the substitution effect.
The demand schedule can be depicted as a curve and individual demands summed up to give a market demand curve. Determinants of demand are to be seen in the context of partial derivatives as mentioned by @ertyu in one of the earlier chapters.
The curve shifts left or rights at the whims of
fashion (taste),
interest (number of buyers - reminds me of a discussion here I think where someone mentioned how pension funds shifting to investing their portfolio in stocks some years back created the wave that lifted many boats - lucky boomers),
income (normal goods and inferior goods - this can be exploited),
price of related goods: mention of substitute goods (pepsi and coke) and complementary goods (pipe and tobacco),
consumer expectations.
Change in demand - move the curve
Change in quantity demanded - move along the curve.
Supply schedule is a schedule of increasing utility for others for each additional 'something' I have. Seems to me here the quantity is function of utility. The law of supply is that the more utility something holds for others, the more of it I am happy to get for them, despite the fact that it costs me increasingly more to get it - increasing marginal cost.
The supply schedule can be depicted as a curve and individual supply curves summed up to give a market supply curve. Determinants of supply are to be seen in the context of partial derivatives as mentioned by @ertyu in one of the earlier chapters.
The curve shifts to the left or right according to
resource prices (a supplier is a demander in terms of pulling resources)
technology
taxes and subsidies
prices of other goods
producer expectations
number of sellers.
Change in supply - move the curve
Change in quantity supplied - move along the curve.
Equilibrium price and quantity is this impossible point where the demander says 'this bit more would be yet less useful to me' and supplier says 'if only this was more useful to you, I would get you more'.
Productive efficiency is that the cost of getting an amount of something on the market is at its minimum.
Allocative efficiency is that the most useful stuff gets on the market.
When the demand and / or supply curves move, this changes where the equilibrium point is.
Price ceiling (that is below the equilibrium point) makes it look for the demander like the opportunity cost of alternatives is higher than how it is seen by the supplier. For the supplier, the inverted opportunity cost (that it the opportunity cost of not engaging in something else) is higher. The supplier proceeds to engage in other activities while the demander is left with no stuff to get for a good price, which results in a shortage. This can result in rationing problem and in black markets.
Price floor (that is above the equilibrium point) creates an illusion for the supplier that the 'something' they supply holds more utility for the demanders than they see it. But since for suppliers quantity is the function of utility, they proceed to get a lot of stuff on the market, more than demanders are happy to clear. The result is surplus.
-
guitarplayer
- Posts: 1349
- Joined: Thu Feb 27, 2020 6:43 pm
- Location: Scotland
Re: McConnell Economics, Chapter 3
So do you think if you find an exchange with favourable trading fees you could make consistent profit this way? I did something like this with sports betting in the past with no knowledge of football, horses, golf or what have you.
-
jacob
- Site Admin
- Posts: 16001
- Joined: Fri Jun 28, 2013 8:38 pm
- Location: USA, Zone 5b, Koppen Dfa, Elev. 620ft, Walkscore 77
- Contact:
Re: McConnell Economics, Chapter 3
No, this doesn't work past the spread. If you have real time level 1 quotes, the next price will likely be the opposite of whichever side has the most bid or ask orders. However, in order to take advantage of that, you have to be first in the queue. OTOH, in order to avoid being taken advantage of, all you have to do is stay out. That's a cheap trick worth $1 per 100 shares per transaction. Not really useful in practice of retailer investors, but a nice proof of concept.guitarplayer wrote: ↑Wed Aug 02, 2023 4:09 pmSo do you think if you find an exchange with favourable trading fees you could make consistent profit this way? I did something like this with sports betting in the past with no knowledge of football, horses, golf or what have you.
-
guitarplayer
- Posts: 1349
- Joined: Thu Feb 27, 2020 6:43 pm
- Location: Scotland
Re: McConnell Economics, Chapter 3
Thanks.
Have also googled level 2 data. I'm only climbing Mt Stupid so for now I put the measures from it parallel to the derived quantities in mechanics, velocity, acceleration, torque etc.
Have also googled level 2 data. I'm only climbing Mt Stupid so for now I put the measures from it parallel to the derived quantities in mechanics, velocity, acceleration, torque etc.