Comparative statics

In this topic we cover three things. Firstly, how demand and supply leads to price equilibrium. Secondly, the key factors that cause shifts in the demand and supply curves and thirdly, how we can use these insights to analyse real world market activity.

Here’s a video showing how the demand curve and supply curve interact to find equilibrium:

Here is a summary of the main factors that cause shifts in demand and supply curves.

What could affect the Demand curve?

– Consumer tastes
– Price of substitute goods
– Income
– Buyers’ expectations
– The number of consumers

What could affect the Supply curve?

– Technological change
– Prices of factor inputs (e.g. land, labour, capital)
– Number of suppliers
– Supplier’s expectations
– Prices of all other goods

Here are two great activities to ensure you understand how to shift the supply and demand curves.

Comparative statics is the use of the demand and supply diagram to see what will happen to price and quantity following changes in the underlying economic conditions. It seems intuitively obvious that an increase in population will cause house prices to rise. But comparative statics helps us to clarify this. It does so by treating the economic shock (the increase in population) in two ways. Firstly, we can see that it affects the demand curve (and not the supply curve). Secondly, it will cause an increase in demand (and not a decrease). By “shifting” the demand curve outwards, we see that the equilibrium price and quantity will both be higher than previously. Ceteris paribus, an increase in population increases house prices.

Here’s a look at applying some comparative statics to the UK housing market:

To engage in comparative statics you need to identify the source of change, and then ask yourself two questions:

1. Does it affect demand or supply?
2. Does it cause an increase or a decrease?

Comparative statics can be as complicated as you wish to make it and in the real world multiple shocks will take place simultaneously, which means there’s a limit to how many of these effects we can observe. But it’s precisely because the real world is complex, that we need a clear theoretical lens. If planning restrictions are lifted at the same time as population rises, the positive shift in the demand curve (upward pressure on prices) will coincide with a positive shift in the supply curve (downward pressure on prices). In the real world we can’t hold all other variables constant, so the predictive power is severely curtailed. But there is use in knowing that a rise in population will mean that prices are higher than they otherwise would be and indeed since both of those shocks imply an increase in quantity, comparative statics can still help us form a vision of the future.

A workable platform for markets:

1. Information flows smoothly
2. People can be trusted to live up to their promises
3. Competition is fostered
4. Property rights are protected but not overprotected
5. Side effects on third parties are curtailed

Source: McMillan, J., 2002, Reinventing the Bazaar, W.W. Norton & Co. (p.135)