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Here at Economic Forces, we like to say that everything is supply and demand. On a certain level, that is true. If you understand supply and demand, that will take you a long way. Nonetheless, we cheat a little bit when we say that. Once someone has a basic understanding of supply and demand, it is possible to start pulling on particular threads and seeing where that leads. Often times, these extensions to the analysis prove particularly useful. And we classify these extensions under the banner of supply and demand. Today, I would like to think about one particular extension often emphasized by the late, great Yoram Barzel: the attributes of goods and the establishment of standards.
In introductory courses the examples one gives for supply and demand are typically pretty simple. Initial supply and demand examples might be for things like oranges. This facilitates easy applications to test one’s knowledge of the model. If a news story comes along and says that oranges have health benefits, this is likely to increase the demand for oranges. We know that the price of oranges will rise and orange growers will respond by growing more oranges. However, we also know that growing oranges takes time. Thus, the initial response will just be a higher price of oranges. That sustained higher price causes producers to grow more oranges. The increase in the supply of oranges at that higher price will lead to an excess supply of oranges. In order for people to buy these oranges, the price will have to decline. In the long run, supply is more elastic than it is in the short run. As a result, the long-run effect of the increase in demand is both a higher price and a larger quantity of oranges being traded.
There is a lot of value in thinking through that process. It is also important to note that one reason that those introductory classes use examples like oranges is that everyone recognizes an orange for what it is.
Given that basic understanding, a thread that one might want to pull on is that many goods are a bundle of different attributes. Some attributes are easily observable. Other attributes require measurement. Take gold, for example. Typically, one measures the quantity of gold in terms of its weight. Nonetheless, gold of equal weight might not be of equal value. The reason is that another attribute of gold is its purity, or fineness. Assessing the weight and fineness of gold requires measurement and measurement entails costs.
To minimize on measurement costs, it might be useful to establish standards. These standards could be created privately. They could also be created by the government. An obvious example would be to think about a time when gold served as money. A dollar might be defined as 1/20 oz of gold, 9/10 fine. A mint could then perform all of the necessary measurements in terms of weight and fineness in order to mint coins denominated in dollars. By minting these coins, the mint is adopting the standard. People will use these coins as long as they trust that the mint isn’t lying about the fineness. Also, to the extent that people trust the mint, this reduces measurement costs associated with using gold.
Measurement costs have important implications for supply and demand. One might think of measurement costs as driving a wedge between the price that the consumer pays and the price that the seller actually receives. If a consumer is willing to pay $10 for a particular good with particular attributes and it costs $3 dollars to verify that the good has those attributes, the most the seller can hope to receive is $7. If the marginal cost of producing another unit of the good with the attributes the consumer desires is $8, then there are no gains from trade to be had despite the fact that the willingness to pay of the consumer exceeds the marginal cost of the producer.
Nonetheless, given the knowledge that a reduction in measurement costs could lead to further gains from trade, the participants in the market will have an incentive to establish particular standards for the goods that are being traded. Standardization of the attributes of a particular goods reduce measurement costs. However, standardization itself isn’t costless.
Standardization could be top down or bottom up. The example of gold for use as money is an important example. Measuring gold in terms of ounces is a bottom up phenomenon. Gold mining will tend to produce gold of various shapes and sizes and fineness. Thus, one doesn’t produce gold in naturally standardized quantities. This means that people have to settle on a way to measure its quantity. However, if there are already established standardized units for weight, one could simply adopt that existing measurement. That can occur without any top down direction.
Fineness, however, might lack a natural, pre-established standardized unit of measurement. One way to deal with that problem is to create a new standardized unit of measurement. The example of the definition of a dollar as 1/20 oz of gold, 9/10 fine is such a standardized unit. This unit of measurement is likely to occur through a top-down process since it requires a new standardized unit. For example, an established government can define the standardized unit of measurement. But it is important to note that top-down doesn’t necessarily require that the new standardized unit is established by the government. A private mint can create its own standardized unit. It can simply start minting coins and stamping those coins with a particular dollar value given the mint’s definition of a dollar.
It is also important to note that establishing a standardized unit of measurement reduces measurement costs, but it doesn’t eliminate measurement costs. Adopting any kind of standard for a good will require that there is some method for verifying that the standard has been met.
One way to enforce standards is through the use of contracting. A contract between two parties will not only define the quantity of the good that is to be exchanged and at what cost, but also the relevant attributes of the good. The existence of this agreement will lead to reliable standardization of measurement as long as the cost of producing the relevant attributes of the good is lower than the costs of deception. Thus, contracts between parties who have repeated dealings are more likely to be self-enforcing than one-time dealings. Regardless, the possibility of deception will require a third party arbiter of whether the standard has been met if there is some dispute. This tells us that parties to the trade will utilize a contract if the costs of writing and enforcing the contract are less than the cost of measurement.
But one need not rely on contracts. In fact, there will be certain types of transactions for which contracts are prohibitively costly. One alternative to contracting is for the producer of the good to establish its brand name. A producer might invest in its reputation by committing to meet some particular standard with respect to the attributes of the good it produces. Repeated interactions of consumers with the brand will give the consumer a sense of whether the producer regularly meets that standard. If it doesn’t, the consumer will look for alternatives and that producer might even be driven out of the market through competition with other, more reliable producers. If the producer does regularly meet the standards, consumers are likely to continue to choose that particular producer’s brand. Such repeated interactions with the brand might be sufficient to sustain the standard.
There are several important implications here. The first is that the nature of measurement costs is likely to determine whether contracting or brand names (or some other alternative) is the more desirable solution to the problem. Contract disputes require some sort of arbitration. This third-party will be required to assess whether or not the standard has been met. However, this third-party’s area of expertise is likely to be in terms of contract enforcement across a wide variety of disputes rather than expertise about the attributes of the goods in question. This would seem to imply that contractual solutions are more likely to occur when the relevant attributes of the good are easy to observe or easy to measure. By contrast, when an attribute is difficult to measure, private solutions like name brands and repeated dealings might be preferable for enforcing the standard.
Another important implication is that producers have a financial incentive to invest in a brand name. Consider the example that I gave earlier. If the marginal consumer is willing to pay $10 and the cost of measurement is $3, the most a producer can hope to charge is $7. If the marginal cost of producing another unit of the good is $8, there are potential gains from trade that are foregone. However, suppose that the producer invests in a brand name. Doing so will increase the producer’s costs since it will increase the stringency of the producer’s commitment to a particular attribute or quality and the standardization thereof. The firm might also rely on advertising to promote the attributes of its product and/or warranties that provide confidence that the firm is committed to those attributes. This increases the producer’s costs. However, if the producer is successful in establishing a brand name, this will generate some degree of product differentiation that will allow the producer to charge a price above the marginal cost of production. In terms of the numerical example, if the firm’s investment in its brand and reputation increases the marginal cost of production by less than $2 and eliminates the cost of measurement, then both the consumer and the producer are better off. For example, suppose that investing in its brand name increases the marginal cost of the firm by $1 per unit of the good and eliminates measurement costs. The firm then starts charging $10 for the good. In that case, consumers are better off because the marginal consumer is actually able to purchase the good that he or she wants, which was impossible with measurement costs. In addition, the producer benefits by being able to charge a mark-up of $1, since the producer charges $10 for a good that its costs $9 to produce.
This example also illustrates the importance of using the proper counterfactual. People tend to look at the markup of producers who have an established name brand and conclude that this “bad” because there is a gap between the price and marginal cost. After all, in a perfectly competitive market, the price would be equal to marginal cost. However, an implicit assumption in the analysis of the perfectly competitive market is that measurement costs are zero. In a world in which measurement costs are not zero, the perfectly competitive market is not the relevant counterfactual. Instead, the relevant counterfactual is a world without those brand names, but with the corresponding measurement costs.
In fact, durable brand names are evidence that the world with markups is the less costly alternative. It is not hard to understand why. If measurement costs are fairly insignificant, there would be an incentive for firms to enter a market, but not waste resources investing in a brand name. And they would do so until the economic profit was driven to zero. In that counterfactual, consumers would be forced to pay the measurement costs. Consumers would only be better off in this counterfactual if the measurement costs were less than the markup. The existence of durable brand names is therefore evidence that the markup charged by producer is lower than the measurement costs of the counterfactual world and yields greater gains from trade.
Finally, another important insight when it comes to attributes, measurement, and standardization is the role of government policy. For example, as I have previously written, when the government taxes a particular good, the government is actually taxing particular attributes of that good. A per unit tax tends to tax goods on the basis of the characteristics that they have in common. A firm might therefore have an incentive to change an attribute that isn’t common across all goods of that type in an effort to minimize the effect of the tax (a tax on cans of soup, for example, might lead to larger cans of soup). Ad valorem taxes are taxes on the value of the good. However, if goods are bundles of different attributes, firms will have an incentive to unbundle some of those attributes to minimize the cost of the tax, if possible.
Overall, what this discussion hopefully demonstrates is that supply and demand serves as the basis for much of what we talk about here. Nonetheless, the basic understanding of supply and demand leaves a number of loose threads upon which one can pull. I don’t view that as a limitation of supply and demand. Sometimes you don’t need to pull on those threads to understand what you observe in the world. Other times, pulling on those threads can lead to a much deeper understanding not only of supply and demand itself, but more importantly of observations from the world around you.