Harvard economics professor Greg Mankiw quotes from a recent book review by Bill Gates:
By the second semester of my freshman year at Harvard, I had started going to classes I wasn’t signed up for, and had pretty much stopped going to any of the classes I was signed up for – except for an introduction to economics class called “Ec 10.” I was fascinated by the subject, and the professor was excellent.
Greg’s interest, understandably, is who the professor was. He wonders if it was Otto Eckstein. I’m wondering if it was Elizabeth Allison. In December 1973, when I was in my second year at UCLA, I did a “busman’s holiday,” flying to Boston en route to Canada to visit my undergrad friend Lawrence Siskind and my econ graduate student friend Danny Steinberg. Danny invited me one evening to go with him to Elizabeth Allison’s place where she had a meeting of her teaching assistants (Danny was one) to go over some questions for an exam for a self-paced economics course she was teaching. It was an introductory course. Maybe she taught Ec 10 also.
But I have a less personal and more professional interest in the Gates’ review. After drawing a supply and demand curve correctly, Gates writes:
There are two assumptions you can make based on this chart. The first is still more or less true today: as demand for a product goes up, supply increases, and price goes down. If the price gets too high, demand falls. The sweet spot where the two lines intersect is called equilibrium. Equilibrium is magical, because it maximizes value to society. Goods are affordable, plentiful, and profitable. Everyone wins.
In the second and third sentences, Gates messes up big time. If demand for a product goes up, the price goes up. With an upward-sloping supply curve such as the one he draws, the quantity supplied rises. Net result: equilibrium price and quantity are higher. The price does not go down.
I’m criticizing Gates not to suggest that I’m smarter than he—I’m positive that I’m not—but simply to correct his analysis. One can make some pretty big follow-on mistakes if one doesn’t understand his mistake. I’m also not suggesting that he should have stayed at Harvard longer and understood economics better. If he had, almost all of us would have been at least slightly worse off.
Interestingly, in the paragraphs that follow, Gates does get at the crucial part of economics that matters for his industry. I’ll leave that part to you if you’re interested.
READER COMMENTS
Fred Foldvary
Aug 17 2018 at 11:46am
“If the price gets too high, demand falls.” Bill Gates evidently forgot the distinction between demand and quantity demanded. At a higher price, quantity demanded is less. The demand of course does not change. Same with supply and quantity supplied.
Philo
Aug 17 2018 at 11:59am
In equilibrium: “Goods are affordable, plentiful, and profitable.” Well, no. Gates’s basic Demand-Supply graph applies just as well to goods that are very expensive and very scarce. As for profitability, we can assume that suppliers expect their activity to be profitable at the equilibrium price, and that on average and in the long run they will be right, but the graph applies even in those cases where they are wrong.
Hazel Meade
Aug 17 2018 at 12:39pm
<i>I had started going to classes I wasn’t signed up for, and had pretty much stopped going to any of the classes I was signed up for </i>
This is how one of my classic grad school recurring nightmares used to start. It would end with me suddenly realizing in the last week of classes that I had forgotten to attend a class for the entire semester and it was a week before the exam and too late to drop it.
John Hall
Aug 17 2018 at 1:09pm
He also says “Even today, GDP doesn’t count investment in things like market research, branding, and training – intangible assets that companies are spending huge amounts of money on.”
I don’t know what he means. You can’t point to a line-item in GDP for these things, but that doesn’t mean they aren’t counted.
1) It certainly would be counted in the income approach to estimating GDP. You have to pay people wages to build the brand or do market research.
2) Market research and branding are like intermediate goods and services than final goods anyway.
3) Building a good brand shows up in higher corporate profits. Selling more goods shows up in consumption/investment, respectively.
Jacob
Aug 17 2018 at 1:33pm
I think he just forgot some steps.
Increased Demand -> Increased Prices( P1) to P2
Firm wants to produce more at P2 so Supply(S1) increases to S2
S2 pushes P2 downward to P3, where we get equilibrium.
(And I’m sure I will come to find that I too forgot some steps as well ha.)
Alan Goldhammer
Aug 17 2018 at 1:34pm
A careful reading of the Gates review clearly notes that the professor in question cannot be Elizabeth Allison as Gates writes, “….One of the first things he taught us was the supply and demand diagram.” More importantly how are we to know that it is Gates who is making this error (I’m not an economist and will just go along with the crowd)? Perhaps his memory of the lecture is accurate and that particular diagram was outlined on the chalkboard. Memories may or may not be faulty and Malcolm Gladwell’s recent podcast on this topic is illustrative.
David Henderson
Aug 17 2018 at 1:46pm
Oops, Alan. Good catch on professor’s gender. Now I’m back to Greg Mankiw’s hunch.
john hare
Aug 17 2018 at 2:37pm
Somehow I am reading the second sentence as correct, supply increases and drives the price down. I’m reading it as the price drops after the supply increase and doesn’t address the price before the increase in supply. I haven’t seen the graph.
Robert Rawlings
Aug 17 2018 at 3:24pm
On ‘as demand for a product goes up, supply increases, and price goes down. ‘
I think he may mean that price comes down relative to what it would have been had supply not increased. That is: Demand increases and price goes up, supply then increases (perhaps with some lag) and the price goes down again , but not below its starting point
Robert Rawlings
Aug 17 2018 at 3:27pm
And in addition (as is very common in the tech industry) as demand increases this may spur both economies of scale and productivity increases that actually do allow prices to fall as demand increases.
pm2
Aug 17 2018 at 6:55pm
Maybe Gates isn’t thinking about the difference in equilibriums but the process by which the new equilibrium is achieved? My memory might be failing me, but I think my intro class mainly focused on comparing the different equilibriums without too much discussion of how that new equilibrium was achieved.
For example, start from equilibrium and then increase demand. Say it takes some time for firms to increase production, so the first thing that happens is quantity stays the same, but the price increases vertically to the point on the new demand curve. As time passes and firms are able to increase output, the quantity supplied starts to increase, and the price slides down the supply curve to the new equilibrium point (which is at a higher quantity and higher price than the original).
Or maybe when demand increases, firms don’t change prices fast enough, and people purchase a quantity that is a horizontal movement to the new demand curve (say firms keep extra inventory and can part with that). After they recognize the new demand, they raise prices and slide back up the supply curve to the new equilibrium point.
Is there a preferred way of thinking about it? Or, do most economists just think quantity and price slide smoothly up the supply curve from equilibrium A to equilibrium B?
Mark Bahner
Aug 18 2018 at 12:11am
I think what Bill Gates is thinking is that the supply curve shifts over to the right and a new equilibrium will be established at a lower price.
I think Julian Simon maintained that the trend for essentially all commodities…even things like metals and fossil fuels, which would supposedly be “depleted”…is that in the *long* run, prices of commodities most often go down even if demand goes up. For example, look at long-term trends in commodity prices indices.
But it’s very surprising that Bill Gates would write something like he did as though it’s some sort of automatic short-term thing. I certainly agree with David Henderson both that Bill Gates is wrong (as a short-term thing) and it’s surprising Bill Gates would write it because he’s a smart fellow.
P.S. I think the book Bill Gates reviewed and Bill Gates’ other comments about it are very interesting and tie into things that I’m working on myself. I’ll try to write something more on that later.
Mark Bahner
Aug 18 2018 at 5:10pm
Hi,
Bill Gates wrote about “intangible assets” and specifically called attention to software. But there is a similar trend that has been noted for several decades. It often goes by the name of “dematerialization.” Dematerialization is the production of equal or greater economic value with smaller and smaller masses of materials. I’m working on several projects that are great examples of “dematerialization.”
After hurricane Katrina, I tried to think of what could have protected New Orleans from the storm surge, which is what caused the flooding of New Orleans. New Orleans was supposed to be protected by a large number of earthen levees, and many concrete storm walls. However, the levees and walls failed and/or were over-topped. And what caused those levees and walls to fail or be overtopped? Storm surge is essentially shallow water that gets “piled up” by wind. In the open sea, storm is just 2-3 feet high…it’s only when the water comes into shallow areas near shore that it “piles up” to significant heights (5, 10, or even 15+ feet).
So I got to thinking about what would stop water? What would be abundantly available? After much thought, I realized that *water* stops water…and even *air* stops water. For example, if one has an small inflatable swimming pool, the sides are typically tubes filled with air. I realized that filling tubes with water and air could actually significantly reduce storm surge. (It would not “stop” storm surge, because there would be some leakage.)
It may be a long, long time before my idea is realized in full scale situations. But if/when it is, a system of tubes could be filled with seawater and air, and could protect any city anywhere in the world, with a few days’ notice. Those portable tubes would replace all the fixed earthen levees and storm walls all around the world. Protection from storm surge would be “dematerialized.”
Scott Sumner
Aug 19 2018 at 11:33am
The statement by Gates regarding supply and demand is clearly false. It’s possible that he was thinking of a long run process of market dynamics, but he did not accurately describe that process.
This may be what he was trying to say:
“An increase in demand causes the price to rise. This boosts profits and causes new firms to enter the industry and/or existing firms to boost capacity. This increases short run supply, which reduces prices.”
The mistake was saying that more demand causes more supply. It does not.
Seth
Aug 20 2018 at 5:59pm
“I’m criticizing Gates not to suggest that I’m smarter than he—I’m positive that I’m not—but simply to correct his analysis.”
It’s good to keep in mind that becoming wealthy does not mean you are an expert on everything.
Todd Kreider
Aug 20 2018 at 7:39pm
It’s also good to keep in mind that very smart people need to study (or review) more complex topics in areas they do not know well.
jack pq
Aug 21 2018 at 12:21pm
To be fair, most people have trouble distinguishing between the concepts of demand and quantity demanded; or supply and quantity supplied. When I taught Ec 101, I emphasized “demand *function*” and “supply *function*” to try to help students see the difference between the function and a specific point.
Adam
Aug 21 2018 at 11:29pm
Hey, Bill’s graph is the just the short run. His full story addresses long run equilibrium in a decreasing cost industry–just like the one Bill’s experienced as an entrepreneur.
Warren Platts
Aug 23 2018 at 3:18pm
I say give Bill the benefit of the doubt, and chalk it up to a typo and bad copy-editing.
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