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ECON 208 (107)


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McGill University
Economics (Arts)
ECON 208
Wendy Dickinson

Linkages Between markets 1 LINKAGES BETWEEN MARKETS In Chapter 5 we explain the difference between partial-equilibrium and general- equilibrium analysis. Here we provide some detailed examples of how markets are linked together. There are three broad reasons that markets may be connected—regional link- ages, input–output linkages, and linkages through resource constraints. Regional Linkages How are geographically separate markets connected? We examine two different link- ages. In the first, mobile supply is what links the markets; in the second, the linkage is provided by mobile demand. Mobile Supply By mobility of supply we mean the ease with which suppliers can move their products from one market to another. This mobility depends on the product in question and the distance between the two markets. If the product is very costly to transport (like gravel or cement) and the markets are far apart (like British Columbia and Nova Scotia) then the two markets will be separate. But if the product is inexpensive to transport (like computer chips or leather gloves) and the markets are close together (like Ottawa and Toronto) then the two markets will be closely linked. Consider the follow- ing example that illustrates how mobile supply can link regional markets. In August 1992, Hurricane Andrew struck the Florida coast and caused a great deal of damage to buildings and houses. As soon as the hurricane was over, the process of rebuilding began. This caused a sharp increase in the demand for plywood. The pre- dicted price increase occurred in Florida almost immediately. But the economic effects of the hurricane were not confined to Florida. As the price of plywood soared in Florida, suppliers from other regions of the country directed their plywood shipments toward high- priced Florida. This reduction in supply in the other regions caused shortages and led to price increases. Builders across the country were forced to adjust to more expensive ply- wood—prices increased by 18 percent in just two weeks. This situation is illustrated in Figure 1. Mobile Demand Now consider a situation in which it is prohibitively expensive to transport a product (immobile supply) but demand can move relatively easily. This would be the case, for example, in the housing market in two residential neighbour- hoods that are close together. It is obviously very expensive to move a house from one neighbourhood to another, and it is not easy to build new houses in the short run. So we can think of these two neighbourhoods as each having very inelastic short-run supplies of housing. Demand, in contrast, may be relatively mobile between the two neighbour- hoods since living in one neighbourhood may be viewed as a reasonable substitute to liv- ing in the other. Suppose that Neighbourhood A experiences a substantial increase in demand for hous- ing, perhaps because its schools are widely reported to be of very high quality. Further, suppose that the increase in demand for housing in Neighbourhood A comes from families currently living in faraway neighbourhoods. This increase in demand will naturally raise hous- ing prices in Neighbourhood A. As prices rise there, however, some of the potential home- owners get crowded out by the price increases and they begin to look more favourably at houses in nearby Neighbourhood B, where prices are not rising. This shift in demand toward Neighbourhood B leads prices to rise there as well. Figure 2 illustrates this example. Copyright © 2008 Pearson Education Canada 2 Linkages Between markets FIGURE 1 Regional Linkages with Mobile Supply F A p Increase in p demand caused by hurricane SA damage SA SF A F p1 p1 Reduction in A supply caused p F p0 by increasepin Price of Plywood Price of Plywood D▯ F D DF A 0 Q F Q F Q F 0 Q A Q A QA 0 1 1 0 Quantity of Plywood in Florida Quantity of Plywood in Region A When the supply of a product is mobile between regions, prices in regional markets tend to move together.The initial equilibrium in Florida is and Q ; in some other region, denoted Region A, it isp and Q . The hurricane leads 0 0 0 F 0 to an increase in demand for plywood in Florida and thus drives prices in Florip1. The supply curve in Region A, however, is drawnfor a given price of plywood in Flsince supplying to Florida isa substitute tosupplyingRegion A. The increase in p therefore reduces the supply in Region A. This reduction in supply (the shift S to S▯ ) shows up as part of the increase in quantity supplied in Florida (the movement alS ). The supply reduction in A F Region A increases price to1p . The two markets are linked through the mobility of supply, and the prices in the two markets move together. The Role of Substitution In both of the previous examples,substitutionplays a key role in linking the regional markets. Indeed, substitution is just another word for themobil- ity of demand and supply. In the plywood example, firms viewed selling plywood in Florida as a substitute for selling plywood in other regions. In the housing example, consumers viewed buying houses in Neighbourhood B as a substitute for buying houses in Neighbourhood A. Linkages between regional markets are determined by substitutability, either in demand or supply. The degree of substitutability, in turn, is determined by distance, transport costs and the nature of the products. In the plywood example, the degree of substitutability of supply—and thus the extent of the linkage between markets—is determined by the cost of transporting the plywood relative to its price. The more costly it is to transport, the less willing firms will be to move the plywood between regions. At some high level of transport costs, it will no longer pay suppliers to move the plywood, and the regional markets will not be linked together. Copyright © 2008 Pearson Education Canada Linkages Between markets 3 FIGURE 2 Regional Linkages with Mobile Demand pA Initial increase p B in demand S A B Increase in p A p B demand due to 1 1 increase in p Price of Housing Price of Housing A B p0 D▯A p0 DB D A DB 0 A 0 Q0 Q A Q B Q B 0 Quantity of Housing in Neighbourhood A Quantity of Housing in Neighbourhood B When demand for a product is mobile between regions, prices in regional markets tend to moveh.e initial equi- librium in Neighbourhood A is QAand p ; the equilibrium in Neighbourhood B is Q and p . Demand increases 0 0 0 0 A in Neighbourhood A to DA (coming from faraway neighbourhoods, not including B) and raises theo1. As price increases in Neighbourhood A, some of the new demand gets crowded out and switches over to the houses in nearby Neighbourhood B. The reduction in quantity demanded along A▯ (due to the increase in price) becomes the increase in Neighbourhood B’s demand toD▯ . The regional markets are linked and the prices in the two markets move together. B In the housing example, the degree of substitutability of demand—and thus the extent of the linkage between markets—is determined by the attributes of the housing in each neighbourhood (and by the characteristics of the neighbourhoods themselves). If living in Neighbourhood A is viewed by consumers as being very similar to living in Neighbourhood B, then the markets will be linked. If the two neighbourhoods are viewed as offering completely different living experiences, the markets will not be linked together. Input–Output Linkages We have considered cases where regional markets of the same product are linked through the mobility of supply or demand. Now think about linkages between markets of very different products. For instance, is the market for anchovies linked in any way to the beef market? Is the market for glass linked to the market for cars? The answer in both cases is yes. The linkages arise because some products (like anchovies and glass) are used as inputs to the production of other products (like beef and cars, respectively). Changes in the price of one product lead to similar changes in the prices of goods that use that product as an input. Consider the following example dealing with anchovies and cattle that is illustrated in Figure 3. One important use of anchovies (besides being used in Caesar salads and as a topping for pizza) is as a protein supplement for livestock, especially beef cattle. In Copyright © 2008 Pearson Education Canada 4 Linkages Between markets 1973, partly as a result of the unusual weather associated with the cyclical recurrence of El Niño, there was a sharp reduction in the Peruvian anchovy catch. Since Peru was a large producer of anchovies, the decline in Peru’s catch led to a significant decline in the world’s supply of anchovies, which then pushed up anchovy prices. The higher price of anchovies, in turn, sharply increased the price of cattle-feed. The increased cost of the cattle-feed then led to a reduction in the supply of beef cattle. Prices for beef increased. The anchovy market and beef markets were linked, with the prices of the two products moving together. This example may seem like an unusual one but the principle involved is very gen- eral. An increase in the price of one product generally leads to price increases for all goods using that product as an input. Through such input–output linkages, we can bet- ter understand co-movements in the prices of many products, including electricity and alu-
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