Exercise 8.1:
Why are the new office buildings in my town only half full?

Adam Smith's invisible hand leads us in pursuit of economic profit-profit above the normal return for an area. This quest for profit leads us, as individuals, to pursue our own private interests while leading us, as a society, to an optimal distribution of goods, services, capital, and labor. Or at least that's the idea. Generally it is the case that leaving the distribution of goods and services to markets leads to outcomes we can all support. Unfortunately, however, the path is neither straight nor smooth.

The notion of perfect competition rests on several assumptions, one of which is complete, or nearly complete, knowledge of the situations about which we are making decisions. The construction of office space is one place where perfect knowledge may not hold. Let's look at an example:

In this example the amount of office space is fixed at 1.0 million square feet and the demand for space follows a normal demand relationship-if the space is more expensive less will be rented. To begin, the market is at equilibrium with full occupancy and a rent of $3.00 per square foot on average. Over time the demand for office space tends to increase as new businesses are started and as an area's economic developers (the Chamber of Commerce, the Mayor's Task Force on Attracting New Business, etc.) do their jobs. If the demand for office space increases from say, D to D', a shortage of 300,000 square feet at current rents will develop. It is clear that pressures to act are mounting. One pressure is an upward trend on office rent, moving from point b toward point c. Another is pressure to take your business to another town where rents are lower, bringing demand back down. Along with these pressures is the opportunity to build the new 300,000 square feet of office space and take advantage of the rising rents. Some builders will be attracted to this last option.

If, for purposes of this example, three separate builders are attracted to construct new office space in town, it is quite unlikely that they will get together and divide up the 300,000 space desired at current prices. It is more likely that they will EACH build not all, but more than 1/3 of the desired amount. If, for example, one decides to build 150,000 square feet, another 200,000 square feet, and the third 100,000 square feet the total new office space will be 450,000 square feet. This increase in supply is shown by the shift from S to S'.

While the building has been going on-usually it takes a couple of years to go from idea to new building-the pressure to increase current rent has been tremendous. This means that by the time the new buildings come on line, increased rental to some point above $3.00 per square foot has reduced the shortage by some portion and the new square footage, rather than being merely 150,000 too much is now actually more than 150,000 square feet beyond current (above $3.00, less than 1.0 million square feet) quantity demanded. In perfectly fluid markets the rent would simply fall to the level that brings the new supply (S') and the new demand (D') equilibrium. We expect prices to fall below $3.00 per square foot and the quantity rented to rise to 1.45 million square feet, the intersection of S' and D'. Again, the truth is not as smooth as the model. This is due to the fact that rents tend to be "sticky" downward as a result of long-term contracts and other imperfections in the market for office space.

Thus, perhaps for a few years, there will be an unfilled surplus of offices in your town. This will clear as rents fall and as the demand for office space continues to increase. Ultimately, in a growing town the demand for office space will grow beyond the 1.45 million square feet available and the market will then move back into a shortage, beginning the cycle again. It is not uncommon for new buildings to remain under full occupancy for quite some time. It merely means that this market does not actually meet the conditions of perfect knowledge and free movement of prices, not that there is something wrong in your town.

Exercise 8.2:
Why Are There So Many Ice Cream Desserts Named After Weather?

In the 1980's, Dairy Queen developed an ice cream treat called a Blizzard. A Blizzard mixes up different types of crushed candy into a cup of ice cream. Today, there are many different versions of a Blizzard, named after other weather phenomena (e.g. flurry, tornado).

Soon after the Blizzard was introduced at Dairy Queen, they became very popular. The demand for Blizzards was such that they generated profits for Diary Queen. While Dairy Queen owned the right to produce Blizzards, Blizzards are very easy to imitate. Other firms, that saw the success of the Blizzard, easily imitated Dairy Queen by providing their own version of the ice cream treat (ice cream in a cup with candy pieces mixed in). Of course, the firms that copied Dairy Queen could not use the name "Blizzard." But, they could convey to consumers that they had a very similar product by naming the product after a different type of (usually cold) weather phenomenon.

Because there is no significant barrier to entry into the market for ice cream treats, firms are able to enter the market. The fact that Dairy Queen made profits from the sale of Blizzards was eventually (in this case, quickly) noticed. "The Quest for Profit" drew additional producers into the market ("as if by an invisible hand"). The increase in the supply of Blizzard-like ice cream treats increased the quantity sold in the market and reduced the price – drawing more resources into Blizzard-treat production and providing more of the good that consumers demanded.