Notes 4, More on demand and supply
Markets
Market:
a meeting of a buyer and a seller to arrange price and quantity and make a trade.
Markets are a really big deal in economics. “Market economics” is the name given to the way of thinking that the best way to organize
economic activity, that is, producing and consuming goods and services, is to assign property rights to all resources to private
individuals (as opposed to the government) and let those self-interested individuals work out on their own, or in free cooperation with
other people (i.e., business firms) how to put those resources to the best use. Market economics requires that the people who own
these resources be able to communicate their wants to each other and to get together to exchange their resources with each other.
That’s what markets do.
What does a market look like? It’s pretty variable. Say you travel to Mexico and go to an open-air market in the middle of town, with
vendors hawking their wares from little tented kiosks, and you stop at a stall where some guy is selling wool scarves. He tells you how
wonderful his scarves are, blah, blah, blah, and that the price is $50. You offer him $10. He pretends to be offended. You walk away.
He comes after you. You eventually end up paying $20 for a scarf. Is this a market? Yes. A buyer and a seller meet, arrange a price
and a quantity, and make a trade. Now, as I’m writing this I’ve just gone to eBay and bought two bottles of dog tapeworm remover pills
for my dear little Lucy. A few mouse clicks and the pills are on their way. Is this a market? Yes. The buyer (me) contacted the seller
(some guy in Harwinton, Connecticut, wherever that is) via eBay. (“meeting of a buyer and a seller “) I looked at his Buy-It-Now
price, thought it was ok (less than half the pet store price), clicked the button, and
entered 2 in the quantity box. (“arrange price and quantity”) He’ll send me
the stuff, I’m pretty sure, since he has all positive ratings, and I’ve sent him the
money via PayPal. (“make a trade”) (Note: the pills, as described, arrived in
four days.)
I want to emphasize the importance of property rights in all this. The tapeworm
pill seller was willing to buy the pills from wherever he got them because he was
confident that he would be able to keep them or sell them as he wished, and that
they would not be taken away from him in the meantime. He was willing to sell
them to me because of his confidence that PayPal would deliver the money to
him. And I’m willing to pay for them, confident that when I get them, I can use
them as I see fit. In a nation without strong property rights, say, Cuba, the seller
would have to worry that the government might confiscate his inventory
arbitrarily. If so, he might be better off not buying the pills in the first place, and
the trade would never take place. Markets can’t work unless participants are
secure in their rights of ownership of the goods and services they trade. That’s
why foreign corporations are leery of investing in places like Cuba. (Most of the ones that do, are doing so in the expectation -remember that expectations are important--of better times after Castro finally kicks the bucket, and they want to have the core of their
business operation in place when the day comes.)
Demand
The consumer, or buyer, side of the market is called the demand side.
Demand: the willingness and ability of buyers to pay for different quantities of goods at different prices during a given
time period.
Law of demand
The law of demand holds that an increase in the price of a good leads to a decrease in the quantity demanded, or the amount
consumers actually buy, ceteris paribus, or all other things constant. In symbols, for a good which we'll call x,
P represents the price of the good, Qd the quantity demanded, i.e., the amount that buyers are willing to buy at that price. The "c.p."
stands for ceteris paribus, which translates approximately from the Latin as “all other things equal.” It also holds true in reverse, i.e., a
decrease in price leads to an increase in quantity demanded. The law of demand is pretty universal; few if any goods are immune to its
effects.
This leads to a demand curve that is downward sloping. As you can see in Figure 1, representing the market for music CDs, the
quantity demanded falls when the price rises—just like the law of demand says. At a price of $10, buyers in the market are willing to
purchase 50 units of the good. But when the price rises to $15, some of the buyers are not willing to pay that higher price, and drop out
of the market. The quantity demanded falls to 30 units.
Why? The substitution effect
The primary--although not the only--reason why demand curves slope downward is the substitution effect, which states that consumers
will substitute cheaper goods for dearer (more expensive) ones. As the price of CDs rises, potential buyers will buy few of them, and
instead buy substitutes. This could mean they download more music in MP3 format. Or it could mean that they buy some other form of
entertainment altogether, like green fees for putt-putt golf. Or more beer; it all depends on the buyers’ preferences. The point is, to
some extent they’ll switch away from CDs, which give them utility at a high price, to something else that gives them utility at a lower
price.
Demand curves as willingness-to-pay curves
Look again at Figure 1 again. How much is the 50th CD worth to the buyer? Or, what is the same thing, how much is he just willing to
th
pay for it, at a maximum, rather than go without it? Apparently, $10. Why? Because at a price of $10, the buyer will buy the 50 CD,
but won’t buy the 51st. If the price rises to something over $10, the buyer chooses not to buy the 50th CD, i.e., Qd < 50. So the buyer
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must value the 50 CD at $10.
The point is that, as Alfred Marshall pointed out, demand curves are willingness-to-pay curves. They show the maximum amount a
consumer is willing to pay for a certain unit of a good. We'll keep this in mind as we proceed.
Responsiveness of buyers to price changes differs among goods
Consider three everyday goods: Yellow delicious apples, movie tickets, and gasoline. Now imagine that, tomorrow, each of them rises
in price by 10%. The law of demand implies that you will buy fewer of each (presuming you buy some now). But for which of the three
will you reduce your consumption the most? Probably not gasoline, I imagine! Why? While the law of demand holds for almost all
goods, consumers respond more strongly to price changes for some goods than others. This subject--known as price elasticity--will be
taken up in more detail in Economics II. For now, let's note that the primary reason for the differences we see is the existence and
closeness of substitute goods. Consumers respond fairly strongly to changes in the price of movie tickets largely because there are
many substitutes for a night at the movies--renting a video, going to a ballgame, etc. There are no really close substitutes for gasoline,
and so an increase in its price leads to a relatively small change in consumer behavior.
In the short run, anyway. Over a period of years, substitutes for gasoline--direct and indirect-- become feasible. Say that, 2 years
after a "permanent" rise in the price of gasoline, you decide to trade in your old car. You will likely trade it for a car which consumes
less fuel. As old cars are sent to the scrap heap, they are replaced by higher-MPG cars, and so gasoline consumption falls. Also, over
time, people can rearrange where they live, where they work and play. High gasoline prices encourage people to reduce the number of
miles they have to travel, and the amount of gasoline they consumer per mile of travel, and so reduce gasoline consumption. It takes
time, but people do respond.
Wants and needs--a myth exploded
Need: a matter in which there is no choice.
There are no needs. You do not need anything.
You probably don’t believe me. Suit yourself. But consider this. If you say that you need water
to live, and you have a bottle of water in front of you, and I take that water and drink it myself,
then you’ll die, right? Well, no, of course not. You might need water in some general sense, but
you don’t need that particular bottle of water. If I drink it up, you’ll just go and find some
substitute source of water. And if I grab that one away from you, too, you’ll run away from me
and find yourself some other substitute source. The point is, we don’t consume goods in an
abstract, general sense. We consume only unique, discrete, identifiable units of goods. And
there are always substitutes for any individual unit of water or anything else. The existence of
substitutes means that choices are available. And if there are always choices are available . . .
well, refer to the definition of need above.
More fundamentally, think of the basic premise of economics: We live in a world of scarcity, a
condition of unlimited human wants but limited resources. This forces us to make choices. You
might say you need something, but even if you do obtain what you “needed,” you had to choose
to give up something else to get it. Choice is everywhere. And where there is choice . . . there
are no needs.
Look at Figure 2a. Here we have a vertical demand curve, say for heroin for Benny, a hard-core
heroin addict. At a street price of $100 per fix, he will buy one fix per day. At a price of $200, he
will steal twice as many car stereos and buy the same quantity. Aha, you say, here is an
example of a need. Not really. Say that the street price of his fix skyrockets to $1000. Unless he
is a really good thief, he won’t be able to steal that much per day, and so he can’t afford his fix,
and his quantity demanded falls to zero.
Figure 2b gives a truer picture of his demand curve. For prices below, say, $500, he can steal
enough goods to raise the money for his fix. At prices above that, he can’t. So his Qd = 1 for
any price of $500 or less, and equals zero for all prices above that. His demand curve really
consists of two discontinuous vertical sections, with the gap at a price of $500.
In Figure 2c, I’ve linearized this relationship. Choose two prices, $1000 and $100. Mark a point
above the corresponding quantities for each. Now draw a straight line between the two points.
What do you have? A downward sloping demand curve. The point is this: The law of demand
always holds. Sometimes it’s a gradual thing, with a small increase in P leading to a small
decrease in Qd. Sometimes it’s all or nothing . . . like with heroin.
Supply
Supply:
the willingness and ability of sellers to offer for sale different quantities of goods at different prices during a
given time period.
With the exception of the highlighted words, this is the same as the definition of demand.
Law of supply
Just as there is a law of demand which explains buyers' behavior there is a law of supply for producers. According to this principle,
increases in the price of a good lead producers to offer more of it for sale, i.e., the
quantity supplied (Qs) increases. In symbols,
Here we have a direct relationship, which gives us an upward-sloping curve in Figure
3.
Why? Higher prices mean more production becomes profitable
Say that you are managing a plant that manufactures CDs, and that your plant is
currently producing close to its capacity. Then a music distributor manufacturer places
a rush order for 50,000 copies of a CD by a new group that is unexpectedly popular.
In order to fill the order, you will have to speed up production lines and work
employees overtime. What will happen to your production costs as a result? Higher
production volumes will probably lead to more waste and defective discs that will have
to be scrapped, and overtime work will cost you more per hour (indeed, even more
than you might think, because worker productivity will fall when workers stay for extra
shifts). Will you be willing to take the order? It depends. If the music distributor will pay you a price high enough to cover your
increased costs, yes.
Categories of goods that do not "obey" the law of supply
If the price offered for land in downtown Huntsville rises, how does the quantity of land supplied respond? Not at all, of course!
Some goods--those which are not produced by human action--are impervious to the law
of supply. An increase in the price of a good promises higher profits and encourages
production; the higher price acts as an incentive. But if people do not produce the good
in the first place, no incentive can bring forth more of it. There are two broad categories
of these goods:
1. "Land," by which we mean all natural resources. This includes land, minerals,
and—remember—human talent. Note that an increase in the price of crude oil will bring
forth more oil "production," but what this really means is that more oil will be pumped from
the ground during a given time period. It does not mean that more oil will come into
existence under the earth’s surface.
2. Irreproducible goods, such as works of art, rare coins and stamps, etc. No matter
how high the price offered for an original Van Gogh painting, there will be only one
authentic painting.
Goods such as these have a vertical supply curve, as shown in Figure 4 . A change in
price has no effect on quantity supplied.
Market equilibrium
A market is in equilibrium if the quantity demanded equals the quantity supplied. That way, we have neither sellers with unsold goods,
nor buyers with unsatisfied demand. That’s why we often say that the market “clears.” We’ll see that this will happen only at one price
among all possible prices that could be charged in the market.
First, let's clarify our terms. The equilibrium price (Pe) is the hypothetical price that "matches" demand and supply exactly. The market
price (Pmkt)is the actual observed price that happens to prevail in the market at a particular time. The two do not have to be the same,
that is, the market does not have to be in equilibrium. But it has a strong tendency to do that, and if it is not exactly in equilibrium, it will
tend to move toward it.
Now our two cases.