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Demand, Supply, and Markets
The concepts of demand and supply are at the foundation of market analysis in microeconomics. This chapter constitutes an overview of the issues, which shall be investigated in much greater detail in the chapters that follow.
Lecture Outline
Lecture Notes
I. The Basis For Demand
Demandis the quantity of a good or a service that buyers are willing to purchase during a particular time period, and for a particular state of the market environment. The market environment typically depends on conditions such as the price of the good in question, the price of various available substitute goods that form the competition for the good in question, the price of available complementary goods (ex: computers and computer software), the incomes and budgets of the consumers, expectations regarding price changes and availability, consumer tastes and preferences, number of consumers, and their travel costs to the point of purchase.The consumer theory of demand, which is relevant for final goods and services (e.g., direct demand for consumer goods), allows economists to derive demand as a function of consumer utility (e.g., the level of value to a consumer), the consumer's available budget, and the price of the good (and of other substitutes and complements that the consumer can also buy). Under the consumer theory of demand, consumers are assumed to be utility maximizers, subject to their budget constraint and prices.
There is also a demand for the inputs used in manufacturing and production of final goods and services, referred to as derived demand because the demand for the input derives from the demand for the final goods and services that can be produced with it. For example, the demand for construction workers, office workers, business machines and computers, commercial tools and equipment, and many basic commodities all derive from the final goods and services that their inputs contribute to. These inputs are also referred to as intermediate goods or producer goods.
Key components of derived demand include the marginal benefits and the marginal costs associated with employing a particular input or factor of production. All else equal, employment of a particular input will tend to rise when its marginal benefit rises relative to its marginal cost. In a market system the ultimate demand for inputs derives from their contribution to profitability.
I.a. The Market Demand Function
A demand function relates the level of demand to the level of the various factors that influence demand. A very general demand function for some good Z can be given as follows:QD = f[price of Z, price of each available substitute, price of each available complement, expectations of future price changes, after-tax consumer incomes, consumer tastes and preferences, advertising expenditures, number of consumers].
Statistical and econometric techniques are used to derive demand functions in practice. Consider the following example of an estimated demand function for running shoes:
QD = -523,000xAVGP + 84,000xWALK + 2108xDISPINC + .44xPOP - 290,459xAVGAGE + .068xADVEXPEND + 32,000xICC
Note that AVGP is the average $ price of running shoes in the US, WALK is the average $ price of walking and aerobic shoes in the US, DISPINC is average disposable income of runners in the US, POP is the number of runners in the US, AVGAGE is the average age of runners in the US, ADVEXPEND is total industry advertising expenditures in $, and ICC is the average value of the Index of Consumer Confidance. In the example below, the ICC for 1996 is given as being 97. As of Sept. 2000 the ICC stood at approximately 144, and all else equal the higher the ICC the more consumers will spend. The table below illustrates how each factor influences the total estimated number of pairs of running shoes that will sell in 1996:
I.a.1. Industry Demand Versus Firm Demand
A market demand curve can be estimated for either an individual firm or for an entire industry, as in the example above. If one is performing an analysis for an individual firm, other factors such as the price of rival firms' running shoes, rival firms' advertising expenditures, etc. Note that the estimated parameters (coefficients) will generally differ across individual firms, and for the entire industry. This is to be expected, since firms' products differ in terms of perceived characteristics, uniqueness, reputation, etc.
I.b. The Demand Curve
While demand functions are very inclusive, meaning that all the measurable factors are typically included, in contrast demand curves are limited to displaying the relationship beteween various prices and the quantity demanded at each price, holding all the other factors that influence demand constant. We tend to think that demand curves are downward-sloping because lower prices, all else equal, will induce a larger volume of consumption. This relationship is in fact usually supported by the data.
I.c. Relation Between Demand Curves and Demand Functions
Using the running shoes example above, holding all other factors constant means that:
QD = -523,000xAVGP + 84,000x50 + 2108x24,000 + .44x80,000,000 - 290,459x30 + .068x200,000,000 + 32,000x97, or, simplifying,
QD = 97,982,230 -523,000xAVGP
We can then plot this estimated demand curve:
A shift in demand occurs when one of the factors that we have held constant changes in some way, such as the price of walking shoes, the average level of disposable income, or the level of advertising expenditure. Practice: Change the average price of walking shoes from $50 to $80 and see how the demand curve shifts for running shoes.
What causes a movement along a demand curve (known as a change in quantity demanded) and what causes a shift in the demand curve (known as a change in demand)?
Practice: Make an example of a market demand function for residential housing, along the lines of the running shoe demand function example given above. Show how a change in neighborhood safety or interest rates affects the demand for residential real estate.
II. The Basis For Supply
Supply refers to the quantity of a good or service that producers are willing to supply under certain conditions of the market environment, and at a certain period of time. The market environmental factors that influence supply include the price of the good, the price of goods that the seller could alternatively provide, the cost of inputs used to make the good, the available production technology, and expectations of future prices.
II.a. The Market Supply Function
The market supply function for some fictitious good Z relates quantity supplied to the various factors in the economic environment that affect that supply:QS = f[price of Z, price of goods the firm could alternatively produce, the price of inputs used to make Z, available production technology, expectations of future prices].
As with demand, we can actually try to measure a supply function using actual market data, and thus determine the constituent effects of each factor on overall supply. As with demand, we can construct a supply function for either an individual supplier, or for an entire industry by way of aggregation.
II.b. The Supply Curve
A supply curve is a graphical relationship between quantity supplied (either by an individual firm or by the market) and price. As with demand curves, supply curves are constructed by holding all other relevant factors in the supply function constant. We tend to think that a rise in price motivates a larger quantity supplied by firms. Why? One way to think about it is that higher prices for something like art or used cars will induce some people who would not otherwise sell to offer their art or their car on the market. Another is that higher prices raises profit margins per unit, and so if prices rise, firms have a stronger incentive to find a way to expand production capacity.
II.c. Relation Between Supply Curves and Supply Functions
Suppose that econometric and statistical analysis indicates that the industry supply function for running shoes is as follows:QS = 1,185,322.40xP - 68,000xWALK - 99,813xWAGE - 52,094xRUBBER - 38,332xLEATHER -2,517xENERGY
Where P is the price of running shoes, currently averaging $60, WALK is the average price of walking/aerobic shoes, currently $50, WAGE is the average hourly cost of labor to the firm, currently at $10/hour, RUBBER is the average unit cost of rubber/pair, currently at $1.50, LEATHER is the average unit cost of leather/pair, currently at $1, and ENERGY is the average unit cost of energy/pair, currently at $1.
If we hold all factors other than P constant, then the supply function reduces down to:
QS = 1,185,322.40xP - 4,517,119.
Which can be plotted as a supply curve for various values of Q:
Practice: How will the supply curve for running shoes change if the price of electricity doubles from $1 per pair to $2 per pair?
III. Market Equilibrium
The concept of equilibrium means in this case that the market system is at rest -- if none of the independent variables that affect supply or demand change, then if the market is at equilibrium then the given price and quantity will continue into the future.
III.a. Shortages and Surpluses
To see why a price of $60 is the equilibrium price, and 66 million is the equilibrium quantity (sales per year), consider different prices. If price were $70 rather than $60, then under the present market environment sellers will bring much more to the market than buyers will be willing and able to buy, leading to surplus. Markets, through Smith's "Invisible Hand", will resolve surpluses by allowing price to drop. As price falls, sellers will bring fewer units to the market while at the same time buyers will bring more. This process ends when the surplus ends.Suppose instead that price were $52. In the present market context, a $52 price will cause buyers to want to buy substantially more than sellers will want to sell, leading to a shortage. The reverse of surpluses, shortages are resolved by the market process through an increase in price.
Note that since you actually have the functions that drive supply and demand, you can actually derive the size of the shortage or the surplus as a function of price.
The equilibrium that we have discussed so far is static, meaning that it only occurs during a period of time. Over time, factors that we hold constant when we draw a supply or demand curve may change, leading to a change in the market equilibrium. We discuss this point below.
III.b. Comparative Statics
Comparative statics are about evaluating how the (static) market equilibrium can be displaced or changed by a change in one of the factors that we hold constant when we draw a supply and a demand curve.
Comparative Statics Practice Problems
Suppose that the cost of the RUBBER input rises from $1.50 per pair to $2.00 per pair. What will be the new market equilibrium price and quantity?Suppose that the price of walking shoes were to rise from $50 to $65. This should cause both the supply and the demand curves above to shift, because the price of walking shoes is a factor that we held constant when we originally drew these curves. Use the actual functions to re-draw supply and demand, and discuss how this change affects the running shoes market equilibrium price and quantity.