Question

You have seen the underpinnings of production economics and utility theory in the derivation of market supply and market demand curves. Clearly explain the concepts of changes in supply and change in demand and changes in quantities supplied and quantities demanded. Explain how different elasticities are related to these concepts.

Answer 1

Demand, in economics, is the willingness and ability of consumers to purchase a given amount of a good or service at a given price. Supply is the willingness of sellers to offer a given quantity of a good or service for a given price. Later, study on the theory of the firm will yield the supply curve. The demand and supply model is useful in explaining how price and quantity traded are determined and how external influences affect the values of those variables. Buyers’ behavior is captured in the demand function and its graphical equivalent, the demand curve. This curve shows both the highest price buyers are willing to pay for each quantity, and the highest quantity buyers are willing and able to purchase at each price. Sellers’ behavior is captured in the supply function and its graphical equivalent, the supply curve. This curve shows simultaneously the lowest price sellers are willing to accept for each quantity and the highest quantity sellers are willing to offer at each price. If, at a given quantity, the highest price that buyers are willing to pay is equal to the lowest price that sellers are willing to accept, we say the market has reached its equilibrium quantity. Alternatively, when the quantity that buyers are willing and able to purchase at a given price is just equal to the quantity that sellers are willing to offer at that same price, we say the market has discovered the equilibrium price. So equilibrium price and quantity are achieved simultaneously, and as long as neither the supply curve nor the demand curve shifts, there is no tendency for either price or quantity to vary from their equilibrium values.

The quantity consumers are willing to buy clearly depends on a number of different factors called variables. Perhaps the most important of those variables is the item’s own price. In general, economists believe that as the price of a good rises, buyers will choose to buy less of it, and as its price falls, they buy more. This is such a ubiquitous observation that it has come to be called the law of demand, although we shall see that it need not hold in all circumstances. Although a good’s own price is important in determining consumers’ willingness to purchase it, other variables also have influence on that decision, such as consumers’ incomes, their tastes and preferences, the prices of other goods that serve as substitutes or complements, and so on. Economists attempt to capture all of these influences in a relationship called the demand function.

The willingness and ability to sell a good or service is called supply. In general, producers are willing to sell their product for a price as long as that price is at least as high as the cost to produce an additional unit of the product. It follows that the willingness to supply, called the supply function, depends on the price at which the good can be sold as well as the cost of production for an additional unit of the good. The greater the difference between those two values, the greater is the willingness of producers to supply the good. In another reading, we will explore the cost of production in greater detail. At this point, we need to understand only the basics of cost. At its simplest level, production of a good consists of transforming inputs, or factors of production (such as land, labor, capital, and materials) into finished goods and services. Economists refer to the “rules” that govern this transformation as the technology of production. Because producers have to purchase inputs in factor markets, the cost of production depends on both the technology and the price of those factors. Clearly, willingness to supply is dependent on not only the price of a producer’s output, but also additionally on the prices (i.e., costs) of the inputs necessary to produce it. For simplicity, we can assume that the only input in a production process is labor that must be purchased in the labor market. The price of an hour of labor is the wage rate, or W. Hence, we can say that (for any given level of technology) the willingness to supply a good depends on the price of that good and the wage rate.

The general model of demand and supply can be highly useful in understanding directional changes in prices and quantities that result from shifts in one or the other curve. At a deeper quantitative level, though, we often need to measure just how sensitive quantity demanded or supplied is to changes in the independent variables that affect them. Here is where the concept of elasticity of demand and supply plays a crucial role in microeconomics. s. When demand is not very sensitive to price, we say demand is inelastic. To be precise, when the magnitude (ignoring algebraic sign) of the own-price elasticity coefficient has a value less than one, demand is defined to be inelastic. When that magnitude is greater than one, demand is defined to be elastic. And when the elasticity coefficient is equal to negative one, demand is said to be unit elastic, or unitary elastic. Note that if the law of demand holds, own-price elasticity of demand will always be negative, because a rise in price will be associated with a fall in quantity demanded, but it can be either elastic or inelastic.