It’s come the time, inevitable though it was, to talk about the concept nearly everyone recognizes to some degree when asked about economics. It’s the bread and butter, really. In my experience, using explicitly a supply and demand curve for analysis is actually rather rare. However, there is no question that this is where the party starts, to coin an expression. This is really the one post that really needs to be made before I can get into more advanced matters. Understanding the laws of supply and demand thoroughly is very akin to understanding how the world of economics operates, what sort of rules we are working with, and how a problem will be approached. Remember, economics is a perspective, a way of looking at things. You need to be able to see through that lens to understand why certain things are being said and why certain conclusions are being made. Without that lens, economics will forever be the “it’s all Greek to me” sort of topic for you.
One last comment before moving on. You should remember while reading this that, for this topic in particular, this is not a college-level course which will go more in-depth and more accurately derive the two laws. There will be a few things that I am sure I will miss or be a little more vague on. Just remember at the very least that the idea is to get the general picture, the intuition behind it all. This is not about trying to memorize definitions and precisely and flawlessly derive the concepts.
But enough of my caveats and concerns. Time to get to the ideas that I am sure most visiting this site are going to look for.
Let’s start with this: Why do I want to derive the laws of supply and demand? To me, this question of “Why” is one that you should ask yourself continuously when you approach a problem or concept of any kind. Understanding the motivation behind the topic helps frame this lens that I keep banging on about. Knowing where you want to get to at the end of it all and why you are trying to get there makes the process of getting there much easier. If I sat you down and started barking commands to do this and then do that, you would be a constant state of confusion. Why I am asking you to do these things? It makes it very difficult to operate at your best when you don’t really know what you are doing.
The same goes for economics. I always ask myself “Why” before I start trying to answer any problem or approach any concept. So why are we looking at the laws of supply and demand? In simple terms, we are trying to explain market behavior. Why do I go to the grocery store and see that the price of bread is $2 or go to the Apple Store and see a big iPod priced at $499? These tools allow us to apply consistent thoughts and rules to any market and make sense of what is happening within that market. This includes making distinctions about market structures (such as competitive markets or monopolistic markets), analyzing equilibrium prices and quantities, and what causes changes in either. Of course, we are also working to develop some principles that we can use and manipulate to create even more interesting models and conclusions. (As an example, in my introductory post, I talked a lot about the Laffer Curve. Before I can even begin to discuss the derivation of that concept, understanding supply and demand is critical.)
Diminishing Marginal Utility
There are two principles we need to cover before we can start talking about supply and demand themselves. The first is the law of diminishing marginal utility. (If you are unfamiliar with utility and utilitarianism, jump back a to an earlier post and brush up.) It is said many times that in economics, decisions are made at the margins. Over time this will become more and more clear, but at least here it can especially be seen. In general, what we are talking about here is the last unit and analyzing what the last of something brought us. In a market, we are talking about the last good that we purchased. Every time we purchase a good or service, we attain a certain level of utility from that good or service. As we consume more and more goods and services we start to compile a certain amount of total utility. Marginal utility, then, is the addition to total utility that the last unit brought us. If the marginal utility of the 8th unit is 10 utils, then that means that the 8th unit added 10 utils to total utility. Diminishing marginal utility points to the idea that at some point, the marginal utility of a good will decrease from one item to the next. The graph below describes this concept:
This is a typical graph of a marginal utility curve for some good. Note that for the first item, the marginal utility is 8 utils; the first item adds an additional 8 utils to total utility. The second item, in the same fashion, adds an additional 10 utils, and the third item adds an additional 8 utils to total utility. Note that the marginal utility of the third item was less than that of the second item. The third item brought me less additional satisfaction than the third item. In an exaggerated example, imagine you are lost and wondering in the desert for a couple days and are desperately dehydrated. Now let’s say that by pure magical luck there appears a vending machine serving ice cold water bottles. Say you buy one water bottle. That first water bottle is going to bring you a huge amount of satisfaction. You would be willing to pay millions to get that water bottle it’s worth so much. But after the first water bottle, you are now a little more hydrated and your thirst a little more quenched. Thus, the second water bottle, though still great to have, brings you less satisfaction than the first. Again, the third water bottle brings you even less satisfaction now that you’ve satisfied your thirst. As a result, you can see the diminishing marginal utility. Each successive water bottle after the first brings you less satisfaction than the previous one. This can be applied to any good or service. I’d love one Big Mac but after the first, I’m pretty full and don’t really need the second. That is, the first Big Mac brings me a lot of satisfaction and diminishing marginal utility sets in after that.
This concept of utility, marginal utility, and diminishing marginal utility is what will eventually form the basis for a lot of the conclusions that will make, particularly with demand. Why is that? Utility represents value, in simple terms. Based upon that value you, the consumer, will make decisions about how much you will be paying to attain that value and how many you will purchase. Without this idea of utility and utils of satisfaction, it makes it extraordinarily difficult to create an objective construct for demand and markets in general.
Demand
This leads up first to demand. As I was just mentioning, marginal utility helps us place objective measures on value. Demand, intuitively, simply represents how much of something we want at a certain price. If the price of a certain product is 1 dollars, how many units will I purchase? Naturally, we are looking to graphically represent this. Hypothetically, could this demand graph be an upward sloping line? Clearly, due to diminishing marginal utility, demand can not be such a line. Otherwise, the conclusion the graph reaches is that for every additional unit I buy, I am more satisfied and attain more utility. There are a couple of special circumstances we will talk about later, but this leads us to conclude that demand must be a downward sloping line because of diminishing marginal utility. Simplified with a linear (straight) line, we get a graph of demand that looks like this:
This graph shows us the inverse relationship between price and quantity that result due to diminishing returns. It’s been simplified with a linear line but all the conclusions that we make will still hold true whether we are using linear or non-linear lines. There’s actually a huge amount of information in this graph, but let’s just start with the most basic and easy to see. I learned demand by talking about candy bars, so, for the sake of nostalgia, let’s call this my own personal demand curve for candy bars. If I go to the store and see that candy bars are priced at one dollar each, I buy none. If I see them priced at 50 cents each, I buy 5. Likewise, if the price is 0, as in free, I buy 10. By definition, then, the demand curve lists the maximum price consumers are willing and able to pay for a given quantity. Again, the maximum price I am willing and able to pay for 5 units is 50 cents as defined by the demand schedule example above.
Law of Diminishing Returns
This concept is one that we can cover a little bit more generally. Let’s explain this one first with an example. Imagine you just purchased and built your own restaurant. You have hired all the staff you need and purchased all the raw materials, but for the wait staff. Thus, the decision you are asking yourself is how many to hire. This decision you will make is based upon how much the waiter/waitress can produce , as in, how many meals the restaurant can serve. If you hire one waiter, let’s say it allows the restaurant to sell 10 meals. With only one waiter, there is only so much he can do, only so many tables he can serve. As a result, you hire an additional waitress to help out. As a result, the restaurant can now serve 22 meals. More tables can now be served and our original waiter can rush just a little less allowing for better productivity. You like this trend so you hire a third waiter. Again, two waiters was still too few for a brand new, busy restaurant and they weren’t able to work very productively. Now with the third waiter, everything is how a restaurant should be. There are just enough tables for each waiter to serve and the restaurant can now sell 38 meals. However, let’s say you want to hire a fourth waiter. Well, having an extra set of hands certainly does allow a little bit more help and more meals can be sold. But things start to get a little crowded around the kitchen and waiters are now bumping into each other. As a result, if you hire that fourth waiter, you could sell more meals (let’s say 45 meals), but that last waiter brought less to the table than any waiter did previously. The table below graphically shows what we are talking about here:
Also just remember that this graph isn't perfectly drawn to scale. Just bear with me on this...
The key again goes back to the margins. What we are looking at here closely is the marginal product of the various inputs (in this case, waiters and waitresses). As we hired the first three employees, the marginal product of those employees increased. Yes, total product (the total amount of meals served) did increase. However, the third waiter was able to add 16 meals to our total whereas the fourth only added 7 meals to our total. At any number of waiters past this third waiter, we say that diminishing returns is setting in. As we hired more and more employees, we could be increasingly more productive but after the third waiter, marginal product was increasing at a decreasing rate. This points to the decreasing productivity of the employees, our employees are marginally returning less than they were before.
One last note. As before with diminishing marginal utility, the idea to grasp is that at some point you can not hire or purchase more units and see increasing returns (marginal product increase). In some industries with huge scale, such as an electric utilities company, this maximum point of marginal product is way out there. The point, though, is that it does exist. An electric utilities company couldn’t just keep making nuclear power plants day after day after day after day and always expect more and more customers to purchase that electricity. Likewise, of course, there are plenty of businesses which would see very quick diminishing returns. A gas station, for example, wouldn’t need two or three cashiers unless it was the only one located on the side of a hugely busy highway.
Supply
Much like before with demand, we can now use this concept of diminishing returns to get a general idea of what the supply curve looks like. With diminishing returns, we looked at how in order to continue to produce more and more units, we had to hire more and more resources (whether they be workers, physical inputs, etc.). Because of this, the supply curve simply can not be a downward sloping line that demand is. The conclusion such a curve would draw is that it would cheapest to produce as many units as possible. What diminishing returns, marginal product, and total product show us is that the supply must be upward sloping. That is, in order for the business to produce and sell more units, it must require a higher price. With costs increasing as we produce more and more units, naturally, a higher price must go along with it. With those general notions, we can simply things (again, with linear lines) to get a supply curve looking like the following:
Much like demand, the interpretation of this graph is quite simple, just reversed. Instead of quantity of demand increasing as price decreases, the quantity of supply decreases as prices decreases (and increases as price increases, of course). And what is important to grasp from all these pictures is that we have taken some simple ideas that we can all agree to be true and turned them into picture form. The demand curve says that if we cant to buy more of something, we need a lower price. Similarly, the supply curve simply says that if businesses are going to produce more units they are going to need higher prices to cover the diminishing returns. These two supply and demand graphs are simplified, yes, with linear lines but that does not make them inaccurate. In fact, all of the same conclusions that we could have drawn from more complex expressions would still hold true here in linear form. Similar to the definition of demand we had before, the supply curve, by definition, shows us the minimum price suppliers are willing and able to sell a given quantity for. That is, in order for a supplier to produce 5 units, they must be able to charge at least 50 cents, in this example.
Determining Equilibrium
This term is clearly a favor with economists: equilibrium. We want things to be in balance; we want things to be stable. So how do we find stability in a market? I am going to do what you knew I was already going to do. Let’s put both supply and demand into the same picture and see what we can learn:
Of course, the question now that we have both curves down simultaneously is where equilibrium is in this market. Of course, you’re answer is probably where the two lines intersect. Where else could equilibrium be? Well, let’s ask ourselves this. Remember, it’s important to understand the “Why” of what you are doing. Remembering something as “the place where two lines intersect” is not nearly as strong as remembering “the point both supply and demand are sufficiently satisfied.” What if we have multiple lines drawn here in all sorts of directions? Understanding only that equilibria exist only where lines intersect won’t necessarily help you in that sort of scenario. Finally, this website isn’t necessarily about getting you through your high school or college econ course (though, admittedly, I’m sure there are all of you that will use this site for that reason). Even if you are here trying to get through a course, you should still try to learn to intuition behind it all. That’s why we are here reading this post: to understand the logic behind what economics is trying to tell us.
So let’s ask ourselves: could a price of 70 cents and 3 units be in equilibrium? It’s can’t for one reason: if the price were set at 70 cents, suppliers would want to sell 7 units, but demanders would only buy 3 units. That is, quantity of supply does not equal quantity of demand. Likewise, let’s see if a price of 30 cents and 7 units is an equilibrium. Again, for very similar reasons as before, this can not be. If the price were 30 cents, consumers would want to purchase 7 units, but, because of increasing costs, a price of 30 cents means suppliers only want to sell 3 units. Thus, supply does not equal demand here either. With that in mind, the point where supply equals demand, the point where the two intersect, must be equilibrium because it’s the point where all the units that the suppliers will supply will be sufficiently purchases. 5 units will be supplied and 5 units will be demanded at a price of 50 cents.
One last point, which tends to be a bit of pet peeve for those of us who have taught economics or been a good student of it for a while. There is a very large distinction between supply, demand, quantity of supply, and quantity of demand. For now, just know that quantity of supply and quantity of demand are changed only by the price of the product. That is, if we are analyzing points along the curve, we are looking at changes at quantity of supply or demand. An increase in price will necessarily lead to a decrease in quantity demanded NOT demand. Saying, “a price increase caused an increase in supply,” is an inaccurate statement. A price increase leads to an increase in quantity of supply. This is an important distinction which will become more clear as we start to shift both supply and demand. For now, if we change other factors other than price, that will lead to an increase/decrease of supply/demand. I will cover these changes in a later post, fear not. Still, it’s important that when these concepts are discussed that we are consistent with the terms being used. Fortunately, if you are reading this because you are desperate to cram for a mid-term, this is something that Econ professors love to use all the time to trick you up. To most, it’s a silly distinction. But it’s a distinction that you either respect or it’s one that will likely see you lose 20% of your grade on your test simply because you weren’t careful enough to spot this distinction.
There’s a lot more to go through with this diagram and a lot more information buried in here. I’m going to save that information for a later post since I’m already very deep into this one. I’ve already said it in this post, but, especially for this site and those of you who aren’t here studying for course material, the key is to grasp the intuition of what is being said. With these simple intuitive ideas, we can make these simple conclusions. But more information and more ideas will be added to make for some more interesting conclusions. This is but the beginning, and if you can’t understand it now, it will be very difficult to understand in the future.
All that said, read through it a couple of times, leave comments, email questions, even if you are looking for helping hand to get you through your mid-term!
And if you think you’ve understood this and are looking for more, go ahead and check out Part 2.
