Right off the bat I will say that this post won’t really provide you much insight into the intuitive concepts of economics. I’m not really intending it to be that sort of post. I mentioned at the end of the first part of my Supply and Demand post that there was a lot more information buried into these concepts that we have to extract and that’s what I am going to do now. But I am doing it mainly because these concepts are tough for those of you who are taking high school or college level econ courses and this is part of my guide to those courses. You may notice that I’ve added a new menu to the top of the page and it’s for posts such as these that are really only serving to help those who are struggling through their courses. I know when I was a student, outside of the very dry and very technically written textbook, there was very little information or help available on some of these introductory concepts. That makes things difficult to understand and difficult to learn.
When I was young, I started to play a lot of tennis and really enjoyed the game. Instead of continuing to miss shots wildly and fail to complete many serves, I found a coach who worked with me to improve my game. The problem was that my coach ultimately taught me some really bad habits that made things very difficult as I got older and wanted to compete at higher and higher levels. I mention all of this to try and highlight the point that good instruction early is really important. If you are a college student sitting down in an introductory economics course right now and have an interest in going future with an economics education, it’s really important to understand these basic concepts really well. Like I said, when I was a student, there wasn’t many auxiliary information available. Given what I have learned and heard from the students that I have taught over the last few years, I think these posts should be a good resource to you. Because of all of this, this post (and others like it) will be much more geared towards a course framework and focus a little less on the intuitive story telling that I try to use throughout the other posts.
OK, enough introductory remarks, let’s get back to some super-duper exciting economics action…
Increases and Decreases in Demand
At the end of the last post, I harped on an important distinction that economists, though more importantly, economics professors, love to drill you on. That’s the important distinction between a change in quantity demanded versus a change in demand. Two very, very different concepts that nearly everyone who first learns about economics will want to use interchangeably. At least in the courses that I have taught, if you aren’t careful about this difference between quantity of demand and demand, you are likely to lose at least 20% on your midterm. The key in understanding it all is this: a change in price of the good itself is the only thing that will change quantity of demand. Everything else will shift the demand curve. Looking at the curve, this should make some pretty simple sense:
The demand curve is a simple plot against all the possible price/quantity combinations for a given product. That is, I have a mathematical expression which allows me to plug in either a price or a quantity into the expression and get the corresponding price or quantity out of it. It’s a fancy way of saying, if I change the price variable, I am simply moving along the curve. None of the factors which define where the curve is or how steep or flat it is haven’t changed. Only price has changed and we can play with that variable by moving along the curve. Again, in this instance of a price change, there is a corresponding change in quantity demanded.
Which, of course, begs the question: what factors will cause a change in demand? More commonly, this will be referred to as a shift in the demand curve, since we will change factors that determine what the curve looks like (i.e., we will get a new curve by changing these variables as opposed to moving along the curve as before with price changes). Again, any change other than price will cause a shift of the demand curve. These factors have been summarized below to describe all the factors that could shift a demand curve. Before I get to that, it’s important to understand intuitively what a shift (increase or decrease) in demand is all about. An increase in demand, intuitively, simply means that at every price, I the consumer now demand a greater quantity. At a price of 4 dollars, where I once demanded 20 units, I now demand 30 units. Same price, but a greater quantity demanded. Likewise, a decrease in demand simply means that at every price, I now demand a fewer units. I have a graph pasted below of what this is like in visual form which might make things more clear. Now, that I have that covered, let’s look at the factors which can shift the demand curve:
- Population: Intuitively, this should be fairly easy to understand. If there is an increase in the population of a market (a market defined as some space of consumers that would interested in the product being sold), it would stand to reason that there would be an increase in demand. As an example, if I am operating a gas station out in the middle of nowhere, I can expect the demand for my gasoline to be pretty low. There simply aren’t are a lot of consumers in my market. But if I am operating a gas station in the middle of a busy suburb, I can expect the demand for my gasoline to be much higher in my market.
- Income: At first, this should make some easy sense but there is a slight catch. If the income of a given market increases, intuitively, you would expect there to be an increase in demand. More money for people spend on things, more demand, right? Well, this only happens for certain goods. This is the distinction between a normal good and an inferior good. A normal good is defined as a good whose demand increases when the income of a market increases (there are mathematical formulas for precisely calculating this which I will try to cover in a later post). An inferior good is then the opposite, a good whose demand decreases when the income of a market increases. The classic example is ground beef versus filet mignon. If the income in a market decreases (such as during a recession), consumers will substitute out of pricer items like filet and into cheaper items like ground beef. But, conversely, if the income in a market increases, the opposite will take place. For this reason, it should come as no surprise that McDonalds has been doing very well throughout this recession. Generally speaking, we can expect a 1 dollar cheeseburger to be an inferior good. As income has decreased throughout the recession, more and more consumers substitute into McDonalds food items, causing an increase in demand for McDonalds. As evidence, take a look at their 2 year chart (ignore the colored moving average lines):
- Seasonality: Again, this should be fairly simple to understand. We demand more Christmas trees during the winter months than we do otherwise. I demand a hell of a lot more electricity during the summer months to keep my apartment cool in the desert than I do during the winter. This just points to the idea that there are certain times of the year when I demand somethings more than I would otherwise.
- Expectations: Imagine that you knew that tomorrow the price of gasoline would be 10 cents per gallon higher than it would be today. What would you do today? Clearly, your demand for gasoline would increase today based upon the expectation that prices will be higher tomorrow. Likewise, if you expect prices to be lower tomorrow, you will likely wait until tomorrow to purchase gasoline.
- Price of Substitute goods: This is where things get a little more complicated. Remember how I mention continuously that everything is relative. Well here is another example. In the grocery store, if I have Coke and Pepsi on the shelf, what would happen to the demand for Coke if I lower the price of Pepsi? It should make some sense that if I lower the price of a good that I can easily substitute (that is, I am fairly indifferent between Coke and Pepsi since I just want to buy cola), it will lower the demand for the good I’m focusing on. Butter and margarine is another classic example. This relationship will make more sense as I discuss…
- The Price of Complementary goods: This is the opposite scenario from before. Whereas I could easily trade off between Coke and Pepsi, complementary goods are those which need to go together. The most classic example is left shoes and right shoes. I only have use for the shoes if I have both a left and a right shoe. Having two left shoes does me nothing. Other examples: tennis balls and tennis rackets, golf balls and golf clubs, hardware and software, etc. When the price of tennis rackets does up, what would happen to the demand for tennis balls? Since you only get value out having both tennis balls and tennis rackets together, an increase in the price of tennis rackets will lead to a decrease in demand for tennis balls. As before with normal and inferior goods, there are mathematical formulas to precisely calculate what are complementary goods and what are inferior goods. I will try to cover this in a later post.
- Taste: This is the one where if we can’t figure out why demand has increased, it’s because of taste. Intuitively, I like to think of this as Apple. The demand for Apple products is normally very, very high and a lot of that has to do with taste. It’s not a very scientific factor, but is one that nevertheless has a clear effect on demand.
Graphically, this what these changes look like (again, demonstrating that every price the consumers are now demand more – or less). A rightward shift of the demand curve shows the increase and, likewise, a leftward shift of the demand curve shows a decrease in demand:
Increases and Decreases in Supply
After all the fun of going over demand, why would you want to stop? Well, fortunately, I have a whole new list of factors which result in increases and decreases in supply as well. Before I get to this list, I want to stress one thing about supply and demand that can tend to be forgotten when these factors that change supply and demand are discussed. It is very important to remember that supply and demand are two separate concepts that do not affect one another. An increase in population of a market will not cause an increase in supply, but it will only cause an increase in demand. Some of the factors seem reasonably similar and it is important to maintain the distinction between supply and demand in order to avoid merging the concepts. That warning now covered, let me first intuitively define what an increase or decrease in supply is like. Much like demand, an increase in supply means that for every price, suppliers are now willing to supply a greater quantity (and opposite for a decrease in supply). Especially in your economics course, it’s good to remember these definitions so that any non-obvious questions can be answered easier. Now, let’s hit the list:
- Number of producers: Note that this is not the same as increase in population. We are only talking about the number of producers here and not the number of consumers (remember, distinction between supply and demand). Otherwise, this is intuitively very simple. The more producers of computers I have, the more computers I can expect to be supplied.
- Prices of resources used in production: If I am a producer of road bikes, the price of metals used in making that bike is very important. If the price of metal increases, I will be able to purchase fewer resources and therefore supply fewer bikes. Of course, if those resource prices decreases, I can purchase more resources and produce more bikes at every product price.
- Change in technology: With the advent of computers, came a change of technology and the ability to use resources more efficiently. It took fewer hours, for instance, to balance a checkbook with a computer than it did by hand. The employee that used to do nothing more than balance checkbooks by hand can now do the same task in less time and have time to do other things as well. Now we can produce more by being able to use resources more efficiently.
- Price of substitutes in production: Given the resources that I have, I can choose to produce certain things. In my bike example, I could produce a road bike or I produce an off-road bike. If the price increases for off-road bikes, I will shift production to produce more off-road bikes. Note that this not the same as a substitute good for consumers. I could be a producer of goods made out of wood and decide between making a big, handcrafted sailboat or a few coffee tables. If the price of coffee tables increases, I will shift production to produce more coffee tables and fewer sailboats. It should be clear that consumers do not view coffee tables and sailboats as substitutes. But, as producers, we can produce one or the other and therefore see the two as substitutes in production.
- Expectations: Very similar to expectations in demand, but still, this is its own concept. I am decided how much to produce today for a certain good. If I expect the price of that good to increase in the future, I will increase production of that good today despite the fact that the price today did not change.
As with demand before, I have a nice Excel-generated graph to demonstrate what these shifts in supply look like (with a rightward shift showing an increase in supply and a leftward shift showing a decrease in supply):
What conclusions can we draw when we shift supply and/or demand?
If you are preparing for your economics midterm, the questions that will be asked a lot will be those which force you to focus on whether or not there was a change in supply versus change in quantity supplied (likewise for demand) as well as those which will force you to make conclusions as to what happens to equilibrium when these changes take place. I won’t go through all of the scenarios but I will go through one here and you should be able to get the idea of what’s going on and what you need to look out for:
In this scenario, I went with the more complicated scenario since I figure if you can understand this scenario, the easier questions with only one change happening at once should make sense to you. Here I have D1 and S1 as the initial demand and supply curves (and D2 and S2 as the new demand and supply curves, representing increases in both supply and demand). Remembering equilibrium determination from the previous post, it should be clear that there is an initial equilibrium with a price equal to 50 cents and a quantity equal to 5. Now, with the increases in supply and demand, I have a new equilibrium price and quantity. I don’t have it precisely marked, but let’s call this new equilibrium at a price of 55 cents and a quantity of 6.5 units. In this more definite example, price increases and quantity increases as well. But most midterms will not ask this question with clear graphs and clear numbers. They will be asked more generally. So what if I don’t give you these initial and new supply and demand curves and just ask you, if demand increases and supply increases, what can we conclude?
I can still use this graph to describe this scenario. No matter how I draw the curves (that is, no matter how big or small I make the increases in supply and demand), quantity increases. Prove this to yourself by experimenting with your own graphs. Make the increase in supply huge and the increase in demand small. You will always see quantity increase. But what about price? In the example I drew above, the price increased. But this doesn’t necessarily have to be the case. Copy the above example exactly except make the increase in supply huge (shift the curve far to the right). Here you will see that that quantity increased but price decreased. So what can we conclude?
Only that quantity will unequivocally increase. Price is indeterminate. Depending upon how big the supply and demand shifts are, price could either increase or decrease.
This example is one that many students will miss on a midterm and something that if you are in a college course looking for help I really recommend you practice. This example also demonstrates how important it is to draw pictures when trying to make some economic conclusions. Trying to memorize what happens when supply increases, what happens when demand increases, when supply increases but demand decreases, etc. will only create confusion. Draw the graphs yourself and understand how to draw the conclusions yourself. Nothing to memorize then.
This is already a fairly long post but I’ve got even more to talk about. What we get to talk about is an interesting concept which we can make some practical applications with.
Elasticity
Imagine you are the CEO of a company selling cereal. What you want to know is whether or not you should lower your price in the hopes of getting more sales. The main factor in this decision is understanding by just how much your price decrease will increase sales. If you lower your price but it only results in a few more sales, it would likely be a poor idea to lower your price. However, if the lower price results in a big increase in sales, it would likely be a great idea to lower your price.
What this example is flirting around is the question of how sensitive consumers are to price changes. Using scientific terms, this is called elasticity of demand. Intuitively, the definition of elasticity of demand is: given a one percentage change in price, there will be a certain percentage change in quantity demanded. That is, Ed (for elasticity of demand) = (Percentage change in quantity demanded) / (Percentage change in price). This relationship helps us to precisely determine just how sensitive consumers are to price changes. Students always like equations since they just require memorization and no real critical thinking. So I will you give you that equation. Elasticity of demand = PDQ / QDP. Given a starting quantity and price and an ending quantity and price, I was always able to remember how to calculate elasticities by remembering this expression. PDQ QDP. (P)(DQ) / (Q)(DP). Step by step: 1) P = average price; 2) DP = change in price; 3) Q = average quantity; 4) change in price. Insert the numbers and off you go. Let’s go back to the original demand curve I used all the back in the last post to demonstrate:
I’ve put a lot of information in this picture, so let’s just start off with the top right corner. I’ve shown the process of calculating the elasticity of demand when a price decrease from 1 dollar to 80 cents results in a quantity increase from 0 to 2. Simply plugging in the numbers gets Ed = – 9. Note that elasticity of demand will always be negative (unless it is 0) due to the inverse relationship between price and quantity. Many times economists, professors and textbooks, the negative sign is dropped and ignored. Just know that elasticity of demand is always negative even if your text doesn’t necessarily show it (it could be a trick question, mind you, if an answer shows Ed equal to some positive number).
But, like I said, there is a lot of information here. I also calculated the elasticity of demand for when price decreases from 30 cents to 10 cents and quantity increases from 7 to 9 (You can do a little practice for yourself by showing that the elasticity of demand is the same if you calculate it the opposite way: price increase from 10 cents to 30 cents with a quantity decrease from 9 to 7 units). What’s interesting with this next elasticity? It’s completely different from the first example. It’s to demonstrate that elasticity even in a linear demand curve is not constant. In more general terms, near the bottom end of the curve, elasticity will be low; at the upper end of the curve, elasticity of demand will be high.
To clean that last sentence up a little bit and make it more precise, we need some new terms about what all these numbers actually mean. Thus, there are five different types of elasticity of demand:
- Elastic demand: Demand is said to be elastic if its elasticity of demand is less than -1. The upper part of the curve is, then, the elastic portion of the curve where all the elasticities are less than -1. (Visually, this is seen when the whole demand curve is more flat)
- Inelastic demand: Demand is said to be inelastic if its elasticity of demand is less than zero but greater than -1. This lower part of the curve is the inelastic portion of the curve where all the elasticities fit this definition. (Visually, this is seen when the whole demand curve is much more steep)
- Unitary elastic demand: This is nothing more than the point where elasticity of demand is equal to -1.
- Infinitely inelastic demand: Visually, this is represented by a vertical demand curve where a price change results in absolutely no quantity change. Elasticity is not able to be calculated since the denumerator here will equal zero.
- Infinitely elastic demand: This will be seen by a completely flat demand curve where a price change results in an infinite increase in quantity demanded. That explains why an infinitely elastic demand curve has its elasticity equal to zero.
Phew, that’s a lot of terms and words. But let’s go back to my favorite question: Why? Why do I care about the elastic, inelastic and unitary elastic portions of the demand curve? One word: revenue. Revenue is simply equal to price times quantity. By definition of these various elasticities we know how revenue will change as we move along the curve. Say we are at a price equal to 10 cents and a quantity equal to 9. As we much up the curve what do you think will happen to revenue? Since this is the inelastic portion of the demand curve, the percentage increase in price will be greater than the percentage decrease in quantity. Because of this, revenue will increase as we move up the inelastic portion of the demand curve.
Now. Start at the other end. What happens when we move down the elastic portion of the demand curve? Because of what we know about elastic demand, we know that the percentage decrease in price will be less than the percentage increase in quantity. Just as before, this results in revenue increasing.
So as we go from the bottom of the curve up, revenue increases. And as we go from the top of the curve down, revenue increases. It does this until we reach the unitary elastic portion of the curve. At this point, the percentage change in quantity will be equal to the percentage change in price. Thus revenue remains constant.
This is all a long way to say that revenue is maximized at the unitary elastic portion of the demand curve.
Note, however, that I am not saying that this is where a business should try and operate. This portion will maximize revenue but a business doesn’t necessarily want to maximize revenue. It wants to maximize profit. Thus, don’t take this conclusion about maximizing revenue too far. All it says is exactly what it says: revenue will be maximize on the unitary elastic portion of the demand curve.
Finally, though I am not going to go through all of this again, the same conclusions and the same methods are used when talking about the elasticity of supply. We use the same formula and the same terms to describe elasticity as it refers to supply. The only difference is that the elasticity numbers will now be positive since price increases as quantity increases. (That is, elastic supply is now those elasticities of supply greater than 1, and so forth).
Now I am confirm that this is the longest post on this site so far. And I think that’s a good sign that I’ve covered enough. Again, this post is more designed for those looking for a little tutoring-type help with their economics course. As a result, I’m sorry for it being so dry. But these concepts are nevertheless still important and ones that are used a lot.
