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:

1. 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.
2. 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):
3. 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.
4. 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.
5. 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…
6. 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.
7. 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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.

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.

Recently, you have probably heard from some pretty “smart” people on CNBC or in the New York Times (err… probably Wall Street Journal) voicing concerns about debt and what that will ultimately for one the most discussed economic concepts: inflation. In many ways, inflation is something that you already know and something that most are pretty capable of discussing. What we need to do, though, is think about it a little bit more closely and start to realize why inflation is a pretty important concept. In a quick historical sense, do research on some of the greatest economic collapses of the last few centuries and chances are you are going to read about stratospheric rates of inflation. When one item doubles in price over night it becomes nearly impossible to hold any sort of stability in an economy.

Of course, this sort of hyper-inflation is not quite what will be discussed or expected by economists and political commentators, but it’s a similar idea just in a more restrained sense. This isn’t supposed to be about doomsday messages and the end of the world, but to demonstrate how drastically important money is in our world. Recently, my dad did a great job of creating a metaphor for describing the role of money and inflation in the real world. So, sorry dad, but I am going to steal that story and share it with you.

Firstly, we need to do a little informal history to understand where we are today and why inflation is more of a problem today than it was in the mid-20th century. Nowadays, cash is something that we take for granted. We walk into the grocery store, pick up a bag of chips on the shelf, and pay the cashier whatever the item is marked for. Seems simple. But think a little bit more. What you are actually doing is taking one good and exchanging it for a piece of paper. This transaction takes place because the buyer and selling both agree that the bag of chips is worth X amount and the amount of cash exchanged is also worth X amount. In other words, both parties believe that the piece of paper has value, it’s worth something. The exchange takes place because of a mutual belief in that value. But why couldn’t I buy an HP printer and print some identically looking 20 dollar bills out of printer paper? For one, I actually could. But what would that 20 dollar counterfeit bill be worth? Certainly not 20 dollars. It would be worth whatever a cut-out of a second-hand piece of paper would sell for. That is, it would be worthless. So why is one piece of paper worth a lot and another is worth nothing when, in essence, they are both just pieces of paper?

Why can't I use a horse as currency?

This is where the informal history comes into play. In the early days of civilization, it would be common to have purchases and sales take place on a barter and exchange basis. You have something I want and I will trade you something that you think is of equal value. Essentially, then, exactly the same as what happens today. But without cash (or money/currency), there became what I like to call the horse problem. Imagine that I wanted to buy a rug that some craftsman made but that the only item of value that I owned was a horse. In this scenario, then, the horse acts as my currency. Instead of carrying cash, I now have a horse. Both have value, which is why I transaction can take place. Thus, the horse has value but the derivation of value brings numerous problems. Firstly, it’s not divisible. If the seller of the rug determines it to be worth half a horse, I can’t take a chainsaw to my horse and give the seller half of my horse while, at the same time, expecting my two halves to worth the same as one live horse. In other words, I can only buy something that is worth exactly one horse or else I have to give up my whole horse to get something of lesser value. My horse brings a lot of value as one live horse, but less value as two dead halves. The next problem is of determining that value. Imagine I am trying to sell the horse to a stable owner who wants to run the horse in a race. I may think that the horse will be very fast and very good on the track. However, the stable owner may not view my horse to be not as fast and not as good on the track. The determination of my horse’s value is a bit unknown. That is, I can’t just look at a horse and know it’s value. On the other hand, I can look at a 20 dollar bill and know it’s value instantly. Finally, there is the practical problem: I can’t fit a horse in my pocket and carry it with me. It makes it very impractical to use as a currency.

What this demonstrates are some basic qualities that a currency must hold. It must be easily divisible so that you have multiple transactions of varying values. It must be of easy determined value. It also must be easy to transport. Because of these ideas, early currencies were mainly that of precious stones. The value of a chunk of silver was easy to determine. It was just a matter of weighing the amount and going from there. For that same reason, you could chop a smaller piece off if attempting to exchange for something of small value. Precious stones and metals could also be easily transported compared to a horse.

Cash came about later as transactions became of increasing value. Sure, carrying a lump of gold or silver was much easier than transporting a horse. But having to lug a huge bag of gold still isn’t the most elegant solution. This is where cash and banks started their role. A bank would allow for a customer to store a large collection of gold in their account and the bank would make accurate records of its size and value. Instead of going to the bank and lugging the precious stones or metals to the market, the bank would issue cash to the customer instead. In this context, cash was actually more akin to a check. The cash bill stated that who ever held that piece of paper was entitled to a certain amount of the customers account in gold or silver or what have you. Thus, someone could carry cash around and exchange goods for cash since at the end of that paper trail lied something that you really valued. The seller didn’t value the piece of paper itself, but valued what the piece of paper represented, what the item at the end of the bill was worth.

Clearly, this idea of cash is much more convenient than anything else previously discussed and is why it continues to be the primary method of transactions today. But what’s really important to grasp here is that cash was something more than a piece of paper. The belief of its value was backed by the lump of gold sitting in the bank. It was that mutual belief in the value the item in the back that allowed the transaction. Without that mutual belief in whatever was backing the currency, the bills were worthless since there was nothing in the end of the paper trail holding tangible value.

Now we get to the Monopoly Theory of Money, as I like to call it. Imagine you are playing a game of Monopoly with your friends. You are deep into the game and things are pretty level with everyone holding some valuable properties but no one in a better position than anyone else. So to make things more competitive and interesting, you decide to take your second Monopoly board game (because, of course, you keep two Monopoly sets just in case you lose one…) and dump its Monopoly money equally among the competitors. Now everyone has more money to use on buying properties and the like. Now, let’s say that you try to buy a property from another competitor. Say its value before the money dump was valued at 400 dollars. If I try and buy that property from my competitor after the money dump, I certainly won’t be able to buy it for 400 bucks now. Why? Because the value of that money is relative to what I think it’s worth. Since there is nothing backing that piece of paper and I know that everyone just got the same amount, my competitor will ask for more of my newly-issued money. Before, I would have bought the property for 400 dollars based upon my belief that 400 dollars was an appropriate price given the amount of money available to everyone else. But now that the money supply has increase, that relative value as decreased.

Now, get apply things to a little more real world scenario. Imagine that gold backing that Monopoly money. That is, if I wanted to, I could take my Monopoly money to a bank and the bank would give me a big pile of gold. Assuming the value for gold hasn’t changed, then the value of the money dumped currency hasn’t changed either. 400 Monopoly dollars is still worth the same since the gold backing that paper is still similarly valued. Without that gold backing the currency, the only thing that makes the money valuable is the belief by both parties that the currency is valuable. But if there is no belief? What if we keep dumping more and more sets of Monopoly money into the game? What keeps me from asking 4,000 dollars for a property I would have bought for 400 dollars before the money dumps?

Nothing is the answer.

That is why inflation, in today’s world, is more heavily discussed and of greater concern. As government debt increases and increases (and chooses to print more money and increase the money supply to fund that debt), the greater the chance of buyers and sellers losing faith in the value of that currency. This idea is what is currently known as the the intrinsic theory of value. In 1975, the United States veered away from the Gold Standard (the valuing of the currency based upon the value of gold held in federal reserve banks). As a result, the United States dollar became known as a fiat currency, a currency which is not backed by any physical asset. That is to say that, unlike before, I can not take a US dollar to a Federal Reserve Bank and receive a determined amount of gold based upon the relative value of the currency and gold. Because there isn’t that gold backing the bill, just like in our Monopoly game, the intrinsic value of that currency is nearly nothing; the currency is only worth the value of the paper itself. Without the common belief in value, transactions become nearly impossible in a modern world to coordinate. What is backing the currency is the US government and its assets, whatever they may be. Of course, as debt increases and increases, the value of those assets to the currency holders become less and less. But, of course, with ever increasing amounts of currency being printed, the value of those bills decrease and decreases even more.

Interestingly, an citation-less Wikipedia article claims that as of 2004, given the amount of US currency in circulation and the amount of gold assets held by the US government and Federal Reserve, if a gold standard were to be reinstated, the value of gold would have to be $2800/ounce (or much more than twice its value today before adjusting for price levels).  Again, the article does not provide a citation so don’t take this figure to the grave, but know that if a gold standard were to be initiated, the value of gold would skyrocket.

The history and theory of money supply and circulation obviously goes much further. But the basic idea is that transactions take place based upon belief with inflation and debt acting to weaken that belief. For this reason, there are many would recommend that you hold investments in gold. This gold is almost like a reserve currency (or alternative currency). Remember, a currency is just something that easily divisible, easily valued, and easily transported. It does not have to be a piece of paper backed by an asset. It simply has to be an asset of value. Thus, as the belief in the US dollar decreases, the value of a tangible asset increases. It makes for a safe investment since most governments and investors have historically turned to gold when searching for value.

Again, this post isn’t about creating doom and gloom. Rather, it’s about understanding what the pieces of paper in your pocket actually do and what they stand for. Understanding that role can make it very clear what happens when more bills are printed, the value of backed assets decreases, and so on.

Isner and Mahut at the end of the longest match in history

This match, though, became a practical application of some more economics. (What did you expect with this being an economics site?) Remember from before when I mentioned how economics is the study of human decision making. Naturally, this field has many diversified, sub-fields and one of the more “hib” fields recently is that of Game Theory. At first, when I told my parents during college that I was studying game theory, their reaction was that I was studying how to make Monopoly board games. That’s sorely inaccurate, but actually gets a little close to what game theory tries to explain. You see, Monopoly is a competitive game and within that game, there are hundreds  of decisions that are made. Do you buy this space or that space? Do you build a house at this property or that property? Do you mortgage a property? Do you not buy any property apart from the “good” ones? All these decisions, ultimately, describe a strategy. Most players, before the game begins, decide what strategy they are going to play. One strategy my mother always plays (quite annoyingly, in fact) is that she always buys any property she lands on and builds houses and hotels as soon as possible. Good property or bad property, it doesn’t matter, she buys all of it. What’s important here is that there is a strategic element to the decision. Thus, game theory is the study of strategic settings, or games. The task, then, is to find a strategy that the players can play within these games that leads to an equilibrium result.

The simplest realization of this equilibrium is what is known as Nash Equilibrium, named after John Forbes Nash (yes, the main character of A Beautiful Mind played by Russell Crowe). The technical derivation of it isn’t very important at this stage, but the intuition of this equilibrium helps explain the dilemma faced in the Isner-Mahut tennis match. In order for there to be a Nash equilibrium the two players (or however many players there are in the game) must play a strategy, which at the end of the game (once an outcome is reached), neither player can benefit by playing a different strategy. That is, if at the end, you say to yourself, “Gee… I should have bought more properties,” then the strategy you played and the ultimate strategies of all the players can not be a Nash equilibrium.  Now, in a tennis match where there must be one winner and one loser this sort of stability isn’t likely to be found. In some cases, it may be that one player simply is always going to be superior and one player will always be inferior. In such a case, there may be a strategy set that allows for there to be a stable equilibrium (that is, no ex-post regret). As the individual player, though, your thought isn’t about trying to find the best outcome for the entire match (that is, both players). You would prefer an outcome that yields 4 payoff for you and 0 payoff for your opponent if it means you win the match. (Payoff here is much like utils of utility discussed before. The more payoff, the happier you are.) Clearly, if an outcome that still yields you 3 payoff but generates 2 payoff for your opponent yields a greater total payoff for all players but is one that you prefer less than the previous outcome (since you only get 3 in the second example versus 4 in the first).

In the tennis match, then, the strategic decision making that is being made is about how to best maximize your payoff at the end of the match (i.e., maximize the outcome for you). In course of the match, the circumstances constantly changed thus forcing you to be constantly evaluating your strategy. For instance, in the early afternoon of the 2nd day of the match, both players were fairly fresh and ready to play. Do you try to play as hard and as good as you can in the hopes of winning the match within the next few games? Do you play defensive and hope that your opponent wears out first? What’s important to remember is the relative nature that all these decisions have on both yourself and your opponent. For instance, how will your opponent respond to your strategy? If your opponent sees that you are trying to power him off the court, will he respond equally or wait for you to wear yourself out? Likewise, think of having a fuel gauge for yourself. If you consume too much energy early on, there may not be enough energy left over to continue playing if you don’t win the match early on.

Going one step further, the decision I was most interested in was when the match neared its 8th and 9th hours on the 2nd day. At this time, the sun started to set and the possibility of having to delay the match yet again began to be more and more real. Of course, at that point, both players were fairly spent and struggling to generate points. Isner, in fact, started throwing in side-armed and under-handed serves in an attempt to save energy. Interestingly, this demonstrates another area of strategic decision making. Isner clearly tried to rely highly on his powerful serve to keep in the match. In fact, it become clear after a dozen or so games that Isner would make very little effort on the return games (that is, make no effort to break Mahut’s serve) and devote all his energy on his powerful. The trade-off is readily apparent here. By saving energy for his serve, it increased the probability that he would ace Mahut, requiring no energy to continue a rally. (Both players, in fact, ended up setting single-match records for number of aces served, again by pretty big margin). Of course, this meant that Isner really made no effort to win the match at this late stage. But that doesn’t necessarily mean that he wasn’t trying to win the match at all. Remember that the sun was starting to set. If the match were delayed, it would allow the ability to rest up and take the court a little more fresh and with a little more energy. Imagine if Isner spent a lot of energy trying to break Mahut but never succeeded in doing so. It would increase the likelihood that Isner wouldn’t be able to hold serve and Mahut, with more energy than the spent Inser, would then be able to beat Isner before the sun set.

That is all a fairly wordy way of saying that both players were simply playing to get a break. If any made an effort to genuinely win the match, it would likely result that the other with more energy would outlast. The relative nature of everything in this tennis scenario is an excellent real world example of the relative nature of economics in most everything else. It’s not enough to think about what the most powerful strategy is for you-yourself. Think of a NASCAR or Formula One race. The best strategy is not necessarily to go out there and drive as fast as humanly possible. Otherwise, your tires and fuel may go off so fast that you will have to stop multiple times where the slower cars only have to stop once. What I am pointing at is long-term profit maximization. It makes no sense to devote so many resources so quickly in the short-term if it means you will have no resources left to profit from in the long term. In the strategic setting of tennis, you wouldn’t want to throw all your effort out in one game if it meant losing all the others.

I wrote in other posts and in the little site description to the side of the site that economics is a perspective. It’s a way of looking at things. It’s a lens. Attaining that lens takes time and effort. I’ve tutored and taught dozens of students whom in particular expected economics to pretty simple, that it was nothing more than a matter of memorizing definitions. That method of memorization simply doesn’t teach the lens. It teaches the terms, and you will likely be able to use the terms in a technical conversation. But to really grasp economics, the understanding of the lens, of how a problem or situation is perceived, is paramount. In simple terms, it’s important to know the story we are trying to tell. No matter what we talk about, there is a story that is trying to be explained or theorized. Understanding that story allows us a more intuitive understanding of what we are trying to accomplish. Yes, we will throw technical jargon at it and turn it into an objective science, but underlying it all is that story. Not understanding that story makes it very difficult to understand anything else.

Fortunately, understanding the story is probably the easiest part of the entire process. It just takes a little time to grasp this lens and get used to recognizing the story. To demonstrate, this post is going to look more closely at some of the decisions that we make every day. The goal isn’t to necessarily bombard with technical knowledge but to drive home the idea that the story, the intuition, is important. So, we all eat, right? How we make that decision is what is going on after the break.

I made the point in the previous post (click if you haven’t taken a look yet) that there are thousands of situations every day that involve economic decision making. The grocery store is a classic example of such decision making. To further gaze upon these familiar settings, let’s take a look a little more closely at the economics of what to have for dinner.

Is a Morton's steak dinner in my future?

The central story is quite easy to grasp here. Imagine you are deciding what to have for dinner (assume for now that it is just you… table for one). Clearly there are multiple answers here. You could eat in and cook yourself something you have at home. You could go pick up something at a fast food joint or a take out restaurant. You could also go to a sit-down restaurant. Within those options there are different foods available. Do you cook yourself the chicken or the steak? Do you pick up a Subway sandwich or from some local Greek place? Does cheesecake at Cheesecake Factory sound good? Lots of options here and the ultimate decision that is made is an economic decision. We understand the intuitive story and the question is how the economics works in this story.

Previously, I’ve written about rationality. It’s a pretty nice concept that allows us to objectively determine what decisions are going to be made. If someone gets more satisfaction from option A than I do from option B, all other things being equal, that someone will choose option A. It makes no rational sense to choose option B which brings you less utility. Previously, even in that last example, I’ve used a little phrase that’s helped simplify a lot of things: “all other things being equal.” It’s helped me to avoid a couple of catches when it comes to rational decision making.

Specifically what I am referring to here is cost. You might have thought that the dinner decision was made simply by picking the thing that you wanted the most. More precisely, you would eat whatever it was that brought you the most satisfaction. Surely you would want to get a lot of utility from your meal, but about the cost of that meal? Sure, I would love to have a Morton’s steak every night. That steak brings me a lot of satisfaction, but it also brings me a lot of cost. Imagine if I had a Morton’s steak that gave me 100 utils of satisfaction. But also imagine that this steak cost me 50 dollars. Should I decide to buy and eat the steak?

This question brings up one of the key ideas that constantly circulates around in this economic world: all things are relative. Whether the steak is a good decision or not is all a matter of relatively. What else could I get with my money? What am I giving up in order to attain the steak? (Note: what I am really talking about here is opportunity cost. The price of the steak is 50 dollars, but the opportunity cost is the potential hamburger I could get or the pasta I could make for myself.) If it turns out that the steak brings me the most satisfaction per dollar compared to any my alternatives, then I make that decision to get the steak. This is the optimality condition for the dinner decision. I want to maximize my utility per dollar spent. It makes no sense to get the steak if it costs me a million dollars to get it. I could easily get just as much satisfaction as the one steak for much less with some other dinner.

Thus, the dinner decision you make is ultimately trying to weigh how much satisfaction you can get per dollar. I end up filling myself up with a Dairy Queen vanilla ice cream cone at night because it brings me a lot of satisfaction for not that much coin. I don’t choose to go get a smoothie since it brings me at most as much satisfaction for more money.

At night, I get in arguments with family and/or friends about where to go to dinner for this very reason. My goal in the group scenario is to maximize the utility per dollar spent for the entire group. This is something that family likes to call “passive aggressive” but what it really is is something a little more complicated than me being annoying. To simplify this scenario, imagine a big pot and in the pot goes all these satisfaction “pieces of gold.” What I want to do is get as many “pieces of gold” in the pot for as little money as possible.

Using this Lucky Charms sort of approach, if I am not particularly hungry and not desperate for a nice meal, my additional utility will be lower than the rest of the family. The marginal utility of my meal is low. Thus, the amount of gold I can put in the pot is very low. If we decide to go to a meal that I like most but that gives less satisfaction to everyone else in the family, I am keeping gold from going in the pot. I want the most gold in the pot and therefore need to let those who will bring more satisfaction (i.e., who are most hungry) make the decision.

Ultimately, with this economic mindset, the decision that is made is quite easy to determine. If I have two options, A which brings 100 utils of total utility for 50 dollars and B which also brings 100 utils of total utility for 25 dollars, the optimal decision for the group is to go with option B. I am getting a lot of gold in my pot for less money. Whether or not you consciously think about getting the most gold in your pot (I’m betting you’re a little more sane than me and don’t imagine your own gold pot), this decision is still made with this framework. You naturally make this decision. Otherwise, you would be constantly paying for things that are bringing you less satisfaction. Eventually, you will determine what you like and will work to get the most of it for the least amount of money. Again, you may not consciously go through all this util-talk but it is human nature to want the most benefit for the least cost.

The last idea I will mention in this post spurs from this last mini-scenario. What if you do make a bad decision? This whole post might suggest that you are always going to make the best decision without fault. This idea is what leads a little modification that can be made to this rationality concept. This modification is called bounded rationality. In simple terms, it means that yo make the best decision you can based upon only what you know. As an example, imagine you go get a Morton’s steak and have a nice meal. At the time of the decision, it was the best decision you could make. But afterwards, let’s say that you remember about this other restaurant you went a year ago but forgot about? It would have brought more satisfaction per dollar than Morton’s. Ultimately, the decision to go to Morton’s wasn’t optimal in the grand scheme of things. But based upon your bounded rationality, based upon what you knew at the time, it was the best decision to make.

This idea of bounded rationality explains how you could make a poor investing decision, for instance. Naturally, you wouldn’t invest in something if you thought it was a poor opportunity. But you might invest in something based upon limited research you have done (that is, you haven’t read every sentence of financial statements or interviewed every employee) yet find later on that the opportunity wasn’t what you thought and end up in a bad investment scenario. Coincidentally, this investment example explains the idea that all stock prices are fairly valued at the time of the transaction. Looking back at the movie “Wallstreet”, Gordon Gekko says something pretty insightful that you might have overlooked. In essence, he says that wealth is essentially transferred and it’s simply a matter who is receiving and who isn’t. I won’t go hugely in depth into that statement right now (it takes more tools still needed to be built) but will use it to explain how a stock trade at the time of the sale sees no winners and no losers. It’s simply a transfer. On each end of the transaction is someone who is buying and someone who is selling. Each buyer and each seller believes, based upon their own bounded knowledge, that the stock price will either go up or go down and respond accordingly. If the buyer thinks the price of a stock is worth 10 dollars per share, he won’t buy it for 11. Likewise, if a seller of a stock believes his/her investment is worth 10 dollars per share, he  or she won’t sell it for 9. You can see then that the only time stock is traded is when both sides of the transaction agree on the fair value of the stock. As a result, all stock prices are fairly valued, otherwise there would never be a transaction since one or both sides of the agreement would back out.

OK, I need a breather, you probably need a breather too. As I said at the end of previous posts, if this doesn’t make sense, I really recommend that you go through it again, especially before moving on to related posts. Also, leave questions, comments, send emails, etc. It’s way early in this project and I am eager to read some feedback on what you think or question about the site.

Quickly before we get to that though, I should clarify that this post is part of series that I am calling “Beginnings.” What that means is that this is part one of a series of posts that introduces you the ideas that dominate all the other posts. Going back to the math example, it’s very difficult to understand multiplication if you don’t understand addition, and it’s very difficult to understand addition if the concept of numbers is completely foreign. These posts are going to (cliche alert) set the foundation for all the others. I really recommend you read all the Beginnings posts  before diving into the others so that you are able to really comprehend all the ideas instead of only skimming the surface (I have more posts coming, it’s just going to take a while to type them up. So check back often in these early stages for these posts).

Back to the fun stuff…

The Very Technical Answer

First let’s look at what the hardcore, technical definition of economics is and see what we can take away from it. There are probably dozens, heck hundreds, of different definitions but I am going with the one that I was originally taught which seems to me to be the most complete:

Economics is the science of the allocation of scarce resources for the satisfaction of human wants and needs.

Nice fancy definition that surely will impress any dictionary writers reading this post… But what does it mean? The key word that needs to be stressed throughout all the discussions on economics is science. Remember some of the things I mentioned in my introductory post about how there is a perception that economics is a “voodoo” science. The implication is, really, that economics isn’t a science at all; it’s just an association of theories that may or may not hold true in reality. But the real truth is the economics is a science, just a social one. What that means is that the goal of economics is to find an objective result.

I remember when I was sitting in a university lecture hall first learning these concepts, the professor went on and on about defining the difference between a positive statement and a normative statement. To be honest, it all just sounded like a big waste of time trying to make something boring sound very fancy and sophisticated. However, it’s actually pretty important to know the difference because it helps explain why economics is so much a science. A positive statement is one that we can test objectively. “The temperature outside is 102 degrees,” is an example. It’s summer, I am in Phoenix, so this statement is probably true. But the key is that I can test it. I go outside with a thermometer and test what the actual temperature. Whether the temperature is 102 degrees or not is irrelevant to the statement being positive. The fact is that I could test it. “It’s too hot outside,” is a normative statement because I can’t test this. How can I decide, objectively, what “too hot” is? I can’t test it. There is no thermometer that can reliably and objectively say, “Yep, it’s too hot outside.” Thus, in economics, the statements are scientific because they are positive. We can test them, we can model the scenarios and derive an objective result. Ultimately, what economics does not do is say, “The price of gas tomorrow will probably be too high.” We may be able to create a study that brings some results that might lead to this opinion, but, again, we are using objective measures to, at the very least, substantiate the normative statement. This will also become much more clear when you start reading about real world examples and the actual study of economics.

What also needs to be added is that human wants and needs are insatiable. This is an important addition to the definition because it is what keeps economics as a constant presence in every day life. Throughout all life, we will always want something and we will always need something. As a result, there is always going to be a decision that needs to be made as to how we allocate resources to accommodate those wants and needs.

So economics is a science about insatiable wants and needs. Accepting that, we can narrow this definition into a shorter one that might help drive home what economics actually is. Economics is about how people allocate resources. How much do I buy? At what price? How much of X do I buy and how much of Y do I buy? And now we get to the real intuitive concept of economics:

The Real World Intuitive Definition

Economics is the study of human decision making.

Look back at those last example scenarios. All of them are focused on a particular decision. In some scenarios, we can have multiple decisions happening simultaneously to create some particular outcome. But the center of it all is the decision making. This encompasses so many different aspects of life. There are business decisions, personal decisions, strategic decisions, long-term decisions, short-term decisions, decisions solely for you, decisions that involve multiple parties, and so on. And this is why economics is always around in everyday life. Here’s a quick, simple example.

You are at the grocery store and look at the shelf and you see two cases of soda, one is Pepsi and the other is Coke. The Coke case costs 3 dollars and the Pepsi case costs 2.50. What decision you ultimately make is an economic decision. You are weighing the costs and benefits of either product. If you prefer the taste of Coke to the taste of Pepsi, you might be willing to pay the extra 50 cents to get it. On the other hand, you might be completely neutral on the taste of Coke and Pepsi, so you buy the Pepsi since it’s giving you an equal amount of satisfaction at a lower price. That is an economic decision. No matter what product you ultimately bought, you bought based upon an economic thought process.

Rationality

This previous example leads us to an absolutely critical assumption in economics which allows us to make some simple looking results. This critical assumption is the rationality of consumers. To make sense of this, we need to go back a little bit in time and learn about utility. In the early 19th Century, a philosopher named Jeremy Bentham (pictured above) lead the way in the concept of utilitarianism. His idea was that everyone attains a certain level of satisfaction from doing/buying/consuming items. To give a clear numeration of these levels of satisfaction, he formulated the concept of “utils.” A util is a unit of satisfaction determined by me or whoever is consuming the good and attaining satisfaction. That’s a fancy way of saying how happy I am when I consume something. For example, when I eat a hamburger, I get 10 utils of satisfaction. But when I eat a cheeseburger I get 12 utils of satisfaction. Who said a hamburger was 10 and a cheeseburger 12? Me! Don’t get hung up on what the actual numbers are. It really does not matter whether I get 1 util from a hamburger or 100 from a cheeseburger. What matters is the relative nature between them. In the original example, I got a little bit more satisfaction from the cheeseburger than the hamburger. In the extreme example, I got a huge amount of satisfaction from a cheeseburger and nearly none from the hamburger. That’s what is important here and it allows us to make a clear way of saying how much satisfaction a consumer is gaining from the consumption.

What does this have to do with rationality? It means that assuming all other things are equal (this is a big statement that reoccurs in economics a lot), if I have a choice between X which gives me 10 utils and Y which gives me 11 utils, I will pick Y. This is me being rational. If all other things are equal, why would I possibly choose X and get less satisfaction than Y? Because of this rationality, we can conclude what decision people will make. Simply, consumers will make whatever decision brings them the most utility, all other things being equal. (We need to clean this up a little bit, but I will do so in a later post.)

Going one step further, remember the soda example I used a little bit ago. The thought process that goes through your mind (even perhaps subconsciously) was an economic thought process… despite the fact that you probably never studied economics intensely. This allows us to generalize things and say that rationality of the consumers (or decision makers) is the idea that they act like they know economics even if they don’t consciously make an economic analysis of the decision. You won’t buy Coke if you don’t like the taste of Coke. That is a pretty simple story that everyone in that situation will follow. The economics, though, is still there. In economic terms, the person who doesn’t like the taste of Coke achieves no utility from consuming Coke (or 0 utils) and thus chooses a different soda which provides a positive number of utils, clearly preferred to having zero satisfaction (2 > 0, for instance).

One last concept… Opportunity Cost

In a simplified statement, economics really boils down to the costs and benefits of a given scenario. The benefits are relatively easy to conceptually derive. In most of the general scenarios we are just talking about the satisfaction we attain from the decision, but this can also incorporate things like the value of future gains, such as avoiding future costs (very common in environmental economics). The costs should be relatively simple conceptually as well, but there is a problem that almost always needs to be addressed.

Chances are if I ask you what the cost of a product is, you will tell me the price. This is an incomplete answer because the price of the product itself is but a component of the cost. This brings us to the idea of opportunity cost. The cost of anything is what I must give up in order to attain it. This means that things like forgone alternatives, time, effort, etc. are components of the cost. The cost of a ski vacation is not just the price of the airplane ticket and rental car to get there, the price of the hotel, and the price of the lift ticket and ski equipment all added up. The cost of the ski vacation is all those prices plus the time that I sacrificed to have that vacation, among other things. (Think of this as similar to lost wages. On vacation, I don’t work and thus also lose any income I would have gained had I not gone on vacation and stopped working.) This concept of opportunity cost will constantly manifest itself in nearly every discussion that revolves around economics. That’s why I can say things like, “The cost of a Harvard education is low when I am young.” Sure, the tuition is high, but given my young age, things like forgone wages and the value of the next-best alternative is really low. When I get older (which generally means I have more experience, have a better job, and earning more income), I have to give up a lot more to get a Harvard education. Thus, the cost of a Harvard education is much higher (even if the tuition stays the same).

This concept of opportunity cost also helps us explain other decisions that you and I constantly make. Let’s go back to a grocery store example. Say, that at store A, a gallon of milk costs 3 dollars. However, at store B a gallon of milk costs 2 dollars. Why would I ever go to store A to buy milk? The price of a gallon of milk is clearly much lower at store B. But what about the cost?  If store A is right next door, but store B is 20 miles away, the cost of the gallon of milk is much lower at store A than it is at store B. I don’t have to drive an hour through rush hour traffic to get to store B, which makes the opportunity cost of store A lower than the opportunity cost of store B. Thus, I will always go to store A even though the price of the milk is higher than the price of milk at store B, again, all other things being equal.

These examples that we used throughout this post are all economics. We are mapping human behavior since we have made some general assumptions that allow us to make these conclusions. We know that, assuming all else is equal, someone will buy milk from store A than from store B. We have successfully derived, objectively, what that person will do based upon the science of economics. In other words, economics is a methodology for determining what decision someone will make. In the supply and demand example that most everyone will be familiar with, the tools of supply and demand allow us to determine how much and at what price consumers will demand and businesses will supply, or what decisions will be made in a market. And this should start to make clear why economics is such a valued tool in the real world. No matter if you operate a business, invest in a market or product, or simply shop in a mall, having a method which determines what decisions will made can help you make a better decision yourself.

What’s important at this point is that, if you haven’t followed me completely to this point, re-read this post again. Going back to the original math example that started this post: If you don’t understand numbers, it’s hard to understand addition. Likewise, if you don’t understand the rationality of consumers, it’s really hard to understand why we can make the conclusions that we will make in economics. Once this post makes sense to you, then you can go on to the next post in this series (I will supply the link below once it is available).

At this early stage, this ends up being a bit like a class lecture, but it is important. I find economics to be very fascinating and very insightful, which is why (once I get the site going at full speed) you will see a lot of posts about a number of different issues and scenarios. But you won’t enjoy this site fully if you don’t have this basic understanding. (Cliche alert) You have to learn to crawl before you can walk. Finally, please ask questions, write comments, or send me an email. Tough these first few posts will be a little dry, I want this to be about discussion more than anything else.

This results mainly because of what I have observed as a large division between groups of people in the world of economics. Imagine an old English castle with a moat surrounding it. On the inside of that castle are the “hardcore” economics with PhDs and sophisticated titles that huddle together to discuss their field of science. On the outside, trying to pass the challenge posed by the mot, is everyone else. That gap is what creates things that drive me up the wall when well-intentioned people try to talk about economics. This is nothing against very smart economists. They have taken huge amounts of time and effort to build theories that give the rest of us a way to understand the world around us.

Trust me on this, though. To get the amount of knowledge required to be able to read an economic journal competently is very difficult. But that shouldn’t be your goal. I am here because the intuitive basis of economics is actually quite simple. It creates a perspective that, at the very least, broadens your ability to approach a given circumstance or problem differently. I am here because there seem to be few sources that will try and take the time to explain basic economic theory to readers simply trying to understand what’s being discussed in the Wall Street Journal.

I’ll give you the example that really spurred me to start this blog. Given the latest administration in the White House and the concerns over governmental budget deficits, a lot of discussion has been taking place over potential tax increases. (Eventually, of course, those tax increases were approved by the Obama administration and are set to see their implementation beginning in 2011.) One economic concept that gets discussed continuously along with tax increases/decreases is the theory outlined by the former member of the Economic Policy Advisory Board for the Reagan administration Arthur Laffer. During the beginnings of that administration, Laffer famously outlined a curve on a cocktail napkin to help explain the basics of his theory, the theory which latter became known as the Laffer Curve. This simplified idea is that under some circumstances, a government could raise taxes yet receive less in tax revenue.

For obvious reasons then the study of this curve is very critical in the setting of tax rates. Sure enough, publications like the Wall Street Journal spend time writing about the Laffer Curve but do little to actually explain the derivation. Conversely, often times, these writers are way off the mark with their analysis. This diagram attempting such explanation typifies why I am writing now:

(Sorry, easy spot for a break. Click on to continue to reading.)

You see, the derivation of the Laffer Curve is not based in statistics. Sure, it comes as no surprise that such a relationship would show a similar representation to the Laffer Curve but this diagram in no way derives a Laffer Curve. Don’t worry at the moment how the curve is derived (I will surely create a post at some point describing the basics of the curve’s derivation), just understand that it becomes difficult to understand economics if the sources you are trying to learn it from can’t derive the theory themselves.

As such, you see plenty of people, including, it turns out, my own mother, who consider economics more of a “voodoo” science. When most people’s understand of economics is very limited and based upon incorrect explanations, it is very difficult for the theories to be viewed as credible by the public. Economics is becoming a “good in theory, bad in reality” sort of concept. This is not because the science of economics is incorrect. (In some cases, sure, it may be. But for the vast majority of cases, economics is very much correct and present among us everyday) This results because most have not be able to find a source of learning of the basic concepts.

This site then is aimed to provide a platform for discussion and learning about the economics that we use everyday in the real world. This isn’t an online textbook or some dry diatribe on purely technical terms. This site is about creating a setting to see and discuss the economics that we see on a continual basis. As such let me say these two things:

Who is this site NOT for?

Yes, I’m actually starting with someone likely other than you. This site is not for “hardcore” economists with PhDs or even Masters degrees looking to expound their greatness among the mere laypeople of the internet. I am not taking the time here to create an absolutely perfect and pristine textbook of economic knowledge and as such there will be mistakes and opinions that many will disagree with. But that’s the point. This is a center of discussion and it’s hard to have an honest discussion if everyone is concerned about the Harvard Professor coming down on them for stating something incorrect. I certainly welcome the discussion and opinion of everyone but want to make it clear that I am not spending hours out of my day writing these posts because I am the infallible leader. I am writing these posts to help bridge the moat that divides most from understanding the basic economics they want to use everyday. As such, if you are looking for a platform to spread thesis ideas or find ways to solve ridiculously complex mathematical expressions, you will walk away from this site disappointed.

Who is this site for?

It may already be clear by now, but this site is here for those of you are aren’t trying to earn their PhD but are trying to learn and discuss concepts of economics that are present everyday, in the real world. My assumption is that everyone who is reading my posts have absolutely no basis of economic knowledge. That is, when I say something like “cross-price elasticity of demand”, I expect to need to derive what that concept refers to. This site can not take you to “infinity and beyond” when it comes this science, but I hope that the site can provide a resource that helps enlighten simple ideas that you can use in the real world. Like I said a little bit ago, economics is not a “voodoo” concept. Take a look at the title: The Economics of the Real World. You may not know it now but every decision you make has an economic thought attached to it. It is present in the real world. This site will be for those of you are looking to begin to learn just a little bit of what economics is all about.

This site also isn”t just for me. I’m not writing this with the goal of profiting exorbitantly from it. I’m also not writing this because I want to project my greatness out to everyone. This site, then, is for every reader as well. I, therefore, encourage everyone to post a comment and be a part of the discussion. Challenge me, question me. When I teach and tutor students in economics classes, believe it or not, I am capable of getting things wrong. Thus, if I write something that you want to understand but simply can’t, it may be because I have made an error. It may also be that you have a misunderstanding about a past or present concept that is keeping from grasping the point. Make a comment, answer other’s comments and questions so that this site can provide respectable ways of addressing those questions and comments.

So who am I? Well, I am not the owner of a crisp new PhD nor a Masters degree. I did graduate university with a BS in Economics and have taught and tutored introductory economics like this for a number of semesters now. That means that even if you wanted to learn enough to grab a PhD I simply can’t take you there. And again, it also means that I am fallible. But my goal, as stated, is not to create topics and discussion of such a drastically advanced nature. The intuition of economics, which is what you will experience every day, can be relatively simple to understand. It’s also, surprise surprise, interesting and fun to discuss and argue about. This is what I enjoy teaching and that is why I am here writing now.

One last note, do be a little bit patient. This is not a news blog that simply regurgitates information from another source. I will take time to make sure that the things I write are as good as I can make them. It means that posts will come in 30-a-day bunches. I will try and get them out as quickly as possible, but understand that it is better for you and I if I spend the time making something right as opposed to rushing things out and confusing you and me.