Natural Price: Context in the Reasonable Dialog Analysis of a Market

Demand Law of Demand

Supply Supply in the Long Run and Short Run

Equilibrium of Supply and Demand Changes in Demand

Shift Factors in Demand Changes in Supply

Shift Factors in Supply

Lection 3. Supply and Demand

A Theory of Price

Adam Smith had argued that each good or service has a "natural price." If the price (of beer, for example), were above the natural price, then more resources would be attracted into the trade (brewing, in the example), and the price would return to its "natural" level.

The modern theory of supply and demand differs from Smith's theory in some important ways. Economists have made some progress in the last 200 years, and great economists such as John Stuart Mill and Alfred Marshall (and many others) have played their part in the growth of the modern theory of supply and demand. Nevertheless, the theory of supply and demand is the modern expression of Smith's great insight about "the natural price."

To make a long story short, before about the 1850's most economists accepted the Labor Theory of Value as the theory of the "natural price." But there were some cases it did not apply to: international trade, for example. John Stuart Mill suggested a "supply and demand" solution for prices in international trade. Other economists extended it to apply to prices in general.

Unlike the "natural price," a long-run theory only, the theory of supply and demand applies in the short run as well as the long.

Demand Demand is the relationship between price and

quantity demanded for a particular good and service in particular circumstances.

For each price the demand relationship tells the quantity the buyers want to buy at that corresponding price.

The quantity the buyers want to buy at a particular price is called the Quantity Demanded.

The key point is to distinguish between demand (the relationship) and quantity demanded. That distinction is important for microeconomics, although people often do not make it in ordinary discussion.

Demand and Need

Clearly, the buyers are the people who want or need the product or service -- but there is more to it than that. The word "demand" refers to the willingness and ability of people to purchase the good or service in the market.

The demand relationship expresses that willingness and ability for the whole range of prices. To say that a person has a demand for a particular product is to say that the person has money with which to buy and is willing to exchange the money for the good. People will not demand what they do not want or need, but a want or a need unbacked by purchasing power is not a demand.

Similarly, it is not enough that the suppliers possess the good or (the capacity to perform) the service. Supply also means willingness to sell.

Most of us have experience living in the market economic system, and that makes economics seem like a common-sense field -- but sometimes that common-sense feel can be deceptive. People sometimes use the term "demand" ambiguously -- as if "demand" were the same thing as need. But it is not. Need without purchasing power will not create effective demand in the marketplace. Economists sometimes stress this point by using the term "effective demand" in place of simple "demand."

Example of The Demand Relation

Here is an example based on that estimate. The prices quoted are wholesale prices, in cents of 1972 purchasing power. Quantity demanded is measured in millions of gallons, for the United States as a whole.

price, cents/gal.

Quantity demanded,

millions of gals.

50 4899.27

60 4355.67

70 3812.07

80 3268.47

90 2724.87

100 2181.27

110 1637.67

120 1094.07

Demand Diagram and Law of Demand

Here is a "demand curve" of the demand for beer in 1960, based on the estimated numbers from the previous page.

At a higher price, the quantity demanded will be less, ceteris paribus.

(Ceteris paribus means: if nothing else changes to offset the change in price).

The example also illustrates three important points about the demand relation:

1. The price must always be adjusted for inflation. We use the "real" (adjusted) price, not the nominal price.

2. The demand relationship can be represented, and approximated, by

numerical graphical

mathematical and statistical methods

SUPPLY

As with demand, supply may be represented not only by a table of numbers, but also by a diagram or a mathematical equation. Here is a diagram of the estimated demand for beer. As before, we put the price on the vertical axis, and the quantity supplied on the horizontal axis.

price, cents/gal.

Quantity demanded,

millions of gals.

50 0

60 0

70 0

80 1304.4

90 2894

100 4483.6

110 6073.2

120 7662.8

The Long and Short Run

With respect to supply, time plays a role that it does not (in most cases) play in the case of demand.

If there is plenty of time for the suppliers to adjust to a change in the price, we have a long run analysis. This means the sellers can invest and expand productive capacity, in response to a high price, or can gradually reduce the productive capacity by under-replacing worn-out equipment in the case of a low price.

However, if the sellers are not sure the high or low price will continue for a long time, a short run analysis may be more appropriate. In a short run analysis, we treat the plant and equipment of the industry as inflexibly given. In that case, output can be increased only by using that fixed plant and equipment more intensively.

Thus, we would expect the adjustment of supply to a change in price to be more complete in the long run than in the short run.

We do not ordinarily apply the long run versus short run distinction to demand, but there are some special cases where it might be important. For example, for durable goods such as cars, buyers might adjust less completely in the short run than in the long, since they can postpone replacement of their durable goods until the price comes down. In the long run, the goods wear out and so the consumers cannot postpone replacement long enough.

In the short run the plant and equipment (productive capacity) of the industry are fixed

In the long run sellers can change the productive capacity, in response to the price

The supply relationship will depend on how long the suppliers have to adjust to a change in the price

Equilibrium of Supply and Demand

This sort of "equilibrium" exists when the price is just high enough so that the quantity supplied just equals the quantity demanded. If we superimpose the demand curve and the supply curve in the same diagram, we can easily visualize this "equilibrium" price. It is the price at which the two curves cross. The corresponding quantity is the quantity that would be traded in a market equilibrium.

ExcessDEMAND SUPPLY

What we see here is that the quantity demanded exceeds the quantity supplied -- we have excess demand. With a price of $30, quantity supplied is 500, while quantity demanded is about 1200. Thus, demanders will compete against one another, offering higher prices for the limited supply, and the price will rise.

Here we have excess supply -- the quantity supplied exceeds the quantity demanded. Quantity supplied is 2000 at a price of 40, while quantity demanded is only 600. Thus, suppliers will compete to sell what they can by cutting the price.

Competition and Equilibrium

What we have seen is that the price will be in constant motion, up or down, except when quantity demanded is equal to quantity supplied. That is the position of rest.

Put another way, it is the price toward which competition pushes the price. At equilibrium, there is no competition either to buy or to sell, because everyone can buy or sell however much they may wish, at the going price. But whenever the market is away from equilibrium, competition will arise and tend to force it back.

Competition eliminates itself, by forcing the market into an equilibrium in which there is no need to compete. (This is a very different concept of competition than the biological "struggle for survival!)

We have seen that competition forces the market into equilibrium. However, this might fail if:

There is only one seller or buyer, hence no competition

Sellers or buyers agree ("conspire") not to compete in this way

It is illegal to compete by offering a higher or lower price

People are unable to compete by price offer -- for example, they do not know who else buys or sells the item, or are unsure of the quality of the good or dervice offered by other traders.

Changing Demand

INCREASE DECREASE

Shifting Demand

Here are some things that would cause the demand curve to shift:

1. A change in income for the average consumer. If an increase in income causes an increase in the

demand for a particular good, that good is called a "normal" good. Example: steak.

If an increase in income causes a decrease in the demand for a particular good, that good is called an "inferior" good. Example: red beans.

2. A change in the population. 3. Changes in the prices of other goods. Complements. Substitutes.4. Changes in consumer tastes.

Changing Supply

INCREASE DECREASE

Shifting Supply

Here are some things that would cause the supply curve to shift:

1. Changes in the prices of input goods. Labor Raw materials2. A change in technology. 3. Changes in natural conditions. Rainfall Environmental Conditions

CHANGES

DEMAND SUPPLY

Before the increase in income, demand was D1 and supply was S, so that the equilibrium quantity of food sold was Q1 and the price per unit of food sold was p1. However, the increase in income resulted in a shift of the demand curve rightward, as shown by D2, and a new equilibrium quantity at Q2 and a price of p2.

With normal weather, supply would be S1 and demand is D, so that the equilibrium quantity of food sold was Q1 and the price per unit of food sold was p1. However, bad weather shifts the supply curve leftward, as shown by S2, and a new equilibrium quantity at Q2 and a price of p2.

Some artificial means for market’s distortion

EXCISE TAX SUBSIDY

The figure shows the impact of an excise tax. From the point of view of sellers, the tax decreases demand from D to D'; the vertical distance between the two curves is the tax. The price paid to the seller falls, but not as much as the tax, because the cutback in production moves downward along the supply curve.

Accordingly, the figure shows the subsidy shifting the supply curve to the right, from S1 to S2. The vertical distance is the amount of the subsidy: one dollar per bushel. Demand is D, as usual. With supply S1 -- before the subsidy is given -- the market equilibrium price is p1 and the equilibrium production is Q1. With supply S2 -- when the subsidy is given -- the market equilibrium price is p2 and the equilibrium production is Q2. We may conclude that a subsidy per unit of production reduces the market price (though not quite by the full amount of the subsidy) and increases the production of the item subsidized.

Elasticity of Demand

Sometimes we need to know something about the numerical characteristics of the demand relationship. For example: we know that if the price is cut, quantity sold will increase. But how much will it increase.

We cannot say much about this in general. The answer will vary from industry to industry. The answer may be different for agriculture, for example, than for computers.

What we can do is define some general terminology and principles to understand these differences.

Elasticity of demand is a measure of how strongly the quantity demanded responds to a change in price.

We can see that the elasticity is related to the slope (and the derivative) but is not quite the same as the slope of the demand curve.

Elasticity and Slope

While elasticity and slope are not the same thing, we can roughly correlate elastic demand with a shallow slope of the demand curve, and conversely. The figure above shows an example of high elasticity: a small decline in price (about 20%) leads to a large increase in quantity (about 120%), so that elasticity would be about 6.

This figure shows an example of inelasticity: a large decrease in price (about 75%) leads to a small increase in quantity (about 25%), so that elasticity would be about 0.33.

When:

e>1 we say that "demand is elastic."

As in "The demand for computers is elastic."

e<1 we say that "demand is inelastic."

As in "The demand for public transportation is inelastic."

Elasticity will be greater:•When substitutes are closer and more numerous •When the proportion of the budget spent is larger

Elasticity and Revenue Elasticity is a key to

understanding the relationship between price and sales revenue.

Example: Demand for public transportation is inelastic -- probably about 0.3. So, when the price is raised by 1%, quantity demanded declines by only three-tenths of 1%, and revenue increases by seven-tenths of 1%.

Example: The demand for computers is elastic, so when prices are cut by 1%, quantity demanded increases by more than 1%, and sales revenue increases.

When elasticity is And price Then

revenue >1 increases decreases>1 decreases increases

=1 increases doesn't change

=1 decreases doesn't change

<1 increases increases<1 decreases decreases

Income Elasticity

Economists use formulae like "elasticity" to measure the responsiveness of quantity demanded (and other things) to various influences.

For example, we have the income elasticity of demand. If the income elasticity is greater than one (demand is income-elastic) then demand increases more than proportionately with income.

Two puzzles In the agriculture puzzle, it's pretty clear from statistical studies that the income elasticity of

demand for agricultural products (mostly unprocessed food) is less than one. In other words, the demand for agricultural products is income-inelastic, and that means that the demand for agricultural goods increases less than in proportion to the overall increase in income. If follows that, when overall income is increasing, agriculture's share would be decreasing, even if nothing else changed.

For example, suppose that we start with a national income of 100 billion, and farm production is 10 billion, a 10% share. Income increases by 10% to 110 billion, and farm demand and production increase by 2.5% to 10.25 billion. That reduces the farm share to 9.3%.

This means that, even without the increasing efficiency of farming and the dropping prices, farm incomes would have been less in proportion to total incomes. When we add the two facts together, we get a powerful explanation for the decline of the farm industry.

Income elasticity is also a complication for public transportation. It is clear that the demand for public transportation is income inelastic -- and in fact, it seems likely that public transportation is an inferior good. I haven't seen clear evidence one way or another on that, but it seems that as people get better off, they shift from the busses and the subways to their private cars, and if enough of them do it it could make for a negative income elasticity of demand -- an inferior good.

That would help to explain the recurring crises in public transportation. As the community as a whole gets better off, demand for most public transportation services drops. (There probably are a few exceptions). To cover the costs of providing public transportation, it's necessary to raise revenue -- and because of the inelastic demand (with respect to price), the only way to do that is to raise the fare, further cutting use of the service.

As we can see, income elasticity of demand, like price elasticity, is an important tool for understanding economic events.

Cross Elasticity

Sometimes the price of one good will influence the demand for another good.

If the cross elasticity is positive then the two goods are substitutes. If it is negative, then they are complements.

For example, butter and margarine are substitutes, so we would expect their cross-elasticities to be positive.

Elasticity of Supply

We can also apply the elasticity concept to the supply curve.

We would use the "elasticity of supply" to measure the response of the supply curve to a change in price.

Now you know: Demand and Supply in economical

mechanisms Factors of demand and supply Law of demand Market’s reactions for demand’s or

supply’s increase\decrease Some means for market’s distortions