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21.
Demand Terminology
If the price of widgets is originally $1.00 and people are buying 100, they may change to 90 for two
reasons. One reason is that the price may rise to $2.00. The other reason is that one of the factors that is
assumed to be constant may change, so that even though the price has not changed, quantity will.
Economists distinguish these two cases. In the first case the demand relationship or schedule has not
changed, but there has been movement within the relationship. Economists call a change of this sort a
change in quantity demanded. The second sort of change is an alteration of the relationship. The original
pairing of price and quantity is destroyed and replaced by a new pairing. Economists call this sort of
change a change in demand.
It is important to realize that though the demand relationship looks concrete when it is illustrated with a
table or graph, in everyday life demand curves are hidden. A demand curve refers to what people would
do if various prices were charged, and very rarely are enough prices charged so a clear demand curve can
be seen. This is not to say that the concept is of no importance to people who sell. They may not be
interested in the demand curve as a relationship, but they do find it a boundary or constraint on their
behavior. If there were an actual widget seller facing the demand curve in our demand table, he would
find that he could not sell more than 90 widgets if he wanted to charge $2.00. He could of course sell
fewer if he wanted to. He could sell only 70 at $2.00, but if he did this, he would earn far less than he
could. If he wanted to sell more than 90, he would have to lower his price.
A Demand Curve
Price of
Widgets
Number of
Widgets
People Want to
Buy
$1.00
100
$2.00
90
$3.00
70
$4.00
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Thus, to an actual businessman the demand curve is important as a limitation on what he can do. A
businessman may not know exactly where the demand curve is, and he may not think of it as fixed.
Advertising--either informing or persuading people--can move the boundary. As we proceed further, we
will see that there are still other ways to view the demand curve in addition to seeing it as a mathematical
relationship and as a boundary that limits sellers.
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The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law
of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity
supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.
A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied
(Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.
Supply Terminology
As with demand, economists separate changes in the amount that sellers will sell into two categories. A
change in supply refers to a change in behavior of sellers caused because a factor held constant has
changed. As a result of a change in supply, there is a new relationship between price and quantity. At
each price there will be a new quantity and at each quantity there will be a new price. A change in
quantity supplied refers to a change in behavior of sellers caused because price has changed. In this case,
the relationship between price and quantity remains unchanged, but a new pair in the list of all possible
pairs of price and quantity has been realized.
Supply curves as well as demand curves appear much more concrete on an economist's graph than they
appear in real markets. A supply curve is mostly potential--what will happen if certain prices are charged,
most of which will never be charged. From the buyer's perspective, the supply curve has more meaning as
a boundary than as a relationship. The supply curve says that only certain price-quantity pairs will be
available to buyers--those lying to the left of the supply curve.
Next we put supply and demand together.
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Invisible hand
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The invisible hand is a metaphor coined by the economist Adam Smith to illustrate how those who seek
wealth by following their individual self-interest assist society as a whole and build the common good. In
The Wealth of Nations and other writings, Smith claims that, in capitalism, an individual pursuing his
own good tends also promotes the good of his community, through a principle that he called “the
invisible hand”. Specifically, a free competitive market ensures that those goods and services perceived
as most beneficial, efficient, or of highest quality will naturally be those that are most profitable. The
mechanism for this, Smith saw as being the free price system.[1]
Adam Smith originally only mentioned the Invisible hand once in each of his three works. The metaphor
has later gained widespread use.
Supply and Demand
Excess Demand
When the price is below equilibrium, as in this case, there is "excess demand" -- the
quantity people want to buy at this low price is greater than the quantity the sellers
would like to sell -- and so we would expect to have upward pressures on the price.
Excess Supply
When the price is above equilibrium, as in this case, there is "excess supply" -- the
quantity people want to buy at this high price is less than the quantity the sellers
would like to sell -- and so we would expect to have downward pressures on the
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price.
Income effect
Another important item that can change is the income of the consumer. As long as the prices remain
constant, changing the income will create a parallel shift of the budget constraint. Increasing the income
will shift the budget constraint right since more of both can be bought, and decreasing income will shift it
left.
Depending on the indifference curves the amount of a good bought can either increase, decrease or stay
the same when income increases. In the diagram below, good Y is a normal good since the amount
purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an
inferior good since the amount bought decreased as the income increases.
is the change in the demand for good 1 when we change income from m' to m, holding the price of
good 1 fixed at p1':
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[edit] Substitution effect
Every price change can be decomposed into an income effect and a substitution effect. The substitution
effect is a price change that changes the slope of the budget constraint, but leaves the consumer on the
same indifference curve. This effect will always cause the consumer to substitute away from the good that
is becoming comparatively more expensive. If the good in question is a normal good, then the income
effect will reinforce the substitution effect. If the good is inferior, then the income effect will lessen the
substitution effect. If the income effect is opposite and stronger than the substitution effect, the consumer
will buy more of the good when it becomes more expensive. An example of this might be a Giffen good.
Substitution effect,
, is the change in the demand for good 1 when the price of good 1 changes to p1'
and, at the same time, the money income changes to m':
[edit] Indifference curves and budget constraints
For an individual, indifference curves and an assumption of constant prices and a fixed income in a
two-good world will give the following diagram. The consumer can choose any point on or below the
budget constraint line BC. This line is diagonal since it comes from the equation
. In other words, the amount spent on both goods together is less than or
equal to the income of the consumer. The consumer will choose the indifference curve with the highest
utility that is within the budget constraint. I3 has all the points outside of their budget constraint so the
best that the consumer can do is I2. This will result in them purchasing X* of good X and Y* of good Y.
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Income effect and price effect deal with how the change in price of a commodity changes the
consumption of the good. The theory of consumer choice examines the trade-offs and decisions people
make in their role as consumers as prices and their income changes.
The Budget Line
Rose Bole has only $100 to spend on her two passions in life: buying books and attending movies. If all
books cost $5.00 and all movies cost $2.50 (these are simply assumptions to make the problem easier--as
is the assumption that only two items are involved in the problem), the graph below shows the options
open to Rose. The budget line is a frontier showing what Rose can attain. The budget line limits choices;
it is due to scarcity. The cost of a book is $5.00 or two movies. Spending money on a product means that
money cannot be used to purchase another product. In the case of books versus movies, the tradeoff is a
straight line because one more book always costs two movies, regardless of how many books Rose has
already.
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You should be able to see that the slope of the budget line depends only on the price of books relative to
the price of movies. If either books get cheaper or movies get more expensive, the budget line in the
graph above will get steeper. If this is not immediately obvious, compute the possibilities open to a
person with $100 to spend if books and movies both cost $5.00 (a case of more expensive movies), and
the possibilities open to a person with $100 to spend if books and movies both cost $2.50 (a case of
cheaper books). Graphing the possibilities open to a person with only $50 to spend but with books costing
$5.00 and movies costing $2.50 gives you a line that is to the left of the line in the graph above, but
parallel to it, which means that it has the same slope. The amount of money available to spend does not
determine the slope of the budget line; only the ratio of prices does that.
A famous example of a budget constraint is the case of guns versus butter. During the Second World War,
the United States decided it needed to produce large amounts of armaments (guns). It shifted factories
that previously produced goods for civilian use (butter) to the production of guns. This tradeoff could be
represented as a move from a point such as a to a point such as b in the graph below, except that at the
start of the war there was still a high level of unemployment left over from the recessions of 1929-33 and
1937-8 (a period better known as the Great Depression). Hence, the United States was not at the limit of
what it could produce, but rather at a point such as c, which indicates that more of all goods could have
been produced given the amount of resources and technology.
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