Demand And Supply

Demand and supply do not have to be complicated. For some students, there are, and I think it’s for three basic reasons. One is that your textbook presents demand and supply in separate chapters. In reality, these charts and graphs won’t help too much unless you can work with demand and supply together. Another is that there is a lot of unfamiliar and polysyllabic jargon, but the ideas are actually pretty simple. You want to have confidence in yourself and apply common sense. Of course, it’s only common sense if you have it! The third reason is that, like math, the ideas build on each other. If you miss a class (including being just physically present), you have to catch up fast or you’re permanently behind.

Demand And Supply Well, let’s begin. First, there is a big difference between demand and quantity demanded. Demand is the amount of a good or service all consumers, together, will buy at any given price. You show it as a curve or on a demand schedule (T-chart). Quantity demanded is the amount all consumers will buy at a particular price. You show it as a dot on the demand curve or a line on the demand schedule.

Demand vs. Quantity Demanded: The blue curve shows demand. The dashed vertical line up from 210 shows the quantity demanded at $425 per unit. Quantity demanded is basically dependent just on price. But many things determine overall demand.

One, demand depends on whether the good or service is “in season”. Ice cream will sell better in the summertime than it will during a snowstorm.

Also, demand is affected by changing consumer tastes. Someone shopping for basketball shorts today might pay $20 for one of these Nike models. For a Dr. J 1983 championship replica, not so much. (Guys today show a little less leg.)

Another thing affecting demand is the availability of substitutes. Not everyone has the same definition of a substitute for each product (if Coke is liquid to you, water’s a substitute; if it’s cola, Pepsi’s a substitute; if it’s caffeine, then coffee is a substitute. But the more substitutes available, and the cheaper they are, the less demand will be for your product. Are the boots at right a substitute for the Uggs at left? (LOWER left, guys. Come on.)

Now, once the demand curve is set, we can look at it and ask how elastic or inelastic it is. Elastic means stretchy, like the waistband of Dr. J’s shorts. Elastic demand curves have a gentle slope. Consumers like them, because with elastic demand a small change in price has a huge impact on quantity demanded.

Producers (suppliers), on the other hand, like demand for their product or service to be inelastic. Even a big change in price has little affect on quantity demanded. So the producer can raise the price and make a big profit. An inelastic demand curve is steep, maybe almost straight up and down. Why is the demand for cigarettes so inelastic? Because they’re addictive, and addicts are not ‘sensitive to price’.

What determines elasticity? A bunch of things. If there are substitutes available (water ice instead of ice cream), demand is more elastic. And if the price of a substitute- the water ice- goes up, the demand for the original product- the ice cream- also goes up.

Another thing affecting elasticity is whether the product is a luxury or a necessity. Luxuries (“wants” that are expensive) have more elastic demand than necessities (things you need, especially if there are no substitutes). The guy with chest pain will pay almost any price for heart medicine: demand is inelastic. By the way, what will happen to demand for the Mercedes (bottom right) if the price of the BMW (top right) goes down? And what other factors will determine demand for the BMW or the Mercedes?

Now we are ready to tackle supply. For the demand curves and schedules to be really useful, they must interact with supply curves and schedules. So, here goes. The good news is that a lot of the vocabulary is similar. Just as with demand vs. quantity demanded, the amount of a good or service all producers are willing and able to sell at any given price is supply (S). The amount of a good or service all of its producers are willing and able to sell at one particular price is the quantity supplied (qS). The qS will be zero if the price is set below the cost of production. If the cost of making a cake is $7, that is the lowest its supplier would charge. Of course it will try to charge more.

What seems to give some students trouble (probably the same students who can’t remember that the public sector is bigger in a command economy and the private sector is bigger in a market economy) is that getting Supply right requires you to think as a supplier. Most of you haven’t been in business, so you don’t know what it’s like to supply a good or a service. For a supplier, it’s all about the profit motive. The quantity supplied will increase if the price can increase, since a higher price means greater profit. “You can have all the (root) beer you want, boys…at $20 a pitcher!”

What determines how much a change in price will affect the quantity supplied? You guessed it: the elasticity of the good or service. If a price increase causes a large increase in the quantity supplied, we say supply is elastic. If a price increase causes little change in the quantity supplied, we say supply is inelastic. In the short run, the supply of most products is inelastic. You can only make your workers do so much overtime before they give out, and it takes time to hire more people and/or set up more production lines. “Sorry, we’re out. Come back Thursday. We’ll have more then.”

Sometimes, there is no way to supply any more than a single unit, as with rare art. That’s why the price can get so crazy. We say there is zero elasticity of supply. Who knows the names of the artists or paintings?

Sometimes, the government steps in to artificially increase or decrease the supply. Say they don’t want you to smoke, and they figure, “Let’s add another dollar of tax to each pack of cigarettes.” That adds to the cost of production, and so the quantity supplied of cigarettes should decrease at any given price. But we know the demand for cigarettes is inelastic: the addicts need their fix. So what will happen? First there will be a shortage, as stores run out of cigarettes. Then, the extra dollar in tax will be added to the price of each pack and passed on to consumers. =

At other times the outcome is different. The demand is elastic so the supplier can’t charge more for the good or service. The tax is added to the cost of production, and the supplier eventually just produces less, creating a permanent shortage. If the tax is greater than his profit margin, this could drive him out of business. Some people want the government to do this to those who supply veal calves for slaughter, or build gas guzzlers.

The government can also get involved to encourage the production of something specific that it would like to see more of, either for its own use or consumers’. A government grant, called a subsidy, to produce electric cars would make them cheaper to produce, and profitable at a lower price (so more people would buy them). Or, the government can guarantee a minimum price for something that’s produced, as it does with many farmers. That guaranteed minimum price is called a price support.

Finally, we have to tackle the subject of a production schedule. That is too tricky to illustrate. We might as well just use the textbook and learn about marginal product, the stages of production, and marginal cost.

Your quest on Supply is Thursday. Friday, you will have a current event due. If you are leaving for spring break before then, do the current event in advance. You probably won’t remember to do it the weekend before you come back.