A Bit of Economics — Part 2

{Read part 1 here.}

The basics of price theory (microeconomics) are simple. First the law of demand. We know without being instructed that when the price of something falls, we tend to buy more of that.

At the grocery store, I may buy donuts at $5 a dozen but may not buy if they were $6 a dozen. At some price, I would not buy donuts, if the price drops, I will buy more and more up to some point. That’s my individual demand for donuts. But other people may buy at $6 and some others may not buy even at $5.

If you aggregate all those individual buying decisions, you notice a pattern: the store sells more when the price is low than when it is high. That’s the aggregate demand function which emerges out of the sum of various individual demand functions.

What’s a function? It’s a relationship between two or more variables. Variables are values that vary. Price is a variable, and so is the quantity demanded or the quantity sold. If a relationship is fairly stable, we like to make a note of it. Here’s a note-worthy relationship — the demand function — graphically illustrated:

It shows the functional relationship between the quantity demanded (on the x-axis) at various prices (on the y-axis.) The blue line above is called “the demand.” It is downward sloping because the quantity demanded increases as the price decreases, and vice versa.

Let’s repeat this: The demand is not some particular quantity; the demand is a relationship between various prices and the corresponding quantities demanded.

Next we note that the quantity demanded is the dependent variable, and the price is the independent variable. Your decision of much to buy depends on the price; the price does not depend on your decision.

The convention is to write the statement “quantity demanded is a function of price” compactly as:

Q(.) = Q(P)                                                                        … (1)

{NOTE:  Be careful. We are used to equations like E = mc2. It equates two quantities, energy on the left hand side and mass times the square of the speed of light on the right hand side of the equal sign. We read that to mean “energy is equal to mass times the square of the speed of light.”

But in equation (1), we are not equating anything. We are merely defining or describing. We don’t read it as “Q is equal to Q(P)” but rather that “Q is a function of the variable P.”}

There is a mirror image of that relationship: it’s called the supply. It’s observed that as the price increases, the quantity supplied by producers increases. Here’s a handy graphic:

The supply is an upward sloping line. Why does this happen? I leave the answer as an exercise for the reader. Once again, the dependent variable is the quantity supplied and the independent variable is the price. So we can write

Q(.) = Q(P)                                                                   … (2)

But wait. Equations (1) and (2) are the same. To distinguish between the two we use subscripts d and s to denote the demand and supply functions, respectively:

Qd(.) = Qd(P)                                                                … (3)

Qs(.) = Qs(P)                                                                 … (4)

A market is said to “clear” when the quantity demanded by consumers in the market is equal to the quantity producers supply to the market. We realize that only at a particular price does that happen — at the intersection of the demand and supply functions. Thus:

That price is called the equilibrium price, denoted by convention as P*. In functional notation:

Qd(P*) = Qs(P*)                                                         … (5)

In plain English, equation (5) says that the quantity that consumers will demand at price P* is the same quantity that producers will supply at price P*.

In the diagram above, the market-clearing price is $6, at which price the quantity demanded (6 dozen) is the same at the quantity supplied.

At a price above P*, the quantity supplied will exceed the quantity demanded. There will be surplus. The market will fail to clear. At a price below P*, the quantity demanded will exceed the quantity supplied. There will be shortage. The market will fail to clear.

*~*~*~*~*~*~*

Governments are always eager to fix prices — leading to surpluses and shortages. It’s stupid to do that. Messing with prices is really retarded because it invariably makes a bad situation worse. Most of all, price controls hurt the most vulnerable in society. Why so? We’ll go into that in the next bit.

*~*~*~*~*~*~*

Simple though the demand-supply-equilibrium concept is, it is surprisingly powerful as a teaching tool. It explains or “models” 94.3% of how markets work. The remaining 5.7% that needs explaining takes up about 99% of the total effort. For only 1% of the effort, we get 94.3% of the way there. I’d say it’s a deal.

But we must note that all this demand and supply, and equilibrium price are fictions. They don’t exist in reality although they help us understand the way markets work.

First of all, markets are never at equilibrium. Meaning there is never an equilibrium price P* because there’s always unsold goods in the market at any point in time, and sometimes people go to buy some stuff and find there’s none in the store. (At the start of the covid pandemic, many stores were out of toilet paper. A very instructive story there.)

In the next bit, we’ll examine consumer behavior — which is what gives rise to demand. And then look at producer behavior — which produces the supply.

                                                                                     {Read part 3 here.}

Author: Atanu Dey

Economist.

2 thoughts on “A Bit of Economics — Part 2”

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