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demand and supply

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ACTG 2011
Eytan Lasry

Principles of Microeconomics: Demand and Supply DEMAND AND SUPPLY This lecture examines the basic Demand/Supply model that is central to microeconomics. We do so by defining the relationship between Price and Quantity in Demand and Supply without analyzing the cause of those relationships. We analyze the cause of the relationships later in the course. We begin with a definition of Microeconomics and Partial Equilibrium Analysis before explaining the importance of Demand/Supply for markets. Definition: Microeconomics is the study of individual units in an economy (households, firms, markets, etc.) and their relationships. This entails the study of the allocation of resources and the distribution of income. Methodology Modern economics relies heavily on two methodological tools: partial equilibrium analysis and atomism. Definition: Equilibrium is a state of rest with no tendency to change given existing forces (variables) Definition: Partial Equilibrium Analysis is the analysis of the relationship between two variables while holding other relevant variables constant (ceteris paribus = other things equal), then examining the effect of the other variables by systematically examining their variation. 0 Example At what temperature does water boil? Most people would answer 100 C but in fact this is only true holding at least two other variables constant: atmospheric pressure (sea level) and purity of the water (not salty, for example). Scientists use partial equilibrium analysis all the time to isolate relationships before they analyze the variations caused by changes in other variables. - 1 - Principles of Microeconomics: Demand and Supply Definition: General Equilibrium Analysis is the analysis of the relationship between all variables simultaneously. (We wont use this approach in this class) General Equilibrium analysis is highly prized because it analyzes all the variables at once but this is a disadvantage because it requires more sophisticated mathematics and it doesnt tell us about the cause-effect relationships between specific variables. We can approximate general equilibrium analysis by relaxing successively relaxing the ceteris paribus assumptions of partial equilibrium analysis. Definition: Atomism is the perspective that society (whole) is the sum of its parts (households and firms). Modern economics builds theory by analyzing the behaviour of the basic components of consumption (households) and production (firms). Demand is the aggregation of the behaviour of the individual consumers (households) and Supply is the aggregation of the behaviour of the individual producers (firms). Late in the course we will examine some of the issues that arise theoretically because of this methodological approach. Types of Economic Systems: There have been various types of economic systems historically, such as patriarchal, slave, feudal, socialist, and communistic. This course concentrates on the market system. Definition: Purchase and sale transactions between economic actors (households and firms) determine the allocation of resources in a market. => Price mechanism determines the allocation of resources in a market. Governments affect the allocation of resources in market economies in 5 ways. 1. Government Spending (roads, education, transfer payments, and wars, for example) 2. Taxation (income, sales, and property taxes, for example - 2 - Principles of Microeconomics: Demand and Supply 3. Public Enterprises (e.g., Ontario Hydro, LCBO, TTC, etc.) 4. Regulation (e.g., environmental, building, etc.) 5. Monetary Policy (control of money supply effects prices, interest rates, and exchange rates) Competitive Markets Definition: Competition is Price Taking Analysis of competition dates from at least Aristotle. Adam Smith described competition as many buyers and sellers in his revolutionary discussion of the benefits of competitive markets in his 1876 The Wealth of Nations, but it was only at the end of the nineteenth century that economists formulated the modern analytic definition. The modern definition captures Smiths meaning that buyers or sellers cannot influence price in a competitive market. It also simplifies the analysis of competitive behaviour since households and firms respond to a given price with no ability to change that price. Imperfect competition occurs when a buyer or seller can influence price. The most extreme examples are monopoly (single seller), which we shall discuss later in the course, and monopsony (single buyer). We shall see that Demand and Supply determine price in a competitive market. DEMAND (function, curve, schedule) Definition: Demand is the quantities of goods and services demanded by consumers (households) 1 at each market price ceteris paribus. Demand is the relationship between 2 variables, price (P) and quantity demanded (q for the household and Q for the market), holding all other variables constant. The most important of the 1 Economists analyse households as the smallest unit of consumption rather than consumers because there are consumers such as babies that do not make economic decisions. - 3 -
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