Supply and Demand

So we know how people decide what to produce but we still don’t know how much they decide to produce?

This is where the supply and demand curves come into the picture. They illustrate how much each side supplies and demands respectively. They’re about as straightforward as a finger painting done by a third-grader could make and a bit of an oversimplification for what is really going on behind the curtains, so to speak.

Not only must we consider who produces what and how much but whether there’s demand at all for what is being supplied. This little caveat will be important later when we discuss several economic issues including employment (or lack thereof) and globalization.

And let’s not forget the web we’re dealing with here. We’ve got thousands, maybe millions of suppliers and consumers in the mix. Who’s producing what, how much of it, where is it distributed to? How should it be distributed? How often? Who would supply not only the goods but the drivers, the routes, the gasoline? Breathe.

It’s likely you sympathize with the other end. Whenever you go to the store, you consider what to buy, when to buy it (i.e. sales), how often to buy it and you’ve probably mastered the art of timing your runs to the store.

All these decisions are what economists lose sleep over – the behind the scenes action that determines what ends up in your cart or on your doorstep.

Now, your mind may have ventured to words bigger than your knowledge like socialism and capitalism. Hold off on that. We got some groundwork to cover so let’s begin with some simpler words.

Market (mɑ́ːkɪt): an opportunity or interaction between all sellers and buyers of a good or service. There are two variables they each care about: quantity and cost (price).

*Insert supply and demand curve graph here eventually*

Let’s start with demand as there’s no market without demand. Picture this: you have a killer skill or product, but unless someone wants it, it’s worthless. Demand almost always creates supply: people want something, someone out there will provide. Of course, there are exceptions where supply creates its own demand. Take soda or recreational substances. It is difficult to imagine demand for such things without them being introduced in the first place.

The demand curve is the downward-sloping (blue) curve. We generally call the individuals in this group consumers or households.

So why does the demand curve slope downward? The straightforward answer is that consumers buy more when goods are sold at lower prices. The more complicated answer is marginal utility, which is the increase in satisfaction from purchasing an additional unit of something. The first unit will always yield the most benefit. Each additional unit will incrementally decline in usefulness, driving down the price people are willing to pay. After all, you can use one item 100% of the time but you cannot use two of the same item both at 100%. This connects to the cost-benefit principle: consumers (theoretically) only purchase a product if there’s more to gain than what they pay.

In the introduction, I explained economists use monetary values to put things into perspective. The maximum an individual is willing to pay for the good in question is their reservation price, on the y-intercept. The slope is determined by how stub – uh, resilient people are to changes in price. In the future, you may notice people buy more or less of a good. There are two outcomes to consider when the price of a good changes: the substitution effect, where they’ll buy more of a cheaper alternative, or the income effect, which is simply a loss in purchasing power. We’ll cover the demand curve in great detail in The House.

With the demand curve adequately explained, let’s focus on the supply curve, the upward-sloping line. You might be wondering, “Shouldn’t they be cheaper if they have an abundance of this good?” And your thought would make sense – selling one of something matters less if you have more of it. It all comes back to opportunity cost. As firms spend more time and resources into increasing production of a good or service, that good or service becomes a lot pricier. The low-hanging fruit principle applies here quite literally in fact. You start with the easy pickings but once those are exhausted, you’ve got to reach higher, maybe get a ladder or a few people blessed with genetics to help.

The intersection between the two curves is where the magic happens. The market equilibrium, marked by a specific equilibrium quantity and price. Does that mean there’s never too much or too little? No. As you probably already know from experience, we will soon discuss there are times practice separates from theory.

That said, the equilibrium does a decent job of capturing why certain goods are sold at a certain quantity and price. If producers tried raising the price, demand would fall, and those units would be dead weight. On the contrary, if prices were lower, there would be excess demand, in which case, producers increase their output and therefore, prices which pulls back demand.

Now, we’re going to elaborate between a change in the quantity supplied or demanded along the curve and an change in supply or demand itself.

When economists mention changes in quantity supplied or demanded, they’re referring to movement on the curve. This occurs in response to a endogenous variable change, endo meaning inside the model, which is either price or quantity. On the other hand, a change in supply or demand is caused by some exogenous variable and changes the relationship between the two curves and the structure of the market itself.

Some examples that would impact the supply, demand, or both curves include:

Supply:

Change in production costs i.e. inputs become cheaper or more expensive
Technological advances
Taxes and government policy, including tariffs or bans
Weather conditions or disasters that impact supply routes

Demand:

Household income
Change in preference or trends that influence purchasing habits
Price of related goods, including substitutes and complements

Now, seems like a lot to digest, but we will tackle them in due time. (Some of these, such as the ray of sunshine that is public policy, will be their own separate section.)

To keep this section nice and contained, I will go one level deeper into the decision-making rabbit hole that firms and households respectively make in the next two sections.

The Machine will delve into the nuts and bolts of the firm, exploring:

Production as a function of labor and capital (for now)
How prices are set and the costs are paid
The producer surplus and profits and how firms seek to maximize them. This will be critical later when we cover the different market structures.

The House will focus on consumer decision-making:

How households maximize utility given a budget (their income)
Complements and substitutes, and understanding how these choices impact consumers
The consumer surplus i.e. the utility households seek to provide for their needs and wants

Once armed with strong grasp of these mechanics, you’ll be able to assemble a broader picture of how both sides employ them to respond to market change. This responsiveness is commonly referred to as elasticity. For example, if a tariff on one good increases, they may opt to produce something different. Likewise, if the cost of a good increases, elasticity would measure how much households would switch to a substitute. While reading the next two sections, consider how certain variables or conditions impact the firm’s or household’s ability to respond.