The theory of market price (supply and demand of a good)
Microeconomics (lesson n.2)
In this lesson we will see the depiction of the supply (S) and demand (D) curves and we will understand why the market balance always comes about at the point where they intersect.
We will also classify the economic assets and study the microeconomic causes of inflation, that is, the general increase in prices. Finally, we will learn about the important concept of “elasticity”.
The theory of market price (supply and demand of a good)
We mentioned in the previous lesson that the study method we will use in microeconomics is that of partial economic balance, developed by the economist Alfred Marshall and called the “Cambridge School”. Remember that the assumption of this method is the regularity of all the parameters outside those of the studied market. In particular, the theory of market price determines the price (p) and the amount (q) of balance of a market, all other conditions being equal, that is, holding firm all those economic measures that are not the price and the exchanged amount of that market (therefore P and Q of other markets, but also the salaries of the same market, the interest rate, the unemployment rate, etc…).
This premise should never be forgotten.
The price theory considers the consumers’ demand as a decreasing curve set in a diagram whose values are price (p) and quantity (q).
This means that the request for a certain commodity, whatever it is, is an inverse function of price to quantity Q= f (P). In other words, the condition,which is at the base of the reasoning, is that the demanded quantity diminishes with the increase in price and increases with the decrease in price. This inverse relationship is graphically represented by a decreasing curve and, from a mathematical point of view, by the negative sign of one of the two variables Q= f (- P). To the growing of a variable the other diminishes. When one variable grows (increases) the other diminishes (decreases) and viceversa.
The reasoning that leads to a negatively inclined demand is intuitive enough: in fact it is plausible to believe that consumers reduce the demanded quantity of a certain good if its price increases, whereas they ask for more if the price decreases.
Unfortunately, in economics,the reasoning that leads to a certain conclusion cannot be limited to its being intuitive.Therefore, in the next lesson ( n. 3) we will see which economic theory “is under” the question curve and justifies the decreasing course. For now it is enough to say that the demand curve expresses an inversely proportional relationship between P and Q.
What we said regarding demand we can repeat about the offer of a certain good,whatever it is, by companies.
Here, however, notice that the trend of the offer curve is growing, because it expresses a direct relationship between the quantity offered bythe producers and the price of the good. The more P increases, the more the salesmen are incentivized to increase the quantity offered on the market and viceversa. This is intuitive reasoning as well, because the producer who sees the P of his good increase is stimulated to offer more on the market in order to increase his profit and viceversa in case of a decrease of the P. Also in this case,however, the growing trend of the offer curve is explained by an economic theory, which we will see in the fourth lesson< 4. From a strictly mathematical point of view, the direct relationship between P and Q in the offer of a good is expressed by the function Q= g (+P).
At this point, in order to reach the situation of abalance inthe market it is sufficient to put together the twocurves, i.e., of supply and demand, in the same diagram, but before let’s define the concept of balance inanymarket.
According to this demand and offer theory, a market is in balance when it establishes a P and an exchanged Q that are stable, i.e., destined to last in time. Anyother value not inbalance betweenthese two variables (P and Q) will lead to an instability inthe system, because the market forces will always push P and Q towards balance values.
Let us now see concretely how the market balance is created.
In the figure we see both the function of demand (decreasing) and the function of offer (increasing).
Remember that the points on the demand curve indicate the quantities demanded by consumers in that market for every price level of the good, while the points on the offer curve identify the quantities the salesmen are willing to offerfor every price. Well, this shows that the balance situation is true in the only point of the diagram (e) in whichthe quantity demanded by consumers is equal to the quantity offered by salesmen at the same price. In other words, there is balance when the P is such that thequantities demanded and offered are exactly the same. Only when the two measures price and quantity acquire the values P* and Q* (the market is not in balance, that is stable, without modification tendencies.)
The E point is the only one that equals the demanded Q and the Q offered, determining the price (P*) and the exchanged quantity (Q*) of balance. From the graphical point of view this point E is the one that intersects the two curves, while in a mathematical perspective it is the one inwhich the two functions of supply and demand are equal:
(Q= f (- P)) = (Q= g (P))
But why isthe market balance formedpreciselyin that point?
The answer can be inferred from the following figure.
If the price were higher than the balance price, i.e. P1, there would be an excess in offer in the marketequal to the difference between Q2’ and Q1’, corresponding to the distance between B and To. In this situation warehouse supplies would be overstocked because of the unsold goods, forcing the salesmen to order (or to produce) a lower quantity of that good due to the consumers’ lack of demand. The reduction of the offered quantity, accompanied by the lowerprice atwhich the bidders would be willing to sell in order to eliminate the warehouse stocks, would pushthe market towards a lower price, i.e., towards the balance price P*.
The reasoning is analogous, but in a speculative vein, if the market has a lower price than the balanced one, i.e. P2,there should be an excess of demand equal to the distance between Q2 and Q1. At the P2 price,someof the consumers would not be able to buy the good and would have to renounce it. That’s why these consumers are willing to spend a little more to have the good they are askingfor. Therefore,the excess demand leads to a rise in price pushes caused by some consumers’ lack of satisfaction. The salesmen indulge with these consumers and accompanythe price increase with a wider offer. All of this leads the market to increase the price, until it reaches the balance P*.
In both cases, the market trends halt when we reach the intersection point between the two curves of supply and demand. Only the balance price P*, situated in point E, causes the market’s stability and undoes the increase or reduction pushes in price. The balance istrue onlywhenthe demanded quantity is equal to the one offered and the consequent measures of price (P*) and quantity (Q*) are the only ones that stabilize the market.
Microeconomics could end here because once we have explained the operation of these measures of supply and demand we have the necessary knowledge to understand the forces that act in any market. However, what we haven’t discussedis the economic reasoning behind the functions of supply and demand.
In the followingmicroeconomics lessons we will analyze the theories that explain and justify the construction and the supply and demand trend curve, for both the goods market and the productive factors market.
In the third lesson we will see the demand for consumer goods, whereas in lessons n. 4 and 5 we will analyze the corresponding offer curve, respectively, in perfectly competitive markets and in those with different forms than that of perfect competition (i.e., monopoly, oligopoly and monopolistic competition).
In lesson 8, in the analysis of the labour market balance, we will introduce the role and the effects of the workers’ trade unions and we willalso examine the markets of the other productive factors (i.e.land and capital).
Before closing this section,we will hint atthe greatest difficulty students havein microeconomics. Studying the diagrams, they often confuse the market movements “on the curves” with the movements “of the supply and demand curves”. The following trick can be used to avoid confusion:
- when the variations concern the axis values, that is, generally, price (p) and quantity (q), then we move “on the supply and demand curves”.
- when the variations regard other economic measures (salary, unemployment rate, other market prices, the quantities demanded or offered of other markets, inflation rate, consumers’ taste, etc…), different from the P and the Q of that market, then there ismovement (translation) “of the demand and supply curves”. In particular, demand moves upward and to the right when it grows (because when P is equal the demanded quantity is greater) and downwards and to the left when it decreases. The offer moves downwards and to the right when it grows (because P is equal the offered quantity is larger) and upwards and to the left when it decreases.
Applications of the supply and demand theory to all markets
What’s beautiful about the instrumentation of supply and demand, as just described, isits applicability to any market, that is, wherever there is someone who is selling and someone who is buying.
It can be applied in both consumer goods markets and in the factors or productive services markets.
In the labor market, the price formed at the intersection of the two curves is the balance salary.
In the capital market, the balance price is the interest rate.
In the foreign currency market, the price determined by the supply and demand functions is the exchange rate between the two currencies (i.e. dollar and euro).
In the credit bond market (i.e. the stock market), the price formed by the negotiations between salesmen and purchasers is the title quotation.
The price theory presentedin the previous paragraph is also needed to explain the distortions and the inefficient allocation of resources in the economies ofsocialist countries.
In fact, these countries are characterized by the fact that the centralized power determines a price (labelled “political”) or an offered quantity (production curtailment / quota system) without takinginto account the value of these measures,whichwould be createdalone/independently in the market if the (supply and demand) forces were left free to move.
In particular, if the political price (i.e. A* in the diagram) set by the central government were higher than the one it would form (that would be created…) freely on the market, there would be a waste of resources due to anexcess of (excessive…) offer, represented by the distance between Q2 and Q1.
If the political price were, instead, lower than the one the market would express on its own, there would be a goods shortagedue to anexcess in demand, which would cause lines in stores and other serious black market phenomena . This is the situation Italy was in,in the real estate rental market,atthe time of equitable fee law.
If, differently, the government of the socialist economy country opted for production curtailment, the result would be market stagnation in which aninferior quantity of goods than that wanted by salesmen and consumers would be offered (i.e. Q in the diagram) at a higher price than that in a free market economy (P and not P*).
In any case, in the socialist countries there is an obvious distortion of economic mechanisms and an inefficient allocation ofresourcesbecause the market forces are not left free to act and to reach abalance.
Categories of economic commodities
Following are some definitions of economic commodities that will be very important in the next lessons.
Substitute goods and complementary goods.
Two goods are substitutes for each other,they are so similar they satisfy the same needs in an equivalent manner, i.e., butter and margarine.
Two goods are, instead, complementary when they are used together to satisfy certain needs, i.e., coffee and sugar.
Therefore, according to the relationship between P and Q:
- one good is a substitute of another one when the increase in P of the first one implies anincrease of the demanded Q (demand curve movement to the top and right) in the second one and viceversa
- a good is, on the other hand, complementary when the increase in P of the first one implies areduction of the demanded Q (demand curve movement to the bottom and to the left) of the second and viceversa.
Normal and inferior goods.
This distinction concerns the reaction of the demand for goods to variations in consumers’ income (relationship between Q and income).
A good is normal if a rise inincome results in an increase in demand for it (upward curve movement) and vice versa in the case of a decrease in income.
A good is inferior if the income rise entails a reduction inits demand (downward curve movement) and vice versa in the case of a decrease in income.
In reality it’s very difficult to come across inferior goods, because there is no economic reason whya person who isricher should reduce consumption of a good rather than increase it.
Inflation in microeconomics
Price theory, together with its instruments, also allows us to explain the phenomenon of inflation.
Let’s start by saying that inflation is a topic of study in macroeconomics, because it is an aggregate measure, whichmeans that it is a measure that does notrefer only to one market, but to all markets in the economic system. Now, thanks to the supply and demand curves, we are already able to understand the meaning of inflation and mostly what causes it.
We define inflation in the first placeas the generalized phenomenon of the economic system that tends towards a rise in prices (i.e.,all prices in all markets).
A first microeconomic reason for inflation is given by the possibilitythat the markets might not be in a balanced situation. We know that in this situation forces act to push the markets towards balance, so if the current price is lower than the balanced one the tendency is for prices to rise. But this is certainlynot the true cause of inflation, because, even assuming that the price inall markets was temporarily distanced (towards the bottom) from the balanced one, the tendencytowards an increase in prices would only be temporary, as long as necessary for the re-balancing of demands and offers. This is not true of inflation,which is a long-term phenomenon.
Two types of inflation exist in microeconomics:
1) inflation pulled by demand, which is further divided into:
- price variation insubstitute goods
- a rise in income
- variation inconsumers’ preferences
- increase in price expectations
2) inflation from costs (from offer)
Let’s look at them in order.
A first microeconomic explanation of inflation is that it is due to an increase in P of substitute goods. As we said, these increases in P cause an increase in the quantity demanded (from the D to D’ curve) of correlated goods to the first ones, causing a consequent variation inthe increase in the price (from P* to P1) of these other goods as well. In other words, an inflationary spiral is activated by the expense settlement from consumers (in fact,the balance passes from E to E’, with an increase in the quantity, which iscommon inall cases ofinflation).
Even a generalized risein income causes inflation, because it moves upwards the normal goods demand curve. In the diagram above (which is identical to the previous one) the demand moves from D to D’, with a variation in increase in price from P* to P1 (therefore, the new balance is in E).
This isthe most frequent (type of?) inflation because it occurs in periods of economic growth, when the income per person of all citizens rises.
Variation of consumers’ preferences
Another reason for inflation due todemand is the simple modification of consumers’ preferences. The power of tastes and socialtrends must not be underrated. Often there is no economic explanation for the excessive price of some goods beyond the fact that those goods are “fashionable” or are goods that represent a “status symbol”. Also in this case the market demand forthese goods rises (the diagram is the same as for other cases of inflation due todemand).
Increase in price expectations
The last case of inflation “pulled” by demand is that of expectations. Economy teaches us that when the wait for a certain event spreads in the society, in the end this event takes place. For example, this concept is true for the stock market, where the operators’ generalized expectation of a title slump inevitably leads the quotation of that title to collapse. If everybody expects an increase in prices, in the end this rise will take place, because it is the market operators’ behavior that causes it (the diagram is the same one as for the other cases of inflation from demand).
Inflation from offer (or because of an increase in costs)
In the inflation from costs what moves is not the demand curve, but the offer curve. The translation of the offer upwards (i.e., reduction of the offered quantity), with the consequent inflation, is due to the increase in price of the productive factors. The latter obligates producers to reduce the offered quantity atevery level of price, so as to keep the profit margin unchanged (in the next diagram we pass from the S curve to the S’ curve). If in the equation [(Revenues – Costs) =profit], costs (c) increase, salesmen are forced to increase revenues (r), i.e., the price of the sold good, in order to maintain profitssteady(p). In the following diagram we pass from E to E’, and therefore from the price P* to P1, whilethe quantity narrows (from Q* to Q1).
The productive factors, whose increase in price generates inflation, are generally those related to the labor force, i.e., to work. Mostly in the 80s the high cost of labour, due to the conquests achieved by thetrade-unions, generated strong inflationary pushes. Currently, however, rises in the costs of raw materials (i.e. paper, oil, etc…)are causing this inflation.
Demand and offer elasticity
A concept of utmost importance, which not only economists, but also market operators (salesmen and producers), should always takeinto account, is that of curve elasticity of demand and offer.
Let me say immediately that what we assert about demand elasticity is also true for offer elasticity; however, the most important is surely the former, because by considering demand elasticity (beyond many economic theory considerations)it isalso possible toobtainimportant cues about understanding the behavior of salesmen regardingtheir trade policies.
Let’s start with the definition.
Demand elasticity,withrespect to price, measures the reactivity of the demanded quantity at a percentage price variation, i.e., it indicates how much the demanded quantity of a good varies if its price increases or decreasesbya certain percentage.
In mathematical terms elasticity is represented by the coefficient in front of the modifying variable (i.e., price).For example, if this is the function of the demand Q= a – bP, the elasticity is given by the value of b.
In graphic terms, the elasticity is the slope of the demand curve. For example, if by increasing the price of a unit we findthat, on the demand curve, there is a decrease in the amount of 3 units, the elasticity of the demandis 3.
In the picture are represented two demand curves with two different elasticities (slopes), as we can see from the different reaction, in terms of reduction of the demanded Q (from Q0 to Q1 or to Q1’), in response to the same variation (increase) of P (from P0 to P1).
The mathematical formula of the elasticity is:
elasticity of the demand = ( variation % of demanded Q)/(variation % of P)
where (variation % of demanded Q) = [(delta Q) /Q)] x 100
and (variation % of P) = [(delta P) /P)] x 100
The elasticity of the demand withrespect to the price can acquire a huge number of values (more or less sloping demand curves correspond to these values).
A classification of the various values of elasticity is the following:
a) Elasticity = 0
there is no demand reactivity. Anyvariation of P leaves the demanded amount indifferent. Graphically the demand is a vertical straight line. In this case we say that the demand is rigid or inelastic.
b) Elasticity = 1
the % variation of P determines the same % variation of demanded Q.
c) Elasticity< 1
there is little Q reactivity to the variations of P. The demand inclination is close to the vertical one. We say that the demand is not veryelastic.
d) Elasticity> 1
indicatesthere is much Q reactivity to the variations of P. The demand slope is close to the horizontal one. We say that the demand is very elastic.
e) Elasticity = infinite
indicates maximum reactivity. Every small variation of P causes a large answer of demanded Q. The demand is a horizontal straight line. The demand, in this case, is perfectly or infinitely elastic.
Infinitely elastic demands do not exist (they are hypothetical borderline cases). There are, however, rigid demands (with elasticity = 0 or close to 0). For example, the dependency of some countries onoil importsleadsus to consider their demand for that fuel as rigid. This explains the reason for the high price of oil in certain historic periods: it wasdetermined only byoffer variations (reductions) by the Arab producing nations (OPEC).
A last consideration.
When the demand elasticity of a good withrespect to its price is inferior to 1, then it is probably a first necessity good (i.e. bread).
When, instead, the elasticity of a good is greater than 1, then that good is probablya luxury good (one we can do without, i.e. an art object, a valuable fur coat, but also a subscription to satellite television, etc…).