Supply and Demand Analysis

Positive versus Normative Analysis

Economists distinguish between statements that describe the world as it is (positive analysis) and statements that prescribe how the world should be (normative analysis).

• Positive Analysis: Objective and fact-based; describes relationships and outcomes without judgment.

• Normative Analysis: Subjective and value-based; involves opinions about what ought to be.

• Example: "An increase in the minimum wage will lead to higher unemployment" (positive). "The government should increase the minimum wage" (normative).

Definition of a Market

A market is any arrangement that allows buyers and sellers to exchange goods and services.

• Markets can be physical (e.g., a grocery store) or virtual (e.g., online marketplaces).

• Key elements: buyers, sellers, and the good or service being exchanged.

Real versus Nominal Prices

Nominal price is the price of a good in current dollars, while real price adjusts for inflation to reflect purchasing power.

• Formula:

• Example: If a gallon of milk cost .

Demand and Supply Curves

The demand curve shows the relationship between price and quantity demanded, holding other factors constant. The supply curve shows the relationship between price and quantity supplied.

• Movements along the curve: Caused by changes in the good's own price.

• Shifts of the curve: Caused by changes in other factors (income, tastes, prices of related goods, technology, input prices).

• Example: An increase in consumer income shifts the demand curve for normal goods to the right.

Competitive Equilibrium, Market Price, Shortage, and Surplus

Competitive equilibrium occurs where quantity demanded equals quantity supplied at the market price.

• Shortage: Quantity demanded exceeds quantity supplied at a given price.

• Surplus: Quantity supplied exceeds quantity demanded at a given price.

• Market price: The price at which the market clears (no shortage or surplus).

Elasticity

Types of Elasticity

Elasticity measures the responsiveness of one variable to changes in another.

• Price Elasticity of Demand:

• Income Elasticity of Demand:

• Cross Elasticity of Demand:

• Elasticity of Supply:

Normal and Inferior Goods; Substitutes and Complements

• Normal Goods: Demand increases as income increases ().

• Inferior Goods: Demand decreases as income increases ().

• Substitutes: Goods for which an increase in the price of one increases demand for the other ().

• Complements: Goods for which an increase in the price of one decreases demand for the other ().

Relation Between Price Elasticity of Demand and Total Revenue

• If demand is elastic (), a price decrease increases total revenue.

• If demand is inelastic (), a price decrease decreases total revenue.

• Formula for Total Revenue:

Consumer Behavior

Rationality According to Economists

Economists assume consumers are rational, meaning they maximize their utility given their budget constraints.

• Consumers weigh costs and benefits to make choices that provide the greatest satisfaction.

Opportunity Cost, Budget Line, Marginal Benefit per Dollar, and Consumer Equilibrium

• Opportunity Cost: The value of the next best alternative forgone.

• Budget Line: Shows all combinations of goods a consumer can afford.

• Equation: (where , are prices, , are quantities, is income)

• Marginal Benefit per Dollar:

• Consumer Equilibrium Condition:

Indifference Curves and Maps, Assumptions About Preferences, Marginal Rate of Substitution (MRS)

• Indifference Curve: Shows combinations of goods that provide equal utility.

• Assumptions: Completeness, transitivity, more is better, convexity.

• Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to substitute one good for another, holding utility constant.

• Formula:

Consumer Choice (MRS = Slope of Budget Constraint)

• At the optimal consumption bundle, the MRS equals the price ratio.

• Condition:

Individual and Market Demand

Graphing Individual Demand Curves from the Price Consumption Curve

• The price consumption curve traces the utility-maximizing combinations of two goods as the price of one changes.

• From this, the individual demand curve for a good can be derived.

Engel Curves, Inferior and Normal Goods

• Engel Curve: Shows the relationship between income and quantity demanded of a good.

• Upward sloping for normal goods, downward sloping for inferior goods.

Market Demand Curve, Elasticities, Consumer Surplus, Revenue Maximizing Prices

• The market demand curve is the horizontal sum of individual demand curves.

• Consumer Surplus: The difference between what consumers are willing to pay and what they actually pay.

• Formula:

• Revenue-maximizing price depends on elasticity: set where marginal revenue is zero.

Network Externalities and Graphical Representation

• Network Externality: When the value of a good increases as more people use it (e.g., social networks).

• Graphically, demand curve shifts right as network size increases.

Empirical Estimation of Demand

• Statistical methods (e.g., regression analysis) are used to estimate demand functions from real-world data.

Production Functions

Market Coordination vs. Firm Coordination

• Market Coordination: Allocation of resources through price signals in the market.

• Firm Coordination: Allocation of resources within a firm, often more efficient for complex production.

Short Run Production Function, Total Product, Marginal Product, Average Product

• Short Run: At least one input is fixed.

• Total Product (TP): Total output produced.

• Marginal Product (MP): Additional output from one more unit of input.

• Average Product (AP): Output per unit of input.

• Formulas:

Long Run Production Functions, Isoquants, Marginal Rate of Technical Substitution (MRTS)

• Long Run: All inputs are variable.

• Isoquant: Curve showing all combinations of inputs that yield the same output.

• MRTS: Rate at which one input can be substituted for another, holding output constant.

• Formula:

Returns to Scale

• Increasing Returns to Scale: Output increases more than proportionally to inputs.

• Constant Returns to Scale: Output increases proportionally to inputs.

• Decreasing Returns to Scale: Output increases less than proportionally to inputs.

Cost of Production

Economic Costs, Accounting Costs, Opportunity Cost, Sunk Cost, Short Run Total Cost, Fixed Cost, Variable Cost, Marginal Cost, Average Cost

• Economic Cost: Explicit + implicit costs (including opportunity cost).

• Accounting Cost: Only explicit costs.

• Opportunity Cost: Value of the next best alternative.

• Sunk Cost: Costs that cannot be recovered.

• Short Run Total Cost (TC):

• Fixed Cost (FC): Costs that do not vary with output.

• Variable Cost (VC): Costs that vary with output.

• Marginal Cost (MC):

• Average Cost (AC):

Cost in the Short Run, Cost Curves, Relation Between Marginal Cost (SMC) and Average Cost Curves (SAC)

• Short-run cost curves show how costs change as output changes, with some inputs fixed.

• Marginal cost curve intersects average cost curve at its minimum point.

User Cost of Capital, Isoquant and Isocost Lines, MRTS, Minimum Cost Solution

• User Cost of Capital: Annual cost of owning and using capital.

• Isocost Line: Shows all combinations of inputs that cost the same total amount.

• Equation: (where is wage, is labor, is rental rate of capital, is capital, is total cost)

• Minimum cost solution occurs where isoquant is tangent to isocost line:

Long-Run Expansion Path and Long-Run Costs, LAC and LMC

• Long-Run Expansion Path: Shows the cost-minimizing combination of inputs for each output level.

• Long-Run Average Cost (LAC):

• Long-Run Marginal Cost (LMC):

Relation Between Long-Run and Short-Run Cost Curves, Economies and Diseconomies of Scale

• The LAC curve is the envelope of all possible short-run average cost curves.

• Economies of Scale: LAC decreases as output increases.

• Diseconomies of Scale: LAC increases as output increases.