Elasticities: Quantifying Supply & Demand

Now that we have established a solid understanding of supply and demand, it is possible to make some basic predictions about market prices and quantities. It is now necessary to delve into a more advanced topic known as elasticities of supply and demand to better quantify these predictions.

Elasticity of supply and demand is a measurement of quantity sensitivity to price changes. Elasticity explains change in quantity supplied or demanded as a result of a price change. Another way to think of elasticity is the supply and demand curves' slope. There are elastic (gradual slope) and inelastic (steep slope) curves. An elastic curve is when a small change in price creates a large change in quantity. The supply curve drawn below goes up in price by $10, but increases in quantity by 20. It is an elastic curve because its percent change in quantity is greater than its percent change in price. The demand curve, as illustrated below, is an inelastic curve. With the exact same change in price, there is only a small change in quantity demanded. The percent change in quantity demanded is smaller than the percent change in price.

Factors that effect elasticity of supply:

• Marginal Production- If it is difficult to increase production of a good then the curve is inelastic and if it is easy to produce more then the curve is more elastic. Hand-made antiques would be an example of a more inelastic good in comparison to toothpicks made quickly through machines. 
• Source of Supply- If a good is already maximizing the global supply of resources then it is very inelastic, where as a product using only a small portion of raw materials can increase production and is more elastic.
• Time Horizon- Over a short period of time, supply curves are more inelastic as it must produce goods with existing capital and infrastructure. In a long run market scenario, companies can expand their production and the product becomes more elastic. 

Factors that effect elasticity of demand:

• Substitutes- The fewer substitutes that exist to replace a good, the more inelastic the demand curve. If there are more options and goods to choose from, the curve is elastic. 
• Scope of Product- The demand for an entire category of a product such as blue jeans is more inelastic than the market for designer blue jeans.
• Necessities vs. Luxuries- The demand for life essentials is significantly more inelastic than the demand for life's luxuries.
• Size of Budget- For those items that are a small part of your budget, your demand for them is largely more inelastic than purchases that consume more of your income.

Elasticity of demand has a very useful application to business. It helps determine total revenues and prices. Total revenues= Price x Quantity. If a business is aware of their good having inelastic demand, they know they can charge a higher price and only lose a few buyers and increase their net revenues. The opposite is true for a businessman with elastic buyers. Other important applications to elasticities will be unpacked in my explanations of taxes and subsidies.

Competition Between Sellers: Corrects Surpluses, Lowers Prices

The opposite of a market shortage is a market surplus. A surplus is when the quantity supplied at a given price is greater than the quantity demanded. In the diagram below, imagine that the model represents the market for generic watches. For simple illustration purposes, we will set the price higher than equilibrium on the original curves to create a surplus. The surplus is caused by a shift in either the supply or demand curve.

Let us say that the price of watches is at $50. At the price of $50, 25 consumers demand watches and sellers supply 75 watches. This results in 50 leftover watches that are produced by sellers that are unwanted by consumers. Similarly to shortages, there is a self-correcting mechanism to resolve surpluses known as competition between sellers.

In order for a seller to ensure a sale of his products to consumers, the seller must compete for the business of consumers against his competitors. The way in which sellers do so is by giving consumers the best value through lower prices or higher qualities. In the event that sellers are producing similar products, producers must lower prices as much as possible. The lowering of prices reduces the number of goods, or watches, supplied and increases the quantity demanded by consumers. In this market, a $30 price will result in market equilibrium at which point the downward pressures of seller competition balances with the upward pressures of consumer competition.

It is important to take away from both shortages and surpluses that the problem is not with the market, as the market is the solution. As you can see, the market does have its own ways of correcting itself towards equilibrium. One must understand that it is not the consumers versus the wealth capitalists, but rather consumers competing amongst one another that lead to price increases. At the same time it is competition between sellers that results in a lower price. Remember that shortages and surpluses are often a problem with pricing. Also keep in mind the complexities of markets with all the buying and selling and levels of production and how that it is impossible for anyone to centrally plan a perfect equilibrium at all times. What we can be sure of is that despite both shortage and surplus, markets will correct and return to equilibrium.

Also, watch this learnliberty.org video to learn about marginal value, a very important economic principle. Learn how a bottle of water can be worth more than diamonds.

Shortages & Consumer Competition

While market equilibrium is the desired outcome, supply and demand curves can change throwing off the balance of the marketplace. Markets can have shortages and surpluses. A shortage is when the quantity demanded at a given price is greater than the quantity supplied.

In the diagram below, there is a market for a normal good. This good is at equilibrium at $20. There are 50 units being produced and 50 units being consumed.

Now, let us say that consumer income has increased thereby increasing the demand for the normal good. Along the curve D', there are 100 units demanded at the price of $20 while sellers are only producing 50 units at $20. As a result, there is a shortage of 50 units in the market. At this point, many argue that markets are no longer efficient because they are not at equilibrium. What these critics fail to realize is that markets have a self-correcting mechanism for shortages known as competition between consumers.

The shortage of 50 units leaves 50 consumers unsatisfied. In order to ensure their possession of the good, consumers must compete with one another to get what they want. The way markets allow for consumers to do this is by demonstrating an increased willingness to pay for the good. Consumer competition results in an upward price pressure that separates consumers who value the good more than the rest. Producers are able to see that their good is sold out and there are lines for their products. Sellers can raise prices for their goods and because of increased prices are able to produce more units. Some consumers will decide that the increased price for the good is more than what they deem worthy and will leave the market. This process sends information to both consumers and producers and alters their behaviors.

In the diagram below, consumer competition results in price pressures from $20 to $30. Sellers increase the quantity of units produced and consumers leave the market until there is a new equilibrium quantity of units supplied and demanded. So the next time you begin to notice higher prices, realize the supply and demand implications and how it is often actually your fellow consumer causing prices to increase. Also notice that there was no central planning agency that achieved this new market equilibrium. It is much too complicated for any government to predict and control prices and quantities of goods- as it would take years to compile the data necessary and by that point market conditions would have already changed- and there is no need for the government to do so. Shortages are essentially a problem in pricing and the market will self-correct the problem.

Economics Music Videos: Hayek vs Keynes and Debt Ceiling

After learning about supply, demand, and market equilibrium I thought I would share a few educational economic music videos that are getting hundreds of thousands of views on the web before continuing to explain market clearing behavior towards equilibrium.

The first two are done by econstories.tv and are highly entertaining and do a great job explaining two major macroeconomic theories by two of the most infamous economists. John Maynard Keynes, the founder of keynesian economics and Frederick Hayek, an important figure in the Austrian school. These videos introduce some concepts that I will explain in the future.

The sequel: The Fight of the Century

A video dedicated to the current debt crisis in America, once again very enjoyable while at the same time including many economic principles.

Supply & Demand Together Determine Prices

Now that we have individually examined both supply and demand, we are a step closer to understanding the market economy. The price and quantity of goods and services in everyday life are determined as a result of supply and demand. The point at which supply and demand intersect is known as market equilibrium. This point on the model represents the price at which the quantity demanded by consumers is equal to the quantity supplied by producers. This is the ideal outcome in the market because the most efficient producers are sellers and those who are most willing to pay are the consumers. Market equilibrium maximizes both consumer and producer surplus and extracts all potential gains from trade.

While it may be clear why market equilibrium is desirable and how supply and demand intersect to create prices, many may ask "How does the market get or stay in equilibrium? How is it that markets naturally correct to equilibrium without any central planning agency determining prices and outputs?" Both of these are valid questions and I will be sure to explain both shortage and surplus and the importance of competition of both buyers and sellers. These concepts coupled with incentives and self-interest make up the invisible hand that steers suppliers and consumers to the point of market equilibrium.

Below is a learnliberty.org video that explains the importance of free market pricing

If you enjoyed this video, CLICK HERE for part 2

The Law of Demand- Supply & Demand Continued

The law of demand is the other contributing factor to the price system in the market economy. Demand represents the quantity of a good or service desired by consumers in the marketplace. The quantity demanded at any given point along the demand curve is the amount of a good consumers are willing to buy at a given price. Exactly as seen with supply, demand is situated on an x-axis that represents quantities and a y-axis that represents prices. While the supply curve focuses on sellers and producer surplus, demand evaluates consumer surplus. Consumer surplus is the difference between a given point on the demand curve (the consumer's willingness to pay) and the price of the good. An example of consumer surplus would be a family looking to purchase a new kitchen table with $500. The family enters the store and the going rate for the kitchen table is only $300. The price that the family was willing to pay was $200 more than what they actually spent, also known as $200 of consumer surplus. The relationship between quantity and price for demand is as follows:

• An increase in price results in a decrease in quantity demanded
• A decrease in price results in an increase in quantity demanded
• Demand curves are always downward sloping as a result of the quantity and price relationship

Along any given demand curve, a change in price yields a different quantity demanded. While quantity demanded may increase or decrease as a result of price changes, the entire demand curve can actually shift. Just as supply can increase or decrease, demand can as well. An increase in demand shifts the curve to the right of the original curve and a decrease in demand shifts demand to the left.

An increase in demand causes:

• The same quantities demanded at a higher price
• Higher quantities demanded at the same price

A decrease in demand causes:

• The same quantities demanded at a lower price
• Lower quantities demanded at the same price

There are numerous factors that can attribute to an increase or decrease in demand. Some of these factors are:

• Income: With an increase in income, comes an increase in demand. This holds true for what economists refer to as normal goods. Most goods such as cars, appliances, and luxuries are normal goods. Sometimes, a decrease in incomes comes with an increase in demand for goods. These goods are called inferior goods. An inferior good would be something like fast food, an item people may consume more of during an economic downturn. 
• Number of buyers: The entry of more consumers in the market for a good increases demand just as the exit of buyers in a market for a product decreases demand.
• Prices of Substitutes: Suppose that both Coke and Pepsi are perfect substitutes. If Coke was to go on sale, the demand for Pepsi would decrease. Generally, the decrease in price of a substitute results in a decrease in demand for the other good.
• Prices of Complements: Things that go well together are considered to be complimentary goods. Shampoo and body wash would be an example of compliments. If the price of shampoo decreases more people will buy shampoo, but more people will also buy more body wash. The general rule for the price of compliments is that a decrease in the price of a good will increase the demand for its compliment. 

Supply & Demand- The Law of Supply

The law of supply and the law of demand are amongst the most fundamentally important concepts of economics. It is crucial to have a thorough understanding of both supply and demand because these laws together serve as models to explain the market economy.

Today we will examine the law of supply. Supply is the amount of goods or services made available on the marketplace by producers. Below is a supply and demand model with only the supply curve present. On every supply and demand model, there is an x-axis that represents quantities and a y-axis that represents prices. The quantity supplied in the marketplace is dependent upon the price. This holds true because a good will not be available on the market if the price is not greater than or equal to the producer's willingness to sell. The area below the price and above the supply curve represents the producer surplus or profit. The relationship between quantity and price is as follows:

• An increase in price results in an increase in quantity
• A decrease in price results in a decrease in quantity
• Supply curves are always upward sloping as a result of the quantity and price relationship

Along any given supply curve, a change in price yields a different quantity available. While quantity supplied may increase or decrease as a result of price changes, the entire supply curve can actually shift. Supply curves can either shift to be an increase in supply or decrease in supply. In increase in supply shifts the supply curve to the right of the original curve and a decrease in supply shifts the original supply curve to the left.

An increase in supply causes:

• Higher quantities to be available at the same price of the original supply curve
• The same quantities to be available at a lower price than the original supply curve

A decrease in supply causes:

• Lower quantities to be available at the same price than the original supply curve
• The same quantities to be available at a higher price than the original supply curve

There are numerous factors that can attribute to an increase or decrease in supply. Some of these factors are:

• Input Prices: if the cost of production increases by a government regulation or through increased scarcity of other goods then the supply curve shifts to the left (decreases). If the costs of production decrease or regulation becomes less burdensome then the supply curve shifts to the right (increases).
• Taxes & Subsidies: taxes result in an a decrease in the supply curve and subsidies result in an increase in the supply curve. 
• Number of Sellers: The more suppliers that enter the market results in an increase in the supply curve. The exit of suppliers causes a decrease in supply. 
• Technology: New technology makes production more efficient and innovative and shifts the supply curve to the right (increase).

Unseen College Costs- A Lesson in Opportunity Cost

The last thing a student wants to hear is that college is even more expensive than the already relentless tuition hikes. While this expense is not a direct bill to pay and the main reason why it is so often unseen, it is highly significant when examining the true cost of a college education. In order to illustrate this very clearly, let us consider attending Penn State University. The cost of tuition for an in-state student for one year is $15,000 and for an out of state student tuition is over $26,000. While a four-year stay will cost $60,000 and $104,000 respectively, 63 percent of college freshmen will take more than four years to complete their bachelor’s degree and spend even more.

While this is the obvious cost of attending college, we must now ask what the student gave up by choosing to continue his education. After high school graduation, many students choose to enter the workforce and typically earn $30,000 a year. Being employed for the four years that it takes to earn a college degree is $120,000 and is the opportunity cost of going to college. Opportunity cost is important to understand because with every choice you make you get and give up something whether you choose to go out and exercise and miss out on your favorite T.V. show or go to college and miss out on income you could have made while in the work force. Opportunity cost is important because you must recognize the complete consequences of your choices and all the tradeoffs you make with every decision. 

Click Here to watch a short video by Prof. Mario Diaz about Opportunity Cost! I will be at an economics seminar at Bryn Mawr University this coming week with the Institute for Humane Studies, so new blogs will not be out until next week. Stay tuned!

Incentives, Self-interest & The Invisible Hand

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” – Adam Smith, Wealth of Nations

One of the most important principles concerning economics is the underlying assumption that people are rational and respond to incentives; or in other words, people are self-interested. We all weigh the costs and benefits of our choices and only make a decision when a choice has a greater benefit than its cost. Costs and benefits are not limited to dollar signs as time, emotions, and reputations amongst other factors come into consideration when making a rational decision.

We are all motivated by incentives as incentives are a representation of a rational decision. Incentives are at work all around us and Adam Smith explains that incentivizing others- often through money- is responsible for making available all the goods that we consume. In order to buy food from a farmer, we must make it be in his self-interest by giving him something in return for his crops. The power’s of incentives are immense and have led to society’s great innovations, whether it is the automobile or air conditioning. What is interesting about incentivizing self-interest is while at the same time an individual benefits society does too.  This phenomenon is commonly referred to as the Invisible hand because the pursuit of our own self-interest results in society’s interest without any authority monitoring along the way.

Below, is the famous economist Milton Friedman explaining his take on the Invisible hand. 

Economics is

Economics is the study of human interaction in a world of scarce resources and never ending wants; or the study of limited means applied to unlimited wants. We see this every day whether we want the bottomless bag of popcorn at the movie theater or a swimming pool in the backyard. While we may want the swimming pool amongst many other things, we all too often find ourselves short in money, a representation of the amount of scare resources we can own.

As a result of scarcity, we are forced to make choices both big and small. These choices are the very study of economics. Economics is not merely tedious number crunching of large data sets, but extends in to all aspects of everyday life. The fundamental principles of economics are universal and can be used for determining outcomes in public policy decisions, fluctuations of prices, and more. Continue to read this blog and you will learn the many invaluable laws of economics that can be used without limits no matter who you are and no matter what you do. By mastering economics, you will ascertain a thorough understanding of how the world works around you.