Economics Basics: Supply, Demand, and Consumer Behavior
Economics Basics
Core Concepts
Reservation Price: The price at which a person would be indifferent between doing x and not doing x.
Opportunity Cost: The value of all that must be sacrificed to do x.
4 Pitfalls to Avoid
- Ignoring Implicit Costs
- Failing to ignore sunk costs
- Failure to understand the average-marginal distinction
Marginal Cost: The cost of doing an additional unit of activity.
Marginal Benefit: The benefit of an additional unit of activity.
Cost-Benefit Rule: Keep increasing the activity as long as marginal benefit exceeds marginal cost.
Demand
Demand Curve: Quantities buyers will wish to purchase at various prices.
Downward Slope of Demand Curve: When price falls, the quantity demanded increases. This is the Law of Demand.
Horizontal Interpretation of the Demand Curve: Start with the price on the vertical axis and read the corresponding quantity demanded on the horizontal axis.
Vertical Interpretation of the Demand Curve: Start with the quantity on the horizontal axis and read the corresponding price on the vertical axis.
Supply
Law of Supply: The empirical observation that when the price of a product rises, firms offer more of it for sale.
Market Equilibrium
Equilibrium Quantity and Price: The price-quantity pair at which both buyers and sellers are satisfied. Also, it’s the price-quantity pair at which supply and demand schedules intersect.
Surplus: Excess supply when the price exceeds the equilibrium level.
Shortage: Excess demand when the price is below the equilibrium level.
Adjustment to Equilibrium:
- Downward price pressure will persist as long as there remain any dissatisfied sellers.
- Consumers will start bidding against each other in the hope of seeing their demands satisfied.
If price and quantity take anything other than their equilibrium values, it will always be possible to reallocate so as to make at least some people better off without harming others.
Factors Affecting Supply and Demand
Determinants of Demand:
- Incomes
- Tastes
- Prices of Complements and Substitutes
- Expectations
- Population
Determinants of Supply:
- Technology
- Factor Prices
- Number of Suppliers
- Expectations
- Weather
Changes in Demand vs. Changes in Quantity Demanded
Changes in Demand: Shift in the entire demand curve.
Changes in Quantity Demanded: Movement along the demand curve.
An increase in demand results in an increase in equilibrium price and quantity. A decrease in demand results in a decrease in both equilibrium price and quantity. An increase in supply results in a decrease in equilibrium price and an increase in equilibrium quantity. A decrease in supply results in an increase in equilibrium price and a decrease in equilibrium quantity.
Consumer Choice
Budget and Preferences
Bundle: A particular combination of two or more goods.
Budget Constraint: The set of all bundles that exactly exhaust the consumer’s income at given prices. Also called the budget line.
Affordable Set: Bundles on or below the budget constraint; bundles for which the required expenditure at given prices is less than or equal to the income available.
Budget Shifts Due to Price Changes: As price increases, the budget line rotates inwards.
Budget Shifts Due to Income Changes: The budget line moves parallel to its initial position (slope does not change).
Kinked Budget Constraints: A quantity discount gives rise to a non-linear budget constraint.
If the budget constraint is the same, the decision should be the same.
Preference Ordering: A ranking of all possible consumption bundles in order of preference.
Preference Order Properties:
- Completeness
- More-Is-Better
- Transitivity
- Convexity
Indifference Curves: A set of bundles among which the consumer is indifferent.
Indifference Map: A representative sample of the set of a consumer’s indifference curves, used as a graphical summary of her preference ordering.
Properties of Indifference Curves and Maps:
- Ubiquitous
- Downward-Sloping
- Indifference curves can’t cross
- Indifference curves are convex
Best Affordable Bundle: The bundle on the budget constraint that lies on the highest attainable indifference curve.
Effects of Price and Income Changes
(Effects of a change in price) Price Consumption Curve (PCC): Holding income and the prices of other goods constant, the PCC for a good X is the set of optimal bundles traced on an indifference map as the price of X varies.
Individual Consumer’s Demand Curve: From the PCC, plot price versus quantity.
(Effects of changes in income) Income Consumption Curve (ICC): Holding the prices of X and Y constant, the ICC for good X is the set of optimal bundles traced on an indifference map as income varies.
Normal Good: One whose demand rises with income.
Inferior Good: One whose demand falls with income.
Substitution Effect: That component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods.
Income Effect: That component of the total effect of a price change that results from the associated change in real purchasing power.
For consumers whose indifference curves have the conventional convex shape, the substitution effect of a price increase will always reduce consumption of the good whose price increased.
Giffen Good: One for which the quantity demanded rises as its price rises. A Giffen good is so strongly inferior that the income effect of a price increase dominates the substitution effect. They are a theoretical possibility. A Giffen good must occupy a large share of the consumer’s budget and have a small substitution effect.
Market Demand
Market Demand Curve: The horizontal sum of individual demand curves.
Price Elasticity of Demand
Price Elasticity of Demand: The percentage change in the quantity of a good demanded that results from a 1 percent change in its price.
Elasticity Categories:
- < -1: Elastic
- = -1: Unit Elastic
- > -1: Inelastic
Price Elasticity Formula: (dQ / Q) / (dP / P) = P / (Slope * Q)
Perfectly Elastic Demand: e = -∞
Perfectly Inelastic Demand: e = 0
Elasticity is unit-free, as opposed to slope.
Total Expenditure (R): R = PQ; where P: Price, Q: Quantity.
When demand is elastic, total expenditure changes in the opposite direction from a change in price. When demand is inelastic, total expenditure and price both move in the same direction. At the midpoint of the demand curve, total expenditure is at its maximum.
Determinants of Price Elasticity (e) of Demand:
- Substitution Possibilities (e increases as the availability of substitutes increases)
- Budget Share (e decreases as budget share decreases)
- Direction of income effect (a normal good has higher elasticity than an inferior good; the income effect reinforces the substitution effect for a normal good but offsets it for an inferior good)
- Time
Consumer Surplus and Pricing Strategies
Consumer Surplus: A dollar measure of the extent to which a consumer benefits from participating in a transaction.
Two-Part Pricing: A pricing scheme that consists of a fixed fee and a marginal charge for each unit purchased.
Intertemporal Choice
Intertemporal Choice Model: Analyzes consumer choices over time.
Intertemporal Consumption Bundle: Alternative combinations of current and future consumption are represented as points (C1, C2). The horizontal axis measures current consumption, and the vertical axis measures future consumption.
Intertemporal Budget Constraint: For every dollar by which current consumption is reduced, it is possible to increase future consumption by a factor of (1 + r), where r is the interest rate.
Present Value: The present value of a payment of X dollars T years from now is X/(1 + r)^T, where r is the rate of interest.
Information and Uncertainty
Costly-to-Fake Principle: For a signal to an adversary to be credible, it must be costly to fake.
Full Disclosure Principle: Individuals must disclose even unfavorable qualities about themselves; otherwise, their silence will be taken to mean that they have something even worse to hide.
Expected Utility: The expected value of utility over all possible outcomes of a gamble.
Diminishing Marginal Utility: For a utility function defined on wealth, one in which the marginal utility declines as wealth rises.
Risk Averse: Preferences described by a utility function with diminishing marginal utility of wealth.
Fair Gamble: A gamble whose expected value is 0.