Chapter 5 – Supply & Demand Analysis

Definition of a Market

• Any device/arrangement that brings buyers (actual or potential) into voluntary exchange with sellers (actual or potential).
• Analysis proceeds in two stages:
  • Examine buyers while ignoring sellers (demand side).
  • Examine sellers while ignoring buyers (supply side).
  • Merge both to explain price formation.

Demand Analysis

The Demand Function

• Short form: D = f(\text{factors that influence buyers})
• Expanded form:
  • D = f(\text{Price of the product},\ \text{Tastes \/ Preferences},\ \text{Product uses (final vs. derived)},\ \text{Number of buyers},
    \text{Product qualities (real/perceived)},\ \text{Advertising},\ \text{Buyer incomes (inferior, normal, superior)},
    \text{Prices of substitutes},\ \text{Prices of complements},\ \text{Time period},\ \text{Expectations},\ \text{Speculation},
    \text{Misc. factors – seasonality, fads, fashion})
• All non-price elements are shift factors; if they change, the whole demand curve moves.

Demand Curve & Ceteris Paribus

• Plots quantity demanded vs. own price, holding other factors constant (ceteris paribus).
• Opposite approach mutatis mutandis: study everything changing at once; abandoned in economics for tractability.

Substitutes vs. Complements

• Substitute: Price↓ of other good ⇒ Demand↓ for our good; Price↑ ⇒ Demand↑.
  • e.g. White vs. coloured T-shirts.
• Complement: Price↓ of other good ⇒ Demand↑ for our good; Price↑ ⇒ Demand↓.
  • e.g. Printers & ink, cameras & film, gasoline & large cars.
• Relationship is economic, not physical; gasoline can be both complement (big cars) and catalyst for substitute purchases (small cars).

Expectations & Speculation

• If buyers expect future price ↑ ⇒ Current demand ↑.
• When expectations dominate → speculative market:
  • Prices become highly volatile; bubbles fueled by self-reinforcing expectation of gains.
  • Bubble bursts with slightest doubt, causing price collapse.

Law of Demand

• Statement: Ceteris paribus, buyers purchase more at lower prices and less at higher prices.
• Negative slope of demand curve explained by:
  1. Substitution Effect
  • Price↓ ⇒ Good becomes cheaper relative to substitutes ⇒ Buyers switch toward it.
  1. Income Effect
  • Price↓ ⇒ Real purchasing power ↑ ⇒ Buyers can afford more.
  1. Law of Diminishing Marginal Utility (LDMU)
  • Consuming additional units yields declining marginal utility; only lower prices justify additional purchases.

Illustrative LDMU Example

• Hot day choice: ice-cream or beer (mutually exclusive each round).
  • 1st ice-cream: utility 9; 2nd: 8; further units decline; may even turn negative.
  • Beer path: 1st: 11; 2nd: 12 (still rising); 3rd: 8; 4th: 6; 5th: ? (led to blackout).
• Declining marginal enjoyment ⇒ demand curve must slope downward.

Exceptions to the Law of Demand

1. Price-as-Quality Signals
   • Rarely purchased goods where buyers use price to judge quality (diamonds, live Maine lobster ▸ sold better at \$30 than \$15).
2. Snob/Status Goods (Veblen goods)
   • Demand driven by exclusivity/high price (designer dresses, Rolex, Gucci bags).

Key rules:

• Acknowledge exceptions exist.
• Unless explicitly stated, assume Law of Demand holds.

Supply Analysis

The Supply Function

• Short form: S = g(\text{profits})
  • Sellers act to cover costs & earn profit (Smithian self-interest).
• Expanded form:
  • S = g(\text{Price of product},\ \text{Prices of other products},\ \text{Input prices},\ \text{Productivity},\ \text{Number of sellers},
    \text{Technology \/ technological change},\ \text{Extra production factors (e.g., COVID-19)})

Supply Curve & Shifters

• Plots quantity supplied vs. own price; other factors constant.
• Shift factors (input costs, technology, # of sellers, etc.) move curve right (↑ supply) or left (↓ supply).

Law of Supply

• Ceteris paribus, sellers offer more at higher prices and less at lower prices.
• Positive slope explained by profit motive: higher price ⇒ higher potential profit ⇒ more willingness to supply.

Change in Supply vs. Change in Quantity Supplied

• Change in Supply = shift of entire curve due to non-price shifter.
• Change in Quantity Supplied = movement along the curve caused solely by own-price change.
• Same terminology for demand side (change in demand vs. change in quantity demanded).

Market Equilibrium & Price Determination

• Combine demand & supply curves.
• Example (hypothetical numbers from text):
  • At P = \$60 ⇒ (QD = 100,\ QS = 200) ⇒ surplus 100 units.
  • Seller competition → price ↓ until surplus gone.
  • At P = \$20 ⇒ (QD = 200,\ QS = 100) ⇒ shortage 100 units.
  • Buyer competition → price ↑ until shortage gone.
  • Equilibrium at P = \$40 and Q = 150 ⇒ QD = QS.
• Surplus: excess supply, sellers drop price to avoid unsold inventory & cash-flow problems.
• Shortage: excess demand, buyers bid price up to secure product.
• Equilibrium is positive, not normative; simply where an unregulated market tends to settle.

Comparative Statics: Shifts & New Equilibria

• Any shift in supply or demand creates a new intersection (new P^, Q^).
• Figures referenced (1–6) illustrate:
  • Pure supply shift (right/left).
  • Pure demand shift.
  • Demand shift under two different supply elasticities.
  • Simultaneous shifts (various combinations) → ambiguous predictions without magnitude info.

Real-World & Managerial Insights

• Identifying substitutes and complements crucial for pricing, bundling, and antitrust market-definition.
• Complementary pricing strategy: lower price of complement (film, ink) to boost primary good (camera, printer) sales.
• Monitoring expectations essential; speculative bubbles (housing, crypto) show how demand can become price driven.
• Recognize when products exhibit Veblen or quality-signaling traits; optimal pricing may be above cost-plus.
• Ceteris paribus simplifies analysis; be cautious when real-world situations are mutatis mutandis (multiple factors shifting).
• COVID-19 cited as a supply-side shock example; demonstrates importance of exogenous events in shifting curves.

Key Terms & Concepts (Quick Reference)

• Demand/Supply Function, Shift Factor, Ceteris Paribus, Mutatis Mutandis.
• Law of Demand, Substitution & Income Effects, LDMU, Speculation.
• Substitute vs. Complement, Veblen Good, Price-as-Quality Signal.
• Law of Supply, Change in Supply vs. Quantity Supplied.
• Surplus, Shortage, Equilibrium, Comparative Statics.

Ethical & Philosophical Notes

• Positive vs. normative: Equilibrium describes “what is,” not “what should be.”
• Speculative bubbles often result in significant welfare losses upon collapse.
• Snob goods raise questions about conspicuous consumption and social equity.