Lesson 1 Markets, Demand, Supply and Elasticity


Hi, aleulinux back at It again: In this lesson we’re going to understand what is a market, what is a price and we’re going to analyze the theory of demand, supply and the concept of elasticity.

 

 

What is a market?

  • We can define as market any place (or online platform) where buyers and sellers meet in order to engage in exchanges of goods and services at a certain price. There are markets for everything; apples, oranges, sex toys, dogecoin, ugly t-shirts etc.

Inside these markets, Price works as an equalizer: Price’s task is to avoid excess of demand (buyers) or supply (sellers).

How does Price function?

That’s easy if you think about it! Sometimes when way too many people desire a certain product, the supply chain is not able to keep up; this brings to a situation when there are more people willing to buy the product than the quantity of product actually available.

Humans are really smart and straightforward economic agents: do you want my limited product? You must pay for it! This means that the price is bound to go up, but now less and less consumers will find the product attractive (at the new price) and therefore, with the price growing and growing, we’re theoretically going to reach a situation when there are going to be exactly an amount of good/service consumed that match the amount of good/service produced. However, the price is much higher than before!

The situation works in the other direction as well: the price is too low so everyone is happy to buy?

“Sorry folks, it’s not even worth to produce it after all”.

Costs are higher than benefits, this means a decrease in production, which will bring to a smaller supply stock, which will bring to growing competition among consumers, which will push the price up etc. etc. until amount of good/service purchased = amount of good/service sold.

Easy, isn’t it? Well, we just explained the theory of demand and supply and even the concept of equilibrium.

What is demand and what is supply?

  • We define as demand the total amount of a good or service that consumers agree to purchase at a specific price level.

ELI 5 = At the set price of 0.70$ I agree to buy 2 Bananas. My individual demand for Bananas at the price of 0.70$ is therefore 2.

It is obvious that given a market, in order to find out the entire market demand to set price levels we just need to sum individual demands.

ELI 5 = Let’s assume a market with just 3 buyers A, B, C. At the price of 0.70$ A buys 2 Bananas, B buys 4 and C hates Bananas so he buys 0. The market demand at the set price of 0.70$ is: Market demand = A demand, + B demand + C demand = 2 + 4 + 0 = 6

 

  • We define as supply the total amount of a good or service that producers agree to produce and sell at a specific price level.

 

Here we need to understand that producers face several costs in order to produce. This means that the Price should be at least high enough to cover such costs or, even better, high enough to make a profit.

I will cover costs and profit later on.

What is the equilibrium?

A point where at a given price level the quantity of product purchased and consumed is equal to the amount of product produced and therefore sold.

 

Precisely, the theory (or law) of demand says that: “at higher price, consumers will be less prone to buy” which means a diminishing demand and the theory (or law) of supply says that: “at higher price, producers will be more prone to produce/sell”.

This is the reason why in every Economics book you will find out that demand has an inverse relation to price (price goes up demand goes down) and vice versa from supply p.o.v. Or graphically you can see that the demand has a negative slope and vice versa for supply.

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Finally, we can talk about Elasticity.

  • Elasticity measures the reaction of the demand of a certain good or service when there is a variation in its price.

E = (ΔQ/Q)/ (ΔP/P)

These ugly symbols are used to say in a short, mathematical way that

                  Variation in quantity purchased (demand)

Elasticity =      ------------------------------

                                    Variation in price

So, let’s assume we have P1=3 $ and Q1=4 and P2=2 $ and Q2=8.

We define:

  • P1 = initial price
  • P2 = final price
  • Q1 = Quantity purchased at P1 level
  • Q2 = New quantity purchased at P2 level after the variation

E = [(8-4)/6] / [(2 – 3)/2,5] = 0,67/-0.4 = 1,68

I need to explain that:

  • As denominator to estimate the variation of Q and the variation of P, I used the average.

An Average is the sum of all terms divide the number of terms so:

 Average Q = (8 + 4)/2= 6 and Average P (2 + 3)/2 = 2,5

  • I got rid of the sign because we describe the Elasticity in absolute terms.

A mathematician could punch me but, imagine it as the number without the sign.

Now, why did we measure this?

Because it is vital to estimate the reaction of consumers to price variation, especially for all the firms willing to sell their product at new prices.            How will customers react?

In our case we have an E > 1 which means that customers reaction to the Price variation was more than proportional; this type of demand is defined Elastic, meanwhile when E < 1 we talk about Inelastic (less than proportional variation) demand. In the special case of E = 1 we talk about Unitary demand, that occurs only when the product PxQ is constant, but that’s just bonus info for you.

The only thing to understand is that inside Economics there is a simple tool to stress customers reaction to price variations.

We can even find the so called “cross-elasticity”: the variation of the demand of a certain good or service when the price of ANOTHER good or service change. Why is it important? Well because the markets are filled with competitors or goods which sell goes in tandem (cereal and milk for example).   

So, firms want to know the reaction of their customers even from this perspective.

 

 

 

That's it for today. I know that i could describe everything in much greater details, but i want this set of "lessons" to give everyone the proper skills to understand Economics and i don't want to write down nightmares =). Well, see you next time with the Consumer's behavior.

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aleulinux
aleulinux

Avid reader, lover of the fantastic, the unknown and finance (yes, really); I make people happy by making them eat... that's it for now. I would like to become one of the best Economics/Finance teacher around, but nowadays, i am a student myself =)


Personal finance - How Economics works
Personal finance - How Economics works

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