Section 5.4 Supply and Demand: IMPORTANT RECAP
We have now reached an important checkpoint in our study of economic markets. At the start of this course, we emphasized how consumer theory provides the foundation for demand, while firm theory provides the basis for supply.
Finally, we have seen both of these connections play out. First, the consumer’s utility maximization problem gives the consumer’s optimal choice of a good, denoted by \(x^*\text{,}\) also known as the quantity demanded of the good. When expressed as a function of price, such as \(x^* = \frac{10}{P_x}\text{,}\) this optimal choice is simply the individual demand function. If the individual demand functions of all consumers in a market are then summed, the result is the market demand function - that familiar, downward-sloping demand curve.
The firm’s profit maximization problem describes the firm’s optimal choice of output to produce, denoted by \(q^*\text{,}\) and is interpreted as the quantity supplied by the firm. When expressed as a function of price, such as \(q^* = \frac{P}{4}\text{,}\) this optimal choice is simple the firm’s individual supply function. If individual supply functions of all sellers in a market are then summed, the result is the market supply function, which is the standard upward-sloping supply curve.
The graphic below illustrates the foundation we have constructed. Demand and supply can be derived from their respective individual choice problems. The importance of this fact cannot be understated, because we can now see both conceptually and mathematically how parameters at the individual level influence demand and supply in markets.
For example, when we discuss the impact of a change in income on demand for a normal good, we say that demand increases. With this foundation, however, we can analyze this impact visually through an outward shift in consumers’ budget constraints, and mathematically though a demand function like \(x^* = \frac{I}{2P_x}\text{.}\) The depth of this foundation allows for a more precise analysis of the interaction between income and demand, since it is now possible to compute exactly how specific income changes influence quantity demanded in a market.
Many common parameter change impacts on supply and demand can now be deconstructed in a sense, as we can dig more deeply into the underlying choice processes that generate them:
- In Econ 101, we discuss how an increase in firm costs, such as input prices, decreases supply. Now, we can see how an increase in variable costs, such as wages, will also increase the firm’s marginal cost. Since \(MC\) and supply are identical, higher costs shift supply to the left. (GRAPH)
- In Econ 101, we discuss how an improvement in production technology increases supply. Now, we can see that improved technology leads to an outward shift in the firm’s production function, and therefore, a downward shift in the firm’s \(TVC\) and \(TC\) functions. This occurs since each unit of variable input generates more output, lowering marginal cost. Lower marginal cost is analogous to greater supply. (GRAPH)
- In Econ 101, we discuss how an increase in the number of buyers increases demand, and how an increase in the number of sellers increases supply. Given our understanding of how market supply and demand are the result of summing individual supply and demand curves, this result makes sense. Computational examples are shown in the sections on summing above: as more individuals get added to the equation, the market quantity must go up at every quantity! (GRAPH)
- In Econ 101, we discuss how more favorable consumer preferences can lead to higher demand. Now, we can re-evaluate the consumer choice problem by increasing a consumer’s marginal utility for a good, and see that higher marginal utility will lead to a higher \(x^*\) and, therefore, higher demand for the good. (GRAPH)
