Microeconomics 101: Theory of Demand and Supply deconstructed

Many of my friends are from a non-economics background. Recently, one of them was visiting me and saw a copy of the famous intermediate microeconomics textbook by Hal Varian lying around. Out of sheer curiosity, she flipped the pages of the book and within thirty seconds placed it back on the table exclaiming- “Wow, this is so not my cup of tea!”

But you know what, the theory of demand and supply is everyone’s cup of tea, a cup of milk even for those feeling lethargic to get up and make themselves some chai! And in this post, I will tell you why- without drawing complicated graphs or using fancy-sounding Latin words! (Ceteris paribus, anyone?)

Let’s do this exercise FAQ-style because I think it’s more effective in tackling head-on, some of the eventual questions you may inevitably have.

Q.    What is the demand curve, why is it downward sloping and what does that imply?

Ans: Let’s try this with an example everyone can relate to. I am writing this post in July- typically the sale time in most malls across India. When you visit the mall in the off-season, you typically find it much less crowded than in the sale time. Because sale means slashed prices and you want to buy everything you can. Now you may think I am stating the obvious! But that is what the demand curve represents- an obvious fact based on human tendencies (well, for most of us, at least!). The lower the prices, the more quantity we want to purchase and vice versa. And that gives you a negatively sloped demand curve.

Q.    Does that mean we can skip all initial chapters on budget, utility, preferences, and choice?

Ans: Not so fast, mister! There is a reason why that book was Bible for us back in the under-graduation days. Because it tried to scientifically explain everything. But let’s continue with the example above, at the cost of oversimplification. Now, imagine it is sale time and you are at the mall. Many things might interest you, but you don’t end up buying everything, right? Why? Because your credit card has a limit of X amount or your wallet has only X rupees cash in it. This is your budget constraint. But even with X rupees, you could either buy 2 shirts and 5 tops or 1 shirt and 7 tops. Now, you might like wearing tops more than shirts- so that is your preference and hence the former option gives you greater utility, or simply put, satisfaction. Thus, optimization is nothing but making the best possible choice, given your budget constraint. Now, the budget constraint is not simply dependent on how much you are buying, i.e. the quantity. It is heavily dependent on the price as well. If prices of tops were to decrease further next week, you might end up buying fewer shirts and more tops even though you like tops more than shirts. Thus, this is a very dynamic adjustment: with changing prices, your final choice also changes because of your ability to substitute between goods and what Hal Varian does is tie back all these concepts back to a negatively sloped demand curve, eventually.

Q. How does the theory of supply fit into the picture?

Ans: It doesn’t. It is a completely different ball game altogether. All we were thinking about till now is the consumers or the buyers. Now let’s talk about the sellers- or in the previous example, the stores in the mall. It is a very common experience during the sale time to find your size out of stock. The sale is mostly about getting rid of old stock at reduced prices. But the non-discounted fresh arrivals section is always stocked up! In a way, this represents how the supply side works- when prices are higher, the seller is willing to sell more. And this is again human psyche, if I’m getting a better price, I stand to get better profits and hence I will sell more to collectively earn more. Hence, the upward-facing supply curve.

Q. What is an equilibrium?

Ans. We bring together the individual pieces of a jigsaw puzzle- demand and supply and allow them to interact. Left to the buyers alone, they would always want to purchase at the lowest possible price. Left to the sellers alone, they would always want to sell it for the highest possible price. There would never be a purchase! But that doesn’t happen, because the buyer knows that no seller would agree to sell at a very low price and the seller knows that no buyer would agree to buy at an exorbitantly high price. Thus, equilibrium is nothing but a mutually agreed-upon price at which a certain quantity gets sold. And this is no magic number at which buyers and sellers settle on buy haggling at the store. There are market surveys, promotions, etc. that the brands conduct that helps them understand the demographic profiles of their customers, their tastes and revealed preferences (since actual preferences are innate and can’t be observed), the market sentiments and so on. So, the next time you visit a supermarket and see slashed prices of a product, it could be one way the seller is trying to draw the invisible demand curve- understand how you as a customer are likely to react at different price levels.

Q. What is excess demand and what are the consequences?

Ans. When we try to book flight tickets, we generally use the incognito mode. Why? Because if there are too many people searching for similar flight routes, the flight booking website’s algorithm picks this up and by the time you are finally ready to book your tickets, the prices have gone up. This is the simplest case of excess demand, and its consequence- increased prices. An even simpler logic, if a greater than anticipated number of people are willing to purchase a product or a service at the given price, a seller will be able to take advantage of this fact and raise the prices. The other scenario that might result in higher prices is supply-driven- say you expect the monsoons to fail this year. There may be a crop failure, and this is going to increase the cost of fruits and vegetables. In either scenario, we find prices rising and when this happens at the level of an economy and not just an individual, we say there is inflation (the former example is demand-pull inflation and the latter is cost-push inflation). That is why the central bank of the country regulates the quantum of money people have in their hands through interest rates- because more money means more purchasing power, which leads to excess demand in the economy and finally inflation.

That’s enough of a rant for today, I guess. On reading this post again, I suddenly realized that I am this close to converting a microeconomics 101 to a macroeconomics 101! But the point I was trying to make is that most of the economic terms we hear of, from inflation to appreciation and depreciation of a currency, have their roots in the theory of demand and supply, and that’s what makes this so important. I shall stop here and let my non-economics friends digest it all up. To others who found the post rather basic, my apologies and I will attempt to work on a more complex concept in the future. As always, thanks to those who have made it to the end of the post and I look forward to your suggestions on potential topics for my future posts.