A Simple Model of Demand and Supply

• For simplicity, assume only one commodity (apples) is being sold.

• Many sellers each with one apple to sell.
• Many buyers none of whom have an apple but money.
• Sellers: A minimum price at which they are willing to sell the apple.
• Buyers: A maximum price at which they are willing to buy the apple.
• A “market maker” calls out various prices and finds the number of apples “demanded”, by those
who currently have none, at each price. In the same way, finds the number of apples supplied at
each price.
• Equilibrium price equates demand and supply intentions: all agents can make the transactions
they want at that price.
• The demand schedule or curve will slope downwards with price.
• The supply curve will slope upwards with price.
• Note that market research of this type, or simply historical experience of adjustment of prices as
• intentions become known, permit a “going” price at which all transactions can take place.
• In the absence of a market price, demanders and suppliers would have to meet and bargain, and
would find that different trades take place at different prices:
• Some trades would thus be at “false” prices, while the market participants learned the supply
and demand conditions.
• Once all agents understand what drives supply and demand they can work out the equilibrium
price from their understanding of the “model” and “rational expectations”
Why the price mechanism is so important
• The world is a world of scarcity.
• Who gets and who doesn’t get has to be determined in some way: the alternative to the price
mechanism is government allocation (rationing) by law.
• Once there is a market price, transactions are easy:
• there is no need for search to find someone with an apple to sell, or to determine a price when
you find her.
• All gains from trade are exhausted at the equilibrium price
Markets can be more complex
• Asymmetric information: Buyer’s are uncertain about the quality of apples being sold and
estimate the average quality at the prevailing market price which, in turn, determines the max
they are willing to pay. The market could shut down!
• If the government taxed the transaction then there is a difference between the price a seller gets
and the price the buyer pays.
• In both cases, some trades will not take place that would make both sellers and buyers better
off.
• Both asymmetric information and taxes have a social welfare cost
Futures and Options
• If demand and/or supply were dependent on the weather, then the market price may vary from
one day to another. Then future supplies or demands might be traded now at a “future” price.
• An extension would be a ticket which enabled a buyer to buy an apple tomorrow from a seller at
a fixed price if he wishes (an option). Such tickets would be bought and sold and there would be
an equilibrium price for any fixed price for tomorrow on the ticket.
• If the actual “spot” market price tomorrow came out as less than the fixed price written on the
ticket, the option to purchase at the fixed price would be worthless and the ticket would be
thrown away, if this were allowed. The option would not be exercised.
Production for supply
• We have been considering a model of a market where apples were exchanged for money in
trades: a market exchange.
• But what factors (costs, technology, and market structure) determines supply for the market?
We thus need to study firms and production.
Demand and preferences
• Buyers have choices over what to buy.
• We have to study how these choices are made (an optimisation issue).
• We also need to study how choices change when market parameters change (comparative static
equilibriums).
Non-competitive elements
• If the sellers of apples got together in a cartel then they could set the price they wanted as a
“take-it-or-leave-it price. They would be acting as a monopoly. They could pick whatever point
on the demand curve they wished for the total sales and the “monopoly price”!
• How do sellers compete/collude when they anticipate that they can manipulate prices to their
advantage?
To Carry Forward
• Markets permit transactions to be made in simple ways.
• There are issues of behaviour of demanders and suppliers.
• There are issues of government intervention
• There are issues of uncertainty and market instruments that allow risks to be spread.
Mathematical Basics
• Partial Derivatives Similar to one variable derivative, but hold other variables constant. This
yields new functions! We can take the derivative of these as well with respect to any of the
variables.
• Young’s Theorem: If a function F(x) is C 2, that is twice continuously differentiable, then the cross
∂2 f ∂2 f
partial derivatives are the same. Namely, = (Not the difference between ∂ and
∂ xi ∂ x j ∂ x j ∂ xi
d)
∂f ∂f
• Total Derivative Suppose y=f ( x 1 , x 2 ) , then dy = dx + dx
∂ x 1 1 ∂ x2 2
Unconstrained Optimization
First Order Conditions
¿
• In order for x to be a maximum, it is necessary that the following conditions hold:
df ¿
• One variable: x =0
dx
df
• Several variables: (x , x , …)=0 for all i
d xi 1 2
Second Order Conditions
• The first order conditions will yield us local maximum when:
 d2 f
• One variable: ≤0
d x2
• Two variables:
∂2 f
• (1) =f ii ≤ 0 for bothi
∂ x 2i
• (2) f 11 f 22−f 12 f 21 ≥ 0
Constrained Optimization
• Definition: The feasible set is the set of values over which we are permitted to maximize. It is
sometimes the combination of several constraints.
Formulation of the Maximization Problem
• Let a function u ( x 1 , x 2 )be well-behaved. Then the consumer’s utility maximization problem can
be described by:
max u(x 1 , x 2 ) st p1 x 1 + p2 x 2=m
x 1 , x2

Lagrange’s Method
• Lagrange came up with the idea that we can change a constrained maximization problem into a
kind-of unconstrained one if we add another variable, namely the Lagrangian multiplier λ –
which is basically the amount of that would have to be added to each pound of overspend to
prevent overspend
• The Lagrangian of the above problem is: L ( x1 , x 2 , λ ) =u ( x 1 , x 2) + λ(m− p 1 x 1− p2 x 2 )
• We now just treat this as an unconstrained problem of three variables in terms of first order
conditions. We check the standard first order conditions and manipulate to get maximum values.
Consumer Theory
• Fundamental object is preferences.
• Bundles of one Good: ”More” is better, or if one option ‘dominates’ the other areas in multiple
dimensions
• Multiple Goods: Preferences of some bundles of goods over others.
• We denote a preference relation as “≺ ” and we write a ≺ b to mean "the bundle b is preferred
to the bundle a ".
• We also have indifference “∼” and weak preference “ ≼”.
• Technically speaking, preference relations are binary relations over an n-dimensional space of
non-negative numbers, where n is the number of different goods. A “point” in the space is a
particular bundle of goods.
• There are many such binary relations that could be considered as preferences. We need more
structure. What are reasonable preferences? We add certain properties for two reasons. We
want to make assumptions that we think more accurately describe human behaviour and we
want to have models that we can handle mathematically. (This is a common dichotomy in
economics)
Key Assumptions
• Completeness (all bundles can be ranked)
• Transitivity (if x ≻ y and y ≻ z, then x ≻ z )
• Continuity (if x ≻ y , then bundles similar to x ≻ bundles similar to y
• Strong Monotonicity (More is better than less – people can never have enough)
• We say that preferences are rational if they satisfy the completeness and transitivity properties.
If preferences are rational and continuous, we can represent them by a continuous utility
function.
Utility Functions
• Definition: A function U is a utility function representing preference relation ≽ if, for all X and Y,
U ( x )≥ U ( y ). The advantage of utility functions is that we can make an "ordering" of bundles by
assigning values to bundles from the real-number line.
• Preferences cannot be represented by a utility function if there are no points of indifference
and/or the system is not continuous – for example, lexicographic preferences
• If three people vote in order of preference, an overall order of preference may not be
established due to what each person votes – so the system may not be transitive (social
preference)
Indifference Curves
• Utility fuctions are three dimensional objects, but can be represented in 2D like contour lines on
a map. Utility increases as you go to a higher indifference cure due to the assumption of non-
satiation.
• Indifference curves cannot cross – otherwise that would violate transitivity
Marginal Utility
• The change in utility when adding a small amount of one of the goods. For u(x , y):
Δu(x , y) ∂U
• M U x= =
Δx ∂x
Δu( x , y) ∂U
• M U x= =
Δx ∂x
• Note that by the chain rule, we can use the marginal utilities to calculate the marginal rate of
substitution -how much is a consumer willing to trade off one good for another. It is exactly the
slope of the indifference curve.
• dU =M U x dx+ M U Y dy=0
−Δ y −dy
• MRS= ( for the same U ( x , y ) ) =
Δx dx
dy
• is never positive as an indifference curve is convex
dx
• If goods are perfect substitutes, MRS is constant, as one can be exchanged freely for another
without making a difference to utility – it gives a linear indifference curve
• If goods are perfect compliments (such as left and right socks) MRS is indefinable as no amount
of extra of one good will increase the utility if the other doesn’t change – it give an L-shaped
indifference curve
Diminishing Marginal Rate of Substitution (aka Convex preferences)
• Suppose two bundles A and B give the same utility. Then if preferences are strictly convex, that
is if the marginal rate of substitution decreases as more good x (and less y) is in the bundle as we
go along an indifference curve, then any weighted average of the bundles is preferred to A or B
(is on a higher indifference curve). This means that all points on the straight line between A and
B are better than A or B.
• Interpretation: When you have a lot of good x relative to good y, you are prepared to give up
more of good x for an additional unit of y than if you have a lot of good y relative to good x.
• Note that Diminishing MRS is a property that will often hold but there would be contrary cases.
Diminishing MRS is thus a common assumption.
Ordinal vs. Cardinal Utility
• Ordinal Utility - Only care about the ”order” of the utilities. I.e. the relative ranking.
• Cardinal Utility - Care about the ”value” of utility. Not practical because utility measures
subjective well-being. Like measuring happiness. However has to be employed to some extent in
the analysis of risk. We deal here only in ordinal utility. Therefore, we can take positive
monotone transformations of utility functions. That is to say, u(x , y) represents the same utility
2
as v ( x , y ) =[ u ( x , y ) ] as the ordering is preserved.
Calculating Indifference Curves
• To calculate one, we just need to solve the equation: u ( x , y )=k . We can vary k to get different
indifference curves.
Cobb-Douglas Utility Function
• u ( x , y )=x α y β - Quite common to have β=1−α .
Budget Sets
• The budget set is defined by: p1 x 1 + p2 x 2 +…+ p n x n ≤ w , where w is the wealth of the consumer
• Walras’ Law - Consumer’s spend all of their money. (application of strong monotonicity). This
means above inequality is changed to an equality and our budget set is a hyperplane.
Utility Maximization
• Agents are ”price-takers”, and maximize utility by choosing optimal bundle out of the budget
set. This means that the consumer faces a constrained optimization problem.
• Utility Maximization Programme:
• max u(x 1 , x 2 , … , x n ) such that p1 x 1 + p2 x 2 +…+ p n x n=w which we can solve with
x1 , x 2 ,… , xn

Lagrange’s method
Demand Functions
• Solution to maximization problem yields demand functions:
• x 1=x 1 ( p 1 , p2 , w) and x 2=x 2 ( p 1 , p2 , w) where x n is the optimal value for x n
¿ ¿ ¿

• These are called Marshillian Demands

Direct and Inverse Demand
• We can express quantities demanded as functions of prices and wealth. This is called the direct
demand function. Alternatively, we can express prices as functions of own quantity and other
prices. This is known as the inverse demand function. It will be useful for the study of markets.
Comparative Statics
• Comparing equilibrium before a change in the economic environment with the equilibrium after.
• Price change – changes the budget line as the consumer can afford a different maximum amount
of the re-priced good. Changes the max utility – usually leads to buying more of the other good if
price is reduced as money is freed up to spend on the other good.
• We can derive the demand curve by looking at successive changes in prices and plotting the
change in the amount of something at the point of maximum utility
• If increasing the price of one good increases consumption of the other, then they are substitutes
• If increasing the price of one good decreases consumption of the other then they are
compliments
Income Expansion Curves and Engel Curves
• Consider two goods X and Y. Suppose prices are given throughout. Let initial wealth be w.
• Consumer chooses optimal bundle, then wealth changes and consumer chooses a revised
optimal bundle – plotting a series of these generates an income expansion curve.
• Normal goods – an increase in wealth increases consumption of both goods
• Inferior good – Increase in wealth reduces consumption
• Plotting the change in demand for one good as wealth increases gives its Engel curve:
• Luxury good – Engel curve has a positive slope
• Necessary good – Engel curve has a shallow slope in either direction
• Inferior good – Good has a negative slope
Aggregation of individual demand into market demand
• At each price sum every person’s unique price curve (horizontally) to obtain total demand for
the whole market.
Two-part pricing
• Some products are sold by more complex instruments than simple per-unit prices – e.g.
telephone calls (rent for line plus price per call)
• The budget line is then very different – it is linear until it reaches the x-axis at the point m−F ,
where m is the income and F is the access charge, but there is also a point on the x-axis at m as
that would be if the person decided to forgoe the item completely.
• This means a small change in preferences – e.g. 1 phone call as opposed to 0 – can lead to a
large change in consumption
Optimal savings
• Consider a simple adult lifetime of two periods (without risk); (young then old).
• Suppose the price level is the same in the two periods, you earn m 1 when you are young and m 2
when you are old. You can save or borrow in either period but must pay back any debts.
• Your budget constraint, if r is the rate of interest and c 1 is the consumption expenditure in
period 1, c 2 is the consumption expenditure in period 2, then: ( m 1−c1 ) ( 1+r )=c2 −m 2
Quantity discounts
• Suppose the unit price for good 1 declines the more you buy: p1= p −α q1 then the budget line
becomes a curve
Price Effect on Demand
• We can decompose this change into two effects: the substitution effect and the income effect.
These can be added to return to the total effect.
Substitution Effect
• At the original optimal choice, p1 x 1 + p2 x 2=w , and the wealth level needed to get the same
consumption after a price change is give by p'1 x 1 + p2 x 2=w'
• The substitution effect is the effect of a price change with compensation so that the same
bundle of goods is still exactly affordable. The change in consumption is give by
∆ X S =X ( p'X , w ' ) −X ( p X , w)
• Trying to find out how much more consumption there is in a more optimal bundle after a price
change and compensation
Income Effect
• The income effect is how after the substitution effect is considered, the income level is returned
to the original – to see if it is now possible to purchase more of both goods. It is given by
∆ X w =X ( p 'X , w ) −X ( p 'X , w' )
Slutsky Compensation
• Adding the two effects together gives the Slutsky Equation, so ∆ X=∆ X S + ∆ X w
• It is affected by the signs of the two component effects. The substitution effect is always
negative because the new optimal bundle has more than the old optimal bundle. The Income
Effect is negative if the good is a superior good, and positive if it’s an inferior good. This means
that a normal good has a negative total effect – but a Giffen (inferior) good has a positive effect
as the income effect outweighs the substitution effect
'
∂ X ( pX , w)
S
• For small price changes: ∂ X = ∂ X − X
∂p ∂p ∂w
Hicksian Compensation
• Since the Slutsky compensation is designed to allow the old bundle of goods to be afforded at
the new prices, and because relative prices have changed, the consumer could choose to do
better than the old bundle: the Slutsky substitution effect permits increased utility. The
consumer will always be better off under Slutsky compensation!
• Now consider the compensation as such to restrict the consumer to the same level of utility as
they had prior to the price change. This will be called exact or Hicksian compensation. The
Slutsky equation is valid for this.
Elasticity
• The price elasticity with respect to good i, is given by the following formula:
% change∈ demand for good i ∂ q i pi
• ε i ( p )= =
% chang∈ price for good i ∂ pi qi
−bp
• If demand is linear, q=a−bp , therefore ε ( p )=
a−bp
• If |ε|<1, demand is inelastic
• If |ε|>1, demand is elastic
• If |ε|=1, demand is unit elastic
Price Elasticity and Revenue
• Revenue =price x quantitiy, so R' =( p+ ∆ p )( q +∆ q )= pq+ p ∆ q +q ∆ p+ ∆ p ∆ q, last term can
be ignored as price change is so small
∆R
• Therefore, =q (1−|ε|) ignore some glaring mathematical problems
∆p
Income Elasticity
• Same general idea as price elasticity, except with respect to income.
% change ∈demand∈quantity ∂q i w
• ηi = =
% change ∈income ∂ w qi
• If η< 0, good is inferior
• If 1 ≥η> 0, good is normal
• If η>1, good is a luxury good
• We can also derive |ε|=|ε S|+ηs - where s is the share of good X in expenditure and η is the
income elasticity of demand
• Hence income effect is big when the good accounts for a large amount of expenditure and/or
the income elasticity is large. A Giffen good has a large but negative income elasticity and a large
share. An inferior good has a negative income elasticity.
Price and Income Elasticities
• Price is how much consumption is affected by a change in priced whereas income is the chage
with respect to income
Application 1: Index Numbers
• The measuring of the general level of prices is key to index-linking of wages, pensions, etc.
• One approach is to find a bundle of goods representing ”average” purchases last year. Then ask
how much that bundle cost last year (Period 0), and how much it costs this year (period 1).
∑ p1i q0i
• A common and implementable measure is thus the relative: × 100 (Technical name:
∑ p 0i q0i
Laspeyre’s Index)
Application 2: Estimating elasticities
• Statistical estimation of elasticities is made easy by the fact that a hypothesis that an elasticity is
a constant within the data set is the same as saying that the relationship between (say) quantity
demanded and price is linear in logs of the variables: ln q=α −ε ln p has ε as the price elasticity
of demand.
• Thus if the maintained hypothesis is that the elasticity is a constant, simple linear regression
techniques can fit the demand equation through a collection of data points of price and demand
observations.
Production Functions
• Let x 1 and x 2 be levels of ’factors’ of production. Let y be the output level.
• Production Function – y=f (x 1 , x 2 )
• Assume that production is increasing in each of its arguments. No ”bad” factors such as militancy
of workers.
• Set of input combinations, holding y constant, yields an isoquant. Similar to indifference curves.
Marginal Product
∂ f ( x1 , x2 )
• Same as marginal utility, but for production: M P1 ( x 1 , x 2 )=
∂ x1
• We often assume that the marginal product is decreasing, as each additional bit of input results
in a smaller increase in production
Marginal Rate of Technical Substitution
• Same as Marginal Rate of Substitution for bundles –
M P1 ( x 1 , x 2 )
MRTS ( x 1 , x 2 )= =slope of isoquant
M P2 ( x 1 , x 2 )
Returns to Scale
• The amount that increasing both production factors by a factor, λ , increases production:
• f ( λ x1 , λ x2 ) =λ k f (x 1 , x 2)
• If k < 1, means ‘decreasing returns to scale’
• If k =1, means ‘constant returns to scale’
• If k < 1, means ‘increasing returns to scale’
Cost Minimization
• After understanding the relation between inputs and output, we need to identify costs.
• To start, we can hold the level of output fixed and minimize costs by choosing the best input
combination or mix.
• It is exactly the same as utility maximisation – except you get the lowest price for a given utility,
not the highest utility for a given price.
Cost Curves
• We have assumed all the factors to be variable. In the short run, this may not be reasonable. E.g.
No time to buy new buildings
• Cost can be decomposed as follows: Total cost = Fixed Cost+ Variable Cost
Average Cost
TC ( y ) VC ( y ) F
• The cost per unit output is given by: AC ( y )= = + =AVC ( y ) + AFC ( y )
y y y
• AVC ( y ) is usually first declining then increasing – reflecting decreasing returns to scale due to
space limitations and capacity constraints
• AFC ( y ) is decreasing over all levels of output as you pay ones no matter how much you make
• Combined, the total cost will be u-shaped
Marginal Cost
VC ( y+ Δ y )−VC ( y )
• MC ( y )=C' ( y )=
Δy
• If MC < AC , there are increasing returns to scale, but the opposite is true
• Minimum average cost is found when MC= AC
¿
• Total variable cost at a level y is equal to the area under the marginal cost curve between that
point and y=0
Long Run Cost Curves
• In the short run, firms cannot adjust one of their factors (usually capital). So a short-run cost
curve will depend upon this level of capital. We can consider the long-run cost curve as tracing
out the minimal costs on the short-run cost curves for every level of output, where the capital
level is chosen optimally.
Profit Maximization
• In this section, we assume that Firms are price-takers. These firms are said to be in Perfect
Competition.
• Profit Revenue - Cost
• Using profit maximization we know that the firm will always want to minimise its costs for any
given output, and then choose output to maximise the difference between revenue and total
cost. We end up with max π= py−C ( y ) so that p=MC using the first order condition

' d2 π ''
p−C ( y ) =0 and the second order condition 2
≤ 0 so C ( y)≥ 0 which means the marginal
dy
cost must be non-decreasing
Combining output choice and input choice
• We can avoid the separation of input and output levels if we wish, and do both together, giving:
• π ( x1 , x2 ) = pf ( x 1 , x 2 ) −w1 x 1−w2 x 2
Constant Returns to Scale and Profit
• What happens when we have constant returns to scale (k=1)? Profits are either zero or infinity –
as the is no ‘most efficient’ level of production
• With increasing returns to scale, there is no interior optimum: each doubling of factor inputs,
doubles costs but more than doubles revenue. (second order conditions don’t hold)
• The most useful way of looking at this is to think of returns to scale being increasing at low levels
of output and decreasing above some ”efficient” level of output.
Negative Profits
• A firm can rationally choose to earn a negative profit assuming there are fixed (sunk) costs.
• Suppose the firm is in the market and has already invested in fixed costs.
• Not operating yields: −F
• Operating yields: py−VC ( y )−F
• Therefore a firm will continue to operate as long as: −F< py −VC ( y )−F so AVC ( y )< p
• When p< AVC ( y ), the firm shuts down.
The Firm’s Supply
• Taking into account the shutdown point of the firm, we see that the firm supplies at p−MC
Application: the efficiency of perfect competition
• Suppose all firms in the supply industry have the same costs and their optimum supply is where
price equals marginal cost.
• If profit is zero (due to entry or exit removing excess profits or losses) then price equals average
cost: Hence, p= AC=MC . Also we have seen that AC is minimised when AC=MC. Hence all
output is being produced at the minimum possible cost.
• Also the cost of producing another unit of output is equal to the price that the marginal
consumer is just willing to pay (if the price was slightly higher, the purchase would not be made).
• Hence p is the market value of the marginal unit of output. Output is thus at an efficient level
and is efficiently produced.
• efficient level: allocative efficiency
• lowest cost at that level: technical efficiency
• In the long run, firms will adopt the best technology and any initial differences in costs will
disappear.