In this post, I would like to go a bit deeper into the concept of demand and supply curves. Almost everybody, economists and non-economists, have heard of these concepts and most have realized that they lie at the basis of a whole bunch of economic theory.
Today, we will construct these curves together, starting from absolute basics.
Imagine that you have just come home from a stressful day at the office. You have worked hard and you are desperate to relax. You feel that you have deserved a bit of quiettime, just you and your girlfriend. You plan to order a pizza, open a six-pack of beers and watch a movie. While waiting for the pizza to arrive, you start already with the beer.
- The first beer feels like pure nectar sliding down your throat. It is deliciously cold and quenches most of your thirst.
- The second bottle of beer increases the intial buzz you felt. However, because your thirst has mostly disappeared with your first beer of the evening, the feeling of pleasure you derive from it is slightly lower.
- Your crack open a third beer. You don't crave it anymore but it is kind of a logical continuation after the first two. You drink it slowly while having a discussion with your girlfriend and even occasionally forget that you are sipping from the bottle.
Why your first beer is the tastiest
You might not have realized it but we have done some valuable economic research so far. By quenching our near-alocholic thirst of beer, we have stumbled upon a key law of economics:
The law of diminishing marginal utility: the first unit of consumption of a good or service yields more utility (pleasure) than the second and subsequent units, with a continuing reduction for greater amounts
Let me unpack some of the wording first. With marginal, we mean an additional unit (of whatever). Utility is just another word for pleasure or happiness. In short, what we are trying to say is that every additional beer gives us a smaller and smaller pleasure increase.
Because we are economists, we would like to calculate exactly how much each additional beer adds to our pleasure and put it in a graph... so that's exactly what I have done:
It may suprise you but we have actually constructed our first demand curve! The y-axis represents additional pleasure. The x-axis represents additional bottle of beers. You can see that the first bottle gave me 8 units of pleasure, while the second bottle gave me 6 units of pleasure, the third 3 units etc. My total pleasure when consuming three bottles of beers thus equals 8 + 6 + 3 = 17.
This ofcourse makes perfect sense. If the additional pleasure of a another bottle of beer didn't decrease, we would probably keep drinking beer forever! An interesting notion is that the additional utility of an extra bottle of beer becomes negative for the 5th and 6th beer. This is because you are so drunk at that point that you start to puke and puking is generally not pleasurable: so we finally reached negative pleasure. (I realize that some of you might say: "Puking after 5 beers? What kind of pathetic example of man are you?" To those people I would say, do you know how much effort it takes to draw such a graph in Publisher?)
But.. how much beers should I drink then?
At first sight, it would seem that this question can be answered rather easily. Ofcourse, it makes sense to keep drinking bottles of beer until the point that a next beer would provide you displeasure.
When the extra pleasure from an extra beer just switches from positive to negative, you have reached the maximum pleasure you can get from drinking beer. (shown in the graph below)
Wait, wait, wait! Aren't we forgetting anything? I have to buy those beers before I can start drinking them! In order to answer this (frankly, crucial) question, we need to step away from hippy concepts like 'pleasure' and 'happiness'. Being economists, we like to think in money (dollar dollar bills yooo).
To do this, we simple ask: "What is the maximum amount of money you are willing to pay to achieve this level of pleasure? This method of putting a monetary value on a squishy concept like 'pleasure' is called Willingness To Pay (WTP) - again, no creativity prizes were won by the inventor of this term. In our example (in order to not have to change my picture) I will assume that 1 unit of pleasure = 1 euro. => this means that to achieve one unit of pleasure, the maximum amount I am willing to pay is 1 euro.
If we then assume that the price of a bottle of beer is €1, we can easily add this to our new graph.
Let's just use a bit of logic now:
- I will (really) want to drink the first beer because it gives me a pleasure of €8 while I only have to pay €1 => yay!, €7 of 'profits'!
- The second beer I will also drink because €6 - €1 is still higher than 0, i.e. I make a 'profit'
- Same for the third beer, that gives me a 'profit' of €2
- Things are different for the fourth beer: while it costs me €1 to buy, I only get a pleasure of €0.5, this means that I would have a 'loss' of €0.50 (= 1-0.50) if I would decide to drink this beer.
In short, we can conclude that I will drink 3 beers.
To summarize sofar, we have constructed a demand curve (the colourful bars) and a supply curve (the horizontal line) for the case of 1 individual (me). The two intersected each other for number of beers = 3, so this is the equilibirum => the equilibrium just means that this is the amount I will chose to drink (if I am acting rationally). Ofcourse, the hypothesis of rationality is a whole other tin of worms, please don't worry too much about that now ;)
What about the world beer demand?
There are ofcourse some differences if we look at the total market demand for beer.
First of all, the total market of beer includes more people than just me (shocking!). Each of these people has their own individual demand curve. Some people might get a lot of pleasure from beer, so their pleasure bars are taller. Other people might be super-resistant to beer so their bars only become negative after 10 beers. Yet others might be teetotalers (=alcochol abstainers) and choose not to drink beer. If you force them to drink a beer (even if its only one), they will immediately experience negative pleasure. This is the same as saying that you will have to pay them a certain amount to drink a beer. Consequently, all their pleasure bars are firmly negative.
In order to get the total market demand you have to sum all the individual demands. I have illustrated this below by summing two individual demand curves.
Graphically, you sum two (or more) demand curves by taking all the pleasure bars, ordering them from high to low and putting them on a new graph. There, done.
You can see that it worked because if the price of a bottle of beer is €1.00, our combined demand is 8 beers, which is the sum of my demand (3, which we established before) and Rita's demand of 5 beers. You can use this method to build a beer demand curve including every person on this planet.
When you do that, you will end up with the total demand curve for beer. Notice that I said 'curve' and not something like bar chart. This is because the aggregation of millions and millions of different bars will eventually turn into a continuous curve. We have finally ended up with a conventional demand curve:
Where does all that beer come from?
In my individual demand curve, I assumed a price per beer of €1. This horizontal line was my perception of the supply curve. It was horizontal because it doesn't matter if I drink 2 or 5 or 10 beers => it won't have any effect on the price I will end up paying for the beer.
However, when we go to the total beer demand, it does make a difference. The beer price will be different when 1 million, 10 million, 100 million or 1 billion people are asking for beer. This is because there are limited hops, glass bottles, clean water supplies and beer brewing masters in this world. If you only have to brew beer for 1 million people, you will be able to use the most optimal location for your beer factory, find a free water source, look around for the best hops and so on. On the other hand, if you are already brewing beer for 100 million people, the cheap hops, the optimal factory locations and the free water will have run out long before that point. So it will cost more to produce a bottle of beer.
This is initially not totally obvious but becomes more obvious with another example. Imagine that you are an oil producer drilling for oil in Texas. You will first drill for the shallow oil supplies but when that's depleted you will have no choice but to drill deeper, at higher cost.
By this reflection, we have arrived at our next law of economics:
The law of increasing marginal costs: an operation running at peak efficiency will experience a higher cost of production per output unit with further attempts at increasing production
I would ask you to stand still for a while and appreciate the beautiful symmetry with the 'law of decreasing marginal utility'. We will not drink unlimited beer because of two reasons: drinking more and more beers give us less and less pleasure while at the same time producing more and more beers costs (proportionally) more and more.
An important consideration is that we are talking about marginal costs: this means that we shouldn't be concerned with costs like building the factory as this cost doesn't change when producing more beers within that factory: it is not a cost you have to think about when you produce 1 more beer than you are currently producing.
Practically, in order to construct a supply curve we can imagine the following course of action:
First, we travel around the world interviewing all people who are already brewing beer and all people who might be capable of starting to brew beer in the (near) future. We ask all of them how much beer they can produce and what are their (marginal) costs to produce that amount (marginal => excluding costs like building the factory or getting the license).
We then take all of these estimates, order them from low cost to high cost and put them in our graph, just as in the case of our demand curve. If we have enough suppliers, with a lot of different prices for different quantities, we will eventually end up with the following (smooth) graph: the total market supply curve:
Total amount of beer consumed and produced worldwide?
Now that we have understood and constructed a demand & supply curve, we can put them together to see what will happen on the total market of beer.
Let me start with putting the two curves together:
Just to reiterate: the demand curve (the curve sloping down) represents the customers' decreasing pleasure for every additional beer they drink. The supply curve (the curve sloping up) on the other hand, represents the increasing costs (per beer) of producing more and more beers.
The intersection of both curves gives us the equilibirum price and quantity.
This makes most sense when you look at the price and then wonder how much consumers will prefer to consume for that price versus how much producers will prefer to produce for that price.
If the price is higher than the equilibrium price, there will be overproduction: less beer will be drunk because there will be less people with pleasure > price. On the other hand, there will be more beer brewed because there will be more producers with costs < price.
If the price is lower than the equilibirum price, there will be underproduction: more beer will be drunk but less beer will be produced.
In both these situations, the price will change until the quantity produced equals the quantity consumed at the equilibrium price. This is the price and quantity at the intersection of the demand and supply curve.
You can congratulate yourself: we now know how many beers will be drunk worldwide!