Macroeconomics: Supply, Demand and Elasticity
By Stephen Simpson
Demand is driven by utility – the pleasure or satisfaction that a consumer obtains from consuming a good or service. Total utility is a function of the quantities of goods/services consumed and the quantities of work done. What is more relevant is the notion of marginal utility – the additional utility that comes from consuming one additional unit of a good or service. This feeds into the law of diminishing marginal utility – at some point, marginal utility will always decrease. (For related reading, see Economic Basics: Utility.)
Consumers maximize their utility by consuming up to the point where the marginal utility is at zero. Consumption is a byproduct of disposable income, where disposable income equals gross income minus net taxes. Expressed differently, disposable income is also equal to the sum of consumption and saving.
There are a variety of equations that can express individual consumption. A person's marginal propensity to consume is largely determined by income, as that marginal propensity equals the change in consumption divided by the change in disposable income. Similarly, a person's marginal propensity to save can be measured as the change in savings divided by the change in disposable income. At all times, then, the marginal propensity to consume and to save must equal "1."
What determines the rate of consumption and savings? Wealth plays a role, as higher wealth leads to more consumption. Consumer expectations also play a significant role; if consumers expect economic conditions to worsen, they will spend less and save more. Household debt is also a factor, as debt represents future consumption brought forward into the present. Finally, taxes and transfers also impact consumption – the more people are taxed, the less they consume, while higher transfer payments from the government can increase consumption.
The total demand for goods and services within an economy is the aggregate demand. Aggregate demand (often expressed as "Y") is the sum of consumer demand, investment spending, government spending and net exports. The curve of aggregate demand is downward-sloping, as demand declines as prices increase. (For related reading, see Understanding Supply-Side Economics.)
Demand can be influenced by a variety of factors. Some of the most significant demand factors include:
- Increase/decrease in real wealth – As consumers' wealth increases, they demand more goods. This rate of increase does slow at higher levels of wealth, though, as more income is devoted to savings (future consumption).
- Decrease/increase in real interest rate – Interest rates are in many respects the price of money and higher rates discourage consumption.
- Increase/decrease in optimism – As consumers feel better about the economy (and by extension, their job and earnings prospects), they spend more.
- Increase/decrease in expected inflation – Inflation erodes the value of unspent money; when consumers expect higher rates of inflation (or rather, the higher prices that make up inflation), they will consume today rather than see their money buy less in the future.
- Higher/lower real incomes abroad – If foreigners earn more, they can spend more money on trade goods (imports).
- Reduction/increase in exchange value of currency – A stronger currency encourages more spending on imported goods as they become cheaper.
The counterpart to aggregate demand is aggregate supply – the total amount of goods and services that are produced in an economy at a given price level. There are a variety of combinations of goods and services that can be produced in an economy and the production possibilities curve illustrates the maximum output that can be achieved in an economy (assuming full employment and full resource utilization). Full production is predicated on using resources in a maximally efficient way. (Gain a deeper understanding of supply and demand. For more, see Economics Basics: Demand and Supply.)
Firms maximize their profits by producing up to the point where the marginal revenue of the next good sold is equal to the marginal cost of producing it. Likewise, a similar philosophy is at work when firms consider whether to make new investments. For a business to make an investment, the expected real rate of return must be equal to or higher than the real cost of investment. Consequently, higher rates generally depress investment activity.
There are numerous factors that can influence supply:
- Increase/decrease in resources – When the availability of materials is a limiting factor in production, an increase in resources allows for a greater supply of goods or services.
- Improvements in technology/productivity – Better technology and/or productivity allow producers to create more goods at a lower price.
- Changes in efficiency of resource use – Better efficiency means that suppliers can produce more goods or services from the same resource base.
- Decrease/increase in resource prices – As the cost of resource inputs declines, suppliers can offer more goods/services at the same price.
- Reduction/increase in inflation – Inflation increases the cost of production; lower inflation allows for a greater supply of goods at the same price.
- Favorable/unfavorable supply shocks – Favorable supply shocks increase the profitability of production for suppliers, while a negative supply shock (an embargo, for instance) can significantly curtail a company's access to supplies and ability to produce goods.
Elasticity refers to the degree to which the demand and supply curves react to changes in price. Expressed as the equation, elasticity equals % change in quantity / % change in price. This means that highly elastic goods and services will see significant changes in demand/supply with very small changes in price.
Elasticity can be influenced by a number of factors, including: the availability of substitutes (more substitutes = more elasticity), the amount of income available, and time. Elasticity is a somewhat intuitive idea (people will pay almost any price for life-saving drugs, but may switch soda brands for a price difference of pennies), but it has many important applications. Elasticity plays a key role in determining the effect of changing prices on business revenue, the analysis of tax burden, the benefits of trade, and the effects of advertising. (For related reading, see Economic Basics: Elasticity.)
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