R E A D I N G 13 Demand and Supply Analysis: Introduction by Richard V. Eastin, PhD, and Gary L. Arbogast, CFA Richard V. Eastin, PhD, is at the University of Southern California (USA). Gary L. Arbogast, CFA (USA). LEARNING OUTCOMES Mastery The candidate should be able to: a. distinguish among types of markets; b. explain the principles of demand and supply; c. describe causes of shifts in and movements along demand and supply curves; d. describe the process of aggregating demand and supply curves; e. describe the concept of equilibrium (partial and general), and mechanisms by which markets achieve equilibrium; f. distinguish between stable and unstable equilibria, including price bubbles, and identify instances of such equilibria; g. calculate and interpret individual and aggregate demand, and inverse demand and supply functions, and interpret individual and aggregate demand and supply curves; h. calculate and interpret the amount of excess demand or excess supply associated with a non- equilibrium price; i. describe types of auctions and calculate the winning price(s) of an auction; j. calculate and interpret consumer surplus, producer surplus, and total surplus; k. describe how government regulation and intervention affect demand and supply; l. forecast the effect of the introduction and the removal of a market interference (e.g., a price floor or ceiling) on price and quantity; m. calculate and interpret price, income, and cross- price elasticities of demand and describe factors that affect each measure. © 2011 CFA Institute. All rights reserved. 2 Reading 13 ■ Demand and Supply Analysis: Introduction 1 INTRODUCTION In a general sense, economics is the study of production, distribution, and con- sumption and can be divided into two broad areas of study: macroeconomics and microeconomics. Macroeconomics deals with aggregate economic quantities, such as national output and national income. Macroeconomics has its roots in microeco- nomics, which deals with markets and decision making of individual economic units, including consumers and businesses. Microeconomics is a logical starting point for the study of economics. This reading focuses on a fundamental subject in microeconomics: demand and supply analysis. Demand and supply analysis is the study of how buyers and sellers interact to determine transaction prices and quantities. As we will see, prices simul- taneously reflect both the value to the buyer of the next (or marginal) unit and the cost to the seller of that unit. In private enterprise market economies, which are the chief concern of investment analysts, demand and supply analysis encompasses the most basic set of microeconomic tools. Traditionally, microeconomics classifies private economic units into two groups: consumers (or households) and firms. These two groups give rise, respectively, to the theory of the consumer and theory of the firm as two branches of study. The theory of the consumer deals with consumption (the demand for goods and services) by utility- maximizing individuals (i.e., individuals who make decisions that maximize the satisfaction received from present and future consumption). The theory of the firm deals with the supply of goods and services by profit-m aximizing firms. The theory of the consumer and the theory of the firm are important because they help us understand the foundations of demand and supply. Subsequent readings will focus on the theory of the consumer and the theory of the firm. Investment analysts, particularly equity and credit analysts, must regularly analyze products and services, their costs, prices, possible substitutes, and complements, to reach conclusions about a company’s profitability and business risk (risk relating to operating profits). Furthermore, unless the analyst has a sound understanding of the demand and supply model of markets, he or she cannot hope to forecast how external events—such as a shift in consumer tastes or changes in taxes and subsidies or other intervention in markets—will influence a firm’s revenue, earnings, and cash flows. Having grasped the tools and concepts presented in this reading, the reader should also be able to understand many important economic relations and facts and be able to answer questions, such as: ■ ■ Why do consumers usually buy more when the price falls? Is it irrational to violate this “law of demand”? ■ ■ What are appropriate measures of how sensitive the quantity demanded or supplied is to changes in price, income, and prices of other goods? What affects those sensitivities? ■ ■ If a firm lowers its price, will its total revenue also fall? Are there conditions under which revenue might rise as price falls and what are those? Why? ■ ■ What is an appropriate measure of the total value consumers or producers receive from the opportunity to buy and sell goods and services in a free mar- ket? How might government intervention reduce that value, and what is an appropriate measure of that loss? ■ ■ What tools are available that help us frame the trade-o ffs that consumers and investors face as they must give up one opportunity to pursue another? Types of Markets 3 ■ ■ Is it reasonable to expect markets to converge to an equilibrium price? What are the conditions that would make that equilibrium stable or unstable in response to external shocks? ■ ■ How do different types of auctions affect price discovery? This reading is organized as follows. Section 2 explains how economists classify markets. Section 3 covers the basic principles and concepts of demand and supply analysis of markets. Section 4 introduces measures of sensitivity of demand to changes in prices and income. A summary and practice problems conclude the reading. TYPES OF MARKETS 2 Analysts must understand the demand and supply model of markets because all firms buy and sell in markets. Investment analysts need at least a basic understanding of those markets and the demand and supply model that provides a framework for analyzing them. Markets are broadly classified as factor markets or goods markets. Factor markets are markets for the purchase and sale of factors of production. In capitalist private enterprise economies, households own the factors of production (the land, labor, physical capital, and materials used in production). Goods markets are markets for the output of production. From an economics perspective, firms, which ultimately are owned by individuals either singly or in some corporate form, are organizations that buy the services of those factors. Firms then transform those services into intermediate or final goods and services. (Intermediate goods and services are those purchased for use as inputs to produce other goods and services, whereas final goods and ser- vices are in the final form purchased by households.) These two types of interaction between the household sector and the firm sector—those related to goods and those related to services—take place in factor markets and goods markets, respectively. In the factor market for labor, households are sellers and firms are buyers. In goods markets: firms are sellers and both households and firms are buyers. For example, firms are buyers of capital goods (such as equipment) and intermediate goods, while households are buyers of a variety of durable and non- durable goods. Generally, market interactions are voluntary. Firms offer their products for sale when they believe the payment they will receive exceeds their cost of production. Households are willing to purchase goods and services when the value they expect to receive from them exceeds the payment necessary to acquire them. Whenever the perceived value of a good exceeds the expected cost to produce it, a potential trade can take place. This fact may seem obvious, but it is fundamental to our understanding of markets. If a buyer values something more than a seller, not only is there an opportunity for an exchange, but that exchange will make both parties better off. In one type of factor market, called labor markets, households offer to sell their labor services when the payment they expect to receive exceeds the value of the lei- sure time they must forgo. In contrast, firms hire workers when they judge that the value of the productivity of workers is greater than the cost of employing them. A major source of household income and a major cost to firms is compensation paid in exchange for labor services. Additionally, households typically choose to spend less on consumption than they earn from their labor. This behavior is called saving, through which households can accumulate financial capital, the returns on which can produce other sources of house- hold income, such as interest, dividends, and capital gains. Households may choose to lend their accumulated savings (in exchange for interest) or invest it in ownership claims 4 Reading 13 ■ Demand and Supply Analysis: Introduction in firms (in hopes of receiving dividends and capital gains). Households make these savings choices when their anticipated future returns are judged to be more valuable today than the present consumption that households must sacrifice when they save. Indeed, a major purpose of financial institutions and markets is to enable the trans- fer of these savings into capital investments. Firms use capital markets (markets for long- term financial capital—that is, markets for long- term claims on firms’ assets and cash flows) to sell debt (in bond markets) or equity (in equity markets) in order to raise funds to invest in productive assets, such as plant and equipment. They make these investment choices when they judge that their investments will increase the value of the firm by more than the cost of acquiring those funds from households. Firms also use such financial intermediaries as banks and insurance companies to raise capital, typically debt funding that ultimately comes from the savings of households, which are usually net accumulators of financial capital. Microeconomics, although primarily focused on goods and factor markets, can contribute to the understanding of all types of markets (e.g., markets for financial securities). EXAMPLE 1 Types of Markets 1 Which of the following markets is least accurately described as a factor market? The market for: A land. B assembly line workers. C capital market securities. 2 Which of the following markets is most accurately defined as a goods mar- ket? The market for: A companies. B unskilled labor. C legal and lobbying services. Solution to 1: C is correct. Solution to 2: C is correct. 3 BASIC PRINCIPLES AND CONCEPTS In this reading, we will explore a model of household behavior that yields the consumer demand curve. Demand, in economics, is the willingness and ability of consumers to purchase a given amount of a good or service at a given price. Supply is the willingness of sellers to offer a given quantity of a good or service for a given price. Later, study on the theory of the firm will yield the supply curve. The demand and supply model is useful in explaining how price and quantity traded are determined and how external influences affect the values of those variables. Buyers’ behavior is captured in the demand function and its graphical equivalent, the demand curve. This curve shows both the highest price buyers are willing to pay Basic Principles and Concepts 5 for each quantity, and the highest quantity buyers are willing and able to purchase at each price. Sellers’ behavior is captured in the supply function and its graphical equivalent, the supply curve. This curve shows simultaneously the lowest price sellers are willing to accept for each quantity and the highest quantity sellers are willing to offer at each price. If, at a given quantity, the highest price that buyers are willing to pay is equal to the lowest price that sellers are willing to accept, we say the market has reached its equilibrium quantity. Alternatively, when the quantity that buyers are willing and able to purchase at a given price is just equal to the quantity that sellers are willing to offer at that same price, we say the market has discovered the equilibrium price. So equilibrium price and quantity are achieved simultaneously, and as long as neither the supply curve nor the demand curve shifts, there is no tendency for either price or quantity to vary from their equilibrium values. 3.1 The Demand Function and the Demand Curve We first analyze demand. The quantity consumers are willing to buy clearly depends on a number of different factors called variables. Perhaps the most important of those variables is the item’s own price. In general, economists believe that as the price of a good rises, buyers will choose to buy less of it, and as its price falls, they buy more. This is such a ubiquitous observation that it has come to be called the law of demand, although we shall see that it need not hold in all circumstances. Although a good’s own price is important in determining consumers’ willingness to purchase it, other variables also have influence on that decision, such as consumers’ incomes, their tastes and preferences, the prices of other goods that serve as substitutes or complements, and so on. Economists attempt to capture all of these influences in a relationship called the demand function. (In general, a function is a relationship that assigns a unique value to a dependent variable for any given set of values of a group of independent variables.) We represent such a demand function in Equation 1: Qd = f(P ,I,P ,...) (1) x x y d where Qx represents the quantity demanded of some good X (such as per household demand for gasoline in gallons per week), P is the price per unit of good X (such as x $ per gallon), I is consumers’ income (as in $1,000s per household annually), and P y is the price of another good, Y. (There can be many other goods, not just one, and they can be complements or substitutes.) Equation 1 may be read, “Quantity demanded of good X depends on (is a function of) the price of good X, consumers’ income, the price of good Y, and so on.” Often, economists use simple linear equations to approximate real- world demand and supply functions in relevant ranges. A hypothetical example of a specific demand function could be the following linear equation for a small town’s per-h ousehold gas- oline consumption per week, where P might be the average price of an automobile y in $1,000s: Qd = 8.4 −0.4P +0.06I −0.01P (2) x x y The signs of the coefficients on gasoline price (negative) and consumer’s income (positive) are intuitive, reflecting, respectively, an inverse and a positive relationship between those variables and quantity of gasoline consumed. The negative sign on average automobile price may indicate that if automobiles go up in price, fewer will be purchased and driven; hence less gasoline will be consumed. As will be discussed later, such a relationship would indicate that gasoline and automobiles have a negative cross- price elasticity of demand and are thus complements. 6 Reading 13 ■ Demand and Supply Analysis: Introduction To continue our example, suppose that the price of gasoline (P ) is $3 per gallon, x per household income (I) is $50,000, and the price of the average automobile (P ) is y $20,000. Then this function would predict that the per-h ousehold weekly demand for gasoline would be 10 gallons: 8.4 − 0.4(3) + 0.06(50) − 0.01(20) = 8.4 − 1.2 + 3 − 0.2 = 10, recalling that income and automobile prices are measured in thousands. Note that the sign on the own- price variable is negative, thus, as the price of gasoline rises, per household weekly consumption would decrease by 0.4 gallons for every dollar increase in gas price. Own-p rice is used by economists to underscore that the reference is to the price of a good itself and not the price of some other good. In our example, there are three independent variables in the demand function, and one dependent variable. If any one of the independent variables changes, so does the value of quantity demanded. It is often desirable to concentrate on the relation- ship between the dependent variable and just one of the independent variables at a time, which allows us to represent the relationship between those two variables in a two- dimensional graph (at specific levels of the variables held constant). To accom- plish this goal, we can simply hold the other two independent variables constant at their respective levels and rewrite the equation. In economic writing, this “holding constant” of the values of all variables except those being discussed is traditionally referred to by the Latin phrase ceteris paribus (literally, “all other things being equal” in the sense of “unchanged”). In this reading, we will use the phrase “holding all other things constant” as a readily understood equivalent for ceteris paribus. Suppose, for example, that we want to concentrate on the relationship between the quantity demanded of the good and its own- price, P . Then we would hold constant x the values of income and the price of good Y. In our example, those values are 50 and 20, respectively. So, by inserting the respective values, we would rewrite Equation 2 as Qd = 8.4−0.4P +0.06(50)−0.01(20) =11.2−0.4P (3) x x x Notice that income and the price of automobiles are not ignored; they are simply held constant, and they are “collected” in the new constant term, 11.2. Notice also that we can rearrange Equation 3, solving for P in terms of Q . This operation is x x called “inverting the demand function,” and gives us Equation 4. (You should be able to perform this algebraic exercise to verify the result.) P = 28 – 2.5Q (4) x x Equation 4, which gives the per-g allon price of gasoline as a function of gasoline consumed per week, is referred to as the inverse demand function. We need to restrict Q in Equation 4 to be less than or equal to 11.2 so price is not negative. x Henceforward we assume that the reader can work out similar needed qualifications to the valid application of equations. The graph of the inverse demand function is called the demand curve, and is shown in Exhibit 1.1 1 Following usual practice, here and in other exhibits we will show linear demand curves intersecting the quantity axis at a price of zero, which shows the intercept of the associated demand equation. Real- world demand functions may be non-l inear in some or all parts of their domain. Thus, linear demand functions in practical cases are viewed as approximations to the true demand function that are useful for a relevant range of values. The relevant range would typically not include a price of zero, and the prediction for demand at a price of zero should not be viewed as usable. Basic Principles and Concepts 7 Exhibit 1 Household Demand Curve for Gasoline P x 28 4 3 Q x 9.6 10 11.2 This demand curve is drawn with price on the vertical axis and quantity on the horizontal axis. Depending on how we interpret it, the demand curve shows either the highest quantity a household would buy at a given price or the highest price it would be willing to pay for a given quantity. In our example, at a price of $3 per gallon households would each be willing to buy 10 gallons per week. Alternatively, the high- est price they would be willing to pay for 10 gallons per week is $3 per gallon. Both interpretations are valid, and we will be thinking in terms of both as we proceed. If the price were to rise by $1, households would reduce the quantity they each bought by 0.4 units to 9.6 gallons. We say that the slope of the demand curve is 1/−0.4, or –2.5. Slope is always measured as “rise over run,” or the change in the vertical variable divided by the change in the horizontal variable. In this case, the slope of the demand curve is ΔP/ΔQ, where “Δ” stands for “the change in.” The change in price was $1, and it is associated with a change in quantity of negative 0.4 3.2 Changes in Demand vs. Movements along the Demand Curve As we just saw, when own- price changes, quantity demanded changes. This change is called a movement along the demand curve or a change in quantity demanded, and it comes only from a change in own price. Recall that to draw the demand curve, though, we had to hold everything except quantity and own- price constant. What would happen if income were to change by some amount? Suppose that household income rose by $10,000 per year to a value of 60. Then the value of Equation 3 would change to Qd = 8.4−0.4P +0.06(60)−0.01(20) =11.8−0.4P (5) x x x and Equation 4 would become the new inverse demand function: P = 29.5 – 2.5Q (6) x x Notice that the slope has remained constant, but the intercepts have both increased, resulting in an outward shift in the demand curve, as shown in Exhibit 2. 8 Reading 13 ■ Demand and Supply Analysis: Introduction Exhibit 2 Household Demand Curve for Gasoline before and after Change in Income P x 29.5 28 Q x 11.2 11.8 In general, the only thing that can cause a movement along the demand curve is a change in a good’s own- price. A change in the value of any other variable will shift the entire demand curve. The former is referred to as a change in quantity demanded, and the latter is referred to as a change in demand. More importantly, the shift in demand was both a vertical shift upward and a hor- izontal shift to the right. That is to say, for any given quantity, the household is now willing to pay a higher price; and at any given price, the household is now willing to buy a greater quantity. Both interpretations of the shift in demand are valid. EXAMPLE 2 Representing Consumer Buying Behavior with a Demand Function and Demand Curve An individual consumer’s monthly demand for downloadable e-b ooks is given by the equation Qd = 2−0.4P +0.0005I +0.15P eb eb hb d where Qeb equals the number of e- books demanded each month, Peb equals the price of e- books, I equals the household monthly income, and P equals the hb price of hardbound books, per unit. Notice that the sign on the price of hard- bound books is positive, indicating that when hardbound books increase in price, more e- books are purchased; thus, according to this equation, the two types of books are substitutes. Assume that the price of e- books is €10.68, household income is €2,300, and the price of hardbound books is €21.40. 1 Determine the number of e- books demanded by this household each month. 2 Given the values for I and P , determine the inverse demand function. hb 3 Determine the slope of the demand curve for e-b ooks. 4 Calculate the vertical intercept (price-a xis intercept) of the demand curve if income increases to €3000 per month. Solution to 1: Insert given values into the demand function and calculate quantity: Qd = 2−0.4(10.68)+0.0005(2,300)+0.15(21.40) = 2.088 eb Basic Principles and Concepts 9 Hence, the household will demand e-b ooks at the rate of 2.088 books per month. Note that this rate is a flow, so there is no contradiction in there being a non- integer quantity. In this case, the outcome means that the consumer buys 23 e- books per 11 months. Solution to 2: We want to find the price–quantity relationship holding all other things con- stant, so first, insert values for I and P into the demand function and collect hb the constant terms: Qd = 2−0.4P +0.0005(2,300)+0.15(21.40) = 6.36−0.4P eb eb eb Now solve for P in terms of Q : P = 15.90 – 2.5Q eb eb eb eb Solution to 3: Note from the inverse demand function above that when Q rises by one unit, eb P falls by 2.5 euros. So the slope of the demand curve is –2.5, which is the eb coefficient on Q in the inverse demand function. Note it is not the coefficient eb on P in the demand function, which is −0.4. It is the inverse of that coefficient. eb Solution to 4: In the demand function, change the value of I to 3,000 from 2,300 and collect constant terms: Qd = 2 −0.4P +0.0005(3,000)+0.15(21.40) = 6.71−0.4P eb eb eb Now solve for P : P = 16.78 – 2.5Q . The vertical intercept is 16.78. (Note eb eb eb that this increase in income has shifted the demand curve outward and upward but has not affected its slope, which is still −2.5.) 3.3 The Supply Function and the Supply Curve The willingness and ability to sell a good or service is called supply. In general, producers are willing to sell their product for a price as long as that price is at least as high as the cost to produce an additional unit of the product. It follows that the willingness to supply, called the supply function, depends on the price at which the good can be sold as well as the cost of production for an additional unit of the good. The greater the difference between those two values, the greater is the willingness of producers to supply the good. In another reading, we will explore the cost of production in greater detail. At this point, we need to understand only the basics of cost. At its simplest level, production of a good consists of transforming inputs, or factors of production (such as land, labor, capital, and materials) into finished goods and services. Economists refer to the “rules” that govern this transformation as the technology of production. Because producers have to purchase inputs in factor markets, the cost of production depends on both the technology and the price of those factors. Clearly, willingness to supply is dependent on not only the price of a producer’s output, but also additionally on the prices (i.e., costs) of the inputs necessary to produce it. For simplicity, we can assume that the only input in a production process is labor that must be purchased in the labor market. The price of an hour of labor is the wage rate, or W. Hence, we can say that (for any given level of technology) the willingness to supply a good depends on the price of that good and the wage rate. This concept is captured in the following equation, which represents an individual seller’s supply function: Qs = f(P ,W,…) (7) x x 10 Reading 13 ■ Demand and Supply Analysis: Introduction s where Qx is the quantity supplied of some good X, such as gasoline, Px is the price per unit of good X, and W is the wage rate of labor in, say, dollars per hour. It would be read, “The quantity supplied of good X depends on (is a function of) the price of X (its “own” price), the wage rate paid to labor, etc.” Just as with the demand function, we can consider a simple hypothetical example of a seller’s supply function. As mentioned earlier, economists often will simplify their analysis by using linear functions, although that is not to say that all demand and supply functions are necessarily linear. One hypothetical example of an individual seller’s supply function for gasoline is given in Equation 8: Qs = −175+250P −5W (8) x x Notice that this supply function says that for every increase in price of $1, this seller would be willing to supply an additional 250 units of the good. Additionally, for every $1 increase in wage rate that it must pay its laborers, this seller would experience an increase in marginal cost and would be willing to supply five fewer units of the good. We might be interested in the relationship between only two of these variables, price and quantity supplied. Just as we did in the case of the demand function, we use the assumption of ceteris paribus and hold everything except own- price and quantity constant. In our example, we accomplish this by setting W to some value, say, $15. The result is Equation 9: Qs = −175+250P −5(15) = −250+250P (9) x x x s in which only the two variables Qx and Px appear. Once again, we can solve this s equation for Px in terms of Qx, which yields the inverse supply function in Equation 10: P = 1 + 0.004Q (10) x x The graph of the inverse supply function is called the supply curve, and it shows simultaneously the highest quantity willingly supplied at each price and the lowest price willingly accepted for each quantity. For example, if the price of gasoline were $3 per gallon, Equation 9 implies that this seller would be willing to sell 500 gallons per week. Alternatively, the lowest price she would accept and still be willing to sell 500 gallons per week would be $3. Exhibit 3 represents our hypothetical example of an individual seller’s supply curve of gasoline. Exhibit 3 Individual Seller’s Supply Curve for Gasoline P x 4 Supply Curve 3 1 Q x –250 500 750 What does our supply function tell us will happen if the retail price of gasoline rises by $1? We insert the new higher price of $4 into Equation 8 and find that quan- tity supplied would rise to 750 gallons per week. The increase in price has enticed the seller to supply a greater quantity of gasoline per week than at the lower price.