In a general sense, economics is the study of production, distribution, and consumption 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 microeconomics, 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 simultaneously 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-maximizing 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 market? 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-offs that consumers and investors face as they must give up one opportunity to pursue another?
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.