Demand curves and supply curves
Let us now consider the definition of a demand curve. A demand curve for some good or sendee X shows the amount of X that is demanded at different prices.5 There are individual demand curves and market demand curves; a demand curve may represent the demand for X of an individual consumer, or it may represent the demand for X of a large population of consumers in a given market area, such as the Denver metropolitan area. Some period of time is implicit in the demand curve; for example, a demand curve may show the monthly demand for avocados in the Denver metropolitan area. A market demand curve is constructed by summing horizontally the individual demand curves of each consumer in the market. For example, suppose Arm and Bob are the only two buyers of product X in the market. At a price of S10, Aim will buy six units of X, and Bob will buy ten units. Therefore at a price of S10, the market demand curve will have a total amount demanded of sixteen units. At a price of $6, Arm will buy nine units of X, and Bob will buy twelve units. Thus another point on the market demand curve will be where the price is S6 and the quantity demanded is twenty-one.
Let us consider a demand curve for avocados per month of an individual in Denver. What exactly is it? His demand curve represents not only the number of avocados he will buy per month at different possible prices, but also, and equivalently, the value of avocados to him. Parenthetically, the word “value” always has a precise meaning in economics: it is the maximum amount the individual is willing to pay for the object. Assume the first avocado is worth $8 to this person, the second one is worth S6, a third one would be worth $5, a fourth $2, and a fifth or further avocados would be worth zero. Now suppose the market price of avocados is $4. Under these circumstances he would buy three avocados. The total value to linn of these avocados is $8 + $6 + $5 = $19. He must pay $12 to purchase them, so he has realized a gain from this exchange (which is known as consumer surplus) of $7. The total value of the avocados to him of $19 equals the area under his demand curve from the origin out to the thud avocado. Thus the demand curve is a curve of marginal value, or marginal social benefit; by “marginal value” we mean value “at the margin,” i.e., the value, given the current amount.
Figure 1.1 Supply and demand curves; market equilibrium.
of one more unit of the good. Mien this person has no avocados, the marginal value of an avocado to him is $8; when he has one avocado, the marginal value is $6, and so forth. The area underneath a curve of marginal value equals the total value. This observation applies to market demand curves as well. In Figure 1.1, the total value of Q* goods to consumers equals area AEQ*0. the total area under the demand curve from the origin to Q*.
It is customary6 to draw demand and supply curves with the quantity of the good on the horizontal axis, and value or price on the vertical axis.7 A critical feature of demand curves is that they are downward-sloping. The demand curve of an individual for, say, refrigerators, slopes down because the first refrigerator has more value to the individual than a second one. A market demand curve is also downward-sloping, which implies that if the price of a good declines, the quantity demanded will increase.
Of course the demand for a good is affected by factors other than its price. For example, an individual’s demand for a good may be affected by his income, the prices of other goods that are substitutes or complements, his information about the good, or by an expectation on his part that the price of the good will change. Miat happens to the demand curve if there is a change in some factor other than price that affects the quantity demanded? A change in some variable that affects the amount demanded, but is not shown on either axis of the demand curve, causes a shift of the demand curve. For example, if we consider a market demand curve for avocados, an increase in the income of the population will cause the demand curve to shift to the right, since at any price more avocados will be demanded. Note that a decline in the price of avocados will also increase the amount demanded, but this corresponds to a movement along the demand сип е, rather than a shift of the curve. Similarly, since rental cars are complementary to air travel, an increase in airline fares will probably cause the demand for rental cars to shift to the left. Some new information about eggs, i.e. scientific studies linking egg consumption to higher levels of cholesterol, will cause the demand curve for eggs to shift to the left. The size of each of these changes - whether movements along the demand curve or shifts of the curve - is measured by a number called an elasticity, which we will examine below.
Here we may introduce a distinction between the intensive and extensive margins, that applies to market demand and supply curves. The word “intensive” means “increasing in degree or amount,” while “extensive” means “characterized by extension.” A change on the intensive margin is a change in the level of activity by those currently participating in the market, while a change on the extensive margin is a change in participation: either entry into the market, or exit from it. When the price of avocados falls, someone who previously bought two avocados per week might increase his purchases to three avocados; this is a change on the intensive margin. Another person, who was not buying avocados, might respond to the decline in price by deciding to buy some; this is a change on the extensive margin.
Supply curx’es
The supply curve for a good X represents the cost of producing each additional unit of output; stating it differently, a supply curve is a curve of marginal cost. Marginal cost is the cost of producing one more unit of the good, given the current level of output.8 Some period of time is implicit in a supply curve, just as it is with a demand curve. Suppose a film’s total cost of production is SI00 for ten units per month, SI 12 for eleven units per month, and $126 for twelve units per month. Then the marginal cost of the eleventh unit is $12, and the marginal cost of the twelfth unit is $14.
While a demand curve represents the maximum amount the buyer is willing to pay for the good, a supply curve represents the minimum amount the supplier will accept for the good. At each level of output, the supply curve shows the price the producer must receive, i.e., the absolute minimum amount, to produce that additional unit of output. If A’s supply price for doing tax returns is $50 per hour, he will insist on that amount, and of course would gladly accept a higher rate.
As with demand curves, there are supply curves for individual persons or firms and there are market supply curves. A market supply curve is constructed by summing horizontally the individual supply curves of all persons or films providing the good to the market. Since a supply curve shows the marginal, or additional, cost of each unit, the area under the supply curve equals the total cost of all units of the good. Referring again to Figure 1.1, the total cost to films of producing Q* goods equals area OBEQ*, the total area under the supply curve, from the origin to Q*.
A change in a factor other than price that affects the amount supplied will cause a shift of the supply curve. For example, a general increase in the wages of the workers in an industry will cause the market supply curve to shift upward. On the other hand, technical progress - a reduction in the costs of production - will cause the supply curve to shift down.
Supply, like demand, is affected by an expectation that the price of the good will change. On January 1. 1992, Russia announced that prices of goods and services would no longer be subject to price controls. This announcement had been expected by suppliers, and the anticipation of it had caused many films to withhold then goods from the market, resulting in severe shortages prior to the announcement. The firms decided to wait until the price controls were removed before selling then goods, so that they could sell at the much higher market price.
The distinction between intensive and extensive margins applies to market supply curves as well as market demand curves. For example, suppose the supply curve in Figure 1.1 represents the supply of nursing services in the United States. If the average hourly wage for registered nurses increases, say from $20 to $25, there will be an increase in the amount of nursing services supplied. On the intensive margin, nurses may choose to work more hours
(or, in some cases, fewer hours). On the extensive margin, there will be changes in the decision to enter or leave the market. Some persons who were originally trained as nurses, and who subsequently left nursing, will be drawn back into it. Some nurses who had previously planned to retire will decide to postpone their retirement. There may well be an increase in immigration, as nurses from other countries like Canada, the Philippines or India, decide to emigrate to the United States. Finally, there will be an increase in enrollment in nursing schools.
Compensating differentials
Let us consider more closely the factors that determine the supply of labor to an occupation, or to a specific job. A particular job will have amenities or disamenities, i.e., favorable or unfavorable working conditions, that have some value (positive or negative) to workers. The term “compensating differential” or “equalizing difference” refers to an upward or downward adjustment of the wage, reflecting any amenities or disamenities of the job. Recall that the labor supply curve shows the wage required to induce a worker to do a job. If working conditions are especially unpleasant or risky, the labor supply curve for that job will be higher than it is for the average job. Adam Smith pointed out that the executioner is paid more than other workers with the same skills because his work is distasteful.9 Coal miners earn a higher wage than workers with comparable skills because coal mining is dirty and dangerous work. Nurses on the night shift receive a wage premium since working at night is disruptive to sleep and to interaction with others. The labor market provides compensation for risks of various kinds. One example is physical risk: police officers on the bomb squad are paid more than those with routine duties. Before the development of modem navigation systems for airplanes, pilots were paid more for flying at night and over mountains. There are also compensating differentials for income risk: construction workers in the private sector generally have a higher wage than state employees because they face a higher probability of layoffs.
In Chapter 8, on torts, we will see that the wage premiums that compensate workers for physical risks have been used to estimate tort damages for loss of life.
Conversely, there is a negative compensating differential for jobs with especially attractive working conditions; other things equal, the supply curve is lower (people are willing to work for a lower wage) for jobs on cruise ships or in Caribbean resorts. Wages are also lower in jobs that enable the worker to improve his productivity and earning capacity (which economists call general human capital) by, for example, learning computer or word-processing skills that increase his value to many potential employers.
Thus if Ms. Jones has a choice between one position with money income of $35,000 and disamenities valued at minus $3,000, and another position with money income of $30,000, and amenities worth $3,000, we assume she will choose the second one. In other words, we assume that an individual chooses the job that will maximize her total real income, instead of considering only the job’s money income.
