Microeconomics for Non-Finance People Part 1: Supply, Demand, and (In)Efficiency

Have you ever been intimidated by seemingly-dense publications like The Wall Street Journal, the Financial Times, and Bloomberg? Curious about how the economy and businesses work but don’t have the time to take a course on economics? Want to sound intelligent and impress your friends?

This series of articles is for you!

Learning the key concepts of microeconomics is a great way to understand finance and business publications. Why is that? Well, let’s start with the definition of microeconomics. From Investopedia:

“The branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets (e.g. coffee industry).”

So microeconomics is concerned with decision-making. It provides a framework to analyze the actions of firms and households – actions that business/finance publications routinely cover. While this framework often involves graphs and mathematical equations, I believe that several key concepts are sufficient enough to make sense of business news:

  1. Resources are scarce.

One of the fundamental starting points of Economics is that resources are scarce. This means that firms and individuals must continually choose how to best allocate resources. When a resource is allocated to its highest-valued use, it is efficiently allocated. The highest-valued use that was traded off is its opportunity cost, which we covered in a previous article.

  1. Resources are efficiently allocated when supply meets demand.

There are several ways to allocate resources (such as lottery, majority rule, even force), but in this article we will focus on market price. In this scenario, producers of a resource will supply it, while buyers of a resource will demand it. Supply will meet demand via an agreed-upon price, the market price, which the buyer will pay and the producer will earn. Although actual supply and demand for a resource may vary over time, in a competitive environment lower supply means higher prices, while lower demand means lower prices. The opposite is also true: higher supply means lower prices, while higher demand means higher prices.

Here’s a real life example of scarce resources, supply and demand, and market prices: an article on oil prices I picked from Bloomberg.

Several things are going on in this Bloomberg article, but let’s boil it down to what’s relevant to us:

  1. Previously, rapid economic growth in China helped oil prices increase.
  2. Currently, surging US oil production has led to a larger supply of oil.
  3. As a result, oil prices are plunging.
  4. The previous scenario when oil prices were increasing was a more of a demand-side issue because of Chinese growth, while the current scenario of weaker oil prices is more of a supply-side issue due to the high output of US oil production.

And just like that, you have a better understanding of the current environment of global oil prices!

  1. Resources are not always allocated efficiently.

Recall that we defined efficient allocation as the case where a resource is allocated to its highest-valued use. In market economies, this often involves paying for that resource at a point where supply of that resource meets demand. However, in many modern economies, resources are not allocated efficiently, for the following reasons:

  1. Price and quantity regulations. Examples: a price on how much someone can charge for a product, or a cap on the quantity produced.
  2. Taxes and subsidies. Taxes increase prices paid and lower prices received, leading to underproduction of a resource. Subsidies (payments by governments to producers) does the opposite, leading to overproduction.
  3. Externalities. Externalities are costs or benefits that affects people other than the buyer and seller. Pollution is a well-known example; when a factory produces widgets, it is also polluting. If it affects people adversely, we could say that there is an overproduction of pollution. Note that externalities can be both positive and/or negative.
  4. Public goods/common resources. Public goods are consumed by people who may not directly pay for it. One example is law enforcement. Firms would underproduce public goods to get rid of freeloaders (formally known in Economics as free-riders). Common resources are the opposite, where a good is used by everyone but owned by no one, leading to overproduction.
  5. Monopoly. Not the board game! A monopoly is a company that is the sole provider of a product, meaning that it will underproduce a produce and therefore charge a high price for it.
  6. High transaction costs. Example: Waiting in line to buy the latest iPhone. Since time is money, this counts as a high transaction cost.

Is inefficiency bad? Not necessarily. In some cases, we may want some of the factors that lead to inefficiency. Depending on your politics, you may want some taxation that, although may translate to higher iPhone prices, would help get roads paved in your neighborhood.

Ilusion concept art, watercolor and graphite sketch

Ilusion concept art, watercolor and graphite sketch

So far, we’ve largely talked about microeconomics as it relates to transactions. In our next post, we will discuss microeconomics as it applies to companies’ costs and production. See you there!

Ramon Rodrigo Cuenca, CFA
Equities Analyst
Artandfinance.net

Source: CFA Program Curriculum Level I, 2009, volume 2: Economics, pp. 36-39, 46-48

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