January 13, 2004
Intermediate Micro
Q: How do students hoping to earn a degree in economics explain the origins of the supply and demand curves?
The demand curves comes from the Theory of the Consumer. An agent's available combinations of two goods is limited by his budget constraint.
His indifference curves are a relief map of his utility function.
Putting these together allows us to show where the agent's utility-maximizing consumption will be. Changing the price of one good changes the quantity the agent consumes. This is the origin of the demand curve.
Theory of the Firm explains the supply curve. If a firm faces one fixed cost and one variable cost (labor) precisely proportional to output, the the average cost curve would be monotone decreasing.
The average cost curve will the "U-shaped" if a limited factor of production (management skill) causes average cost to rise at high levels of output. The marginal cost curve passes through the minimum of the average cost curve. (See calculations.) The profit-maximizing level of output for a firm facing a horizontal demand curve is at the point where the marginal cost equals the price of the output.
To learn more about this topic, check out the Classic Economic Models.