Chapter 5 of 22 · Unit 2 · The economy · 12 min read
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Microeconomics studies single markets: one good, its buyers, its sellers and the price that settles between them. For an investor it answers two practical questions. Why do some prices, such as oil, swing so hard while others hardly move? And why do a few companies keep earning high returns year after year while most see their profits competed away? This chapter builds the answers from supply and demand up to the idea of a moat, then tests them on three oil shocks.
For every reader: the idea in plain words, no formulas.
At a higher price, buyers want less and sellers want to sell more. At a lower price, the reverse. Somewhere between, the amount buyers want matches the amount sellers offer, and the market settles there. When something changes, such as a war cutting supply or a new technology cutting costs, the settling point moves and the price moves with it.
How far a price moves depends on how easily people can change what they do. Drivers cannot stop buying gasoline overnight; they still need to get to work. So when supply falls, the price has to rise a lot before enough buyers cut back. For something with many substitutes, like one brand of breakfast cereal, a small price rise sends buyers elsewhere, and the price cannot rise much at all. Economists call this responsiveness elasticity.
In most industries, high profits attract new competitors, who cut prices until the extra profit is gone. A few companies resist that for decades. They might own a brand people trust, a network that gets more useful as it grows, or costs no rival can match. Warren Buffett called such a lasting advantage a moat, after the water around a castle. For a long-term shareholder, the width of a company's moat matters as much as this year's earnings.
For readers who want the mechanism, with the diagrams.
Beginner path stops here
A demand curve plots the quantity buyers want at each price; it slopes down. A supply curve plots what sellers offer at each price; it slopes up. Where they cross we find the market price and quantity, the equilibrium.
A change in the good's own price moves us along a curve. A change in anything else shifts a whole curve. Demand shifts when incomes, tastes, the prices of substitutes or the number of buyers change. Supply shifts when costs, technology, the number of sellers or a disruption such as a war or a storm changes the amount offered at every price.
Four cases cover every shift. More demand raises both price and quantity. Less demand lowers both. More supply lowers the price and raises the quantity. Less supply raises the price and lowers the quantity. When both curves move at once, one of the two outcomes is certain and the other depends on which shift is larger.
The price elasticity of demand compares the percentage change in quantity with the percentage change in price. Demand is inelastic when the quantity changes by a smaller percentage than the price, elastic when it changes by more.
Elasticity depends on a few things we can usually see. Goods with close substitutes are elastic. Necessities are inelastic. Items that take a large share of a budget are more elastic than small ones. And time raises every elasticity: given a year, drivers can buy smaller cars, move closer to work or share rides, so long-run demand for gasoline responds far more than short-run demand.
Elasticity tells a seller what a price rise does to revenue. When demand is inelastic, a higher price brings in more money, because few buyers leave. When demand is elastic, a higher price brings in less. This is why firms with pricing power tend to sell things customers cannot easily replace.
| Price | Quantity | Revenue | |Elasticity| |
|---|---|---|---|
| 10 | 90 | 900 | 0.11 |
| 20 | 80 | 1600 | 0.25 |
| 30 | 70 | 2100 | 0.43 |
| 40 | 60 | 2400 | 0.67 |
| 50 | 50 | 2500 | 1 |
| 60 | 40 | 2400 | 1.5 |
| 70 | 30 | 2100 | 2.33 |
| 80 | 20 | 1600 | 4 |
| 90 | 10 | 900 | 9 |
Source: computed: demand Q = 100 - P; revenue = P x Q; |ε| = P / Q, as of 2026-10-28.
Consumer surplus is the gap between what buyers would have paid and what they did pay. Producer surplus is the gap between the price sellers got and the lowest price they would have accepted. Together they measure the gain from the market existing. A tax or a price cap shrinks that total, and part of the loss goes to nobody; economists call that part the deadweight loss. Investors meet the idea when governments cap prices in energy or drugs, because the cap moves surplus away from producers and their shareholders.
Industries sit on a spectrum by how much power each firm has over its price.
Perfect competition has many sellers of an identical product, such as wheat. No seller can charge more than the market price, and in the long run profits only cover the cost of capital. Monopolistic competition has many sellers with slightly different products: restaurants, clothing brands. Each has a little pricing power, which entry keeps eroding. Oligopoly has a few large sellers that watch each other, as in aircraft, wireless networks or credit card networks; profits can stay high when the few avoid price wars. Monopoly has one seller and the most pricing power, which is why governments regulate or break up the clearest cases.
Michael Porter's 1979 framework asks what limits an industry's profits. We look at five pressures: rivalry among existing firms, the threat of new entrants, the threat of substitute products, the bargaining power of buyers and the bargaining power of suppliers. An industry with weak forces on all five, such as one with high entry costs, loyal customers and scattered suppliers, can keep high margins. One with strong forces, such as airlines with their fierce rivalry, powerful unions, costly aircraft from two main makers and price-shopping travellers, rarely does.
Morningstar's equity research, which made moat ratings a standard tool, names five sources of a lasting advantage.
A moat shows up as a return on invested capital above the cost of capital, held for a long time. Without a moat, competition pulls the return down toward the cost of capital within a few years. With one, the gap fades slowly or not at all. The present value of that gap is what a moat is worth to a shareholder. Analysts look for two signs: a high return held through a recession, when weaker rivals lose money, and a return that stays high as the company grows, which shows the advantage covers new capital too. A single good year proves little. Ten good years across a downturn say much more.
Moats fail more often than investors expect. Technology can make an advantage worthless: a company that dominated photographic film had a brand, scale and patents, and digital cameras and then phones took its market within about a decade. Regulation can remove a licence or cap a price. A network can lose users to a newer one once a rival reaches enough size. And a company with a comfortable lead can stop investing in the thing that made it strong. For that reason we treat a moat rating as a forecast with error bars, and the fade rate in Level 3 as the number to argue about.
When a government holds a price below the equilibrium, buyers want more than sellers offer at that price, and the gap shows up as queues, rationing or a black market. The 1970s US price controls on gasoline produced long lines at filling stations. A price floor does the opposite and leaves a surplus, as with some farm support programmes. For investors, a cap on the price a company can charge works like a narrowed moat: it limits the upside while leaving the costs in place. Regulated utilities live with this all the time: a commission sets the return they may earn on their asset base. Their shares then behave more like bonds than like growth stocks, and they react strongly to interest rates.
| Year | ROIC, no moat (%) | ROIC, with a moat (%) |
|---|---|---|
| 0 | 20 | 20 |
| 2 | 17.6 | 19.2 |
| 4 | 15.2 | 18.4 |
| 6 | 12.8 | 17.6 |
| 8 | 10.4 | 16.8 |
| 10 | 8 | 16 |
| 12 | 8 | 15.2 |
| 14 | 8 | 14.4 |
| 16 | 8 | 13.6 |
| 18 | 8 | 12.8 |
| 20 | 8 | 12 |
Source: computed: ROIC 20 % fading linearly to the 8 % cost of capital over 10 years (no moat) or 30 years (moat), as of 2026-10-28.
For Series 65 and CFA readers: formulas and worked examples.
Series 65 path stops here
In words, the price elasticity of demand is the percentage change in quantity divided by the percentage change in price.
Demand elasticities are negative, since quantity falls when price rises; we often quote their size. With demand is inelastic, with elastic. Revenue is price times quantity, so a price change of changes revenue by a factor of .
Worked example A 10 % price rise
With an elasticity of −0.2, a 10 % price rise cuts quantity by −2.0 % and lifts revenue by +7.8 %. With an elasticity of −1.5, the same rise cuts quantity by −15.0 % and revenue changes by −6.5 %. A seller facing the first kind of demand raises prices; one facing the second does not.
For changes that are not small, economists use the midpoint formula, which divides each change by the average of the before and after values so that the answer does not depend on direction. If the price of a good goes from $4 to $5 and the quantity bought goes from 100 to 97, the midpoint elasticity is −0.14.
Two more elasticities appear in analysts' work. The cross-price elasticity measures how the quantity of one good responds to the price of another; it is positive for substitutes (coffee and tea) and negative for complements (cars and gasoline). The income elasticity measures how the quantity responds to income.
In words, the income elasticity is the percentage change in quantity divided by the percentage change in income.
Goods with an income elasticity above one, such as travel and luxury goods, gain share in booms and lose it fast in recessions, which is why their makers' shares tend to have high betas. Goods with low income elasticity, such as groceries and utilities, give steadier sales through the cycle.
A firm with some pricing power picks the price where one more unit adds as much to revenue as to cost. That rule gives a neat link between elasticity and the markup over marginal cost, called the Lerner index.
In words, the share of the price that is markup over marginal cost equals one over the size of the demand elasticity the firm faces.
A firm facing an elasticity of −4 sets a markup of 25 % of the price; with a marginal cost of $75 it charges $100.00. Under perfect competition each firm faces near-infinite elasticity and the markup goes to zero. A moat lowers the elasticity a firm faces, which is another way of saying it can charge more without losing its customers.
Suppose a share of supply disappears, and buyers and sellers respond with elasticities (negative) and (positive). For modest changes the price moves by about this much.
In words, the price change is the size of the shift divided by the sum of how strongly buyers and sellers respond.
When supply cannot respond in the short run, is near zero, and a 5 % supply cut needs a price rise of +50 % if demand has an elasticity of −0.1, or +17 % at −0.3. Short-run estimates for gasoline demand in the research literature sit in that low range, which is why oil prices swing so much on small changes in supply.
Accounting profit pays the lenders and ignores what the shareholders' money could earn elsewhere. Economic profit charges for all capital at its cost.
In words, economic profit is the return on invested capital minus the weighted average cost of capital, times the capital invested.
Worked example Twenty percent returns on $10 billion
A company earns a 20 % return on $10 billion of invested capital, and its capital costs 8 %. Its economic profit is , or $1.2 billion a year. A rival with the same capital earning 8 % makes accounting profits and zero economic profit: it covers its cost of capital and creates no value beyond it.
We value the moat as the present value of future economic profit. Let the spread between ROIC and WACC start at and fall in a straight line to zero over years, so that year earns on capital , discounted at rate .
In words, the moat is worth the sum of each year's shrinking excess return on capital, discounted back to today.
Worked example A 12-point spread on $10 billion at 8 %
| How the spread behaves | Value of the excess returns |
|---|---|
| fades to zero over 3 years | $2.1 billion |
| fades to zero over 10 years | $4.9 billion |
| fades to zero over 20 years | $7.6 billion |
| holds for 10 years, then stops | $8.1 billion |
Stretching the fade from three years to twenty multiplies the value more than three times. Much of the gap between a company trading at fifteen times earnings and one trading at thirty is a market view about how long such a spread will last.
For readers who want past episodes run through the Level 3 math.
1973 The Arab oil embargo
From October 1973 to March 1974, Arab members of OPEC cut exports and embargoed shipments to the United States and some other countries. The price of crude roughly quadrupled over a few months (US Energy Information Administration).
Run this through the shift formula. Drivers and factories could not change their use of oil quickly, so short-run demand elasticity was small, and output elsewhere could not rise fast either. With supply responding little, a supply cut of 5 % needs a price rise of +50 % at a demand elasticity of −0.1. A fourfold rise points to a mix of a real supply cut, an even lower short-run elasticity and fear-driven buying to build stocks. Over the following years elasticities rose: cars became more efficient and power plants switched fuels, which is the long-run response the curve model predicts.
2014 OPEC declines to cut output
On 27 November 2014 OPEC chose to keep its production target unchanged in the face of rising US shale output. Brent crude, already falling, dropped from $115.19 a barrel on 19 June 2014 to $45.13 on 13 January 2015, a fall of −61 % (EIA via FRED).
Between the last trading day before the meeting, 26 November, and the first after it, 28 November, Brent fell −7.1 %. US shale had added supply for several years, and the market had expected OPEC to offset it. When it did not, the supply curve stayed further right than expected.
We can ask what size of shift the whole fall implies. With short-run elasticities of −0.1 for demand and 0.05 for supply, a −61 % fall implies a glut of 9.2 % of the market; with elasticities twice as large, 18.3 %. Either number is large for the world oil market, which suggests the price also fell on a change in expectations: traders came to believe the glut would last, and the futures curve priced it in.
2020 WTI crude settles at minus $37.63
On 20 April 2020 the May futures contract for West Texas Intermediate crude settled at −$37.63 a barrel on the New York Mercantile Exchange (CME Group). Lockdowns had cut fuel demand, and storage at Cushing, Oklahoma, the contract's delivery point, was close to full.
The EIA's spot price series shows the same day: $18.31 on 17 April, −$36.98 on 20 April and $8.91 on 21 April, a fall of $55.29 in one session. A negative price means sellers paid buyers to take oil. That makes sense once storage counts as part of supply. A holder of the expiring contract had to take delivery at Cushing, and with tanks nearly full, the cost of storing a barrel exceeded the barrel's value. Supply was close to vertical in the short run, because shutting a well is costly and slow, so the demand shift pushed the price through zero. The next contract month, with time for storage to clear, stayed positive. Funds that held the expiring contract were hit hard, a case Chapter 13 works through with the roll.
In each episode a modest change in physical quantities moved the price by a large fraction, because both curves were steep in the short run. That is the main lesson of elasticity for investors: in markets for necessities with slow supply, price risk is large and comes in bursts. It also explains why energy producers rarely keep a moat for long. Their product is a commodity, so they sit near the perfect-competition end of the spectrum, and their returns rise and fall with a price they do not set.
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