EMBA 511 Economics for Managers PDF

EMBA 511 Economics for Managers The Interaction of Demand and Supply  The market forces of supply and demand...

EMBA 511 Economics for Managers The Interaction of Demand and Supply  The market forces of supply and demand When there is a longer and colder winter in Florida, the price of oranges in supermarkets across the US increases. When there is political tension in the Arab world, the price of fuel increases and there is a drop in car sales. When the weather is warm in England, there is a drop in the price of hotels in Spain. All these show the workings of supply and demand. Supply and demand are the forces that make market economies work. They determine the quantity of each Source: Bloomberg, Telegraph, Floridacitrus.org good produced and the price at which it is sold. A Water Bottle as a Status Symbol? In recent years, reusable water bottles have become fashionable; for example: WSJ referred to Stanley Quencher as “the new office status symbol.” The Yeti Rambler is a “cult favorite.” Some “smart” water bottles even interact with smartphone apps. How do these changes in tastes affect prices and quantities? Copyright © 2025, 2021, 2018 Pearson Education, Inc. All Rights Reserved Our Model of a Market To analyze the market for Nike athletic shoes or anything else, we need a model of how buyers and sellers behave. The model we use in this chapter is a perfectly competitive market, a market with (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. While these assumptions are quite restrictive, the model is still useful for analyzing many markets. The Demand Side of the Market List and describe the variables that influence demand. We begin our analysis of where prices come from by investigating how buyers behave. We refer to this as market demand, the demand by all the consumers of a given good or service. A Demand Schedule and Demand Curve (1 of 3) Demand schedule: A table that shows the relationship between the price of a product and the quantity of the product demanded. Demand curve: A curve that shows the relationship between the price of a product and the quantity of the product demanded. A Demand Schedule and Demand Curve (2 of 3) Quantity demanded: The amount of a good or service that a consumer is willing and able to purchase at a given price. Law of demand: A rule that states that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. What Explains the Law of Demand? When the price of a good falls, two effects take place: 1. Consumers substitute toward the good whose price has fallen. 2. Consumers have more purchasing power, which is like an increase in income. We call these the substitution effect and the income effect: Substitution effect: The change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods, holding constant the effect of the price change on consumer purchasing power. Income effect: The change in the quantity demanded of a good that results from the effect of a change in the good’s price on a consumer’s purchasing power, holding all other A Demand Schedule and Demand Curve (3 of 3) When drawing the demand curve, we assume ceteris paribus. Ceteris paribus (“all else equal”) condition: The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant. Shifting the Demand Curve (1 of 2) A change in something other than price that affects demand causes the entire demand curve to shift. A shift to the right (D1 to D2 ) is an increase in demand. A shift to the left (D1 to D3 ) is a decrease in demand. Shifting the Demand Curve (2 of 2) As the demand curve shifts, the quantity demanded will change, even if the price doesn’t change. The quantity demanded changes at every possible price. Variables That Shift Market Demand Income An increase in income increases demand if the product is normal, and decreases demand if the product is inferior. Prices of related goods An increase in the price of related goods increases demand if products are substitutes, and decreases demand if products are complements. Tastes Population and demographics Expected future prices Natural Disasters and Pandemics Congestion Network effect Changes in Income of Consumers Normal good: A good for which the demand increases as income rises and decreases as income falls. Examples New clothes : Restaurant meals Vacations Inferior good: A good for which the demand increases as income falls and decreases as income rises. Examples Second-hand clothes : Instant noodles Effects of Changes in Income An increase in income would increase the demand for new clothes, ceteris paribus. However, the same increase in income would likely decrease the demand for second-hand clothes. Changes in the Price of Related Goods Substitutes: Goods and services that can be used for the same purpose. Examples Big Mac and Whopper : Ford F-150 and Dodge Ram Reusable water bottles and bottled spring water Complements: Goods and services that are used together. Examples Big Mac and McDonald’s fries : Left shoes and right shoes Reusable water bottles and gym memberships Effects of Changes in the Price of Related Goods An increase in the price of a Pepsi would increase the demand for Coke However, the increase in the price of toothbrushes would decrease the demand for toothpastee. Changes in Tastes Tastes If consumers’ tastes change, they may buy more or less of the product. Example: If influencers successfully advertise reusable water bottles, they affect consumers’ tastes, increasing demand for reusable water bottles. Changes in Population/Demographics Demographics: The characteristics of a population with respect to age, race, and gender. Increases in the number of people buying something will increase the amount demanded. Example: An increase in the elderly population increases the demand for medical care. Millennials and Gen Z Are Changing Existing Markets Millennials (born 1981- 1996) and Gen Z (born 1997-2012) have different tastes than prior generations. These groups are more likely than older generations to own reusable water bottles. WSJ: “Canned tuna is struggling to connect with younger generations.” Harley Davidson’s “greatest challenge is to bring younger people Changes in Expectations About Future Prices Consumers decide which products to buy and also when to buy them. Future products are substitutes for current products. An expected increase in the price tomorrow increases demand today. An expected decrease in the price tomorrow decreases demand today. Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today. Natural Disasters and Pandemics (1 of 3) Temporary disruptions to economic activity can happen via natural disasters or pandemics. Natural disaster: (in an economic context) A hurricane, flood, or similar act of nature that causes damage to stores, factories, or office buildings. Pandemic: (in an economic context) A situation in which a disease becomes sufficiently widespread as to significantly affect economic activity. Natural Disasters and Pandemics (2 of 3) Example: The Covid-19 pandemic reduced the demand for goods that required people gathering (restaurants, concert tickets, etc.) but increased the demand for computing equipment to work from home. A Change in Demand versus a Change in Quantity Demanded A change in the price of the product being examined causes a movement along the demand curve. This is a change in quantity demanded. Any other change affecting demand causes the entire demand curve to shift. This is a change in demand. The Supply Side of the Market List and describe the variables that influence supply. There are some similarities, and some important differences, between the demand and supply sides of the market. In this section, we examine the market supply, i.e., the decisions of (generally) firms about how much of a product to provide at various prices. A Supply Schedule and Supply Curve (1 of 2) Supply schedule: A table that shows the relationship between the price of a product and the quantity of the product supplied. Supply curve: A curve that shows the relationship between the price of a product and the quantity of the product supplied. A Supply Schedule and Supply Curve (2 of 2) Quantity supplied: The amount of a good or service that a firm is willing and able to supply at a given price. Law of supply: A rule that states that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied. Shifting the Supply Curve (1 of 2) A change in something other than price that affects supply causes the entire supply curve to shift. A shift to the right (S to S ) 1 3 is an increase in supply. A shift to the left (S to S ) 1 2 is a decrease in supply. Shifting the Supply Curve (2 of 2) As the supply curve shifts, the quantity supplied will change, even if the price doesn’t change. The quantity supplied changes at every possible price. What Variables Shift Market Supply? Prices of inputs Technological change Prices of related goods in production Number of firms in the market Expected future prices Natural disasters and pandemics We will discuss how each of these affect supply. Change in Prices of Inputs Inputs are anything used in the production of a good or service. For a reusable water bottle, this includes plastic, labor, and transportation services. An increase in the price of input decreases the profitability of selling the good, causing a decrease in supply. A decrease in the price of an input increases the profitability of selling the good, causing an increase in supply. Technological Change A firm may experience a positive or negative change in its ability to produce a given level of output with a given quantity of inputs. We call this a technological change. Examples: A new, more efficient way of producing water bottles would increase their supply. Governmental restrictions on how much workers are allowed to work might decrease the supply of water bottles. Prices of Related Goods in Production Many firms can produce and sell alternative products: substitutes in production. Example: An Illinois farmer can plant either corn or soybeans. If the price of soybeans rises, that farmer will plant (supply) less corn. Sometimes, two products are necessarily produced together: complements in production Example: Cattle provide both beef and leather. An increase in the price of beef encourages more cattle farming, which increases the supply of leather. Number of Firms and Expected Future Prices More firms in the market will result in more products available at a given price (greater supply). Fewer firms supply decreases. If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it later. Natural Disasters and Pandemics (3 of 3) Less of a good will be supplied due to disruptions in production Example: During hurricanes and floods, some manufacturing plants will be damaged and forced to shut down. The result will be fewer units supplied. Fracking, the U.S. Oil Boom, and Expected Oil Prices The development of hydraulic fracturing (fracking) disrupted the world oil market, propelling the U.S. to be the world’s largest oil producer. In 2016 and during the Covid-19 pandemic, U.S. oil producers believed the price of oil was temporarily low. Each time they reduced current production, intending to sell more later when prices recovered. A Change in Supply Versus a Change in Quantity Supplied A change in the price of the product being examined causes a movement along the supply curve. This is a change in the quantity supplied. Any other change affecting supply causes the entire supply curve to shift. This is a change in supply. Market Equilibrium: Putting Demand and Supply Together Market equilibrium is a situation in which quantity demanded equals quantity supplied. Recall that markets with many buyers and sellers are perfectly competitive markets; a market equilibrium in one of these markets is called a competitive market equilibrium. There ~ 100 firms selling reusable water bottles; we are will assume this is enough to generate competitive behavior in the market for reusable water bottles. Market Equilibrium At a price of $20, consumers want to buy 5 million water bottles per week, and producers want to sell 5 million water bottles per week. We say the equilibrium price in this market is $20, and the equilibrium quantity is 5 million reusable water bottles per week. Since buyers and sellers want to trade the same quantity at the price of $20, we do not expect the price to change. The Effect of Surpluses and Shortages on the Market Price (1 of 2) What if the price were $25 instead? At a price of $25, consumers want to buy 4 million water bottles, while producers want to sell 6 million water bottles. This gives a surplus of 2 million water bottles: a situation in which the quantity supplied is greater than the quantity demanded. Prediction: Sellers will compete among themselves, driving the price down. The Effect of Surpluses and Shortages on the Market Price (2 of 2) Now what if the price were $10? At a price of $10, consumers want to buy 7 million water bottles, while producers want to sell 3 million. This gives a shortage of 4 million water bottles: a situation in which the quantity demanded is greater than the quantity supplied. Prediction: Sellers will realize they can increase the price and still sell as many water bottles, so the price will rise. Demand and Supply Both Count Price is determined by the interaction of buyers and sellers. Neither group can dictate price in a competitive market (i.e., one with many buyers and sellers). However, changes in supply and/or demand will affect the price and quantity traded. The Effect of Demand and Supply Shifts on Equilibrium Predictions about price and quantity in our model require us to know demand and supply curves. Typically, we know price and quantity but do not know the curves that generate them. The power of the demand and supply model is in its ability to predict directional changes in price and quantity. The Effect of an Increase in Demand on Equilibrium Suppose incomes increase. What happens to the equilibrium in the reusable water bottle market? Reusable water bottles are a normal good, so as income rises, demand shifts to the right (D1 to D2 ). Equilibrium price rises (P1 to P2 ). Equilibrium quantity rises (Q1 to Q2 ). The Effect of an Increase in Supply on Equilibrium (1 of 2) The graph shows the market for reusable water bottles as a new producer, Yeti, enters the market. When Yeti enters, more water bottles are supplied at any given price—an increase in S1 to S2. supply from Equilibrium price falls from P1 to P2. Equilibrium quantity rises Q1 to Q2. The Effect of an Increase in Supply on Equilibrium (2 of 2) By how much will the price fall? By how much will quantity rise? We cannot say, without knowing more information. For now, we can only predict that price will fall and quantity will rise. How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q) (1 of 2) Supply Curve Supply Curve Supply Curve Blank Shifts to the Shifts to the Unchanged Right Left Demand Curve Q unchanged Q increases Q decreases Unchanged P unchanged P decreases P increases Demand Curve Q increases Shifts to the Blank Blank Right P increases Demand Curve Q decreases Shifts to the Blank Blank Left P decreases Shifts in Demand and Supply Over Time (1 of 3) Over time, it is likely that both demand and supply will change. For example, as new firms enter the market for water bottles and incomes increase, we expect: The supply curve will shift to the right, and The demand curve will shift to the right. Shifts in Demand and Supply Over Time (2 of 3) What does our model predict? S  (P  and Q  ) D  (P  and Q  ) So we can be sure equilibrium quantity will rise, but the effect on the equilibrium price is not clear. This panel shows demand shifting more than supply: equilibrium price and quantity both rise. Shifts in Demand and Supply Over Time (3 of 3) This panel shows supply shifting more than demand: quantity rises, but equilibrium price falls. Without knowing the relative size of the changes, the effect on the equilibrium price is ambiguous. It is possible, but unlikely, that the equilibrium price will remain unchanged. How Shifts in Demand and Supply Affect Equilibrium Price (P) and Quantity (Q) (2 of 2) Supply Curve Supply Curve Supply Curve Blank Shifts to the Shifts to the Unchanged Right Left Demand Curve Q unchanged Q increases Q decreases Unchanged P unchanged P decreases P increases Q increases Q increases, Demand Curve Q increases P increases, decreases, or is Shifts to the P increases decreases, or is unchanged Right unchanged P increases Q increases, Q decreases Demand Curve Q decreases decreases, or is P increases, Shifts to the P decreases unchanged decreases, or is Left P decreases unchanged The cell in red is the example that we just saw.