MANECON Midterms Reviewer PDF

Chapter 5: Investment Decisions A positive NPV is both necessary and a sufficient condition for an investment to be All investment decisions involve a trade- profitable off between current sacri...

Chapter 5: Investment Decisions A positive NPV is both necessary and a sufficient condition for an investment to be All investment decisions involve a trade- profitable off between current sacrifice and future When using shortcuts, make sure that you gain understand the context in which the Before investing, we need to know that shortcut is being used and that it gives the future benefits > current costs – to same answer as NPV analysis know this we use discounting Break-Even Analysis Discounting: - Can give you the wrong answer as it Present value = future value/(1+r)k ignores the time value of money - Easy to do and generates simple, Compounding: opposite of discounting intuitive answers Future value = present value x (1+r)k If you sell more than the break-even Rule of 72 = interest rest x time it takes quantity, then you earn a profit (MR > MC) - The higher the interest rates, money will If you sell less than the break-even double in a short amount of time quantity, then you don’t earn a profit (MR < MC) CV IR Yrs FV Rate*Time $100 2.00% 36.0 $204 72 Formulas: $100 4.00% 18.0 $203 72 Break-even quantity = FC/(P-MC) $100 6.00% 12.0 $201 72 Break-even price = FC + MC/Q $100 7.20% 10.0 $200 72 $100 10.00% 7.2 $199 72 Break-Even Quantity – quantity that will lead $100 12.00% 6.0 $197 72 to zero profit $100 15.00% 4.8 $196 72 Each unit sold earns the contribution margin (P-MC) – amount that one sale Use discounting to determine whether contributes to profit the investment is profitable Do not use break even analysis to justify NPV Rule: higher prices or more output - Discount + future benefits and compare with the current cost of the investment Pricing and production – extent - If difference is positive, investment decisions that require marginal analysis, earns more than cost of capital not break-even analysis - Managers sometimes reason that they Ex.: must raise price to cover fixed costs Both projects require an initial investment of and that since average fixed costs $100. Project 1 returns $115 at the end of the decline with quantity, they must sell as first year. Project 2 returns $60 at the end of much as they can reduce average cost first year and $60 at the end of the second. The company’s cost of capital is 14% Shut Down Decisions and Break-Even Prices Project 1 Project 2 Shut down decisions – work with break-even YR CF PV CF PV prices rather than quantities 0 -100.00 -100.00 -100.00 -100.00 If you shut down, you lose revenue, but get 1 115.00 100.88 60.00 52.63 back you avoidable costs 2 0.00 0.00 60.00 46.17 If revenue < avoidable cost or if price < NV 15.00 0.88 20.00 -1.20 average avoidable cost, shut down Project 1 earns more than the cost of Break-Even Price – average avoidable cost per capital while Project 2 does not unit Positive NPV of project 1 = return is higher than 14% Ex. Fixed cost is $100/year, MC is $5/year, Negative NPV of project 2 = return is producing 100 units/year lower than 14% Short run: MC is only avoidable (variable costs) NPV Rule illustrates link between - Shut down price is $5 economic profit Long run: - Projects with positive NPV create MC and FC are avoidable (fixed and variable economic profit because they earn costs) more than the company’s opportunity - Shut down price is $6 cost of capital Sunk Costs and Post-Investment Hold Up Internal rate of return (IRR) – close cousin of Before investing, look ahead and reason NPV analysis and is the discount rate that sets back NPV equal to zero Economics is a dismal science Break-Even Analysis Post-Investment Hold Up NPV analysis is the correct way to evaluate investment decisions  Sunk costs are unavoidable, even in the long run, after incurring sunk costs, you are vulnerable to post-investment hold- up Profit = Revenue – Cost Quantity x Price – Quantity (Cost/Quantity) Quantity (Price – Average Cost) If cost includes all cost, including opportunity cost, then you are breaking even when P=AC Ex. For a magazine, using a regional printer reduces shipping costs but to print a high- quality magazine, the printer must buy a $12 million rotogravure printing press. Firm has no capital cost. MC of printing a single copy is $2 and the printer expects to print one million copies per year over a two-year period Compute the average cost of printer over the length of the contract Yr Quan. SC VC ($2/Unit) 0 12,000,000 1 1,000,000 2,000,000 2 1,000,000 2,000,000 Tl 2,000,000 12,000,000 4,000,000 Ave. $6 $2 AC $8 The One Lesson of Business: Figure out how to profitably consummate the transaction between the printer and the magazine Hold-up can occur only if costs are sunk In general, many investments are vulnerable to hold-up. Anytime that one party makes a specific investment Specific Investment – one that is sunk or lacks value outside of a trading relationship Trading Relationship – the party can be held up by its trading partner If one party anticipates that she is at risk of being help up, she will be reluctant to make relationship-specific investments, or demand costly safeguards Goal: ensure each party has both the incentive to make relationship-specific investments and to trade after these investments have been made Contracts should encourage both investment and trade Long-term contracts induce higher levels of relationship-specific investments Solution to Post-Investment Hold-Up: Anticipate hold-up and choose contracts or organizational forms that give each party both the incentive to make sunk-cost investments and to trade after these investments are made Chapter 6: Simple Pricing Consumers’ price sensitivity: relatively low Elasticity: < 1 Pricing is an extent decision - Reduce price (increase quantity) MR > MC - Increase price (decrease quantity) MC > MR - Optimal price MR = MC Law of Demand – consumers demand more as price falls, assuming all other factors are held constant - Price and quantity demand inverse relationship 3. Unit elastic demand - Consumer purchases more as price falls % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 10% Consumers make consumption decisions 𝑃𝐸𝐷 = = =1 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% using marginal analysis, consume more if marginal value > price Demand curve: immediate slope Marginal value of consuming each Consumers’ price sensitivity: intermediate subsequent unit diminishes the more you Elasticity: 1 consume Consumer surplus = value to customer – price paid - As price declines, consumer surplus, the difference between total value and amount paid increases Fundamental Trade Off: Lower price -> sell more, but earn less on each unit sold Higher price -> sell less, but earn more on each unit sold 4. Elastic Demand Demand curves – functions that relate the price % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 > 10% 𝑃𝐸𝐷 = = =>1 of a product to the quantity demanded by % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% consumer Demand curve: relatively flat Variety of Demand Curves Consumers’ price sensitivity: relatively high Elasticity: > 1 Rule of thumb: The flatter the curve, the bigger the elasticity The steeper the curve, the smaller the elasticity 1. Perfectly inelastic demand % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 0% 𝑃𝐸𝐷 = = =0 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% Demand curve: vertical 5. Perfectly Elastic Demand Consumers’ price sensitivity; 0 Elasticity: 0 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑎𝑛𝑦% 𝑃𝐸𝐷 = = = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 0% Demand curve: horizontal Consumers’ price sensitivity: extreme Elasticity: infinity 2. Inelastic demand % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 < 10% 𝑃𝐸𝐷 = = =< 1 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% Demand curve: relatively steep Elasticity of a Linear Demand Curve The slope of a linear demand curve is The fall in revenue from lower Q is constant, but its elasticity is not greater than the increase in revenue from higher P so revenue falls Aggregate / market demand curve – received when we add up all the individual demand Inelastic – quantity changes less than price curves to describe the buying behavior of a 𝐼𝑓 |𝑒| < 1, 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑠 𝑖𝑛𝑒𝑙𝑎𝑠𝑡𝑖𝑐 group of customers - Relationship between the price and the The fall in revenue from lower Q is less number of purchases made by this than the increase in revenue from higher group of consumers P so revenue rises Marginal Analysis of Pricing Compute for percentage change in price and quantity If marginal revenue (MR) is greater than marginal cost = sell more – you do this Midpoint method: by reducing price start value – end value / average of start and end value Ex. How to use marginal analysis to increase profit Price elasticity of demand: - Measures how much Qd responds to a Suppose that the product costs $1.50 to make. change in P At a price of $7, one consumer would purchase, e = % change in quantity / % change in price so revenue would be $7. Cost would be $1.50, so profit on the first sale would be $5.50 e > 1 – demand is elastic - Quantity changes more than price - Price increases, revenue will decrease - Price decreases, revenue will increase e < 1 – demand is inelastic - Quantity changes less than price - Price increases, revenue will increase - Price decreases, revenue will decrease - Second unit, reduce price to $6 for Ex.: The store’s manager decreased the price of revenue to increase to $12 and MR to three-liter Coke from $1.79 to $1.50 because $5 – profit increases to $9.00 they wanted to match a price offered at a - Third unit, reduce price to $5 for nearby Walmart. In response to the price drop, revenue to increase to $15 and MR to the quantity sold doubled, from 210 to 420 units $3 – profit increase to $10.50 per week. Average revenue or price vs Marginal (210 − 420) revenue 𝑒= 315 (1.79 − 1.50) 1.645 As long as price is greater than average −0.6667 cost, it appears that an increase in quantity = 0.1763 would increase profits (WRONG) 𝑒 = −3.8 - Reasoning is incorrect as you cannot sell more without reducing price on Price elasticity is -3.8 = elastic demand all goods, and not just on the extra 1% decrease in price of three-liter Coke units your boss wants to sell leads to a 3.8% increase in quantity Marginal analysis – tells you where to price or The change resulted to the change in revenue: equivalently, how many units to sell ($1.50 x 420) - ($1.79 x 210) = 630 - 375.9 = - Finds the profit increasing solution to $254.10 the pricing tradeoff - Tells you which direction to go, but not 𝑴𝑹 = 𝑷(𝟏$𝟏) - exact numerical relationship how fare to go |𝒆| between MR (change in revenue) and elasticity Profit is maximized when MR = MC - If MR > 0, then total revenue will Marginal analysis rule using price elasticity: increase if you sell one more MR > MC implies that (P – MC)/P > 1/|𝒆| - If MR > MC, then total profit will increase if you sell one more Left side = current margin Right side = desired margin, which is Price Elasticity and Marginal Revenue the inverse elasticity 𝑒 = %Δ𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 ÷ %∆𝑃𝑟𝑖𝑐𝑒 Price Elasticity and Total Revenue Elastic – quantity changes more than price Revenue = P x Q 𝐼𝑓 |𝑒| > 1, 𝑑𝑒𝑚𝑎𝑛𝑑 𝑖𝑠 𝑒𝑙𝑎𝑠𝑡𝑖𝑐 Two effects of price increase on revenue: 1. Products with close substitutes have more 1. Higher price means more revenue on elastic demand each unit you sell Consumers respond to a price increase 2. But you sell fewer units (lower quantity), by switching to their next-best due to Law of Demand alternative If next best alternative is very close What Determines Price Elasticity? substitute, then it doesn’t take much price increase to make consumers 1. Price Elasticity is higher when close switch substitutes are available 2. Demand for an individual brand is more elastic than industry aggregate demand As a rough estimate, brand price elasticity is approximately equal to industry price elasticity divided by the brand share Industry price elasticity estimates that you can combine with market share estimates to get an estimate of brand elasticity 2. Price elasticity is higher for narrowly 3. Products with many complements have defined goods than broadly defined ones less elastic demand Individual products that are consumed as part of a larger bundle of complementary goods have less elastic demand Ex.: If the price of an iPhone increases, you are less likely to substitute to another product because of the complementary apps 4. In the long run, demand curves become more elastic 3. Price elasticity is higher for luxuries than Time – factor affecting elasticity for necessities Given more time, consumers are more responsive to price changes. They have more time to find substitutes when price goes up and more time to find new uses for a good when price goes down As time passes, information about a new price becomes more widely known, so more consumers react to the change 5. As price increases, demand becomes 4. Price elasticity is higher in the long run more elastic than the short run Elasticity is related to price As price increases, consumers find more alternatives to the good whose price has gone up More substitutes, demand becomes more elastic Forecasting Demand Using Elasticity 𝐹𝑎𝑐𝑡𝑜𝑟 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = The Determinants of Price Elasticity: (%∆𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑) ÷ %∆𝐹𝑎𝑐𝑡𝑜𝑟 The extent to which close substitutes are available Factors can be anything that affects Whether the good is a necessity or a demand, such as temperature, other luxury prices, or incomes How broadly or narrowly the good is defined Income Elasticity of demand – measures the The time horizon: elasticity is higher in change in demand arising from changes in the long run than the short run income - Measures the response of Qd to a change in consumer income What Makes Demand More Elastic? The more elastic is demand, the lower is %∆ 𝑖𝑛 𝑄𝑑 the profit-maximizing price 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = %∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 Positive Income Elasticity – good is normal The Rule of Thumb: - Income increases, demand increase The flatter the curve, the bigger the - Income decrease, demand decreases elasticity The steeper the curve, the smaller the Negative Income Elasticity – good is inferior elasticity - Income increases, demand decreases - Income decreases, demand increases 1. Perfectly Inelastic Cross Price Elasticity of Demand % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 0% 𝑃𝐸𝐷 = = =0 - Measures the response of demand for % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% one good to changes in the price of another good Supply curve: vertical Sellers’ price sensitivity: 0 %∆ 𝑖𝑛 𝑄𝑑 𝑓𝑜𝑟 𝑔𝑜𝑜𝑑 1 Elasticity: 0 𝑐𝑟𝑜𝑠𝑠 𝑝𝑟𝑖𝑐𝑒 𝐸𝐷 = %∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 2 Positive Cross Price Elasticity – goods are substitute - substitute Price increase, demand increases Negative Cross Price Elasticity – goods are complements - complement price increases, demand decreases 2. Inelastic Marginal analysis – finds the profit increasing solution to the pricing tradeoff % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 < 10% 𝑃𝐸𝐷 = = =< 1 - tells to whether increase or decrease % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% the price but not how far to go Supply curve: relatively steep Stay-Even Analysis, Pricing, and Elasticity Sellers’ price sensitivity: relatively low Elasticity: < 1 Stay-Even Analysis – simple two step procedure that tells you whether a given price increase will be profitable - give quick answer to the question of whether changing price is profitable - can be used to determine the quantity change required to offset a price change %∆* Stay-Even Quantity = %∆𝑄 = (%∆*+,-./01) 3. Unit Elastic Decision Rule: If the predicted quantity is less than the stay-even quantity, then the price % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 10% increase will likely be profitable and vice versa 𝑃𝐸𝐷 = = =1 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% A proposed price increase is profitable if Supply curve: intermediate slope the predicted quantity loss is less than the Sellers’ price sensitivity: intermediate stay-even quantity Elasticity: 1 Cost-Based Pricing Expression (MR = MC / (P-MC = 1/|𝒆|) takes into account the firm’s cost structure and its consumer demand The consumer side is ignored in pricing decisions, leading to cost-based pricing Firms do not have the demand picture and need to invest in a market research division to take profitability seriously Price Elasticity of Supply - Measures how much 𝑄 2 responds to a 4. Elastic change in P - Measures the price-sensitivity of sellers’ % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 > 10% 𝑃𝐸𝐷 = = => 1 supply % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 10% % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 2 𝑃𝐸𝑆 = Supply curve: relatively flat % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 Sellers’ price sensitivity: relatively high The Variety of Supply Curves Elasticity: > 1  b. 50% 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 20% 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 2.50 Since our IED is 2.50 and is positive, it means that it is a normal good. 5. Perfectly Elastic % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄 𝑎𝑛𝑦 % 𝑃𝐸𝐷 = = = 𝑖𝑛𝑓𝑖𝑛𝑖𝑡𝑦 % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃 0% Supply curve: horizontal Sellers’ price sensitivity: extreme Elasticity: infinity The Determinants of Supply Elasticity The more easily sellers can change the quantity they produce, the greater the price elasticity of supply Price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market How the Price Elasticity of Supply Can Vary Supply often becomes less elastic as quantity rises, due to capacity limits PROBLEM: Calculate your income elasticity of demand as the income increases from 10,000 to 12,000 if (a) the price is 12 and if (b) the price is 16 %∆ 𝑖𝑛 𝑄𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = %∆ 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 a. 25% 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 20% 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 = 1.25 Since our IED is 1.25 and is positive, it means that it is a normal good. Chapter 7: Economies of Scale and Scope In the presence of fixed costs, increasing Law of Diminishing Marginal Returns – states marginal cost gives you a U-shaped that as you expand output, your marginal average cost curve productivity eventually declines The curve initially falls due to the presence of fixed costs, but then it rises due to Marginal Productivity – the extra output increasing marginal costs associated with extra inputs Increasing marginal costs eventually causes an increase in average costs and Diminishing Marginal occurs: make it more difficult to compute break- Difficulty of monitoring and motivating even prices larger workforces The increasing complexity of larger When negotiating contracts, it is important systems to know what your costs curves look like; Fixed nature of some factors otherwise, you could end up accepting These are known as “bottlenecks” contracts with unprofitable prices Bottlenecks – often arise when more workers Economies of Scale or any variable input, must share a fixed amount Law of diminishing marginal returns is of a complementary input primarily a short run phenomenon arising When productivity falls from bottlenecks, from the fixity of at least on factor of costs increase production (capital or pant size) Diminishing marginal returns -> marginal In the long run, you can increase plant, hire productivity declines more workers, purchase more machines, and remove production bottlenecks Diminishing marginal productivity -> increasing marginal costs Definition: short run “fixity” vs long run “flexibility” Diminishing marginal productivity implies increasing marginal cost Fixed costs become variable costs in the - If more inputs are needed to produce long run each extra unit of output, then the cost of producing these extra units o In the long run, average costs are constant (marginal costs) must increase with the output, you have constant returns to the scale Ex. Average cost to produce 100 units cost $50 per unit. If marginal cost of the 101st unit is more o In the long run, average costs are than $50, overall average cost will increase increasing with the output, you have decreasing returns to scale or diseconomies of scale o In the long run, average costs are decreasing with the output, you increasing returns to scale or economies of scale Economies of Scale – result from: - Larger firms can benefit more from capital equipment - Average cost decrease as volume increase and fixed costs are unchanged Increasing marginal costs eventually lead - Larger firms may purchase economies if to increasing average costs they receive discounts for buying in larger quantities Ex. Baseball player’s season batting average - Average costs associated with shared will increase if his game batting average is administrative services can also fall as above is season batting average, so too does output increase average cost rise if marginal cost is above the average Same factors that cause diminishing marginal returns, in the short run, can also cause decreasing returns to scale in the long run Learning Curves - Characteristics of many processes - Means that current production lowers future costs As you produce more, you learn from When marginal cost rises above average, the experience, this experience helps you average cost rises produce future units at a lower cost Ex. Every time an airplane manufacturer doubles production, marginal cost decreases by 20%. If the first plane costs $100M, then the second will cost $80M, the fourth will cost $64M, the eighth will cost $51.2M Economies of Scope - If the cost of producing two outputs jointly is less than the cost of producing them separately Cost (Q1,Q2) < Cost(Q1) + Cost(Q2) Major cause of mergers: you want to exploit economies of scope by producing both Q1 and Q2 Diseconomies of Scope - If cost of producing two products together is higher than the cost of producing them separately - Basically, you reduce costs by pairing down the product line 80-20 Rule: 80% of a firm’s product comes from around 20% of its customers Because of big customers (20%) order in bulk, the manufacturers can set its extruders for long production run - Big orders are much more profitable than smaller orders because all orders require the same set up time Chapter 8: Understanding Markets and Industry Changes Ex. At every price, demand shifts to the right which increases by 4 units. At the price of $8, Setting a single price for a single product of quantity demanded is nine units compared to a firm is referred to as a monopoly model five (movement along the demand curve) of pricing Increase in substitute price, increase demand “Market” setting – how prices are for other product (shift of demand curve to the determined in an industry where many right) sellers and many buyers come together Note: Do not use demand and supply analysis for an individual firm The Market Forces of Supply and Demand Market – group of buyers and sellers of a particular product - Has a product, geographic, and time dimension At a given price, more quantity demanded Competitive market – one with many buyers = shift of the demand curve and sellers, each has a negligible effect of price Demand Schedule – a table that shows the Perfect competition – how prices are relationship between the price of a good and determined in an industry where many sellers the quantity demanded and many buyers come together in a market setting Ex. Helen’s demand for latte - Sellers must compete with one another in order to sell to buyers Price of Quantity of Latte Latte Demanded Perfectly competitive market: $0.00 16 All goods exactly the same $1.00 14 Buyers and sellers so numerous that no one can affect market price – price $2.00 12 taker $3.00 10 $4.00 8 Market Demand – describes buyer behavior $5.00 6 Market Supply – describes seller behavior in a $6.00 4 competitive market A. DEMAND Quantity Demanded – the amount of the good that buyers are willing and able to purchase Law of demand: quantity demand of a good falls when the price of the good rises and vice versa, holding all other things equal Uncontrollable Factor – something that affects demand that a company cannot control Market Demand vs Individual Demand Ex. Income, weather, interest rates, prices of substitute and complements owned by other The quantity demanded in the market companies is the sum of the quantities demanded by all buyers at each price Controllable Factor – something that affects demand that a company can control Ex. Suppose Helen and Ken are the two buyers Ex. Price, advertising, warranties, product in the Latte market (Qd = quantity demanded) quality, distribution speed, service quality and price of substitute and complements owned by the company A firm can manipulate controllable factors to increase demand for its products We have two variables on our demand graph: price and quantity – the only way to represent our third variable is with the shift of the demand curve  that good and shift the demand to the right Ex. The Atkins diet became popular in the 90s, caused an increase in demand for eggs, shifting the demand of egg to the right 5. Expectations Expectations affect consumers’ buying decisions Ex. If people expect their incomes to rise, their Demand Curve Shifters demand for expensive meals may increase The demand curve show price affects If the economy soars and people worry about quantity demanded, other things being their future job security, demand for new autos equal may fall “Other things” – are non-price determinants of Variables That Influence Buyers demand - Changes in other things shift the demand curve Factors That Shift The Demand Curve: 1. Number of Buyers B. SUPPLY Quantity Supplied – the amount that sellers are willing and able to sell Law of Supply: the claim that the quantity supplied of a good rises when the price of the 2. Income good rises and vice versa, holding other things Demand for a normal good is positively equal related to increase - Increase in income = increase in Supply curves – describe the behavior of a quantity demanded at each price group of sellers and tell you how much will be sold at a given price Demand for an inferior good is negatively - Slope upward – direct relationship: the related to income higher the price, the higher the quantity - Increase in income shifts demand curve supplied to the left - At higher prices, more suppliers are willing to sell 3. Prices of Related Goods Two goods are substitutes if an increase Like demand curves, supply curves shift in the price of substitute A cause an when a variable other than price changes increase in demand for substitute B - Entry and exit of firms along with changes in costs, technology, capacity Ex. Pizza and Hamburgers will all result in a shift of the supply - Increase in the price of pizza, increase curve demand of hamburgers If other sellers are situated similarly, the Two goods are complements if an aggregate supply curve will decrease or increase in the price of complement A shift upward (to the left) causes a decrease in demand for - Higher prices are necessary to induce complement B sellers to supply the same quantities. Alternatively, smaller quantities will be Ex. Pasta and Tomato Sauce made available at the previous price - Increase in the price of pasta, decreases demand of hamburgers 4. Tastes Anything that causes a shift in tastes toward a good will increase demand for  Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal “Other things” – are non-price determinants of supply - Changes in other things shift the supply curve 1. Input Price – price of raw materials A fall in input prices makes production Supply Schedule – a table that shows the more profitable at each output price, so relationship between the price of a good and firms supply a larger quantity at each the quantity supplied price, and the supply curve shifts to the right Ex. Starbucks’ supply of lattes Price of Quantity of Latte Latte Demanded $0.00 0 $1.00 3 $2.00 6 $3.00 9 $4.00 12 $5.00 15 $6.00 18 2. Technology - Determine how much inputs are required to produce a unit of output A cost-saving technological improvement, increases supply causing a shift in the supply to the right 3. Number of Sellers An increase in the number of sellers increases the quantity supplied at each price, shift supply curve to the right 4 Expectations Market Supply vs. Individual Supply Ex. Events in the Middle East lead to expectations of higher oil prices The quantity supplied in the market is the sum of the quantities supplied by all sellers In response, owners reduce supply at each price now, save some oil for inventory to sell later at a higher price Ex.: Suppose Starbucks and Jitters are the only Supply curves shifts to the left two sellers in this market (Qs = quantity supplied) In general, sellers may adjust supply when their expectations of future prices change Variables that Influence Sellers Supply and Demand Together Market Equilibrium – price at which quantity supplied equals quantity demanded At equilibrium price, there is no pressure for the price to change because the number of sellers equals the number of  buyers (quantity demanded = quantity supplied) In market equilibrium, there is no unconsummated wealth-creating transactions Supply and demand curves can be used to describe changes that occur at the industry level Ex. Initial equilibrium is $8. After demand shift, the new equilibrium is $10 Surplus (Excess Supply) – when quantity supplied is greater than quantity demanded Facing a surplus, sellers try to increase sales by cutting price, this would cause quantity demanded to rise and quantity supplied to fall At the old price of $8, there is excess demand (9-5=4, more buyers than sellers) which puts upward pressure on price until it settles at the new $10 equilibrium Ex. Model the increase in quantity of mobile phones and the decline in the price over the past decade Shortage (Excess Demand) – when quantity demanded is greater than quantity supplied Equilibrium – Price has reached the level where quantity supplied equals quantity demanded Facing a shortage, sellers raise the price, causing quantity demanded to fall Equilibrium Price – the price that equates and quantity supplied to rise quantity supplied with quantity demanded Equilibrium Quantity – the quantity supplied and quantity demanded at the equilibrium price Three Steps to Analyzing Changes in Equilibrium To determine the effects of any event, 1. Decide whether event shifts supply curve, demand curve or both 2. Decide in which direction curve shifts 3. Use supply-demand diagram to see how the shift changes equilibrium price and quantity EXAMPLE: The Market For Hybrid Cars 3. Price of gas rises and new technology reduces production costs - this means a shift in both the demand curve and the supply curve - demand curve shifts to the right as higher gas prices would make hybrids more attractive and supply curve shifts to the left as new technology that reduces cost would increase the production of hybrids 1. Increase in the price of gas - this means a shift in demand curve as - equilibrium quantity increase, but effect price of gas affects the demand for the on equilibrium price is uncertain; if hybrid car, no changes in the supply demand increase more than supply, curve as price of gas does not affect the price rises but if supply increases cost of hybrid cars more than demand, price falls - demand curve shifts to the right because high gas prices makes hybrids more attractive to other cars - shift causes an increase in price and quantity of hybrid cars Terms for Shifting vs Movement Along the Curve Change in Supply – shift in the supply curve occurs when a non-price determinant of supply changes 2. New technology reduces cost of producing Change in Quantity Supplied – a movement hybrid cars along a fixed supply curve occurs when price changes - this means a shift in supply curve as the new technology decreases the cost of Change in Demand – a shift in the demand production for the hybrid car, no curve occurs when a non-price determinant of changes in demand curve as new demand changes technology does not affect the demand of the new technology Change in Quantity Demanded – a movement along a fixed demand curve occurs when price - supply curve shifts to the right because changes new technology reduces the cost of producing hybrid cars hence, suppliers would increase the supply with decreased cost - shift causes a decrease in price and increase in quantity supplied PRACTICE PROBLEMS: Using the three-step method to analyze the 3. Events A and B both occur effects of each event on the equilibrium price and quantity of music downloads - demand and supply curve both shift - demand curve shifts to the left as CDs and music downloads are substitutes, a decrease in the price of CDs would lead to a decrease in demand of music downloads and supply curve shifts to the right as a reduction in royalties would lead to a reduction in cost when selling music downloads - equilibrium price and equilibrium quantity unambiguously falls 1. A fall in the price of CDs Conclusion: How Prices Allocate Resources - shift in the demand curve as price of Markets are usually a good way to CDs affects the demand of music organize economic activity downloaded - demand curve shifts to the left because In market economies, price adjust to decrease in price of CDs would make balance supply and demand. These decrease the demand of music equilibrium price – are signals that downloads as CDs and music guide economic decisions and thereby downloads are substitutes allocate scarce resources - equilibrium price decreases and Explaining Industry Changes Using Supply equilibrium quantity decrease and Demand The preceding analysis has asked you to predict what happens to price and quantity following increases or decreases in supply and demand or both Four changes that can occur: 1. Increase in supply 2. decrease in supply 3. Increase in demand 4. Decrease in Demand Prices Convey Information 2. Sellers of music downloads negotiate a Prices are a primary way that market reduction in the royalties they must pay for participants communicate with one each song they sell another Buyers signal their willingness to pay - supply curve shifts as reduction in Sellers signal their willingness to sell royalties reduces the cost of selling with prices music downloads Price information especially important in financial markets - supply curve shifts to the right as a reduction in the cost of royalties would Market Making lead to sellers selling more music Market maker – makes a market – by buying downloads low and selling high - Someone has to incur cost to identify - equilibrium price decreases, equilibrium high-value buyers and low value sellers, quantity increase bring them together, and devise ways of profitability facilitating transactions among them We are ignoring the costs of making market Buyer and sellers don’t simply appear in a trading pit and begin transacting with one another Single Market Maker – does not want to have too much or hold too much inventory - Has to pick prices that equalize quantity supplied and demanded  Market maker faces a familiar trade off - Can consummate fewer transactions but earn more on each transaction - Can consummate more transactions, but earn less on each transaction