Number 2

Chapter 2

Demand and Supply

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All businesses perform essentially the same function—producing goods or services for sale in the market. Unfortunately, many businesses fail because managers sweat the day-to-day details while losing sight of the firm’s primary objective—maximizing shareholder value. A manager who becomes mired in the firm’s operational minutia and ignores market trends courts financial disaster.

In this chapter, we will examine how the interaction of buyers and sellers in competitive markets determine prices and availability of goods or services. The market mechanism discussed in this chapter makes several simplify-ing assumptions. We begin by assuming that the market consists of a large number of relatively small buyers and sellers with complete and symmetrical information. Since their respective contributions are very small, the decisions made by individual buyers or sellers have no effect on the market-determined price. In other words, individual buyers and sellers are said to be price takers.

DEMAND

A market is any arrangement that brings together buyers and sellers. The market demand curve is the horizontal summation of individual consum-ers’ demand curves.1 According to the law of demand, which pertains to market (not individual) demand, the quantity demanded of a good or service is inversely related to its price, ceteris paribus . This relationship is depicted as the downward-sloping demand curve in Figure 2.1. A decline in the market price of good x from P1 to P2, for example, results in an increase in quan-tity demanded from Q1 to Q2. This relationship is described as a movement along a stationary demand curve from point A to point B. At a basic level,

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22 Chapter 2

Figure 2.1 

the law of demand can be justified on the basis of common sense and simple observation.

Income and Substitution Effects

At a more subtle level, the law of demand reflects the income and substitu-tion effects of a buyer’s purchasing decisions. The income effect says that as a product’s price declines, a buyer’s real purchasing power increases. By contrast, an increase in prices reduces a buyer’s real income and purchasing power. We will have more to say about the relationship between changes in income and demand in the next section.

The substitution effect says that when there is no change in real purchas-ing power, an increase in the price of a good will cause buyers to unambigu-ously shift their purchases into a relatively less expensive substitutes. The substitution effect reflects changes in a consumer’s opportunity costs from the price change.

The income and substitution effects usually complement and reinforce each other. A price decline, for example, will have both positive income and substitution effects, in which case there is no question that the ordinary demand curve will be downward sloping. In some cases, however, a price decline will result in a negative income effect. Fortunately, the positive sub-stitution effect almost always dominates, which gives the demand curve its expected downward slope.

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Demand and Supply

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Demand Determinants

In addition to the price of the product, the market demand for a good or ser-vice depends on a variety of other factors, including money income, tastes and preferences, the prices of related goods, the number of consumer, price and income expectations, and so on. Factors other than the price of the good in question are collectively referred to as demand determinants.

Money Income

The most important limitation on a consumer’s ability to purchase a good or service is money income. An increase in consumers’ money income will increase the demand for most goods and services. This is shown in Figure 2.2 as a right-shift in the market demand curve from D1 to D2. Likewise, in most cases a decrease in money income, such as would occur during an economic downturn, results in fewer purchases and a left-shift of the demand curve (not shown). Such products are referred to as normal goods.

By contrast, the demand for an inferior good varies inversely with con-sumers’ money income. During an economic expansion, rising incomes, sales and profits, the market demand for the services of bankruptcy lawyers and accountants declines. This decline is depicted as a shift to the left of the market demand curve. Conversely, the market demand curve for bankruptcy services will shift to the right during economic downturns. Other types of

Figure 2.2 

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24 Chapter 2

inferior goods include the demand for automobile repair services and used cars as consumers postpone purchases of new cars during recessions.

Tastes and Preferences

Changes in consumer tastes will also shift the market demand curve. Although changes in fads and fashions can be difficult to predict, there is an entire industry devoted to manipulating consumer tastes and preferences— marketing, but especially advertising. Advertising is generally of two types—informative and persuasive. Informative advertising provides pro-spective consumers with information about new or existing products, such as the seemingly ubiquitous advertisements for the iPad “tablet” during 2010. Persuasive advertising attempts to boost sales by creating an image that may have little or nothing to do with the product’s physical characteristics. Persuasive advertising appeals to consumers’ emotions.

An increase in advertising-inspired purchases is depicted as a right-shift in the market demand curve. If consumers have a negative opinion, the demand curve will shift to the left. In recent years, for example, consum-ers’ concern about the health hazards of smoking has resulted in a dramatic decline in the demand for tobacco products in the United States. Many political candidates are notorious for running negative campaign ads against their opponents.

Prices of Related Goods

Changes in the prices of related goods also affect market demand. Related goods may be substitutes or complements. If two goods are substitutes in consumption, an increase in the price of good y will cause some consum-ers to shift their purchases into relatively less expensive good x. An increase in the price of Coca-Cola, for example, results in a decrease in the quantity demanded for Coca-Cola, but an increase in the demand by many consum-ers for relatively less expensive Pepsi Cola, Dr. Pepper, or fruit juices. Other examples of substitute goods include margarine and butter, coffee and tea, beer and ale, and laptop and tablet computers.

Figure 2.3 illustrates the effect of an increase in the price of good y on the demand for substitute good x. An increase in the price of good y results in a decrease in the quantity demand of good y, which is illustrated as a movement along the D curve from point A to point B. As the quantity demanded of good y falls, the demand for substitute good x increases. This is shown as a right-shift of the demand curve for good x from D1 to D2. Analogously, a decrease in the price of good y leads to an increase in the quantity demanded for good y and a left-shift of the demand curve for good x (not shown).

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Figure 2.3 

Goods are complements in consumption if they are consumed together, such as tennis rackets and tennis balls, skis and ski boots, kites and kite string, and computers and software. If goods x and y are complements, a decrease in the price of good y results in an increase in the quantity demanded of good y, and an increase in the demand for good x. The increase in the price of good y results in a decrease in the demand for complementary good x, which shifts the demand curve for good x to the left. Conversely, a decrease in the price of good y results in an increase in the quantity demanded of good y and an increase in the demand for good x, which shifts the demand function for good x to the right.

Sales Taxes

Sales taxes also affect the demand for a good or service. A per-unit tax, for example, is a fixed tax (t) per unit purchased. Suppose that the price is $10 and local authorities impose a $1 per-unit sales tax. This effectively raises the price to $11. A consumer who buys 100 units pays $1,100, of which $100 is collected by the government. If the price is $20 and the consumer buys 100 units, the amount going to the vendor doubles, but there is no change in government sales tax revenues.

In general, imposing a per-unit tax increases the price to the buyer to P + t. Suppose that the inverse demand equation with the per-unit tax is P + t = a – bQ. After subtracting t from both sides this becomes P = (a – t) – bQ. Increasing a per-unit sales tax lowers the P-intercept, but leaves the slope of the demand equation unchanged. In other words, there is a parallel left-shift of the demand curve. Conversely, removing or reducing the tax results in a parallel right-shift of the demand curve.

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26 Chapter 2

Alternatively, an ad valorem tax (from the Latin “according to value”) is expressed as a percentage (τ) of the purchase price. Suppose that the price is $10 and there is a 10 percent ad valorem tax. A consumer who purchases 100 units at a price of $10 pays (1.1 × $10) × 100 = $1,100, of which $100 is collected by the government. A consumer who purchases 100 units at a price of $20 pays (1.1 × $20) × 100 = $2,200. In this case, the revenues going to the vendor and the government both double.

Imposing an ad valorem tax increases the price to the buyer to (1 + τ)P. In this case, the inverse demand equation becomes (1 + τ)P = a – bQ. After dividing both sides by (1 + τ) this becomes P = a/(1 + τ) – [b/(1 + τ)]Q. Increasing an ad valorem tax not only lowers the P-intercept, but the quantity demanded becomes more sensitive to a price change. In other words, the demand curve shifts to the left and becomes flatter. Reducing an ad valorem tax causes the demand curve to shift to the right and become steeper.

Number of Consumers

The market demand curve for a good or a service is the sum of the demand curves of the individual consumers. Thus, an increase in the number of buy-ers will increase the consumer purchases and shift the market demand curve to the right. The flood of Mexican immigrants since the 1980s, for example, increased the demand for Mexican cuisine in the Southwest. Conversely, economic recession in the Rust Belt lowered demand for real estate, home and auto repair services, and so on. Shifts in the market demand curve also reflect demographic changes, such as the significant increase in demand for health care and other senior citizen services as World War II “baby boomers” enter their retirement years.

Consumer Expectations

A change in consumer expectations regarding market conditions tomorrow can affect the demand for goods and services today. Suppose, for example, that pharmaceutical investors come to believe that a drug company’s stock price is about to fall because of multimillion dollar law suit. To avoid getting caught “holding the bag,” investors will act on those expectations, thereby turning their beliefs into a reality. If prospective new car buyers believe that prices for this year’s models will be lowered in October as dealerships make room for next year’s model, the demand curve for new cars in September will shift to the left.

Summarizing, a change in the quantity demanded for a good or service in response to a change in its price is illustrated as a movement along a station-ary demand curve. A change in demand following a change in something other than price is depicted as a shift in the demand curve. Table 2.1 sum-marizes several of the demand shifts discussed in this section.

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		Demand and Supply	27
Table 2.1  Changes in Demand Determinants
Determinant	Change	Demand Curve Shift
Income	↑	→
	Normal goods
		↓	←
	Inferior goods	↑	←
		↓	→
Tastes and preferences	↑	→
	↓	←
Prices of related goods	↑	→
	Substitutes
		↓	←
	Complements	↑	←
		↓	→
Sales taxes	↑	←
	↓	→
Population	↑	→
	↓	←

Estimating the Market Demand Equation

The relationships discussed in the preceding sections are of little practical value to managers unless the demand for a firm’s good or service can be quantified. Suppose, for example, that the demand for good x (Qxd) depends on its price (Px), per capita money income (M), and the price of a related good y (Py). Although the precise manner in which these variables are related may never be known with complete certainty, a useful first step is to assume a linear relationship of the form

Qd = b	0	+ b P + b	M	M + b P .	(2.1)
x		x x		y y

The hypothesized signs of the parameter values in Eq. (2.1) are βx < 0 by the law of demand, βM > 0 if x is normal, βM < 0 if good x is an inferior, βy > 0 if good y is a substitute, and βy < 0 if good y is a complement.

Several statistical techniques are used to derive estimates of the coeffi-cients on the basis of empirical data.2 A statistical estimate of Eq. (2.1) will provide the manager with more precise information about how the company’s unit sales will be affected by changes in each of these hypothesized explana-tory variables. Expanding on ideas presented earlier, rewrite Eq. (2.1) as

Qd = B + b P ,	(2.2)
x	x x

where B = β0 + βMM + βyPy. Solving for Px we obtain the inverse demand equation

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28 Chapter 2

		B		1
Px	= −			+		Qx .	(2.3)
	b x	bx

Suppose an economic recession results in a decline in money income. If x is a normal good (βM > 0), the result is a decline in the value of B and a shift to the left of the demand curve.

Solved Exercise

The estimated demand equation for a popular brand of fruit juice is given by the equation

Qx = 10 − 5Px + 0.001M +10Py ,

(2.4)

where Qx is the per family monthly purchases in gallons, Px is the price per gallon of the fruit drink ($2.00), M is the median annual family income ($20,000), and Py is the price per gallon of a competing brand of fruit juice ($2.50).

a. Interpret the parameter estimates of Eq. (2.4).

b. What are estimated monthly, per family purchases (sales) of this brand of fruit juice?

c. Rewrite the Eq. (2.4) to resemble Eq. (2.3) .

d. Suppose that median annual family income increases to $30,000. How does this change your answers to parts b and c?

Solution

a. A $1 increase in the price of this brand of fruit juice will result in a 5-gallon, per-family decline monthly purchases. A $1,000 increase in median annual family income will result in a 1 gallon increase in per-family, monthly purchases. Since a $1 increase in the price of the compet-ing brand results in a 10-gallon, per-family increase in monthly purchases of this brand, the two brands of fruit juices are substitute goods.

b. Substituting the indicated values into the demand equation yields

Qx = 10 − 5( 2) + 0.001( 20,000) +10 ( 2.5) = 45gallons.

(2.5)

c. Eq. (2.4) may be rewritten

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Demand and Supply	29
Q x = 55 − 5Px .	(2.6)

d. The new monthly consumption of fruit drink is

Qx = 10 − 5( 2) + 0.001( 30,000) +10 ( 2.5) = 55 gallons.

(2.7)

At the higher family income, Eq. (2.6) becomes

Qx = 65 − 5Px .

(2.8)

Since the value of the horizontal intercept has increased from 55 to 65, the demand curve for this brand of fruit juice shifts to the right.

Consumer Surplus

A detailed understanding of the market demand for a good or service has several important business applications. In the next chapter, for example, the estimated demand equation will be used to identify the effect of a price change on the firm’s unit sales and total revenues. It can also be used to approximate the value that consumers receive from their purchases of goods and services. In Chapter 11 we will learn how managers can use this to for-mulate pricing strategies that enhance the firm’s bottom line.

Consumer surplus is the value that buyers received from the purchase of a good or service in excess of the amount paid. In order to explain what we mean by this, consider the demand curve depicted in Figure 2.4, which illus-trates the number of bottles of Gatorade that Joe will purchase after a game of softball on a hot summer day. Suppose in this thought experiment that Joe lives in a world populated only by truth tellers. After the game, Joe goes to his health club and orders a bottle of Gatorade. The health club does not have a menu of prices. Instead, each patron is asked to pay an amount equal to the value received from each bottle purchased. In keeping with this policy, Joe is asked how much a bottle is worth to him. Being very thirsty, Joe says that a bottle of Gatorade is worth $8, which is the amount that he pays.

After finishing his first bottle, Joe orders another. As before, Joe is asked how much the second bottle is worth to him. Not being as thirsty, Joe responds that he is willing to pay $6, $4 for the third bottle, and so on. If Joe stops after the third bottle, his total expenditures will be $18, which is precisely the value that Joe received from his purchases.

In a “perfect” world, a strategy of charging a price equal to the value of each unit consumed may be practical, but in the real world buyers have an incentive to understate the true value received so as to a lower price. For this

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30 Chapter 2

Figure 2.4 

reason, firms typically publish a menu of fixed prices. The buyer knows precisely how much each unit will cost before deciding how many units to purchase. Suppose that a bottle of Gatorade is $4. How many bottles will Joe buy, and how much will he spend?

According to the information provided in Figure 2.4, Joe will certainly purchase the first bottle because the $4 paid is greater than the $8 of value received. Joe will also buy a second bottle since he will receive $2 of value in excess of the price paid. Joe will even buy a third bottle because the amount paid is equal to the value received. Joe will not purchase a fourth bottle, however, since he would lose $2 in value. Joe has spent 3 × $4 = $12 for total value received value of $8 + $6 + $4 = $18. Joe’s consumer surplus of $18 – $12 = $6 is illustrated by the shaded area in Figure 2.4.

In the above example, we assumed that Joe’s beer purchases were in discrete increments. Now, consider Figure 2.5, which represents the market demand for a good or service. If prices are infinitely divisible, consumer sur-plus is given by the shaded triangle P*AE. At a price of P*, the total value received from purchasing Q* units consumed is given by the area 0P*AEQ*. Total consumer expenditures is given by the area of the rectangle 0P*EQ*. Thus, consumer surplus is 0P*AEQ* – 0P*EQ* = P*AE. For a linear demand equation, consumer surplus can be calculated using the equation

CS =	1	(A − P* )Q*.	(2.9)
	2

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Figure 2.5 

Solved Exercise

Suppose that a consumer’s inverse demand equation is

P =20−2Q.

(2.10)

a. How many units will be purchased at a price is $6? What are the consum-ers’ total expenditures?

b. Calculate the consumer surplus.

c. How much total value is received by this consumer?

Solution

a. From Eq. (2.10), at a price of $6, this consumer will purchase 7 units and spend $6(7) = $42.

b. From Eq. (2.9), consumer surplus is CS = 0.5(20 – 6)7 = $49.

c. The total value received is equal to the amount paid plus the value of con-sumer surplus, which is $42 + $49 = $91.

SUPPLY

According to the law of supply, the quantity supplied of a good or service is directly related to a change in its market price, ceteris paribus. The market

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32 Chapter 2

Figure 2.6

supply curve is the horizontal summation of the supply curves of the indi-vidual firms in an industry. This relationship is depicted in Figure 2.6. An increase in the market price of good x from P1 to P2 results in an increase in the quantity supplied from Q1 to Q2. This cause and effect relationship is depicted as a movement along the stationary supply curve from point A to point B. This is because an increase in the price of good x increases firms’ expected revenues and profits from its sale. To exploit these profit opportuni-ties, firms will increase the number of units offered for sale.

Supply Determinants

A change in any factor that affects a firm’s bottom line will change the num-ber of units offered for sale. An increase in the market price will result in an increase in the quantity supplied of a good or service. This is illustrated as a movement along a stationary market supply curve. A change in any other factor that affects the firm’s profit will result in a shift in the market supply curve. These supply determinants include, among other things, input prices, production technology, taxes and government regulation, prices of related goods, and number of firms in the industry.

Input Prices

Other things being equal, a lower input price, such as might occur from a decline in energy prices, will reduce production costs and increase expected

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profit. Firms will respond by increasing output at each price, which will shift the market supply curve to the right. Conversely, an increase in employee wages and benefits from a new collective bargaining agreement will increase production costs, lower expected profit, and cause the market supply curve to shift to the left (not shown).

Production Technology

We typically think of a firm’s production technology in terms of the eco-nomic capital (machinery, plant, equipment, and so on) used to inputs into outputs for sale in the market. In fact, production technology can also refer to the process by which managers organize production processes, such as improved inventory control and personnel management. Improved produc-tion technology implies that more output can be produced from given com-bination of inputs, or an unchanged amount of output can be produced using fewer inputs. In the first instance, this suggests an increase in revenues. In the second instance, this means a decrease in production costs. Either way, an improvement in production technology at fixed input and output prices suggests an increase in profits, which provided managers with an incentive to increase supply. This would be depicted as a right-shift of the supply curve.

Taxes and Government Regulation

The objective of the firm is to maximize shareholder value, which is related to after-tax profits. From a manager’s perspective, higher corporate taxes and mandated government regulations increase the firm’s cost of doing business and lower expected after-tax profit. Managers will respond by reducing out-put, causing the market supply curve to shift to the left. Conversely, lowering corporate taxes, receiving government subsidies, and removing costly regula-tions increase expected after-tax profits, encourage production and shift the market supply curve to the right.

Another type that affects industry supply is an excise tax, which is a tax on each unit sold. The difference between an excise tax and a sales tax is that an excise tax is levied on specific goods, whereas a sales tax is a general levy. Another difference is that excise taxes are collected from the supplier—not the consumer.

The manner in which excise taxes affect the supply curve depends on whether it is a per-unit tax or an ad valorem tax. Suppose, for example, that the government levies a $1 per-unit tax on a gallon of gasoline. This has the effect of shifting the supply curve up by the amount of the tax. This upward parallel shift results in a decline in supply. In a similar fashion, a reduction in a per-unit excise tax results in a downward parallel shift of the supply, which results in an increase in supply.

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34 Chapter 2

Alternatively, the government could levy an ad valorem excise tax. Since the amount of the tax is greater at higher prices than at lower prices, the supply curve not shifts up and becomes steeper. As in the case of a per-unit tax, the imposition of the ad valorem excise tax results in a decrease in supply. In an analogous fashion, the supply curve shifts down and becomes flatter following a reduction in an ad valorem excise tax resulting in an increase in supply.

Prices of Related Goods

Changes in the prices of goods sharing the same resources can also affect supply. These related goods are may be substitutes or complements in production. Substitutes in production involve trade-offs in the produc-tion of two or more goods or services using the same production facilities, such as the choice of producing halogen light bulbs or compact fluorescent light (CFL) bulbs on the same assembly line. Other things being equal, an increase in the price of halogen light bulbs will cause managers to devote a greater share of the firm’s production capacity to its production, which reduce the assembly line time available to produce CFL bulbs. Thus, the higher price of halogen bulbs resulted in a decline in the supply of CFL bulbs.

Complements in production involve the joint production of two or more goods with the same production facilities. Cowhide, for example, is a by-product of beef production. An increase in the price of beef will result in an increase in the quantity supplied of beef and an increase in the supply of cowhide, even when there is no change in the price of cowhide leather.

Number of Firms

The market supply curve of a good or service is the sum of the supply curves of each individual firm in an industry. Thus, an increase in the number of firms will cause the market supply curve to shift to the right. In fact, any flow of new investment into the industry, perhaps because of the lure of above-normal profits, will increase market supply. Conversely, when investment flows out of an industry, the market supply curve will shift to the left.

Summary

A change in the quantity supplied of a product following a change in its market price is depicted as a movement along a stationary supply curve. A change in supply following a change in something other than the market price of the product is depicted as a shift in the entire supply curve. Table 2.2 sum-marizes the supply shifts discussed in this section.

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		Demand and Supply	35
Table 2.2  Changes in Supply Determinants
Determinant	Change	Supply Curve Shift
Input prices	↑	←
	↓	→
Technology	↑	→
Taxes	↑	←
	↓	→
Prices of related goods
	Substitutes	↑	←
		↓	→
	Complements	↑	→
		↓	←
Number of firms	↑	→
	↓	←

Producer Surplus

The analytical supply counterpart to consumer surplus is producer surplus, which is the difference between total revenues received from the sale of a good or service and the minimum needed to produce it. A firm’s supply curve reflects its marginal cost of production. A profit-maximizing firm will produce up to a level of output where marginal cost equals marginal revenue. A firm’s total variable cost is equal to the sum of the marginal cost of produc-ing each unit. Thus, producer surplus is equal to the firm’s operating profit, which is the difference between the firm’s total revenue and expenses relat-ing to a firm’s ongoing operations (total variable cost). This is not the same thing as the firm’s total (economic) profit, which is the difference between total revenue and total (economic) cost. A firm’s total cost is the sum of total variable and total fixed cost. On the other hand, if total fixed cost is “small,” producer surplus is a good approximation of the firm’s total profit.

Producer surplus for continuous prices is illustrated by the area of the shaded triangle in Figure 2.7. If the supply curve is linear, producer surplus equals

PS =	1	(P* − B)Q*.	(2.11)
	2

A firm’s producer surplus can be particularly valuable information for a manager. A profit maximizing firm will produce up to the level of output where marginal cost equals marginal revenue, which is the extra revenue received from the next unit sold. This occurs in Figure 2.7 at the output level Q*. For every unit of output up to the last unit produced, P* = MR > MC. Thus, the shaded area represents the extra revenue received in excess of what the firm would have been willing to produce each unit up to Q*.

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36 Chapter 2

Figure 2.7 

Producer surplus tells managers the maximum amount the firm can save by bargaining with resources suppliers over price. For example, suppose that the manager of a construction company is negotiating with a supplier over the price of steel rods. If the manager of the construction company knows the supplier’s producer surplus, he or she also knows the minimum amount that the supplier would be willing to accept for the steel rods.

MARKET EQUILIBRIUM

We will now bring together the forces of demand and supply to explain how market price and output is determined. Figure 2.8 illustrates the con-cept of market equilibrium, which is the price (P*) where the quantity demanded (Qd) equals the quantity supplied (Qs). At prices below the equi-librium price, a shortage exists since the quantity demanded exceeds the quantity supplied. At this low price, consumers compete amongst them-selves to acquire the good or service that is in short supply. As consumers bid up the price, buyers who are unwilling or unable to pay the higher price will exit the market. At the same time, the higher price provides firms to an incentive to increase production. The increase in the quantity supplied coupled with the decrease in the quantity demanded as the price rises continues shortage is eliminated and a higher market-clearing price established.

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Figure 2.8 

At prices above P*, the quantity supplied exceeds the quantity demanded. Managers will respond to the unsold output and a build-up of inventories by lowering price and reducing production to more sustainable levels. This pro-cess will continue until the quantity supplied equals the quantity demand at a lower market-clearing price.

NET SOCIAL WELFARE

Consumer surplus is the value received by consumers from purchases of a product in excess of their expenditures. Producer surplus is the amount received by firms from sales of a product in excess of the minimum amount that they would have accepted to make the product available. The sum of consumer surplus and producer surpluses is referred to as net social welfare, which is depicted in Figure 2.9 for a purely competitive market.

The demand curve is a measure of the marginal social benefit (MSB) of consuming an additional unit. The supply curve measures the marginal social cost (MSC) of increasing output by another unit. As long as MSB > MSC it pays for society to increase output. But, when MSC > MSB it is in society’s best interest to reduce output. Net national welfare is maximized at the level of output where MSB = MSC.

Net social welfare can be used as a measure of market efficiency. The greater the sum of consumer and producer surplus, the more socially beneficial

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38 Chapter 2

Figure 2.9

is the market structure. In this chapter, we have restricted out discussion to purely competitive market structures, which is considered the ideal way to organize commercial activity because it maximizes net social welfare.

Solved Exercise
Suppose that the inverse market demand and supply equations are
P = 9 − 2Qd ;	(2.12)
P = 6 + Qs .	(2.13)
Calculate the value of net social welfare in this market.

Solution

Solving Eqs. (2.12) and (2.13), the market equilibrium price is P* = $7 and the equilibrium quantity is Q* = 1. The value of consumer surplus is CS = 0.5($9 − $7)1 = $1. The value of producer surplus is PS = 0.5($7 − $6) = $0.5. Thus, the value of net social welfare is NSW = CS + PS = $1.50. This solution is depicted in Figure 2.10.

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Demand and Supply

39

Figure 2.10 

CHANGES IN DEMAND AND SUPPLY:

PRICE AND OUTPUT DETERMINATION

We will now analyze the effects of a change in demand and supply conditions on the market-clearing price and equilibrium output. We will begin by first considering the effects of a change in market demand.

Demand Shifts

Suppose that medical research determines that eating cheeseburgers is healthy, which results in an increase in the demand for cheeseburgers. Other things being equal, this will cause the cheeseburger demand curve to shift to the right, as depicted in Figure 2.11. In a similar manner, if medical research demon-strates that cheeseburgers are unhealthy, the demand curve will shift to the left.

In general, a right-shift of the demand curve with no change in supply will result in an increase in both the equilibrium price and quantity. Conversely, a left-shift of the demand curve will cause the equilibrium price and quantity to fall.

Supply Shifts

Suppose that a decline in the price of cheese leads fast-food restaurants to expect higher profits from the sale of cheeseburgers. Other things being equal, profit-maximizing cheeseburger producers will increase output, which

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40 Chapter 2

Figure 2.11 

causes the supply curve to shift to the right, resulting in a decline in the equi-librium price and quantity. This is depicted in Figure 2.12.

Conversely, an increase in the price of cheese reduces expected profits resulting in a left-shift of the supply curve. This results in an increase in the equilibrium price and a decline in the equilibrium quantity. In general, a right-shift of the supply curve will result in a fall in the equilibrium price and an increase in the equilibrium quantity. Conversely, a left-shift of the supply curve will result in an increase in the equilibrium price and a decrease in the equilibrium quantity.

Demand and Supply Shifts

A shift in either the demand curve or the supply curve will result in an unambiguous change in both the equilibrium price and quantity. These pre-dictable changes are summarized in the second column of Table 2.3. When both demand and supply change simultaneously, however, the effect on the market-clearing price and equilibrium quantity is more difficult to predict. The final outcome depends on how demand and supply change relative to each other. In the absence of such information, all we can say is that there will be an unambiguous change in either the equilibrium price or quantity, but an ambiguous change in the other.

To appreciate the difficulty associated with predicting equilibrium price and quantity changes when demand and supply changes, consider Case 1

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Figure 2.12 

Table 2.3  Changes in Demand and Supply Determinants

Case	Separately	Together
1	∆D↑ → ∆P↑ and ∆Q↑	∆P? (ambiguous)
	∆S↑ → ∆P↓ and ∆Q↑	∆Q↑ (unambiguous)
2	∆D↑ → ∆P↑ and ∆Q↑	∆P↑(unambiguous)
	∆S↓ → ∆P↑ and ∆Q↓	∆Q? (ambiguous)
3	∆D↓ → ∆P↓ and ∆Q↓	∆P↓ (unambiguous)
	∆S↑ → ∆P↓ and ∆Q↑	∆Q? (ambiguous)
4	∆D↓ → ∆P↓ and ∆Q↓	∆P? (ambiguous)
	∆S↓ → ∆P↑ and ∆Q↓	∆Q↓ (unambiguous)

in Table 2.3, which summarizes the effects of an increase in both demand (∆D↑) and supply (∆S↑). The second column of the table tells us what will happen when demand and supply change separately. An increase in demand alone results in an increase in both the equilibrium price and quantity, which is illustrated in Figure 2.11. An increase in supply alone results in a decrease in the equilibrium price and an increase in the equilibrium quantity, which is depicted in Figure 2.12. When demand and supply increase together, how-ever, the analysis becomes a bit more complicated.

As we have seen, an increase in demand and supply both result in an unambiguous increase in the equilibrium quantity. On the other hand, an increase in demand causes the equilibrium price to rise while an increase in

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42 Chapter 2

supply causes the equilibrium price to fall. In the first instance there is upward pressure on price, while in the second instance there is downward pressure on price. In the absence of additional information, it is not possible to know whether the demand-side or supply-side effect dominates, in which case the effect on the equilibrium price is ambiguous.

Solved Exercise

The marketing department of The Great Bombay Tea Company has estimated the weekly demand for its brand of gourmet pizza as

Q = 500 −100P + 50I + 20Py + 30A,

(2.14)

where Q is the number of pizzas (000’s), P is the market-determined price of Bombay’s pizza, I is weekly per capita income, Py is the price of the brand of pizza sold by Universal Foods, Inc., and A is Bombay’s weekly advertising expenditures ($000’s). The supply equation for Bombay’s gourmet pizza is

Q = 1,800 + 450P. (2.15)

a. What is the relationship between Bombay’s pizza and Universal’s pizza?

b. Suppose that I = $200, Py = $20 and A = $100. What is the equilibrium price and quantity of Bombay pizza?

c. Suppose that Bombay’s chief economist predicts that the current economic expansion will increase weekly per capita income to $255. What effect will this have on the equilibrium price and quantity?

d. Based on your answer to part c, how would you characterize Bombay’s pizza?

Solution

a. Since a $1 increase in the price of Universal pizza results in a 20 thousand unit weekly increase in Bombay pizza sales, the two brands of pizza are substitutes.

b. Substituting these values into the demand equation yields

Q = 13, 900 −100P.

(2.16)

The equilibrium price and quantity are P* = $22 and Q* = 11,700.

c. At the higher per capita income, the demand equation becomes

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Demand and Supply	43
Q = 16,650 − 100P.	(2.17)

Equating this new demand with supply, the equilibrium price and quantity are P* = $27 and Q* = 13,950. The increase in per capita income has resulted in a higher market-clearing price and equilibrium quantity.

d. An increase in per capita income resulted in an increase in the demand for Bombay’s pizza. This was depicted as a right-shift of the demand curve. Bombay pizza can be characterized as a normal good.

RATIONING FUNCTION OF PRICES

How realistic is the assumption of market equilibrium? Markets are con-tinually buffeted by changes in demand and supply conditions. Temporary shortages and surpluses resulting from unexpected market disturbances are inevitable. The remarkable thing about unfettered markets is the speed at which market equilibrium is reestablished following a demand-side or supply-side shock. This fact should reinforce our faith in the underlying logic and stability of the free-market process.

When prices are “too low” and shortages result, competition among con-sumers will push up prices. Consumers who are unable or unwilling to pay the higher price drop out of the market. At the same time, higher prices are an incentive for firms to increase supply. Eventually, the shortage is eliminated and market equilibrium is reestablished. On the other hand, when prices are too high, there is a surplus of unsold goods. Firms will respond by lowering prices to dispose of excess inventory and reduce output to more sustainable levels. Consumers who were previously unwilling or unable to pay a higher price will be drawn into the market until the surplus is eliminated. This pro-cess by which changes in market-determined prices eliminate shortages and surpluses is referred to as the rationing function of prices. The essence of a decentralized free market is that impersonal changes in prices ultimately determines who gets what and how much.

The rationing function of prices underscores the notion of scarcity. Eco-nomically well-to-do consumers have a greater command over available goods and services than consumers of more modest means. This inevitably leads to complaints by some consumers who cannot afford to pay that the market-determined price is “unfair.” The fact that an individual may not be able to afford a Bentley or a private island is not a problem of fairness, but a problem of limited resources. Still, this does not dissuade some individuals who believe that market outcomes are pernicious from seeking redress through other means, such as the political process.

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44 Chapter 2

Price Ceilings

While price rationing is fundamental to the market mechanism, it is not the only way to allocate scarce goods and services. At various times, and for vari-ous reasons, governments have short-circuited the price rationing function of markets by imposing a price ceiling, which is the maximum legal price that a firm can charge for its product.

To be effective, a price ceiling must be set below the market equilibrium price to prevent prices from rising. An example of a price ceiling is rent control. The political objective of rent control is to provide low-cost housing to low-income voters. The problem with price ceilings is that they create artificial shortages that are likely to persist and become worse over time. Moreover, price ceilings are socially inefficient because they result in a misallocation of resources. To understand what is involved, consider the situation depicted in Figure 2.13.

Suppose, initially, that the equilibrium price and quantity in Figure 2.13 is P* and Q*, respectively. Net social welfare, which is a measure of market effi-ciency, is the sum of consumer surplus and producer surplus. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e + f. Thus, net social welfare is given by the area a + b + c + d + e + f. Now, suppose that government imposes a price ceiling of Pc, which creates a shortage in the market of Qs − Qd. The imposition of the price ceiling reduces producer surplus to area f. Area d is the amount transferred from producers to consumers who are paying less than the full value of the last unit consumed (PF ).

Figure 2.13 

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Demand and Supply

45

The total value received by consumers from Qs units of output is given by the area a + b + d + f + g. Consumer expenditures are given by the area f + g. Thus, consumer surplus under the price ceiling is the area a + b + d. Net social welfare is now a + b + d + f. The change in net social welfare from the imposi-tion of the price ceiling is (a + b + d + f) − (a + b + c + d + e + f) = − c − e. While consumers who have been able to acquire the product at a lower price have benefitted, the loss to consumers as a whole is −c, which is referred to as consumer deadweight loss. The loss to society as a whole from the misalloca-tion of resources and a less than optimal amount of the product being supplied is given by the area −e, which is referred to as producer deadweight loss. The sum of consumer and producer deadweight loss, which is called total dead-weight loss, is given by the shaded area in Figure 2.13. Total deadweight loss is a measure of the lost net social welfare that results from the price ceiling.

Alternatively, MSB > MSC at the output level QS. In this market “too little” rental housing is supplied at the price ceiling. Society is made better off by allowing the market-clearing price to rise to P*. Moreover, freed from the economic shackles of rent control, new construction will shift the supply curve to the right, which puts downward pressure on rents.

When the price rationing mechanism of the free market is not permitted to operate, some non-price rationing mechanism must be used to allocate products that are in short supply. The most common of these non-price ration-ing mechanisms is queuing. Standing line for sometimes hours on end was how gasoline was rationed after the U.S. Congress enacted a 57¢ per gallon price ceiling following the embargo of crude oil shipments to the U.S. in 1973–1974 by Organization of Petroleum Exporting Countries (OPEC).

Without the price ceiling, lines at gasoline stations would have disappeared overnight as higher prices would have equated the quantities demanded and supplied. Higher gasoline prices, however, would have jeopardized the reelection prospects of many members of Congress, and so the price at the pump was kept low. The full economic price of gasoline, which included the opportunity cost of waiting in line for hours on end, however, was much higher. In Figure 2.13, the full economic price is PxF , which is equal to the price ceiling plus the opportunity cost of waiting in line PxF − PxC . The differ-ence between the full economic price and the price ceiling is the amount that consumers would be willing to pay to avoid waiting in line.

Solved Exercise

The market demand and supply equations for a product are

Qd = 300 − 3P;

(2.18)

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46 Chapter 2

Q s = −100 + 5P.

(2.19)

a. Calculate the equilibrium price and quantity for this product?

b. Suppose that an increase in consumer income increases demand to

Qd = 420 − 3P.

(2.20)

What are the new equilibrium price and quantity for this product? What is the value of net social welfare as a result of the increase in demand?

c. What is the value of net social welfare as a result of the increase in demand?

d. Suppose that the government imposes a price ceiling that is equal to the original equilibrium price. What is the result of this legislation?

e. Calculate the change in the value of net social welfare after the imposition of the price ceiling.

Solution

a. Solving Eqs. (2.18) and (2.19), the equilibrium price is P* = $50. Sub-stituting this price into the demand or supply equation and solving, the equilibrium quantity is Q* = 150 units of output.

b. Solving Eqs. (2.18) and (2.20), the new equilibrium price is P* = $65 and the equilibrium quantity is Q* = 225 units of output. This new situation is depicted in the following Figure 2.14.

Figure 2.14 

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Demand and Supply

47

c. As a result of the increase in demand, consumer surplus is CS = 0.5(140 − 65)225 = $8,437.50. The value of producer surplus is PS = 0.5(65 − 20)225 = $5,062.50. Thus, the value of net social welfare before the price ceiling is NSW = CS +PS = $13,500.

d. At the ceiling price of Pc = $50, the quantity demanded is Qd = 270 units and the quantity supplied is Qs = 150 units. The price ceiling creates a shortage of Qd − Qs = 120 units of output.

e. After the imposition of the price ceiling, the value of consumer surplus is CS = 0.5(140 − 90)150 + (90 − 50)150 = $9,750. The value of producer surplus after the price ceiling is PS = 0.5(50 − 20)150 = $2,250. The value of net social welfare is NSW = CS +PS = $12,000. This is given by the shaded area in Figure 2.14. The imposition of the price ceiling has reduced net national welfare by $1,500.

Price Floors

The counterpart of a price ceiling is a price floor, which is the minimum legal price that a supplier can expect for its product. To be effective a price floor must be set above the market determined price of the product. Notable examples of prices floors are agricultural price supports and minimum wages.

An example of the social welfare effect of a price floor is depicted in Figure 2.15. Suppose that the market for cheese is initially in equilibrium at

Figure 2.15 

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48 Chapter 2

P* and Q*. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e. Thus, net social welfare is given by the area a + b + c + d + e.

Now, suppose the government announces that it will guarantee cheese manufacturers a minimum price of Pf. The effect of the price floor is to create a market surplus of Qs − Qd. In the case, consumer surplus is given by area a. Producer surplus is given by the area b + c + d + e + g. Together, the sum of consumer and producer surplus is a + b + c + d + e + g. While it might appear that society has been made better off as a result of cheese price supports, this is not the end of the story.

There are several ways that federal government can administer an agricultural price support. One way is for the government to purchase the surplus at a cost to taxpayers of c + e + f + g + h + i. So far, net social welfare is (a + b + c + d + e + g) − (c + e + f + g + h + i) = a + b + d − f − h − i. The final outcome depends on what the government does with the surplus cheese. If the government distributes the cheese to low-income families free of charge, consumers receive value in the amount of the area c + e + f + i. Thus, the final outcome is net social welfare of (a + b + d − e − f − h − i) + (c + e + f + h + i) = a + b + c + d + e − h. National welfare is reduced by the area − h, which represents the amount of deadweight loss to society. Since the change in net social welfare is unambiguously negative, society has been made worse from the price floor.

Alternatively, MSC > MSB at the output level QS. In this market, “too much” cheese is being supplied at the price floor. Society will be made better off by allowing prices to fall to its market-clearing P*. Allowing the market mechanism to ration excess supply will eliminate the deadweight loss given by area h.

Another example of a price floor occurs in the labor market when the government enacts minimum-wage legislation, ostensibly to provide unskilled and uneducated workers with a “living wage.” Although government can mandate a higher minimum wage, in a free market it cannot force employ-ers to hire workers whose productivity is valued below the minimum wage. A profit-maximizing firm will not hire a worker if the addition to the firm’s revenues is less than the minimum wage paid. The result is a surplus of unskilled and uneducated workers and a loss of social welfare. To make mat-ters worse, a legal minimum wage makes it difficult for low-skilled workers to obtain work experience and on-the-job training that will enable them to command higher wages in the future. Society in general suffers because higher unemployment is associated with an increase in the crime rate. Tax-payers are made worse off because payroll taxes fund unemployment insur-ance and welfare payments.

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Solved Exercise

Consider the following demand and supply equations for the product of a perfectly competitive industry:

Qd = 25 − 3P;	(2.21)
Qs = 10 + 2P.	(2.22)

a. What is the equilibrium price and quantity in this market?

b. Suppose that government enacts a “price floor” on this product of P = $4. What is the result of this legislation?

Solution

a. Solving Eqs. (2.28) and (2.29), the equilibrium price and quantity are P* = $3 and Q* = 16 units of output.

b. At P = $4, the quantity demanded is Qd = 13 units of output and the quan-tity supplied is Qs = 18 units of output. As a result of the price floor there is a surplus of 5 units of output.

ALLOCATING FUNCTION OF PRICES

An examination of the price-rationing mechanism of individual markets is called partial equilibrium analysis. By contrast, general equilibrium analy-sis is concerned with the simultaneous determination of equilibrium in all markets. General equilibrium analysis examines the process whereby a dis-turbance in one sector of a market economy is transmitted to other sectors of the economy and the resulting reallocation of productive resources.

The prices of final goods and services reflect changes in a variety of demand determinants, including consumer tastes and preferences. Since the demand for productive resources is derived from the demand for final goods and services, producers use price information to reallocate inputs from lower to higher valued uses. This process is referred to as the allocating function of prices. To see how this works, consider an increase in the demand for restaurant meals, which leads to an increase in prices and industry profits.3 As a result, new capital investment flows into the restaurant and hospitality industry, which increases the demand for servers, chefs, and so on, thereby pushing up wages and benefits. This acts as a magnet for displaced workers, workers experiencing cuts in wages and benefits, and investment capital from contracting industries.

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50 Chapter 2

Benjamin Franklin warned the signers of the American Declaration of Independence from Great Britain that “We must all hang together, or assur-edly we will all hang separately.” In a way, this admonition underscores the important role of managers in identifying emerging market trends. It is often said that in economics everything hangs together. Changes in consumer demand for seemingly unrelated goods and services may produce ripple effects that could threaten a company’s survival, or they may create new and promising profit opportunities.

CHAPTER EXERCISES

2.1 In recent years there has been a sharp increase in commercial and rec-reational fishing in the waters around Long Island. Illustrate the effect of “over fishing” on inflation-adjusted seafood prices at Long Island area restaurants.

2.2 New York City is a global financial center. In the late-1990s the financial and residential real estate markets reached record-high price levels. Are these markets related? Explain.

2.3 Large labor unions always support higher minimum-wage legislation even though no union maker earns just the minimum wage. Explain.

2.4 Discuss the effect of a frost in Florida, which damaged a significant portion of the orange crop, on each of the following.

a. Price of Florida oranges

b. Price of California oranges

c. Price of tangerines

d. Price of orange juice

e. Price of apple juice

2.5 What is consumer surplus and producer surplus? How can these con-cepts be used to evaluate changes in market efficiency?

2.6 Discuss the effect of an imposition of a wine import tariff on the price of California wine.

2.7 The market demand for Brand x has been estimated as:

Q xd = 1,500 − 3Px − 0.05M − 2.5Py + 7.5Pz ,

where Px is the price of Brand x, M per capita income, Py the price of Brand y, and Pz the price of Brand z. Assume that Px = $2, M = $20,000, Py = $4, and Pz = $4.

a. With respect to changes in per capita income, what kind of good is Brand x?

b. How are Brands x and y related?

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Demand and Supply

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c. How are Brands x and z related?

d. How are Brands z and y related?

e. What is the market demand for Brand x?

2.8 Yell-O Yew-Boats, Ltd. produces Blue Meanies. Consider the demand and supply equations for Blue Meanies:

Qxd = 150 − 2Px + 0.001M + 1.5Py ;

Qxs = 60 + 4Px − 2.5W,

where Qx is monthly per family consumption of Blue Meanies, Px the price per unit of Blue Meanies, M median annual per family income ($25,000), Py the price per unit of Apple Bonkers ($5.00) and W the hourly per worker wage rate ($8.60).

a. What type of good is Apple Bonkers?

b. What are the equilibrium price and quantity of Blue Meanies?

c. Suppose that median per family income increases by $6,000. What are the new equilibrium price and quantity of Blue Meanies?

d. Suppose that in addition to the increase in median per family income, collective bargaining by Blue Meanie Local # 1 results in a $2.40 hourly increase in the wage rate. What are the new equilib-rium price and quantity?

e. In a same diagram, illustrate your answers to parts b, c, and d.

2.9 Consider the following demand and supply equations for sugar:

Qd = 1, 000 −1, 000P;

Qs = 800 + 1, 000P.

P is the price of sugar per pound and Q is the quantity of sugar in thousands of pounds.

a. What are the equilibrium price and quantity for sugar?

b. What is the value of net social welfare in this market?

c. Suppose that the government subsidizes sugar production by placing a price floor of $0.20 per pound. What is the relationship between the quantity supplied and quantity demand for sugar?

d. What is the effect on social welfare as a result of the price floor?

2.10 Occidental Pacific University is a large private university in California that is known for its strong athletics program, especially in football. At the request of the Dean of the College of Arts & Sciences, a professor

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52 Chapter 2

from the economics department estimated that student demand for student enrollment at the university is

Q xd = 5, 000 − 0.5Px + 0.1M + 0.25Py ,

where Qx is the number of full-time students, Px tuition charged full-time students per semester, M national income ($ billions), and Py tuition charged full-time students per semester by Oriental Atlantic University in Maryland, Occidental’s closest competitor on the grid iron.

a. Suppose that full-time enrollment at Occidental is 4,000 students. If M = $7,500 and Py = $6,000, how much tuition is Occidental charging its full-time students?

b. The administration is considering a promotional campaign designed to bolster admissions and tuition revenues. The cost of the cam-paign will be $750,000. The economics professor believes that the promotional campaign will increase demand to

Q xd = 5,100 − 0.45Px + 0.1M + 0.25Py .

If the economic professor is correct, forecast Occidental’s full-time enrollment?

c. Assuming no change in real GDP or full-time tuition charged by Oriental, will the promotional campaign be effective? (Hint: Com-pare Occidental’s tuition revenues before and after the promotional campaign.)

d. The director of Occidental’s athletic department claims that the increase in enrollment resulted from the football team’s NCAA Division I national championship. Is this claim reasonable? How would it show up in the new demand equation?

2.11 The market demand and supply equations for a good are:

Q d = 50 −10P;

Q s = 20 + 2.5P.

a. What is the equilibrium price and equilibrium quantity?

b. What is the value of net social welfare?

c. What is the effect on net social welfare if the government imposes a price ceiling of $3.00?

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Notes

1. The word “horizontal” indicates that the market quantity demanded is the sum of the quantities demanded by individual consumers along the horizontal axis.

2. A brief discussion of ordinary least squares regression analysis, which is used to generate parameter estimates of equations in linear form on the basis of historical data, is presented in the Appendix.

3. In 1970, Americans spent about $6 billion on fast food. By 2000, this had increased to more than $110 billion. The reason was principally economic. After peaking in1973, the hourly wage in the U.S. declined steadily for the next twenty-five years. Housewives responded by entering the workforce in record numbers, which resulted in a dramatic increase in the demand for such services as cooking, cleaning, and child care. A generation earlier, three-quarters of the family budget allocated for food was used to prepare meals at home. By 2000, about half the family budget was spent dining out, mainly at fast-food restaurants. Americans now spend more money on fast food than on higher education, personal computers, computer software, or new cars, and more on movies, books, magazines, newspapers, videos, and recorded music combined.

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