CHAPTER 2 A change in income shifts the entire

demand curve. Whether an increase in

Supply and Demand – Driving forces behind the income shifts the demand curve to the right or
market economies. to the left depends on the nature of consumer
Supply and demand analysis is a qualitative tool consumption patterns.
that empowers managers by enabling them to see the - Changes in income tend to have
“big picture.” It is a qualitative forecasting tool you profound effects on the demand for
can use to predict trends in competitive markets, durable goods, and these effects are
including changes in the prices of your firm’s typically amplified in developing
products, related products (both substitutes and countries and rural areas.
complements), and the prices of inputs (such as labor - It is important to point out that by calling
services) that are necessary for your operations. such goods inferior, we do not imply
that they are of poor quality; we use
law of demand. Price and quantity demanded this term simply to define products that
are inversely related. As the price of a good rises consumers purchase less of when their
(falls) and all other things remain constant, the incomes rise and purchase more of when
quantity demanded of the good falls (rises). their incomes fall

market demand curve. A curve indicating the total Two types of Goods
quantity of a good all consumers are willing and able 1. normal good. A good for which an
to purchase at each possible price, holding the prices increase (decrease) in income leads to an
of related goods, income, advertising, and other increase (decrease) in the demand for that
variables constant. good. DIRECT
2. inferior good. A good for which an
change in quantity demanded. Changes in the
increase (decrease) in income leads to a
price of a good lead to a change in the quantity
decrease (increase) in the demand for that
demanded of that good. This corresponds to a
good. INVERSELY RELATED
movement along a given demand curve.
b. PRICES OF RELATED GOODS
1. substitutes. Goods for which an increase
(decrease) in the price of one good leads to
an increase (decrease) in the demand for
the other good. DIRECTLY
2. complements. Goods for which an
increase (decrease) in the price of one
good leads to a decrease (increase) in the
demand for the other good. INVERSELY

c. ADVERTISING AND CONSUMER

TASTES

A representative demand curve is given by D0. The

movement along a demand curve, such as the
movement from A to B, is called a change in
quantity demanded.

An increase in advertising shifts the

demand curve to the right, from D1 to D2
1. Informative Advertising - Advertising
often provides consumers with
information about the existence or
quality of a product, which in turn
induces more consumers to buy the
product
2. Persuasive Advertising - Advertising can
change in demand. Changes in variables other than also influence demand by altering the
the price of a good, such as income or the price of underlying tastes of consumers.
another good, lead to a change in demand. This
corresponds to a shift of the entire demand d. POPULATION
curve. - The demand for a product is also
Demand Shifters - Variables other than the influenced by changes in the size and
price of a good that influence demand composition of the population.
- As the population rises, more and more
Rightward shift – increase in demand individuals wish to buy a given product,
and this has the effect of shifting the
Leftward shift - decrease in demand demand curve to the right. DIRECTLY
- Composition of the population can also
a. INCOME affect the demand for a product.
 o middle-aged consumers desire 1
different types of products than ¿ BxH
2
retirees
o increase in the number of market supply curve summarizes the total quantity
consumers in the 30- to 40-year-old all producers are willing and able to produce at
age bracket will increase the alternative prices, holding other factors that affect
demand for products like real supply constant.
estate.
o as a greater proportion of the
population ages, the demand for
medical services will tend to
increase.

e. CONSUMER EXPECTATIONS
- Changes in consumer expectations also
can change the position of the demand
curve for a product. e.g., consumers
suddenly expect the price of automobiles
to be significantly higher next year, the
demand for automobiles today will
increase.
- STOCKPILING - If consumers expect
future prices to be higher, they will change in quantity supplied. Changes in the price
substitute current purchases for future of a good lead to a change in the quantity supplied of
purchases. that good. This corresponds to a movement along a
- The current demand for a perishable given supply curve.
product such as bananas generally is not
affected by expectations of higher change in supply. Changes in variables other than
future prices. the price of a good, such as input prices or
technological advances, lead to a change in supply.
Any variable that affects the willingness or ability of This corresponds to a shift of the entire supply curve.
consumers to purchase a particular good is a potential
demand shifter. Prices of the good itself – movement along the
supply curve. The movement along a supply curve,
demand function. A function that describes how such as the one from A to B in Figure 2–6, is called a
much of a good will be purchased at alternative prices change in quantity supplied. The fact that the market
of that good and related goods, alternative income supply curve slopes upward reflects the inverse law of
levels, and alternative values of other variables supply: As the price of a good rises (falls) and other
affecting demand. things remain constant, the quantity supplied of the
good rises (falls). DIRECTLY
linear demand function. A representation of the
demand function in which the demand for a given SUPPLY SHIFTERS
good is a linear function of prices, income levels, and
other variables influencing demand. Shift to the left – decrease

d Shift to the right - increase

Q x= quantity demanded of good
a. Input Prices
P x = price of good - As production costs change, the
willingness of producers to produce
P y = price of related good output at a given price change. As the
price of an input rises, producers are
M = price of related good willing to produce less output at each
given price. This decrease in supply is
H = any other variable that that affects depicted as a leftward shift in the supply
demand curve. INVERSE
b. Technology or Government Regulations
Q x =a 0+ a x P x+ a y P y + aM M +a H H
d
- Technological changes and changes in
government regulations also can affect the
d
Demand is linear if Q x is a linear function of position of the supply curve. Changes that
prices, income, and other variables that make it possible to produce a given output
influence demand. at a lower cost, such as the ones
highlighted in Inside Business 2–2, have
The a iare fixed numbers that the firm’s research the effect of increasing supply. INVERSE
department or an economic consultant typically c. Number of Firms
provides to the manager. - The number of firms in an industry affects
the position of the supply curve. As
By the law of demand, the amount a consumer is additional firms enter an industry, more
willing to pay for an additional unit of a good falls as and more output are available at each
more of the good is consumed. given price. This is reflected by a rightward
shift in the supply curve. Similarly, as firms
consumer surplus—the value consumers get from a
leave an industry, fewer units are sold at
good but do not have to pay for. This concept is
each price, and the supply decreases
important to managers because it tells how much
(shifts to the left).
extra money consumers would be willing to pay for a
d. Substitutes in Production
given amount of a purchased product.
- When the price of cars rises, these firms
Total consumer suprlus – sum of consumer surplus can convert some of their Truck assembly
of all buiyers lines to car assembly lines to increase the
 quantity of cars supplied. This has the
effect of shifting the truck supply
curve to the left.
e. Taxes
- excise tax - where the tax revenue is
collected from the supplier. Effect of
decreasing the supply of a good. Fixed
taxes
- Thus, an excise tax has the effect of
decreasing the supply of a good
- Ad valorem literally means “according to
the value.” An ad valorem tax is a
percentage tax; the sales tax is a well-
known example. The higher, the selling
price the higher the tax.
- An ad valorem tax will rotate the Geometrically, producer surplus is the area
supply curve counterclockwise and above the supply curve but below the market
the new curve will shift farther away price of the good. Thus, the shaded area in Figure
from the original curve as the price 2–9 represents the surplus producers receive by
increases. This explains why S1 is steeper selling 800 units at a price of $400—an amount above
than S0 in Figure 2–8. what would be required to produce each unit of the
good. The shaded area, ABC, is the producer surplus
when the price is $400. Mathematically, this area
is one-half of 800 times $266.67, or $106,668.
MARKET EQUILIBRIUM. The equilibrium price in a
competitive market is determined by the interactions
of all buyers and sellers in the market. The concepts
of market supply and market demand make this
notion of interaction more precise: The price of a good
in a competitive market is determined by the
- interaction of market supply and market demand for
the good
f. Producer expectations
In situations where a shortage exists, there is a
- Producer expectations about future prices
also affect the position of the supply curve. natural tendency for the price to rise; consumers
unable to buy the good may offer producers a higher
In effect, selling a unit of output today and
price in an attempt to get the product.
selling a unit of output tomorrow are
substitutes in production. Whenever a surplus exists, there is a natural
- If firms suddenly expect prices to be tendency for the price to fall to equate quantity
higher in the future and the product is supplied with quantity demanded; producers unable
not perishable, producers can hold to sell their products may ask for a lower price in an
back output today and sell it later at a attempt to reduce their unsold inventories.
higher price. This has the effect of
shifting the current supply curve to the
left.

Supply function. A function that describes how

much of a good will be produced at alternative prices price ceiling. The maximum legal price that can be
of that good, alternative input prices, and alternative charged in a market.
values of other variables affecting supply.
It is important to keep in mind that it is not the price
linear supply function. A representation of the system that is “unfair” if one cannot afford to pay
supply function in which the supply of a given good is the market price for a good; rather, it is unfair
a linear function of prices and other variables that we live in a world of scarcity.
affecting supply
Do not be confused by the fact that the price ceiling is
producer surplus. The amount producers receive in below the initial equilibrium price; the term ceiling
excess of the amount necessary to induce them to refers to that price being the highest
produce the good. permissible price in the market.
Just as consumers want price to be as low as possible,
producers want price to be as high as possible.

full economic price. The dollar amount paid to a

firm under a price ceiling, plus the nonpecuniary
price.
The answer lies in who benefits from and who is
harmed by ceilings. When lines develop due to a
shortage caused by a price ceiling, people with
high opportunity costs are hurt, while people
with low opportunity costs may actually benefit.
For example, if you have nothing better to do than
wait in line, you will benefit from the lower dollar
price; your nonpecuniary price is close to zero.
On the other hand, if you have a high opportunity
cost of time because your time is valuable to you,
you are made worse off by the ceiling. If a
particular politician’s constituents tend to have a
lower-than-average opportunity cost, that
politician naturally will attempt to invoke a price
ceiling.
price floor. The minimum legal price that can be
charged in a market.
When price floors are above the equilibrium price,
there will be consumers with willingness to-pay that is
more than production costs but is less than the price
floor.
These consumers will be unable to purchase when the
price floor is in place, which results in a loss of
social welfare.
lost social welfare is the vertical difference
between the demand and supply curve for all units
between Qd and Qe
Perhaps the best-known price floor is the minimum
wage, the lowest legal wage that can be paid to
workers.
This type of price floor, where the government
purchases the surplus, is called a price support.