1
Give clear and detailed answers
(Chapter 1)
1. Many analysts have argued that the federal government should stop spending money on
programs such as agricultural price supports and should redirect that spending to such things
as improvements in the nation's roads and bridges. Construct an economic argument that
supports this proposed change in policy.
ANSWER:
(Chapter 5)
2. Distinguish between implicit and explicit costs and give examples of each. In addition,
explain how explicit and implicit costs affect the distinction between economic profit and
accounting profit. What explains the distinction between the two measures of profit?
ANSWER:
(Chapter 7)
3. Over time, state and local governments have passed regulations that limit entry into certain
markets. For example, in most locations beauty shops and barber shops must obtain a license
to do business. The usual justification for such licensing requirements is to better ensure that
only qualified people are offering such services. Considering the efficiency implications of
having more or less firms serve a particular market, and the fact that consumers can "vote
with their feet" (i.e., buy from a different if they aren't satisfied), is such regulation justified
from an economic perspective? Why or why not?
ANSWER:
(Chapter 8)
4. Describe the basic characteristics of the monopoly model and explain how these
characteristics affect the ability of a monopolist to earn positive economic profits, both in the
short run and over time.
ANSWER:
5. Compare and contrast the potential for a perfectly competitive firm and a monopolistically
competitive firm to earn positive economic profits in the short run versus the long run.
Explain your reasoning.
ANSWER:
2
6. Assume the market shares of the six largest firms in an industry are 12 percent each.
Calculate the six-firm concentration ratio and Herfindahl-Hirschman index for this industry.
What does each of these measures have to say about the degree of concentration in the
industry? Explain.
ANSWER:
(Chapter 9)
7. Assume two firms are currently competing in a market. If one of the two firms wants to try to
eliminate the other firm as a competitor, should it undertake a strategy of limit pricing or
predatory pricing? Why? In addition, describe the conditions under which the strategy you
have selected will be most successful.
ANSWER:
8. Summarize the three conditions cited in the text under which a cartel is most likely to
succeed. Of these three, which do you think is most important? Why?
ANSWER:
9. Explain the difference between a cartel and tacit collusion. Is tacit collusion illegal in the
United States? Explain.
ANSWER:
(Chapter 11)
10
What are some of the issues associated with the consumer price index?
ANSWER:
(Chapter 13)
11. Describe the fractional reserve banking system.
ANSWER:
(Chapter 14)
12. Briefly explain the difference between leading, coincident, and lagging indicators.
ANSWER:
PART 1 Microeconomic Analysis
1
Managers and Economics
W
hy should managers study economics? Many of you are
probably asking yourself this question as you open this text.
Students in Master of Business Administration (MBA) and
Executive MBA programs usually have some knowledge of
the topics that will be covered in their accounting, marketing, finance, and
management courses. You may have already used many of those skills on
the job or have decided that you want to concentrate in one of those areas in
your program of study.
But economics is different. Although you may have taken one or two introductory economics courses at some point in the past, most of you are not
going to become economists. From these economics classes, you probably
have vague memories of different graphs, algebraic equations, and terms such
as elasticity of demand and marginal propensity to consume. However, you
may have never really understood how economics is relevant to managerial
decision making. As you’ll learn in this chapter, managers need to understand the insights of both microeconomics, which focuses on the behavior of
individual consumers, firms, and industries, and macroeconomics, which analyzes issues in the overall economic environment. Although these subjects are
typically taught separately, this text presents the ideas from both approaches
and then integrates them from a managerial decision-making perspective.
As in all chapters in this text, we begin our analysis with a case study. The
case in this chapter, which focuses on the global automobile industry, provides an overview of the issues we’ll discuss throughout this text. In particular, the case illustrates how the automobile industry is influenced by both the
microeconomic issues related to production, cost, and consumer demand and
the larger macroeconomic issues including the uncertainty in global economic
activity, particularly in Europe, and the value of various countries’ currencies
relative to the U.S. dollar.
32
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Case for Analysis
Micro- and Macroeconomic Influences on the Global Automobile Industry
In September 2012, U.S. automobile sales increased to 1.19
million cars and light trucks per month, a 12.8 percent increase
from a year earlier. This increase represented an annualized rate
of 14.94 million vehicles, the highest sales rate since March
2008 before the recession began in the United States. Much of
the increase was driven by passenger car sales at Toyota Motor
Corp., Honda Motor Co., and Chrysler Group LLC. There was
a significant increase in sales for Toyota and Honda from the
previous year, as both companies were recovering from the
earthquake that hit Japan in March 2011.1 Analysts noted similar increases in August 2012 that were attributed to pent-up
consumer demand for replacing aging vehicles and the lowinterest financing and other incentives Japanese auto makers
offered to regain market share lost in 2011 due to the lack of
availability of their cars.2
Automobile production in the United States had expanded
in 2012, given favorable foreign exchange rates and a plentiful supply of affordable labor. Toyota, Honda, and Nissan
Motor Co. all increased their production capacity in the
United States with the goal of shipping automobiles to
Europe, Korea, the Middle East, and other countries. The
strong value of the yen, and conversely the weak U.S. dollar,
gave Japanese producers the incentive to produce cars in the
United States for export around the world. This investment
by foreign automobile producers helped the U.S. economy
that was still struggling to recover from the recession of
2007–2009. Automobile industry employment in the United
States was estimated to increase from 566,400 in 2010 to
756,800 in 2015. Although these estimates were well below
the 1.1 million automobile workers employed in 1999, they
indicated that the economic recovery was moving forward.
General Motors Co., which had once encouraged auto parts
1
Jeff Bennett, “Corporate News: Passenger Cars Lift U.S. Sales—
Big Gains for Toyota, Honda, Chrysler: Pickup Weakness Weighs
on GM, Ford,” Wall Street Journal (Online), October 3, 2012.
2
Christina Rogers, “August U.S. Car Sales Surge,” Wall Street
Journal (Online), September 4, 2012.
suppliers to relocate in low-wage countries, now encouraged
them to locate near U.S. auto plants.3
U.S. auto producers, who had once essentially lost the competition to their Japanese rivals in the 1980s and 1990s and
who went through government-backed (GM and Chrysler)
or private (Ford) restructurings during the U.S. recession,
regained profitability and invested in the engineering and redesign of their cars. Several Fords were designed with a voiceoperated Sync entertainment system, and the Chevrolet Cruze
that was launched in 2010 came with 10 air bags compared
with 6 for the Toyota Corolla. As the U.S. economy recovered,
Americans also began purchasing more trucks and sport-utility
vehicles (SUVs), which helped to restore profits and market
share for the Detroit auto makers. Trucks and SUVs made up
47.3 percent of the U.S. market in 2009, 50.2 percent in 2010,
and 50.8 percent in 2011. This segment of the market had been
hit particularly hard during the U.S. recession.4
As the U.S. automobile industry revived, the competition
between Ford and GM again became more intense. In 2008,
Ford supported the government bailout for GM and Chrysler
because Ford was worried that a collapse of these companies
would also impact the auto parts industry. As the domestic
auto industry recovered, Ford, which had often focused just
on Toyota as its key competitor, began developing strategies to
counter GM. Ford realized that customers who had long been
loyal to Asian brands were again looking at U.S. cars, given the
generally perceived quality increases in the U.S. auto industry.5
3
Joseph B. White, Jeff Bennett, and Lauren Weber, “Car Makers’
U-Turn Steers Job Gains,” Wall Street Journal (Online),
January 23, 2012; Neal Boudette, “New U.S. Car Plants Signal
Renewal for Manufacturing,” Wall Street Journal (Online),
January 26, 2012.
4
Mike Ramsey and Sharon Terlep, “Americans Embrace SUVs
Again,” Wall Street Journal (Online), December 2, 2011; Jeff
Bennett and Neal E. Boudette, “Revitalized Detroit Makes Bold
Bets on New Models,” Wall Street Journal (Online), January 9,
2012.
5
Sharon Terlep and Mike Ramsey, “Ford and GM Renew a Bitter
Rivalry,” Wall Street Journal (Online), November 23, 2011.
33
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34
PART 1 Microeconomic Analysis
Japanese auto makers in 2011 and 2012 faced managerial
decisions that were influenced both by the nature of the competition from their rivals and by macroeconomic conditions,
most importantly the value of the exchange rate between the
yen and the U.S. dollar.6 Production by both Toyota and Honda
was hit by the earthquake and tsunami in Japan in March 2011
and by subsequent flooding in Thailand that disrupted the supply of electronics and other auto parts made there. Toyota sales
were also influenced by the recall and quality issues in 2010
related to the gas pedal and floor mat design. Honda’s redesigned 2012 Civic was criticized for its technology and lessthan-luxurious interior. The car was dropped from Consumer
Reports’ recommended list in August 2011. Honda officials
acknowledged that they had underestimated the competition
from U.S. producers.
The strong yen, which made exports from Japan less price
competitive, also gave the Japanese producers the incentive
to produce their cars in the United States. Honda, which had
produced 1.29 million vehicles in North America in 2010,
planned to open a new plant in Mexico and expand production in all seven of its existing assembly plants to 2 million
cars and trucks per year. Production abroad was a particular issue for Toyota, which made half of its automobiles
in Japan, compared to Honda and Nissan, which produced
about one-third of their output in Japan. The president of
Toyota, Akio Toyoda, grandson of the company founder, had
made a public commitment to build at least 3 million cars
in Japan annually, half of which would be for export. Some
company officials argued for streamlining production in
Japan by decreasing production without raising costs, essentially redefining the economies of scale in the company’s
production process. These officials believed the company
could meet domestic goals with high-precision production,
cost-cutting, and collaboration on new technology with parts
suppliers.
Auto producers also focused on China during this period,
although there was concern about the slowing Chinese economy.7 Auto sales in China increased only 2.5 percent in 2011
compared with increases of 46 percent in 2009 and 32 percent
6
The following discussion is based on Jeff Bennett and Neal
E. Boudette, “Revitalized Detroit Makes Bold Bets on New
Models”; Mike Ramsey and Yoshio Takahashi, “Car Wreck:
Honda and Toyota,” Wall Street Journal (Online), November 1,
2011; Chester Dawson, “For Toyota, Patriotism and Profits May
Not Mix,” Wall Street Journal (Online), November 29, 2011;
Mike Ramsey and Neal E. Boudette, “Honda Revs Up Outside
Japan,” Wall Street Journal (Online), December 21, 2011; and
Yoshio Takahashi and Chester Dawson, “Japan Auto Makers on
a Roll,” Wall Street Journal (Online), April 22, 2012.
7
This discussion is based on Andrew Galbraith, “Car Makers
Still Look to China,” Wall Street Journal (Online), April 19,
2012; Sharon Terlep and Mike Ramsey, “Ford Bets $5 Billion on
Made in China,” Wall Street Journal (Online), April 20, 2012;
Chester Dawson and Sharon Terlep, “China Ramps Up Auto
Exports,” Wall Street Journal (Online), April 24, 2012; and
Sharon Terlep, “Balancing the Give and Take in GM’s Chinese
Partnership,” Wall Street Journal (Online), August 19, 2012.
M01_FARN0095_03_GE_C01.INDD 34
in 2010. However, the size of the Chinese economy continued to be the major incentive for expansion in that country. In
April 2012, Ford announced that it would build its fifth factory in eastern China as part of its plan to double its production capacity and sales outlets in the country by 2015. This
production increase would make the company capable of
producing 1.2 million passenger cars in China, approximately
half of the number of cars it built in North America in 2011.
Ford lagged behind other major auto producers in entering
the world’s largest car market. Ford’s strategy was to build
cars from platforms developed elsewhere to minimize costs.
However, these platforms might not provide enough space
in the back seats to appeal to affluent Chinese, who often
employed drivers. General Motors developed a partnership
with Chinese SAIC Motor Corp. to become the dominant foreign competitor in China. This partnership resulted in production changes such as designing Cadillacs with softer corners,
dashboards with more gadgets, and increasing the comfort of
the rear seats to appeal to Chinese consumers. The challenge
for GM was that SAIC could also use GM’s expertise and
technology to make itself a major competitor with the U.S.
company. In 2012, the Chinese automobile industry began
increasing exports, although these were not thought to be a
threat in developed markets in the United States and Europe,
given perceived quality issues including lack of air-conditioning and power windows. However, Chinese producers were
making inroads into emerging markets in Africa, Asia, and
Latin America.
The other major influence on the global auto industry in
2011 and 2012 was the recession and economic crisis in
Europe.8 In October 2012, Ford announced a plan to cut its
operating losses in Europe by closing three auto-assembly and
parts factories in the region, reduce its workforce by 13 percent, and decrease automobile production by 18 percent. Ford
predicted a loss of $1.5 billion in Europe in 2012 and a similar
loss in 2013. The cost-cutting in Europe was combined with
the introduction of several new commercial vans and SUVs and
the introduction of the Mustang sports car for the first time. All
European auto makers faced decreased car sales and chronic
overcapacity at this time. Daimler AG, maker of MercedesBenz automobiles, announced that it would not achieve its
profit targets, while PSA Peugeot Citroen SA announced a
government bailout of its financing arm and a cost-sharing
pact with General Motors. There had been a smaller decrease
in auto-producing capacity in Europe since the 2008 financial
crisis compared with that during the restructuring of the U.S.
auto industry that was influenced by the federal government
bailout.
8
This discussion is based on Sharon Terlep and Sam
Schechner, “GM, Peugeot Take Aim at Europe Woes,” Wall
Street Journal (Online), July 12, 2012; Mike Ramsey, David
Pearson, and Matthew Curtin, “Daimler Warns as Europe Car
Makers Cut Back,” Wall Street Journal (Online), October 24,
2012; and Marietta Cauchi and Mike Ramsey, “Ford to Shut
3 Europe Plants,” Wall Street Journal (Online), October 25,
2012.
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CHAPTER 1 Managers and Economics
35
Two Perspectives: Microeconomics
and Macroeconomics
As noted above, microeconomics is the branch of economics that analyzes the
decisions that individual consumers and producers make as they operate in a market economy. When microeconomics is applied to business decision making, it is
called managerial economics. The key element in any market system is pricing,
because this type of system is based on the buying and selling of goods and services. As we’ll discuss later in the chapter, prices—the amounts of money that
are charged for different goods and services in a market economy—act as signals
that influence the behavior of both consumers and producers of these goods and
services. Managers must understand how prices are determined—for both the
outputs, or products sold by a firm, and the inputs, or resources (such as land,
labor, capital, raw materials, and entrepreneurship) that the firm must purchase
in order to produce its output. Output prices influence the revenue a firm derives
from the sale of its products, while input prices influence a firm’s costs of production. As you’ll learn throughout this text, many managerial actions and decisions
are based on expected responses to changes in these prices and on the ability of a
manager to influence these prices.
Managerial decisions are also influenced by events that occur in the larger economic environment in which businesses operate. Changes in the overall level of
economic activity, interest rates, unemployment rates, and exchange rates both
at home and abroad create new opportunities and challenges for a firm’s competitive strategy. This is the subject matter of macroeconomics, which we’ll cover
in the second half of this text. Managers need to be familiar with the underlying macroeconomic models that economic forecasters use to predict changes in
the macroeconomy and with how different firms and industries respond to these
changes. Most of these changes affect individual firms via the pricing mechanism,
so there is a strong connection between microeconomic and macroeconomic
analysis.9
In essence, macroeconomic analysis can be thought of as viewing the economy from an airplane 30,000 feet in the air, whereas with microeconomics the
observer is on the ground walking among the firms and consumers. While on the
ground, an observer can see the interaction between individual firms and consumers and the competitive strategies that various firms develop. At 30,000 feet,
however, an observer doesn’t see the same level of detail. In macroeconomics,
we analyze the behavior of individuals aggregated into different sectors in the
economy to determine the impact of changes in this behavior on the overall level
of economic activity. In turn, this overall level of activity combines with changes
in various macro variables, such as interest rates and exchange rates, to affect
the competitive strategies of individual firms and industries, the subject matter of
microeconomics. Let’s now look at these microeconomic influences on managers
in more detail.
Microeconomics
The branch of economics that
analyzes the decisions that
individual consumers, firms, and
industries make as they produce,
buy, and sell goods and services.
Managerial economics
Microeconomics applied to
business decision making.
Prices
The amounts of money that are
charged for goods and services in
a market economy. Prices act as
signals that influence the behavior
of both consumers and producers
of these goods and services.
Outputs
The final goods and services
produced and sold by firms in
a market economy.
Inputs
The factors of production, such as
land, labor, capital, raw materials,
and entrepreneurship, that are used
to produce the outputs, or final
goods and services, that are bought
and sold in a market economy.
Macroeconomics
The branch of economics that
focuses on the overall level of
economic activity, changes in the
price level, and the amount of
unemployment by analyzing group
or aggregate behavior in different
sectors of the economy.
9
Note that the terms micro and macro are used differently in various business disciplines. For example, in
Marketing Management, The Millennium Edition (Prentice Hall, 2000), Philip Kotler describes the “macro
environment” as dealing with all forces external to the firm. His examples include both (1) the gradual opening of new markets in many countries and the growth in global brands of various products (microeconomic
factors for the economist) and (2) the debt problems of many countries and the fragility of the international
financial system (macroeconomic problems from the economic perspective). In each business discipline,
you need to learn how these terms and concepts are defined.
M01_FARN0095_03_GE_C01.INDD 35
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36
PART 1 Microeconomic Analysis
Microeconomic Influences on Managers
Relative prices
The price of one good in relation to
the price of another, similar good,
which is the way prices are defined
in microeconomics.
The discussion of the global automobile industry in the opening case illustrates several microeconomic factors influencing managerial decisions. In 2012, Japanese auto
makers used low-interest financing and other incentives to regain market share lost
in previous years. Toyota had to recover from the impact of its recall and negative
quality issues in 2010, while Honda stumbled on the redesign of its 2012 Civic by not
incorporating features offered by its competitors. U.S. auto makers reengineered and
redesigned their production processes to add features with greater customer appeal.
They also responded to the increased demand for trucks and SUVs, a market segment that had been negatively impacted by the recession. Ford and GM began reengaging in their traditional market rivalry. All producers who planned to sell in China,
the world’s largest automobile market, had to recognize the difference in tastes and
preferences of Chinese consumers, such as the desire for larger back seats.
Decisions about demand, supply, production, and market structure are all microeconomic choices that managers must make. Some decisions focus on the factors
that affect consumer behavior and the willingness of consumers to buy one firm’s
product as opposed to that of a competitor. Thus, managers need to understand
the variables influencing consumer demand for their products. Because consumers
typically have a choice among competing products, these choices and the demand
for each product are influenced by relative prices, the price of one good in relation to that of another, similar good. Relative prices are the focus of microeconomic analysis. The Japanese auto makers’ use of low-interest financing and other
pricing incentives noted above is an example of a strategy based on influencing
relative prices. All auto makers discussed in the case had to respond to changing
consumer demand over time and to variations in consumer tastes and preferences
that influenced demand in different countries.
Production technology and the prices paid for the resources used in production
influence a company’s final costs of production. The relative prices of these resources
or factors of production will influence the choices that managers make among different production methods. Whether a production process uses large amounts of
plant and equipment relative to the amount of workers and whether a business operates out of a small office or a giant factory are microeconomic production and cost
decisions managers must make. As noted in the case, Ford Motor Co. used production platforms developed elsewhere to minimize its production costs as it entered
the Chinese market. However, this cost-minimizing strategy was not appropriate for
producing cars with larger back seats that appealed to affluent Chinese customers.
General Motors also had to redesign its Cadillac to meet Chinese demand.
Markets
Markets
The institutions and mechanisms
used for the buying and selling of
goods and services. The four major
types of markets in microeconomic
analysis are perfect competition,
monopolistic competition,
oligopoly, and monopoly.
All of the auto makers in the opening case made strategic decisions in light of their
knowledge of the market environment or structure. Markets, the institutions and
mechanisms used for the buying and selling of goods and services, vary in structure
from those with hundreds or thousands of buyers and sellers to those with very few
participants. These different types of markets influence the strategic decisions that
managers make because markets affect both the ability of a given firm to influence
the price of its product and the amount of independent control the firm has over
its actions.
There are four major types of markets in microeconomic analysis:
1.
2.
3.
4.
M01_FARN0095_03_GE_C01.INDD 36
Perfect competition
Monopolistic competition
Oligopoly
Monopoly
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CHAPTER 1 Managers and Economics
Large Number of Firms
Perfect Competition
Single Firm
Monopolistic Competition
Oligopoly
Monopoly
37
FIGURE 1.1
Market Structure
These market structures can be located along a continuum, as shown in Figure 1.1.
At the left end of the continuum, there are a large number of firms in the market,
whereas at the right end of the continuum there is only one firm. (We’ll discuss other
characteristics that distinguish the markets later in the chapter.)
The two market structures at the ends of the continuum, perfect competition
and monopoly, are essentially hypothetical models. No real-world firms meet all
the assumptions of perfect competition, and few could be classified as monopolies. However, these models serve as benchmarks for analysis. All real-world firms
contain combinations of the characteristics of these two models. Managers need
to know where their firm lies along this continuum because market structure will
influence the strategic variables that a firm can use to face its competition.
The major characteristics that distinguish these market structures are
1. The number of firms competing with one another that influences the firm’s
control over its price
2. Whether the products sold in the markets are differentiated or undifferentiated
3. Whether entry into and exit from the market by other firms is easy or difficult
4. The amount of information available to market participants
The Perfect Competition Model The model of perfect competition, which
is on the left end of the continuum in Figure 1.1, is a market structure characterized by
1.
2.
3.
4.
A large number of firms in the market
An undifferentiated product
Ease of entry into the market
Complete information available to all market participants
In perfect competition, we distinguish between the behavior of an individual
firm and the outcomes for the entire market or industry, which represents all firms
producing the product. Economists make the assumption that there are so many
firms in a perfectly competitive industry that no single firm has any influence on
the price of the product. For example, in many agricultural industries, whether an
individual farmer produces more or less product in a given season has no influence
on the price of these products. The individual farmer’s output is small relative to
the entire market, so the market price is determined by the actions of all farmers supplying the product and all consumers who purchase the goods. Because
individual producers can sell any amount of output they bring to market at that
price, we characterize the perfectly competitive firm as a price-taker. This firm
does not have to lower its price to sell more output. In fact, it cannot influence the
price of its product. However, if the price for the entire amount of output in the
market increases, consumers will buy less, and if the market price of the product
decreases, they will buy more.
In the model of perfect competition, economists also assume that all firms in an
industry produce the same homogeneous product, so there is no product differentiation. For example, within a given grade of an agricultural product, potatoes or
peaches are undifferentiated. This market characteristic means that consumers do
not care about the identity of the specific supplier of the product they purchase.
They may not even know who supplies the product, and that knowledge would be
irrelevant to their purchase decision, which will be based largely on the price of
the product.
M01_FARN0095_03_GE_C01.INDD 37
Perfect competition
A market structure characterized
by a large number of firms in
an industry, an undifferentiated
product, ease of entry into the
market, and complete information
available to participants.
Price-taker
A characteristic of a perfectly
competitive firm in which the firm
cannot influence the price of its
product, but can sell any amount of
its output at the price established
by the market.
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38
PART 1 Microeconomic Analysis
Profit
The difference between the total
revenue that a firm receives for
selling its product and the total cost
of producing that product.
Market power
The ability of a firm to influence the
prices of its products and develop
other competitive strategies that
enable it to earn large profits over
longer periods of time.
Imperfect competition
Market structures of monopolistic
competition, oligopoly, and
monopoly, in which firms have
some degree of market power.
Monopoly
A market structure characterized by
a single firm producing a product
with no close substitutes.
Barriers to entry
Structural, legal, or regulatory
characteristics of a firm and its
market that keep other firms from
easily producing the same or similar
products at the same cost.
Monopolistic competition
A market structure characterized
by a large number of small firms
that have some market power as a
result of producing differentiated
products. This market power can be
competed away over time.
Oligopoly
A market structure characterized by
competition among a small number
of large firms that have market
power, but that must take their
rivals’ actions into account when
developing their own competitive
strategies.
M01_FARN0095_03_GE_C01.INDD 38
The third assumption of the perfectly competitive model is that entry into the
industry by other firms is costless. This means that if a perfectly competitive firm
is making a profit (earning revenues in excess of its costs), other firms will also
enter the industry in an attempt to earn profits. However, these actions will compete away excess profits for all firms in a perfectly competitive industry.
The final assumption of the perfectly competitive model is that complete information is available to all market participants. This means that all participants
know which firms are earning the greatest profits and how they are doing so.
Thus, other firms can easily emulate the strategies and techniques of the profitable firms, which will result in greater competition and further pressure on any
excess profits.
While the details of this process will be described in later chapters, these four
assumptions mean that perfectly competitive firms have no market power—the
ability to influence their prices and develop other competitive strategies that allow
them to earn large profits over longer periods of time. All of the other market structures in Figure 1.1 represent imperfect competition, in which firms have some
degree of market power. How much market power these firms have and how they
are able to maintain it differ among the market structures.
The Monopoly Model At the right end of the market structure continuum in
Figure 1.1 is the monopoly model, in which a single firm produces a product for
which there are no close substitutes. Thus, as we move rightward along the continuum, the number of firms producing the product keeps decreasing until we reach
the monopoly model of one firm. A monopoly firm typically produces a product
that has characteristics and qualities different from the products of its competitors. This product differentiation often means that consumers are willing to pay
more for this product because similar products are not considered to be close
substitutes.
In the monopoly model, there are also barriers to entry, which are structural,
legal, or regulatory characteristics of the market that keep other firms from easily
producing the same or similar products at the same cost and that give a firm market power. However, while market power allows a firm to influence the prices of its
products and develop competitive strategies that enable it to earn larger profits, a
firm with market power cannot sell any amount of output at a given market price,
as in perfect competition. If a monopoly firm raises its price, it will sell less output,
whereas if it lowers its price, it will sell more output.
The Monopolistic Competition and Oligopoly Models The intermediate
models of monopolistic competition and oligopoly in Figure 1.1 better characterize the behavior of real-world firms and industries because they represent a blend
of competitive and monopolistic behavior. In monopolistic competition, firms
produce differentiated products, so they have some degree of market power.
However, because these firms are closer to the left end of the continuum in
Figure 1.1, there are many firms competing with one another. Each firm has only
limited ability to earn above-average profits before they are competed away over
time. In oligopoly markets, a small number of large firms dominate the market,
even if other producers are present. Mutual interdependence is the key characteristic of this market structure because firms need to take the actions of their rivals
into account when developing their own competitive strategies. Oligopoly firms
typically have market power, but how they use that power may be limited by the
actions and reactions of their competitors.
The opening case of this chapter did not explicitly discuss the market structure
of the major auto producers. However, because all of these firms are large multinational companies that sell globally, they obviously have substantial market power
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CHAPTER 1 Managers and Economics
39
and are located far from the model of perfect competition on the continuum in
Figure 1.1. The case noted that U.S. automobile sales were at an annualized rate of
14.94 million vehicles in 2012.
Large national or multinational companies typically find themselves operating in
multiple markets, making the analysis of market structure more complicated as the
market environment may differ substantially among these markets. Each of these
markets has its own characteristics in terms of the number and size of the competitors and product characteristics. Differences between the Chinese and U.S. markets were discussed throughout the case.
The Goal of Profit Maximization In all of the market models we have just
presented, we assume that the goal of firms is profit maximization, or earning
the largest amount of profit possible. Because profit, as defined above, represents
the difference between the revenues a firm receives for selling its output and its
costs of production, firms may develop strategies to either increase revenues or
reduce costs in an effort to increase profits. Profits act as a signal in a market
economy. If firms in one sector of the economy earn above-average profits, other
firms will attempt to produce the same or similar products to increase their profitability. Thus, resources will flow from areas of low to high profitability. As we
will see, however, the increased competition that results from this process will
eventually lead to lower prices and revenues, thus eliminating most or all of these
excess profits.
Profitability is the standard by which firms are judged in a market economy.
Profitability affects stock prices and investor decisions. If firms are unprofitable, they will go out of business, be taken over by other more profitable companies, or have their management replaced. Subsequently, we model a firm’s
profit-maximization decision largely in terms of static, single-period models where
information on consumer behavior, revenues, and costs is known with certainty.
Real-world managers must deal with uncertainty in all of these areas, which
may lead to less-than-optimal decisions, and managers must be concerned with
maximizing the firm’s value over time. The models we present illustrate the basic
forces influencing managerial decisions and the key role of profits as a motivating
incentive.
Profit maximization
The assumed goal of firms, which
is to develop strategies to earn the
largest amount of profit possible.
This can be accomplished by focusing on revenues, costs, or both.
Managerial Rule of Thumb
Microeconomic Influences on Managers
To develop a competitive advantage and increase their firm’s profitability, managers need to
understand:
How consumer behavior affects their revenues
How production technology and input prices affect their costs
How the market and regulatory environment in which managers operate influences their ability to
set prices and to respond to the strategies of their competitors ■
Macroeconomic Influences on Managers
The discussion of the impact of the global recession, the continued problems
in Europe’s financial recovery, and the role of currency exchange rates in the
case that opened this chapter can be placed within the circular flow model of
M01_FARN0095_03_GE_C01.INDD 39
Circular flow model
The macroeconomic model that
portrays the level of economic
activity as a flow of expenditures
from consumers to firms, or
producers, as consumers purchase
goods and services produced by
these firms. This flow then returns
to consumers as income received
from the production process.
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40
PART 1 Microeconomic Analysis
FIGURE 1.2
GDP and the Circular Flow
C = consumption spending
I = investment spending
G = government spending
X = export spending
M = import spending
Y = household income
S = household saving
TP = personal taxes
TB = business taxes
Foreign Sector
X
M
Domestic Markets for
Currently Produced
Goods and Services
C
Revenue
I
G
Household Sector
TP
S
Government Sector
Borrowing
Borrowing
TB
Firm Sector
Borrowing
Financial Markets
Y
Income:
Wages,
Rent,
Interest,
Profit
Absolute price level
A measure of the overall level of
prices in the economy.
Personal consumption
expenditures (C)
The total amount of spending by
households on durable goods,
nondurable goods, and services in a
given period of time.
Gross private domestic
investment spending (I)
The total amount of spending
on nonresidential structures,
equipment, software, residential
structures, and business inventories
in a given period of time.
M01_FARN0095_03_GE_C01.INDD 40
Expenses
Resource
Markets
macroeconomics, shown in Figure 1.2. This model portrays the level of economic
activity in a country as a flow of expenditures from the household sector to business firms as consumers purchase goods and services currently produced by these
firms and sold in the country’s output markets. This flow then returns to consumers as income received for supplying firms with the inputs or factors of production, including land, labor, capital, raw materials, and entrepreneurship, which are
bought and sold in the resource markets. These payments, which include wages,
rents, interest, and profits, become consumer income, which is again used to purchase goods and services—hence, the name circular flow. Figure 1.2 also shows
spending by firms, by governments, and by the foreign sector of the economy.
Corresponding to these total levels of expenditures and income are the amounts of
output produced and resources employed.
The levels of expenditures, income, output, and employment in relation to the
total capacity of the economy to produce goods and services will determine whether
resources are fully employed in the economy or whether there is unemployed labor
and excess plant capacity. This relationship will also determine whether and how
much the absolute price level in the economy is increasing. The absolute price level
is a measure of the overall price level in the economy as compared with the microeconomic concept of relative prices, which refers to the price of one particular good
compared to that of another, as we discussed earlier.
Economists use the circular flow model in Figure 1.2 to define and analyze the
spending behavior of different sectors of the economy, including
Personal consumption expenditures (C) by all households on durable goods,
nondurable goods, and services
Gross private domestic investment spending (I) by households and firms
on nonresidential structures, equipment, software, residential structures, and
inventories
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CHAPTER 1 Managers and Economics
Federal, state, and local government consumption expenditures and gross
investment (G)
Net export spending (F) or total export spending (X) minus total import
spending (M)
Consumption spending (C) is largely determined by consumer income (Y), but it
is also influenced by other factors such as consumer confidence, as noted below.
Much business investment spending (I) is derived from borrowing in the financial
markets and is, therefore, affected by prevailing interest rates. The availability of
funds for borrowing is influenced by the amount of income that consumers save (S)
or do not spend on goods and services.10 Some consumer income (Y) is also used
to pay personal taxes (TP) to the government sector to finance the purchase of its
goods and services. The government also imposes taxes on business (TB). If government spending (G) exceeds the total amount of taxes collected (T = TP + TB), the
resulting deficit must be financed by borrowing in the financial markets. This government borrowing may affect the amount of funds available for business investment, which in turn may cause interest rates to change, influencing firms’ costs of
production.
The foreign sector also plays a role in a country’s circular flow of expenditures
because some currently produced goods and services are purchased by residents
of other countries, exports (X), while a given country’s residents use some of
their income to purchase goods and services produced in other countries, imports
(M). Net export spending (F), or export spending (X) minus import spending (M),
measures the net effect of the foreign sector on the domestic economy. Import
spending is subtracted from export spending because it represents a flow of expenditures out of the domestic economy to the rest of the world.11
Spending by all these sectors equals gross domestic product (GDP), the comprehensive measure of overall economic activity that is used to judge how an
economy is performing. Gross domestic product measures the market value of all
currently produced final goods and services within a country in a given period of
time by domestic and foreign-supplied resources. GDP equals the sum of consumption spending (C), investment spending (I), government spending (G), and export
spending (X) minus import spending (M).
41
Government consumption
expenditures and gross
investment (G)
The total amount of spending
by federal, state, and local
governments on consumption
outlays for goods and services,
depreciation charges for existing
structures and equipment, and
investment capital outlays for newly
acquired structures and equipment
in a given period of time.
Net export spending (F)
The total amount of spending on
exports (X) minus the total amount
of spending on imports (M) or
(F = X − M) in a given period of time.
Export spending (X)
The total amount of spending
on goods and services currently
produced in one country and
sold abroad to residents of other
countries in a given period of time.
Import spending (M)
The total amount of spending
on goods and services currently
produced in other countries and
sold to residents of a given country
in a given period of time.
Gross domestic product
(GDP)
The comprehensive measure of the
total market value of all currently
produced final goods and services
within a country in a given period
of time by domestic and foreignsupplied resources.
Factors Affecting Macro Spending Behavior
In macroeconomics, we develop models that explain the behavior of these different sectors of the economy and how changes in this behavior influence the overall
level of economic activity, or GDP. These behavior changes arise from
1. Changes in the consumption and investment behavior of individuals and firms
in the private sector of the economy
2. New directions taken by a country’s monetary or fiscal policy-making institutions (its central bank and national government)
3. Developments that occur in the rest of the world that influence the domestic
economy
10
Households also borrow from the financial markets, but they are net savers on balance.
If a country’s export spending and import spending do not balance, there will be a flow of financial capital
among different countries. This flow will affect a country’s currency exchange rate, the rate at which one
country’s currency can be exchanged for another (Chapter 15).
11
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42
PART 1 Microeconomic Analysis
Changes in Private-Sector Behavior Although there are many factors
that influence consumption spending (C) and investment spending (I), credit
availability, consumer wealth in the housing and stock markets, and confidence
on the part of both consumers and businesspeople were extremely important factors influencing the U.S. economy in the recession of 2007–2009 and the slow
economic recovery since that time.
Monetary policies
Policies adopted by a country’s
central bank that influence the
money supply, interest rates, and
the amount of funds available for
loans, which, in turn, influence
consumer and business spending.
Fiscal policy
Changes in taxing and spending
by the executive and legislative
branches of a country’s national
government that can be used to
either stimulate or restrain the
economy.
Monetary Policies In response to the slowing U.S. economy in 2007, the
Federal Reserve, the central bank in the United States, began lowering its targeted interest rate, which had been 5.25 percent since June 2006. In December
2008, the Federal Reserve cut the targeted rate to historic lows of between 0 and
0.25 percent. This policy has been maintained up through the writing of this chapter. These rate changes were reactions to sluggish growth in consumer spending,
employment and manufacturing activity, continued turmoil in the housing and
financial markets, and sharp drops in the stock market. Managers in any economy must be aware of the monetary policies of their country’s central bank
that influence interest rates and the amount of funds available for consumer and
business loans.
Fiscal Policies To respond to the recession and financial crisis in the United
States, Congress passed the American Recovery and Reinvestment Act (ARRA)
in February 2009. This legislation represented changes in fiscal policy—taxing
and spending policies by a country’s national government that can be used to
either stimulate or restrain the economy (T = TP + TB and G in the circular flow
model in Figure 1.2). Fiscal policy decisions are made by a country’s executive
and legislative institutions, such as the president, his or her administration, and
the Congress in the United States. As a result, fiscal policy actions may be undertaken to promote political as well as economic goals.
The ARRA had numerous spending and revenue provisions that can be grouped
as follows: (1) providing funds to states and localities, including aid for education
and support for transportation projects; (2) supporting people in need through
measures such as extending unemployment benefits; (3) purchasing goods and
services including construction and other investment activities; and (4) providing
temporary tax relief for individuals and businesses.12
Changes in the Foreign Sector The opening case for this chapter noted
that the strong yen, which made exports from Japan less price competitive, gave
Japanese producers the incentive to produce cars in the United States. This was
a strategic problem for Toyota, whose president had made a public commitment
to build at least 3 million cars in Japan annually. The value at which a country’s
currency can be exchanged for another currency affects the flow of imports and
exports to and from the country and the level of economic activity in the country.
Policies to keep that exchange rate at a certain level can have negative effects on
other economic goals and can be offset by the actions of currency traders in financial markets. Exchange rate policies need to be coordinated with monetary and
fiscal policies to maintain the proper rate of economic growth.
12
Congressional Budget Office. Estimated Impact of the American Recovery and Reinvestment Act on
Employment and Economic Output from April 2012 Through June 2012. August 2012. Available at
www.cbo.gov.
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CHAPTER 1 Managers and Economics
43
Managerial Rule of Thumb
Macroeconomic Influences on Managers
Changes in the macro environment affect individual firms and industries through the microeconomic factors of demand, production, cost, and profitability. Managers don’t have control over
these changes in the larger macroeconomic environment. However, managers must be aware of the
developments that will have a direct impact on their businesses. Managers sometimes hire outside
consultants for reports on the macroeconomic environment, or they ask in-house staff to prepare
forecasts. In any case, they need to be able to interpret these forecasts and then project the impact
of these macroeconomic changes on the competitive strategies of their firms. Although overall
macroeconomic changes may be the same, their impact on various firms and industries is likely to
be quite varied. ■
Summary
In this chapter, we discussed the reasons why both microeconomic and
macroeconomic analyses are important for managerial decision making.
Microeconomics focuses on the decisions that individual consumers and firms
make as they produce, buy, and sell goods and services in a market economy,
while macroeconomics analyzes the overall level of economic activity, changes
in the price level and unemployment, and the rate of economic growth for the
economy. All of these factors affect the decisions managers make in developing
competitive strategies for their firms.
We illustrated these issues by discussing the challenges and problems facing the
global automobile industry in 2011 and 2012. Some of these challenges arose from
changes in consumer preferences and demand over time, while others resulted
from differences in preferences in various markets. However, all automobile producers were affected by the slow global economic recovery at this time and by
fluctuating values of currency exchange rates.
We then briefly introduced the concept of market structure and presented the
four basic market models: perfect competition, monopolistic competition, oligopoly, and monopoly. We also showed how the economic activity between consumers
and producers fits into the aggregate circular flow model of macroeconomics, and
we defined the basic spending components of that model: consumption, investment, government spending, and spending on exports and imports. We illustrated
the effects of changes in monetary policy by a country’s central bank and changes
in fiscal policy by the national administrative and legislative institutions on the
overall level of economic activity.
We will next analyze these issues in more detail. We first focus on the microeconomic concepts of demand and supply, pricing, production and cost, and market
structures (Chapters 2 through 10). We’ll then turn our attention to macroeconomic models and data (Chapters 11 through 15). We return to integrate these
issues further where we’ll look at more examples of the combined impact of both
microeconomic and macroeconomic variables on managerial decision making
(Chapter 16).
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44
PART 1 Microeconomic Analysis
Key Terms
absolute price level, p. 40
barriers to entry, p. 38
circular flow model, p. 39
export spending (X), p. 41
fiscal policy, p. 42
government consumption
expenditures and gross
investment (G), p. 41
gross domestic product (GDP), p. 41
gross private domestic investment
spending (I), p. 40
imperfect competition, p. 38
import spending (M), p. 41
inputs, p. 35
macroeconomics, p. 35
managerial economics, p. 35
market power, p. 38
markets, p. 36
microeconomics, p. 35
monetary policies, p. 42
monopolistic competition, p. 38
monopoly, p. 38
net export spending (F), p. 41
oligopoly, p. 38
outputs, p. 35
perfect competition, p. 37
personal consumption
expenditures (C), p. 40
prices, p. 35
price-taker, p. 37
profit, p. 38
profit maximization, p. 39
relative prices, p. 36
Exercises
Technical Questions
1. What are the differences between the microeconomic and macroeconomic perspectives on the
economy?
2. Why are both input and output prices important to
managers?
3. What are the four major types of markets in microeconomic analysis? What are the key characteristics that distinguish these markets?
4. Since a monopolist has some degree of market
power, and can also take measures to keep
competitors away from the market, a monopolist can set the price of their product as high
as they want. The higher the price charged, the
higher the revenue. Do you agree? Explain your
answer.
5. In macroeconomics, what are the five major categories of spending that make up GDP? Are all five
categories added together to determine GDP?
6. Discuss the differences between fiscal and monetary policies.
Application Questions
1. Give illustrations from the opening case in this
chapter of how both microeconomic and macroeconomic factors influence the global automobile
industry.
2. In each of the following examples, discuss which
market model appears to best explain the behavior described:
a. Corn prices reached record highs in the United
States in August 2012, given the worst drought
in decades. However, by October these prices
started to drop again as countries including
China, Japan, and South Korea began to purchase from producers in other countries such
as Argentina and Brazil.13
b. In 2012, Staples Inc., OfficeMax Inc., and
Office Depot Inc. were all closing many stores,
decreasing the size of their stores, and focusing more on online operations. All three chains
struggled to deal with changing consumer
shopping habits as consumers tested equipment in the stores and then made purchases
online.14
13
Andrew Johnon Jr., “Weak Exports Hurt Corn,” Wall Street Journal (Online), November 2, 2012.
Ann Zimmerman and Shelly Banjo, “New Web Victim: Office-Supply Store,” Wall Street Journal (Online),
September 25, 2012.
14
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CHAPTER 1 Managers and Economics
c. In fall 2012, T-Mobile announced it was close
to a merger with its smaller rival MetroPCS.
This merger would strengthen T-Mobile’s position as the fourth-largest wireless operator in
the United States. The merger would allow the
combined company to cut costs and operate on
a larger scale.15
d. Chinese cooking is the most popular food in
America that isn’t dominated by big national
chains. Chinese food is typically cooked in a
wok that requires high heat and a special stove.
Specialized chefs are also required. Small momand-pop restaurants comprise nearly all of the
45
nation’s 36,000 Chinese restaurants, which have
more locations than McDonald’s, Burger King,
and Wendy’s combined.16
3. HSBC’s revenue after insurance claims fell from
$68.3 billion in 2012 to $64.6 billion in 2013.17 Does
it necessarily mean that HSBC made less profit in
2013 than in 2012? Explain your answer.
4. The slow recovery from the recession of 2007–
2009 forced many firms to develop new competitive strategies to survive. Find examples of these
strategies in various business publications.
15
Anton Troianovski, “T-Mobile Finds a New Lifeline,” Wall Street Journal (Online), October 2, 2012.
Shirley Leung, “Big Chains Talk the Talk, But Can’t Walk the Wok,” Wall Street Journal, January 23, 2003.
17
Howard Mustoe and Gavin Finch, “HSBC’s 2013 Profit Misses Estimates on Cost Reductions,” Bloomberg
(Online), February 25, 2014.
16
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2
Demand, Supply, and
Equilibrium Prices
I
n this chapter, we analyze demand and supply—probably the two most
famous words in all of economics. Demand—the functional relationship
between the price of a good or service and the quantity demanded by consumers in a given period of time, all else held constant—and supply—the
functional relationship between the price of a good or service and the quantity supplied by producers in a given period of time, all else held constant—
provide a framework for analyzing the behavior of consumers and producers
in a market economy. Managers need to understand these terms to develop
their own competitive strategies and to respond to the actions of their competitors. They also need to understand that the role of demand and supply
depends on the environment or market structure in which a firm operates.
We begin our discussion of demand and supply by focusing on an analysis
of the copper industry from 1997/98 to 2011. In our case analysis, we’ll discuss
how factors related to consumer behavior (demand) and producer behavior (supply) determine the price of copper and cause changes in that price.
In the remainder of the chapter, we’ll look at how the factors from the copper industry fit into the general demand and supply framework of economic
theory. We’ll develop a conceptual analysis of demand functions and demand
curves; discuss the range of factors that influence consumer demand; analyze
how demand can be described verbally, graphically, and symbolically using
equations; and look at a specific mathematical example of demand. We’ll then
describe the supply side of the market and the factors influencing supply in
the same manner. Finally, we’ll discuss how demand- and supply-side factors
determine prices and cause them to change.
46
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Case for Analysis
Demand and Supply in the Copper Industry
The copper industry illustrates all the factors on the demand
and supply side of a competitive market that we discuss in this
chapter. Shifts in these factors can cause current and expected
future prices of copper to change rapidly. In addition, the copper industry serves as a signal for the status of the global economy. Because copper is used in so many industries around the
world, the metal has been given the name “Dr. Copper,” since a
strong demand and high prices for it can indicate that the overall economy is healthy.1
In February 2011, copper prices reached an all-time high of
$4.62 per pound, having almost quadrupled after a two-year series
of increases. At that time there was a fear that this rally in prices
had stopped, given speculation about events in China. Previously,
traders and industry observers had thought that China had an
insatiable demand for the metal. However, rising interest rates in
China could have forced speculators to sell copper to reduce their
financing costs, while consumers kept their inventories low to
save capital. At this time previously unreported stockpiles of copper were also discovered in China, many of which were in bonded
warehouses where traders stored goods before moving them in or
out of the country. Analysts observed that these supplies could
easily have been moved into the market.2
In April 2011, copper analysts worried about further
decreases in prices. The worldwide economic downturn had
caused demand to decrease in key markets, such as housing and
construction. Copper consumers had reacted to previous high
prices by seeking cheaper alternative substitute materials, such
as aluminum and plastic.3 In June 2011, analysts reported that
copper prices surged to the highest level in two weeks due to
the reporting of better-than-expected Chinese industrial production data. Unfavorable U.S. economic data and concern over
Chinese inflation had caused prices to decrease, but the industrial output report indicated that demand could increase again.4
However, later that month concerns over economic conditions
in Europe, an important consumer of copper for plumbing and
electrical wiring, put further downward pressure on prices.5
During the summer of 2011, copper prices increased in
response to a U.S. Department of Labor report that new claims
1
Carolyn Cui and Tatyana Shumsky, “Dr. Copper Offers a Mixed
Prognosis,” Wall Street Journal (Online), April 11, 2011.
2
Cui and Shumsky, “Dr. Copper Offers a Mixed Prognosis.”
3
Andrea Hotter, “Lofty Copper Prices Remain at Risk,” Wall
Street Journal (Online), April 28, 2011.
4
Matt Day, “Copper Rises on China Industrial-Production Data,”
Wall Street Journal (Online), June 14, 2011.
5
Amy D’Onofrio, “Copper Falls on Uncertainty Over Global
Economy,” Wall Street Journal (Online), June 20, 2011.
for unemployment benefits fell for the first time in three weeks.
The widespread use of the metal in construction and manufacturing meant that any changes in unemployment could impact
copper prices. There was also concern on the supply side,
given that recent severe winter weather in Chile and a potential
strike at a large copper plant could disrupt production.6
The extreme volatility of the copper market was illustrated
in September 2011. On September 27 the Wall Street Journal
reported that copper prices rose sharply, given a report that the
European Union might expand its support of the Euro zone’s
troubled banks and a Federal Reserve Bank of Chicago report
showing increased manufacturing output in the Midwest region
of the United States.7 However, one day later it was reported
that price declines had erased the previous market increase of
more than 5 percent as investors continued to worry about the
European financial crisis and whether previously anticipated
strong imports into China might not occur.8
Unforeseen events have also influenced the copper market.
Copper prices reached a seven-week high after a massive earthquake hit Chile in March 2010. There were concerns that supply
from the world’s largest copper producer would be impacted by
the quake. Analysts attempted to determine as quickly as possible how much the country’s infrastructure had been damaged.9
Similar factors affected the copper market in 2006 and
2007.10 Analysts predicted a decrease in the supply of copper
in 2007 after many strikes limited production in 2006. This
decreased production along with strong worldwide demand
caused the price of copper to remain at historic highs during
that year. Much of this demand was stimulated by the economic growth in China. A lack of new mining projects also
limited supply, given that many large, known copper deposits
were in areas with unstable governments or were difficult to
reach.11 Another impact of the high prices was the increased
theft of copper coils in air-conditioning units, copper wires,
and copper pipes used for plumbing in homes and businesses
6
Matt Day, “Copper Surges on Improved U.S. Labor Market
View,” Wall Street Journal (Online), July 7, 2011.
7
Matt Day, “Copper Continues Gains as Global Markets Rally,”
Wall Street Journal (Online), September 27, 2011.
8
Matt Day, “Copper Slides to a 13-Month Low on Worries About
Demand,” Wall Street Journal (Online), September 28, 2011.
9
Allen Sykora, “Copper Prices Rise Following Quake,” Wall
Street Journal (Online), March 1, 2010.
10
Allen Sykora, “Copper Surplus is Foreseen in ’07,” Wall Street
Journal, February 28, 2007.
11
Patrick Barta, “A Red-Hot Desire for Copper,” Wall Street
Journal, March 16, 2006.
47
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PART 1 Microeconomic Analysis
in many parts of the United States.12 Thefts, even of cemetery bronze vases containing large amounts of copper, continued with the relatively high prices of copper in subsequent
years.13
Analysts predicted that increased quantities of copper
would be available in 2007 due to several factors. (1) The
strikes that occurred in 2006 were not expected to continue the
next year. (2) The higher copper prices encouraged companies
to mine lower-grade copper that would not have been economically feasible with lower prices. However, the high copper
prices also gave many copper users the incentive to find substitutes for the metal. Aluminum producers benefited from the
high copper prices, and these prices stimulated the increased
use of plastic piping in home construction.
Forecasts of future prices and production can be very uncertain, given the variety of factors operating on both the demand
and supply side of the market. One report estimated a surplus
of 108,000 metric tons for the first 11 months of 2006, while
another estimated a surplus of 40,000 metric tons for the entire
year. The extent of substitution with other products was also
difficult to estimate, as was the substitution with scrap metal.14
Moreover, in February 2007, the first impacts of the slowing
housing market on the U.S. economy were just beginning to
appear. This is another example of changes in the macroeconomy impacting this industry, leading to the name “Dr. Copper.”
Copper prices continued to be influenced by the demand
from China. This demand slowed in 2008 as the Chinese drew
down their inventories when global prices were high and shut
down some industrial activity preceding the Olympics in August
2008. The slowing Chinese economy in fall 2008 also impacted
the world copper market where prices continued to fall.15
12
Sara Schaefer Munoz and Paul Glader, “Copper and Robbers:
Homeowners’ Latest Worry,” Wall Street Journal, September 6,
2006.
13
Joe Barrett, “Sky-High Metal Prices Lead to a Grave Situation,”
Wall Street Journal (Online), November 22, 2011.
14
Sykora, “Copper Surplus is Foreseen in ’07.”
15
Allen Sykora, “China Copper Need Set to Rise,” Wall Street
Journal, August 25, 2008; James Campbell and Matthew Walls,
“China Drags Down Metals: Slump in Real Estate: Export
Industries May Keep Lid on Oil Prices, Wall Street Journal,
October 29, 2008; Allen Sykora, “Copper Is Vulnerable to Falling
Further,” Wall Street Journal, November 24, 2008.
An analysis of a substantial decline in copper prices 10
years earlier from November 1997 to February 1998 illustrated many of these same factors.16 The 1997 financial crisis and recession in Southeast Asia had a significant impact
on the copper industry, as did uncertain demand from China
and the increased use of copper in communications technology in North America. Expectations also played a role as many
copper users were hesitant to buy because they thought prices
might continue their downward trend.
On the supply side, the low price of copper forced mining
companies to decide whether certain high-cost mines should
be kept in operation. However, a new mining process called
“solvent extraction” also allowed some companies to mine
copper at a lower cost, which permitted more copper mines to
stay in business.
We can see from this discussion that a variety of factors
influence the price of copper and that these factors can be categorized as operating either on the demand (consumer) side or
the supply (producer) side of the market. Sometimes the influence of one factor in lowering prices is partially or completely
offset by the impacts of other factors that tend to increase
prices. Thus, the resulting copper prices will be determined by
the magnitude of the changes in all of these variables.
Note also that the case discusses general influences on the
copper industry. There is no discussion of the strategic behavior of individual firms. This focus on the entire industry is a
characteristic of a perfectly or highly competitive market,
where there are many buyers and sellers and the product is relatively homogeneous or undifferentiated. Prices are determined
through the overall forces of demand and supply in these markets. All firms, no matter where they are located on the market
structure continuum, face a demand from consumers for their
products. The factors influencing demand, which are discussed
in this chapter, thus pertain to firms operating in every type
of market. However, the demand/supply framework and the
resulting determination of equilibrium prices apply only to
perfectly or highly competitive markets. We’ll now examine
the concepts of demand and supply in more detail to see how
managers can use this framework to analyze changes in prices
and quantities of different products in various markets.
16
Aaron Lucchetti, “Copper Limbo: Just How Low Can It Go?”
Wall Street Journal, February 23, 1998.
Demand
Although demand and supply are used in everyday language, these concepts have
very precise meanings in economics.17 It is important that you understand the difference between the economic terms and ordinary usage. We’ll look at demand
first and turn our attention to supply later in the chapter.
17
Even basic terms such as demand may be defined differently in various business disciplines. For example,
in Marketing Management, The Millennium Edition (Prentice Hall, 2000), Philip Kotler defines market
demand as “the total volume that would be bought by a defined customer group in a defined geographical
area in a defined time period in a defined marketing environment under a defined marketing program”
(p. 120). Since advertising and marketing expenditures are the focus of this discipline, demand is defined
to emphasize these issues rather than price.
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CHAPTER 2 Demand, Supply, and Equilibrium Prices
Demand is defined in economics as a functional relationship between the price
of a good or service and the quantity demanded by consumers in a given period
of time, all else held constant. (The Latin phrase ceteris paribus is often used in
place of “all else held constant.”) A functional relationship means that demand
focuses not just on the current price of the good and the quantity demanded at that
price, but also on the relationship between different prices and the quantities that
would be demanded at those prices. Demand incorporates a consumer’s willingness and ability to purchase a product.
Nonprice Factors Influencing Demand
The demand relationship is defined with “all else held constant” because many
other variables in addition to price influence the quantity of a product that consumers demand. The following sections summarize these variables, many of which
were discussed in the opening case on the copper industry.
49
Demand
The functional relationship
between the price of a good or
service and the quantity demanded
by consumers in a given time
period, all else held constant.
Functional relationship
A relationship between variables,
usually expressed in an equation
using symbols for the variables,
where the value of one variable, the
independent variable, determines
the value of the other, the dependent variable.
Tastes and Preferences Consumers must first desire or have tastes and
preferences for a good. For example, in the aftermath of the September 11, 2001,
terrorist attacks on New York and Washington, D.C., the tastes and preferences
of U.S. consumers for airline travel changed dramatically. People were simply
afraid to fly and did not purchase airline tickets regardless of the price charged. In
October 2001, most of the major airlines began advertising campaigns to increase
consumer confidence in the safety of air travel. United Airlines’ advertisements
featured firsthand employee accounts, while American Airlines encouraged
people to spend time with family and friends over the upcoming holidays and
beyond.18
Changing attitudes toward cigarette smoking have had a major impact on Zippo
Manufacturing Co., which produced “windproof” cigarette lighters for 78 years.
Annual lighter sales decreased from 18 million in 1998 to 12 million in 2010. The
company tried to influence consumer behavior with new lighter designs, including those with images of Elvis Presley and the Playboy logo. However, the company also developed new products including a men’s fragrance, casual clothing,
watches, and camping supplies as a response to these changes in preferences.19
The U.S. pecan industry has been impacted by changing Chinese preferences for
these nuts. China bought one-quarter of the U.S. crop in 2009, whereas the country
had little demand five years earlier. A belief that eating pecans would help ward off
Alzheimer’s disease and influence the brain development of babies helped generate
this demand.20
The Japanese earthquake in March 2011 influenced the demand for luxury goods
in that country. Although Japanese consumers traditionally were willing to pay
some of the world’s highest prices for fashion and other luxury goods, surveys following the quake showed that many consumers believed that showing off luxury
goods was in bad taste. Sales of expensive fashion items and accessories in Japan
were second only to that in the United States before the quake.21
Socioeconomic variables such as age, gender, race, marital status, and level of
education are often good proxies for an individual’s tastes and preferences for a
particular good, because tastes and preferences may vary by these groupings and
products are often targeted at one or more of these groups. Beer brewers have targeted Hispanics who will account for 23 percent of the nation’s legal-drinking-age
18
Melanie Trottman, “Airlines Launch New Ad Campaigns Using Emotion to Restore Confidence,” Wall
Street Journal, October 24, 2001.
19
James R. Hagerty, “Zippo Preps for a Post-Smoker World,” Wall Street Journal (Online), March 8, 2011.
20
David Wessel, “Shell Shock: Chinese Demand Reshapes U.S. Pecan Business,” Wall Street Journal
(Online), April 18, 2011.
21
Mariko Sanchanta, “Japan Grows Leery of Luxury,” Wall Street Journal (Online), May 27, 2011.
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PART 1 Microeconomic Analysis
population in 2030, particularly given the decline in overall sales due to high unemployment among men ages 21–34. Corona developed Spanish- and English-language
advertisements focusing on luxurious beach settings to convey the brand’s premium status. It also developed a 32-ounce bottled version of the beer designed for
family gatherings that was targeted on states with large Hispanic populations, such
as Arizona and California. MillerCoors began a campaign to promote its products
to Mexican soccer fans.22
Similarly, Procter & Gamble Co. retargeted its marketing, changed its mix of
celebrity spokeswomen, and increased the amount of Spanish on its products.
This was part of its competitive strategy particularly in the U.S. toothpaste market where Colgate-Palmolive Co. built a dominant position based on its strength in
Latin American markets. Procter & Gamble found that Hispanic customers were
more likely to use fragrances in their homes than other sociodemographic groups.
Hispanic households spent more on cleaning and beauty products and were more
loyal to their brands than the average U.S. customer. Procter & Gamble also used
actress Eva Mendes and singer-actress Jennifer Lopez as spokeswomen to promote
its products in the Hispanic community.23
Economic theory may also suggest that one or more of these socioeconomic variables influences the demand for a particular good or service. For example, persons
with more education are believed to be more knowledgeable about using preventive services to improve their health. Marital status may influence the demand for
acute care and hospital services because married individuals have spouses who
may be able to help take care of them in the home.24 Thus, tastes and preferences
encompass all the individualistic variables that influence a person’s willingness to
purchase a good.
Normal good
A good for which consumers will
have a greater demand as their
incomes increase, all else held
constant, and a smaller demand
if their incomes decrease, other
factors held constant.
Inferior good
A good for which consumers will
have a smaller demand as their
incomes increase, all else held
constant, and a greater demand
if their incomes decrease, other
factors held constant.
Income The level of a person’s income also affects demand, because demand
incorporates both willingness and ability to pay for the good. If the demand for
a good varies directly with income, that good is called a normal good. This definition means that, all else held constant, an increase in an individual’s income
will increase the demand for a normal good, and a decrease in that income will
decrease the demand for that good. If the demand varies inversely with income,
the good is termed an inferior good. Thus, an increase in income will cause a
consumer to purchase less of an inferior good, while a decrease in that income
will actually cause the consumer to demand more of the inferior good. Note that
the term inferior has nothing to do with the quality of the good—it refers only to
how purchases of the good or service vary with changes in income.
Normal Goods In many cases, the effect of income on particular goods and services is related to the general level of economic activity in the economy. Although
jewelers used the transition from the year 1999 to 2000 to influence consumer
tastes and preferences for jewelry, the strong economy and the booming stock market in 1999 also played a role in influencing demand.25 On the other hand, the loss
of both jobs and stock market wealth in fall 2008 caused retail spending to decline
below already-weak forecasts.26 This frugality continued throughout the recession
and the slow recovery in the subsequent years. Wal-Mart noted an increase in paycheck-cycle shopping where consumers stocked up on products soon after getting
22
David Kesmodel, “Brewers Go Courting Hispanics,” Wall Street Journal (Online), July 12, 2011.
Ellen Bryon, “Hola: P&G Seeks Latino Shoppers,” Wall Street Journal (Online), September 15, 2011.
24
The demand for health and medical services is discussed in Donald S. Kenkel, “The Demand for
Preventive Medical Care,” Applied Economics 26 (April 1994): 313–25; and in Rexford E. Santerre and
Stephen P. Neun, Health Economics: Theories, Insights, and Industry Studies, 4th ed. (Mason, OH:
Thomson South-Western, 2007).
25
Rebecca Quick, “Jewelry Retailers Have Gem of a Holiday Season,” Wall Street Journal, January 7, 2000.
26
Ann Zimmerman, “Retailers Wallow and See Only More Gloom,” Wall Street Journal, November 7, 2008.
23
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51
paid and moved toward smaller product sizes toward the end of the month when
their cash ran low. Wal-Mart customers also demanded a return of a Depressionera strategy, layaway, which the company had cancelled in 2005. Target, which
attracts more affluent customers than Wal-Mart, found that its sales rebounded
more quickly to prerecession patterns than did Wal-Mart.27
Both increases in income and changes in tastes and preferences have resulted
in an increased demand for gourmet pet food, especially for dogs. The head of Del
Monte’s food and pet division said in 2006 that “the humanization of pets is the
single biggest trend driving our business.”28 Changes in tastes in human food spill
over into the pet food market. However, the demand for gourmet pet food was also
driven by the change in pet ownership from parents of small children, who had neither the time nor money to spend lavishly on their pets, to childless people ranging
from gay couples to parents whose children have left home. These couples have
larger incomes and treat their pets as they would their children.
Inferior Goods Firms producing inferior goods do not benefit from a booming economy. One such example is the pawnshop industry, which suffered during
the economic prosperity of the late 1990s and 2000, as fewer people swapped jewelry and other items for cash to cover car payments and other debts.29 Although
pawnshops have always suffered from a somewhat disreputable image, the strong
economy provided an income effect that further hurt the business and caused
many chains to incur large losses.
Dollar stores’ sales increased during the 2007 recession and moderated only
somewhat during the slow recovery. These stores experienced increases in the
number of customers who traded down out of economic necessity and who could
have gone elsewhere but were still exercising frugality. 30 Payday lenders also
increased their business during the recession. Although these companies often
charged interest rates of more than 500 percent on their loans, they developed
strategies to lure customers away from traditional banks by appealing to people
with substandard credit records. The 22 payday loan offices in West Palm Beach,
Florida made $328.9 million in loans in fiscal year 2010, an increase of 119 percent
from fiscal year 2008.31
In the health care area, it is argued that tooth extractions are an example of an
inferior good. As individuals’ incomes rise, they are able to afford more complex
and expensive dental restorative procedures, such as caps and crowns, and they
are able to purchase more regular preventive dental services. Thus, the need for
extractions decreases as income increases.32
Prices of Related Goods There are two major categories of goods or products whose prices influence the demand for a particular good: substitute goods
and complementary goods.
Substitute Goods Products or services are substitute goods for each other
if one can be used in place of another. Consumers derive satisfaction from either
good or service. If two goods, X and Y, are substitutes for each other, an increase
in the price of good Y will cause consumers to decrease their consumption of
27
Ann Zimmerman, “Frontier of Frugality,” Wall Street Journal (Online), October 4, 2011.
Deborah Ball, “Nothing Says, ‘I Love You, Fido’ Like Food with Gourmet Flair,” Wall Street Journal,
March 18, 2006.
29
Kortney Stringer, “Best of Times Is Worst of Times for Pawnshops in New Economy,” Wall Street Journal,
August 22, 2000.
30
Zimmerman, “Frontier of Frugality.”
31
Jessica Silver-Greenberg, “Payday Lenders go Hunting: Operations Encroach on Banks during Loan
Crunch; ‘Here, I Feel Respected,’ ” Wall Street Journal (Online), December 23, 2010.
32
Rexford E. Santerre and Stephen P. Neun, Health Economics: Theories, Insights, and Industry Studies,
rev. ed. (Orlando, FL: Dryden, 2000), 90.
Substitute goods
Two goods, X and Y, are substitutes
if an increase in the price of good Y
causes consumers to increase their
demand for good X or if a decrease
in the price of good Y causes consumers to decrease their demand
for good X.
28
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PART 1 Microeconomic Analysis
good Y and increase their demand for good X. If the price of good Y decreases,
the demand for substitute good X will decrease. Thus, changes in the price of
good Y and the demand for good X move in the same direction for substitute
goods. The amount of substitution depends on the consumer’s tastes and preferences for the two goods and the size of the price change.
By 2006 the abundance and relatively low prices of cell phones, iPods, and laptop
computers resulted in many teens and young adults no longer purchasing wristwatches. In 2005, sales of watches priced between $30 and $150, the type most
often purchased by these age groups, declined more than 10 percent from 2004.33
In response to this threat from substitute products, watchmakers developed new
models that do much more than tell time, including watches with earbuds that play
digital music files, watches with programmable channels, and models with compasses and thermometers.
In 2007, large increases in the price of platinum resulted in an increased demand
for palladium, a lesser-known platinum-group metal. The price of an ounce of platinum was approximately $1,190 compared with $337 for an ounce of palladium.
Because the two metals have a similar look and feel, many jewelers offered palladium to customers as a less expensive alternative, particularly for wedding and
engagement rings. World demand for palladium in jewelry was 1.12 million ounces
in 2006 compared with 1.74 million ounces for platinum.34
There are many substitutes for a given brand of bottled water, including both
other types of drinks and other brands of water. Customers bought less of Nestle’s
bottled water during the 2007 recession, due to both the loss of income and the
switch to the large number of cheaper private-label brands launched by supermarkets. Nestle responded by pushing Pure Life, a lower-priced water derived from
purified municipal sources.35
Complementary goods
Two goods, X and Y, are complementary if an increase in the price
of good Y causes consumers to
decrease their demand for good X
or if a decrease in the price of good
Y causes consumers to increase
their demand for good X.
Complementary Goods Complementary goods are products or services
that consumers use together. If products X and Y are complements, an increase in
the price of good Y will cause consumers to decrease their consumption of good
Y and their demand for good X, since X and Y are used together. Likewise, if the
price of good Y decreases, the demand for good X will increase. Changes in the
price of good Y and the demand for good X move in the opposite direction if X
and Y are complementary goods.
As prices of personal computers have dropped over time, there has been an
increased demand for printers and printer cartridges. This complementary relationship has allowed Hewlett-Packard Company to actually sell its printers at a
loss that it recouped through its new ink and toner sales. Analysts estimated that in
2005 the company earned at least a 60 percent profit margin on both ink and toner
cartridges and two-thirds of the company’s profits were derived from these sales.
In 2006, Walgreen Company, the drugstore chain, announced plans for an ink-refill
service in 1,500 of its stores with a price at less than half the cost of buying new
cartridges.36 OfficeMax and Office Depot also offered these services. This example
shows how a complementary relationship between two goods can create a profit
opportunity for a firm, which then may still be competed away by the development
of substitute goods.
Future Expectations Expectations about future prices also play a role in
influencing current demand for a product. If consumers expect prices to be lower
in the future, they may have less current demand than if they did not have those
33
Jessica E. Vascellaro, “The Times They Are a-Changin’,” Wall Street Journal, January 18, 2006.
Elizabeth Holmes, “Palladium, Platinum’s Cheaper Sister, Makes a Bid for Love,” Wall Street Journal,
February 13, 2007.
35
Deborah Ball, “Bottled Water Pits Nestle vs. Greens,” Wall Street Journal (Online), May 25, 2010.
36
Pui-Wing Tam, “A Cheaper Way to Refill Your Printer,” Wall Street Journal, January 26, 2006.
34
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53
expectations. In 2011, steel prices fell due to decreased demand arising from
unrest in the Middle East, the impact of Japan’s earthquake and tsunami, and
relatively high supply. Yet some buyers, including Moscow-based Central Steel
Co., held off on further purchases, given an expectation that prices would drop
another 2–5 percent in the following weeks. A U.K.-based steel consulting firm
noted that many Western European customers with adequate stockpiles were
also waiting on the sidelines for future price decreases.37
Likewise, if prices are expected to increase, consumers may demand more of the
good at present than they would without these expectations. In fall 2007, world
grain prices were surging from major demand increases stimulated by U.S. government incentives encouraging businesses to turn corn and soybeans into motor
fuel, increased incomes from the growing economies of Asia and Latin America,
and a growing middle class in these areas that was eating more meat and milk,
increasing the demand for grain to feed the livestock. Even though U.S. corn farmers expected a record harvest, which should have had a moderating effect on grain
prices, traders in the futures markets for corn were already betting that the price
of corn would increase from $3.25 per bushel to more than $4.00 in March 2008 and
would stay above that level until 2010.38
Number of Consumers Finally, the number of consumers in the marketplace influences the demand for a product. A firm’s marketing strategy is typically based on finding new groups of consumers who will purchase the product.
In many cases, a country’s exports may be the source of this increased demand.
Although the U.S. timber industry continued to be depressed in 2011 from the
weakness in the U.S. housing market, exports to China surged, particularly from
mills in the Pacific Northwest. Russia increased tariffs on its exports to China
in 2007, so Chinese buyers turned to the United States and Canada to satisfy the
demand arising from that country’s construction boom. The number of U.S. logs
shipped to China increased more than 10 times between 2007 and 2010.39
The effect of growing populations on demand and grain prices was discussed
above in the “Future Expectations” section of the chapter. Both increases in the
size of the population in Asian and Latin American economies and growth in the
middle-class segments of these economies had a stimulating effect on the demand
for many types of grain.
Demand Function
We can now summarize all the variables that influence the demand for a particular
product in a generalized demand function represented as follows:
2.1
QXD = f(PX, T, I, PY, PZ, EXC, NC, N)
where
QXD = quantity demanded of good X
PX = price of good X
T = variables representing an individual’s tastes and preferences
I = income
PY, PZ = prices of goods Y and Z, which are related to the
consumption of good X
EXC = consumer expectations about future prices
NC = number of consumers
37
Robert Guy Matthews, “Steel Price Softens as Supply Solidifies,” Wall Street Journal (Online), April 10, 2011.
Scott Kilman, “Historic Surge in Grain Prices Roils Market,” Wall Street Journal, September 28, 2007.
39
Jim Carlton, “Chinese Demand Lifts U.S. Wood Sales,” Wall Street Journal (Online), February 8, 2011.
38
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PART 1 Microeconomic Analysis
Individual demand
function
The function that shows, in
symbolic or mathematical terms,
the variables that influence the
quantity demanded of a particular
product by an individual consumer.
Market demand function
The function that shows, in symbolic or mathematical terms, the
variables that influence the quantity
demanded of a particular product
by all consumers in the market and
that is thus affected by the number
of consumers in the market.
Demand curve
The graphical relationship between
the price of a good and the quantity
consumers demand, with all other
factors influencing demand held
constant.
Demand shifters
The variables in a demand function
that are held constant when defining a given demand curve, but that
would shift the demand curve if
their values changed.
Negative (inverse)
relationship
A relationship between two
variables, graphed as a downward
sloping line, where an increase in
the value of one variable causes a
decrease in the value of the other
variable.
FIGURE 2.1
The Demand Curve for a Product
A demand curve shows the
relationship between the price of a
good and the quantity demanded,
all else held constant.
Equation 2.1 is read as follows: The quantity demanded of good X is a function (f)
of the variables inside the parentheses. An ellipsis is placed after the last variable
to signify that many other variables may also influence the demand for a specific
product. These may include variables under the control of a manager, such as the
size of the advertising budget, and variables not under anyone’s control, such as the
weather.
Each consumer has his or her own individual demand function for different
products. However, managers are usually more interested in the market demand
function, which shows the quantity demanded of the good or service by all consumers in the market at any given price. The market demand function is influenced
by the prices of related goods, as well as by the tastes and preferences, income,
and future expectations of all consumers in the market. It can also change because
more consumers enter the market.
Demand Curves
Equation 2.1 shows the typical variables included in a demand function. To systematically analyze all of these variables, economists define demand as we did earlier
in this chapter: the functional relationship between alternative prices and the quantities consumers demand at those prices, all else held constant. This relationship is
portrayed graphically in Figure 2.1, which shows a demand curve for a given product. Price (P), measured in dollar terms, is the variable that is explicitly analyzed
and shown on the vertical axis of the graph. Quantity demanded (Q) is shown on
the horizontal axis. The other variables in the demand function are held constant
with a given demand curve, but act as demand shifters if their values change.
As we just mentioned, demand curves are drawn with the price placed on the
vertical axis and the quantity demanded on the horizontal axis. This may seem
inconsistent because we usually think of the quantity demanded of a good (dependent variable) as a function of the price of the good (independent variable). The
dependent variable in a mathematical relationship is usually placed on the vertical
axis and the independent variable on the horizontal axis. The reverse is done for
demand because we also want to show how revenues and costs vary with the level
of output. These variables are placed on the vertical axis in subsequent analysis. In
mathematical terms, an equation showing quantity as a function of price is equivalent to the inverse equation showing price as a function of quantity.
Demand curves are generally downward sloping, showing a negative or inverse
relationship between the price of a good and the quantity demanded at that price,
all else held constant. Thus, in Figure 2.1, when the price falls from P1 to P2, the
quantity demanded is expected to increase from Q1 to Q2, if nothing else changes.
This is represented by the movement from point A to point B in Figure 2.1. Likewise,
an increase in the price of the good results in a decrease in quantity demanded, all
else held constant. Most demand curves that show real-world behavior exhibit this
P
P1
A
B
P2
0
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Demand
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Q2
Q
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CHAPTER 2 Demand, Supply, and Equilibrium Prices
55
inverse relationship between price and quantity demanded. (We’ll later discuss the
economic model of consumer behavior that lies behind this demand relationship.)
(Chapter 3 appendix.)
Change in Quantity Demanded and Change in Demand
The movement between points A and B along the demand curve in Figure 2.1 is
called a change in quantity demanded. It results when consumers react to a
change in the price of the good, all other factors held constant. This change in
quantity demanded is pictured as a movement along a given demand curve.
It is also possible for the entire demand curve to shift. This shift results when the
values of one or more of the other variables in Equation 2.1 change. For example, if
consumers’ incomes increase, the demand curve for the particular good generally
shifts outward or to the right, assuming that the good is a normal good. This shift
of the entire demand curve is called a change in demand. It occurs when one or
more of the variables held constant in defining a given demand curve changes.
This distinction between a change in demand and a change in quantity demanded
is very important in economic analysis. The two phrases mean something different and should not be used interchangeably. The distinction arises from the basic
economic framework, in which we examine the relationship between two variables
while holding all other factors constant.
An increase in demand, or a rightward or outward shift of the demand curve, is
shown in Figure 2.2. We’ve drawn this shift as a parallel shift of the demand curve,
although this doesn’t have to be the case. Suppose this change in demand results
from an increase in consumers’ incomes. The important point in Figure 2.2 is that
an increase in demand means that consumers will demand a larger quantity of the
good at the same price—in this case, due to higher incomes. This outcome is contrasted with a movement along a demand curve or a change in quantity demanded,
where a larger quantity of the good is demanded only at a lower price. This distinction can help you differentiate between the two cases.
Changes in any of the variables in a demand function, other than the price of
the product, will cause a shift of the demand curve in one direction or the other.
Thus, the relationship between quantity demanded and the first variable on the
right side of Equation 2.1 (price) determines the slope of the curve (downward
sloping), while the other right-hand variables cause the curve to shift. In Figure 2.2,
we assumed that the good was a normal good so that an increase in income would
result in an increase in demand, or a rightward shift of the demand curve. If the
good was an inferior good, this increase in income would result in a decrease in
demand, or a leftward shift of the curve. An increase in the price of a substitute
good would cause the demand curve for the good in question to shift rightward,
while an increase in the price of a complementary good would cause a leftward
Change in quantity
demanded
The change in quantity consumers
purchase when the price of the
good changes, all other factors held
constant, pictured as a movement
along a given demand curve.
Change in demand
The change in quantity purchased
when one or more of the demand
shifters change, pictured as a shift
of the entire demand curve.
FIGURE 2.2
P
Change (Increase) in Demand
A change in demand occurs when
one or more of the factors held
constant in defining a given
demand curve changes.
D2
D1
P1
0
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Q2
Q
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PART 1 Microeconomic Analysis
shift of the demand curve. A change in consumer expectations could also cause
the curve to shift in either direction, depending on whether a price increase or
decrease was expected. If future prices were expected to rise, the current demand
curve would shift outward or to the right. The opposite would happen if future
prices were expected to decrease. An increase in the number of consumers in the
market would cause the demand ...
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