MODULE 1- Managers, Profit, Markets, and owners of resources, individual firms,

Demand, Supply, and Equilibrium industries, and markets for goods and
services. Using marginal analysis,
1.1 Managers, profits, and the markets
microeconomics provides the foundation for
The success of any business means winning understanding the everyday business
in the marketplace. A Manager's decisions managers routinely make in
understanding of his lack of understanding running a business. Such decisions are
of the fundamentals of economics accounts frequently referred to as business practices
for the difference between the success and or tactics.
failure of business decisions.
Industrial organization is a specialized
The primary goal in this text is to show you branch of microeconomics that focuses on
how business managers can use economic the behavior and structure of firms and
concepts and analysis to make decisions and industries. The industrial organization
design strategies that will achieve the firm’s supplies the foundation for understanding
primary goal, which is usually the strategic decisions through the application of
maximization of profit. game theory.

1.1 THE ECONOMIC WAY OF Strategic decisions differ from routine

THINKING ABOUT BUSINESS business practices or tactics because, in
PRACTICES AND STRATEGY contrast to routine business practices,
strategic decisions seek to shape or alter the
Economic Theory Simplifies Complexity conditions under which a firm competes
Managerial economics applies the most with its rivals in ways that will increase
useful concepts and theories from two and/or protect the firm’s long-run profit.
closely related areas of economics— While routine business practices are
microeconomics and industrial necessary for keeping organizations moving
organization—to create a systematic, logical toward their goal of profit-maximization,
way of analyzing business practices and strategic decisions are generally optional
tactics designed to get the most profit, as actions managers can take as circumstances
well as formulating strategies for sustaining permit.
or protecting these profits in the long run.
Economic theory helps managers
understand real-world business problems by
using simplifying assumptions to abstract
away from irrelevant ideas and information
and turn complexity into relative simplicity.
The Roles of Microeconomics and
Industrial Organization
Microeconomics is the study and analysis
of the behavior of individual segments of the
economy: individual consumers, workers
Figure 1.1 shows a list of economic (1) the opportunity cost of cash provided by
forces that determine the level of profit owners, known as equity capital,
a firm can expect to earn in the long run
and the durability of long-run profits. (2) the opportunity cost of using land or
This forces are from Michael Porter's capital owned by the firm, and
book, Competitive Strategy. (3) the opportunity cost of the owner’s time
The industrial organization identifies seven spent managing the firm or working for the
economic forces that promote long-run firm in some other capacity.
profitability: few close substitutes, strong Economic Profit versus Accounting Profit
entry barriers, weak rivalry within markets,
the low market power of input suppliers, the Economic profit is the difference between
low market power of consumers, abundant total revenue and total economic cost:
complementary products, and limited
harmful government intervention.
Economic profit = Total
1.2 MEASURING AND MAXIMIZING revenue – Total economic
ECONOMIC PROFIT cost
Economic profit = Total
Economic Cost of Using Resources
revenue – Explicit costs –
The economic cost of using resources to Implicit costs
produce a good or service is the opportunity
cost to the owners of the firm using those
resources. The opportunity cost of using Economic profit belongs to the owners and
any kind of resource is what the owners of will increase the wealth of the owners.
the firm must give up to use the resource. When revenues fall short of total economic
cost, economic profit is negative, and the
The total economic cost is the sum of the loss must be paid for out of the wealth of the
opportunity costs of market-supplied owners.
resources plus the opportunity costs
of owner-supplied resources. The When accountants calculate business
opportunity costs of using market-supplied profitability for financial reports, they
resources are the out-of-pocket monetary follow a set of rules known as “generally
payments made to the owners of resources, accepted accounting principles” or
which are called explicit costs. The GAAP. If you have taken courses in
opportunity cost of using an owner-supplied Accounting, GAAP provides accountants
resource is the best return the owners of the with detailed measurement rules for
firm could have received had they taken developing accounting information
their own resource to market instead of presented in the financial statements. These
using it themselves. Such non-monetary rules, which are constructed by the
opportunity costs are called implicit costs. Securities and Exchange Commission (SEC)
and the Financial Accounting Standards
Businesses may incur numerous kinds of Board (FASB) do not allow accountants to
implicit costs, but the three most deduct most types of implicit costs for the
important types of implicit costs are:
purposes of calculating taxable accounting Maximizing the Value of the Firm
profit.
The value of a firm is the price for which it
can be sold, and that price is equal to the
present value of the expected future profit of
the firm.
The risk premium is an increase in the
discount rate to compensate investors for
uncertainty about future profits.
The risk associated with not knowing the
future profits of a firm is accounted for by
adding a risk premium to the discount rate
used for calculating the present value of the
firm’s future profits. The larger (smaller) the
risk associated with future profits, the higher
(lower) the risk premium used to compute
the value of the firm, and the lower (higher)
the value of the firm will be.
The Equivalence of Value Maximization
and Profit Maximization
If cost and revenue conditions in any period
are independent of decisions made in other
time periods, a manager will maximize the
value of a firm by making decisions that
maximize profit in every single time period.
The equivalence of single-period profit
Thus, accounting profit differs from
maximization and maximizing the value of
economic profit because accounting profit
the firm holds only when the revenue and
does not subtract from total revenue the
cost conditions in one time period are
implicit costs of using resources.
independent of revenue and costs in future
time periods. When today’s decisions affect
Accounting profit = Total profits in future time periods, price or output
revenue – Explicit costs decisions that maximize profit in each
(single) time period will not maximize the
value of the firm.
Since the owners of firms must cover the Two examples of these kinds of situations
costs of all resources used by the firm, occur when:
maximizing economic profit, rather than
accounting profit, is the objective of the (1) a firm’s employees become more
firm’s owners. productive in future periods by producing
more output in earlier periods—a case of who will typically be assisted by additional
learning by doing—and subordinate managers which creates an
executive management team that relieves the
(2) current production has the effect of
owners of management duties.
increasing cost in the future—as in
extractive industries such as mining and oil This separation forms a special relationship
production. between business owners and managers
known as a principal-agent relationship. In
Thus, if the increasing current output has a
this particular type of principal-agent
positive effect on future revenue and profit,
relationship, a business owner (the principal)
a value-maximizing manager selects an
enters an agreement with an executive
output level that is greater than the level that
manager (the agent) whose job is to
maximizes profit in a single time period.
formulate and implement tactical and
Some Common Mistakes Managers Make strategic business decisions that will further
the objectives of the business owner (the
Taking a course in managerial economics principal). The agency “agreement” can, and
can help you avoid making a number of usually does, take the form of a legal
common mistakes in business decision contract to confer some degree of legal
making: never increase output simply to enforceability, but it can also be something
reduce average costs, generally avoid the as simple as an informal agreement settled
pursuit of market share because doing so by a handshake between the owner and
usually lowers profit, focus on maximizing manager.
total profit rather than profit margin,
understand that maximizing total revenue The Principal-Agent Problem
does not maximize profit, and avoid the use
In firms for which the manager is not also
of cost-plus pricing methods when setting
the owner, the managers are agents of the
prices.
owners or principles. A principal-agent
• Never increase output simply to problem exists when agents have objectives
reduce average costs different from those of the principal, and the
• Pursuit of market share usually principal either has difficulty enforcing
reduces profit agreements with the agent or finds it too
• Focusing on profit margin won’t difficult and costly to monitor the agent to
maximize total profit verify that the agent is furthering the
• Maximizing total revenue reduces principal’s objectives.
profit Agency problems arise because of moral
• Cost-plus pricing formulas don’t hazards. A moral hazard exists when either
produce profit-maximizing prices party to an agreement has an incentive not to
1.3 SEPARATION OF OWNERSHIP abide by all provisions of the agreement, and
AND CONTROL OF THE FIRM one party cannot cost-effectively find out if
the other party is abiding by the agreement,
Business owners frequently choose to or cannot enforce an agreement even when
delegate control of their business to information is available.
professional executives or senior managers
In order to address agency problems, A market is any arrangement that enables
shareholders can employ a variety of buyers and sellers to exchange goods and
corporate control mechanisms. services, usually for money payments.
Shareholders can reduce agency problems Markets exist to reduce transaction costs, the
by: costs of making a transaction.
(1) requiring managers to hold a stipulated Different Market Structures
amount of the firm’s equity,
Market structure is a set of market
(2) increasing the percentage of outsiders
characteristics that determines the economic
serving on the company’s board of directors,
environment in which a firm operates. As
and
we now explain, the structure of a market
(3) financing corporate investments with
governs the degree of pricing power
debt instead of equity. Corporate takeovers
possessed by a manager, both in the short
also create an incentive for managers to
run and in the long run. The list of economic
make decisions that maximize the value of a
characteristics needed to describe a market
firm
is actually rather short:
1.4 MARKET STRUCTURE AND
Market structure is a set of
MANAGERIAL DECISION MAKING
characteristics that determines the
As mentioned, managers cannot expect to economic environment in which a firm
succeed without understanding how market operates:
forces shape the firm’s ability to earn profit.
(1) the number and size of firms operating in
A particularly important aspect of the market,
managerial decision making is the pricing (2) the degree of product differentiation, and
decision and this decision is affected by the (3) the likelihood of new firms’ entering.
structure of the market in which the firm
Markets may be structured as one of four
operates can limit the ability of a manager to
types:
raise the price of the firm’s product without
losing a substantial amount, possibly even (1) A perfectly competitive market has a
all, of its sales. large number of relatively small firms
selling an undifferentiated product in a
• A price-taking firm cannot set the
market with no barriers to entry.
price of the product it sells because
(2) A monopoly market is one in which a
the price is determined strictly by the
single firm, protected by a barrier to entry,
market forces of demand and supply.
produces a product that has no close
• A price-setting firm sets the price of
substitutes.
its product because it possesses some
(3) In monopolistically competitive
degree of market power, which is
markets, a large number of relatively small
the ability to raise the price without
firms produce differentiated products
losing all sales.
without any barriers to entry.
What Is a Market? (4) In oligopoly markets, there are only a
few firms whose profits are
interdependent—each firm’s decisions about
pricing, output, advertising, and so forth • She earned P120,000 per year
affect all other firms’ profits—with varying renting out his building before she
degrees of product differentiation. started her business.
Globalization of Markets In 2021, Mariah was trying to decide if she
should stay in business or go back to
Globalization of markets is the economic
teaching
integration of markets located in nations
around the world. Globalization provides Requirements
managers with both an opportunity to sell
1. How much are the explicit
more goods and services to foreign buyers as
costs?
well as the threat of increased competition
from foreign producers. 2. How much is the Accounting
profit?
3. How much are the implicit costs?
1.1.1 Illustrative problem: Economic
profit 4. How much is the Economic
profit?
Mariah is a CPA professor and earned
P650,000 per year. 5. What should be the decision of
Mariah?
However, due to the pandemic, she decided
to start her Accounting firm.
In 2020, the result's of Mariah's business are
as
follows:
Revenue 1,800,000
Staff
salary 195,000
Other operating
expenses 150,000
Since the economic profit is P175,000,
Other related
Mariah should continue running her
data:
business. She is earning more than
• Mariah used her P500,000 savings teaching.
that were earning a 2% interest per
year to start the business.
• She used the P500,000 to purchase 1.2 Demand, Supply, and the Market
equipment and supplies for the firm. equilibrium
• Mariah also had to give up renting 2.1 DEMAND
out a building he started using for her
business. Quantity Demanded The amount of a good
or service consumers are willing and able to
purchase during a given period of time Consumers are
(week, month, etc.). willing and able
Three types of demand relations: to buy more of a
good the lower
(1) general demand functions, which show the price of the Inverse/
P=Price
how quantity demanded is related to product good and will Negative
price and five other factors that affect buy less of a
demand, good the higher
the price of the
(2) direct demand functions, which show
good.
the relation between quantity demanded and
the price of the product when all other 1)
variables affecting demand are held constant An increase in Normal
at specific values, and income can Good-
cause the Direct/Po
(3) inverse demand functions, which give
amount of a sitive
the maximum prices buyers are willing to M=Inco
commodity
pay to obtain various amounts of product. me 2)
consumers
The General Demand Function: purchase either Inferior
to increase or to Good-
decrease. Inverse/
Qd = f (P, M, PR, I, PE, N) Negative

If an increase in
where f means “is a function of” or the price of a
“depends on,” related good
causes
The general demand function shows how all 3)
consumers to
six variables jointly determine the quantity Substitut
demand more of
demanded. In order to discuss e goods-
a good, then the
the individual effect that any one of these six PR=Price two goods Direct/Po
variables has on Qd, we must explain how of related are substitutes. sitive
changing just that one variable by itself goods 4)
influences Qd. Isolating the individual effect and If the demand
Comple
of a single variable requires that all other services for one good mentary
variables that affect Qd be held constant. increases when
goods-
Thus whenever we speak of the effect that a the price of a
Inverse/
particular variable has on quantity related good
Negative
demanded, we mean the individual effect decreases, the
holding all other variables constant. two goods
are complements
Relations .
Variable Effect
hip
 A movement in number of
consumer tastes consumers will d
toward a good or ecrease the
service will demand for a
I=Taste
increase demand good.
patterns
and a movement Direct/Po
of 1) Normal good A good or service for
in consumer sitive
consume which an increase (decrease) in income
tastes away
rs causes consumers to demand more (less) of
from a good will
decrease the good, holding all other variables in the
demand for the general demand function constant.
good. 2) Inferior good A good or service for
which an increase (decrease) in income
If consumers
causes consumers to demand less (more) of
expect the price
the good, all other factors held constant.
to be higher in a
future 3) Substitutes Two goods are substitutes if
period, demand an increase (decrease) in the price of one of
will the goods causes consumers to demand more
probably rise in (less) of the other good, holding all other
the current factors constant.
period.
PE=Expe 4) Complements Two goods are
ctations On the other Direct/Po complements if an increase (decrease) in the
on future hand, sitive price of one of the
prices expectations of goods causes consumers to demand less
a price (more) of the other good, all other things
decline in the held constant.
future will
The general demand function just set forth is
cause some
expressed in the most general mathematical
purchases to be
form. Economists and market researchers
postponed—
often express the general demand function in
thus demand in
a more specific mathematical form in order
the current
to show more precisely the relation between
period will fall.
quantity demanded and some of the more
An increase in important variables that affect demand. They
the number of frequently express the general demand
N=Numb consumers in the function in a linear functional form. The
er of market Direct/Po following equation is an example of a linear
consume will increase the sitive form of the general demand function:
rs demand for a
good, and
a decrease in the
 (substitute goods d is positive and
Qd = a + bP + cM + dPR + eI + complementary, d is negative)
gN
• I, PEPEand N are each directly
related to the quantity, the
where Qd , P, M, PR, I, PE, and N are as parameters e, f and g are all positive.
defined above, and a, b, c, d, e, f, and g are
parameters.
Slope parameters
• Parameters in a linear function that
measure the effect on the dependent
variable (Qd) of changing one of the
independent variables (P, M, PR, Iℑ,
PE, and N) while holding the rest of Table 2.1 summarizes this discussion of
these variables constant. the general demand function. Each of the
• The slope parameter b, for example, six factors that affect quantity deman ded
measures the change in quantity is listed, and the table shows whether
demanded per unit change in price; the quantity demanded varies directly or
inversely with each variable and gives
the sign of the slope parameters. Again
b=ΔQd/ΔP let us stress that these relations are in
the context of all other things being
equal.
(Qd and P are inversely related, thus, b is
Direct Demand Functions
negative)
Direct demand function A table, a graph,
• The slope parameter c measures the
or an equation that shows how quantity
effect on the amount purchased of a
demanded is related to product price,
one-unit change in income:
holding constant the five other variables that
influence demand:
c=ΔQd/ΔM
Qd = f (P)
(for normal goods, c is positive, for inferior
goods, c is negative)
which means that the quantity demanded is a
• The parameter d measures the function of (i.e., depends on) the price of the
change in the amount consumers good, holding all other variables constant. A
want to buy per unit change in PR: direct demand function is obtained by
holding all the variables in the general
demand function constant except price. For
d=ΔQd/ΔPR example, using a three-variable demand
function,
 Qd = 1,400 − (10 × $60) = 800
or if price is $40,
where the bar over the variables M and PR
Qd = 1,400 − (10 × $40) = 1,000
means that those variables are held constant
at some specified amount no matter what Demand schedule A table showing a list of
value the product price takes. possible product prices and the
corresponding quantities demanded.
To illustrate the derivation of a direct
demand function from the general demand
function, suppose the general demand
function is
Qd =3,200 - 10P + 0.05M - 24PR
To derive a demand function, Qd = f(P), the As shown in Table 2.2, each of the seven
variables M and PR must be assigned combinations of price and
specific (fixed) values. Suppose consumer quantity demanded is derived from the
income is $60,000 and the price of a related demand function exactly as shown
good is $200. To find the demand function, above.
the fixed values of M and PR Demand curve A graph showing the
are substituted into the general demand relation between quantity demanded and
function price when all other variables influencing
Qd = 3,200 - 10P + 0.05(60,000) - 24(200) quantity demanded are held constant.
=3,200 - 10P + 3,000 - 4,800
=1,400 - 10P
Thus, the direct demand function is
expressed in the form of a linear demand
equation, Qd =1,400 − 10P.
The intercept parameter, 1,400, is the
amount of the good consumers would
The seven price and quantity demanded
demand if price is zero. The slope of this
combinations in Table 2.2 are plotted in
demand function (=ΔΔQd /ΔΔP) is −10 and
Figure 2.1, and these points are
indicates that a $1 increase in price causes
connected with the straight line D 0 ,
quantity demanded to decrease by 10 units.
which is the demand curve associated
This linear demand equation satisfies all the with the demand equation Q d = 1,400 -
conditions set forth in the definition of 10P.
demand. All variables other than product
Inverse Demand Functions
price are held constant—income at $60,000
and the price of a related good at $200. At Inverse demand function The demand
each price, the equation gives the amount function when price is expressed as a
that consumers would purchase at that price. function of quantity demanded:
For example, if price is $60,
 negative; in the demand schedule, price and
P = f (Qd) quantity demanded are inversely related; and
in the graph, the demand curve is negatively
sloped. This inverse relation between price
Figure 2.1 is, mathematically speaking, a
and quantity
graph of the inverse demand function.
demanded is not simply a characteristic of
The horizontal intercept is 1,400, which is the specific demand function discussed here.
the maximum amount of the good buyers This inverse relation is so pervasive that
will take when the good is given away (P = economists refer to it as the law of
0). demand.

This inverse demand, as you can see in the Law of Demand Quantity demanded
figure, yields price-quantity combinations increases when price falls, and quantity
identical to those given by the direct demand demanded decreases when price rises, other
equation, Qd = 1,400 - 10P. In other words, things held constant.
the demand relation shown in Table 2.2 is
Once a direct demand function, Qd = f(P), is
identically depicted by either a direct or
derived from a general demand function,
inverse form of the demand equation.
a change in quantity demanded can be
Consider, for example, point A ($100, 400) caused only by a change in price.
on the demand curve in Figure 2.1. If the
Change in Quantity Demanded A
price of the good is $100, the maximum
movement along a given demand curve that
amount consumers will purchase is 400
occurs when the price of the good changes,
units.
all else constant.
Equivalently, $100 is the highest price that
The other five variables that influence
consumers can be charged in order to sell a
demand in the general demand function (M,
total of 400 units. This price, $100, is called
PR, I, PE, and N) are fixed in value for any
the “demand price” for 400 units, and every
particular demand equation. A change in
price along a demand curve is called
price is represented on a graph by a
the demand price for the corresponding
movement along a fixed demand curve.
quantity on the horizontal axis.
Shifts in Demand
Demand price The maximum price
consumers will pay for a specific amount of When any one of the five variables held
a good or service. constant when deriving a direct demand
function from the general demand relation
Movements along Demand
changes value, a new demand function
Before moving on to an analysis of changes results, causing the entire demand curve
in the variables that are held constant when to shift to a new location. To illustrate
deriving a demand function, we want to this extremely important concept, we will
reemphasize the relation between price and show how a change in one of these five
quantity demanded, which was discussed variables, such as income, affects a demand
earlier in this chapter. In the schedule.
demand equation, the parameter on price is
We begin with the demand schedule from reflected by a leftward shift in the demand
Table 2.2, which is reproduced in columns 1 curve.
and 2 of Table 2.3. Recall that the quantities
A decrease in demand occurs when a change
demanded for various product prices were
in one or more of the variables M, PR, I, PE,
obtained by holding all variables except
or N causes the quantity demanded to
price constant in the general demand
decrease at every price and the demand
function.
curve shifts to the left. Column 4 in Table
2.3 illustrates a decrease in demand caused
by income falling to $52,000. At every
price, quantity demanded in column 4 is less
than quantity demanded when income is
either $60,000 or $64,000 (columns 2 and 3,
• If income increases from $60,000 to respectively, in Table 2.3). The demand
$64,000, quantity demanded curve in Figure 2.2 when income is $52,000
increases at each and every price, as is D2 , which lies to the left of D0 and D1.
shown in column 3. Determinants of Demand Variables that
• When the price is $60, for example, change the quantity demanded at each price
consumers will buy 800 units if their and that determine where the demand curve
income is $60,000 but will buy 1,000 is located: M, PR, I, PE, and N.
units if their income is $64,000.
• In Figure 2.2, D0 is the demand While we have illustrated shifts in demand
curve associated with an income caused by changes in income, a change in
level of $60,000, and D1 is the any one of the five variables that are held
demand curve after income rises to constant when deriving a demand function
$64,000. will cause a shift in demand. These five
variables—M, PR, I, PE, and N—are called
Increase in Demand A change in the the determinants of demand because they
demand function that causes an increase in determine where the demand curve is
quantity demanded at every price and is located.
reflected by a rightward shift in the demand
curve. Change in Demand A shift in demand,
either leftward or rightward, that occurs
Since the increase in income caused quantity only when one of the five determinants of
demanded to increase at every price, the demand changes.
demand curve shifts to the right from D0 to
D1 in Figure 2.2. Think of M, PR, I, PE, and N as the five
“demandshifting” variables. The demand
Everywhere along D1 quantity demanded is curve shifts to a new location only when one
greater than along D0 for equal prices. or more of these demand-shifting variables
changes.
Decrease in Demand A change in the
demand function that causes a decrease in
quantity demanded at every price and is
 prices of the inputs used in production (PI),
the prices of goods that are related in
production (Pr), the level of available
technology (T), the expectations of
producers concerning the future price of the
good (Pe), and the number of firms or
amount of productive capacity in the
industry (F).

2.2 SUPPLY
Relationsh
Variable Effect
Quantity supplied The amount of a good or ip
service offered for sale during a given period
of time (week, month, etc.). The higher the
price, the greater
In general,economists assume that the the quantity firms
quantity of a good offered for sale depends wish to produce
on six major variables: Direct/Pos
P=Price and sell, all other
itive
1. The price of the good itself. things being equal.
The lower the
2. The prices of the inputs used to produce price, the smaller
the good. the quantity.
3. The prices of goods related in production. Increase in the
4. The level of available technology. price of one of the
inputs will increase
5. The expectations of the producers the cost of
concerning the future price of the good. production--if cost
6. The number of firms or the amount of rises, supply will
productive capacity in the industry. Pi=Prices of be lower. Decrease Inverse/Ne
Inputs in the price will gative
The General Supply Function: decrease the costs
The relation between quantity supplied and of production,
the six factors that jointly affect quantity goods will become
supplied: more profitable--
producers will
supply more.
Qs = f ( P, Pi, Pr, T, PeF)
1) If an increase in
1)
Pr=Prices of the price of good X
Inverse/Ne
The quantity of a good or service offered for related goods relative to good Y
sale (Qs ) is determined not only by the price causes producers to gative
of the good or service (P) but also by the increase production
 of good X and 2) producers to increase production of the now
decrease Direct/Pos higher priced good and decrease production
production of good itive of the other good.
Y. 2) Complements in production Goods for
2) If an increase in which an increase in the price of one good,
the price of good X relative to the price of another good, causes
causes producers to producers to increase production of both
supply more of goods.
good Y. As in the case of demand, economists often
find it useful to express the general supply
An improvement in
function in linear functional form:
technology
generally results in
T- Direct/Pos
one or more of
Technology itive Qs = h + kP + lPi + mPr + nT +
the inputs used in
rPe + sF
making the good to
be more productive
where Qs , P, PI, Pr, T, Pe , and F are as
If firms expect the
defined earlier, h is an intercept parameter,
price of a good they
and k, l, m, n, r, and s are slope parameters.
produce to rise in
the future, they
Pe=Price may withhold some Inverse/Ne
expectations of the good, gative
thereby reducing
supply of the good
in the
current period.
Direct Supply Functions
If the number of Just as demand functions are derived from
firms in the the general demand function, direct supply
industry increases functions are derived from the general
or if the productive supply function. A direct
F=Number of capacity of existing Direct/Pos supply function (also called simply
Firms firms increases, itive “supply”) shows the relation between Qs
more of the good or and P holding the determinants of
service will be supply (PI , Pr , T, Pe , and F) constant:
supplied
at each price.

1) Substitutes in Production Goods for

which an increase in the price of one good where the bar means the determinants of
relative to the price of another good causes supply are held constant at some specified
value. Once a direct supply
function Qs=f(P) is derived from a general
supply function, a change in quantity or if the price is $100,
supplied can be caused only by a change in
price.
Qs = -400 + 20($100) = 1,600
Direct Supply Function A table, a graph, or
A supply schedule (or table) shows a list of
an equation that shows how quantity
several prices and the quantity supplied at
supplied is related to product price, holding
each of the prices, again holding all
constant the five other variables that
variables other than price constant. Table 2.6
influence supply: Qs = f(P).
shows seven prices and their corresponding
Determinants of Supply Variables that quantities supplied. Each of the seven price–
cause a change in supply (i.e., a shift in the quantity-supplied combinations is derived,
supply curve). as shown earlier, from the supply equation
Qs = -400 + 20P, which was derived from
Change in quantity supplied A movement
the general supply function by setting PI =
along a given supply curve that occurs when
$100 and F = 25. Figure 2.3 graphs
the price of a good changes, all else
constant. the supply curve associated with this supply
equation and supply schedule.
To illustrate the derivation of a supply
function from the general supply function,
suppose the general supply function is
Qs = 100 + 20P - 10PI + 20F
Technology, the prices of goods related in
production, and the expected price of the
Supply curve A graph showing the relation
product in the future have been omitted to
between quantity supplied and price, when
simplify this illustration.
all other variables influencing quantity
Suppose the price of an important input is supplied are held constant
$100, and there are currently 25 firms in the
industry producing the product. To find the
supply function, the fixed values of PI and F
are substituted into the general supply
function:
Qs = 10+ 20P - 10($100) + 20(25)
= 2400 + 20P
Any particular combination of price and
The linear supply function gives the quantity quantity supplied on a supply curve can be
supplied for various product prices, holding interpreted in either of two equivalent ways.
constant the other variables that affect A point on the supply schedule indicates
supply. For example, if the price of the either (1) the maximum amount of a good or
product is $40, service that will be offered for sale at a
Qs = -400 + 20($40) = 400 specific price or (2) the minimum price
necessary to induce producers to offer a
given quantity for sale. This minimum price
is sometimes referred to as the supply
price for that level of output.
Supply price The minimum price necessary
to induce producers to offer a given quantity
for sale.
Shifts in Supply Table 2.8 summarizes this discussion of
shifts in supply.
As we differentiate between a change in
quantity demanded because of a change in 2.3 MARKET EQUILIBRIUM
price and a shift in demand because of a
change in one of the determinants of Market equilibrium A situation in which,
demand, we must make the same distinction at the prevailing price, consumers can buy
with supply. A shift in supply occurs only all of a good they wish and producers can
when one of the five determinants of supply sell all of the good they wish. The price at
as mentioned above changes value. which Qd = Qs.

Increase in supply A change in the supply Equilibrium price The price at which Qd =
function that causes an increase in quantity Qs.
supplied at every price, and is reflected by a Equilibrium quantity The amount of a
rightward shift in the supply curve. good bought and sold in market equilibrium,
Decrease in supply A change in the supply To illustrate how market equilibrium is
function that causes a decrease in quantity achieved, we can use the demand and supply
supplied at every price, and is reflected by a schedules set forth in the preceding sections.
leftward shift in the supply curve. Table 2.9 shows both the demand schedule
for D0 (given in Table 2.2) and the supply
schedule for S0 (given in Table 2.6). As the
table shows, equilibrium in the market
occurs when price is $60 and both quantity
demanded and quantity supplied are equal to
800 units. At every price above $60,
quantity supplied is greater than quantity
demanded.
Excess supply (surplus) Exists when which is the result shown in column 4.
quantity supplied exceeds quantity
Graphically:
demanded.
Excess demand (shortage) Exists when
quantity demanded exceeds quantity
supplied.
Market clearing price The price of a good
at which buyers can purchase all they want
and sellers can sell all they want at that
price. This is another name for the
Figure 2.5 shows the demand curve
equilibrium price. D0 and the supply curve S0 associated
Before moving on to a graphical analysis of with the schedules in Table 2.9. These
equilibrium, we want to reinforce the are also the demand and supply curves
concepts illustrated in Table 2.9 by using the previously shown in Figures 2.1 and 2.3.
demand and supply functions from which Clearly, $60 and 800 units are the
the table was derived. To this end, recall that equilibrium price and quantity at point A in
the demand equation is Figure 2.5. Only at a price of $60 does
Qd = 1,400 - 10P and the supply equation is quantity demanded equal quantity supplied.
Qs = -400 + 20P. Since equilibrium
requires that Qd = Qs , in equilibrium, Market forces will drive price toward $60. If
price is $80, producers want to supply 1,200
1,400 - 10P = -400 + 20P units while consumers only demand 600
Solving this equation for equilibrium price, units. An excess supply of 600 units
develops. Producers must lower price in
1,800 = 30P order to keep from accumulating unwanted
P = $60 inventories. At any price above $60, excess
At the market clearing price of $60, supply results, and producers will lower
Qd = 1,400 - 10(60) = 800 price.
Qs = -400 + 20(60) = 800 If price is $40, consumers are willing and
As expected, these mathematically derived able to purchase 1,000 units, while
results are identical to those presented in producers offer only 400 units for sale. An
Table 2.9. excess demand of 600 units results.

According to Table 2.9, when price is $80, Since their demands are not satisfied,
there is a surplus of 600 units. Using the consumers bid the price up. Any price below
demand and supply equations, when P = 80, $60 leads to an excess demand, and the
shortage induces consumers to bid up the
Qd = 1,400 - 10(80) = 600 price.
Qs = -400 + 20(80) = 1,200
Therefore, when price is $80, Given no outside influences that prevent
price from being bid up or down, an
Qs - Qd = 1,200 - 600 = 600 equilibrium price and quantity are attained.
2.4 MEASURING THE VALUE OF $100 also represents the maximum
MARKET EXCHANGE amount for which the 400th unit of the
good can be
Consumer Surplus sold. Notice in the blow up at point r
Typically, consumers value the goods they that the consumer who is just willing to
purchase by an amount that exceeds the buy the 400th unit at $100 would not buy
purchase price of the goods. For any unit of the 400th unit for even a penny more
a good or service, the economic value: than $100. It follows from this reasoning
that the demand price of $100 measures
Economic value The maximum amount any the
buyer in the market is willing to pay for the economic value of the 400th unit, not
unit, which is measured by the demand price the value of 400 units. You can now see
for the unit of the good. that the consumer surplus for the 400th
unit equals $40 (= $100 - $60), which is
the difference between the demand price
Economic value of a (or economic value) of the 400th unit
particular unit = Demand and
price for the unit the market price (at point A).
= Maximum amount buyers
are willing to pay In Figure 2.6, consumer surplus of the
400th unit is the distance between points
r and s.
Consumer surplus The difference between Total consumer surplus for 400 units is
the economic value of a good (its demand equal to the area below demand and above
price) and the market price the consumer market price over the output range 0 to 400
must pay. units. In Figure 2.6, total consumer surplus
for 400 units is measured by the area
bounded by the trapezoid uvsr. One way to
compute the area of trapezoid uvsr is to
multiply the length of its base (the distance
between v and s) by the average height of its
two sides (uv and rs):
400 x (($80 + $40)/2) = $24,000.
Figure 2.6 illustrates how to measure
consumer surplus for the 400th unit of a Of course you can also divide the trapezoid
good using the demand and supply into a triangle and a rectangle, and then you
curves developed previously. Recall from can add the two areas to get total consumer
our discussion about inverse demand surplus. Either way, the total consumer
functions that the demand price for 400 surplus when 400 units are purchased is
units, $24,000.
which is $100 in Figure 2.6, gives the
maximum price for which a total of 400 Producer Surplus
units can be sold (see point r). But, as we
just mentioned, the demand price of
For each unit supplied, the difference for managers. In reality, the
between market price and the minimum variables held constant when deriving
price producers would accept to supply the demand and supply curves do change.
unit (its supply price).
Consequently, demand and supply curves
The producer surplus generated by the shift, and equilibrium price and quantity
production and sale of the 400th unit is the change. Using demand and supply,
vertical distance between points s and t, managers may make either qualitative
which is $20 (= $60 - $40). The total forecasts or quantitative forecasts.
producer surplus for 400 units is the sum of
Qualitative forecast A forecast that predicts
the producer surplus of each of the
only the direction in which an economic
400 units. Thus, total producer surplus for
variable will move.
400 units is the area below market price and
above supply over the output range 0 to 400. Quantitative forecast A forecast that
In Figure 2.6, total producer surplus for 400 predicts both the direction and the
units is measured by the area of the magnitude of the change in an economic
trapezoid vwts. By multiplying the base vs variable.
(5 400) times the average height of the two
parallel sides vw ($40) and st ($20), you can Changes in Demand (Supply Constant)
verify that the area of trapezoid vwts is
$12,000 [= 400 x ($40 + $20)/2].
Social surplus
The sum of consumer surplus and producer
surplus, which is the area below demand and
above supply over the range of output
Equilibrium occurs at $60 and 800 units,
produced and consumed.
shown as point A in the figure. The demand
At market equilibrium point A in Figure 2.6, curve D1 , showing an increase in demand,
social surplus equals $48,000 (= $32,000 + and the demand curve D2 , showing a
$16,000). As you can now see, the value of decrease in demand, are reproduced from
social surplus in equilibrium provides a Figure 2.2. Recall that the shift from D0 to
dollar measure of the gain to society from D1 was caused by an increase in income.
having voluntary The shift from D0 to D2 resulted from the
exchange between buyers and sellers in this decrease in income.
market.
Begin in equilibrium at point A. Now let
2.5 CHANGES IN MARKET demand increase to D1 as shown. At the
EQUILIBRIUM original $60 price, consumers now
demand a' units with the new demand. Since
If demand and supply never changed,
firms are still willing to supply only 800
equilibrium price and quantity would remain
units at $60, a shortage of a' 2 800 units
the same forever, or at least for a very long
results. As described in section 2.3, the
time, and market analysis would be
shortage causes the price to rise to a new
extremely uninteresting and totally useless
equilibrium, point B, where quantity Begin in equilibrium at point A. Let supply
demanded equals quantity supplied. As you first increase to S1 as shown. At the original
can see by comparing old equilibrium point $60 price consumers still want to purchase
A to new equilibrium point B, the increase 800 units, but sellers now wish to
in demand increases both equilibrium price sell a' units, causing a surplus or excess
and quantity. supply of a' - 800 units. The surplus causes
price to fall, which induces sellers to supply
To illustrate the effect of a decrease in
less and buyers to demand more. Price
demand, supply held constant, we return to
continues to fall until the new equilibrium is
the original equilibrium at point A in the
attained at point B. As you can see by
figure. Now we decrease the demand to
comparing the initial equilibrium point A in
D2. At the original equilibrium price of $60,
Figure 2.8 to the new equilibrium point B,
firms still want to supply 800 units, but now
when supply increases and demand remains
consumers want to purchase only a" units.
constant, equilibrium price will fall and
Thus, there is a surplus of A - a" units. As
equilibrium quantity will increase.
already explained, a surplus causes price to
fall. The market returns to equilibrium only To demonstrate the effect of a supply
when the price decreases to point C. decrease, we return to the original input
Therefore the decrease in demand decreases price to obtain the original supply curve
both equilibrium price and quantity S0 and the original equilibrium at point A.
(compare points A and C). We have now Let the number of firms in the industry
established the following principle: decrease, causing supply to shift from S0 to
S2
Principle: When demand increases and
in Figure 2.8. At the original $60 price,
supply is constant, equilibrium price and
consumers still want to buy 800 units, but
quantity both rise. When demand
now sellers wish to sell only a" units, as
decreases and supply is constant,
equilibrium price and quantity both fall.
shown in the figure. This leads to a shortage
or excess demand of a" - A units. Shortages
Changes in Supply (Demand Constant) cause price to rise. The increase in price
induces sellers to supply more and buyers to
demand less, thereby reducing the shortage.
Price will continue to increase until it attains
the new equilibrium at point C. Therefore,
when supply decreases while demand
remains constant, price will rise and quantity
The supply curve S1 , showing an increase sold will decrease. We have now established
in supply, and the supply curve S2, showing the following principle:
a decrease in supply, are reproduced from
Figure 2.4. Recall that the shift from S0 to Principle: When supply increases and
S1 was caused by a decrease in the price of demand is constant, equilibrium price
an input. The shift from S0 to S2 falls and equilibrium quantity rises.
resulted from a decrease in the number of When supply decreases and demand is
constant, equilibrium price rises and
firms in the industry.
equilibrium quantity falls.
Simultaneous Shifts in Both Demand and (Q to Q0), but now equilibrium price
Supply decreases from P to P0.
In situations involving both a shift in In the case where both demand and supply
demand and a shift in supply, it is possible increase, a small increase in supply relative
to predict either the direction in which price to demand causes price to rise, while a large
changes or the direction in which quantity increase in supply relative to demand causes
changes, but not both. price to fall.
When it is not possible to predict the In the case of a simultaneous increase in
direction of change in a variable, the change both demand and supply, equilibrium output
in that variable is said to be indeterminate. always increases, but the change in
equilibrium price is indeterminate.
Indeterminate Term referring to the
unpredictable change in either equilibrium When both demand and supply shift
price or quantity when the direction of together, either (1) the change in quantity
change depends upon the relative can be predicted and the change in price is
magnitudes of the shifts in the demand and indeterminate or (2) the change in quantity is
supply curves. indeterminate and the change in price can be
predicted.
The change in either equilibrium price or
quantity will be indeterminate when the
direction of change depends upon the
relative magnitudes of the shifts in the
demand and supply curves.

In Figure 2.9, D and S are, respectively,

demand and supply, and equilibrium
price and quantity are P and Q (point A).
Figure 2.10 summarizes the four possible
Suppose demand increases to D' and supply
outcomes when demand and supply both
increases to S'. Equilibrium quantity
shift. In each of the four panels in Figure
increases to Q', and equilibrium price rises 2.10, point C shows an alternative point
from P to P' (point B). of equilibrium that reverses the direction
Suppose, however, that supply had increased of change in one of the variables, price
even more to the dashed supply S0 so that or quantity. You should use the
the new equilibrium occurs at point C reasoning process set forth above to
instead of at point B. Comparing point A to verify the conclusions presented for each
point C, equilibrium quantity still increases
of the four cases. We have established
the following principle:
Thus, the equilibrium output of milk is
Principle: When demand and supply both
predicted to be 160 billion pounds
shift simultaneously, if the change in
quantity (price) can be predicted, the Even though that’s a lot of milk, the
change in price (quantity) is American Dairy Association plans to begin a
indeterminate. The change in equilibrium nationwide advertising campaign to promote
quantity or price is indeterminate when milk by informing consumers of the
the variable can either rise or fall nutritional benefits of milk—lots of calcium
depending upon the relative magnitudes and vitamin D. The association estimates the
by which demand and supply shift. advertising campaign will increase demand
Advertising and the Price of Milk: A to
Quantitative Analysis Qd = 500 - 25P
The American Dairy Association estimates Assuming supply is unaffected by the
next year’s demand and supply functions for advertising, you would obviously predict the
milk in the United States will be market price of milk will rise as a result of
Qd = 410 - 25P the advertising and the resulting increase in
Qs = -40 + 20P demand. However, to determine the actual
market-clearing price, you
where quantity demanded and quantity must equate the new quantity demanded
supplied are measured in billions of pounds with the quantity supplied
of milk per year, and price is the wholesale
price measured in dollars per hundred 500 - 25P = -40 + 20P
pounds of milk. First, we predict the price P = 12
and quantity of milk next year. The market The price of milk will increase to $12 per
clearing price is easily determined by setting hundred pounds with the
quantity demanded equal to quantity advertising campaign. Consequently, the
supplied and solving algebraically for prediction is that the national advertising
equilibrium price campaign will increase the market price of
milk by $2 per hundred pounds. To make
Qd = Qs a quantitative forecast about the impact of
410 - 25P = -40 + 20P the ads on the level of milk sales,
450 = 45P you simply substitute the new market price
10 = P of $12 into either the demand or the
Thus, the predicted equilibrium price of milk supply function to obtain the new Q
next year is $10 per hundred pounds.
The predicted equilibrium output of milk is
determined by substituting the market price
This is an example of a quantitative forecast
of $10 into either the demand or the supply
since the forecast involves both
function to get
the magnitude and the direction of change in
price and quantity.
2.6 CEILING AND FLOOR PRICES results from the imposition of the $1 price
ceiling.
Shortages and surpluses can occur after a
shift in demand or supply, but as we have Market forces will not be permitted to bid up
stressed, these shortages and surpluses are the price to eliminate the shortage because
sufficiently short in duration that they can producers cannot sell the good for more than
reasonably be ignored in demand and supply $1. This type of shortage will continue until
analysis. government eliminates the price ceiling or
until shifts in either supply or demand cause
Typically these more permanent shortages
the equilibrium price to fall to $1 or lower.
and surpluses are caused by government
imposing legal restrictions on the movement Alternatively, the government may believe
of prices. Shortages and surpluses can be that the suppliers of the good are not earning
created simply by legislating a price below as much income as they deserve and,
or above equilibrium. Governments have therefore, sets a minimum price or floor
decided in the past, and will surely decide in price a shown in the Panel B. of Figure 2.12.
the future, that the price of a particular
Dissatisfied with the equilibrium price of $2
commodity is “too high” or “too low” and
and equilibrium quantity of 50, the
will proceed to set a “fair price.”
government sets a minimum price of $3.
Since the government cannot repeal the law
of demand, consumers reduce the amount
they purchase to 32 units. Producers,
of course, are going to increase their
production of X to 84 units in response to
the $3 price. Now a surplus of 52 units
exists. Because the government is not
Ceiling price The maximum price the allowing the price of X to fall, this surplus is
government permits sellers to charge for a going to continue until it is either eliminated
good. When this price is below equilibrium, by the government or demand or supply
a shortage occurs. shifts cause market price to rise to $3 or
higher. In order for the government to
Floor price The minimum price the ensure that producers do not illegally sell
government permits sellers to charge for a their surpluses for less than $3, the
good. When this price is above equilibrium, government must either restrict the
a surplus occurs. production
In Panel A of Figure 2.12, a ceiling price of of X to 32 units or be willing to buy (and
$1 is set on some good X. No one can store or destroy) the 52 surplus units.
legally sell X for more than $1, and $1 is Principle : When the government sets a
less than the equilibrium (market clearing) ceiling price below the equilibrium price,
price of $2. At the ceiling price of $1, the a shortage or excess demand results
maximum amount that producers are willing because consumers wish to buy more
to supply is 22 units. At $1, consumers wish units of the good than producers are
to purchase 62 units. A shortage of 40 units willing to sell at the ceiling price. If the
government sets a floor price above the
equilibrium price, a surplus or excess
supply results because producers offer
for sale more units of the good than
buyers wish to consume at the floor
price.

For managers to make successful decisions

by watching for changes in economic
conditions, they must be able to predict how
these changes will affect the market.

1.2.1 Illustrative problem: Demand,

Supply, and Market Equilibrium
highlights