Executive Economic Analysis BUS 571 Module 2, lecture 2

Topics Supply & Demand Supply Curve Changes in Supply & Demand Elasticity of Supply Supply, Demand & Price Three Essential Principles of the Market System Shortages & Surpluses Four S&D scenarios Role of the Price System Consumers’ Surplus Sellers’ Rent Prices Determined at the Margin

Supply & Demand Recall… Law of Demand Law of Supply The lower the price the higher the number of buyers Demand is like an inverted cone, a wizard's hat Law of Supply The higher the price, the higher the number of sellers. Supply is like an ice-cream cone.

Supply & Demand Supply and Demand helps us understand micro markets just as they do highly aggregated (i.e., macro) markets Supply and demand analysis is limited Each graph/diagram applies to one product Cannot how or why a producer may adjust the quality of its product or introduce a new one, e.g. Despite its limitations, it offers a great deal of insight about how markets work

Supply & Demand Supply and demand is at the heart of the market economy Individual consumers, through their collective choices, set prices and determine the production of goods and services Supply schedule is quantity of goods a producer is willing to sell at various prices

Supply Curve The supply curve is upward sloping (to the right) Reflects firm’s perceived improvement in profitability As demand increases producers expand output and, ceteris paribus, raise their prices Recall: Prices are the signal producer’s look to when determining how much to produce and at what price point

Changes in Supply & Demand Factors that shift demand Changes in real wealth Changes in the real rate of interest Increased optimism/pessimism about future economic conditions: firms and households Changes in regulation/taxes Changes in expected rate of inflation

Changes in Supply & Demand Factors that shift supply Long-run Changes in availability of resources Changes in technology and productivity Institutional changes that affect efficiency of resource use Short-run Changes in resource prices (i.e., production costs) Changes in expected rate of inflation Supply shocks (e.g., oil price changes brought about by OPEC pricing or weather patterns that affect the supply chain)

Elasticity of Supply Elastic = flexible and adaptable Markets are responsive to price changes Law of Supply: Producers tend to increase or decrease their supply when prices for G&S change Elasticity = Responsiveness Responsiveness refers to the connection between prices and # of people who will buy at each price

Elasticity of Supply Helps the discovery process Where does the firm’s most profitable opportunities lie? How will a price increase or decrease impact market share and profitability? What market segments might the firm enter into or lose share in by a change in price, quality, quantity?

Elasticity of Supply How do we calculate price elasticity of supply? PES = Price Elasticity of Supply Q = Quantity P = Price See illustration on board How do we measure elasticity? 0 = perfect inelasticity > price increase will not affect demand 0-1 = inelastic demand 1 = unitary elasticity > 1 - infinity = elastic demand Infinity = perfectly elastic demand Calculations are based on historical data; as substitutes rise, demand changes and, thus, so do prices

Elasticity of Supply Price Elasticity of Supply What happens to supply when price changes? PES measures the responsiveness of suppliers (output) to changes in price As price moves up, % of supply typically increases As price moves down, % of supply typically decreases Example: Market for high school math and science teachers > “How much do we need to increase salaries in order to have more of both?”

Elasticity of Supply How do we measure price elasticity of supply (PES)? PES = Percentage Change in Quantity Supplied/Percentage Change in Price PES = % ▲QS/% ▲P

Supply, Demand & Price Prices tend to stabilize at the point where supply equals demand Three possibilities Quantity supplied exceeds quantity demanded > surplus Quantity demanded exceeds quantity supplied > shortage Quantity demanded is equal to quantity supplied Supply and demand clear the market > equilibrium See figure 6.10

Supply, Demand & Price Prices tend to stabilize at the point where supply equals demand Three possibilities Quantity supplied exceeds quantity demanded > surplus Quantity demanded exceeds quantity supplied > shortage Quantity demanded is equal to quantity supplied Supply and demand clear the market > equilibrium See figure 6.10

Three Essential Principles of the Market System The Principle of Non-Discrimination Effort on the part of firms to discover new markets As markets become more competitive, price discrimination becomes more the exception than the rule The Market as Incentive System Because more one earns, the more resources one can command and the more G&S one can obtain the market rewards productivity and discourages the lack of productivity The Benefit Principle Those who benefit from a good or service should pay for it Also known as the Principle of Accountability

Consumer Choice & Marginal Utility People make decisions on the margin Why? Limited income Nature of human action: purposeful choice Available substitutes/alternatives Imperfect knowledge Law of diminishing utility

Shortages & Surpluses The market consists of persons, consumers and producers who make decisions about prices and production based on available information If demand exceeds supply, prices will rise and bring the market back to equilibrium If supply exceeds demand, prices will decrease and bring the market back to equilibrium

Four Supply & Demand Scenarios Increase in demand Decrease in demand Increase in supply Decrease in supply See figure 6.14

Role of the Price System Prices ration scarce resources They tell producers what to produce, how much, when and how Prices influence human behavior They inform consumers and help them decide whether or not to make a purchase Prices are a signal to both buyers and sellers Buyers and sellers perceive they are getting the better value Buyers value the product or service more than the money required to purchase it; sellers value the money more than the product or service they must provide

Consumers’ Surplus Consumers’ surplus = the net benefits buyers receive from a given exchange A measure of economic well-being Arises when a consumer pays less than they expect to pay for a product or service If producers can cause prices to decrease, they expand consumers’ surplus

Sellers’ Rent Sellers’ Rent = the net benefits producers receive from a given exchange A measure of economic well-being Arises when a producer receives more than they expect to be paid for a product or service If buyers cause prices to increase, they expand sellers’ rent

Prices Are Determined at the Margin Prices are determined by the number of buyers and sellers in the market… In relation to the available quantity of a good or service While the number of buyers and sellers may be large, it is those who come the closest in price (willing to buy at, willing to sell at) that set the market rate, i.e., “at the margin”

Wrap-Up/Close Questions? Comments?