Economics for Managers

Week 2: Pricing: demand and supply

The demand side of the market
 Quantity demanded: The amount of a good or service that
a consumer is willing and able to buy at a given price.
 Demand schedule: A table showing the relationship
between the price of a product and the quantity of the
product demanded.
 Demand curve: A curve showing the relationship between
the price of a product and the quantity of the product
demanded.
 Market demand: The demand by all the consumers of a
given good or service.
The demand side of the market
 The law of demand: Holding everything else constant,
when the price of a product falls the quantity demanded
will increase, and when the price of a product rises the
quantity demanded will decrease.
 Holding everything else constant: the ceteris paribus
condition.
 Ceteris paribus (‘all else being equal’): The requirement
that, when analysing the relationship between two
variables such as price and quantity demanded, other
variables must be held constant.
 The demand side of the market
What explains the law of demand?
1. The substitution effect: The change in the quantity
demanded of a good or service that results from a change
in price, making the good or service more or less expensive
relative to other goods and services that are substitutes
(holding constant the effect of the price change on
consumer purchasing power).
The demand side of the market
What explains the law of demand? cont.
2. The income effect: The change in the quantity demanded
of a good or service that results from the effect of a
change in price on consumer purchasing power (holding all
other factors constant).
The demand side of the market
Variables that shift market demand
The five most important variables are:
1. Income
2. Prices of related goods
3. Tastes
4. Population and demographics
5. Expected future prices
 The demand side of the market
Variables that shift market demand, cont.
1. Income
 Normal good: A good for which the demand increases as
income rises and decreases as income falls.
 Inferior good: A good for which the demand increases as
income falls and decreases as income rises.
The demand side of the market
Variables that shift market demand, cont.
2. Prices of related goods
 Substitutes: Goods or services that can be used for the
same or similar purpose.
 Complements: Goods and services that are used together.
The demand side of the market
Variables that shift market demand, cont.
3. Tastes
 A broad category that refers to the many subjective
elements that can influence a consumer’s plans to buy a
good or service.
– Seasons
– Trends/fashion
The demand side of the market
Variables that shift market demand, cont.
4. Population and demographics
 As the population increases, the demand for most goods
and services will increase.
 Demographics: Changes in the characteristics of a
population with respect to age, race and gender.
 Demographics influences demand for particular goods and
services.
The demand side of the market
Variables that shift market demand, cont.
5. Expected future prices
 Consumers choose when to buy goods and services based
on their expectations regarding future prices relative to
present prices.
 If consumers expect prices to increase in the future, they
have an incentive to increase purchases now, and vice
versa.
Making the Connection 3.1
The aging of the baby boom generation
The average age of populations in many countries throughout
the world is increasing.
This will change the types of goods and services demanded in
the future.
The demand side of the market
A change in demand versus a change in quantity demanded
 A change in demand refers to a shift in the demand curve.
– Occurs due to a change in variables, other than
the product’s own price, that affect demand.
 A change in the quantity demanded refers to a movement
along the demand curve as a result of a change in the
product’s price.
Solved Problem 1
Changes in quantity demanded versus changes in demand
Explain whether each of the following causes a movement
along, or a shift in, the demand curve for Dell laptops. Indicate
the direction of the shift in demand or the movement along the
curve and the reason for the change.
a) The price of Toshiba laptops decreases.
b) A fall in the value of the Australian dollar against the US
dollar which increases the price of Dell laptops in Australia.
c) Dell’s customised laptops become increasingly appealing.
Solved Problem 1
Changes in quantity demanded versus changes in demand
Solving the problem:
STEP 1: Review the material. The problem addresses the
difference between changes in demand and changes in quantity
demanded, and the determinants of both. This material is
covered in the section in the textbook, ‘The demand side of the
market’.
STEP 2: Answering a)—Toshiba laptops are a substitute for Dell
laptops. A decrease in the price of Toshiba laptops will decrease
demand for Dell laptops, shifting the demand curve for Dell
laptops to the left.
Solved Problem 1
Changes in quantity demanded versus changes in demand
STEP 3: Answering (b)—The reason for the change in price is
not significant (at this stage). The important issue is that the
price of Dell laptops has increased. As a result, quantity
demanded will decrease, resulting in a movement up the
demand curve.
STEP 4: Answering (c)—This change is an example of a change
in consumer tastes. The result will be an increase in demand for
Dell laptops, which will shift the demand curve to the right.
The supply side of the market
 Quantity supplied: The amount of a good or service that a
firm is willing and able to supply at a given price.
  Supply schedule: A table showing the relationship
between the price of a product and the quantity of the
product supplied.
 Supply curve: A curve that shows the relationship
between the price of a product and the quantity of the
product supplied.
The supply side of the market
 Market supply: The supply by all the firms of a given good
or service.
 The law of supply: Holding everything else constant, an
increase in the price of a product causes an increase in the
quantity supplied, and a decrease in the price of a product
causes a decrease in the quantity supplied.
The supply side of the market
Variables that shift supply
The five most important variables are:
1. Prices of inputs
2. Technological change
3. Prices of substitutes in production
4. Number of firms in the market
5. Expected future prices.
The supply side of the market
Variables that shift supply, cont.
1. Prices of inputs.
 An input is anything used in the production of a good or
service.
 An increase in the cost of an input increases the cost of
production. The firm supplies less.
 A decrease in the cost of an input decreases the cost of
production at every price. The firm supplies more at every
price.
The supply side of the market
Variables that shift supply, cont.
2. Technological change.
 A change in the ability of a firm to produce output with a
given quantity of inputs.
 Technological change allows the firm to produce more
outputs with the same amount of inputs.
 Productivity: The output produced per unit of input.
The supply side of the market
Variables that shift supply, cont.
3. Prices of substitutes in production.
 Substitutes in production are alternative products a firm
can produce with the same resources.
  An increase in the price of a substitute in production
decreases the supply of the initial good, while a decrease
in the price of a substitute in production increases the
supply of the initial good.
The supply side of the market
Variables that shift supply, cont.
4. Number of firms in the market.
 When new firms enter the market, supply increases.
 When firms exit the market, supply decreases.
5. Expected future prices.
 If firms expect the price of its product will increase in the
future, they have an incentive to decrease supply now.
The supply side of the market
A change in supply versus a change in quantity supplied
 A change in supply refers to a shift in the supply curve.
– Occurs due to a change in variables, other than
the product’s own price, that affect supply.
 A change in the quantity supplied refers to a movement
along the supply curve as a result of a change in the
product’s price.
Market equilibrium
  Market equilibrium: A situation in which quantity
demanded equals quantity supplied.
 Competitive market equilibrium: A market equilibrium
with many buyers and many sellers.
Market equilibrium
 Surplus: A situation in which the quantity supplied is
greater than the quantity demanded.
 Shortage: A situation in which the quantity demanded is
greater than the quantity supplied.
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
Demand for flat-screen televisions has increased significantly
over recent years; however, the price of these televisions has
decreased. Clearly this is an example of an exception to the ‘law
of demand’.
Do you agree?
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
Solving the problem:
STEP 1: Review the material. The problem examines
simultaneous shifts in the demand and supply curves and the
resulting impact on equilibrium price. This material is covered
in the section of the textbook, ‘The effects of shifts in demand
and supply over time’.
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
STEP 2: To answer this question we need to look at changes in
both demand and supply.
If we begin from the demand side, it is clear that demand for
flat-screen televisions has increased. This would cause a
rightward shift of the demand curve, and, all else held constant,
the equilibrium price would increase.
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
STEP 3: In the real world, it is common for more than one
variable to change at the same time. In the case of flat-screen
televisions, production technology has improved, decreasing
the cost of production and causing the supply curve to shift to
the right.
In addition, there are many more producers in the industry—
for example, from Japan, South Korea and China—which
further increases supply. A rightward shift in supply alone
would lead to a decrease in equilibrium price.
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
STEP 4: If we compare the shifts in demand and supply, we can
see that a right shift in demand increases price and a right shift
in supply decreases price. In this case, both shifts have occurred
simultaneously, but the shift in supply has been of a greater
magnitude than the shift in demand.
As a consequence, the supply effect has dominated the
outcome, resulting in a decrease in the equilibrium price for
flat-screen televisions.
Solved Problem 2
Demand and supply both count: The market for flat-screen
televisions
STEP 5: Our result is not an example of an exception to the ‘law
of demand’. The ‘law of demand’ relates to the inverse
relationship between the price of a good and the quantity of
the good demanded. The case of flat-screen televisions is an
example of changes in tastes leading to an increase in demand
and, simultaneously, an increase in the number of suppliers and
improvements in production technology increasing supply.
Check Your Knowledge
Q1. Which of the following establishes the inverse relationship
between the price of a product and the quantity of the product
demanded?
a. The substitution effect
b. The income effect
c. The law of demand
d. The price effect
Check Your Knowledge
Q1. Which of the following establishes the inverse relationship
between the price of a product and the quantity of the product
demanded?
a. The substitution effect
b. The income effect
c. The law of demand
d. The price effect
Check Your Knowledge
Q2. When analysing the relationship between the price of a
good and quantity demanded, other variables must be held
constant. Which term best describes such an assumption?
a. The substitution effect
b. The income effect
c. The law of demand
 d. The term ceteris paribus
Check Your Knowledge
Q2. When analysing the relationship between the price of a
good and quantity demanded, other variables must be held
constant. Which term best describes such an assumption?
a. The substitution effect
b. The income effect
c. The law of demand
d. The term ceteris paribus

Check Your Knowledge

Q3. When two goods, X and Y, are complements, which of the
following occurs?
a. An increase in the price of good X leads to an increase in
the price of good Y.
b. An increase in the price of good X leads to a decrease in
the quantity demanded of good Y.
c. An increase in the price of good X leads to a decrease in
demand for good Y.
d. An increase in the price of good X leads to an increase in
demand for good Y.
Check Your Knowledge
Q4. Which of the following would cause a shift in the supply
curve of a good to the right?
a. A fall in the price of the good
b. A reduction in the price of an input used in the
production process
c. An increase in demand for the good
d. A rise in the price of intermediate goods used in the
production of the good
Check Your Knowledge
Q4. Which of the following would cause a shift in the supply
curve of a good to the right?
a. A fall in the price of the good
b. A reduction in the price of an input used in the
production process
c. An increase in demand for the good
d. A rise in the price of intermediate goods used in the
production of the good
Appendix
Behavioural economics: Do people make their choices
rationally?
 Behavioural economics: The study of situations in which
people act in ways that are not economically rational.
  Consumers commonly commit the following three
mistakes when making decisions:
– They take into account monetary costs but ignore
non-monetary opportunity costs.
– They fail to ignore sunk costs.
– They are overly optimistic about their future
behaviour.
Appendix
Behavioural economics: Do people make their choices
rationally?
Ignoring non-monetary opportunity costs
 Opportunity cost: The highest-valued alternative that
must be given up in order to engage in an activity.
- Businesses sometimes make use of consumers’ failure to
take opportunity costs into account.
Appendix
Behavioural economics: Do people make their choices
rationally?
Ignoring non-monetary opportunity costs, cont.
 Endowment effect: The tendency of people to be
unwilling to sell something they already own even if they
are offered a price that is greater than the price they
 would be willing to pay to buy the good if they didn’t
already own it.
Appendix
Behavioural economics: Do people make their choices
rationally?
Failing to ignore sunk costs
 Sunk cost: A cost that has already been paid and that
cannot be recovered.
Being unrealistic about future behaviour
 Examples: People saying they will quit smoking ‘sometime’
or diet ‘soon’, but it doesn’t happen.
 Current utility is over-valued and future utility is under-
valued.