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Rules, rules everywhere
24 Part I: The Nature of Managerial Economics
How Much Is That Doggie in the Window? Setting Prices through Markets
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A popular children’s song asks, how much is that doggie in the window? The song’s chorus goes:
How much is that doggie in the window? The one with the waggley tail. How much is that doggie in the window? I do hope that doggie’s for sale.
The last line of the lyrics — “I do hope that doggie’s for sale” — is too vague. To an economist (see, economists can even ruin a children’s song), the question is not whether the doggie is for sale. Of course, it’s for sale. The question is how much does it cost.
If the price is very low, customers are more likely to buy the dog, but the store does not make much profit; it may even lose money. If the doggie is too expensive, nobody will buy it. So the question is what price will lead to someone buying the doggie while the store owner makes some profit.
This apparent conflict between customers wanting low prices and sellers wanting high prices is resolved in the market — or through supply and demand.
Demanding Lower Prices
The relationship between how much customers must pay for an item and how much customers buy is called demand. More precisely, demand shows the relationship between a good’s price and the quantity of the good customers purchase, holding everything else constant.
Wow! Holding everything else constant, even the dog’s waggley tail? Not quite, but holding things like income, customer preferences, and the price of other goods — say cats — constant. (Are cats a good?)
So quite simply, demand tells you how much customers purchase at each possible price.
Chapter 2: Supply and Demand: You Have What Consumers Want
Quantity demanded and demand sound like the same thing. Indeed, as you read the newspaper, you’re likely to see demand all the time and never see quantity demanded. (That’s because very few reporters take economics classes.) But to economists, there is a big difference between the terms quantity demanded and demand.
To economists, quantity demanded is the amount of the good customers purchase at a given price. Quantity demanded is a specific number.
On the other hand, demand refers to the entire curve. Demand shows how much is purchased at every possible price.
Demand is an equation or line on a graph that indicates how price and quantity demanded are related.
Graphing demand
The graph of the demand curve enables you to focus on the relationship between price and quantity demanded. Figure 2-1 illustrates the demand curve for dog treats. (You want to keep that tail wagging.) The graph shows you that when prices are very high, customers want to buy fewer treats. More specifically, if the price of treats is $5.00, customers want to buy only 50 boxes of treats a week. On the other hand, if the price of treats decreases, say, to $1.00 a box, the quantity demanded of treats increases to 250 boxes a week.
Changing price
Price changes cause movements along the demand curve, or a change in quantity demanded. In Figure 2-1, when the price of dog treats decreased from $5.00 to $1.00, the quantity demanded increased from 50 to 250 boxes per week — a movement from point A to point B on the demand curve in Figure 2-1.
An inverse relationship exists between price and quantity demanded — price and quantity demanded move in opposite directions.
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26 Part I: The Nature of Managerial Economics
Figure 2-1:
Changes in quantity demanded.
Shifting the demand curve
When one of the things being held constant — income, tastes, and the prices of other goods — changes, the entire demand curve shifts. For example, advertisements indicate that treats lead to happy dogs. People want happy dogs, so their preference for treats changes; dog treats become more desirable. So more dog treats are purchased, even though nothing happened to the price of dog treats.
Figure 2-2 illustrates the increase in demand as the curve shifts from D0 to D1. Because the desirability of dog treats increases, stores are selling a lot more dog treats. Stores were previously selling 250 boxes of treats per week at a price of $1.00. Now, with the price still $1.00, stores are selling more treats — 350 boxes a week. That point isn’t on the original demand shown in Figure 2-1. What happened is the demand curve shifts so that this new point is on the new demand curve, D1. Because the new demand curve is to the right of the original demand curve, economists say demand has increased.
Any rightward shift in the demand curve is an increase in demand, and any leftward shift in the curve is a decrease in demand.
Chapter 2: Supply and Demand: You Have What Consumers Want
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Figure 2-2:
Changes (shifts) in demand.
The factors that shift the entire demand curve are
✓ Consumer tastes or preferences: A direct relationship exists between desirability (consumer tastes) and demand. Thus, an increase in desirability increases demand. ✓ Income: Income’s impact on demand is a little more complicated.
Economists note two types of goods — normal goods and inferior goods. For normal goods, a direct relationship exists between income and demand — an increase in income increases demand. This is the expected, or normal, relationship. For an inferior good, an increase in income decreases demand; therefore, an inverse relationship exists between income and demand for an inferior good. ✓ Prices of other goods: Changes in the prices of other goods are also a little complicated. If the goods are consumer substitutes for one another, they are used interchangeably. Hot dogs and hamburgers at a picnic are an example of consumer substitutes. A direct relationship exists between one good’s price and the demand for the second, substitute, good. Thus, when the price of hot dogs increases, the entire demand curve for hamburgers shifts to the right (increases). Consumer complements are a second type of goods. Consumer complements are used together, such as coffee and cream. An inverse relationship exists between one good’s price and the demand for its consumer complement. As the price of coffee increases, the amount of coffee you drink decreases.
This decrease in the quantity demanded of coffee is because you’re responding to a change in coffee’s price. And because you’re drinking less coffee, your demand for cream decreases. The higher price for coffee decreases your demand for cream — an inverse relationship.
Even if the price of cream doesn’t change, you use less of it.
28 Part I: The Nature of Managerial Economics
Supplying Higher Prices
Supply describes the relationship between the good’s price and how much businesses are willing to provide. Supply is a schedule that shows the relationship between the good’s price and quantity supplied, holding everything else constant.
Holding everything else constant seems a little ambitious, even for economists, but there is a reason for that qualification. By holding everything else constant, supply enables you to focus on the relationship between price and the quantity provided. And that is the critical relationship.
Understanding quantity supplied and supply
You must be able to distinguish between two terms that sound the same, quantity supplied and supply, but mean very different things. It is common for others not to make the distinction and as a result their analysis is confused.
Quantity supplied refers to the amount of the good businesses provide at a specific price. So, quantity supplied is an actual number. Economists use the term supply to refer to the entire curve. The supply curve is an equation or line on a graph showing the different quantities provided at every possible price.
Graphing supply
The supply curve’s graph shows the relationship between price and quantity supplied. Figure 2-3 illustrates the supply curve for dog treats. The graph indicates that when the price is very high, businesses provide a lot more treats. There’s money to be made in dog treats. But if the price of dog treats is very low, there’s not much money to be made, and businesses provide fewer dog treats. For example, if the price of treats is $5.00, businesses provide 650 boxes of treats a week. On the other hand, if the price of treats decreases to $1.00 a box, the quantity of treats provided decreases to 50 boxes a week.
Changing price
Figure 2-3 illustrates that price and quantity supplied are directly related. As price goes down, the quantity supplied decreases; as the price goes up, quantity supplied increases.
