MBADM812:

Course Overview

This course is concerned with the economic way of thinking, the economics of effective management, the economic foundation of business strategy, and the economic environment of business. It draws on and integrates microeconomic and macroeconomic disciplines to bring new insights into business strategy and effective management.

Managerial economics is one of the important fundamental courses of the OMBA program. All fields under the business program need to use information based on economics. The topics that we will cover in this course will be relevant to management, marketing, finance, and accounting. For example,

• identifying production and pricing strategies in different market structures is important for successful management;
• understanding tax policies and cost structures of firms can be essential for accountants;
• analyzing consumers and the market’s features will be significant for accurate marketing decisions;
• the time value of money is a basic concept in finance; and
• market structures and production strategies are important for decisions on supply chain management.

Economics uses mathematical modeling as a tool to understand the complex nature of consumption and production behaviors. In this course, we will use simple mathematical models. Because this is an introduction-level course, these economic models will be simple, and they will be assigned to illustrate the different market structures and consumption and production decisions. If you have a solid grounding in basic algebra, basic calculus, and quantitative relationships, you should have no trouble with the quantitative content of the course. In this course, you also need to understand and interpret graphs, make calculations from tables or figures, and solve simple equations to keep up with the class material.

Remember that you need to work hard to learn how to do economic analysis and that memorization alone will not get you through the course. In this course, you will learn to think like an economist, so you're encouraged to work on lots of problems. In the textbook, many small cases are discussed. It's strongly suggested that you read these applications to better understand the concepts. If you want to practice, there are many exercise questions to study in this course. The solutions to the selected questions from the textbook will be given in each lesson. It will be important for you to go over these questions and their solutions. Try to solve the assigned questions alone, and then compare your answers with the correct answers. The textbook is accompanied by an excellent study guidebook with many questions and their answers. This study guidebook can be helpful while you're getting prepared for the quizzes and other exams.

Lesson 1 Overview

Two main topics will be covered in Lesson 1:

• introduction to the economic foundations of business strategy, and
• basics of demand and supply analysis.

In this lesson, we will investigate the main concepts of managerial economics. We will try to understand why it is important to study managerial economics. Many definitions will be given to introduce you to the new concepts that we will be covering. We will learn the definition of economics with a special emphasis on scarcity and trade-offs. We will understand that the objective of economics is to explain observed phenomena and predict the behavior of consumers and firms as economic conditions change.

We will investigate both microeconomic and macroeconomic environments throughout the semester. In this lesson, after learning about the major concepts in managerial economics, we will continue studying the basics of the microeconomics field of managerial economics.

Successful economic analysis for managers starts with knowing the supply and demand structures in their market. In this lesson, we also start to review the basics of supply and demand. In the textbook, you can find many real-world markets (copper, office space in New York City, wheat, gasoline, natural gas, coffee, and others). With these examples, you can understand better how to analyze these markets with the tools of supply and demand. The real-world applications are intended to show you the relevance of supply and demand analysis for business and personal economic decisions. In this part of Lesson 1, we will also start to discuss simple economic theories and models. They may be a bit abstract at the beginning, but these models and theories will lay the groundwork for a deeper economic discussion. We will see how markets can reach equilibrium and how prices are determined.

The focus is also going to be on consumers/customers. Thanks to this topic, we can gain a better understanding of what lies behind demand curves. Without understanding consumer behavior, managers cannot make correct decisions in the production process. We will learn how to obtain the market demand curve from individual-level demand curves.

Lesson Objectives

By the end of this lesson, you should be able to do the following:

• Recognize the importance of economics and managerial economics.
• Distinguish between the two branches of economics: macroeconomics and microeconomics.
• Evaluate the principles of effective management.
• Understand the basics of microeconomics.
• Define market and recognize what it means in a global context.
• Define and calculate supply and demand.
• Analyze the supply and demand mechanism in markets.
• Determine and calculate market equilibrium.
• Analyze supply and demand to predict the impacts of changes in market conditions.
• Analyze individual and market demands.
• Know the definitions of different types of goods, such as normal versus inferior goods, substitutes, and complements.

Lesson Readings and Activities

By the end of this lesson, make sure you have completed the readings and activities found in the Course Schedule.

What Is Economics?

Scarcity: Society's resources are limited. For example, time, natural resources, labor, money, wealth, income, capital, and other factors of production.

Economics studies how society manages its scarce resources and investigates such questions as the following:

• How do we decide on the allocation of our income for consumption, our time for work, and our savings for retirement?
• How do firms decide what they produce and how much? How do firms decide on renting capital or hiring workers?
• How do societies decide on the allocation of their resources between consumption, fixed capital investment, environmental protection, public spending, and goods and services (macroeconomics)?

Microeconomics and Macroeconomics

Economics is studied on two major levels:

• Microeconomics: Microeconomics focuses on individual economic units (such as firms, consumers, investors, entrepreneurs, and workers) and the markets in which they function (Lessons 1–11).
• Macroeconomics: Macroeconomics focuses on total economic activities. Examples are total production, total consumption, total investment, inflation, economic policies, trade, interest rates, and unemployment (Lessons 12–15).

Microeconomics and macroeconomics are closely related because overall changes in an economy start from the economic decisions of individual firms and households. Given that microeconomics and macroeconomics focus on different questions, each branch has its own models to explain economic activities.

Economists use scientific methods to explain economic activities:

1. Observations of economic events lead us to develop theories. Then, we collect data to analyze the accuracy of theories. Mostly, historical data are used in economic analyses.
2. In order to explain economic events, we use many economic models, which mostly consist of equations and graphical presentations of these equations. We use economic models to better comprehend the nature of current and future economic events.
3. Some models include simplifying assumptions so that we can evaluate economic events more understandably. For example, we start analyzing the total production of firms by assuming that there are only labor and capital as inputs. Then, after initial analyses, if we need to extend the nature of the model, we can relax these assumptions or include more realistic assumptions. If we do not use assumptions, it is not easy to see the main findings.

Some Principles of Economics

Various principles are used in economics. We will use these principles throughout the semester. Related to microeconomics, we can group them into two categories:

• how people and firms make decisions, and
• how people and firms interact.

How People and Firms Make Decisions

Trade-Offs

It should always be remembered that economic actors, including households, consumers, and firms, face trade-offs. If we want to get something that we enjoy, we need to give up something else. For example, because companies have scarce resources to cover the costs of production, they need to carefully decide what factors of production they will use. Consumers also have limited resources. They need to allocate their income among various goods and services. While investigating any economic decision, such as production and consumption, the trade-offs associated with such decisions must be considered.

Benefits and Costs

While analyzing any economic decisions, we need to analyze the costs and benefits of these economic decisions. The costs of economic decisions are associated with what you need to give up to accomplish your goal. The benefits of economic decisions will be measured by the returns from these economic decisions. For example, entrepreneurs contribute their time and funds to establish a firm. Because both time and funds are limited, they are considered in the cost of production. The benefit from this business will be the revenue that they will gain.

In addition to the actual cost of our economic activities, we need to consider the opportunity costs of actions. Opportunity cost is defined as whatever we need to give up to obtain some other items. For example, when entrepreneurs invest their time and funds to start a new business, they give up other possible business opportunities. Entrepreneurs could have used their time and funds for other possible business or investment opportunities. Therefore, whatever they give up starting a new business will be the opportunity cost of this business.

Thinking at the Margin

In the models, we assume that firms and households are rational. That means that they do their best to achieve their aims. For example, given the prices of goods and services and their income, consumers buy the goods and services that give them the greatest satisfaction. Similarly, firms want to maximize their profit, and they set their production levels accordingly.

Economic decisions may involve focusing on marginal (incremental) decisions. For example, firms should decide on such questions as these: Should I produce one more unit of output? Should I hire one more worker? Should I purchase one more machine?

We can give the following example to understand how marginal decisions are made:

Therefore, a rational decision-maker will take action if and only if the marginal cost of their action is lower than the marginal benefit of the same action.

Importance of Incentives

Economic incentives are defined as anything that makes people act. Our economic decisions change with our incentives as conditions change. For example, when a good is more expensive, consumers purchase less of this good because of its higher cost. On the other hand, rising prices will be good for producers, and they will produce more when the price of their products gets more expensive. Therefore, incentives may change from one group to the other.

How People and Firms Interact

Importance of Trade

Trade can make all participants better off. We continuously trade with each other. For example, firms sell their products to consumers for revenue; households sell their labor to firms for income. Not only individuals but countries can benefit from trading with each other. The most important benefit of trade is that trade lets us specialize in production that households, firms, and countries can do best.

Specialization at the individual level or the country level benefits us. The global links can be seen in many economic activities. Economic activities depend on many individuals that we don’t know. Earning income (wages, profits, and other incomes) gives individuals the incentive to accomplish their tasks. Firms depend on consumers. Consumers depend on firms.

For example, smartphones in the global economy involve a significant amount of trade. Such questions may explain the importance of trade:

• Where did your smartphones come from?
• Who worked and produced these phones?
• Which other inputs are used in production?

Importance of Markets

Markets are the locations (physical or digital) where we organize economic activities. Market economies have many advantages when compared to centrally planned economies. In market economies, resources, goods, and services are allocated through the decentralized economic decisions of many participants (firms and households) as they interact with each other in markets. These collective interactions determine market prices of goods and services, and they reflect both the value of them to consumers and the cost of producing them to producers. In this course, we will learn about the market economy (i.e., capitalist economy). In such economies, when economic participants do what is best for themselves, mostly this will do the best for society. Such market forces are called an "invisible hand," following Adam Smith (the founder of the science of economics). In his 1776 book, he states that an invisible hand (market forces) guides individuals’ self-interest into increasing the whole society’s well-being.

When governments try to control markets, prices cannot adjust as expected from free markets. This leads to distortions in the economic decisions of households and firms. Because of this, it is important to minimize government interventions in markets, unless it is necessary for social welfare, such as health, climate issues, or other externalities.

Role of Government in Free Market Economies

Still, we need governments, even in free market economies. We need the help of governments to

• protect property rights and
• improve the functioning of markets in case of market failures.

Importance of Property Rights

The invisible hand of free market economies can work if and only if we have property rights enforced and guaranteed by governments. Property rights are defined as the ability to own and control our resources.

Role of Government in Case of Market Failure

Governments are sometimes expected to interfere with markets to promote equality and efficiency in economies. Efficiency is obtained when society gets the most it can from its limited resources. Equality is related to the distribution of economic prosperity across the members of society. As we will investigate in the future, markets sometimes may fail due to the actions of large dominant firms or externalities. In such cases, government interventions can increase efficiency and improve market outcomes.

What Is a Manager?

A manager is a person who determines how to make use of limited resources to accomplish a specific aim:

• Manages workers and other people involved in production.
• Manages purchasing of inputs, such as capital, natural resources, and labor, used in the production process.
• Manages pricing of products and their quality.

What Is Managerial Economics?

Managerial economics is the study of ways of managing limited resources to accomplish a goal most efficiently.

Following are some examples of topics studied under managerial economics:

• Where will the inputs of production come from? How many workers does the firm need to hire? How many machines does the firm need to get? Will the firm rent them or purchase them?
• What will the firm produce, exactly? Should the firm specialize in producing one type of good or various types?
• How many outputs will the firm produce? What will be the price of outputs?

Some Principles of Effective Management

1. Management goals must be well-defined, and constraints, such as available technology and costs of inputs, should be considered.
2. The main aim of firms is to earn the maximum possible profit. The nature of profits under different market structures should be known well:
   • Managers should identify the conditions to enter a market. They need to calculate the entry costs, sunk costs, speed of production adjustment, and other costs of starting a business.
   • Managers should identify the market power of the suppliers of inputs. They should understand their pricing system well. Managers should decide on the level of fixed investment based on production aims.
   • Managers should know the power of consumers well to set the right prices for their products.
   • Managers should know the market that they operate in well. The level of competition in the market, pricing decisions, product differentiation, and availability of information in the market can make a difference in terms of the way to maximize profits.
   • Managers should know the available substitutes and complements in their market to set the right prices to maximize profit.
3. Trade-offs involved in the decision-making process and related opportunity costs should be considered:
   • The opportunity cost of any decision is whatever must be given up to realize it. It is like the second-best use of limited resources.
   • Example: The opportunity cost of investing your money in a firm is not just the cost of funds (real costs of investment) but also the foregone interest income (opportunity cost). If you had deposited your money at a bank instead of investing at a firm, you would have earned interest income. So foregone interest income is the opportunity cost of your money invested in a firm. If the benefits of investment in a firm are higher than the opportunity cost, then you would pick the option of investment in a firm.
4. It is important to understand the incentives of consumers, competitors, and suppliers of inputs:
   • Incentive: something that motivates any individual to act. The motivation source can be punishment or reward.
   • Examples: When gas prices increase (negative incentive), consumers buy more hybrid or electric cars (rational response to a negative incentive).
   • When alcohol taxes rise (negative incentive), teen drinking falls (rational response to a negative incentive).
5. Managers should understand the input and output markets well:
   • Markets consist of a group of sellers and buyers. They can be physical markets or online markets.
   • Organizing management activities in a market means determining
     • what goods to produce (output),
     • how to produce them (inputs),
     • how much to produce (quantity),
     • how much to charge (price), and
     • who gets them (buyers).
6. Managers should understand the role of the government in the production process and its control mechanism.
7. Managers should understand the importance of the macroeconomic environment while making decisions in the production process, such as economic growth, recession periods, inflation, unemployment, and interest rates.
8. Managers should recognize the importance of some economic concepts, such as the difference between nominal and real variables, the time value of money, and marginal analysis.

Importance of Demand and Supply Analysis for Managers

Supply and demand make market economies work. This is true for all free market economies, including the U.S. economy and many advanced economies. Therefore, managers need to complete some supply and demand analyses to understand the market structure and to make rational business decisions. Many firms fail only because their managers cannot consider current and/or expected changes and trends in markets.

If managers prefer to worry only about the details of their business without proper knowledge of future trends in prices and sales, they will be at a significant disadvantage compared to the position of their competitors. In the absence of adequate knowledge about market prices and sales, managers are likely to negotiate the wrong prices with input suppliers and customers. They may hire more or less than the necessary number of workers. They may end up with high inventory levels. Contracts for future rent payments or future supplies may ruin the profits of firms. Overall, managers must understand the functioning of markets to analyze the environment where they make their business decisions.

Supply and demand analysis is an economic tool that allows managers to see the big picture of their business environment. Supply and demand analysis allows managers to understand both current and expected developments in markets. Supply and demand are qualitative forecasting tools that managers can use to predict trends in competitive markets, including changes in the prices of their companies’ products, related substitute or complementary products, and the prices of their inputs, such as labor, capital, and technology, that are essential for their rational production decisions. Such valuable knowledge will help managers to determine how much prices would change and how much sales, revenue, and costs would change.

In this part of Lesson 1, a simple economic model will be used to explain the behavior of supply and demand and how markets work. We will establish the model of supply and demand. You will see how supply and demand for a good determine both the quantity produced and the price at which the good sells. Given that the model of supply and demand is the foundation for the discussion for the remainder of this course, this lesson is one of the most important lessons in this course. After you learn about supply and demand analysis in this lesson, Lesson 2 will add precision to the discussion of supply and demand by addressing the concept of elasticity—the sensitivity of the quantity supplied and quantity demanded to changes in economic variables. Lesson 2 will also address the impact of government policies on prices and quantities in markets.

Key Points About Supply and Demand Analysis

• Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price.
• The demand curve shows how the quantity of a good demanded depends on the price. According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward.
• In addition to price, other determinants of how much consumers want to buy include income, the prices of substitutes and complements, consumer preference, expectations, and the number of buyers. If one of these factors changes, the demand curve shifts.
• The supply curve shows how the quantity of a good supplied depends on the price. According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward.
• In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. If one of these factors changes, the supply curve shifts.
• The intersection of the supply and demand curves determines the market equilibrium. At the equilibrium price, the quantity demanded equals the quantity supplied.
• The behavior of buyers and sellers naturally drives markets toward their equilibrium. When the market price is above the equilibrium price, there is a surplus of the good, which causes the market price to fall. When the market price is below the equilibrium price, there is a shortage, which causes the market price to rise.
• To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects equilibrium price and quantity. To do this, we follow three steps. First, we decide whether the event shifts the supply curve or the demand curve (or both). Second, we decide in which direction the curve shifts. Third, we compare the new equilibrium with the initial equilibrium.
• In market economies, prices are the signals that guide economic decisions and thereby allocate scarce resources. For every good in the economy, the price ensures that supply and demand are in balance. The equilibrium price then determines how much of the good buyers choose to consume and how much sellers choose to produce.

Markets

What Is a Market?

• Definition of a market: a group of buyers and sellers of a particular good or service.
• Markets can take many forms and may be organized (e.g., agricultural commodities) or less organized (e.g., ice cream).

What Is a Competitive Market?

• Definition of a competitive market: a market in which there are so many buyers and so many sellers that each has a negligible impact on the market price.
• Each buyer knows that there are several sellers from which to choose. Sellers know that each buyer purchases only a small amount of the total amount sold.

What Is a Perfectly Competitive Market?

• In this lesson, we will assume that markets are perfectly competitive.
• Characteristics of a perfectly competitive market:
  • The goods being offered for sale are exactly the same.
  • The buyers and sellers are so numerous that no single buyer or seller has any influence over the market price.
• Because buyers and sellers must accept the market price as given, they are often called price takers.
• Not all goods are sold in a perfectly competitive market.
  • A market with only one seller is called a monopoly market.
  • Other markets fall between perfect competition and monopoly.

Studying Perfect Competition

• Perfectly competitive markets are the easiest to analyze because buyers and sellers take the price as a given.
• It should be noted that because some degree of competition is present in most markets, many of the lessons learned by studying supply and demand under perfect competition apply in more complicated markets.

Demand

The Demand Curve

The demand curve (or demand line, for simplification reasons, in this lesson) shows the relationship between price and quantity demanded:

• The definition of quantity demanded is the amount of a good that buyers are willing and able to purchase.
• One important determinant of quantity demanded is the price of the product.
  • Quantity demanded is negatively related to price. This implies that the demand curve is downward sloping. It should be noted that this negative link assumes that we hold all other variables constant, such as income, prices of related goods, and so on.
  • The definition of the law of demand: the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises.
• The definition of a demand schedule: a table that shows the relationship between the price of a good and the quantity demanded.

Example of Demand Schedule

Assume that you run a bakery shop and sell pastries. In Table 1.1, you can find the demand schedule for your pastries. It shows how many pastries people are willing to purchase at different price levels.

Table 1.1. Demand Schedule

Price of pastry	Quantity of pastries demanded
$0.00	24
$1.00	20
$2.00	16
$3.00	12
$4.00	8
$5.00	4
$6.00	0

The definition of demand curve: a graph of the relationship between the price of a good and the quantity demanded.

• Price is traditionally drawn on the vertical axis.
• Quantity demanded is represented on the horizontal axis.

Example of Demand Curve

The demand curve is drawn by plotting each of the points from the demand schedule like an (x, y) coordinate system (see Figure 1.1).

Market Demand Versus Individual Demand

• The market demand is the sum of all of the individual demands for a particular good or service.
• The demand curves are summed horizontally—meaning that the quantities demanded are added up for each level of price.
• The market demand curve shows how the total quantity demanded of a good varies with the price of the good, holding constant all other factors that affect how much consumers want to buy.

Shifts in the Demand Curve

First, please note the difference between a change in price (which causes a movement along the demand curve) and a change in another determinant (which shifts the demand curve). If the price of the product is the only changing determinant, this will lead to change in quantity demanded. In Figure 1.2, this is represented by a movement along the demand curve. If other determinants change, such as income, prices of related goods, and so on, this will lead to change in demand. In the figure, it is represented by shifts in the demand curve.

In Figure 1.2, assume that a market has been represented. S is the supply curve in the market and D1 (blue line) is the original demand curve. D2 (red line) represents a higher demand (D1 shifts to the right and becomes D2). D3 (black line) represents a lower demand (D1 shifts to the left and becomes D3).

• Because the market demand curve holds other things constant, it need not be stable over time. If any of the following factors, such as income, prices of related goods, and so on, change, the demand curve will shift.
  • An increase in demand is represented by a shift of the demand curve to the right.
  • A decrease in demand is represented by a shift of the demand curve to the left.
• Income
  • The relationship between income and quantity demanded depends on what type of good the product is. Higher income leads to higher demand for normal goods but lower demand for inferior goods. Oppositely, lower income leads to a lower demand for normal goods but a higher demand for inferior goods.
  • Definition of a normal good: a good for which, other things equal, an increase in income leads to an increase in demand. For example, clothes are a normal good. As income levels rise, people spend more money on clothes.
  • Definition of an inferior good: a good for which, other things equal, an increase in income leads to a decrease in demand. For example, noodles can be considered an inferior good. Because noodles are a cheap product, the demand for noodles gets higher when income gets lower.
• Prices of related goods
  • Definition of substitutes: two goods for which an increase in the price of one good leads to an increase in the demand for the other. For example, apples and oranges can be considered substitute products because one fruit can be consumed instead of the other fruit.
  • Definition of complements: two goods for which an increase in the price of one good leads to a decrease in the demand for the other. For example, coffee and milk can be considered complementary products because they are mostly consumed together.
• Consumer preference: If any product is preferred more, it will increase the demand for that product.
• Expectations:
  • Future income: Higher future income tends to increase the current demand for normal goods and services.
  • Future prices: Higher future prices tend to increase the current demand for goods and services because consumers prefer purchasing goods and services when they are cheap now.
• Number of buyers: Increasing population raises the demand for goods and services.

The Demand Function

The demand function for Good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a related Good Y, income, and other factors that affect the demand for Good X.

One simple but useful representation of a demand function is the linear demand function:

$Q{x}^d={\alpha }_O+{\alpha }_X{P}_X+{\alpha }_Y{P}_Y+{\alpha }_{M}M+{\alpha }_{H}H$

where

• Q_X^d is the number of units of Good X demanded;
• P_X is the price of Good X;
• P_Y is the price of a related Good Y;
• M is the income; and
• H is the value of any other affecting demand.

The signs and magnitude of the $\alpha$ coefficients determine the impact of each variable on the number of units of X demanded:

$Q{x}^d={\alpha }_O+{\alpha }_X{P}_X+{\alpha }_Y{P}_Y+{\alpha }_{M}M$

For example:

• ${\alpha }_X<0$ by the law of demand; ${\alpha }_X=\frac{\text{Change in }}{Q_X^d}$
• ${\alpha }_Y>0$ if Good Y is a substitute for Good X
• ${\alpha }_Y<0$ if Good Y is a complement for Good X
• ${\alpha }_M<0$ if Good X is an inferior good
• ${\alpha }_M>0$ if Good X is a normal good

Lesson 1.2 Exercise Questions

The following exercise questions are for self-study (nongraded). They are adapted from Chapter 2 of Microeconomics by Pindyck and Rubinfeld (2017). Please try to solve the questions by yourself after completing all required readings. Then select to see the correct answer and explanation.

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Supply

The Supply Curve: The Relationship Between Price and Quantity Supplied

• The definition of quantity supplied: the amount of a good that sellers are willing and able to sell.
  • Quantity supplied is positively related to price. This implies that the supply curve will be upward sloping.
  • The definition of the law of supply: the claim that, other things equal, the quantity supplied of a good rises when the price of the good rises.
• The definition of supply schedule: a table that shows the relationship between the price of a good and the quantity supplied.
• The definition of supply curve: a graph of the relationship between the price of a good and the quantity supplied.

Example of Supply Schedule

Assume that you run a bakery shop and sell pastries. In the following table, you can find the supply schedule of your pastries. Table 1.2 shows how many pastries you are willing to sell at different price levels.

Table 1.2. Supply Schedule

Price of pastry	Quantity of pastries supplied
$0.00	0
$1.00	4
$2.00	8
$3.00	12
$4.00	16
$5.00	20
$6.00	24

Example of Supply Curve

We draw the supply curve by plotting each of the points from the supply schedule like an (x, y) coordinate system (see Figure 1.3).

Market Supply Versus Individual Supply

• The market supply curve is obtained from individual supply curves. We add up individual supply curves horizontally at each price.
• The market supply curve shows how the total quantity supplied varies as the price of the good varies.

Shifts in the Supply Curve

First, please note the difference between a change in price (which causes a movement along the supply curve) and a change in another determinant (which shifts the supply curve). If the price of the product is the only changing determinant, this will lead to a change in quantity supplied. In Figure 1.4, this is represented by a movement along the supply curve. If other determinants change, such as cost of production, expected profits, and so on, this will lead to a change in supply. In the figure, this is represented by shifts in the supply curve.

In Figure 1.4, assume that a market has been represented. D is the demand curve in the market, and S1 (blue line) is the original supply curve. S2 (red line) represents a higher supply (S1 shifts to the right and becomes S2). S3 (black line) represents a lower supply (S1 shifts to the left and becomes S3).

• Because the market supply curve holds other things constant, the supply curve will shift if any of the following factors, such as input prices, technology, and so on, change.
  • An increase in supply is represented by a shift of the supply curve to the right.
  • A decrease in supply is represented by a shift of the supply curve to the left.
• Input prices
  • Higher cost of production (higher wages and/or higher costs of materials) lowers supply.
  • Lower cost of production (lower wages and/or lower costs of materials) raises supply.
• Technology: Improved technology shifts the supply curve to the right.
• Expectations: Higher expected profits raise current supply. Lower expected profits cut the current supply.
• Number of sellers: A higher number of producers raises supply, and a lower number of producers lowers supply.

The Supply Function

• The supply function for Good X is a mathematical representation describing how many units will be produced at alternative prices for X, alternative input prices W, and alternative values of other variables that affect the supply for Good X.
• One simple but useful representation of a supply function is the linear supply function:

${Q_X}^s={\beta }_0+{\beta }_X{P}_X+{\beta }_{W}W+{\beta }_{\mathrm{r }}T+{\beta }_{H}H$

• Q_X^s is the number of units of Good X produced;
• P_X is the price of Good X;
• W is the price of an input, such as wages, raw materials, or capital;
• T is technologically related inputs; and
• H is the value of any other variable affecting supply.

• The signs and magnitude of the $\beta$ coefficients determine the impact of each variable on the number of units of X produced:

${Q_X}^s={\beta }_0+{\beta }_X{P}_X+{\beta }_{W}W+{\beta }_{r}T$

• For example:
  • ${\beta }_X>0$ by the law of supply. Higher prices, higher quantity supplied. ${\beta }_X=\frac{\text{Change in} {Q_X}^s}{\text{Change in} P_X}$
  • ${\beta }_W<0$ increasing input price. Higher input prices, lower quantity supplied.
  • ${\beta }_r>0$ technology lowers the cost of producing Good X. Better technology, higher quantity supplied.

Market Equilibrium: Supply and Demand Together

Equilibrium

• The point where the supply and demand curves intersect is called the market’s equilibrium.
• The definition of equilibrium: a situation in which the market price has reached the level at which quantity supplied equals quantity demanded.
• The definition of equilibrium price: the price that balances quantity supplied and quantity demanded.
• The equilibrium price is often called the market-clearing price because both buyers and sellers are satisfied at this price.
• The definition of equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price.

Example of Equilibrium

In the demand and supply schedule, you need to find the price level where quantity supplied is equal to quantity demanded. The following demand and supply schedule (Table 1.3) is from the previous pages. Assume that this demand and supply information is market demand and market supply. When the price level is $3.00, the quantity supplied is equal to the quantity demanded: 12 units.

Table 1.3. Demand and Supply Schedule

Price of pastry	Quantity of pastries demanded	Quantity of pastries supplied
$0.00	24	0
$1.00	20	4
$2.00	16	8
$3.00	12	12
$4.00	8	16
$5.00	4	20
$6.00	0	24

In Figure 1.5, the equilibrium point will be the intersection point between supply and demand curves. In the figure, the equilibrium point, price, and quantity are identified.

If the actual market price is higher than the equilibrium price in the market, then we observe a surplus of the product in the market.

• The definition of surplus: refers to cases where quantity supplied is greater than quantity demanded. The surplus will be eliminated as producers cut the price until the market reaches the equilibrium point where supply balances demand.

• If the actual price is lower than the equilibrium price, there will be a shortage of the good.
  • Definition of shortage: a situation in which quantity demanded is greater than quantity supplied.
  • Sellers will respond to the shortage by raising the price of the good until the market reaches equilibrium.
• The definition of the law of supply and demand: the claim that the price of any good adjusts to bring the supply and demand for that good into balance.

Three Steps to Analyzing Changes in Equilibrium

• Decide whether the event shifts the supply or demand curve (or perhaps both).
• Determine the direction in which the curve shifts.
• Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity.

Example: A Change in Market Equilibrium Due to a Shift in Demand (Higher Demand)

The following illustrates the effect of higher income on the market for pastries.

A pastry is a normal good. You have learned that higher incomes increase the demand for normal goods. In this case, the demand curve for pastries will shift to the right. How much it will shift will depend on the size of the increase in income. If demand rises, a shortage will occur at the original equilibrium price. This leads to an increase in price, which causes quantity supplied to rise and quantity demanded to fall until equilibrium is achieved. The end result is an increase in both the equilibrium price and equilibrium quantity.

General rule: When demand increases, at the new equilibrium the price will get higher and the quantity traded will increase too.

Example: A Change in Market Equilibrium Due to a Shift in Demand (Lower Demand)

The following illustrates the effect of declining demand for pastries due to the health issues of consumers on the market for pastries.

You have learned that the changing tastes of consumers can change demand conditions. A lower demand for pastries due to health concerns shifts the demand curve to the left. How much it will shift will depend on the size of the lower preference. At the new equilibrium, the price will get lower, and the quantity traded will decrease too.

General rule: When demand decreases, at the new equilibrium the price will get cheaper, and the quantity traded will fall too.

Example: A Change in Market Equilibrium Due to a Shift in Supply (Lower Supply)

The following illustrates the effect of a hurricane that destroys part of the sugarcane crop and drives up the price of sugar.

Sugar is one of the important inputs for pastry production. Thus, higher sugar prices mean higher costs of production for pastry producers. This leads to a lower supply of pastries. The supply curve of pastries will shift to the left. At the new equilibrium, the price of pastries will increase, and the quantity traded will fall.

General rule: When supply decreases, at the new equilibrium the price will get higher and the quantity traded will fall.

Example: A Change in Market Equilibrium Due to a Shift in Supply (Higher Supply)

The following illustrates the effect of improving technology on the pastry market.

Changes in technology will affect the supply side. Improvements in technology lower the cost of production. Thus, supply will increase, and the supply curve of pastries will shift to the right. At the new equilibrium, the price of pastries will drop, and the quantity traded will increase.

General rule: When supply increases, at the new equilibrium the price will get lower and the quantity traded will increase.

Example: Shifts in Both Supply and Demand (Lower Demand and Lower Supply)

The following illustrates the effect of economic recession on the pastry market. Please note that during an economic recession, income declines (which leads to lower demand for normal goods) and expected profits decline (which leads to a lower supply of goods and services).

What is different in this example is that both the supply and demand sides are affected by one main event. It is suggested that you analyze these effects one by one and then combine them to find the overall effect on the equilibrium price and quantity.

A lower demand (the demand curve shifts to the left) means lower prices and lower quantity traded (see the example above).

A lower supply (the supply curve shifts to the left) means higher prices and lower quantity traded (see the example above).

When these two effects are combined, we can say that the quantity traded will fall in the pastry market because both lower supply and lower demand mean the quantity will get lower. The ultimate effect on the equilibrium price is not clear: Lower demand leads to lower prices; lower supply leads to higher prices. So the price may increase or decrease, depending on the relative sizes of the shifts in the demand and supply curves. If the demand shock is dominant, the equilibrium price will fall. If the supply shock is dominant, the equilibrium price will increase. Thus, if the relative sizes of these shifts (or shocks) aren't known, the end effect on the equilibrium price will be ambiguous.

In Figure 1.11, the demand shift is dominant (its shift is larger than the shift in the supply curve). You can see that in this case, the equilibrium price will end at a lower rate compared to the level before the shifts.

Conclusion: How Prices Allocate Resources

• The model of supply and demand is a powerful tool for analyzing markets.
• Supply and demand together determine the prices of the economy’s goods and services.
  • These prices serve as signals that guide the allocation of scarce resources in the economy.
  • Prices determine who produces each good and how much of each good is produced.
  • Prices serve to allocate resources to their highest-valued uses. For example, suppose that consumers develop an increased taste for electronic products. This leads to an increase in the demand for electronic goods, pushing the price up. This increased price provides incentives to producers to produce more electronic goods. Thus, price signals our wants and desires. This is one reason why markets generally serve as the best way to organize economic activity.

Summary Results for Shifts in Demand and Supply

What happens to equilibrium price (P) and equilibrium quantity (Q) when supply (S) or demand (D) shifts?

In Lesson 1, you've learned about different factors that can change the demand and supply structures in a market. Some possible factors are changes in income, changes in the prices of related goods, changes in general economic conditions, and changes in consumer preferences.

Table 1.4 summarizes what would happen to the market price and quantity when the demand (consumer side) conditions and/or the supply (producer side) conditions change.

Please note that this summary table will be more meaningful after you complete the supply and demand section of the lesson. The table shows the combination of factors listed in the first column and the first row. For example, the first cell saying, "No change in eq. P / No change in eq. Q" is the outcome of the combination of "No change in S" and "No change in D."

Table 1.4. Summary Results for Shifts in Demand and Supply

	No change in S	An increase in S	A decrease in S
No change in D	No change in eq. P No change in eq. Q	P lower Q higher	P higher Q lower
An increase in D	P higher Q higher	P ambiguous Q higher	P higher Q ambiguous
A decrease in D	P lower Q lower	P lower Q ambiguous	P ambiguous Q lower

Exercise Questions 1.4

The following exercise questions are for self-study (nongraded). They are adapted from Chapter 2 of Microeconomics by Pindyck and Rubinfeld (2017). Please try to solve the questions by yourself after completing all required readings. Then select to see the correct answer and explanation.

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1. Suppose that unusually hot weather causes the demand curve for ice cream to shift to the right.
(Chapter 2, Question for Review 1)

2. Use supply and demand curves to illustrate how each of the following events would affect the price of butter and the quantity of butter bought and sold.
(Chapter 2, Question for Review 2)

3. Suppose the demand curve for a product is given by Q = 300 − 2P + 4I, where Q is the quantity demanded, P is the price of the good, and I is average income measured in thousands of dollars. The supply curve is Q = 3P − 50.
(Chapter 2, Exercise 1)

4. In 1998, the total demand for U.S. wheat was Q_D = 3,244 − 283P, and the domestic supply was Q_s = 1,944 + 207P. At the end of 1998, both Brazil and Indonesia opened their wheat markets to U.S. farmers. Suppose that these new markets added 200 million bushels to U.S. wheat demand.
(Chapter 2, Exercise 3)

Lesson 1 Summary

• A manager is a person directing the use of limited resources to achieve a goal.
• Economics is the science of optimization, or making decisions about the allocation of limited resources.
• Managerial economics is the study of directing limited resources in an efficient way to accomplish business goals.
• Microeconomists focus on the economic decision-making process of households and firms and their links in markets.
• Macroeconomists focus on the aggregate forces and trends determining the overall economic structure.
• Market models (supply and demand) are introduced to analyze markets. In competitive market models, there are many buyers and sellers, and they are all price takers (they take market prices as given).
• The demand curve presents the link between the quantity demanded for a good and its price.
  • The law of demand indicates that the link between the quantity demanded for a product and its price is negative. If prices get higher, the quantity demanded falls. If prices get lower, the quantity demanded increases. The demand curve has a negative slope (downward sloping).
  • In addition to the price of the product, there are other determinants of demand, such as the level of the consumer's income, prices of related goods (substitutes and complements), tastes of consumers, expectations of consumers about the future, and number of consumers (population).
  • If any of these additional determinants change, the demand curve will shift.
• The supply curve presents the relationship between the quantity supplied and the price of the product.
  • The law of supply states that the link between the quantity supplied and the price is positive. If the price is higher, the quantity supplied will increase as well. If the price gets lower, the quantity supplied will fall too. The supply curve has a positive slope (upward sloping).
• In addition to prices, there are other determinants of supply—for example, input prices (cost of production), technology improvement or decline, expectations about the future, and the number of sellers (number of firms).
  • If any of these additional factors change, the supply curve will shift (toward the right if it is a positive shock and toward the left if it is a negative shock).
• The intersection of the demand and supply curves determines the market equilibrium price and quantity.
  • At the equilibrium price, quantity demanded will be equal to quantity supplied.
• The economic actions of buyers and sellers make markets move toward their equilibrium conditions.
  • If the market price (current price charged in a market) is above the equilibrium price of the market, then we observe a surplus. This leads to the market price falling.
  • If the current market price in a market is below the equilibrium price, we observe a shortage. This leads to a higher market price.

Lesson 1 Quiz

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Important note: You should take your quizzes and exams in Chrome or Firefox, which are also recommended by Canvas. Several students informed the course instructor that they could not see the figures in the questions when taking the quizzes or exams in Safari. Canvas does not work consistently well with Safari.

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Aim: Test your understanding of definitions and calculations related to Lesson 1.

Time: After you open the quiz, you will need to complete it within 60 minutes. You cannot stop the timer after you've started.

The quizzes are designed in a way that you are expected to study before you take the quiz, not during the quiz. Please study thoroughly all lesson materials before you take the quiz.

Number of questions: 10

Grading: Each question is 10 points; 100 points in total.

Style of questions: True-or-false questions

Lesson 1 Supplemental Activities and Recommended Materials

Lesson 1 Supplemental Videos

On this page, you will find video presentations of the topics that we covered in the lesson. They are like lecture videos. There are also videos explaining the correct answers to the exercise questions included in lesson modules. These videos are not required. However, because some students prefer learning the topics from video presentations, these videos are included in the modules.

Video Presentation—5 parts

• L1 Part 1 (35 minutes)
• L1 Part 2 (29 minutes)
• L1 Part 3 (12 minutes)
• L1 Part 4 (35 minutes)
• L1 Part 5 (17 minutes)—further graphical explanations on the S and D summary table at the end of presentation in Part 4
• Explanations of Lesson 1 Exercise Questions (19 minutes)

Note: Videos removed. You will have access to the videos in the actual course.

Lesson 1: Highlight Exercise Questions and Answers (Supplemental)

The videos for highlight exercise questions include answers to the highlight exercise questions given in the PDF files.

Note: Presentation file and video removed. You will have access to the file and video in the actual course.

Lesson 1: Applications—Selected Articles from The Wall Street Journal and New York Times (Supplemental)

We will try to share different recent real-world examples (articles) in the area of managerial economics for each chapter. We suggest that you read some of them to be able to see how theoretical models taught in the chapter apply in real life. You can discuss them in the discussion board, with your classmates (off the board), or if any of them raises special interests/questions, we can discuss them in our live sessions, also.

Note that subscription to Wall Street Journal and New York Times is free for Penn State students. For details, see Subscribe for Free to Wall Street Journal and New York Times in Canvas modules.

• Consumers Change Food-Delivery Habits WSJ 1/6/2023
• Tesla Slashes Prices in China After Deliveries Slump WSJ 1/13/2023
• The Pandemic Used-Car Boom Is Coming to an Abrupt End NYT 2/3/2023
• Rising Jet-Fuel Costs Threaten to Send Airfares Higher WSJ 2/10/2023
• Dealers and Buyers Are Both Worried Cars Are Too Expensive WSJ 2/10/2023
• Clothing Companies Lean on Retailers to Help Ease Inventory Glut WSJ 2/17/2023
• Pets Don’t Get Inflation, but They Are Feeling Its Effects WSJ 2/24/2023
• As Oil Companies Stay Lean, Workers Move to Renewable Energy NYT March 3, 2023
• Vinyl Records Outsell CDs for the First Time Since 1987 WSJ 3/17/2023
• Surging Chinese Oil Demand Pushes Shipping Costs Sharply Higher WSJ 3/24/2023
• The World Faces an Imminent Water Crisis, U.N. Warns WSJ 3/31/2023
• Coal Prices Tumble While Use of Wind Power, Solar Energy Leaps Ahead WSJ 4/7/2023
• Iraqi Oil-Pipeline Closure Supports Global Crude Prices WSJ 4/7/2023
• Tesla Reports Uptick in Vehicle Deliveries After Price Cuts WSJ 4/7/2023
• Samsung Forecasts Worst Profit in Over a Decade as Tech Slump Hits Memory Chips WSJ 4/14/2023
• PC Shipments Fall 29%, Led by Drop in Apple Devices WSJ 4/14/2023
• Home Prices in March Posted Biggest Annual Decline in 11 Years WSJ 4/28/2023
• China’s Demand for Oil Hits Record as IEA Raises Global Forecasts WSJ 5/19/2023
• For Sale: The World’s Most Expensive Hebrew Bible. Ask for Sharon WSJ 5/19/2023
• How America’s Largest Restaurant Franchisee Decides When to Raise Prices WSJ 5/26/2023
• Kohl’s, Costco, Lowe’s Sales Sluggish as Shoppers Pull Back WSJ 6/2/2023
• Oil Traders Are Unfazed by Potential OPEC+ Production Cuts WSJ 6/9/2023
• Grilling Hasn’t Been This Cheap in Years WSJ 6/16/2023
• ‘War for Talent’ at Mines Could Drive Up Cost of Energy Transition WSJ 6/16/2023
• Market Bets on Cheaper Oil, Dashing Saudi Hopes for a Price Rebound WSJ 7/7/2023
• As Greedflation Starts to Fade, Wageflation Creeps In WSJ 7/14/2023
• Home-Builder Stocks Are Booming as Homeowners Stay Put WSJ 7/14/2023
• The Supermarket Aisle Where Prices Are Still Soaring WSJ 7/14/2023
• United Pilots Would Get Raises of Up to 40% Under Preliminary Deal WSJ 7/21/2023
• California Law Threatens to Help Drive Up Bacon Prices WSJ 8/11/2023
• Weather and Wall Street Conspire to Push Up Gas Prices WSJ 8/11/2023

Lesson 1 Additional Practice

Additional study materials: If you want to practice more, you can solve the following exercise questions from the recommended textbook from Chapter 2:

• 1–6, 17–19, 24, 25

Note: Solutions to these questions are given at the end of each chapter in the book.