Supply and Demand

Supply and Demand

What is Microeconomics?Microeconomics is the branch of economics which looks at choices made by narrowly defined units, such as individual buyers/consumers, and firms that produce goods.

Two of the most important principles used by economists are the Law of Supply and the Law of Demand:

Law of SupplyThe law of supply says that, all other things remaining equal, as the price of a good increases (decreases), the quantity of that good supplied will increase (decrease).

Law of DemandThe law of demand states that, all other things remaining equal, as the price of a good increases (decreases), the quantity of that good demanded will decrease (increase).

Economists often use graphs as a way to demonstrate what is being discussed. The laws of supply and demand can be represented by a simple graph such as the one below.

Figure 3.1: Law of Supply and Demand

In figure 3.1, we can see that at the price of $1, the suppliers are willing to provide one million widgets (Point A), while the quantity demanded will be much higher - eight million (Point B).

At a higher price, such as $5, suppliers will be willing to provide six million widgets (Point D), while the quantity demanded is only one million (Point E).

Finally, at the price of $3, the quantity demanded is equal the quantity supplied (Point C). This price is also referred to as the "market clearing" or equilibrium price because no suppliers are left with the desire to provide goods at that price and no buyers are left wishing to purchase the goods at that price either.

Look Out!

Note that supply and demand curves depict a quantity supplied or a quantity demanded at a particular price, all other things remaining equal.

Change in Consumer PreferenceSuppose there was a significant change in consumer preferences. For example, consumers suddenly have an increased desire for corn. This change in taste may be due to a new health study touting the benefits of corn, alternative grains such as wheat may have gotten more expensive, or corn growers may have conducted an effective advertising campaign. Regardless of the reason, the increase in demand results in a greater quantity demanded at particular price levels. This is an example of a demand shift.

Figure 3.2: Shift in the Demand Curve

In the graph above D0 represents the original demand curve, while D1 shows the new demand curve. Note that at a particular price level, such as $4, the quantity demanded increases from three million to five million.

Suppose something happens where the quantity of a good supplied changes at many particular price levels. For example, technological changes might occur whereby computer memory manufacturers would be able to produce a particular type of memory at a lower cost. So for many price levels, the quantity suppliers are willing to provide will increase. This situation could be diagrammed as below:

Figure 3.3: Shift of the Supply Curve

S0 represents the original supply curve, while S1 represents the new supply curve. At the price of $30 per 256MB chip, the quantity supplied will increase from three million to four million units per month.

Supply and Demand MovementsChanges in quantity demanded strictly as a function of price are referred to as movement along a demand curve. A shift of the entire demand curve is referred to as a change in demand; this could be due to any factor(s) that affects demand, other than price.

Changes in quantity supplied strictly as a function of price are referred to as movement along a supply curve. A shift of the entire supply curve is referred to as a change in supply; this could be due to any factor(s) that affects supply, other than price.

Demand Curve ShiftsSome of the factors that can cause a demand curve to shift include:

1. Change in income - If consumer incomes increase, we might reasonably expect that demand for some luxury goods will increase.

2. Change in preferences/tastes - If a product becomes more (less) liked, the quantity demanded will increase (decrease).

3. Change in prices of goods that are complimentary - If the price of gasoline goes up substantially, the demand curve for large SUV's should shift down.

4. Changes in prices of goods that are substitutes - If the price of pork increases (decreases), demand for beef would likely increase (decrease).

5. Advertising - An effective advertising campaign could increase the quantity demanded of a particular good. It could also decrease the demand for a competing good.

6. Expectations - If consumers expect a good to become more expensive or hard to get in the future, it could alter current demand

7. Shifts in market demographics - As segments of the population age or their composition changes, their demands also change. Because segments are not equally distributed – that is, there are not a consistent number of people in every age category

– larger segments have a more noticeable impact on demand. The baby boomers are an excellent example of this.

8. Distribution of income - For example, if the rich get richer, and the poor get poorer, demand for luxury goods could increase.

Supply Curve ShiftsFactors that would cause a shift in the supply curve include:

1. Cost - An increase in crude oil costs for a plastic manufacturer would shift the supply curve up and to the left. Changes in technology can dramatically decrease costs.

2. Government tax policy - Increases in business taxes will cause the supply curve to shift up and to the left. A government subsidy to producers will cause more supply to be available - the supply curve will shift down and to the right.

3. Weather/climate - Changes in weather and/or climate will especially influence agricultural product supply.

4. Prices of substitute products - If farmers can grow wheat instead of corn, and the price of wheat goes up, then the supply curve for corn will shift up and to the left as more farmers switch from corn to wheat.

5. Number of producers - As the number of firms/individuals producing a product increases, we would expect more supply to be available.

Short- and Long-Run Market EquilibriumIn the short run, market equilibrium is achieved when the quantity demanded is equal to quantity supplied and the market clears. The market is said to be cleared because there is no additional quantity supplied, or quantity demanded, at the market clearing price.

However, that particular market price may not lead to equilibrium in the long run. In the short run, producers do not have time to fully adjust to current market conditions. Some current producers may not be making a profit or covering all their costs at the current market price. Producers in that situation will consider leaving the industry, or at least will not allocate further capital to that industry. If producers are making profits, then we would expect more resources to be allocated to the industry such as the building of additional factories. In the long run, all factors of production can be varied.

Long-run equilibrium is something we expect the market to move towards over time. The process could take years. It actually may never be achieved because demand and supply curves are constantly shifting.

Suppose there is an increase in demand, as shown by the graph below.

Figure 3.4: Effects of a Shift in Demand

D0 is the original demand curve, and D1 is the new demand curve. The market equilibrium price will increase from P0 to P1, at least in the short-run. The quantity will also increase from Q0 to Q1.

Over time, in a market economy, two forces will come into play:

1. Buyers will have an incentive to search for substitutes, thereby decreasing their purchase of the original good; this effect will tend to lower the quantity demanded and the market price

2. Suppliers will have an incentive to supply more of the good, and more resources will be allocated towards production of this good; this effect will tend to increase the quantity and lower the market price

Shortages and Surpluses and their Effect on Equilibrium PricesA "shortage" exists when the quantity demanded at the current price is greater than the quantity supplied. In the case of shortage, we would expect the market price to go up. In this case, less motivated buyers do not purchase the good and producers have a strong incentive to supply more at the higher market price. This process will continue until the quantity demanded is equal to the quantity supplied. A "surplus" exists when the quantity supplied is greater than the quantity demanded. In this case, we would expect the market price to go down. The lower market price entices more consumers into buying, but lower profits create an incentive for producers to reduce the quantity supplied.

Invisible Hand PrincipleMarket prices deliver information to producers on how to allocate capital and other resources. Prices tell producers about consumer needs and wants by showing them how much consumers are willing to pay for a particular good or service. Prices also inform consumers by sending signals about how much of a given product is available.

These market prices act as an "invisible hand" that pushes self-interested individuals toward the correct allocation of resources, benefitting both the individuals and society as a whole. No one person is consciously making these decisions.

The following tutorial, entitled Economics Basics, will prime you for the topics discussed in this chapter.

Price Elasticity

Now that you have completed the basics, let us move onto the various learning outcomes on Microeconomics you should look to know for your upcoming exam.

Price ElasticityIn general, the elasticity of a particular variable is the percentage change in quantity demanded or supplied, divided by the percentage change in the variable of concern. This ratio is often called the elasticity coefficient.

Price elasticity is defined as the percentage change in quantity demanded divided by the percentage change in price.

The price elasticity of demand can be expressed as:

Formula 3.1

Example: Price ElasticityWhere Ep is the price elasticity coefficient, %ΔQ represents the percentage in quantity, and %ΔP represents the percentage in price. If the price of gasoline goes up by 50%, and the quantity demanded decreases by 20%, the price elasticity of gasoline would be:

Ep = %Δ Quantity = -20% = -0.4%Δ Price +50%

Typically, the negative sign is ignored and we would say that the price elasticity of gasoline is 0.4.

To calculate elasticity we must first have data for quantities purchased at different prices. Suppose that the price of a good goes from P0 to P1, and that we have data for the change in quantity demanded, which goes from Q0 to Q1. The calculation is typically made by dividing the actual change by the average(or midpoint) of the beginning and ending values. Suppose that the quantity demanded of a good goes from 10 to 14. The percentage change in quantity demanded could be expressed as:

(Q0 - Q1) = 4 = 0.3330.5(Q0 + Q1) 0.5(24)

That number would be multiplied by 100 to get the percentage change, which in this case would be 33.3%.

Similarly, the percentage change in price can be expressed as:

(P0 - P1) x 1000.5(P0 + P1)

Look Out!Sometimes the denominator used for these percentage change calculations is simply the original value (P0 and Q0). Because the CFA text uses the midpoint method, unless the exam has instructions to the contrary, it would be safer to use the midpoint method.

The full elasticity calculation can be simplified by canceling out the 0.5 (one-half) and 100. The more simplified expression can be stated as:

Example:Suppose, to continue the example given above, that the change in quantity demanded for the good (10 to 14) was in response to a price decrease from $8 to $7. In that case, the elasticity would be expressed as:

(10 - 14) / (10 + 14) = -4 / 24 = -1/6 = -15 = -2.5(8 - 7) / (8 + 7) 1 / 15 1/15 6

Alternatively, the elasticity could have been calculated as: -4 divided by half of 24, which is equal to -0.333, over 1 divided by half of 15, which equals 0.1333.

So the elasticity would be -0.333 over 0.133 = - 2.5, the same answer as above.

The following definitions apply to calculations of price elasticity:

1) If Ep > 1, Demand is elastic. The percentage change in price will produce a greater percentage in quantity demanded. If the price goes up, then total revenues will go down. If the price goes down, then total revenues willincrease.

2) If Ep < 1, Demand is inelastic. The percentage change in price will produce a lower percentage in quantity demanded. If the price goes up, then total revenues will go up. If the price goes down, then total revenues will decrease. Put simply, these changes will be less drastic than if demand is elastic.

3) If Ep = 1, Demand has unitary elasticity. A percentage in price will produce the exact same percentage change in quantity. Therefore, changes in price will no have effect on total revenues.If demand is elastic for a product, then a small change in price will cause a large change in

quantity demanded. If the demand for a product is inelastic, even a large change in price might cause little change in quantity demanded.

Elasticity of Demand

Determinants of price elasticity include:

Availability of substitutes - if substitutes are plentiful, then demand should be elastic. Relative percentage of expenditure - if an item takes up a considerable proportion of a

consumer's income, then demand should be elastic; if it takes up a very small amount, then demand should be expected to be inelastic.

Amount of time - consumers can make more adjustments to prices changes over time and, therefore, demand tends to be more elastic as time passes.

Necessities or luxuries - demand for necessities will tend to be inelastic, while demand for luxuries will tend to be elastic.

Cross Elasticity of DemandCross elasticity of demand relates the percentage change in quantity demanded of a good to the percentage change in price of a substitute or complementary good. Examples of complementary goods would include peanut butter and jelly, and large SUVs and gasoline. The cross elasticity of demand will be positive for a substitute, and negative for a complement; i.e. demand for a substitute (complement) will go up (down), if the price of the substitute (complement) goes up.

The following formula can be used to calculate cross-elasticity of demand:

Formula 3.2

Where: CEp is the cross-price elasticity coefficient,

%ΔQ represents the percentage change in quantity demanded, and

%ΔP represents the percentage change in price of the substitute or complement.

Income ElasticityIncome Elasticity is defined as the percentage change in quantity demanded divided by the percentage change in income. The calculations are similar to those for price elasticity, except that the denominator would include a change in income instead of a change in price.

Usually the amount of goods purchased will be positively correlated with income; if consumers' incomes go up (down), more (less) goods will be purchased. Any good with a positive income of elasticity of demand is said to be a normal good. Luxury goods have high income elasticity (greater than one). The proportionate amount of spending for those goods will go up as incomes increase.

The amount spent on some goods decrease as incomes goes up. Such goods are referred to as inferior goods. Examples of inferior goods include margarine (inferior to butter) and bus travel (inferior to owning a vehicle).

Elasticity of Supply

Supply elasticity is defined as the percentage change in quantity supplied divided by the percentage change in price. It is calculated as per the following formula:

Formula 3.3

The calculation of elasticity of supply is comparable to the calculation of elasticity of demand, except that the quantities used refer to quantities supplied instead of quantities demanded.

Factors that influence the elasticity of supply include the ability to switch to production of other goods, the ability to go out of business, the ability to use other resource inputs and the amount of time available to respond to a price change.

Over a short time period, firms may be able to increase output only slightly in response to an increase in prices. Over a longer period of time, the level of production can be adjusted greatly as production processes can be altered, additional workers can be hired, more plants can be built, etc. Therefore, elasticity of supply is expected to be greater over longer periods of time.

We would expect the supply elasticity of wheat to be very high as farmers can easily switch land that is used for wheat over to other crops such as corn and soybeans. On the other hand, an oil refinery cannot easily switch its production capacity over to another product, so low oil-refining margins do not reduce the quantity supplied by very much. Due to high capital costs, higher refining margins do not necessarily induce much greater supply. So the supply elasticity for oil refining is fairly low.

Market Efficiency

Marginal (or Opportunity) Cost and the Minimum Supply PriceThe supply curve (see figure 3.3) represents the quantities of a particular good that producers are willing to supply at various price points. For any particular quantity, the height of the supply curve represents the minimum price that suppliers of a good must get in order to supply the additional unit. That minimum supply price must cover the increase in total costs, or marginal cost, of producing the additional unit. The opportunity cost represents the value of other goods that may have been produced with the resources used. Producers must receive a price at least equal to their opportunity cost.

Producer surplus is defined as the difference between what a producer actually receives (which will be the market price) for a product and the producer's minimum supply price (marginal cost) for that product. If a producer is willing to provide a unit of a good for $3.00,

and actually gets $4.00, then the producer would have $1.00 of producer surplus.

Consumer Surplus, Producer surplus, and Equilibrium.We expect consumers to keep consuming additional units of a good until the marginal benefit no longer exceeds the price, or there is no longer an increase in consumer surplus. Producers will continue to provide additional units of a good up to the point where the market price no longer exceeds their minimum supply price.

The marginal benefit for all people in a society can be described as the marginal social benefit. Similarly the marginal costs for all producers in a society of a good can be described as the marginal social cost. At market equilibrium, the marginal social benefit of consuming an additional unit of a good is just equal to the marginal social cost of producing the additional unit.

In the figure 3.5 below, the triangle defined by the points P2PmQm represents consumer surplus, while the triangle defined by points P1PmQm represents producer surplus.

Figure 3.5: Consumer and Producer Surplus

How Resources Move Toward Their Most Efficient AllocationIn economics, a market is efficient if the maximum amount of goods and services are being produced with a given level of resources, and if no additional output is possible without increasing the amount of inputs. Efficient markets ensure optimal resource utilization by allowing for price to motivate independent actors in the economy. If buyers and sellers are free to choose how to allocate resources, prices will direct resources towards those who value them most and can utilize them most effectively.

Suppose consumer preferences change so that good A is now more desired than good B. We would expect the price of good A to shift higher and the price of good B to shift lower. This in turn will induce the production of additional units of good A and the devotion of more input resources to good A, while similarly decreasing production of B and its associated input resources.

In the real world today we have seen higher oil prices stimulate more drilling for oil and more investment in oil substitutes. The wage rates of mainframe programmers in the United States has decreased over the last several years in comparison to the year 2000, as there less of a need for their services. The lower wage rates have induced more mainframe programmers to

retrain themselves with other computer skills, or to leave the field.

Obstacles to achieving efficiency include:

· Price Ceilings/Floors - Sometimes governments impose price ceilings, which define a maximum price, or price floors, which define a minimum price. Effective price ceilings or floors prevent normal market equilibrium.

· Public Goods are goods available to everyone, even if they don't pay. Examples include police protection and public parks. One reason competitive markets don't produce the optimum amount of a public good is due to the "free-rider" problem: those who don't pay get a "free ride" with regards to getting the benefit.

· Externalities reflect costs and benefits not borne by the person or firm making the economic decision, which are imposed on or granted to others. Runoff from large cattle feedlots can damage nearby farms, and this potential cost may not be considered by feedlots when they look at their supply curve. A landowner who chooses not to develop her land may benefit several other homes for purposes of flood control. The benefit to others may not be taken into account when deciding to develop the land.

· Taxes lead to lower quantities produced, higher prices for buyers and lower effective prices for sellers.

· Subsidies increase the quantity produced, lower prices for buyers and increase seller prices.

· Quotas limit the quantity that can be produced.

· High transaction costs reduce the price that customers are willing to pay and increase supplier costs, leading to an equilibrium quantity that is lower than either party would desire absent the higher costs.

· Asynchronous information creates a perceived cost for buyers and sellers if they cannot adequately evaluate a proposed transaction. Drug companies can charge premium prices for pharmaceuticals due in part to the established evidence that the drug works. Auto makers entering new markets often have to offer lower prices and/or better warranties because customers do not have sufficient information about the new brands.

· Discrimination deprives market participants of the ability to conduct business at prices that otherwise be acceptable to them. Businesses that discriminate against certain types of job-seekers may have to pay more for labor, while customers that discriminate against a business may have to pay more for goods.

· A monopoly means that only one firm can provide a certain good or service. A monopolist will charge a higher price and produce a lower quantity in comparison to a competitive market.

With the exception of the above-mentioned obstacles, a competitive market will use resources efficiently. Goods are produced up to the point where the marginal benefit is equal to the marginal cost, and the sum of consumer and producer surplus is maximized.

Although price is the dominant means of allocating resources in a market economy, it is not the only way for markets to allocate resources. A command economy relies upon a central planning authority to allocate resources. Markets can also allocate resources by majority rule (citizens vote on the desired allocation of resources), lottery, or force and theft.

The Fairness Principle, Utilitarianism, and the Symmetry PrincipleEconomists often like to examine the "fairness" of a situation or economic system. Ideas about fairness can be lumped into one of two categories:

· "Results" must be fair.· "Rules" must be fair.

Utilitarianism, which is a moral philosophy developed in 18th and 19th century Great Britain, posits that an action is correct if it increases overall happiness for the performer of the act and those affected by the act. Utilitarians argued that income should be transferred from the rich to the poor until complete equality was achieved.

One problem with utilitarianism is the tradeoff between fairness and inefficiency. An effort to transfer wealth by heavily taxing rich people will decrease incentives for people to save money or work hard. This can lead to inefficient uses of capital and labor. Another source of inefficiency is the administrative cost of transferring money from the rich to the poor.

The symmetry principle is based on the intuitive principle that people in similar situations should be treated the same. From an economic perspective, we would like to achieve equality of opportunity. The symmetry principle adheres to the viewpoint that "rules" must be fair.

Price Ceilings and Floors

Price CeilingsIf the price ceiling is above the market price, then there is no direct effect. If the price ceiling is set below the market price, then a "shortage" is created; the quantity demanded will exceed the quantity supplied. The shortage may be resolved in many ways. One way is "queuing"; people have to wait in line for the product, and only those willing to wait in line for the product will actually get it. Sellers might provide the product only to family and friends, or those willing to pay extra "under the table". Another effect may be that sellers will lower the quality of the good sold. "Black markets" tend to be created by price ceilings.

Figure 3.6: Effect of Price Ceilings

Figure 3.6 illustrates the shortage that occurs when a price ceiling is imposed on suppliers. Consumers demand QD while Suppliers are only willing to supply QS. If the price ceiling is set above the equilibrium, consumers would demand a smaller quantity than suppliers are producing.

Economic Efficiency: Black Vs. Legal MarketsLegal systems provide various benefits to economic systems.

Economic efficiency may be said to occur when an action creates more benefits than costs. Legal systems help economic systems become more efficient by reducing risks to economics participants. Risk represents a cost that must be compensated for by higher charges.

One risk reduced by government regulation is theft. Government protects the property rights of owners so that they can benefit from the assets they own and use them in an efficient, economic manner. Participants in a "black market system" face a high risk of theft in their transactions as well as exposure to other forms of violence.

Governments often also provide a regulatory framework for the safety of products. In a market operating within a legal system, purchasers of drugs have a reasonable expectation about the quality of the drugs and the expected benefits of the drugs. Participants in a black market for drugs will have incomplete information about the quality of drugs purchased and, therefore, appropriate decisions are more difficult to make.

Price FloorsWhen a "price floor" is set, a certain minimum amount must be paid for a good or service. If the price floor is below a market price, no direct effect occurs. If the market price is lower than the price floor, then a surplus will be generated. Minimum wage laws are good examples of price floors. In many states, the U.S. minimum wage law has no effect, as market wage rates for low-skilled workers are above the U.S. minimum wage rate. In states where the minimum wage is above the market wage rate, the law will increase unemployment for low-skilled workers. Although some low-skilled workers will get higher pay, others will lose their jobs.

Effect of Taxes on Supply and Demand

Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax.

Actual and Statutory Incidence of TaxTax authorities usually require either the buyer or the seller to be legally responsible for payment of the tax. Tax incidence is the way in which the burden of a tax is shared among the market participants ("who bears the cost?"). Taxes will typically constitute a greater burden for whichever party has a more inelastic curve – e.g., if supply is inelastic and demand is elastic, the burden will be greater on the producers.

Suppose that a state government imposes a tax upon milk producers of $1 per gallon.

Figure 3.7: Incidence of Tax

Figure 3.7 shows the original price for milk was $2 per gallon. After imposition of the tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per gallon after paying the tax. So sixty cents of the tax is actually paid by consumers, while forty cents is paid by the milk producers.

The triangle ABC above represents the deadweight loss due to taxation, which occurs because now there are fewer mutually beneficial exchanges between buyers and sellers. Deadweight loss stems from foregone economic activity and is a loss that does not lead to an offsetting gain for other market participants; it is a permanent decrease to consumer and/or producer surplus.

Elasticity of Supply and Demand and the Incidence of TaxIf buyers have many alternatives to a good with a new tax, they will tend to respond to a rise in price by buying other things and will, therefore, not accept a much higher price. If sellers easily can switch to producing other goods, or if they will respond to even a small reduction in payments by going out of business, then they will not accept a much lower price. The incidence of the tax will tend to fall on the side of the market that has the least attractive alternatives and, therefore, has a lower elasticity.

Cigarettes are one example where buyers have relatively few options; we would therefore expect the primary burden of cigarette taxes to fall upon the buyers.

A subsidy shifts either the demand or supply curve to the right, depending upon whether the

buyer or seller receives the subsidy. If it is the buyer receiving the subsidy, the demand curve shifts right, leading to an increase in the quantity demanded and the equilibrium price. If the seller receives the subsidy, the supply curve shifts right and the quantity demanded will increase, while the equilibrium price decreases.

A quota limits the amounts of a good that can be produced. If the quota is greater than what would be produced under normal market conditions, then it will have no effect. If the amount is less, than the market equilibrium that is achieved will be at a higher price than what would occur without the quota, as consumers will be willing to pay more.

Making a good or service illegally impacts demand, supply and market equilibrium by imposing a cost (prosecution and punishment) on the buyer or seller (or both) of the good/service. Quantities of illegal goods will always be less than if they were legal, but the impact on price is determined by whether the buyer or seller (or both) is punished. If the only the buyer is penalized, the equilibrium price will be lower; the risk of punishment is regarded by buyers as a cost, and reduces the price they will pay to the seller. If the seller is penalized, the equilibrium price will be higher as the cost of punishment is factored into the seller's cost. Prices will remain relatively unchanged if the risk and cost of punishment is shared equally.

Effects on Equilibrium in the Short and Long Run

The Firm vs. the Industry's Short-Run Supply CurveA company will continue to produce output until marginal revenue (MR) is equal to marginal cost (MC).

In other words, the condition for maximum profit occurs where:MR = MC

Another condition for profit to be maximized, because it is possible that MR=MC at a point where MC is falling, is that the marginal cost curve must be rising. Therefore, the supply curve for a competitive firm will be that part of the marginal cost curve which lies above the low point of the average cost curve. The supply curve slopes upward because marginal costs increase with the greater quantity supplied in the short run. With a competitive market, the supply curve will be a summation of the individual firms' supply curves.

Long-Run Effects on Equilibrium In the short-run, increases (decreases) in demand in a competitive market will cause prices and output to increase (decrease).

In the long-run, increases (decreases) in demand in a competitive market will cause increases (decreases) in output. Initially, markets with an increase (decrease) in demand will have firms experiencing economic profits (losses). Over time, markets with firms experiencing economic profits (losses) will have additional firms enter (existing firms will exit) the market, and prices will decrease (increase) towards previous levels. If cost conditions remain the same, then prices will revert to what they were before the increase (decrease) in demand.

If the market price falls below a firm's average total cost, the firm will incur economic losses. The firm may be able to lower its average total cost by changing to a different plant size. Suppose a firm increases its plant size, and lowers its average total costs. If other firms

follow, then the industry supply curve will shift to the right. This will result in lower prices and less economic profit.

If a firm does not expect market conditions to improve then it may decide to go out of business. This would be the preferred option as, by selling out, neither fixed nor variable costs would be incurred.

Impact From Changes in TechnologyThe impact of a permanent change of demand on price and output for a market will be influenced by the cost structure of suppliers in the market. The long-run market supply curve in a competitive industry will depend on the returns to scale.

For a constant-cost industry, if demand increases, then firms temporarily will make a profit as price will go above the minimum needed for the firms to stay in business. This will cause firms to expand output or new firms to enter the industry. Because costs are constant in the long run, the long-run supply curve will be horizontal. In the graph below, as demand shifts from D1 to D2, over the long run quantity will increase from Q1 to Q2. However, price will remain the same.

Figure 3.12: Long Run Supply: Constant Cost Industry

For an increasing cost industry, if demand increases, firms will need higher prices over the long run in order to justify higher levels of production. For example, prices for raw materials used in the industry may go up with higher levels of production, which will force the long-run supply curve to slope upward.

Figure 3.10: Long Run Supply: Increasing Cost Industry

For a decreasing cost industry, if demand increases, in the long run firms can provide more output at lower prices. The need to produce larger quantities of goods and services in response to increased demand induces technological change, which lowers costs for the producer and these savings are passed on to consumers in the long run.

Figure 3.11: Long Run Supply: Decreasing Cost Industry

Opportunity Costs

Explicit CostsExplicit costs reflect monetary payments made to resource owners. Examples include wages, lease payments and interest payments.

Implicit CostsImplicit costs are those associated with resources used by the firm, but with no direct monetary payment. For example, there may not be an explicit monetary payment associated with the work efforts of a sole proprietor; however, there is an implicit cost associated with those work efforts as the sole proprietor could earn wages elsewhere. For a firm's capital, there is an implicit cost involved as the firm could be getting interest or earning a rate of return elsewhere. The implicit cost associated with the highest-valued alternative opportunity is referred to as the opportunity cost.

On the reverse side, particularly for an individual, there may be forms of implicit ("psychic") revenues; for example, a person may particularly enjoy "being his own boss".

Economic ProfitEconomic profit is equal to total revenues less both implicit and explicit costs. For a firm to stay in business, both implicit and explicit costs must be covered. If firms are receiving a negative economic profit in a market, they will leave that market. A normal profitrate exactly covers wage costs and the competitive rate of return on capital.

Accounting ProfitsAccounting profits are generally higher than economic profits, as they omit certain costs, such as the value of owner-provided labor and the firm's equity capital.

When calculating "economic profit", explicit and opportunity costs are taken into account.

Example:Suppose someone owns and runs a candy store that grosses $20,000 per month and has operating expenses of $14,000 per month. The store owner particularly enjoys socializing with the customers; this aspect of the business provides a comfort to the owner which is worth $2,000 a month to her. The owner could receive $3,000 a month in interest with the capital that is tied up in the store's inventory. She could earn $5,000 a month at a different job.

An income statement would show an accounting profit of $6,000 a month:

Explicit Revenues $20,000

Explicit Costs $14,000----------Accounting Profit $ 6,000

Answer:The economic profit, which should determine the economic decision, would be calculated as follows:

Explicit Revenues $20,000

Implicit Revenue(value of socialization) $ 2,000- - - - - -Economic Revenues $22,000Explicit Costs $14,000

Implicit Costs:Value of owner's labor $5,000Required rate of return oninventory investment $3,000- - - - - -Economic Profit ($2,000)

From an economic viewpoint, keeping the candy store open does not make sense. The implicit value of enjoying being with the customers is not of sufficient value in comparison to

the fact that the store owner could make more money by working elsewhere and employing the capital elsewhere.

Achieving Economic & Technological Efficiency

Firm ConstraintsConstraints on a firm include:

Information - firms will not have complete information regarding strategies of competitors, ethics of their workers, customer buying plans, forthcoming technologies and many other factors that affect firm profitability. Acquiring relevant information can be costly, so benefits and costs of acquiring information must be weighed.

Market - prices firms charge will be impacted by the offerings of other firms. Firms are in competition with other firms for resources such as employees and raw materials. Market constraints limit what firms can charge and enforce pricing on the input side.

Technology - economists view technology as the methods and processes that firms use to produce goods and/or services. There is a "technology" associated with any business, and the set of available technologies will limit what a firm can do and impact its profit.

Technological vs. Economic EfficiencyTechnological efficiency relates quantities of inputs to the quantity of output, while economic efficiency relates the dollar value of inputs to the dollar value of output. A firm would be operating with technological efficiency when it produces a certain level of output with the least amount of input. Economic efficiency would be achieved when a certain level of output is produced with the lowest cost of inputs.

Suppose there are two available methods to produce widgets, one that is highly automated with industrial robots, and a mostly manual one that requires significantly more workers. The automated method costs $50,000 per month to produce 1,000 widgets over a monthly period, using three robots and one worker. The manual method costs $40,000 per month to produce 1,000 widgets over the same time period, with 10 workers that have a minimal amount of tools. We can't say that either method is technologically inefficient - the automated method requires fewer workers, while the manual method requires less capital for the same quantity of output. However, we can say that the manual method is economically efficient, since it produces 1,000 widgets at the lower cost.

Ways to Organize ProductionThere are two broadly defined methods of organizing production. A command system utilizes a hierarchical organization whereby commands flow down from the top of the organization. Armies typically are organized by this method. An incentive system tries to provide market-like incentives to each layer of the organization. Sales organizations predominantly use incentive systems. Incentives also can be provided to personnel, such as assembly line workers, by relating pay to certain production targets.

The Principal-Agent ProblemThe principal-agent problem is an example of incomplete and asymmetric information. Principal-agent problems occur when the principal (buyer) has less information than the agent (supplier). For example, a patient at a hospital has much less information about the medical

treatments being conducted than the doctors. The patient would prefer to have the illness resolved at the lowest possible cost to him. The doctors may be facing pressures or may be influenced by incentives that are not in the best interests of the patient. It is difficult for the patient to judge the quality of his or her own treatment.

Owners (shareholders) of firms face similar problems. The owner (principal) compensates an agent (an employee) to perform acts that are useful to the principal, costly (or otherwise undesirable) to the agent, and where performance is costly or difficult to observe. Because of the difficulty/cost of observing the work, the principal finds it difficult to assess the agent's competence and achievements and adjusting compensation accordingly. Likewise, there is an inherent conflict of interest at work – the principal seeks to gain maximum output for minimum compensation, while the agent seeks to maximize compensation and minimize output.

A firm can reduce principal-agent problems by giving the agent an ownership stake in the enterprise, incentive compensation and/or a long-term employment contract. These serve to give the agent a vested interest in the overall health of the enterprise and align the interests of the principal and the agent.

Types of Business Firms:

ProprietorshipsProprietorships are businesses owned by a single individual (or sometimes a family). Risks and rewards for the business are the responsibility of that one individual. Note that the sole proprietor is legally responsible for the debts of the business.

PartnershipsPartnerships are businesses that have two or more people acting as co-owners of the business. Agreements are made beforehand as to how to share the risks and rewards. As with proprietorships, owners are personally responsible for all debts associated with the business. Law firms and accounting firms are organized often as partnerships.

CorporationsCorporations are businesses that have been granted a charter so that they are recognized as separate legal entities. Individuals in a corporation are not subject to the liabilities of the firm; the most that they can lose is the amount they invested. Taxes are paid, assets are acquired and contracts are entered into n the name of the corporation. Corporations generally have easier access to capital than proprietorships or partnerships.

Major factors promoting cost efficiency and customer service within the corporate world include:

1. The threat of takeover - Inefficient corporate management can attract the interest of outsiders, who will try to take over of the corporation with the intent of running the corporation more efficiently, so as to increase shareholder value. The takeover company most likely would remove the current management. The threat of such a takeover gives management an incentive to serve the interests of corporate shareholders.

2.Competition for capital and customers - Poor management will tend to drive the price of a company's stock down, which will tend to make raising more capital difficult. An efficient

and/or innovative management will tend to cause the price of a company's stock to go up, which will make raising additional capital easier. The corporation's products must be competitive, in terms of both price and quality, in order to attract customers. The production of inferior goods will tend to drive customers away, which will decrease corporate revenues. Therefore, competitive forces tend to limit the ability of management to serve their own needs in lieu of stockholder and customer needs.

3.Management compensation - Compensation can be set up so that management incentives are in line with those of the corporation. For example, a significant amount of executive compensation can be in the form of stock options, which are of value only when a certain stock price is met.