3.1 Microeconomics

Demand

Microeconomics focuses on the decisions and actions of individual agents, such as businesses or customers, within the economy. The interactions of the decisions that businesses and customers make will determine the price and quantity of a good or service that is sold in the marketplace. Financial managers need a strong foundation in microeconomics. This foundation helps them understand the market for the company’s products and services, including pricing considerations. Microeconomics also helps managers understand the availability and prices of resources that are necessary for the company to create its products and services.

A successful business cannot just create and manufacture a product or provide a service; it must produce a product or service that customers will purchase. Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a given time period, ceteris paribus (a Latin phrase meaning “all other things being equal”).

Let’s consider what the demand for pizza might look like. Suppose that at a price of $30 per pizza, no one will purchase a pizza, but if the price of a pizza is $25, 10 people might buy a pizza. If the price falls even lower, more pizzas will be purchased, as shown in Table 3.1.

The information in Table 3.1 can be viewed in the form of a graph, as in Figure 3.2. Economists refer to the line in Figure 3.2 as a demand curve. When plotting a demand curve, price is placed on the vertical axis, and quantity is placed on the horizontal axis. Because more pizzas are bought at lower prices than at higher prices, this demand curve is downward sloping. This inverse relationship is referred to as the law of demand.

Figure 3.2 Demand Curve for Pizzas

The inverse relationship between the price of a good and the quantity of a good sold occurs for two reasons. First, as you consume more and more pizza, the amount of happiness that one more pizza will bring you diminishes. If you have had nothing to eat all day and you are hungry, you might be more willing to pay a high price for a pizza, and that pizza will bring you a great deal of satisfaction. However, after your hunger has been somewhat satisfied, you may not be willing to pay as much for a second pizza. You may only be willing to purchase a third pizza (to freeze at home) if you can get it at a fairly low price. Second, demand depends not only on your willingness to pay but also on your ability to pay. If you have limited income, then as the price of pizza rises, you simply cannot buy as much pizza.

The demand curve is drawn as a relationship between the price of the good and the quantity of the good purchased. It isolates the relationship between price and quantity demand. A demand curve is drawn assuming that no relevant factor besides the price of the product is changing. This assumption is, as mentioned above, ceteris paribus.

If another relevant economic factor changes, the demand curve can change. Relevant economic factors would include consumer income, the size of the population, the tastes and preferences of consumers, and the price of other goods. For example, if the price of hamburgers doubled, then families might substitute having a pizza night for having a hamburger cookout. This would cause the demand for pizzas to increase.

If the demand for pizzas increased, the quantities of pizza purchased at every price level would be higher. The demand schedule for pizzas might look like Table 3.2 after an increase in the price of hamburgers.

This change leads to a movement in the demand curve—outward to the right, as shown in Figure 3.3. This is known as an increase in demand. Now, at a price of $25, people will purchase 19 pizzas instead of 10; and at a price of $15, people will purchase 39 pizzas instead of 30.

Figure 3.3 An Increase in Demand Represented as a Movement of the Demand Curve to the Right

A decrease in demand would cause the demand curve to move to the left. This could happen if people’s tastes and preferences changed. If there were, for example, increased publicity about pizza being an unhealthy food choice, some individuals would choose healthier alternatives and consume less pizza.

Supply

Supply is the quantity of a good or service that firms are willing to sell at various prices, during a given time period, ceteris paribus. Table 3.3 is a fictional example of a supply schedule for pizzas. In some cases, higher prices encourage producers to provide more of their product for sale. Thus, there is a positive relationship between the price and quantity supplied.

The data from the supply schedule can be pictured in a graph, as is shown in Figure 3.4. Because a higher price encourages suppliers to sell more pizzas, the supply curve will be upward sloping.

Figure 3.4 Supply Curve for Pizzas

The supply curve isolates the relationship between the price of pizzas and the quantity of pizzas supplied. All other relevant economic factors are assumed to remain unchanged when the curve is drawn. If a factor such as the cost of cheese or the salaries paid to workers changes, then the supply curve will move. A shift to the right indicates that a greater quantity of pizzas will be provided by firms at a particular price; this would indicate an increase in supply. A decrease in supply would be represented by a shift in the supply curve to the left.

Equilibrium Price

Demand represents buyers, and supply represents sellers. In the market, these two groups interact to determine the price of a good and the quantity of the good that is sold. Because both the demand curve and the supply curve are graphed with price on the vertical axis and quantity on the horizontal axis, these two curves can be placed in the same graph, as is shown in Figure 3.5.

Figure 3.5 Graph of Demand and Supply Showing Equilibrium Price and Quantity

The point at which the supply and demand curves intersect is known as the equilibrium. At the equilibrium price, the quantity demanded will equal exactly the quantity supplied. There is no shortage or surplus of the product. In the example shown in Figure 3.5, when the price is $15, consumers want to purchase 30 pizzas and sellers want to make 30 pizzas available for purchase. The market is in balance.

A price higher than the equilibrium price will not be sustainable in a competitive marketplace. If the price of a pizza were $20, suppliers would make 40 pizzas available, but the quantity of pizzas demanded would be only 20 pizzas. This would be a surplus, or excess quantity supplied, of pizzas. Restaurant owners who see that they have 40 pizzas to sell but can only sell 20 of those pizzas will lower their prices to encourage more customers to purchase pizzas. At the same time, the restaurant owners will cut back on their pizza production. This process will drive the pizza price down from $20 toward the equilibrium price.

The opposite would occur if the price of a pizza were only $5. Customers may want to purchase 50 pizzas, but restaurants would only want to sell 10 pizzas at the low price. Quantity demanded would exceed quantity supplied. At a price below the equilibrium price, a shortage would occur. Shortages drive prices up toward the equilibrium price.

Think It Through

Graphing Demand and Supply

Consider the demand and supply schedules for sweatshirts shown below. Sketch a graph of demand and supply, placing quantity on the horizontal axis and price on the vertical axis. What will the equilibrium price for sweatshirts be? Table 3.4 provides the demand and supply schedules for the sweatshirts.

Demand Schedule for Sweatshirts		Supply Schedule for Sweatshirts
Price ($)	Quantity	Price ($)	Quantity
55	0	55	45
50	4	50	40
45	8	45	35
40	12	40	30
35	16	35	25
30	20	30	20
25	24	25	15
20	28	20	10
15	32	15	5
10	36	10	0
5	40

Table 3.4 Demand and Supply Schedules for Sweatshirts

Solution:

The demand curve for sweatshirts is the downward-sloping curve in Figure 3.6, showing the inverse relationship between price and quantity demanded. The upward-sloping curve is the supply curve for sweatshirts. The equilibrium price will be $30. At a price of $30, the quantity demanded of 20 sweatshirts equals the quantity supplied of 20 sweatshirts.

Figure 3.6 Graph of Demand and Supply for Sweatshirts

Changes in Equilibrium Price

A price that is either too high (above the equilibrium price) or too low (below the equilibrium price) is not sustainable in a competitive market. Market forces pull prices to the equilibrium, where they stay until either supply or demand changes.

If supply increases and the curve moves outward to the right, as in Figure 3.7, then the equilibrium price will fall. With the original supply curve, Supply₁, the equilibrium price was $15; quantity demanded and quantity supplied were both 30 pizzas at that price. If a new pizza restaurant opens, increasing the supply of pizzas to Supply₂, the equilibrium will move from Equilibrium₁ $\left(E_1\right)$ to Equilibrium₂ $\left(E_2\right)$. The new equilibrium price will be $10. This new equilibrium is associated with a quantity demanded of 40 pizzas and a quantity supplied of 40 pizzas.

Figure 3.7 Supply Curve Changes When Supply Increases An increase in supply leads to a lower equilibrium price and an increase in quantity demanded.

It is important to note that the demand curve in Figure 3.7 does not move. In other words, demand does not change. As the equilibrium price falls, consumers move along the demand curve to a point with a combination of a lower price and a higher quantity. Economists call this movement an increase in quantity demanded. Distinguishing between an increase in quantity demanded (a movement along the demand curve) and an increase in demand (a shift in the demand curve) is critical when analyzing market equilibriums.

Equilibrium price will also fall if demand falls. Remember that a decrease in demand is represented as a shift of the demand curve inward to the left. In Figure 3.8, you can see how a decrease in demand causes a change from $E_1$ to $E_2$.

Figure 3.8 A Decrease in Demand

At the new equilibrium, $E_2$, the price of a pizza is $10. The new equilibrium quantity is 20 pizzas. Note that the supply curve has not moved. Producers moved along their supply curve, producing fewer pizzas as the price dropped; this is known as a decrease in quantity supplied.

Think It Through

Graphing Demand

Suppose that the demand for sweatshirts in our previous example changes, and the demand schedule becomes the data shown in Table 3.5.

Price ($)	Quantity
55	18
50	22
45	26
40	30
35	34
30	38
25	42
20	46
15	50
10	54
5	58

Table 3.5 Demand Schedule for Sweatshirts

Has the demand for sweatshirts increased or decreased? Show this movement in a graph. What happens to the equilibrium? What are some reasons you can think of that may have caused this change in demand?

Solution:

This is an increase in demand. At every price, consumers now want to purchase more sweatshirts than they did before. This is shown in the graph as a movement of the demand curve outward to the right. Both the equilibrium price and the equilibrium quantity will rise because of this increase in demand. The equilibrium price will now be $40, and the equilibrium quantity of sweatshirts will be 30. Note that there is not an increase in supply; the supply curve does not move. There is simply an increase in quantity supplied (see Figure 3.9).

Figure 3.9 Graph Showing Increase in Sweatshirt Supply

A change in any of the factors that are assumed to be held constant under the ceteris paribus assumption could have caused the demand curve to shift to the right. Perhaps a rise in consumers’ incomes led them to purchase more clothing, including sweatshirts. Or an unseasonably cool fall could result in more people purchasing sweatshirts. If a popular TV personality indicates that their favorite weekend wardrobe consists of jeans and a sweatshirt and the tabloids run pictures of the celebrity wearing sweatshirts, the tastes and preferences of consumers may change. Another possibility is that the price of sweaters may have risen, causing people to substitute sweatshirts for sweaters.