MANAGERIAL ECONOMICS

Maryhill College

II. THE FREE MARKET, DEMAND AND SUPPLY ANALYSIS

CAPITALISM: FREE-MARKET ECONOMY

 The nature of economic activity, at the microeconomic, macroeconomic and international levels, depends on
the political environment or ECONOMIC SYSTEM within which economic activities take place.

 CAPITALISM is a “free market” economic system where individuals & business firms determine production,
distribution and consumption of goods and services in an open or free market.
 Resources are privately owned rather than state-owned (as opposed to socialism).
 Economic decisions are made primarily by individuals and business firms rather than by the state.
 The price of goods and services is based on supply and demand in the general market (i.e., MARKET
ECONOMY) rather than through central planning (i.e., COMMAND ECONOMY).
 Advantages and disadvantages of Capitalism (source: Wikipedia)
“Critics of capitalism argue that it concentrates power in the hands of a minority capitalist class that exists through the exploitation
of the majority working class and their labor, prioritizes profit over social good, natural resources and the environment, is an engine of
inequality, corruption and economic instabilities, and that many are not able to access its purported benefits and freedoms, such as freely
investing.
Supporters argue that capitalism provides better products and innovation through competition, promotes pluralism (diversity) and
decentralization of power, disperses wealth to people who are able to invest in useful enterprises based on market demands, allows for a
flexible incentive system where efficiency and sustainability are priorities to protect capital, creates strong economic growth and yields
productivity and prosperity that greatly benefit society.”
 FACTORS of PRODUCTION are the scarce economic resources needed to produce goods and services. The
four (4) most common factors of production include:
1. LAND – refers to NATURAL resources such as land, water, mineral, timber
2. LABOR – refers to HUMAN resources such human works, human skills, human efforts
3. CAPITAL – refers to FINANCIAL resources (e.g., savings) and MAN-MADE resources (e.g., equipment)
4. ENTREPRENEURSHIP – refers to the human resource that organizes land, labor and capital
 To earn INCOME, individuals sell the services of the factors of production they own:
 Land earns rentals and royalties  Capital earns interests, dividends and rentals
 Labor earns wages and salaries  Entrepreneurship earns profit

DEMAND
 DEMAND is the relationship between the price of a good and the quantity demanded. It is also defined as the
schedule of quantities of a good that people are willing to buy at different prices.
 QUANTITY DEMANDED of a good is the amount that consumers plan to buy at a particular price.
 LAW OF DEMAND: “ceteris paribus, the higher the price of a good, the smaller the quantity demanded.”
 Higher prices decrease the quantity demanded for two reasons:
A) SUBSTITUTION effect – a higher relative price raises opportunity cost of buying a good; as a result, people
buy less of the good as there could be other available goods with a lower price.
B) INCOME effect – a higher relative price reduces the amount of goods people can afford to buy.
 DEMAND CURVE shows the inverse relationship between the quantity demanded and price, ceteris paribus.
Demand curves are negatively sloped.
DEMAND CURVE
Price
 A change in the price of product causes a
(Pesos) D1 D2
movement along the demand curve, also called a
5
4 CHANGE IN QUANTITY DEMANDED.
3  A shift in the demand curve is called a CHANGE
2 IN DEMAND. An increase in demand drives the
1 demand curve to shift rightwards (D1 to D2).
1 2 3 4 5 Quantity (Units)

FACTORS affecting DEMAND EFFECT on DEMAND

Price of SUBSTITUTE goods
Price of COMPLEMENTARY
goods
Expected future prices
Consumer wealth/income
Consumer wealth/income
Population growth
Size of market
Consumer tastes/preference
DIRECT. Example: if the price of pork increases, the demand for beef may increase.
INVERSE. Example: if the price of gasoline increases, the demand for cars tends to
decrease.
DIRECT. If the price of the good is expected to increase in the future, there will
be an increase in demand.
DIRECT for NORMAL goods. As consumer income goes up, the demand for
many products (normal goods) increases.
INVERSE for INFERIOR goods. Demand for inferior goods (e.g., instant noodle,
sardines) increases as consumer income decreases since consumers buy more
inferior goods when they are short of money.
DIRECT. An increase in population increases number of potential buyers.
DIRECT. As market size expands, demand for the product also increases.
INDETERMINATE. The effect depends on whether the shift in taste or preference
is favorable or unfavorable to the demand for the product.

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  SUBSTITUTE GOODS are goods that can be used in place of another because they could perform the same
function. Examples: butter and margarine; pen and pencil.

 COMPLEMENTARY GOODS are goods that go hand in hand as one usually cannot function without the other.
Examples: whiteboard and marker; CPU and monitor.

 When an individual’s income declines, the individual buys less NORMAL goods and more INFERIOR goods.


 ELASTICITY OF DEMAND (ED) measures the sensitivity of quantity demanded to any change in price. Using
the Arc or mid-point method, the formula is:

ED = ∆% in Quantity Demanded ÷ ∆% in Price

Where: ∆% in Quantity Demanded = ∆ in Quantity Demanded ÷ Average Quantity
∆% in Price = ∆ in Price ÷ Average Price

Example: Day 1 - unit price was set at P 1.00 each, the sales reached 100 units.
Day 2 - unit price was increased to P 1.50 each, the sales decreased to 60 units.
Average Quantity = (100 + 60) ÷ 2 = 80* Average Price = (1 + 1.5) ÷ 2 = 1.25**
ED = [(100 - 60)/80*] ÷ [(1.5 - 1)/1.25*)] = 0.50 ÷ 0.40 = 1.25

 In the above example, the price increase of P 0.50 led to a decrease in total revenue from P 100 to P 90
(60 @ P 1.50). Since ED > 1 (ED = 1.25), demand is said to be elastic. Consider the following:

ED ELASTICITY QUANTITY DEMANDED (degree of reaction) EFFECT of PRICE INCREASE
>1 Elastic Reacts MORE proportionately to changes in Decrease in total revenue
price
=1 Unitary Reacts proportionately to changes in price No effect on total revenue
<1 Inelastic Reacts LESS proportionately to changes in price Increase in total revenue
=0 Perfectly inelastic Does not react to changes in price Increase in total revenue
 The demand for LUXURY goods tends to be more elastic than the demand for BASIC or STAPLE goods.
 The demand for badly needed goods like ‘maintenance’ medicine tends to be perfectly inelastic.

 The satisfaction derived from the acquisition or consumption of a particular good is called UTILITY. The more
goods an individual consumes, the more utility the individual receives. However, according to the LAW OF
DIMINISHING MARGINAL UTILITY, the marginal (additional) utility from consuming each additional unit
usually decreases. When various quantities of two commodities the give the same total utility are plotted on
a graph the result is an INDIFFERENCE CURVE.

 CONSUMPTION decisions depend on many factors but the main one is DISPOSABLE INCOME, which is the
amount of income consumers have after paying taxes to the government. When personal disposable income
goes up, consumers buy more.
 MARGINAL PROPENSITY TO CONSUME (MPC), a.k.a. marginal propensity to spend, describes how much
of each additional peso in personal disposable income that the consumer will spend.
 MARGINAL PROPENSITY TO SAVE (MPS) is the percentage of additional income that is saved.
 Since consumers can either spend or save money: MPC + MPS = 100%
Where: MPC = ∆ in Consumption ÷ ∆ in Disposable Income
MPS = ∆ in Savings ÷ ∆ in Disposable Income
SUPPLY
 SUPPLY is the relationship between the price of a good and the quantity supplied.
 QUANTITY SUPPLIED is the amount of a good that producers plan to sell at particular price.
 LAW OF SUPPLY: “ceteris paribus, the higher the price of a good, the greater is the quantity supplied.”
 SUPPLY CURVE shows the positive relationship between the quantity supplied and price, ceteris paribus.
Supply curves are positively sloped.

Price
(Pesos) S1 S2
5
4
3
2
1 SUPPLY CURVE
1 2 3 4 5 Quantity (Units)  A change in the price of product causes a
movement along the supply curve, also called a
CHANGE IN QUANTITY SUPPLIED.
 A shift in the supply curve is called a CHANGE IN
SUPPLY. An increase in supply drives the supply
curve to shift rightwards (S1 to S2).

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 FACTORS affecting SUPPLY
Production costs
Number of producers
Price of substitute goods
Price of complementary goods
Expected future prices
Technology
Government subsidies
Government tax and tariffs
Special influences
EFFECT on SUPPLY
INVERSE. As production costs go up, fewer products will be supplied at a
given price. If costs go down, more products will be produced.
DIRECT. An increase in the number of producers will cause an increase in the
amount of goods supplied at a certain level of price.
INVERSE. If other products can be produced with greater returns, producers
will produce those goods.
DIRECT. A rise in the price of a complement in production increases supply
and shifts the supply curve rightward.
DIRECT. If it is expected that prices will be higher for the good in the future,
production of the good will increase.
DIRECT. Technological advancement increases supply and thus shifts the
supply curve rightward.
DIRECT. Subsidies reduce the production cost of goods and, therefore,
increase the goods supplied at a given price.
INVERSE. Increase in taxes would raise production costs, thereby decreasing
supply.
Government restrictions, weather conditions, and innovations or new method
may affect supply of goods. Example: unexpected storms may destroy farms,
decreasing the supply of certain crops.

EQUILIBRIUM
 EQUILIBRIUM is a state wherein the demand and supply are in balance. EQUILIBRIUM
Price
(Pesos) D S  EQUILIBRIUM PRICE (P 6.00) is the price at which
10 the quantity demanded equal quantity supplied -
8 - the intersection of the demand curve and the
6 ● Equilibrium Point supply curve. This is also known as the market-
4 clearing price.
2  EQUILIBRIUM QUANTITY (3 units) is the quantity
bought and sold at the equilibrium price.
1 2 3 4 5 Quantity (Units)

 Equilibrium is a MARKET-CLEARING situation where no surplus or shortage exists.

 MARKET SHORTAGE – actual price is less than the equilibrium price; therefore, quantity demanded
exceeds quantity supplied. Shortage can be caused by a PRICE CEILING, which is a maximum price that
a seller may charge for a good and is normally set below the equilibrium price.
 MARKET SURPLUS – actual price is more than the equilibrium price; therefore, quantity supplied exceeds
quantity demanded. Surplus can be caused by a PRICE FLOOR, which is a minimum price that a seller
may charge for a good and is normally set above the equilibrium price.

 GOVERNMENT INFLUENCES may change market equilibrium through various means like:
 TAXES – higher taxes increase product input costs causing the equilibrium price to be higher.
 SUBSIDIES – subsidies reduce production costs causing the equilibrium price to be lower.
 RATIONING – rationing is intended to curb demand causing equilibrium price to be lower.
 REGULATION – Government can affect price of commodity through price fiat by establishing an artificial
price ceiling or price floor.
 Another factor that causes inefficiencies in the pricing of goods in the market is the existence of
EXTERNALITIES -- damage to environment caused by production (e.g., pollution).
 predicts that after some optimal level of capacity is reached, adding an additional factor of production will
actually result in smaller increases in output. Example: a factory employs workers to manufacture its products, and, at
some point, the company operates at an optimal level. With all other production factors constant, adding additional workers beyond
this optimal level will result in less efficient operations.

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COSTS of PRODUCTION
 The analysis of PRODUCTION COSTS distinguishes analysis in the short run vs. analysis in the long run:
 In the short run, at least one input of production is fixed (e.g., plant depreciation).
 In the long run, no inputs are fixed -- all inputs are variable (e.g., additional plant can be built).

 While business firm can vary all inputs in the long run, they must nevertheless operate in the short run.
Hence, analysis of production costs tends to focus on the SHORT RUN where total production costs are
separated into fixed costs and variable costs:

COST FORMULA LEGEND
1 TC FC + VC (= ATC x Q) TC = Total Cost ATC = Average TC
2 VC TC – FC (= AVC x Q) FC = Fixed Cost AVC = Average VC
3 FC TC – VC (= AFC x Q) VC = Variable Cost AFC = Average FC
4 MC ∆TC ÷ ∆Q (= ∆ TVC ÷ ∆Q) MC = Marginal Cost Q = Quantity
5 ATC TC ÷ Q (= AFC + AVC) ∆TC = Change in Total Cost
6 AVC VC ÷ Q (= ATC – AFC) ∆Q = Change in Quantity
7 AFC FC ÷ Q (= ATC – AVC) ∆TVC = Change in Total Variable Cost

 AVC is initially constant until inefficiencies in a fixed-size facility would cause variable costs to rise.
 MC initially decreases but begins to increase due to inefficiencies.


 The cause of inefficiencies is known as the LAW OF DIMINISHING RETURNS -- an economic theory that
LONG-RUN production costs are all variable costs. As the firm expands by increasing plant size, ATC tends
to fall at first because of the economies of scale, but as this expansion continues, ATC begins to rise because
of the diseconomies of scale:

 ECONOMIES OF SCALE (a decline in ATC) arise because of labor and management specialization, efficient
capital, and factors such as spreading advertising cost over an increasing level of output.
Example: If a firm increases labor hours by 10%, output increases by 50%. Hence, ATC decreases.

 DISECONOMIES OF SCALE arise primarily from the problems of inefficiently managing and coordinating
the firm’s operations as it becomes a large-scale producer, especially in the long-run.
Example: If a firm increases input by 60%, output increases by 3%. Hence, ATC increases.

 CONSTANT RETURNS TO SCALE refers to the range of output where long-run ATC does not change.
Example: A firm may double its production by doubling its production facility; so when production
increases, ATC remains constant.


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