II. Give English equivalents of the following

8

SUPPLY AND DEMAND

Supply and demand graphs, tables, and equations summarize those factors or forces in a market that determine the price and quantity of a particular good, product, or service. Exhibit 6.1 is a representative graph containing a supply curve and a demand curve. Before looking at the details of the factors that influ­ence the shape and position of the curves, let us first examine the conclusions that can be drawn from them by learning what those conclusions are and by what means these conclusions are determined. While this may initially appear a bit mechanical, we will flesh out the details later.

The intersection of the two curves reflects the interaction of all the forces in the market for that product. In our example, assume the product is a six-pack of beer. The price of a six-pack of beer is $3.75, and the quantity produced and sold is 4 million units (remember, this is the whole market for beer, so this is probably too small a number). This combination of price and quantity represents the market-clearing equilibrium (point Ei on Exhibit 6.1). These terms are important. Equilibrium implies that there are no forces leading to a change in price or quantity. As long as all the factors stay as they are, brewers will continue

EXHIBIT 6.1 Supply and demand for beer.

Price

S₁

$3.75 E₁

4.000 D₁

to produce 4 million six-packs and consumers will buy them at $3.75 each. It is the market-clearing point because all of the six-packs that are produced are sold, and everyone willing and able to pay $3.75 for a six-pack gets one.

What would happen if producers attempted to set a price different from the equilibrium, say $4.00 (see Exhibit 6.2)? At that price, brewers want to sell more than 4 million units. They are getting a higher price per six-pack so they produce a higher quantity: 4.25 million. At that higher price, however, consumers will buy less than 4 million six-packs; in fact, they will buy only 3.75 million. What happens to the difference between 4.25 million and 3.75 million? The market does not clear; brewers will find themselves with unwanted inventories. As the inventories build up, brewers will cut their production and their prices. Brewers reduce pro­duction because they have too much in stock; they cut their prices in order to sell off the excess. As the price falls, the quantity bought will increase, and eventually the market will clear. At what price? We know that already: $3.75 per unit is the equilibrium price.

What happens if something occurs to disturb the equilibrium as repre­sented by the shift in the demand curve shown in Exhibit 6.3?

The outward movement of the demand curve implies that consumers are now willing and able to buy more six-packs at any and every price that brewers might charge. A number of things could lead to the shift: higher income levels, leading consumers to buy more of everything; an increase in the price of wine and spirits, leading consumers to substitute beer for these products; or a decrease in the price of pizza, leading consumers to eat more pizza and, of

EXHIBIT 6.2 A temporary disequilibrium.

course, drink more beer. At the point in time when demand changes, brewers are still producing 4 million six-packs and selling them at $3.75 apiece, but now consumers want 4.25 million six-packs. Brewers experience a decrease in their inventories, and some consumers are unable to get all they are willing and able to buy. This signals the brewers to do two things: Increase prices and increase production. As prices rise, some of the additional demand for beer from con­sumers at the old price disappears, and eventually the quantity of beer produced and consumed becomes equal again. The market thus arrives at a new equilib­rium, with a price of $3.90 per six-pack and production of 4.15 million units. Notice that this new equilibrium has a higher price and quantity than the origi­nal equilibrium because it was caused by an increase in demand. It is a change in equilibrium because demand changed, unlike the temporary changes brought about by the failed efforts of producers to raise prices and output in the face of no changes in the fundamental factors driving the market.

What is it that determines the shape and position of the demand and sup­ply curves? We have already alluded to several of the most important factors:

1. 
   The income level of consumers.
   
2. 
   The price of substitute goods or products.
   
3. 
   The price of complementary goods or products.
   
4. 
   Tastes, style, and fashion.
   

In general, as income, the price of substitute goods, and tastes (preferences) increase, the demand increases and the curve will be farther to the right, because

there is a positive relationship between the demand for a good and those three factors. Regarding complementary goods, the relationship is reversed. As the price of a complement rises, the demand falls. In the previous example, pizza was a complement to beer, because when the price of pizza fell, the demand for beer increased. Had pizza prices risen, beer demand would have fallen.

The supply curve is equally intuitive; it is related to the cost of produc­tion. For firms in many industries, the cost of producing an additional unit increases at some point. That is, if it costs a brewer $3.00 to make the millionth six-pack, the millionth and one costs $3.02. Economists refer to the incremen­tal cost of producing a unit of output as its marginal cost. Because the marginal cost increases as output increases, suppliers are willing and able to produce more only if they get higher prices. This leads to the upward-sloping supply curve.

What factors determine the shape and position of the curve? Those that affect costs. The prices and availability of labor and materials are the key com­ponents. Therefore, if hops and yeast prices rise, then brewers will be willing to produce a given quantity only if the prices they receive also rise. A more subtle factor that affects the supply curve is the opportunity cost of using resources to produce a particular good. The opportunity cost is the next-best available use of those resources. What happens if the resources needed to brew beer could also be used to produce soft drinks and the price of soft drinks rises? Brewers will look at their alternatives and switch to the soft-drink industry, because the higher prices in this latter market represent greater profit opportunities. This would shift the beer supply curve upward to the left and reduce the quantity of beer produced. Beer prices would rise (see Exhibit 6.4).

Although we have simplified this process enormously, the framework out­lined here is a very powerful tool. It is an analytical tool that allows decision mak­ers to quickly evaluate the impact of changes that occur in the marketplace. This framework can be used by policymakers to assess the effect of changes in regu­lation, taxes, subsidies, and tariffs. Moreover, this process is an important philo­sophical concept. What has been outlined here in terms of the price mechanism and how it reacts to changes in supply and demand is what Adam Smith called "the invisible hand" in his classic book The Wealth of Nations, published in 1776. Resource allocation is determined in a market system by reactions to and changes in prices.

An Industry Example

To be a little more concrete about demand and supply, let's examine an impor­tant policy change and how it led to major changes in an industry. The industry or product in this discussion pertains to the long-distance telephone service

EXHIBIT 6.4 A shift in supply.

Price

Units of

Beer (000)

industry, and the policy change involving this industry was the decision to open long-distance service to competition and to deregulate prices.

Prior to January 1, 1984, the only long-distance provider in the United States was AT&T. No other company could even offer to sell long-distance ser­vices. AT&T had a monopoly. It was the sole company in the industry.

Being a monopolist and left to its own devices, AT&T would have set a very high price for long-distance service, one that maximized its profits. To determine that price, AT&T would have estimated its marginal cost and marginal revenue and delivered that quantity of service at which the two were equal. We have already defined marginal cost. Marginal revenue is the change in a firm's rev­enues brought about by selling one more unit. Usually selling another unit means lowering prices. Thus, the marginal revenue is the net effect of selling the last unit and getting lower prices on all of the preceding ones. As long as mar­ginal revenue is greater than marginal cost, it is worth it to the firm to produce and sell that last unit.

As a monopolist, AT&T had a lot of power in the marketplace. A company acquires or achieves this power by developing products or services that no one else can match. Intel is not a monopolist, but it comes close to being one in the micro­processor market. Intel has achieved such a dominant position that it sets the prices for the whole industry. As a result, this firm has profit margins in excess of 60%. Intel got there by developing superior technology and by skillful marketing. So much of the software that people want to use in their PCs is based on the Intel processors that no other firm can develop a position to fight them. Other firms

have to compete aggressively on price; hence, they have lower profits and less abil­ity to develop new products. Intel uses its profits to stay ahead of the competition.

Unlike Intel, however, AT&T did not win its monopoly power by superior performance. The government gave AT&T its monopoly because it viewed a sin­gle supplier as socially efficient. Until recently, telephone service required wires or lines. It was considered wasteful to build multiple-line systems and, moreover, once a company had a network in place, it could manipulate prices to keep other competitors out. The cost of building a system was so great that anyone attracted to the industry by the high profits would have to make a significant investment to enter the market. Since the existing provider already had made the invest­ment, it could cut prices temporarily to discourage or damage new competitors. Situations like long-distance service were considered natural monopolies. The solution was to allow them to exist, but as regulated monopolies.

Regulators limited the profit that the monopolist could earn by establishing prices that were below the profit-maximizing price. In the case of long-distance service, the regulator was the Federal Communications Commission. The FCC tried to establish a price that was consistent with allowing AT&T shareholders a fair return on investment—a return that reflected the risk to the shareholders. Under this arrangement, long-distance prices were relatively stable. Changes needed to be approved by the regulator and were brought about either by AT&T demonstrating a change in its costs, which caused its supply curve to shift, or a change in the required or fair return demanded by the shareholders.

All of this changed dramatically when long-distance service was deregu­lated. In a complicated settlement, the entire telecommunications industry was suddenly restructured. The major factor leading to this change was the develop­ment of new technology, which allowed for alternative means of signal transmis­sion. Satellites, microwave, and other technologies meant that land-based transmission could be bypassed, opening long-distance service to competition.

As companies made the investments necessary to enter the market, a num­ber of things changed. First, prices and profits fell. The new competition forced AT&T to cut its prices as it attempted to hold onto market share. As prices fell, the amount of long-distance usage increased dramatically. Using supply and demand graphs, the new competition brought about an increase in supply (an outward shift of the curve). The new equilibrium was at a lower price and an increased quantity. However, the changes did not stop there. The competitors, including AT&T, began to offer better and expanded services. Also, because there was competition, the firms in the industry aggressively pursued new technology and lower costs. As costs fell, the supply curves moved out even farther, prices fell, and the rate usage increased (see Exhibit 6.5). Thus, by 1997, there were hundreds of providers of long-distance services, and the price per minute was


approximately 15. At that price, the quantity demanded was 220 million, in com­parison with a price of $.74 and quantity of 37.5 million prior to deregulation.

There are a number of lessons that can be learned from the AT&T case and the related supply and demand analysis. When a firm is able to gain competitive advantages, it can increase prices and profits. In fact, a measure of its competi­tive advantage is the level of profit margin compared with those earned by firms in more competitive industries. When prices are held at high levels because of regulation or monopoly power, then the quantity produced is lower than in more competitive industries. High profits attract competition. To maintain these prof­its, the monopolist or near monopolist must have some means of keeping new competitors out of the industry. The barrier to entry might be that the industry is regulated (e.g., AT&T) or that the technological lead of the dominant firm (e.g., Intel) is too great to overcome. There are many other possible barriers, but the point here is that firms strive to keep competition out because of the ability to earn superior returns, and the lure of these same returns makes maintaining a competitive advantage difficult.