D

etermination of the prices depends internal and external factors. Pricing goals

represents internal policy. Also, price policy should be aligned on several other factors.

Demand is the key determinant for market oriented company. Demand is the starting point for all activities. Simply, the average customer will be demanding different product quantities, depending on price. Law of the market says that demand and price are counter proportional ( price increase leads to demand decrease and vice versa ).

etermination of the prices depends internal and external factors.

Pricing goals represents internal policy. Also, price policy should be aligned on several other factors. Competition has a significant influence to price determination of market oriented companies. Prices need to be adjusted in order to address the competition. Every company should research market and competition, prior to launch of the new product. Survey should include direct competitors but also the substitutes. Based on market survey and the strength of the company the prices can be the same, lower or higher. Costs While demand and competition are external factor, the costs are internal. The costs must be embedded in every stage of price determination process. There are several methods of cost embedding into price: 1.) Costs Plus company calculates the costs and increase price for the specific profit. 2.) Markup price based on cost increased for amount of specific markup percentage. 3.) Target Return Method calculated required markup, in order to achieve return on investment. 4.) Profit Maximizing is the price where the marginal profit equals marginal cost.

5.) Breakeven Analysis is the number of units sold that generates profit that can cover cost. This point does not have profit nor lost. Life Cycle pricing approach analysis the current phase of product life in market. 1.) Entering phase usually requires higher sales prices in order to payback initial development costs. Also customers are willing to pay more for a new product. 2.) Growth phase is bringing the market stabilization. Prices are more or less stabile. 3.) Saturation phase leads to price decline, due to competition entrance and loss of consumer's interest 4.) Declining phase is the last part of product life cycle. Prices are still going down. Sales Channels have the different shopping occasion. Consequently the pricing is adjusted to sales channel. For example, the same products is cheaper in hypermarket than on petrol station. Government is usually do not interfere into price determination. Exceptionally it may limit maximal prices for a certain products. Still, government is influencing pricing, since the taxes & custom duties are the part of the price.

DEFINITION
A fair and reasonable price determination is an assessment by the Government that an offerors proposed price for a supply or service can be considered fair and reasonable on the basis of applying one or more price analysis techniques. FAR Part 15(Contracting by Negotiation) does not explicitly define the term fair and reasonable. The concept of a fair and reasonable price has elsewhere been described as the price that a prudent businessperson would pay for an item or service under competitive market conditions, given a reasonable knowledge of the marketplace. Regardless of the precise definition, the FAR clearly establishes the need for determining a price to be fair and reasonable price before a Government contracting officer or ordering officer may award contracts or place orders.

GENERAL INFORMATION/NARRATIVE
Background Fair and reasonable price determinations are used for evaluating quotations, bids, and proposals for the source selection decision. They are also used during sole-source negotiations. The policy of the U.S. Government is to contract for supplies and services at fair and reasonable prices. While buyers in the private sector are also interested in paying fair and reasonable prices, it is particularly important in Government procurement because of the scrutiny that Congress and the general public places on Government procurement. The Government is also interested in fair and reasonable price determinations to promote a healthy and efficient competitive sourcing environment. The Federal Acquisition Streamlining Act (FASA) of 1994 established a preference for the types of information used to assess price reasonableness. Techniques for Making a Fair and Reasonable Determination FASA made submission of cost or pricing data the least preferred method of determining price reasonableness. FAR 15.404-1(b)(2) lists seven price analysis techniques by which the Government can make a fair and reasonable price determination.

1. Comparison of proposed prices received in response to the solicitation. Normally, adequate price competition
establishes price reasonableness. This is the most commonly used technique, as the majority of Government procurement actions attract two or more offers that are competing independently for award.

2. Comparison of previously proposed prices and previous Government and commercial contract prices with 3. 4. 5. 6. 7.
current proposed prices for like items. Both the validity of the comparison and the reasonableness of the previous price(s) must be established. Use of parametric estimating methods/application of rough yardsticks to highlight significant inconsistencies that warrant additional pricing inquiry. Comparing the proposed price per square foot for a certain type of building construction against an established commercial standard is an example of this technique. Comparison with competitive published price lists, published market prices of commodities, similar indexes, and discount or rebate arrangements. The Government may be able to seek discounts from published price lists based on volume buying. Comparison of proposed prices with independent Government cost estimates. A contractor-developed cost estimate may not be used in lieu of a Government cost estimate. Comparison of proposed prices with prices obtained through market research for the same or similar items. Trade journals, newspapers, and economic indexes can provide useful comparative information. Analysis of pricing information provided by the offeror. This catch-all category includes information that does not fall into the other categories. The FAR identifies the first two techniques above as the preferred methods. However, if there is a lack of adequate price competition (first technique) or the contracting officer determines that information on previous contract prices is insufficient to determine a price to be fair and reasonable (second technique), the contracting officer must use one or more other techniques appropriate to the circumstance. For example: In response to a solicitation for identical quantities of a standard item, the Government receives three price quotes -- $450; $1,100, and $2,500. These prices are widely dispersed and appear to bear little correlation to one another. As a result, the first method for making a fair and reasonable determination would be inadequate. One or more other techniques (along with additional information) would be needed.

Different Types of Market Structure Introduction This report will look at the competition policy within the UK and state what it does within the different market structures. With this the report will show two examples of where the competition authorities have had to investigate. Also the report will use the supermarkets as an example and show how they are able to meet their company's objectives within their market structure.

The different Market structures =============================== In this section the report will look at the different market structures and show examples of the types of companies, which trade within them. Also the report will look at the advantages and disadvantages to each of the market structures.

Perfect competition =================== This market structure has a vast amount of companies with no barriers to entry new companies can join easily. Product pricing rarely changes, and is usually low, as no one company has the resources to develop the product or business image. E.g. advertising. The downside to this type of market is that there is little reason for competition, as the price will not have a significant difference when consumers go to a different company. Another is that there is no chance of the market being able to innovate as all business in the sector are small and cannot afford a research and development. Oligopoly Market An oligopoly market has a small number of firms, which are all able to make supernormal profits. The advantages are that these companies have the resources to reduce the price of their products, this can sometimes lead to price wars such as in the case of the big supermarkets. Also the supernormal profit can help innovate the market through research and development programs. As there a fewer firms the more market share there is between them and the more influence they can have on the market. Another advantage is that these companies do not always compete on price and sometimes try to entice customers into their shops through: Advertisements - showing their level of service is better than competitors. Celebrity endorsement - Jamie Oliver helps Sainsbury's through special advertisements and exclusive products with his name on. Loyalty card - Giving something back to the consumer every time they shop at their store. The downside is that the barrier to entry is very high and any company coming into the market would need a big backer or they would run the

risk of being squeezed out. Another real threat is the risk of two or more companies wanting to form collusions, which would affect the balance of market power in their favour.

Monopolistic Market =================== A company is classified as having a monopoly when it is either the only company within its market or holds over 70% of the market share. E.g. Microsoft is affectively a monopoly as almost every computer uses their Widow's operating system. The advantage to monopolistic company is that it is able to price its products at what ever it wants as no company can compete with them. Even though innovation is slow the company will still have a research and development section of their business. The downside to this is that there is almost no entry for new companies to join the market and the monopolistic company can be very wasteful. By this the report means that the company could be wasting money through slack working practises, bad deliveries, bad after care service, etc Looking at the different markets that businesses are in the report has found that for a company to succeed it needs a good amount of competition to keep the company working efficiently. The barriers of entry need to be low to allow new companies to enter, as they will bring in new competition and innovation. The amount of profit a company is able to receive should be high enough to allow them the chance to innovate the market with new products. The structure of the U.K. competition policy The Competition Act 1998 came into force on the 1 March 2000. When it was introduced in March the act added two main prohibitions: 1. Chapter 1 - prohibition of anti-competitive agreements, based closely on Article 81 of the EC treaty. 2. Chapter 2 - prohibition of abuse of a dominant position in a

market, based closely on Article 82 of the EC Treaty. The key aspects of the new legislation are: Anti-competitive agreements, cartels and abuses of a dominant position are now unlawful from the outset. Businesses, which infringe the prohibitions, are liable to financial penalties of up to 10% of UK turnover for up to 3 years. Competitors and customers are entitled to seek damages. The Director General of Fair Trading has new powers to step in at the outset to stop anti-competitive behaviour. Investigators are able to launch 'dawn raids', and to enter premises with reasonable force. The new leniency policy will make it easier for cartels to be exposed. The intention is to create a regulatory framework that is tough on those who seek to impair competition but allows those who do compete fairly the opportunity to thrive. (Information above retrieved from: http://www.dti.gov.uk/ccp/topics2/competition_act.htm) There are three main areas where the competitions authority will usually intervene with a business. These areas are: 1. Collusion - A secret agreement between two or more parties for a fraudulent, illegal, or deceitful purpose. This is usually on price of products and is done to stop the amount of competition between the companies and allow them to gain more market share over the companies not involved in the collusion. If companies are found to be colluding it means they are in breach of the chapter 1 prohibition in the Competition Act 1998. This means that the OFT (office of fair trading) has the power to impose fines of up to 10% of each companies turnover found to be colluding. 2. Abuse of market power - Where a company takes it on themselves to force their smaller suppliers to cut their prices, as they are

more powerful. Having a healthy sum of market power is not unlawful and usually there is always one market leader in any given market. It becomes illegal when a company starts to abuse its power by means of discrimination to suppliers, predatory pricing, etc By abusing their market power company's are in breach of Chapter 2 of the Competition Act 1998. If found in violation of this through investigation the OFT have the power to impose a fine of a maximum of 10% of the company's turnover. 3. Mergers - The union of two or more commercial interests or corporations. This can sometimes be beneficial to the market as it could generate more competition within the market. This was the case when Morrison's took over Safeway. As a result there are now four big players in the supermarket sector rather than 3 with one big market leader. With this though there are some mergers that make the amount of competition limited and this is where the OFT step in and start an investigation into whether or not it will affect the level of competition. In this area the OFT have the power to block the merger going ahead or impose key steps that both companies have to take before the merger can take place. Two examples of the OFT using their powers Here the report has shown two real examples of where the OFT have been informed of illegitimate trading and have establish an investigation. A copy of each example can be found in the appendix. 1. Record fines for toys price fixing (A copy can be found under appendix 1.0) This is a good example of Argos and Littlewoods forming a cartel, along with Hasbro (the toy manufacturer). The companies were found to have entered into an agreement to fix the price of Hasbro toys. By doing so it gave them a bigger amount of profit and market share from 1999 to 2001. From their investigation, the OFT found that they were in breach of chapter one of the competition act 1998. OFT took the action of fining both, Argos (17.28 million) and Littlewoods (5.37 million), but Hasbro was granted full leniency and did not have to pay any part of their initial fine of 15.59 million

due to their co-operation with the OFT's investigation. Although Hasbro had been given full leniency from the initial investigation they were still fined 4.95 million in November 2002 for their agreement with 10 distributors to not sell their toys below list price. 2. Scottish Newspaper group fined for predatory pricing (A copy can be found under appendix 2.0) Here the OFT were contacted to look into the Aberdeen Journal, which was, according to its competitors, to be predatory pricing its advertising space to cut out their only competitor of the market The Aberdeen & District Independent. The OFT found that the predatory pricing by the Aberdeen Journal had been going on since the Aberdeen & District Independent had been launched back in 1996. The predatory pricing was still taking place in 2000 with the Aberdeen Journal making losses. At this point the OFT were able to use their powers from the Competition Act 1998 as the newspaper had affectively broken both chapter 1 and 2 of the act. The OFT proceeded to use their powers and fined Aberdeen Journal 1.328 million in July 2001.

Market Structures - Summary

Another summary note on the key characteristics of market structure. Market structure is best defined as the organisational and other characteristics of a market. We focus on those characteristics which affect the nature of competition and pricing but it is important not to place too much emphasis simply on the market share of the existing firms in an industry. Traditionally, the most important features of market structure are:

The number of firms (including the scale and extent of foreign competition) The market share of the largest firms (measured by the concentration ratio see below) The nature of costs (including the potential for firms to exploit economies of scale and also the presence of sunk costs which affects market contestability in the long term) The degree to which the industry is vertically integrated - vertical integration explains the process by which different stages in production and distribution of a product are under

the ownership and control of a single enterprise. A good example of vertical integration is the oil industry, where the major oil companies own the rights to extract from oilfields, they run a fleet of tankers, operate refineries and have control of sales at their own filling stations.

The extent of product differentiation (which affects cross-price elasticity of demand) The structure of buyers in the industry (including the possibility of monopsony power) The turnover of customers (sometimes known as market churn) i.e. how many customers are prepared to switch their supplier over a given time period when market conditions change. The rate of customer churn is affected by the degree of consumer or brand loyalty and the influence of persuasive advertising and marketing

Summary of market structures

Characteristic Number of firms Type of product Barriers to entry Supernormal short run profit Supernormal long run profit Pricing Profit maximization? Non price competition Economic efficiency Innovative behaviour

Perfect Competition Many Homogenous None Price taker High Weak

Oligopoly Few Differentiated High Price maker Not always Low Very Strong

Monopoly One Limited High Price maker Usually, but not always Low Potentially strong

Market structure and innovation Which market conditions are optimal for effective and sustained innovation to occur? This is a question that has vexed economists and business academics for many years. High levels of research and development spending are frequently observed in oligopolistic markets, although this does not always translate itself into a fast pace of innovation. The recent work of William Baumol (2002) provides support for oligopoly as market structure best suited for innovative behaviour. Innovation is perceived as being mandatory for businesses that need to establish a cost-advantage or a significant lead in product quality over their rivals. As soon as quality competition and sales effort are admitted into the sacred precincts of theory, the price variable is ousted from its dominant position..But in capitalist reality as distinguished from its textbook picture, it is not that kind of competition which counts but the competition which commands a decisive cost or quality advantage and which strikes not at the margins of profits and the outputs of the existing firms but at their foundations and their very lives. This kind of competition is as much more effective than the other as a bombardment is in comparison with forcing a door Supernormal profits persist in the long-run in an oligopoly and these can be used to finance R&D Government policy and innovation in the economy

The current government places a huge emphasis on the potential value from more innovation across all sectors of the British economy. This is because of the economic gains that follow: For example: Improvements in the competitiveness of UK producers in home and overseas markets. Innovation helps to protect and develop comparative advantage. Higher productivity will keep down unit labour costs against the challenge of low-cost competition from emerging market economies. Innovation is a potential source of higher long-term trend growth indeed supply creates its own demand (Says Law) and can give businesses much higher rates of return on their investment than an expansion of their existing capacity and product range. Innovation can also create many thousands of new jobs even though some jobs may be lost because of the adoption of labour-saving technology. The new jobs emerge in training & other services together with the demand for labour that comes from expanding output to supply an expansion to new markets. There might also be significant social benefits (positive externalities) from innovative behaviour for example the delivery of new health treatments or innovations that provide safer forms of transport.

Government policy and innovation Supply-side strategies are usually linked directly with attempts to promote more innovative behaviour. Indeed the focus of government policy is firmly focused on improvements in the microeconomics of markets. Consider this extract from a recent speech by Gordon Brown If the past century of economic policymaking has taught us anything, it is that achieving strong long term growth often has less to do with macroeconomic policies that with good microeconomics, including fostering competitive markets that reward innovation and restricting government to only a limited role. Which policies might encourage more innovation? Tax credits / investment allowances Policies to encouragement small business creation and entrepreneurship Toughening up of competition policy to expose cartel behaviour, but to allow and promote joint ventures to fund research and development Lower corporation taxes to encourage innovative foreign companies to establish in Britain Increased funding for research in our universities

Important developments:

1. Increasingly most innovation is done by smaller firms indeed multinational corporations

are now out-sourcing their research and development spending to small businesses at home and overseas much is being shifted to cheaper locations offshorein India and Russia

2. Innovation is now a continuous process in part because the length of the product cycle
is getting shorter as innovations are rapidly copied by competitors, pushing down profit margins and (according to a recent article in the economist) transforming today's consumer sensation into tomorrow's commonplace commodity a good example of this is the introduction of two major competitors to the anti-impotence drug Viagra

3. Innovation is not something left to chance the most successful firms are those that
pursue innovation in a systematic fashion

4. Demand innovation is becoming more important: In many markets, demand is either

stable or in long-run decline. The response is to go for demand innovation - discovering new forms of demand from consumers and adapting an existing product to meet them the

toy industry is a classic example of this

5. Globalisation is driving innovation and not just in manufactured goods but across a vast
range of household and business services and in particular in high-value knowledge industries Classic examples of innovation first achieved by smaller firms: Air-conditioning Hydraulic brakes Digital X-Rays Soft contact lenses Quick frozen food Zip fastener

The notion of competition is very widely used in economics in general and in microeconomics in particular. Competition is also considered the basis for capitalist or free market economies. In standard usage of the term, competition may also imply certain virtues. Markets are the heart and soul of a capitalist economy, and varying degrees of competition lead to different market structures, with differing implications for the outcomes of the market place. This entry will discuss the following market structures that result from the successively declining degrees of competition in the market for a particular commodity. These elements are perfect competition, monopolistic competition, oligopoly, and monopoly. Based on the differing outcomes of different market structures, economists consider some market structures more desirable, from the point of view of the society, than others.

CHARACTERISTICS OF A MARKET STRUCTURE

Each of the above mentioned market structures describes a particular organization of a market in which certain key characteristics differ. The characteristics are: (a) number of firms in the market, (b) control over the price of the relevant product, (c) type of the product sold in the market, (d) barriers to new firms entering the market, and (e) existence of nonprice competition in the market. Each of these characteristics is briefly discussed below.

NUMBER OF FIRMS IN THE MARKET.

The number of firms in the market supplying the particular product under consideration forms an important basis for classifying market structures. The number of firms in an

industry, according to economists, determines the extent of competition in the industry. Both in perfect competition and monopolistic competition, there are large numbers of firms or suppliers. Each of these firms supplies only a small portion of the total output for the industry. In oligopoly, there are only a few (presumably more than two) suppliers of the product. When there are only two sellers of the product, the market structure is often called duopoly. Monopoly is the extreme case where there is only one seller of the product in the market.

CONTROL OVER PRODUCT PRICE.

The extent to which an individual firm exercises control over the price of the product it sells is another important characteristic of a market structure. Under perfect competition, an individual firm has no control over the price of the product it sells. A firm under monopolistic competition or oligopoly has some control over the price of the product it sells. Finally, a monopoly firm is deemed to have considerable control over the price of its product.

TYPE OF THE PRODUCT SOLD IN THE MARKET.

The extent to which products of different firms in the industry can be differentiated is also a characteristic that is used in classifying market structures. Under perfect competition, all firms in the industry sell identical products. In other words, no firm can differentiate its product from those of other firms in the industry. There is some product differentiation under monopolistic competitionthe firms in the industry are assumed to produce somewhat different products. Under an oligopolistic market structure, firms may produce differentiated or identical products. Finally, in the case of a monopoly, product differentiation is not truly an issue, as there is only one firmthere are no other firms from whom it should differentiate its product.

BARRIERS TO NEW FIRMS ENTERING THE MARKET.

The difficulty or ease with which new firms can enter the market for a product is also a characteristic of market structures. New firms can enter market structures classified as perfect competition or monopolistic competition relatively easily. In these cases, barriers to entry are considered low, as only a small investment may be required to enter the market. In oligopoly, barriers to entry is considered very highhuge amounts of investment, determined by the very nature of the product and the production process,

are needed to enter these markets. Once again, monopoly constitutes the extreme case where the entry of new firms is blocked, usually by law. If for whatever reasons, new firms are allowed to enter a monopolistic market structure, it can no longer be termed a monopoly.

EXISTENCE OF NON-PRICE COMPETITION.

Market structures also differ to the extent that firms in industry compete with each other on the basis of non-price factors, such as, differences in product characteristics and advertising. There is no non-price competition under perfect competition. Firms under monopolistic competition make considerable use of instruments of non-price competition. Oligopolistic firms also make heavy use of non-price competition, Finally, while a monopolist also utilizes instruments of non-price competition, such as advertising, these are not designed to compete with other firms, as there are no other firms in the monopolist's industry. We now turn to discussing each of the four market forms mentioned at the beginning, in light of the preceding characteristics used to classify market structures. The discussion that follows also provides additional details about the four market structures.

PERFECT COMPETITION
Perfect competition is an idealized version of market structure that provides a foundation for understanding how markets work in a capitalist economy. The other market structures can also be understood better when perfect competition is used as a standard of reference. Even so, perfect competition is not ordinarily well understood by the general public. For example, when business people speak of intense competition in the market for a product, they are, in all likelihood, referring to rival suppliers, about whom they have quite a bit of information. However, when economists refer to perfect competition, they are particularly referring to the impersonal nature of this market structure. The impersonality of the market organization is due to the existence of a large number of suppliers of the productthere are so many suppliers in the industry that no firm views another supplier as a competitor. Thus, the competition under perfect competition is impersonal. To understand the nature of competition under the perfectly competitive market form, one should briefly examine the three conditions that are necessary before a market

structure is considered "perfectly competitive." These are: homogeneity of the product sold in the industry, existence of many buyers and sellers, and perfect mobility of resources or factors of production. Homogeneity of product means that the product sold by any one seller in the market is identical to the product sold by any other supplier. The homogeneity of product has an important implication for the market: if products of different sellers are identical, buyers do not care who they buy from, so long as the price is also the same. While the first condition of a perfect market sounds extreme, it is, in fact, met in markets for many products. Wheat and corn are good examples. Wheat and corn produced by different farmers is essentially the same, and can thus be considered identical. The second condition, existence of many buyers and sellers, again leads to an important outcome. When there is a large number of buyers or sellers, each individual buyer or seller is so small relative to the entire market that he or she does not have any power to influence the price of the product under consideration. As a result, whether a person is a buyer or a seller, he or she must accept the market price. All buyers and sellers in the market are effectively price takers, not price makers. The market as a whole establishes product prices, and individual buyers or sellers simply decide how much to buy or sell at the given market price. The third condition, perfect mobility of resources, requires that all factors of production (resources used in the production process) can be readily switched from one use to another. Furthermore, it is required that all buyers, sellers, and owners of resources have full knowledge of all relevant technological and economic data. The implication of the third condition is that resources move to the most profitable industry. No industry in the world (now or in the past) satisfies all three conditions stipulated above fully. Thus, no industry in the world can be considered perfectly competitive in the strictest sense of the term. However, there are token examples of industries that come quite close to being a perfectly competitive market. Some markets for agricultural commodities, while not meeting all three conditions, come reasonably close to being characterized as perfectly competitive markets. The market for wheat, for example, can be considered a reasonable approximation. The wheat market is characterized by an almost homogenous product, and it has a large number of buyers and sellers. It thus

satisfies the first two conditions fairly well. However, it is difficult to assert that resources employed in the wheat industry are perfectly mobile. Despite the fact that no industry is truly perfectly competitive, it is still worthwhile to study perfect competition as a market structure. Conclusions derived from the study of the idealized version of perfect competition are often helpful in explaining behavior in the real world.

THE ECONOMICS OF PERFECT COMPETITION.

The study of the idealized version of perfect competition leads to some important conclusions regarding solutions to key economic problems, such as quantity of the relevant product produced, price charged, the mechanism of adjustment in the industry. As mentioned earlier, under perfect competition, an individual supplier of the product has to take the market price as given. Given this price, the supplier determines how much to produce and sell. The quantity he or she decides to produce is the quantity that maximizes profit for the firm (more technically, where marginal cost of producing the product equals the market price of the product). The total production of all firms in the industry determines the market supply of the product under consideration. This market supply of the product, in conjunction with the total demand for the product by all consumers, determines the market price. Thus, while an individual buyer or seller is a price taker, the collective decisions affect the market price. Since the consumers of the product receive a price that is equal to the cost of production (on the margin), it is argued that consumers are treated fairly under perfect competition. In addition, the total output produced under perfect competition is larger than, for example, under monopoly. To understand this, we should look at the mechanics of maximizing profit, the guiding force behind a supplier's output decision. In order to maximize profits, a supplier has to look at cost and revenue. Usually, it is assumed that a supplier's marginal cost (the cost of producing an additional unit of the product under consideration) rises ultimately. The producer then, in making the output decision, must compare the cost of producing an additional unit of the product with the revenue the sale of that additional unit (called the marginal revenue) brings to the firm. So long as the marginal revenue from the sale exceeds the marginal cost, there is a gain from producing that additional unitthe unit adds more to revenue (proceeds) than to costs.

The supplier will continue producing while the process is profitable (i.e., it increases profits or reduces loss). The firm will stop production where marginal revenue equals marginal costthis output level maximizes profits (or minimizes loss). In the case of a perfectly competitive firm, the market price for the product is also the marginal revenue. Since the firm is a price taker and supplies an insignificant portion of the total market supply of the product, it can sell as many units of the product as it desires at the going price. We will later show that this is not the case with a monopolist, for example. A monopolist stops production of the product before reaching the point where marginal cost of the product equals the market price of the product.

THE DESIRABILITY OF PERFECT COMPETITION.

Perfect competition is considered desirable for society for at least two reasons. First, the price charged to individuals equals the marginal cost of production to each firm. In other words, one can say sellers charge buyers a reasonable or fair price. Second, in general, output produced under a perfectly competitive market structure is larger than other market organizations. Thus, perfect competition becomes desirable also for the amount of the product supplied to consumers as a whole. These are two reasons why a capitalist society adores the virtues of perfect competition. In fact, to maintain a reasonable amount of competition in a market is generally considered a goal of government regulatory policies. No single firm dominates the market under perfect competition; this parallels the status of an individual citizen in a democracy, a widely practiced form of government in capitalist countries.

MONOPOLISTIC COMPETITION
As pointed out above, industries in the real world rarely satisfy the stringent conditions necessary to qualify as perfectly competitive market structures. The world in which we live is invariably characterized by competition of lesser degrees than stipulated by perfect competition. Many industries that we often deal with have market structures that are monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition.

MAJOR CHARACTERISTICS OF MONOPOLISTIC COMPETITION.

As in the case of perfect competition, monopolistic competition is characterized by the existence of many sellers. Usually, if an industry has 50 or more firms (producing products that are close substitutes of each other), it is said to have a large number of firms. However, the number of firms must be large enough that each firm in the industry can expect its actions go unnoticed by rival firms. Unlike perfect competition, the sellers under monopolistic competition differentiate competitive product. In other words, the products of these firms are not considered identical. It is, in fact, immaterial whether these products are actually different or simply perceived to be so. So long as consumers treat them as different products, they satisfy one of the characteristics of monopolistic competition. This product differentiation is considered a key attribute of monopolistic competition. In many U.S. markets, producers practice product differentiation by altering the physical composition, using special packaging, or simply claiming to have superior products based on brand images and/or advertising. Toothpastes and toilet papers are examples of differentiated products. In addition to the existence of a large number of firms and product differentiation, relative ease of entry into the industry is considered another important requirement of a monopolistically competitive market organization. Also, there should be no collusion among firms in the industry, like price fixing or agreements regarding the market shares of individual companies. With the large number of firms that monopolistic competition requires, collusion is generally difficult, though not impossible. The above mentioned characteristics of monopolistic competition basically yield a market form that is very competitive, but probably not to the extent of perfect competition.

THE ECONOMICS OF MONOPOLISTIC COMPETITION.

As in the case of perfect competition, a firm under monopolistic competition decides about the quantity of the product produced on the basis of the profit maximization principleit produces the quantity that maximizes the firm's profit. Also, conditions of profit maximization remain the samethe firm stops production where marginal revenue equals marginal cost of production. But unlike perfect competition, a firm under monopolistic competition has some control over the price it charges, as the firm

differentiates its products from those of others. However, this price making power of a monopolistically competitive firm is rather small, since there are a large number of other firms in the industry with somewhat similar products. Remember that a perfectly competitive firm has no price making powereach firm is a price taker, as it produces a product identical to those produced by a large number of other firms in the industry. An important consequence of the price making power of a monopolistically competitive firm is that when such a firm reduces price, it can attract customers buying other "brands" of the product. The opposite is also true when the firm increases the price it charges for its product. Because of this, price charged for a product is different from the marginal revenue for the product (marginal revenue refers to the increase in total revenue as a result of selling one more unit of the product under consideration). To understand this, consider, for example, that a firm reduces the price for its product. The firm must now sell all units at this lower price. Because the lower price applies to all units sold, not just the last or the marginal unit, price for the product is higher than the marginal revenue at each level of sale. It should be noted that as there are a large number of firms under monopolistic competition, individual firms in the industry are not appreciably affected by a particular firm's behavior. As mentioned above, a monopolistically competitive firm stops production where marginal revenue equals marginal cost of productionthe output level that maximizes its profits (often called the equilibrium output for the firm).

THE DESIRABILITY OF MONOPOLISTIC COMPETITION.

Aforementioned profit maximizing behavior of a monopolistically competitive firm implies that now the price associated with the product (at the equilibrium or the profit maximizing output) is higher than marginal cost (which equals marginal revenue). Thus, the production under monopolistic competition does not take place to the point where price equals marginal cost of production. Remember that, with increased production, price charged (which is higher than marginal revenue at every level of output) is successively falling while the marginal cost of production is rising. Therefore, if a monopolistically competitive firm were to stop production where price is equal to marginal cost (a condition met under a perfectly competitive market structure), output produced would be greater than when it stops production where marginal revenue equals marginal cost (its profit maximizing output). The net result of the profit

maximizing decisions of monopolistically competitive firms is that price charged under monopolistic competition is higher than under perfect competition. In addition, quantity of the commodity produced under monopolistic competition is simultaneously lower. Thus, both on the basis of price charged and output produced, monopolistic competition is less socially desirable than perfect competition.

OLIGOPOLY
Oligopoly is a fairly common market organization. In the United States, both the steel and auto industries (with three or so large firms) provide good examples of oligopolistic market structures.

MAJOR CHARACTERISTICS OF OLIGOPOLY.

An important characteristic of an oligopolistic market structure is the interdependence of firms in the industry. The interdependence, actual or perceived, arises from the small number of firms in the industry. However, unlike monopolistic competition, if an oligopolistic firm changes its price or output, it has perceptible effects on the sales and profits of its competitors in the industry. Thus, an oligopolist firm always considers the reactions of its rivals in formulating its pricing or output decisions. There are huge, though not insurmountable, barriers to entering an oligopolistic market. These barriers can involve large financial requirements, availability of raw materials, access to the relevant technology, or simply patent rights of the firms currently in the industry. Several industries in the United States provide good examples of oligopolistic market structures with obvious barriers to entry. The U.S. auto industry provides an example of a market where financial barriers to entry exist. In order to efficiently operate an automobile plant, one needs upward of half a billion dollars of initial investment. The steel industry in the United States, on the other hand, provides an example of an oligopoly where barriers to entry have been created by the ownership of raw materials needed for producing the product. In this industry, a few huge firms own most of the available iron ore, a necessary raw material for steel production. An oligopolistic industry is also typically characterized by economies of scale. Economies of scale in production imply that as the level of production rises the cost per unit of product falls for the use of any plant (generally, up to a point). Thus, economies of scale lead to an obvious advantage for a large producer. Once again, the automobile

industry provides an example of a market structure where firms experience economies of scale. It should be noted that there may exist economies of scale in promotion just as there exist economies of scale in production. In the automobile industry, the promotion cost per unit of product falls as sales increase since promotion costs rise less than proportionately to sales.

ECONOMICS AND DESIRABILITY OF OLIGOPOLY.

There is no single theoretical framework that provides answers to output and pricing decisions under an oligopolistic market structure. Analyses exist only for special sets of circumstances. For example, if an oligopolistic firm cuts its price, it is met with price reductions by competing firms; however, if it raises the price of its product, rivals do not match the price increase. For this reason, prices may remain stable in an oligopolistic industry for a prolonged period of time. It is hard to make concrete statements regarding price charged and quantity produced under oligopoly. However, from the point of view of the society, one can say that an oligopolistic market structure provides a fair degree of competition in the market place if the oligopolists in the market do not collude. Collusion occurs if firms in the industry agree to set price and/or quantity. In the United States, there are laws that make collusion illegal.

MONOPOLY
Monopoly can be considered the opposite of perfect competition. It is a market form in which there is only one seller. While at first glance a monopoly may appear to be a rare market structure, it is not so. Several industries in the United State have monopolies. Some utility companies provide examples of a monopolist.

CAUSES AND CHARACTERISTICS OF MONOPOLY.

There are many factors that give rise to a monopoly. For example, in the United States the inventor of an item has the exclusive right to produce that product for 17 years. Thus, a monopoly can exist in an industry because a patent was obtained for a product by its inventor. The United Shoe Machinery Company held such a monopoly in certain important shoe making equipment until 1954, when the monopoly was broken under the antitrust laws. A monopoly can also arise if a company owns the entire supply of a necessary material needed to produce a product. The Aluminum Company of America

exercised such power until 1945, when its monopoly was also broken under provisions of the antitrust laws. A monopoly can be legally created by a government agency when it sells a market franchise a particular product or service. Often a monopoly so established is also regulated by the appropriate government agency. Provision of local telephone service in the United States provides an example of such a monopoly. Finally, a monopoly may arise due to declining cost of production for a particular product. In such a case the average cost of production falls and reaches a minimum at an output level that is sufficient to satisfy the entire market. In such an industry, rival firms will be eliminated until only the strongest firm (now the monopolist) is left in the market. This is often called a case of natural monopoly. A good example of a natural monopoly is the electricity industry. The electric power industry reaps benefits of economies of scale and yields decreasing average cost. A natural monopoly is usually regulated by the government.

THE ECONOMICS OF MONOPOLY.

Generally speaking, price and output decisions of a monopolist are similar to those of a monopolistically competitive firm, with the major distinction of a large number of firms under monopolistic competition and only one firm under monopoly. Thus, one may technically say that there is no competition under monopoly. This is not strictly true, as even a monopolist is threatened by indirect and potential competition. Like monopolistic competition, a monopolistic firm also maximizes its profits by producing up to the point where marginal revenue equals marginal cost. As the monopolist is a price maker and can increase the amount of sales by lowering the price, a monopolist does not lure consumers away from rivals, rather he or she induces them to buy more. Nevertheless, at any output level, the price charged by a monopolist is higher than the marginal revenue. As a result, a monopolist also does not produce to the point where price equals marginal cost (a condition met under a perfectly competitive market structure).

DESIRABILITY OF MONOPOLY.
An industry characterized by a monopolistic market structure produces less output and charges higher prices than under perfect competition (and presumably under monopolistic competition). Thus, on the basis of price charged and quantity produced, a

monopoly is less desirable socially. However, a natural monopoly is generally considered desirable if the monopolist's price behavior can be regulated.

SUMMARY
Industry in the real world is rarely characterized by perfect competition. In certain circumstances, society has to tolerate monopoly (say, the case of a natural monopoly or a monopoly due to patent rights). However, the idea of competition is very deeply ingrained in society. So long as there is a reasonable degree of competition (as in the case of monopolistic competition or oligopoly), society feels reasonably secure with respect to the working of its markets.

efine Market Structure

By Jeanne Grunert

Both economists and marketers define market structure, but each defines the term a bit differently. Economists look at the overall market structure with the goal of defining and predicting consumer behavior. Marketing managers seek to define market structure to create competitive strategies as part of an overall marketing plan. In both cases, managers define market structure with the

understanding that market structure is fluid. What the market looks like today, and what it looks like tomorrow, may be two completely different pictures.

Economists Define Market Structure

Economists examine market structure to help with decision-making. Economists seek to analyze broad trends to understand consumer motivation. While marketers also look at this too, economists tend to focus on the big picture. They want to know how this information affects large segments of the population. Marketers are keen to understand the information and apply it to their particular product, company, ormarketing situation.

The Four Major Market Structures

Talk to an economist and she'll define market structure according to how the industry serving the market is arranged. In economics, there are four general market structures. These four are:

Monopoly: A monopoly exists when one company and one only provides services in a particular industry, or one company dominates and consumers cannot substitute anything that comes close. Today, very few industries are monopolies. Utility companies such as water companies or electric companies may be considered monopolies. Consumers can't exactly substitute something else for electricity from the local provider, unless they switch to firewood and candles!

Oligopoly: An oligopoly consists of only a handful of companies selling similar products. Consumers can substitute products, but only one company's offerings for another. An example would be the three big American car companies of today: Ford, GM and Chrysler.

Monopolistic Competition: In monopolistic competition, many sellers sell different products. It's very similar to competition, below, with the exception that the products themselves are a bit different from one another, so consumers look for those differences rather than price differences. An example is the restaurant industry. Anyone can obtain the proper permits, licenses and such and open a restaurant offering any cuisine or food in the world. Whether the restaurant is successful or not depends upon whether or not consumers like the food, service, dcor, location, and all the other factors that make restaurants successful.

Competition: In markets with perfect competition, there are no barriers to entry, and many offering different goods. Consumers often shop on price differences alone. Wal Mart

may be viewed as a purely competitive company within the grocery industry for its super centers that offer lower prices than competing grocery chains.

Marketers and Market Structures

Marketing managers define market structure a little differently than economists. While knowing if their industry is an oligopoly or a purely competitive environment is important, marketers dig deeper into the industry, searching for the market structure to understand the competition and customer behavior.

Market Structure and Competition

Understanding the market structure and landscape helps marketers develop marketing plans and enact successful marketing strategies. As part of a business plan, a definition of the market structure and competitive landscape is vital to planning effective advertising or other marketing campaign. To define market structure from a marketing perspective, ask the following questions: Who is the top player in this market? When you look at the business category, what company or companies stand out? Among booksellers, the obvious choice is Amazon, Barnes & Nobles, and Borders. Examine your own industry and define the top layer of the competitive pyramid with the top player or players. Who are their competitors? Now who's playing among the second, third, and fourth tier? Who is online in this category, and who has only brick and mortar stores? Can you research their gross revenues, their marketing plans? That may not be as far-fetched as it sounds. Using any search engine, type in the company names and see what comes up. Publicly traded companies (companies traded on one of the stock exchanges) must publish Annual Reports. These provide potential investors with detailed information on the company from finances to marketing strategies, but they're free, public knowledge, so you can gather them online, read them, and distill your competitor's marketing strategies from them. Many companies divulge juicy bits of competitive intelligence in their press releases. Releases are often archived on their websites, providing another glimpse into their strategies. Who will be the local competitors? If you are competing locally with a brick and mortar store, pay particular attention to local competition. Marketers look across the various companies in these categories of competition and examine the goods and services offered. They look at the four P's of marketing among the competitors: product, price, place and promotion. They seek to use this information to help them form their own strategies to drive customer acquisition, retention, and overall profitability.

Defining Market Structure Isn't Always Easy

Defining market structure isn't always easy. Definitions remain fluid and subject to change among various disciplines, such as economists and marketers, and even different companies may view market structure differently. For the small business owner or entrepreneur, focusing on market structure with an eye towards defining the competition, suppliers and other factors helps focus the marketing strategy to pinpoint potential strengths, weaknesses, opportunities and threats. Define market structure in the way that makes the most sense to your business opportunity or the topic at hand.

Economics Basics: Demand and Supply

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Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply. A. The Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C). B. The Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.) Time and Supply Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand. C. Supply and Demand Relationship Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price. Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied. If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high. D. Equilibrium When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. E. Disequilibrium Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*. 1. Excess Supply If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high. 2. Excess Demand Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.

F. Shifts vs. Movement For economics, the movements and shifts in relation to the supply and demand curves represent very different market phenomena:

1. Movements A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

2. Shifts A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in

the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.

Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.

Review of the Laws of Supply and Demand The Law of Supply states that at higher prices, producers are willing to offer more products for The Law of Demand states that people will buy more of a product

sale than at lower prices states that the supply increases as prices increase and decreases as prices decrease states that those already in business will try to increase productions as a way of increasing profits

at a lower price than at a higher price, if nothing changes states that at a lower price, more people can afford to buy more goods and more of an item more frequently, than they can at a higher price states that at lower prices, people tend to buy some goods as a substitute for others more expensive

Economics Basics: Elasticity

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The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. To determine the elasticity of the supply or demand curves, we can use this simple equation:

Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic. As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

A. Factors Affecting Demand Elasticity There are three main factors that influence a demand's price elasticity: 1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes. 2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel. Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven - highly elastic. With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.

Economics Basics: Utility

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We have already seen that the focus of economics is to understand the problem of scarcity: the problem of fulfilling the unlimited wants of humankind with limited and/or scarce resources. Because of scarcity, economies need to allocate their resources efficiently. Underlying the laws of demand and supply is the concept of utility, which represents the advantage or fulfillment a person receives from consuming a good or service. Utility, then, explains how individuals and economies aim to gain optimal satisfaction in dealing with scarcity.

Utility is an abstract concept rather than a concrete, observable quantity. The units to which we assign an amount of utility, therefore, are arbitrary, representing a relative value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility corresponds to the person's level of consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption. Although total utility usually increases as more of a good is consumed, marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed. Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day.

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units. The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you

demand more. In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.

Economics Basics: Monopolies, Oligopolies and Perfect Competition

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Economists assume that there are a number of different buyers and sellers in the marketplace. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price.

In some industries, there are no substitutes and there is no competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control price, meaning that a consumer does not have choice, cannot maximize his or her total utility and has have very little influence over the price of goods. A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and

prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits.

Economics Basics: Conclusion

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We hope that this has given you some insight to the market and, in turn, your investment strategies. Let's recap what we've learned in this tutorial: Economics is best described as the study of humans behaving in response to having only limited resources

to fulfill unlimited wants and needs. Scarcity refers to the limited resources in an economy. Macroeconomics is the study of the economy as a whole. Microeconomics analyzes the individual people and companies that make up the greater economy. The Production Possibility Frontier (PPF) allows us to determine how an economy can allocate its resources in order to achieve optimal output. Knowing this will lead countries to specialize and trade products amongst each other rather than each producing all the products it needs. Demand and supply refer to the relationship price has with the quantity consumers demand and the quantity supplied by producers. As price increases, quantity demanded decreases and quantity supplied increases. Elasticity tells us how much quantity demanded or supplied changes when there is a change in price. The more the quantity changes, the more elastic the good or service. Products whose quantity supplied or demanded does not change much with a change in price are considered inelastic. Utility is the amount of benefit a consumer receives from a given good or service. Economists use utility to determine how an individual can get the most satisfaction out of his or her available resources. Market economies are assumed to have many buyers and sellers, high competition and many substitutes. Monopolies characterize industries in which the supplier determines prices and high barriers prevent any competitors from entering the market. Oligopolies are industries with a few interdependent companies. Perfect competition represents an economy with many businesses competing with one another for consumer interest and profits.

Supply and demand

From Wikipedia, the free encyclopedia

For other uses, see Supply and demand (disambiguation).

The price P of a product is determined by a balance between production at each price (supply S) and the desires of those withpurchasing power at each price (demand D). The diagram shows a positive shift in demand from D1 to D2, resulting in an increase in price (P) and quantity sold (Q) of the product.

Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium of price and quantity. The four basic laws of supply and demand are:[1] 1. If demand increases and supply remains unchanged, then it leads to higher equilibrium price and quantity. 2. If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and quantity. 3. If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity. 4. If supply decreases and demand remains unchanged, then it leads to higher price and lower quantity.
Contents
[hide]

1 The graphical representation of supply and demand

1.1 Supply schedule 1.2 Demand schedule

2 Microeconomics

2.1 Equilibrium

3 Changes in market equilibrium

3.1 Demand curve shifts 3.2 Supply curve shifts

4 Elasticity

4.1 Vertical supply curve (perfectly inelastic supply)

5 Other markets 6 Empirical estimation 7 Macroeconomic uses of demand and supply 8 History 9 Criticism

9.1 Economies of scale: Mass production

10 See also 11 References 12 External links

[edit]The

graphical representation of supply and demand

The supply-demand model is a partial equilibrium model representing the determination of the price of a particular good and the quantity of that good which is traded. Although it is normal to regard the quantity demanded and the quantity supplied as functions of the price of the good, the standard graphical representation, usually attributed to Alfred Marshall, has

price on the vertical axis and quantity on the horizontal axis, the opposite of the standard convention for the representation of a mathematical function. Determinants of supply and demand other than the price of the good in question, such as consumers' income, input prices and so on, are not explicitly represented in the supplydemand diagram. Changes in the values of these variables are represented by shifts in the supply and demand curves. By contrast, responses to changes in the price of the good are represented as movements along unchanged supply and demand curves.
[edit]Supply

schedule

The supply schedule, depicted graphically as the supply curve, represents the amount of some good that producers are willing and able to sell at various prices, assuming ceteris paribus, that is, assuming all determinants of supply other than the price of the good in question, such as technology and the prices of factors of production, remain the same. Under the assumption of perfect competition, supply is determined by marginal cost. Firms will produce additional output as long as the cost of producing an extra unit of output is less than the price they will receive. By its very nature, conceptualizing a supply curve requires that the firm be a perfect competitorthat is, that the firm has no influence over the market price. This is because each point on the supply curve is the answer to the question "If this firm is faced with this potential price, how much output will it be able to and willing to sell?" If a firm has market power, so its decision of how much output to provide to the market influences the market price, then the firm is not "faced with" any price, and the question is meaningless. Economists distinguish between the supply curve of an individual firm and the market supply curve. The market supply curve is obtained by summing the quantities supplied by all suppliers at each potential price. Thus in the graph of the supply curve, individual firms' supply curves are added horizontally to obtain the market supply curve. Economists also distinguish the short-run market supply curve from the long-run market supply curve. In this context, two things are assumed constant by definition of the short run: the availability of one or more fixed inputs (typically physical capital), and the number of firms in the industry. In the long run, firms have a chance to adjust their holdings of physical capital, enabling them to better adjust their quantity supplied at any given price. Furthermore, in the long run potential competitors can enter or exit the industry in response to market conditions. For both of these reasons, long-run market supply curves are flatter than their short-run counterparts.

The determinants of supply follow: 1. Production costs 2. The technology used in production 3. The price of related goods 4. Firm's expectations about future prices 5. Number of suppliers
[edit]Demand

schedule

The demand schedule, depicted graphically as the demand curve, represents the amount of some good that buyers are willing and able to purchase at various prices, assuming all determinants of demand other than the price of the good in question, such as income, tastes and preferences, the price of substitute goods, and the price of complementary goods, remain the same. Following the law of demand, the demand curve is almost always represented as downward-sloping, meaning that as price decreases, consumers will buy more of the good.[2] Just as the supply curves reflect marginal cost curves, demand curves are determined by marginal utility curves.[3] Consumers will be willing to buy a given quantity of a good, at a given price, if the marginal utility of additional consumption is equal to the opportunity cost determined by the price, that is, the marginal utility of alternative consumption choices. The demand schedule is defined as the willingness and ability of a consumer to purchase a given product in a given frame of time. As described above, the demand curve is generally downward-sloping. There may be rare examples of goods that have upward-sloping demand curves. Two different hypothetical types of goods with upward-sloping demand curves are Giffen goods (an inferior but staple good) and Veblen goods (goods made more fashionable by a higher price). By its very nature, conceptualizing a demand curve requires that the purchaser be a perfect competitorthat is, that the purchaser has no influence over the market price. This is because each point on the demand curve is the answer to the question "If this buyer is faced with this potential price, how much of the product will it purchase?" If a buyer has market power, so its decision of how much to buy influences the market price, then the buyer is not "faced with" any price, and the question is meaningless. As with supply curves, economists distinguish between the demand curve of an individual and the market demand curve. The market demand curve is obtained by summing the

quantities demanded by all consumers at each potential price. Thus in the graph of the demand curve, individuals' demand curves are added horizontally to obtain the market demand curve. The determinants of demand follow: 1. Income 2. Tastes and preferences 3. Prices of related goods and services 4. Buyer's expectations about future prices 5. Number of Buyers
[edit]Microeconomics [edit]Equilibrium

Equilibrium is defined to the price-quantity pair where the quantity demanded is equal to the quantity supplied, represented by the intersection of the demand and supply curves. Market Equilibrium: A situation in a market when the price is such that the quantity that consumers wish to demand is correctly balanced by the quantity that firms wish to supply. Comparative static analysis: Examines the likely effect on the equilibrium of a change in the external conditions affecting the market.
[edit]Changes

in market equilibrium

Practical uses of supply and demand analysis often center on the different variables that change equilibrium price and quantity, represented as shifts in the respective curves. Comparative statics of such a shift traces the effects from the initial equilibrium to the new equilibrium.
[edit]Demand

curve shifts

Main article: Demand curve

An outward (rightward) shift in demand increases both equilibrium price and quantity

When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. A movement along the curve is described as a "change in the quantity demanded" to distinguish it from a "change in demand," that is, a shift of the curve. there has been an increase in demand which has caused an increase in (equilibrium) quantity. The increase in demand could also come from changing tastes and fashions, incomes, price changes in complementary and substitute goods, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Note in the diagram that the shift of the demand curve, by causing a new equilibrium price to emerge, resulted in movement along the supply curve from the point (Q1, P1) to the point Q2, P2). If the demand decreases, then the opposite happens: a shift of the curve to the left. If the demand starts at D2, and decreases to D1, the equilibrium price will decrease, and the equilibrium quantity will also decrease. The quantity supplied at each price is the same as before the demand shift, reflecting the fact that the supply curve has not shifted; but the equilibrium quantity and price are different as a result of the change (shift) in demand.

The movement of the demand curve in response to a change in a non-price determinant of demand is caused by a change in the x-intercept, the constant term of the demand equation.
[edit]Supply

curve shifts

Main article: Supply (economics)

An outward (rightward) shift in supply reduces the equilibrium price but increases the equilibrium quantity

or when technological progress occurs, the supply curve shifts. For example, assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2an increase in supply. This increase in supply causes the equilibrium price to decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as consumers move along the demand curve to the new lower price. As a result of a supply curve shift, the price and the quantity move in opposite directions.

If the quantity supplied decreases, the opposite happens. If the supply curve starts at S2, and shifts leftward to S1, the equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded. The quantity demanded at each price is the same as before the supply shift, reflecting the fact that the demand curve has not shifted. But due to the change (shift) in supply, the equilibrium quantity and price have changed. The movement of the supply curve in response to a change in a non-price determinant of supply is caused by a change in the y-intercept, the constant term of the supply equation.

The supply curve shifts up and down the y axis as non-price determinants of demand change.
[edit]Elasticity

Main article: Elasticity (economics) Elasticity is a central concept in the theory of supply and demand. In this context, elasticity refers to how strongly the quantities supplied and demanded respond to various factors, including price and other determinants. One way to define elasticity is the percentage change in one variable (the quantity supplied or demanded) divided by the percentage change in the causative variable. For discrete changes this is known as arc elasticity, which calculates the elasticity over a range of values. In contrast, point elasticity uses differential calculus to determine the elasticity at a specific point. Elasticity is a measure of relative changes. Often, it is useful to know how strongly the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand or the price elasticity of supply, respectively. If a monopolist decides to increase the price of its product, how will this affect the amount of their good that customers purchase? This knowledge helps the firm determine whether the increased unit price will offset the decrease in sales volume. Likewise, if a government imposes a tax on a good, thereby increasing the effective price, knowledge of the price elasticity will help us to predict the size of the resulting effect on the quantity demanded. Elasticity is calculated as the percentage change in quantity divided by the associated percentage change in price. For example, if the price moves from $1.00 to $1.05, and as a result the quantity supplied goes from 100 pens to 102 pens, the quantity of pens increased by 2%, and the price increased by 5%, so the price elasticity of supply is 2%/5% or 0.4. Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes by a greater percentage than the price did, then demand or supply is said to be elastic. If the quantity changes by a lesser percentage than the price did, demand or supply is said to be inelastic. If supply is perfectly inelastic; that is, has zero elasticity, then there is a vertical supply curve. Short-run supply curves are not as elastic as long-run supply curves, because in the long run firms can respond to market conditions by varying their holdings of physical capital, and because in the long run new firms can enter or old firms can exit the market.

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How strongly would the demand for a good change if income increased or decreased? The relative percentage change is known as the income elasticity of demand. Another elasticity sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studyingcomplements and substitute goods. Complements are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute. Cross elasticity of demand is measured as the percentage change in demand for the first good divided by the causative percentage change in the price of the other good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -2.0. In a frictionless economy, the price and quantity in any market would be able to move to a new equilibrium position instantly, without spending any time away from equilibrium. Any change in market conditions would cause a jump from one equilibrium position to another at once. In real economic systems, markets don't always behave in this way, and markets take some time before they reach a new equilibrium position. This is due to asymmetric, or at least imperfect, information, where no one economic agent could ever be expected to know every relevant condition in every market. Ultimately both producers and consumers must rely on trial and error as well as prediction and calculation to find the true equilibrium of a market.
[edit]Vertical

supply curve (perfectly inelastic supply)

When demand D1 is in effect, the price will beP1. When D2 is occurring, the price will be P2. The equilibrium quantity is always Q, and any shifts in demand will only affect price.

If the quantity supplied is fixed in the very short run no matter what the price, the supply curve is a vertical line, and supply is called perfectly inelastic.
[edit]Other

markets

The model of supply and demand also applies to various specialty markets. The model is commonly applied to wages, in the market for labor. The typical roles of supplier and demander are reversed. The suppliers are individuals, who try to sell their labor for the highest price. The demanders of labor are businesses, which try to buy the type of labor they need at the lowest price. The equilibrium price for a certain type of labor is the wage rate.[4] A number of economists (for example Pierangelo Garegnani,[5] Robert L. Vienneau,[6] and Arrigo Opocher & Ian Steedman[7]), building on the work of Piero Sraffa, argue that that this model of the labor market, even given all its assumptions, is logically incoherent. Michael Anyadike-Danes and Wyne Godley [8] argue, based on simulation results, that little of the empirical work done with the textbook model constitutes a potentially falsifying test, and, consequently, empirical evidence hardly exists for that model. Graham White [9] argues, partially on the basis of Sraffianism, that the policy of increased labor market flexibility, including the reduction of minimum wages, does not have an "intellectually coherent" argument in economic theory.

This criticism of the application of the model of supply and demand generalizes, particularly to all markets for factors of production. It also has implications for monetary theory[10] not drawn out here. In both classical and Keynesian economics, the money market is analyzed as a supply-anddemand system with interest rates being the price. The money supply may be a vertical supply curve, if the central bank of a country chooses to use monetary policy to fix its value regardless of the interest rate; in this case the money supply is totally inelastic. On the other hand,[11] the money supply curve is a horizontal line if the central bank is targeting a fixed interest rate and ignoring the value of the money supply; in this case the money supply curve is perfectly elastic. The demand for money intersects with the money supply to determine the interest rate.[12]
[edit]Empirical

estimation

Demand and supply relations in a market can be statistically estimated from price, quantity, and other data with sufficient information in the model. This can be done with simultaneousequation methods of estimation in econometrics. Such methods allow solving for the modelrelevant "structural coefficients," the estimated algebraic counterparts of the theory. The Parameter identification problem is a common issue in "structural estimation." Typically, data on exogenous variables (that is, variables other than price and quantity, both of which areendogenous variables) are needed to perform such an estimation. An alternative to "structural estimation" is reduced-form estimation, which regresses each of the endogenous variables on the respective exogenous variables.
[edit]Macroeconomic

uses of demand and supply

Demand and supply have also been generalized to explain macroeconomic variables in a market economy, including the quantity of total output and the general price level. The Aggregate Demand-Aggregate Supply model may be the most direct application of supply and demand to macroeconomics, but other macroeconomic models also use supply and demand. Compared to microeconomic uses of demand and supply, different (and more controversial) theoretical considerations apply to such macroeconomic counterparts as aggregate demand andaggregate supply. Demand and supply are also used in macroeconomic theory to relate money supply and money demand to interest rates, and to relate labor supply and labor demand to wage rates.

[edit]History

The power of supply and demand was understood to some extent by several early Muslim economists, such as Ibn Taymiyyah who illustrates:[verification needed] "If desire for goods increases while its availability decreases, its price rises. On the other hand, if availability of the good increases and the desire for it decreases, the price comes down."[13] John Locke's 1691 work Some Considerations on the Consequences of the Lowering of Interest and the Raising of the Value of Money.[14]includes an early and clear description of supply and demand and their relationship. In this description demand is rent: The price of any commodity rises or falls by the proportion of the number of buyer and sellers and that which regulates the price... [of goods] is nothing else but their quantity in proportion to their rent. The phrase "supply and demand" was first used by James Denham-Steuart in his Inquiry into the Principles of Political Oeconomy, published in 1767. Adam Smith used the phrase in his 1776 book The Wealth of Nations, and David Ricardo titled one chapter of his 1817 workPrinciples of Political Economy and Taxation "On the Influence of Demand and Supply on Price".[15] In The Wealth of Nations, Smith generally assumed that the supply price was fixed but that its "merit" (value) would decrease as its "scarcity" increased, in effect what was later called the law of demand. Ricardo, in Principles of Political Economy and Taxation, more rigorously laid down the idea of the assumptions that were used to build his ideas of supply and demand. Antoine Augustin Cournot first developed a mathematical model of supply and demand in his 1838 Researches into the Mathematical Principles of Wealth, including diagrams. During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, andLon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price. In his 1870 essay "On the Graphical Representation of Supply and Demand", Fleeming Jenkin in the course of "introduc[ing] the diagrammatic method into the English economic literature" published the first drawing of supply and demand curves therein,
[16]

includingcomparative statics from a shift of supply or demand and application to the labor

market.[17] The model was further developed and popularized by Alfred Marshall in the 1890 textbook Principles of Economics.[15]
[edit]Criticism

At least two assumptions are necessary for the validity of the standard model: first, that supply and demand are independent; and second, that supply is "constrained by a fixed resource"; If these conditions do not hold, then the Marshallian model cannot be sustained. Sraffa's critique focused on the inconsistency (except in implausible circumstances) of partial equilibrium analysis and the rationale for the upward-slope of the supply curve in a market for a produced consumption good.[18] The notability of Sraffa's critique is also demonstrated by Paul A. Samuelson's comments and engagements with it over many years, for example: "What a cleaned-up version of Sraffa (1926) establishes is how nearly empty are all of Marshall's partial equilibrium boxes. To a logical purist of Wittgenstein and Sraffa class, the Marshallian partial equilibrium box of constant cost is even more empty than the box ofincreasing cost.".[19] Aggregate excess demand in a market is the difference between the quantity demanded and the quantity supplied as a function of price. In the model with an upward-sloping supply curve and downward-sloping demand curve, the aggregate excess demand function only intersects the axis at one point, namely, at the point where the supply and demand curves intersect. The Sonnenschein-Mantel-Debreu theorem shows that the standard model cannot be rigorously derived in general from general equilibrium theory.[20] The model of prices being determined by supply and demand assumes perfect competition. But: "economists have no adequate model of how individuals and firms adjust prices in a competitive model. If all participants are price-takers by definition, then the actor who adjusts prices to eliminate excess demand is not specified".[21] Goodwin, Nelson, Ackerman, and Weissskopf write: "If we mistakenly confuse precision with accuracy, then we might be misled into thinking that an explanation expressed in precise mathematical or graphical terms is somehow more rigorous or useful than one that takes into account particulars of history, institutions or business strategy. This is not the case. Therefore, it is important not to put too much confidence in the apparent precision of supply and demand graphs. Supply

and demand analysis is a useful precisely formulated conceptual tool that clever people have devised to help us gain an abstract understanding of a complex world. It does not - nor should it be expected to - give us in addition an accurate and complete description of any particular real world market." [22]
[edit]Economies

of scale: Mass production

The intent of mass production is to produce in extremely large quantities at the lowest possible cost so as to drive down price and create demand. There is also a learning curve with the production of most new products that exhibits a similar phenomenon of lowering costs, which in turn drives demand. In the case of mass production, both the assumptions of supply and demand being independent and constraints on supply are not applicable. The price response to the change in supply curve is valid, but the price response to the change in demand curve is not. The lowered price in response to increased demand is because the incremental cost of production is less than the average cost, assuming that there is excess capacity, which is the condition of most manufactured goods today. In typical business cycles, prices do increase as maximum capacity is approached; however, this usually results in an expansion of capacity using more efficient processes, leading to even lower prices in the next cycle.

Microeconomics - Understand the Law of Demand and Supply

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Microeconomics is a concern with 1. Determining the price we pay for products and services. 2. What output is required by the market place.

3. The impact of the government's intervention in market forces. Understand the microeconomics will help us to analyze the fundamental nature of supply and demand concepts and how they influence the operation of a market economy. A. Demand In terms of microeconomics,demand is defined as the relationship between the price of a product and the consumer willingness to purchase a certain quality.The law of demand also determine the price and quality sold, if the price of certain increase then the qualities of product sold decrease and the price of certain decrease then the qualities of product sold increase. B. Supply Supply decisions reflect a supplier willingness to produce and sell at the prevailing market price and these factors all influence the supplier qualities. supplied. For most products, the quantity supplied will increase as the price level increases, all other factors remaining constant. The Law of Supply determines as a) The quantity supplied increases as price increases. b) The quantity supplied decreases as price decreases. c) Producers increase the supply as their product prices rise. C. Equilibrium of Demand and supply When the price fall to the level the buyers are willing to pay, this produces equilibrium. The opposite effect occurs when prices are too low. In fact, the forces of demand and supply lead to an equilibrium price and quantity. a) As demand is greater than supply, price levels increase. b) As supply is greater than demand, price levels decrease. c) Only one price guarantees equilibrium D. Other influences There are four fundamental shifts we can examine, each shift having an effect on supply or demand: a) Positive demand shift will increase demand. b) Negative demand shift will decrease in demand. c) Positive supply shift will increase demand. s) Negative supply shift will decrease in demand. E. Government intervention Government intervention is designed to achieve the following: a) A fair distribution of income among individuals and regions. b) To encourage growth in employment and income.

c) To protect low-income earners. and including: a) Minimum wages. b) Rent control. c) Farm marketing Board. d) Taxes.
Economics > Supply and Demand

Supply and Demand

The market price of a good is determined by both the supply and demand for it. In 1890, English economist Alfred Marshall published his work, Principles of Economics, which was one of the earlier writings on how both supply and demand interacted to determine price. Today, the supply-demand model is one of the fundamental concepts of economics. The price level of a good essentially is determined by the point at which quantity supplied equals quantity demanded. To illustrate, consider the following case in which the supply and demand curves are plotted on the same graph.

Supply and Demand

On this graph, there is only one price level at which quantity demanded is in balance with the quantity supplied, and that price is the point at which the supply and demand curves cross. The law of supply and demand predicts that the price level will move toward the point that equalizes quantities supplied and demanded. To understand why this must be the equilibrium point, consider the situation in which the price is higher than the price at which the curves cross. In such a case, the quantity supplied would be greater than the quantity demanded and there would be a surplus of the good on the market. Specifically, from the graph we see that if the unit price is $3 (assuming relative pricing in dollars), the quantities supplied and demanded would be: Quantity Supplied = 42 units Quantity Demanded = 26 units

Therefore there would be a surplus of 42 - 26 = 16 units. The sellers then would lower their price in order to sell the surplus. Suppose the sellers lowered their prices below the equilibrium point. In this case, the quantity demanded would increase beyond what was supplied, and there would be a shortage. If the price is held at $2, the quantity supplied then would be: Quantity Supplied = 28 units Quantity Demanded = 38 units Therefore, there would be a shortage of 38 - 28 = 10 units. The sellers then would increase their prices to earn more money. The equilibrium point must be the point at which quantity supplied and quantity demanded are in balance, which is where the supply and demand curves cross. From the graph above, one sees that this is at a price of approximately $2.40 and a quantity of 34 units. To understand how the law of supply and demand functions when there is a shift in demand, consider the case in which there is a shift in demand:

Shift in Demand

In this example, the positive shift in demand results in a new supply-demand equilibrium point that in higher in both quantity and price. For each possible shift in the supply or demand curve, a similar graph can be constructed showing the effect on equilibrium price and quantity. The following table summarizes the results that would occur from shifts in supply, demand, and combinations of the two.

Result of Shifts in Supply and Demand

Demand Supply + + Equilibrium Equilibrium Price Quantity + + + + -

+ + -

+ +

? ? + -

+ ? ?

In the above table, "+" represents an increase, "-" represents a decrease, a blank represents no change, and a question mark indicates that the net change cannot be determined without knowing the magnitude of the shift in supply and demand. If these results are not immediately obvious, drawing a graph for each will facilitate the analysis.

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A market is defined as a group of buyers and sellers of a particular product or service. Competitive markets are markets with many buyers and sellers, so that each has a very small influence on the price. Supply and demand is the most useful model for a competitive market, and shows how buyers (citizens) and sellers (businesses) interact in that market. Quantity Demanded & Supplied The demand for a product is the amount that buyers are willing and able to purchase. Quantity demanded is the demand at a particular price, and is represented as the demand curve. The supply of a product is the amount that producers are willing and able to bring to the market for sale. Quantity supplied is the amount offered for sale at a particular price. The main determinant of supply/demand is the price of the product. Law of Demand The Law of Demand states that other things held constant, as the price of a good increases, the quantity demanded will fall. Other factors that can influence demand include:

1. Income - Generally, as income increases, we are able to buy more of most goods. When
demand for a good increases when incomes increase, we call that good a "normal good". When demand for a good decreases when incomes increase, then that good is called an inferior good.

2. Price of related products - Related goods come in two types, the first of which are

"substitutes".Substitutes are similar products that can be used as alternatives. Examples of substitute goods are Coke/Pepsi, and butter/margarine. Usually, people substitute away to the

less expensive good. Other related products are classified as "complements". Complements are products that are used in conjunction with each other. Examples of complements are pencil/eraser, left/right shoes, and coffee/sugar.

3. Tastes and preferences - Tastes are a major determinant of the demand for products, but
usually does not change much in the short run.

4. Expectations - When you expect the price of a good to go up in the future, you tend to
increase your demand today. This is another example of the rule of substitution, since you are substituting away from the expected relatively more expensive future consumption. Demand Curves and Schedules Demand curves isolate the relationship between quantity demanded and the price of the product, while holding all other influences constant (in latin: ceteris paribus). These curves show how many of a product will be purchased at different prices. Note that demand is represented by the entire curve, not just one point on the curve, and represents all the possible price-quantity choices given the ceteris paribus assumptions. When the price of the product changes, quantity demanded changes, but demand does not change. Price changes involve a movement along the existing demand curve. Market demand is the summation of all the individual demand curves of those in the market. It is the horizontal sum of individual curves and add up all the quantities demanded at each price. The main interest is in market demand curves, because they are averages of individual behaviour tend to be well-behaved. When any influence other than the price of the product changes, such as income or tastes, demand changes, and the entire demand curve will shift (either upward or downward). A shift to the right (and up) is called an increase in demand, while a shift to the left (and down) is called a decrease in demand. In example, there are two ways to discourage smoking: raise the price through taxes or; make the taste less desirable. Law of Supply As the price of a product rises, ceteris paribus, suppliers will offer more for sale. This implies that price and quantity supplied are positively related. The major factor that influences supply is the "cost of production", and includes:

1. Input prices - As the prices of inputs such as labour, raw materials, and capital increase,
production tends to be less profitable, and less will be produced. This leads to a decrease in supply.

2. Technology - Technology relates to methods of transforming inputs into outputs.

Improvements in technology will reduce the costs of production and make sales more profitable so it tends to increase the supply.

3. Expectations - If firms expect prices to rise in the future, may try to product less now and
more later. Supply Curves and Schedules The relationship between the price of a product and the quantity supplied, holding all other things constant is generally sloping upwards. Supply is represented by the entire curve and not just one point on the curve. When the price of the product changes, the quantity supplied changes, but supply does not change. When cost of production changes, supply changes, and the entire supply curve will shift. Market Supply is the summation of all the individual supply curves, and is the horizontal sum of individual supply curves. It is influenced by the factors that determine individual supply curves, such as cost of production, plus the number of suppliers in the market. In general, the more firms producing a product, the greater the market supply. When quantity supplied at a given price decreases, the whole curve shifts to the left as there is a decrease in supply. This is generally caused by an increase in the cost of production or decrease in the number of sellers. An increase in wages, cost of raw materials, cost of capital, ceteris paribus, will

decrease supply. Sometimes weather may also affect supply, if the raw materials are perishable or unattainable due to transportation problems. Reaching Equilibrium We can analyze how markets behave by matching (or combining) the supply and demand curves. Equilibrium is defined as the intersection of supply and demand curves. The equilibrium price is the price where the quantity demanded matches the quantity supplied. The equilibrium quantity is the quantity where price has adjusted so that QD = QS. At the equilibrium price, the quantity that buyers are willing to purchase exactly equals the quantity the producers are willing to sell. Actions of buyers and sellers naturally tend to move a market towards the equilibrium. Excess Supply/Demand Excess Supply is where Quantity supplied > Quantity demanded, and results in surpluses at the current price. A large surplus is known as a "glut". In cases of excess supply: price is too high to be at equilibrium suppliers find that inventories increase suppliers react by lowering prices this continues until price falls to equilibrium

Excess Demand occurs when Quantity demanded > Quantity supplied, and results in shortages at current prices. In cases of excess demand: buyers cannot buy all they want at the going price sellers find that their inventories are decreasing sellers can raise prices without losing sales prices increase until market reaches equilibrium

Law of Supply and Demand In free markets, surpluses and/or shortages tend to be temporary and obey the law of supply and demand, since actions of buyers and sellers tend to match prices back toward their equilibrium levels.

SUPPLY AND DEMAN

D
SUPPLY AND DEMAND The concept of supply and demand is arguably the most important in economics. Few have not heard it before, but what does it really mean. Frankly, supply and demand is a very easy concept to understand. First, the law of demand, which states that the lower something's price it, the more people want it. Now, this is not practically true (for example, nobody wants to buy really outdated cars, even though they're cheap.) We must add that, only given no other factors to consider is this law true. As just about any other thing in economics, demand can be represented in a graph. The following demand curve shows the relationship above. As the price goes up, demand comes down and vice versa. As demand goes up, price comes down. A demand curve like this can be created by getting a variety of products, plotting them on the graph (their price and the amount of the product purchased) and fitting a line to these points. LAW OF DEMANDthe lower something's price is, the more demand there is for it LAW OF SUPPLYthe higher something's price is, the more it will be supplied
Fig 1.2.1-the relationship between demand and price is an inverse relationship. As one goes up, the other comes down, given that no other factors are considered. Fig 1.2.2-the relationship between supply and price is a direct relationship. As one goes up, the other goes up, given that no other factors are considered.

Fig 1.2.1-demand curve There is also a law of supply. The law of supply

states that the higher something's price is, the more it will be supplied. The concept of supply involves getting many factors of production: resources, labor, etc., getting these things together to make a product which is then demanded. The law of supply is because people want to charge the highest price possible for the least amount of production possible. As prices increase, so do the expectations for profits. As people expect more profits from a product, they naturally produce more of that product. They produce this high-priced product rather than a low-priced one. Of course, if all products' prices rise evenly, than no change would happen. Again, this model assumes there are no other factors considered.

Fig 1.2.2-demand curve A market-wide analysis of these trends can be built by combining individual graphs. The supply and demand curves of each individual is different, but what is important in an economy is that something is being sold to someone, so the to get a good picture of the market, we combine the add the individual demand and supply curves. (So person A buys 10 of something at 5 money units each, but person B buys only 6; adding everyone in an economy yields say, 1000000 purchases of the product at 5 monetary units).

SHIFTS OF SUPPLY AND DEMAND

Note that the previous discussion took place under the condition that no other factors are considered. A constant graph shows that price affects supply and demand in precisely defined ways. Real life, as always, is different from simple theory. There are certain factors that does not only cause movement on the graphs (meaning movement occuring on the line, i.e. the price goes up or down and the supply and demand changes, following the graph exactly), these factors actually shift the line itself. Basically everything in the world is a shift factor. There are many important shift factors, however, like people's overall income and their ever-changing preferences of one product over another.

DYNAMIC LAWS OF SUPPLY AND DEMAND Supply, demand, and prices always work together in a real life economy. We can put both supply and demand on the same graph to illustrate this point of how they work together with price. EQUILIBRIUM-the state to which the market tends to push itself
Fig 1.2.3-the top portion of the graph, the area where the price is very high, represents excess supply. There, the market tends to push things downward towards equilibrium. The bottom of the graph, where prices are too low, represents excess demand and the market pushes things upwards towards equilibrium. Fig 1.2.4-individuals first supply factors or production (labor, etc.), which firms buy, converting them into consumer goods, which the consumer then in turn buys. Individuals also sell directly to the goods market

Fig 1.2.3-demand curve Note the point at which the supply line and the demand line meet. That is the point of equilibrium, the perfect point of balance.

However, the economy is never completely balanced. Anywhere outside the balanced point, there is a disparage in numbers between supply and demand (remember, supply is directly related to price while demand is inversely related). Thus, market forces must push things towards the equilibrium point. The first law of supply and demand states: when demand is greater than supply, prices rise and when supply is greater than demand, prices fall. These forces that push markets towards equilibrium also depend on how great the difference between supply and demand is. The second law of supply and demand, then, states: the greater the difference between supply and demand, the greater the forces on prices are. Naturally, then, the third law would say: when supply is the same as demand, prices do not change. These theories apply to the real economy very well. When there's is an excess of supply and no demand for it, then suppliers have to drop the price until people do want to buy all their extra stuff. The suppliers are desperate to get all the excess products off their hands. However, when there's great demand and no supply (there's scarcity), people are willing to pay any price, so long they get the desperately needed, but rare, product. Thus, the market for any product tends to push its price towards equilibrium. Of course, perfect equilibrium is never reached as we've demonstrated earlier; the supply and demand curves are constantly shifting. The market adjustment is always going on. To get a good picture of how supply and demand on markets work on in an economy, look at the following picture:

Fig 1.2.4-the production process Supply and demand comes into play in all markets. The factor market, firms buy factors of production like labor and natural resources. They then produce them into marketable goods for the consumer to buy in the goods market. Individuals also contribute to the goods market.

The New Law of Demand and Supply Author: Rick Kash Publisher: Doubleday, New York Copyright year: 2002 Library of Congress or ISBN: 0-385-50432-2 Author bio and credits: Rick cash is the founder and CEO of the Cambridge Group, one of the premier consulting firms in the US, whose clients include many of the worlds largest and most successful businesses from Merrill Lynch to Gatorade and from Levis to Abbott laboratories. Kash serves on a number of community and

corporate boards of directors and is a frequent speaker to corporate audiences on Demand Strategy. Author's Big Thought: For more than two hundred years companies have based their approach to business on supply-side economics, concentrating on creating products and services and then attempting, through marketing, publicity, distribution, and promotion to stimulate a demand for them. Cambridge Group CO Rick Kash argues that in order to succeed in todays market, companies must reverse their approach. Companies must first determine what current and emerging demand exists, and only then create products and services to meet those demands. Kash outlines a specific six-step demand Strategy on how to implement this new approach. Chapter notes: Demand Strategy How to Outperform the Competition and create an Enterprise that Endures Demand Strategy requires a change in how you think about your business, and a

corresponding change in the sequence by which you run your business. The central thesis is that a business must understand the demand in its market before it 2 creates supply. It is the only way to understand and satisfy your targeted customers better than your competitors. Businesses use their understanding of demand to differentiate their products so that they align as closely as possible with the demand of the customer targets in the marketplace from which they earn the most profit. Demand Strategy will help you anticipate demand and focus on the most profitable customer demand segments, to better align products before creating new products or services. What demand is and is not Demand is multifaceted it includes consumers desire or need for a product, its features, the availability of substitutes and their prices, the channels customers prefer, the availability of credit, and the convenience of purchasing the product. In todays global economy, where information flows

instantly and technological change is almost continuous, demand is highly dynamic and subject to rapid change. Demand Strategists identify, then concentrate on, the segments that yield the most profit for their companies. A segment is a group of customers within a given business category who share a set of common demands. It is critical to familiarize yourself with all segments and select those that are most profitable to you as your primary target. Demand can be either current or emerging. If you dont have a good grasp of current demand, its very unlikely that youll recognize emerging demand demand that will generate revenue and profits in the months ahead. Since emerging demand can transform an existing industry or even create an industry that will render your product obsolete, it is critical that companies not miss it. Emerging demand can be a predictable, logical shift that evolves from obvious trends. (e.g. baby boomer needs). One of the most famous

cases of spotting emerging demand and developing an entirely new product in response to it was Sony Corporations creation of the Walkman portable tape player. Companies that use a formalized business system dedicated to identifying emerging demand early achieve the most important innovation successes. What demand strategy is: Demand Strategy is, broadly speaking, a new way of thinking about the role of demand in running your business. It includes a set of specific steps companies can take to identify the forces and factors that drive demand in their most profitable 3 demand segments. By understanding current and emerging demand, they can build a differentiated supply that meets that segments needs better than their competitors can. Applying demand Strategy gives your business four distinct advantages that will increase profits; first, you will be selling what your customers actually want. Second, you will be able to differentiate your company and its

products from its competitors. Third, you will be able to reduce costs by eliminating products for which there is limited demand. Fourth, you will be able to sell your goods or services at a premium price because a differentiated product that satisfies demand earns inelastic pricing. The Six basic Steps of Demand Strategy 1 Analyze the demand forces and industry factors impacting your business Create proprietary, actionable insights into the drivers of changes in past, current, and emerging demand Results: Allows you to capture the highest profit demand and the greatest possible returns Demand shifts are anticipated rather than reacted to Earnings surprises due to demand shifts are avoided 2 Select your most

profitable demand segments Identify specific demand segments you can satisfy that yield the highest profits for your company. Results: Products and offers targeted for specific market segments, versus mass market offers By satisfying specific demands well, your competitors are less likely to appeal to the same customers Efficient targeting of budgets maximizes sales at lower costs, resulting in higher profits. 3 Build enduring value propositions to differentiate your offers Collaborate with your best customers to build your enduring value Proposition. Results: A value proposition that differentiates and 4 insulates you from the competition Allows you to charge more, and avoid discount

pricing Increased loyalty as products/brands deliver on customer expectations 4 Identify the strategies and business systems needed to meet your demand Leverage supply chain and channel sales expertise to achieve superior execution. Results: Improved efficiency and effectiveness due to alignment with demand Enables a company to create a portfolio that appeals to multiple target segments New products/ offers benefits from the companys superior distribution, sales, and marketing 5 Allocate your resources Use demand insights to align resources behind best

growth/profit opportunities. Results: Allows companies to align with and satisfy demand at high levels of profit Shareholder value remains at consistently high levels 6 Execute demand strategy Follow a disciplined proven process that directs your supply to customers who most want what your products deliver. Results: Total organizational alignment Superior execution that trumps competition The First Principle Analyze the Demand Forces and Industry factors that have an Impact on Your Business5 Look at what has created demand in the past, what is causing it now, and what is most likely to influence emerging demand. The purpose of forces and factors analysis is two fold: first, to identify and

understand the causal forces that create demand; second, to identify the context within which a business operates. This includes the economics of a companys business category as well as the economic realities that directly affect its business. It also includes changes in pricing, legislation, existing and near-term technology, new channels, new competitors, changes in an industrys structure and the price of materials. In addition, the process focuses on social mega trends and demographics that will potentially affect the demand for goods and services in the future. Forces and factors Analysis 1. Understand past forces and factors how was demand shaped in the past, how has it changes, and why. By reviewing previous patterns a companys past experience can continue to help shape success in the future. Several years of forces and factors analysis can function as reminders of the influences that cause demand to evolve. 2. Assess Current forces and factors. Among the most significant findings to

look for are anomalies, or unexplained discrepancies, in the data. 3. Identify emerging forces and factors. Those just beginning to affect demand and show potential to play an extensive role in shaping it over time. Patterns that look promising must be investigated because an emerging demand can become important very quickly. Understanding it can give a company significant opportunity for competitive advantage. For insightful information define which customers are likely to be the most useful. Include your customers end customers too. The Second Principle Select Your Most profitable demand Segments One of the central premises of Demand Strategy is that every business category must be divided into segments so that you can understand how customers must be divided into segments so that you can understand how customers in each segment are motivated and why they make decisions. Only after knowing that can you practice demand Strategy.

In every industry, total demand can be divided into segments, groups, or clusters, of customers who buy for similar reasons. Knowing as much as you can about each segment allows you to create supply that will satisfy its specific demand. Although 6 there are many ways to classify or segment an industry, demand segmentation is the most useful for a business. Because it clarifies existing demand, such segmentation identifies immediately actionable opportunities to improve a business by focusing on high-priority demand segments. The goal is to select the segments that are likely to yield the highest profits, considering your business system, infrastructure, competition, and core competencies. Once you have done that, you have taken an enormous step toward seizing control of your companys performance and profitability. Understanding what each segment values gives you a substantial competitive edge. It also allows you to match your supply to what that segment values. In doing so, you gain pricing power because you have the opportunity to create differentiated supply that earns relatively inelastic pricing.

Viewing the market through the lens of demand segmentation allows you to reach three crucial ends. The first is a better understanding of the volume and economic value of various segments. This data can enable you to focus and allocate resources on the specific demand segments that can give you the most profit. Finally, you can get wonderfully rich direction for innovation, differentiation, and communication in simple preference comparisons. It is equally vital that you determine which demand segments your competitors are focusing on, and then choose one that gives you the best chance of differentiation. Selecting your demand segment is usually the most important decision you can make. The Third Principle Build Ensuring Value Propositions Through Differentiation Every Demand value Proposition (DVP) had multiple platforms, or planks; while the individual planks of the DVP are important in and of themselves, together they form an integrated picture of your proposition and the value you promise to deliver.

A DVP is the promise you make to customers, as well as a summary of the strategy you will use t o compete. Companies tend to fall in to one of two camps: those that have an enduring strategy and those that resort to episodic strategies. Companies with episodic strategies lack the information, the comprehension of the market, and the confidence that are required to create a successful, competitive proposition. Highly successful companies usually have an enduring strategy. All successful DVPs have multiple planks. This is because all products and service offer several benefits. In addition, the multiple planks, when taken together, create an integrated value proposition that is greater than the sum of its individual 7 parts. Appealing to a demand segment with multiple planks protects it from its competitors. Although a competitor may imitate one or two benefits, it is nearly impossible to replicate all of them. MacDonalds five planks, quick service and goodtasting food, cleanliness, consistency, special attention to children, and community citizenship, are the premises upon which their enduring value proposition competes.

A companys high-profit target segments should deliver anywhere from 50 60 percent of its sales volume. The remaining volume will come from other segments that use its products occasionally or are widening their choices of products and services. It is the high-profit-yielding customers who select the planks that make up the companys specific value proposition. Once the DVP had been drafted, its planks should be reviewed by members of senior management to determine their practicality and profitability. The next step is to prioritize the demands of the high-profit-yielding customers. Usually when managers do this there is a 70% variance within the group. From this exercise they can immediately see the differences that exist internally. It can be a powerful way to point out the gaps between what they think their customers want and what their customers say they want. Once they see the incongruity, management teams tend to become markedly more open to change and markedly more open-minded. Whatever the variance between managements views, the company cannot maximize

its results if it is not aligned with the demand of the customers who yield the highest profit. No company can achieve its full potential until all members of senior management are working together toward the same goal. One of the great benefits of the DVP is its use as a guide for aligning senior management. A business performs best when its people share common goals and strategies, and when its products or services are designed to address two particular objectives: relevance to the targeted demand segment and differentiation from what the competition is offering. The Fourth Principle Identify the Strategies and Business Systems Needed to Meet Demand The most successful Demand Strategists depend upon their strategies to guide their business systems. The design and implementation of the four elements of their key business systems 1) research and customer interface systems, 2) operational processes, 3) organizational functions, and 4) technological support reflect the Demand Strategies they develop that drive product differentiation and

create competitive advantage. Each area is critical, and must be coordinated with the others to ensure success. Each needs an individualized strategy and a system that works in conjunction with 8 the others. Your systems must work together to deliver the DVP that you have developed for your targeted demand segments. Research and customer interface These systems area critical starting point because they set the objectives for all your other business systems. As research and customer interaction identify changes in demand and new customer expectations, this information must shape the operational, organizational, and technological systems used to deliver on demand. The customer interface includes both the ways customers are involved in developing offers, who and how, and the ways they are served, determining exactly what types of customers to include in these tests is a critical part of conducting test research successfully.

Research is frequently limited to reporting what happened in the past rather than identifying current and emerging demand. The customer-focused projections developed by research departments are often faulty. First, they typically fail to include the perspective of customers own end customers. Second, they frequently include all customers in the research rather than focusing on the companys most profitable demand segments. Finally, sometimes ask the wrong customers, unprofitable segments or infrequent users, and draw incorrect or misleading conclusions from their input. Operational systems and strategies The second set of strategies involves the production and delivery of products and services to the target demand segment. These systems and strategies also track demand, govern the way decisions are made, develop innovations on an ongoing basis, and determine the flow of information. Demand-driven companies develop strategies and systems that respond to customers needs, then measure if they are

meeting them adequately. Their first step is to understand demand, then to develop the operational processes, organization, and technology items that can best meet that demand. Organizational systems and strategies For a company to change its approach from a supply-driven perspective t a demand driven one, everyone in the company must work together toward the central, organizing goal of implementing demand Strategy. The changes may involve creating cooperative, cross-functional teams that can move across traditional departmental boundaries. Benefits include: 9 Keeping all functions closer to demand and an understanding of it Driving absolute clarity in communications rather than having messages altered or garbled with each handoff to another silo Resolving potential issues and gaining agreement to plans and priorities across functions before the fact, rather than trying to solve them midstream Aligning all functions to work toward a common goal rather than having each department focus on its own objectives

Technological systems and strategies In demand Strategy, technologys value must be based on whether it adds value, real or perceived, that enables you to create supply or customer service that brings you closer to satisfying demand. Technology considerations refer first and foremost to information technology, but also include innovations in any areas, manufacturing, packaging, distribution where it creates advantages in fulfilling demand. Technology can rejuvenate and transform even the most successful companies. Technology alone can neither solve a fundamental misalignment with demand nor fix a flawed business model. Technology should be improved when your DVP is in place. The goal of technology is to enhance each part of your proposition, which is the enduring formula by which you have chosen to compete. To determine the best technological strategies and systems for your business, you must develop a fact base about the business you are in, the demand segment you have chosen, and the unique combination of demand forces and industry factors at

work in your market. Only then can you see and assess the technological opportunities open to you and decide which options will provide the greatest advantages in driving your Demand Strategy. This assessment will also show you how the new technology will interact with your research and customer interface, organizational and operational systems and strategies. The Fifth and Sixth principles Allocate your resources and execute your Demand Strategy A CEOs single most important job is the allocation of resources. Doing it correctly gives the organization the best chance to carry forward its strategic and tactical plans. Allocating resources correctly means using your dollars, the skills of your people, and intangible resource such as brand equity, intellectual capital, and customer relationships in order to get the highest financial return and have a greater impact on the market than you competitors. The key is in determining priorities. 10 Nowhere is it more evident that you must understand demand before creating

supply than in resource allocation. More often than not, the real problem facing most businesses is not limited resources but limited insights into demand and how best to use resources. Demand Strategy allows you to realize cost efficiencies by aligning your resources against demand. If you spend the right amount on what your target demand segment values, and very little on what it doesnt, you will get the highest return on your investment. Principles to guide more effective resource allocation: 1. Both current and emerging demand must be assessed when making resource allocation decisions. You must understand how changes in demand might impact profitability of your current business. 2. Resource allocation decisions should leverage not just dollars and people but all of the companys assets, including brands, talent, intellectual capital, and key relationships. 3. To succeed, you must have a clear understanding of the features and activities- service, convenience, product features, customization, and other

benefits that drive demand for your business and how investments in key areas can improve your performance. There are several demand Strategy Criteria that will help you calculate the right percentages of your total resources so that each business will be nourished according to its contribution to your companys profits: Impact of the various forces and factors on your business Current size and growth potential of your business Current and expected profitability Changes in the size of segment(s) targeted by business units Changes in your share of market, in demand share, or in the nature of your competition Size and growth of emerging demand versus current demand Ability to differentiate from competitors Level of insulation from competition Core competencies Competitive activities Distribution channels Profit margins Percent of portfolio your willing to have at risk Implementation: 11

 A gap analysis is often a good way The analysis reflects where you stand on your DVP in relation to where you wish to be For resource allocation to succeed, it is essential that each level of the company understands and behaves according to the priorities established by the Demand Strategy. Implementation of the allocation plan needs to be mapped out in detail including the whys, the whats, the hows, the whos, and the when and wheres. When you deploy resources within an organization it is vital that you regularly track performance on the measures that have been agreed upon earlier, such as differentiation relative to the competition, segment level profitability, and margins. Reviewer's recommendation: This is a must read in todays economy and global market conditions. The book is rich with examples like the Demand Strategy created by Gatorade, Countrywide Credit Industries and EMCs Demand Strategy.

Wise leaders recognize that they and their organizations need periodic refocusing to be the best they can be. Frumi helps such leaders rediscover the strengths and values that energize them so they in turn can renew their colleagues, employees, and business operations.

Contact Frumi at 949-729-1577 Elasticity of Supply and Demand 40 14

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What happens to the quantity demanded when the price of a good changes? If quantity changes a lot, we say that demand is elastic and stretches. If quantity changes only a little, demand is inelastic and the quantity does not stretch much. The "price elasticity (E)" of demand is equal to "% change in quantity demanded" divided by "% change in price". When the value of E is equal to zero, demand is perfectly inelastic. If E is between 0 and 1, then demand is inelastic. When the value of E is equal to one, demand is unit elastic. If E happens to be greater than one, then demand is elastic. If E is equal to infinity, then demand is perfectly elastic. Note that although price and quantity demanded move in opposite directions, elasticity will always be positive by convention. Determinants of Elasticity Many factors influence elasticity, some of which include:

1. Necessities versus Luxuries - It is harder to find substitutes for necessities so quantity

demanded will change less.

2. Availability of Close Substitutes - If there are close substitutes, buyers will move away
from more expensive items and demand will be elastic.

3. Definition of the Market - The more broadly we define an item, the more possible
substitutes and the more elastic the demand. elastic the demand.

4. Time Horizon - The longer the time available, the easier to find substitutes and the more 5. Relative Size of Purchase - Purchases which are a very small portion of total expenditure
tend to be more inelastic, because consumers are not worried about the extra expenditure. Total Revenue and Elasticity Raising the price will have two effects: more revenue per unit sold and; fewer units sold. In order to increase total revenue, we must decide which of the two effects is greater. When demand is inelastic, total revenue is more influenced by the higher price and increases as price increases. When demand is elastic, total revenue is more influenced by the lower quantity and decreases as price increases. Income Elasticity of Demand There are factors other than price that influence the demand for a product. Income elasticity of demand is calculated as the percent change in quantity demanded divided by percent change in income, ceteris paribus. There are two possible relationships. If demand increases when income increases, elasticity is positive and good is normal. If demand decreases when income increases, elasticity is negative and good is inferior. The main influence on income elasticity of demand is whether a good is a luxury or a necessity. When goods are luxuries, elasticity is usually highly positive (greater than one). When goods are necessities, elasticity is usually lower (less than one). When goods are very basic, they can even be inferior (less than zero), such that demand falls when income rises. Elasticity of Supply This is a measure of how much quantity supplied (QS) reacts to a change in prices. Elasticity of Supply is equal to "percent change of QS" divided by "percent change in price". This value can range from zero to infinity. When elasticity is less than one, supply is inelastic. If elasticity is greater than one,

then supply is elastic. The main determinant of supply elasticity is length of time. The shorter the time period, the more inelastic the supply, because it is harder to get the additional inputs to increase production. It also depends on whether the firm is near its capacity.

Costs and Production 14 6 8

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Firms are defined as economic organizations that purchase inputs and sell outputs. We will assume that a firm's objective is to maximize profits. Let's take a look at some equations relating to costs. Profit = Total Revenue (TR) - Total Costs (TC) Total Revenue = Price x Quantity Sold Total Costs = Sum of all opportunity costs related to the production process Opportunity Costs = Explicit Costs + Implicit Costs Explicit costs of production include: wages and salaries to employees costs of raw materials taxes value of time of owner/entrepreneur opportunity cost of financial capital invested in the firm i.e. interest rate foregone

Implicit costs of production include:

"Economic profit" is the difference between total revenue and total cost, where total cost includes both explicit and implicit costs. In contrast, "accounting profit" is the difference between total revenue and explicit cost. For example: A dancer gives dancing lessons for $20 per hour. Instead, he could be performing on stage for $30 per hour. What is the economic profit of performing on stage? Total costs = $0 (explicit cost) + $20 (implicit cost) Economic Profit = $30 (TR) - $20 (TC) Recall that supply is primarily determined by the productivity of inputs, and the cost of the inputs. The production functions show the relationship between quantity of inputs and the quantity of output. The short run refers to a period in which at least one input (usually capital) is fixed. The short run production function shows a relationship between total output and inputs, when one input is varied and one is fixed. This is also referred to as the total product (TP). Average product (AP) is the average production per unit of variable input, and is equal to TP/L, where L is labour (the variable input). Marginal product (MP), shows the change in total output when input changes by one unit. Therefore, MP is the slope of the total product curve, and thus shows the productivity of labor.

Total Product Function A very key assumption, is that of the diminishing marginal product (or diminishing marginal returns). If we add more and more of the variable input(s) and there is at least one fixed input, then eventually the MP of the variable input will decline. The TP curve will flatten out as the quantity of the variable input increases. Therefore, MP may rise initially, but it must fall (TP is increasing but at a decreasing rate). Product and Cost curves To go from production to cost, we assume that the costs of inputs are fixed (i.e. a firm can hire all the labour it wants at the going wage). Cost are divided into two broad categories: Fixed costs - costs that do not vary with output, such as cost of plant or some fixed inputs Variable costs - costs that vary with output, such as cost of labour or other variable inputs.

Total costs (TC) is the sum of Total Fixed Costs (TFC) and Total variable Costs (TVC). Graphically, TFC is represented by a horizontal line since costs are fixed. The total cost eventually gets steeper as more is product is produced. Average cost (AC) is how much a typical unit costs and is equal to TC divided by number of units produced. Mathematically we have, AC = (TFC + TVC)/Q = AFC + AVC AFC: average fixed costs AVC: average variable costs Note that AFC will constantly fall as output increases. AVC will fall and then increase due to diminishing returns. Marginal Cost (MC) is the change in total cost divided by change in output, and addresses the question: how much will it cost to produce one additional unit of output?

Perfect Competition 16 6 11
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In competitive markets there are: 1. 2. 3. Many buyers and sellers - individual firms have little effect on the price. Goods offered are very similar - demand is very elastic for individual firms. Firms can freely enter or exit the industry - no substantial barriers to entry.

Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC). Revenue in a Competitive Business Businesses in competitive markets take the market price (P) as given (price takers). How much does the business receive for a typical unit is known as the "average revenue" (AR) and is equal to TR/Q =

(P x Q)/Q = Price. So average revenue is equal to price, and is constant. How much additional revenue does the firm get if it sells one additional unit? To answer this question, we take a look at "marginal revenue" (MR) which is equal to the change in TR divided by the change in quantity. Note that this too is equal to price, so the marginal revenue is constant as well, and is equal to average revenue. Profit Maximization To maximize profit, we need to know the revenue and costs of the business. Profit is maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why, recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is the additional cost from 1 additional unit. When MR > MC, revenue is increasing faster than costs and the firm should increase production. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC. So what happens to output at various prices? Since MC is upward sloping, as price increases, quantity produced will increase too. As price falls, quantity produced falls. In each case, the marginal cost curve determines how much the firm is willing to produce at each price, so it translates into the supply curve. Shutting Down a Company (temporary) A company is considered to have shut down, if it temporary ceases production but keeps fixed capital. A company has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a business depends on a few factors. Recall that ATC = AVC + AFC. So average fixed cost is the vertical distance between average variable cost and average total cost. Now if a business shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the company should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the company's short-run supply curve = MC curve above AVC. The firm therefore produces where profit equals marginal cost. Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore cannot be recovered by shutting down in the short run. The decision to continue producing depends on revenues and variable costs. If average revenue is greater than average variable cost, then the business should continue to produce. It is rational to continue producing, so long as AVC < P < ATC. When to Leave An Industry (permanent) A business should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a company will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If companies are making zero economic profits, there is no entry and no exit, which is a long run condition.

Monopoly Companies 2 7

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A monopoly is a single producer of a product which does not have close substitute. A monopoly is characterized bybarriers to entry. Sources of a monopoly include: Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond monopoly). Exclusive Right Given by Government - patents, copyrights, franchises (pharmaceutical companies, research, authors). Falling Average Total Cost - making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output. Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions A monopoly is a large enough business to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the market demand is the companys demand. Monopolists are still constrained by the negative relationship between price and quantity demanded. With fraud becoming more widespread, it's important to do a criminal background check prior to engaging in business activities. Revenue for a Monopoly A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity): 1. 2. Output effect - gains more revenue because it sells more. Price effect - gains less revenue because it gets less from each unit sold because of the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E]. When E > 1, MR > 0 because output effect > price effect When E < 1, MR < 0 because price effect > output effect When E = 1, MR = 0 because price effect = output effect Therefore, the monopolist will never produce in the inelastic portion of the demand curve since MR < 0. A straight-line demand has elasticity that varies from zero to infinity. Assuming a linear demand curve P = a-bQ, the MR curve for a straight line will: be a straight line with the same intercept and; have twice the slope of the demand curve (i.e. it is zero at the halfway point of the demand curve).

Profit Maximization Recall that the objective of a business is to maximize profits. As such, a company should produce where profit is at a maximum. In marginal terms, 1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly should increase quantity.

2. 3.

If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly should decrease quantity. Only when MR = MC (and MC cuts MR from below) is profit maximized.

A monopolist will generally produce less than a socially efficient level of output, and charge too high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still part of surplus but has been transferred from consumers to producers. Social cost arises from inefficiently low output which leads to the dead weight loss. However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then this can be a welfare cost to society. Price Discrimination Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, there must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent resales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive. Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.

Oligopoly Market Structure 18 10 16

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Between the definitions of perfect competition and pure monopoly lie oligopolies and monopolistic competition. An oligopoly is where there are a few sellers with similar or identical products, such as hockey skates (Bauer, CCM). Monopolistic competition has many companies with similar but not identical products. Each firm has monopoly power over what it produces, but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of oligopolies include crude oil businesses and auto manufacturers. The main key to behaviour in an oligopoly, is that companies must take into account what other companies will do. In perfect competition, firms are price-takers and can ignore other firms. In a monopoly, there is only one firm, and it does not take into account what competitors will do. Oligopolists are torn between: 1. 2. cooperating to increase profits by obtaining the monopoly outcome, or; competing to try to gain an advantage over competitors.

Duopolies and Cartels A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and agree to restrict output to the monopoly quantity, where price is greater than margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies come from collusion where firms agree to share output and set prices such as in a cartel. A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up with the competitive position with profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and consequently profits. Size of an Oligopoly and the Market Outcome Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the number of companies increases, the more the industry resembles a competitive outcome, since each company has a smaller effect on the outcome. The mentality where each company tends to think only of its own profits and strategic behaviour is reduced. Each company will increase production as long as price is greater than marginal cost. As the number of companies increases, we tend to move towards a perfectly competitive outcome. Game Theory and Prisoners' Dilemma Game theory is the study of how people behave in strategic situations (i.e. when they must consider the effect of other peoples responses to their own actions). In an oligopoly, each company knows that its profits depend on actions of other firms. This gives rise to the "prisoners dilemma". The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for shortsighted personal gain. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non-dominant) strategy.

Monopolistic Competition 7 12 7
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Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run, marginal revenue is always less than demand profit is maximized where MR = MC profit = (price - average total cost) x quantity

The short-run equilibrium in monopolitic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run. Long Run Equilibrium In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each companys demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each companys market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity. If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero. Monopolistic Competition and Welfare Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are: 1. Excess Capacity 2. companies in perfect competition produce where ATC is at a minimum (efficient scale) companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity) could increase capacity and lower average costs for a competitive firm, price = marginal cost for a monopolistic competition firm, price > marginal cost there is a mark-up above MC even though the firm makes zero profits

Make-up Over Marginal Cost

Efficient Outcomes and Externalities When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as, Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality Business-Stealing Externality - this is a negative externality whereby other businesses lose customers

Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market. Product Differentiation through Advertising Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits. One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost. Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing

and availability. Advertising may also be a signal of quality, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal.