Q&A: Decision-Making Strategies Question 1: What is supply and demand? Answer 1: Supply refers to the actions of firms to create, distribute, and market goods and services. Firms create products that they think will be desirable and will earn a profit. Firms are not always successful in offering products because the ultimate judge is the consumer. Firms will provide more products when prices are high because they can earn more money. If prices are low, firms will want to supply less. Consumers demand goods and services to meet their basic needs of survival as well as for enjoyment, safety, and personal fulfillment. When prices are high, consumers tend to demand less because they only have so much money to spend. When prices are low, consumers will usually increase their demand. Consumers are the reason why firms supply goods. Firms and consumers rely on each other to provide a steady stream of goods and services. When the forces of supply and demand meet, an exchange takes place. This basic idea is the underpinning of our entire economy. Question 2: What is elasticity? Answer 2: Elasticity answers this question: If we change price, how much will demand change? The law of supply and demand states that as the price of a good goes up, producers are willing to supply more of it and consumers will demand less. Also, as the price of a good goes down, producers are willing to supply less of it, but consumers will demand more of it. Hence, elasticity quantifies the law of supply and demand by telling us how much demand will change. As an example, consider a lollipop factory. Currently, the price of a lollipop is 25, and the factory sells 1 million lollipops a year. Suppose that the factory wants to raise the price 5. Using the law of supply and demand, the factory can predict that it will sell fewer lollipops. It can also calculate the price elasticity by dividing the percent change in quantity demanded by the percent change in price. This information can be used to classify what will happen into three categories: the lollipops will be elastic, inelastic, or unitary elastic. 1
If the lollipops are elastic, consumers will strongly respond to a price change. Thus, a 5 increase will result in a lot fewer lollipops being demanded. If the lollipops are inelastic, that means consumers will not change their lollipop purchases much. Hence, the factory can raise price and expect to sell slightly fewer lollipops. If the lollipops are unitary elastic, the demand for lollipops will move in direct proportion to the change in price. Question 3: What factors influence the price elasticity of demand? Answer 3: There are four main influences on elasticity: The availability of substitutes: If consumers can easily substitute one good for another, prices tend to be elastic. For example, suppose that the price of both red and green grapes is $3.99 a pound. Then, the price of red grapes falls to $1.99 a pound. Red and green grapes are similar goods, and a consumer can substitute one for another. Hence, consumers can be expected to buy a lot more red grapes now. This makes green grapes elastic. The specific nature of the good: Consider how goods are defined. Soda pop is a specific type of beverage. The more specifically you define a good, the more elastic it will be. In other words, suppose you are very thirsty; you will buy a drink even if it is at a high price. However, you might not be willing to pay such a high price for a soda maybe you do not like the bubbles and taste. This makes the the soda more elastic than other beverages in general. The part of income spent on the good: If a good is a significant part of your budget, then you will shop around a lot more. For example, you might spend a lot of time looking for an apartment because you might be spending half of your income on it. This will make the good elastic. Compare this to buying a pack of gum you generally do not shop around for the best price. The time available to buy the good: The more time a consumer has to shop around, the more elastic the good is. When it is an emergency situation, consumers are more willing to pay any price. However, if a person can shop around, he or she most likely will. Question 4: What does consumer behavior describe? 2
Answer 4: Consumer behavior tells economists how consumers make choices. Consumers are people who buy goods and services to meet the basic needs of life and enjoy some luxury. Think of all the goods and services a typical person buys in a week. Each decision a person makes is an example of consumer behavior. Many times, consumers do not carefully weigh each consumption decision. We tend to buy what we have always bought unless there is a change in circumstances. The price of the good may have changed, income may be different, or marketing may have influenced perceptions. One reason why marketers try to reach young consumers is to set their buying patterns. Each person has different needs and budgets. Consequently, economists can have a difficult time predicting what all consumers will do. They have to make a lot of assumptions by relying on past behaviors. Question 5: What is utility maximization? Answer 5: Utility means how much usefulness a person gets out of consuming a product. Utility can also provide happiness. For example, consuming chocolate may double a consumer's happiness; chocolate may have a lot of utility to this particular consumer. For others, chocolate may not be desirable at all. All consumers try to get the most utility from their purchases. They make choices among different goods and services and try to pick the best possible combination of goods. A person may choose to have a roommate and own a car. This may give a person higher utility than living alone with no car. Of course, we all have a budget there is only so much we can buy. Our budget limits our choices. Thus, consumers try to pick the best combination of goods and services to maximize the utility subject to their budget. Question 6: What are the costs of production? Answer 6: There are four factors of production: land, labor, capital, and entrepreneurship. These four factors are the components that humans use to transform raw 3
materials into the goods and services consumers enjoy. The cost of producing a good can be partly found by examining the four factors of production. Land consists of components such as soil for agriculture, a place to build a factory, and raw materials that can be mined. Gold would be an example of something that comes from land. Labor is people power. An example of labor is when humans expend effort on producing something. Capital is the tool humans use to make things. Capital can be simple or complex, such as using a simple calculator for addition or using a graphing calculator for a linear equation. Entrepreneurship is the willingness to take risks and assembling the other factors of production. To figure out the costs of production, a manager could begin by adding up the amount of land, labor, capital, and entrepreneurship. When one of the factors is very expensive, producers will substitute one of the other factors, which is less expensive. For example, bank tellers can be expensive to employ; consequently, banks substitute this type of human labor with capital for example, an ATM. Question 7: Which decisions are made in the short run? Answer 7: The short run is defined as the time when a firm can change a single factor of production. The four factors of production are land, labor, capital, and entrepreneurship. Market conditions change, and the costs of production will fluctuate. Firms need to constantly evaluate the mix of each factor of production. Almost always, firms will adjust labor in the short run. This is because it is usually easiest to hire and fire workers. For example, it might take several months to buy a new piece of land, but a factory can ask workers to work overtime any day. Question 8: Which decisions are made in the long run? Answer 8: The long run is defined as the time when a firm can change two or more factors of production. The four factors of production are land, labor, capital, and entrepreneurship. Market conditions change, and the costs of production will fluctuate. Firms need to constantly evaluate the mix of each factor of 4
production. In the long run, firms have a lot of freedom to shape their production process and reduce costs. Land, capital, and entrepreneurship are the factors that are most often changed after an adjustment in labor. For example, a firm may purchase a new piece of factory equipment, and this would be a change in capital. Question 9: What are supply and demand curves? Answer 9: Supply and demand curves are graphical representations of the amount of goods and services that will be offered for sale by firms and demanded by consumers. Supply and demand curves are created from schedules tables of various prices with the resulting amount of goods demanded and supplied. Supply and demand curves tell the same information as a schedule, but it is just in a different form. Supply curves tend to slope upward. This supports the law of supply: As prices rise, more goods will be supplied. Demand curves slope downward. This supports the law of demand: As prices fall, more goods will be demanded. Equilibrium means balance. A teeter-totter needs to have people of equal weight on both sides to balance. If one side is too heavy, then it will tilt. When the people are the same weight, the teeter-totter will perfectly balance and be in equilibrium. Where the supply and demand curves meet is called equilibrium. This is the place where producers are willing to supply goods, and consumers are willing to demand them at a certain price. At equilibrium, an exchange is made between producers and consumers. Question 10: How can supply and demand curves be used to predict changes in the market? Answer 10: There are two key ways economists can use supply and demand curves to predict changes in the market. The first way is analyzing movement along the curves. A change in the price of a good causes a movement along the supply and demand curves. For example, the price of a CD player may drop by $10; 5
we can then read along the demand curve to see how many more CD players will be demanded. Supply and demand curves can also shift; that is the second way economists can predict changes in the market. These curves shift when some other variable (other than price) changes. For example, if there is a hurricane, the available supply of a good may drop. This will cause the supply curve to shift down, and economists can predict that the price will rise. In reality, supply and demand curves can shift around quite a bit because the marketplace is always in flux. It is better to think of supply and demand curves as a picture of the market at a single point in time. Over time, economists can build supply and demand models to predict changes in the market. 6