Theory of Costs - Introduction to Costs

Theory of Costs - Introduction to Costs

Theory of Costs - Introduction to Costs Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Why Study Costs?: 

Why Study Costs? Whatever may be the type of firm, it is important to ascertain that it is not incurring losses Decisions relating to expansion (or otherwise), new product development, forecasting and policy making, etc can be taken only after considering costs Concept of cost is closely related to production theory Cost function is the relationship between a firm’s costs and the firm’s output The production function combined with input prices yields the firm’s cost function

Cost Concepts: 

Cost Concepts Money costs (Actual Costs) are the total money incurred by a firm in producing a commodity or service wages and salaries, cost of raw materials, expenses on machines/buildings/capital goods, power charges, transportation, advertisement, interest expenses, taxes, depreciation etc Implicit costs are the imputed value of the entrepreneurs own resources and services Variable costs are costs that vary with the volume of output Fixed costs do not vary with output in the short-run

Cost Concepts: 

Cost Concepts Opportunity cost is the cost of missed opportunity or alternative forgone in having one thing rather than the other (since resources are limited they cannot be used to produce all things simultaneously) Actual Cost Vs Opportunity Cost Measurement of opportunity cost is difficult Marginal Cost is the addition to the total cost by producing an additional unit of out put MC = change in TC/change in TO

Costs: 

Costs

Cost Curves: 

Cost Curves

Cost Concepts: 

Cost Concepts TC=TFC+TVC AFC=TFC/Total Output AVC=TVC/Total Output AC=TC/Q = (TVC+TFC)/Q = AVC+AFC MC = change in TC/change in TO

Short-run and Long-run: 

Short-run and Long-run Meaning of Short-run and Long-run in Economics Short-run is defined as a time period during which some factors of production are fixed and others are variable In the Long-run all factors of production are variable It is important to note that these periods are not defined by any specified length of time but instead are determined by the variability of factors of production

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Short-run Cost Curves: 

Short-run Cost Curves AFC+AVC= ATC and therefore, ATC curve lies above both AFC and AVC AFC curve does not touch Y and X axes. Because the total FC is constant and increased output is accomplished by falling AC MC curve cuts AVC and ATC curves from below at the lowest points of both the curves

Why Short-run Avg Cost curve U shaped?: 

Why Short-run Avg Cost curve U shaped? Average Cost curve is made of of AFC and AVC AFC and AVC both slopes downwards in the initial stages (therefore, AC) After a particular point, AVC starts raising (rate which more than offsets the rate of fall in AFC) This results in U shaped Average Cost curve fixed factor better utilized as output increases marginal cost increases - therefore average cost

Long-run Average Cost: 

Long-run Average Cost SAC1 SAC2 SAC3 SAC4 SAC5 LAC

Long-run Average Cost: 

Long-run Average Cost In the long-run all factors of production are variable LAC can only be tangential to an SAC, because long-run cost can not be higher than short-run LAC is also known as planning curve Shape of LAC depends on the returns to scale (if returns are constant LAC will be parallel to X axis. If increasing returns then, LAC will be falling downward and if diminishing returns LAC will move upwards)

PowerPoint Presentation: 

MC ATC AVC AFC cost output

Law of Variable Proportions: 

Law of Variable Proportions “as the quantity of a variable input is increased by equal doses, keeping the quantities of other inputs constant, the total product will increase, but after a point, at a diminishing rate” In other words, when more and more units of the variable factor is used (holding the quantities of other factors constant), a point is reached beyond which the marginal product, then the average product and finally the total product will diminish This law is also known as law of diminishing returns

Law of Diminishing Returns: 

Law of Diminishing Returns

PowerPoint Presentation: 

Law of Diminishing Returns

Importance of Law: 

Importance of Law It applies to not only agriculture but also industry - universal applicability By substituting one factor in place of other, efficiency (or higher levels of production and productivity) can be achieved Remember the importance of capital and labour as factors of production in developing nations

Law of Returns to Scale: 

Law of Returns to Scale What happens when all the inputs are increased in the same proportion? The scale of production will increase - but effect on production shows three stages Increasing Returns to Scale Constant Returns to Scale Diminishing Returns to Scale

Law of Returns to Scale: 

Law of Returns to Scale

Production Function Isoquant and Isocost Approach: 

Production Function Isoquant and Isocost Approach An isoquant is a curve on which the various combinations of labor and capital show the same output. This curve is also known as production indifference curve

Production Function Isocost Approach: 

Production Function Isocost Approach Isocost curves are also known as outlay lines, price lines, input-price lines, factor-cost lines, constant-outlay lines etc. Each isocost line represents the different combinations of two inputs that a firm can buy for a given sum of money at the given price of each point.

Equilibrium of Firm -What is equilibrium?: 

Equilibrium of Firm -What is equilibrium? Firms will produce in such a way that the profit is maximized Firms will not change the production function at equilibrium output Profit = TR-TC TR = P x Q (price x quantity) AR = TR/Q = (P x Q)/Q = P therefore, AR curve showing different values of AR at various levels of output is same as the demand curve faced by an individual firm (latter shows quantities)

Shape of Demand Curve: 

Shape of Demand Curve Relationship between AR and Q is shown by the shape of the demand or AR curve AR upward sloping or rising left to right AR downward sloping AR horizontal to X axis First possibility is unlikely - a firm may not be able to sell larger and larger output by charging higher and higher price The second and third depends on the type of market

Marginal Revenue: 

Marginal Revenue MR= TR (N+1) - TR (N) or change in total revenue upon change in quantity Therefore, MR is equal to the slope of TR curve Relation between AR and MR MR = change TR/change Q MR = change (PxQ)/change Q = change (ARxQ)change Q =AR(change Q/change Q) + Q (change AR/change Q) MR=AR+Q(change AR/change Q) therefore (MR-AR) = Qx(slope of AR curve) MR = AR when AR is horizontal and MR is <AR when AR is downward sloping

Thank You: 

Thank You Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Market Theory and the Price System

 Market Theory and the Price System

 

About this Title:

The second volume in Liberty Fund’s The Collected Works of Israel M. Kirzner series, Market Theory and the Price System was published in 1963 as Kirzner’s first (and only) textbook. This volume presents an integrated view of Austrian price theory. The basic aim of Market Theory is to utilize the tools of economic reasoning to explain the market process. The unique framework Kirzner develops for microeconomic analysis, following Mises and Hayek, examines errors in decision-making, entrepreneurial profit, and competition as a process of discovery and learning.

Copyright information:

The copyright to this edition, in both print and electronic forms, is held by Liberty Fund, Inc.

Fair use statement:

This material is put online to further the educational goals of Liberty Fund, Inc. Unless otherwise stated in the Copyright Information section above, this material may be used freely for educational and academic purposes. It may not be used in any way for profit.

Table of Contents:

• THE COLLECTED WORKS OF ISRAEL M. KIRZNER
• CONTENTS
• INTRODUCTION TO THE LIBERTY FUND EDITION
• ACKNOWLEDGMENTS
• BIBLIOGRAPHY OF WORKS CITED IN THE INTRODUCTION
• PREFACE
• MARKET THEORY AND THE PRICE SYSTEM
• 1: THE NATURE AND TASKS OF MARKET THEORY
• THE INDIVIDUAL AND THE MARKET
• THE MARKET SYSTEM
• THE FOUNDATIONS OF MARKET THEORY
• THE INDIVIDUAL AND ECONOMIC BEHAVIOR
• ECONOMIC THEORY AND ECONOMIC REALITY
• MARKET THEORY, ECONOMIC THEORY, AND ECONOMICS
• SUMMARY
• SUGGESTED READINGS
• 2: THE MARKET: ITS STRUCTURE AND OPERATION
• THE CONDITIONS UNDER WHICH THE MARKET OPERATES
• MARKET ROLES
• THE STRUCTURE OF THE MARKET SYSTEM: VERTICAL RELATIONSHIPS
• THE STRUCTURE OF THE MARKET SYSTEM: HORIZONTAL RELATIONSHIPS
• THE ANALYSIS OF HUMAN ACTION IN THE MARKET: THE CONCEPT OF EQUILIBRIUM
• COMPLETE AND INCOMPLETE EQUILIBRIUM
• THE PATTERN OF MARKET ADJUSTMENT
• THE CHANGING MARKET
• THE MARKET SYSTEM AS A WHOLE
• SUMMARY
• SUGGESTED READINGS
• 3: EFFICIENCY, COORDINATION, AND THE MARKET ECONOMY
• THE ECONOMIC PROBLEM
• SOCIETY AND THE ECONOMIC PROBLEM
• THE PROBLEM OF COORDINATION
• HOW THE MARKET SOLVES THE PROBLEMS OF COORDINATION
• THE COORDINATING FUNCTION OF PROFITS IN A MARKET ECONOMY
• SUMMARY
• SUGGESTED READINGS
• 4: UTILITY THEORY
• THE SCALE OF VALUES
• MARGINAL UTILITY
• DIMINISHING MARGINAL UTILITY
• THE MARGINAL UTILITIES OF RELATED GOODS
• MARGINAL UTILITY—SOME FURTHER REMARKS
• The Paradox of Value
• The Subjective Character of Utility
• Utility as a Relative Concept
• The Ordinal Character of Utility
• Total Utility and Marginal Utility
• MARGINAL UTILITY AND THE CONDITIONS FOR EXCHANGE
• SUMMARY
• SUGGESTED READINGS
• 5: CONSUMER INCOME ALLOCATION
• MARGINAL UTILITY AND THE ALLOCATION OF INCOME
• THE POSITION OF CONSUMER’S EQUILIBRIUM
• A GEOMETRICAL ILLUSTRATION
• THE EFFECTS OF CHANGES
• 1.: Change of Tastes
• 2.: Change of Income
• 3.: Change of Prices
• Price Change for a Single Good
• THE INDIVIDUAL DEMAND CURVE
• SOME REMARKS ON EXPECTATIONS
• SUMMARY
• SUGGESTED READINGS
• 6: MARKET DEMAND
• MARKET DEMAND
• THE MARKET DEMAND CURVE
• DEMAND ELASTICITY
• MEASURES OF ELASTICITY
• MARKET DEMAND AS SEEN BY THE INDIVIDUAL ENTREPRENEUR
• DEMAND AND REVENUE
• DEMAND AND THE PRICES OF OTHER GOODS
• DEMAND AS A MARKET FORCE
• SUMMARY
• SUGGESTED READINGS
• 7: MARKET PROCESS IN A PURE EXCHANGE ECONOMY
• THE NATURE OF COMPETITION
• A SIMPLE CASE OF PRICE COMPETITION
• SIMPLE PRICE COMPETITION WITHOUT PERFECT KNOWLEDGE
• THE MARKET FOR SEVERAL NON-PRODUCIBLE GOODS: THE PROBLEM
• THE EQUILIBRIUM SITUATION FOR THE MULTI-COMMODITY MARKET
• THE MULTI-COMMODITY MARKET WITHOUT PERFECT KNOWLEDGE
• MONOPOLY IN A PURE EXCHANGE MARKET
• THE AGITATION OF THE MARKET
• SUMMARY
• SUGGESTED READINGS
• APPENDIX
• 8: PRODUCTION THEORY
• THE ECONOMIC ASPECT OF PRODUCTION
• PRODUCTION BY THE ISOLATED INDIVIDUAL
• PRODUCTION IN SOCIETY
• PRODUCTION IN THE MARKET ECONOMY
• FACTORS OF PRODUCTION
• PRODUCTION FUNCTIONS AND ISOQUANTS
• THE SHAPE OF THE ISOQUANT AND THE SUBSTITUTABILITY OF FACTORS
• CHANGES IN FACTOR PROPORTIONS, AND CHANGES IN THE SCALE OF FACTOR EMPLOYMENT
• RETURNS TO SCALE
• THE LAWS OF VARIABLE PROPORTIONS: THE PROBLEM
• THE LAWS OF VARIABLE PROPORTIONS
• ECONOMIC IMPLICATIONS OF THE LAWS OF VARIABLE PROPORTIONS
• THE LEAST-COST COMBINATION
• GRAPHIC ILLUSTRATION OF THE LEAST-COST COMBINATION
• SUMMARY
• SUGGESTED READINGS
• 9: COSTS AND SUPPLY
• COSTS AND RENTS
• OPPORTUNITY COSTS AND SUPPLY THEORY
• PROSPECTIVE AND RETROSPECTIVE COSTS
• CAPITAL GOODS AND COST THEORY
• FACTOR DIVISIBILITY AND SHORT-RUN PER-UNIT COSTS
• SHORT-RUN COSTS AND THEIR EFFECT ON SUPPLY
• LONG-RUN COSTS AND SUPPLY
• FACTOR PRICES AND SUPPLY
• SUMMARY
• SUGGESTED READINGS
• 10: PARTIAL MARKET PROCESSES—THE DETERMINATION OF PRODUCT PRICES AND FACTOR PRICES
• THE MARKET FOR A SINGLE PRODUCT
• LONG-RUN EQUILIBRIUM
• SHORT-RUN EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET
• EQUILIBRIUM IN THE SINGLE-PRODUCT MARKET IN THE VERY SHORT RUN
• ADJUSTMENT TO CHANGE IN A MARKET FOR A SINGLE PRODUCT
• THE MARKET PROCESS IN A MARKET FOR A SINGLE PRODUCT
• THE MARKET FOR A SINGLE FACTOR OF PRODUCTION
• EQUILIBRIUM IN A FACTOR MARKET
• THE MARKET PROCESS IN A MARKET FOR A SINGLE FACTOR OF PRODUCTION
• TOWARD THE GENERAL MARKET PROCESS
• SUMMARY
• SUGGESTED READINGS
• 11: THE GENERAL MARKET PROCESS
• A PRELIMINARY MODEL
• THE PRELIMINARY MODEL AND THE GENERAL MODEL
• GENERAL MARKET EQUILIBRIUM CONDITIONS
• A GENERAL MARKET IN DISEQUILIBRIUM
• DISEQUILIBRIUM IN THE GENERAL MARKET AND ENTREPRENEURIAL OPPORTUNITIES
• ENTREPRENEURIAL ACTIVITY AND THE GENERAL MARKET PROCESS
• PARTIAL ANALYSIS AND THE ANALYSIS OF A GENERAL MARKET
• TOWARD FURTHER EXTENSIONS OF THE GENERAL MARKET MODEL
• SUMMARY
• SUGGESTED READINGS
• 12: MONOPOLY AND COMPETITION IN THE GENERAL MARKET
• THE MONOPOLIZED RESOURCE
• THE RESOURCE CARTEL
• RESTRICTION OF SUPPLY: A SPECIAL CASE
• COMBINATIONS OF RESOURCE BUYERS
• MONOPOLY IN PRODUCTION
• THE CONSEQUENCES OF MONOPOLY OUTPUT RESTRICTION
• THE MONOPOLIST-PRODUCER AS A RESOURCE BUYER
• FURTHER REMARKS ON MONOPOLIZED PRODUCTS
• THE SINGLE PRODUCER WITHOUT MONOPOLY
• SOME REMARKS ON THE MODEL OF “PURE” OR “PERFECT” COMPETITION
• MONOPOLISTIC PRICE DISCRIMINATION
• SUMMARY
• SUGGESTED READINGS
• 13: THE PRICE SYSTEM AND THE ALLOCATION OF RESOURCES
• THE POSSIBLE LEVELS OF “WELFARE” APPRAISAL
• MISALLOCATION OF A RESOURCE IN A MARKET SYSTEM
• IMPERFECT KNOWLEDGE, THE SOURCE OF RESOURCE MISALLOCATION
• PRICES, PROFITS, AND THE REALLOCATION OF RESOURCES
• THE ENTREPRENEUR AND RESOURCE ALLOCATION
• RESOURCE MOBILITY AND THE ALLOCATION PATTERN
• MONOPOLY AS AN OBSTACLE TO CORRECT RESOURCE ALLOCATION
• ARTIFICIAL OBSTACLES TO CORRECT RESOURCE ALLOCATION
• SUMMARY
• SUGGESTED READINGS
• Appendix:: THE APPLICATION OF MARKET THEORY TO MULTI-PERIOD PLANNING
• MULTI-PERIOD DECISIONS IN THE PURE EXCHANGE ECONOMY
• THE INTERTEMPORAL MARKET
• SPECULATION AS AN ASPECT OF INTERTEMPORAL MARKETS
• MULTI-PERIOD DECISIONS OF PRODUCERS
• THE PLACE OF CAPITAL GOODS IN PRODUCTION
• SUGGESTED READINGS

Cross-Price Elasticity of Demand

Cross-Price Elasticity of Demand

The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. Your course may use the more complicated Arc Cross-Price Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity. The common formula for the Cross-Price Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y)

Calculating the Cross-Price Elasticity of Demand

You're given the question: "With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from $9.00 to $10.00." Using the chart on the bottom of the page, we'll answer this question. We know that the original price of Y is $9 and the new price of Y is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity demanded of X when the price of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=190. You should have these four figures written down:
Price(OLD)=9
Price(NEW)=10
QDemand(OLD)=150
QDemand(NEW)=190
To calculate the cross-price elasticity, we need to calculate the percentage change in quantity demanded and the percentage change in price. We'll calculate these one at a time.

Calculating the Percentage Change in Quantity Demanded of Good X

The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD)
By filling in the values we wrote down, we get:
[190 - 150] / 150 = (40/150) = 0.2667
So we note that % Change in Quantity Demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%).

Calculating the Percentage Change in Price of Good Y

The formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD)
We fill in the values and get:
[10 - 9] / 9 = (1/9) = 0.1111
We have our percentage changes, so we can complete the final step of calculating the cross-price elasticity of demand.

Final Step of Calculating the Cross-Price Elasticity of Demand

We go back to our formula of: CPEoD = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y)
We can now get this value by using the figures we calculated earlier.
CPEoD = (0.2667)/(0.1111) = 2.4005
We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to $10 is 2.4005.

How Do We Interpret the Cross-Price Elasticity of Demand?

The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. A high positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes?". To answer that question, you use the following rule of thumb:

• If CPEoD > 0 then the two goods are substitutes
• If CPEoD =0 then the two goods are independent (no relationship between the two goods
• If CPEoD < 0 then the two goods are complements

In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between $9 and $10. If you'd like to ask a question about elasticity, microeconomics, macroeconomics or any other topic or comment on this story, please use the feedback form.

ease use the feedback form.

Types of Elasticity

A Shift versus a Movement Along a Demand Curve

A Shift versus a Movement Along a Demand Curve

It is essential to distinguish between a movement along a demand curve and a shift in the demand curve. A change in price results in a movement along a fixed demand curve. This is also referred to as a change in quantity demanded. For example, an increase in video rental prices from $3 to $4 reduces quantity demanded from 30 units to 20 units. This price change results in a movement along a given demand curve. A change in any other variable that influences quantity demanded produces a shift in the demand curve or a change in demand. The terminology is subtle but extremely important. The majority of the confusion that students have with supply and demand concepts involves understanding the differences between shifts and movements along curves.

TABLE 4 Change in Demand for Videos after Incomes Rise
Price	Initial Quantity Demanded	New Quantity Demanded	Quantity Supplied
$5	10	30	50
$4	20	40	40
$3	30	50	30
$2	40	60	20
$1	50	70	10

Suppose that incomes in a community rise because a factory is able to give employees overtime pay. The higher incomes prompt people to rent more videos. For the same rental price, quantity demanded is now higher than before. Table 4 and the figure titled "Shift in the Demand Curve" represent that scenario. As incomes rise, the quantity demanded for videos priced at $4 goes from 20 (point A) to 40 (point A'). Similarly, the quantity demanded for videos priced at $3 rises from 30 to 50. The entire demand curve shifts to the right.

A shift in the demand curve changes the equilibrium position. As illustrated in the figure titled "Equilibrium After a Demand Curve Shift" the shift in the demand curve moves the market equilibrium from point A to point B, resulting in a higher price (from $3 to $4) and higher quantity (from 30 to 40 units). Note that if the demand curve shifted to the left, both the equilibrium price and quantity would decline.

Equilibrium: Determination of Price and Quantity

Equilibrium: Determination of Price and Quantity

What price should the seller set and how many videos will be rented per month? The seller could legally set any price she wished; however, market forces penalize her for making poor choices. Suppose, for example, that the seller prices each video at $20. Odds are good that few videos will be rented. On the other hand, the seller may set a price of $1 per video. Consumers will certainly rent more videos with this low price, so much so that the store is likely to run out of videos. Through trial and error or good judgement, the store owner will eventually settle on a price that equates the forces of supply and demand.

In economics, an equilibrium is a situation in which:

• there is no inherent tendency to change,
• quantity demanded equals quantity supplied, and
• the market just clears.

At the market equilibrium, every consumer who wishes to purchase the product at the market price is able to do so, and the supplier is not left with any unwanted inventory. As Table 3 and the figure titled "Equilibrium" demonstrate, equilibrium in the video example occurs at a price of $3 and a quantity of 30 videos.

TABLE 3 Video Market Equilibrium
Price	Quantity Demanded	Quantity Supplied
$5	10	50
$4	20	40
$3	30	30
$2	40	20
$1	50	10

Suppose that the video store owner charges $2 per video rental. The result is a shortage. A shortage occurs when quantity demanded exceeds quantity supplied. At a price of $2, quantity supplied is 20 videos but quantity demanded is 40 videos. Some consumers who wish to rent videos are unable to do so. A shortage implies the market price is too low. Shortages are common in socialist economies because low prices for common staples such as food and energy are set by the government. Rather than pay higher prices, people are forced to wait in long lines to purchase the desired goods and services. 

A surplus occurs when quantity supplied exceeds quantity demanded. With a rental price of $4, quantity supplied is 40 videos but quantity demanded is only 20 videos. A surplus of 20 videos exists. A surplus implies the market price is too high.

Perhaps more often than not, markets are not exactly in equilibrium. Minor surpluses and shortages are common in a market economy. A stroll through most malls at the end of the clothing season reveals the excess clothing inventory that many stores carry. How do they manage this situation? By lowering prices. Lower prices reduce the incentive for stores to carry the clothes while simultaneously increasing the incentive for consumers to purchase the clothes. The important point is that even though a market may not be in perfect equilibrium, it tends to gravitate towards equilibrium over time. This fact makes markets stable most of the time such that persistent surpluses and shortages are uncommon and self-correcting.

Persistent and severe shortages and surpluses do occur in the U.S. economy every now and then. At the end of 1998, for example, the supply of hogs in the U.S. markets was so much greater than demand that the price of hogs fell from about $50 per hundredweight to $13 per hundredweight. Many farmers were so badly hurt by that experience that they left the hog market completely--a painful but self-correcting force. In the late 1970s the relative shortage of gasoline resulted in long lines at the gas pumps. The shortages lasted for a couple years until oil producers stepped up production and consumers learned to use fuel more efficiently.

Source: http://www.econweb.com/MacroWelcome/sandd/notes.html#3

The Law of Supply

The Law of Supply 

The Law of Supply and the Supply Curve

Supply is slightly more difficult to understand because most of us have little direct experience on the supply side of the market. Supply is derived from a producer's desire to maximize profits. When the price of a product rises, the supplier has an incentive to increase production because he can justify higher costs to produce the product, increasing the potential to earn larger profits. Profit is the difference between revenues and costs. If the producer can raise the price and sell the same number of goods while holding costs constant, then profits increase.

The law of supply holds that other things equal, as the price of a good rises, its quantity supplied will rise, and vice versa. Table 2 lists the quantity supplied of rental videos for various prices. At $5, the producer has an incentive to supply 50 videos. If the price falls to $4 quantity supplied falls to 40, and so on. The figure titled "Supply Curve" plots this positive relationship between price and quantity supplied.

TABLE 2 Supply of Videos
Price	Quantity Supplied
$5	50
$4	40
$3	30
$2	20
$1	10

A supply curve is a graphical depiction of a supply schedule plotting price on the vertical axis and quantity supplied on the horizontal axis. The supply curve is upward-sloping, reflecting the law of supply.

Source: http://www.econweb.com/MacroWelcome/sandd/notes.html#2

The Law of Demand

The Law of Demand 

The Law of Demand and the Demand Curve

We begin with demand because demand is usually easier to understand from our personal experiences. We are all consumers and we all demand goods and services. Demand is derived from consumers' tastes and preferences, and it is bound by income. In other words, given a limited income (whether it be $30,000 or $5 million), the consumer must decide what goods and services to purchase. Within his budget, the consumer will purchase those goods and services that he likes best. Each consumer will purchase different things because individual preferences and incomes differ.

The law of demand holds that other things equal, as the price of a good or service rises, its quantity demanded falls. The reverse is also true: as the price of a good or service falls, its quantity demanded increases. This law is a simple, common sense principle. Think of your trips to the grocery store. When the price of orange juice rises, for example, you buy less of it. When that item is on sale, you purchase more of it. This is all that we mean by the law of demand.

Table 1 lists the monthly quantity of rental videos demanded by an individual given several different prices. If the rental price is $5, the consumer rents 10 videos per month. If the price falls to $4, the quantity demanded increases to 20 videos, and so on. The figure titled "Demand Curve" plots the inverse relationship between price and quantity demanded.

TABLE 1 Demand for Videos
Price	Quantity Demanded
$5	10
$4	20
$3	30
$2	40
$1	50

A demand curve is a graphical depiction of the law of demand. We plot price on the vertical axis and quantity demanded on the horizontal axis. As the figure illustrates, the demand curve has a negative slope, consistent with the law of demand.

 Source: http://www.econweb.com/MacroWelcome/sandd/notes.html#1