works similarly in a corporate setting, replacing marginal utility with marginal profit, when the question is optimal output amount.
This kind of marginal analysis works best when there is a single point where total profit is maximized. However, there can be several points where there is a local maximum which is different than the global maximum. Consider the chart shown in Figure 3 below:
Figure 3 Minima and Maxima.
Using a marginal analysis, the manager may believe that the local maximum is the global maximum if the changes made are sufficiently small. However, a larger sample of wider points might reveal that a much larger quantity creates a global maximum.
Incentives
In economics, the acts of establishing rewards or punishments for certain behaviors is called incentivizing and disincentivizing, and the reward itself is called an incentive; the punishment, a disincentive. Students who learn useful skills incentivize a firm to hire them—while the firm, that establishes the practice of hiring trained professionals, incentivizes students as they consider their directions of study. The remainder of this book focuses on how firms can create incentives to get people to purchase services (Chapter 4), goods (Chapter 5), pay bills (Chapter 6), work toward the employer’s best interests (Chapter 7), and form new firms (Chapter 8).
Introduction to Markets
In the market model, costs, benefits, and subjective valuation all play a part. In economics, a market is a place where buyers and sellers of a product meet. This might be a physical location, an on-line location, or just an abstract concept.
The market model is centered around the concepts of supply and demand. Supply describes the behavior of the sellers, demand the behavior of buyers. Both of these terms are defined for individuals as well as for entire markets. Individual demand describes a single buyer, while market demand is the aggregate of all buyers of the particular good or service.
Individual Demand
Individual demand shows how much of a given product a buyer is willing and able to purchase, which is dependent on the price of the product at the time of consideration. Higher prices make the consumer both (1) able to buy less of the product and (2) have to give up more consumption of other products for each unit of the given good consumed (the opportunity cost increases).4 This tendency of consumers to buy more of cheaper things is called the law of demand.5
Similarly, individual supply shows how much of a product a seller is willing and able to sell of a given product. The tendency for suppliers to increase the availability of their product is called law of supply.6
Case Problems
Alice’s individual demand for hamburgers is shown below.
How many hamburgers will Alice buy if the price is $7?
There is a sale and the price of hamburgers goes down to $5. How many will Alice buy now?
Bob sells hamburgers as shown in the figure below:
Figure 4 Alice’s individual weekly supply of hamburgers.
Figure 5 Bob’s individual weekly supply of hamburgers.
How many hamburgers will Bob make if the price is $4 each?
There is a hamburger boom, and the price goes up to $5 each. How many hamburgers will Bob make now?
Market Demand, Supply, and Equilibrium
When analyzing markets, the individual supplies and individual demands are aggregated. For each price, market demand shows the total amount that can be sold of a product, and market supply shows the total amount of the available product.7 Since market demand and supply are aggregates of individual demand and supply, the laws of demand and supply remain in effect. Because of the way the addition works, the price axis will not change either for demand or supply. The quantity axis, however, will expand dramatically.
Once individual demands and supplies are transformed to market demand and supply, their functions are comparable. Before the aggregation, it makes no sense to try to offset individual supplies or demands. The quantities depicted in Figure 4 and Figure 5 differ greatly, which happens in the common market scenario when the number of buyers greatly exceeds the number of producers. Once they are aggregated, however, they are directly comparable, by focusing only on the combined amounts rather than the quantity of entities involved.
The very core of the workings of the market model is that market demand and market supply meet each other at the marketplace. All the entities who want to buy a product meet all the entities who want to sell it. As a result, the market demand and the market supply can be graphically depicted with the same set of coordinates, and their interaction can be observed, as in Figure 6.
Figure 6 The market supply and demand of hamburgers during an average week in Marketville.
Demand is the quantity that buyers want and are able to buy at each price point, while supply is the quantity the sellers want and are able to sell for each price. The price value ($5) of the intersection in Figure 5 is called the equilibrium price. When the price on the market equals the equilibrium price, it means that buyers want to buy exactly the same number of goods that the sellers are willing to sell. This amount is known as the equilibrium quantity. When the price is the equilibrium price, all the products brought to the market by the producers will be bought by the buyers, and all the buyers who want to buy products at that price will be able to do so. The market effectively “clears” itself of goods, and all the demand is satiated, thus equilibrium price is also called market-clearing price.8
Markets tend to move toward equilibrium under certain circumstances. Those circumstances include: 1) The entities are rational. That is, they realize their own self-interests and always follow them, 2) the markets are competitive, meaning that the buyers and sellers are relatively numerous and similar in size, so no single one of them can exert undue influence on what is happening on the market, and 3) perfect information ensures that all buyers and sellers are familiar with all of the relevant information regarding the product. When a market exhibits these traits, it is a perfectly competitive market or perfect competition.
In a perfect competition, the behavior of individual buyers and suppliers ensures that the market converges towards equilibrium. Consider the situation depicted in Figure
