To appreciate these laws in action, consider the market for pizza in your town (or neighborhood). If everyone is willing to pay $25 for a pizza (a relatively high price), the town’s only pizzeria will produce a large supply. But if everyone is willing to pay only $5 (a relatively low price), it will make fewer pizzas. Through careful analysis, we can determine how many pizzas will be sold at different prices. These results, called a demand and supply schedule, are obtained from marketing research, historical data, and other studies of the market. Properly applied, they reveal the relationships among different levels of demand and supply at different price levels.

The demand and supply schedule can be used to construct demand and supply curves for pizza in your town. A demand curve shows how many products—in this case, pizzas—will be demanded (bought) at different prices. A supply curve shows how many pizzas will be supplied (baked or offered for sale) at different prices.

Figure 1.2 shows demand and supply curves for pizzas. As you can see, demand increases as price decreases; supply increases as price increases. When demand and supply curves are plotted on the same graph, the point at which they intersect is the market price (also called the equilibrium price), the price at which the quantity of goods demanded and the quantity of goods supplied are equal. In Figure 1.2, the equilibrium price for pizzas in our example is $10. At this point, the quantity of pizzas demanded and the quantity of pizzas supplied are the same: 1,000 pizzas per week.

Figure 1.2

Demand and Supply

1.3-1 Full Alternative Text

1.3-1 Full Alternative Text

What if the pizzeria decides to make some other number of pizzas? For example, what would happen if the owner tried to increase profits by making more pizzas to sell? Or what if the owner wanted to lower overhead, cut back on store hours, and reduce the number of pizzas offered for sale? In either case, the result would be an inefficient use of resources and lower profits. For instance, if the pizzeria supplies 1,200 pizzas and tries to sell them for $10 each, 200 pizzas will not be bought. Our demand schedule shows that only 1,000 pizzas will be demanded at this price. The pizzeria will therefore have a surplus, a situation in which the quantity supplied exceeds the quantity demanded. It will lose the money that it spent making those extra 200 pizzas.

Conversely, if the pizzeria supplies only 800 pizzas, a shortage will result, meaning the quantity demanded will be greater than the quantity supplied. The pizzeria will “lose” the extra profit that it could have made by producing 200 more pizzas. Even though consumers may pay more for pizzas because of the shortage, the pizzeria will still earn lower total profits than if it had made 1,000 pizzas. It will also risk angering customers who cannot buy pizzas and encourage other entrepreneurs to set up competing pizzerias to satisfy unmet demand. Businesses should seek the ideal combination of price charged and quantity supplied so as to maximize profits, maintain goodwill among customers, and discourage competition. This ideal combination is found at the equilibrium point.

This simple example involves only one company, one product, and a few buyers. The U.S. economy—indeed, any market economy—is far more complex. Thousands of companies sell hundreds of thousands of products to millions of buyers every day. In the end, however, the result is much the same: Companies try to supply the quantity and selection of goods that will earn them the largest profits. For example, most families vacation during the summer months when children are out of school. As a result, airlines increase their capacity to popular travel destinations and hotels, and resorts, and car rental agencies at those destinations adjust their rates to account for the increased demand. But when September rolls around, airlines adjust their routes to other destinations and many resorts start to lower their rates. Adjustments continue throughout the year to account for fluctuations during ski season, spring break, long weekends, and other times that people may decide to take vacations.

For perfect competition to exist, two conditions must prevail: (1) all firms in an industry must be small, and (2) the number of firms in the industry must be large. Under these conditions, no single firm is powerful enough to influence the price of its product. Prices are, therefore, determined by such market forces as supply and demand.

In addition, these two conditions also reflect four principles:

1. The products of each firm are so similar that buyers view them as identical to those of other firms.

2. Both buyers and sellers know the prices that others are paying and receiving in the marketplace.

3. Because each firm is small, it is easy for firms to enter or leave the market.

4. Going prices are set exclusively by supply and demand and accepted by both sellers and buyers.

U.S. agriculture is a good example of perfect competition. The wheat produced on one farm is the same as that from another. Both producers and buyers are aware of prevailing market prices. It is relatively easy to start producing wheat and relatively easy to stop when it’s no longer profitable.

In monopolistic competition, numerous sellers are trying to make their products at least seem to be different from those of competitors. Although many sellers are involved in monopolistic competition, there tend to be fewer than in pure competition. Differentiating strategies include brand names (Tide versus Cheer versus in-store house brands of detergent), design or styling (Diesel versus Lucky versus True Religion jeans), and advertising (Coke versus Pepsi versus Dr. Pepper). For example, in an effort to attract weight-conscious consumers, Kraft Foods promotes such differentiated products as low-fat Cool Whip, low-calorie Jell-O, and sugar-free Kool-Aid.

Monopolistically competitive businesses may be large or small, but they can still enter or leave the market easily. For example, many small clothing stores compete successfully with large apparel retailers, such as Abercrombie & Fitch, Banana Republic, and J. Crew. A good case in point is bebe stores. The small clothing chain controls its own manufacturing facilities and can respond just as quickly as firms such as the Gap to changes in fashion tastes. Likewise, many single-store clothing businesses in college towns compete by developing their own T-shirt and baseball cap designs with copyrighted slogans and logos.

Product differentiation also gives sellers some control over prices. For instance, even though Target shirts may have similar styling and other features, Ralph Lauren Polo shirts can be priced with little regard for lower Target prices. But the large number of buyers relative to sellers applies potential limits to prices; although Polo might be able to sell shirts for $20 more than a comparable Target shirt, it could not sell as many shirts if they were priced at $200 more.

When an industry has only a handful of sellers, an oligopoly exists. As a general rule, these sellers are quite large. The entry of new competitors is hard because large capital investment is needed. Thus, oligopolistic industries (automobile, airline, and steel industries) tend to stay that way. Only two companies make large commercial aircraft: Boeing (a U.S. company) and Airbus (a European consortium). Furthermore, as the trend toward globalization continues, most experts believe that oligopolies will become increasingly prevalent.

Oligopolists have more control over their strategies than do monopolistically competitive firms, but the actions of one firm can significantly affect the sales of every other firm in the industry. For example, when one firm cuts prices or offers incentives to increase sales, the others usually protect sales by doing the same. Likewise, when one firm raises prices, others generally follow suit. Therefore, the prices of comparable products are usually similar. When an airline announces new fare discounts, others adopt the same strategy almost immediately. Just as quickly, when discounts end for one airline, they usually end for everyone else.

A monopoly exists when an industry or market has only one producer (or else is so dominated by one producer that other firms cannot compete with it). A sole producer enjoys complete control over the prices of its products. Its only constraint is a decrease in consumer demand as a result of increased prices. In the United States, laws, such as the Sherman Antitrust Act (1890) and the Clayton Act (1914), forbid many monopolies and regulate prices charged by natural monopolies, industries in which one company can most efficiently supply all needed goods or services. Many electric companies are natural monopolies because they can supply all the power needed in a local area. Duplicate facilities—such as two power plants and two sets of power lines—would be wasteful.