AUD CPA Practice Questions: Supply and Demand, Elasticity, and Profit Maximization

Supply and Demand, Elasticity, and Profit Maximization

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In these videos, we walk through 5 AUD practice questions in each to teach about supply and demand, elasticity, and profit maximization. These questions are from AUD content area 2 on the AICPA CPA exam blueprints: Assessing Risk and Developing a Planned Response.

The best way to use each video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.

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Supply and Demand, Elasticity, and Profit Maximization

Supply and demand are the foundation of economics, determining how goods and services are produced, priced, and consumed. In this post, we’ll break down key concepts such as the laws of supply and demand, elasticity, and profit maximization, explaining how they work with real-world examples.

The Law of Supply and the Law of Demand

The law of supply states that as the price of a good increases, producers are willing to supply more of it to maximize profits. Conversely, as the price decreases, producers supply less since lower prices make production less profitable.

For example, if the price of smartphones rises, manufacturers will ramp up production to take advantage of the higher selling price. But if smartphone prices drop, some manufacturers may scale back production or even leave the market.

The law of demand states that as the price of a good increases, consumers will buy less of it. Likewise, as the price decreases, consumers buy more because the product becomes more affordable.

A great example is gas prices—when fuel prices rise, people try to drive less or seek alternatives like public transportation. When gas prices fall, consumers tend to drive more and may even switch to larger, less fuel-efficient vehicles.

Changes in Quantity Supplied/Demanded vs. Changes in Supply/Demand

A common mistake is confusing a movement along the supply or demand curve with a shift of the entire curve.

  • A change in quantity supplied or quantity demanded happens only because of a price change and results in movement along the curve.
    • Example: If the price of coffee rises, fewer people buy it, moving along the demand curve to a lower quantity.
  • A change in supply or demand happens because of external factors other than price and results in the entire curve shifting left or right.
    • Example: If a new study claims that coffee has major health benefits, demand increases at all price levels, shifting the demand curve to the right.

Factors That Shift Supply

Several factors influence supply beyond just price, including:

  • Input Costs: If the cost of raw materials, labor, or production rises, supply decreases because it’s more expensive to produce goods. For example, if the cost of steel increases, fewer cars will be produced at each price point.
  • Technology: Advances in production efficiency can increase supply by making goods easier and cheaper to produce. Automation in manufacturing is a great example of this.
  • Government Policies: Taxes and regulations can reduce supply, while subsidies and incentives can increase it. For example, government subsidies for electric vehicles encourage more production.
  • Number of Suppliers: More firms entering a market increase supply, while fewer firms reduce it.

Factors That Shift Demand

Likewise, demand can change due to several external factors, including:

  • Consumer Income: Higher incomes lead to increased demand for normal goods (e.g., luxury items, restaurant meals) and decreased demand for inferior goods (e.g., generic brands, used cars).
  • Trends and Preferences: Consumer tastes shift over time. If a new diet trend promotes plant-based eating, demand for meat substitutes rises.
  • Prices of Related Goods:
    • Substitutes: If the price of Coca-Cola rises, more people may buy Pepsi, increasing its demand.
    • Complements: If the price of gaming consoles drops, demand for video games increases because they are used together.
  • Consumer Expectations: If people expect housing prices to rise, demand increases now as buyers rush to purchase before costs climb higher.

Price Elasticity: Measuring Responsiveness to Price Changes

Price Elasticity of Demand

Price elasticity of demand measures how much consumer demand changes in response to price fluctuations:

  • Elastic demand (> 1): Demand changes significantly when price changes. Luxury goods like designer handbags or vacations are elastic—if the price rises, consumers cut back on purchases.
  • Inelastic demand (< 1): Demand barely changes when price changes. Essential goods like gasoline and prescription medications are inelastic—people will still buy them even at higher prices.

Price Elasticity of Supply

Price elasticity of supply measures how quickly producers can respond to price changes:

  • Elastic supply (> 1): Producers can quickly increase output when prices rise. Mass-produced items like clothing or bottled water are elastic because manufacturers can adjust production easily.
  • Inelastic supply (< 1): Producers struggle to adjust supply quickly. Goods requiring long production times, like real estate or crops, are inelastic because supply cannot be increased immediately.

Profit Maximization

Businesses maximize profit by producing until marginal revenue (MR) equals marginal cost (MC):

  • Marginal Revenue (MR): The additional revenue earned from selling one more unit.
  • Marginal Cost (MC): The additional cost incurred from producing one more unit.

If MR > MC, the company should increase production because each additional unit adds profit.
If MR < MC, the company should decrease production because producing more leads to losses.
Profit is maximized when MR = MC, ensuring the most efficient level of production.

For example, if a company sells handmade furniture and earns $500 per extra chair (MR), but each additional chair costs $400 to make (MC), they should keep producing. But if material costs rise and MC becomes $550 per chair, they should reduce production to avoid losing money.

Final Thoughts

Understanding supply, demand, elasticity, and profit maximization is essential for making informed business and financial decisions. These concepts explain why prices fluctuate, how businesses adjust to market conditions, and how companies determine their optimal production levels. Whether you’re an economist, a business owner, or a consumer, recognizing these forces can help you navigate the market more effectively.

By mastering these principles, you can better understand why businesses set prices the way they do, how external factors influence markets, and how companies make decisions to maximize profit.

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