Managerial economics and business strategy chap 2

• Market demand curve– Illustrates the relationship between the total quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables const

CHAPTER 2

MARKET FORCES:

DEMAND AND SUPPLY

Objectives:

1 Explain the laws of demand and supply, and identify factors that

cause demand and supply to shift.

2 Calculate consumer surplus and producer surplus, and describe

what they mean.

3 Explain price determination in a competitive market, and show how

equilibrium changes in response to changes in determinants of demand and supply.

4 Explain and illustrate how excise taxes, ad valorem taxes, price

floors, and price ceilings impact the functioning of a market.

5 Apply supply and demand analysis as a qualitative forecasting tool to

see the “big picture” in competitive markets.

– Factors that change quantity supplied and factors that change supply

– The supply function

Demand

• Market demand curve

– Illustrates the relationship between the total

quantity and price per unit of a good all

consumers are willing and able to purchase,

holding other variables constant

• Law of demand

– The quantity of a good consumers are willing and

able to purchase increases (decreases) as the

price falls (rises)

2-4

Demand

Demand

Market Demand Curve

• Changing only price leads to changes in

quantity demanded.

– This type of change is graphically represented by a

movement along a given demand curve, holding

other factors that impact demand constant

• Changing factors other than price lead to

changes in demand.

– These types of changes are graphically

represented by a shift of the entire demand curve

2-6

Demand

Changes in Quantity Demanded

Changes in Demand

Quantity 0

Price

D 1

Increase

in demand

Demand Shifters

– Normal good: A good for which an increase (decrease)

in income leads to an increase (decrease) in the demand for that good

– Inferior good: A good for which an increase (decrease)

in income leads to a decrease (increase) in the demand for that good

Demand Shifters

– Substitute goods: Goods for which an increase (decrease)

in the price of one good leads to an increase (decrease)

in the demand for the other good

– Complement goods: Goods for which an increase

(decrease) in the price of one good leads to a decrease (increase) in the demand for the other good

Demand

Advertising and the Demand for Clothing

2-10

Quantity of high-style clothing 0

Demand

D 1

Demand Shifters

• Income

• Prices of related goods

• Advertising and consumer tastes

Demand

• The demand function for good X is a

mathematical representation describing how

many units will be purchased at different

prices for good X, different prices of a related

good Y, different levels of income, and other

factors that affect the demand for good X.

2-12

Demand

The Demand Function

• One simple, but useful, representation of a

demand function is the linear demand function:

, where:

– 𝑄!" is the number of units of good X demanded;

– 𝑃! is the price of good X;

– 𝑃# is the price of a related good Y;

• The signs and magnitude of the 𝛼 coefficients

determine the impact of each variable on the

number of units of X demanded.

𝑄!" = 𝛼# + 𝛼!𝑃! + 𝛼$𝑃$ + 𝛼%𝑀

• For example:

– 𝛼! < 0 by the law of demand;

– 𝛼" > 0 if good Y is a substitute for good X;

– 𝛼# < 0 if good X is an inferior good

2-14

Demand

Understanding the Linear Demand Function

• Suppose that an economic consultant for X Corp

recently provided the firm’s marketing manager with

this estimate of the demand function for the firm’s

product:

𝑄!$ = 12,000 − 3𝑃! + 4𝑃" − 1𝑀 + 2𝐴!

Question: How many of good X will consumers

purchase when 𝑃! = $200 per unit, 𝑃" = $15 per unit,

𝑀 = $10,000 and 𝐴! = 2,000? Are goods X and Y

substitutes or complements? Is good X a normal or an

inferior good?

Demand

The Linear Demand Function in Action

Inverse Demand Function

Graphing the Inverse Demand Function in Action

• Marketing strategies – like value pricing and

price discrimination – rely on understanding

consumer value for products

– Total consumer value is the sum of the maximum

amount a consumer is willing to pay at different

quantities

– Total expenditure is the per-unit market price

times the number of units consumed

– Consumer surplus is the extra value that

consumers derive from a good but do not pay for

2-18

3

Consumer Surplus

• The demand curve for product X is given by

𝑄!" = 460 - 4 P&

– Find the inverse demand curve

– How much consumer surplus do consumers receive when P% =$35?

– How much consumer surplus do consumers receive when P% =$25?

– In general, what happens to the level of consumer

surplus as the price of a

– good falls?

Copyright © 2014 by the McGraw-Hill Companies, Inc All rights

• Market supply curve

– Summarizes the relationship between the total

quantity all producers are willing and able to

produce at alternative prices, holding other

factors affecting supply constant

• Law of supply

– As the price of a good rises (falls), the quantity

supplied of the good rises (falls), holding other

factors affecting supply constant

• Changing only price leads to changes in

quantity supplied.

– This type of change is graphically represented by a

movement along a given supply curve, holding

other factors that impact supply constant

• Changing factors other than price lead to

changes in supply.

– These types of changes are graphically

represented by a shift of the entire supply curve

2-22

Supply

Changes in Quantity Supplied

Change in Supply in Action

Change in Supply in Action

Quantity of gasoline per

Change in Supply in Action

Quantity of backpacks per week

The Supply Function

• The supply function for good X is a

mathematical representation describing how

many units will be produced at different prices for X, different prices of inputs W, prices of

technologically related goods, and other

factors that affect the supply for good X.

Supply

The Linear Supply Function

• One simple, but useful, representation of a

supply function is the linear supply function:

𝑄!' = 𝛽# + 𝛽!𝑃! + 𝛽(𝑊 + 𝛽)𝑃) + 𝛽*𝐻

, where:

– 𝑄!& is the number of units of good X produced;

– 𝑃! is the price of good X;

– 𝑊 is the price of an input;

– 𝑃' is price of technologically related goods;

– 𝐻 is the value of any other variable affecting

supply

2-28

Supply

• The signs and magnitude of the 𝛽 coefficients

determine the impact of each variable on the

number of units of X produced.

𝑄!' = 𝛽# + 𝛽!𝑃! + 𝛽(𝑊 + 𝛽)𝑃)

• For example:

– 𝛽! > 0 by the law of supply

– 𝛽( < 0 increasing input price

– 𝛽' > 0 technology lowers the cost of producing

good X

Supply

Understanding the Linear Supply Function

• Your research department estimates that the

supply function for televisions sets is given by:

𝑄!' = 2,000 + 3𝑃! − 4𝑃+ − 1𝑃(

Question: How many televisions are produced

when 𝑃! = $400 , 𝑃+ = $100 per unit, and

Inverse Supply Function

• By setting 𝑃( = $2,000 and 𝑃) = $100 in

𝑄!' = 2,000 + 3𝑃! − 4 100 − 1 2,000

the linear supply function simplifies to

𝑄!' = 3𝑃! − 400 Solving this for 𝑃! in terms of 𝑄!' results in

, which is called the inverse supply function

This function is used to construct a market

supply curve.

Supply

• The amount producers receive in excess of the amount necessary to induce them to produce

the good.

2-32

Supply

Producer Surplus

Producer Surplus in Action

• The supply curve for product X is given by

𝑄!' =340+10 𝑃!

• Find the inverse supply curve

• How much surplus do producers receive when

Q! = 350? When Q! = 1,000?

Copyright © 2014 by the McGraw-Hill Companies, Inc All rights

• Competitive market equilibrium

– Price of a good is determined by the interactions

of the market demand and market supply for the

good

– A price and quantity such that there is no shortage

or surplus in the market

– Forces that drive market demand and market

supply are balanced, and there is no pressure on

prices or quantities to change

Market Equilibrium Market Equilibrium

• Consider a market with demand and supply

functions, respectively, as

• In a competitive market equilibrium, price and quantity freely adjust to the forces of demand

and supply.

• Sometimes the government restricts how

much prices are permitted to rise or fall

e Lost social welfare

Price Restrictions and Market Equilibrium

Price Ceiling in Action I

• Consider a market with demand and supply

functions, respectively, as

the market but then set a price ceiling at the

Chinese equivalent of $ 1.50?

– 𝑄" = 10 − 2 $1.50 = 7 units.

– 𝑄$ = 2 + 2($1.50) = 5 units.

– Since 𝑄" > 𝑄$ a shortage of 7 − 5 = 2 units exists.

– Full economic price of 5𝑡ℎ unit is 5 = 10 − 2𝑃%&'', or

𝑃%&'' = $2.50 Of this,

2-40

Price Restrictions and Market Equilibrium

Price Ceiling in Action II

Price Restrictions and Market Equilibrium

Price Floor in Action I

Cost of purchasing excess supply

= 𝑃)(Qs − Qd)

G F

M

• Consider a market with demand and supply

Price Restrictions and Market Equilibrium

Price Floor in Action II

– Determine the quantity demanded, the quantity

supplied, and the magnitude of the surplus if a price

floor of $42 is imposed in this market

– Determine the quantity demanded, the quantity

supplied, and the magnitude of the shortage if a price

ceiling of $30 is imposed in this market

– Also, determine the full economic price paid by

consumers

• Comparative static analysis

– The study of the movement from one equilibrium

to another

• Competitive markets, operating free of price

restraints, will be analyzed when:

• Increase in demand only

– Increase equilibrium price

– Increase equilibrium quantity

– Decrease equilibrium price

– Decrease equilibrium quantity

– Suppose that consumer incomes are projected to

increase 2.5% and the number of individuals over 25

years of age will reach an all-time high by the end of

next year What is the impact on the rental car

market?

Changes in Demand Comparative Statics

Change in Demand in Action

Quantity

(thousands rented per day)

Comparative Statics

108 A

B

• Increase in supply only

– Decrease equilibrium price

– Increase equilibrium quantity

• Decrease in supply only

– Increase equilibrium price

– Decrease equilibrium quantity

• Example of change in supply

– Suppose that a bill before Congress would require

all employers to provide health care to their

workers What is the impact on retail markets?

Changes in Supply Comparative Statics

• Suppose that simultaneously the following

events occur:

– an earthquake hit Kobe, Japan and decreased the

supply of fermented rice used to make sake wine

– the stress caused by the earthquake led many to

increase their demand for sake, and other

Simultaneous Shifts in Supply and Demand in Action

Japan’s Sake Market

• Demand and supply analysis is useful for

– Clarifying the “big picture” (the general impact of

a current event on equilibrium prices and

quantities)

– Organizing an action plan (needed changes in

production, inventories, raw materials, human

resources, marketing plans, etc.)

Conclusion

Changes in Quantity Demanded

International Oil Market

(Dollars per Barrel)

Increase in quantity demanded

Demand

International Oil Market

Increase in quantity supplied

Supply

Change in Quantity Supplied

Change in Supply in Action

e Lost social welfare

Price Restrictions and Market Equilibrium

Price Ceiling in Action I

• Increase in demand only

– Increase equilibrium price

– Increase equilibrium quantity

• Decrease in demand only

– Decrease equilibrium price

– Decrease equilibrium quantity

• Example of change in demand

– Suppose that worldwide demand for automobiles

is projected to decrease by 30% next year What is

the impact on the international crude oil market?

2-60

Note: Changes in DemandComparative Statics

Change in Demand in Action

• Increase in supply only

– Decrease equilibrium price

– Increase equilibrium quantity

• Decrease in supply only

– Increase equilibrium price

– Decrease equilibrium quantity

• Example of change in supply

– Suppose that war breaks out in a major

oil-producing country in the Middle East What is the

impact on the international crude oil market?

2-62

Note: Changes in SupplyComparative Statics

• Suppose that simultaneously the following

two events occur:

– worldwide demand for automobiles is projected

to decrease by 30% next year

– war breaks out in a major oil-producing country in

the Middle East

• What is the combined impact on the

international crude oil market?

2-64

Comparative Statics

Simultaneous Shifts in Supply and Demand

The equilibrium price increases

or decreases depending on the magnitude of the demand and supply changes.

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Use the accompanying graph next slide to answer these questions.

• A Suppose demand is D and supply is S! If a price ceiling of $6 is

imposed, what are the resulting shortage and full economic price?

• B Suppose demand is D and supply is S! If a price floor of $12 is

imposed, what is the resulting surplus? What is the cost to the

government of purchasing any and all unsold units?

• C Suppose demand is D and supply is S! so that the equilibrium price is

$10 If an excise tax of $6 is imposed on this product, what happens to the equilibrium price paid by consumers? The price received by

producers? The number of units sold?

• D Calculate the level of consumer and producer surplus when demand and supply are given by D and S! respectively

• E Suppose demand is D and supply is S! Would a price ceiling of $2

benefit any consumers? Explain

Copyright © 2014 by the McGraw-Hill Companies, Inc All rights

Practice

Consider a market where supply and demand are given by 𝑄!' =-10 +𝑃! and 𝑄!, = 56 - 2Px

Suppose the government imposes a price floor of

$25, and agrees to purchase any and all units

consumers do not buy at the floor price of $25 per unit

firms’ unsold units

loss) that stems from the $25 price floor

Copyright © 2014 by the McGraw-Hill Companies, Inc All rights

• Consider a market where supply and demand

are given by QXS = -16 + PX and QXd = 92 - 2PX

Suppose the government imposes a price floor

of $40, and agrees to purchase and discard any and all units consumers do not buy at the floor price of $40 per unit.

• a Determine the cost to the government of

buying firms’ unsold units.

• b Compute the lost social welfare (deadweight loss) that stems from the $40 price floor.