Managerial Economics & Business Strategy
Chapter 2 Market Forces: Demand and Supply
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Overview I. Market Demand Curve – The Demand Function – Determinants of Demand – Consumer Surplus
III. Market Equilibrium IV. Price Restrictions V. Comparative Statics
II. Market Supply Curve – The Supply Function – Supply Shifters – Producer Surplus
Market Demand Curve Shows the amount of a good that will be purchased at alternative prices, holding other factors constant. Law of Demand – The demand curve is downward sloping. Price
D Quantity 2-3
Determinants of Demand Income – Normal good – Inferior good
Prices of Related Goods – Prices of substitutes – Prices of complements
Advertising and consumer tastes Population Consumer expectations 2-4
The Demand Function A general equation representing the demand curve Qxd = f(Px , PY , M, H,) – Qxd = quantity demand of good X. – Px = price of good X. – PY = price of a related good Y. • Substitute good. • Complement good. – M = income. • Normal good. • Inferior good. – H = any other variable affecting demand. 2-5
Inverse Demand Function Price as a function of quantity demanded. Example: – Demand Function • Qxd = 10 – 2Px
– Inverse Demand Function: • 2Px = 10 – Qxd • Px = 5 – 0.5Qxd
Change in Quantity Demanded Price A to B: Increase in quantity demanded 10
Change in Demand Price
D0 to D1: Increase in Demand
6 D1 D0 7
Consumer Surplus The value consumers get from a good but do not have to pay for. Consumer surplus will prove particularly useful in marketing and other disciplines emphasizing strategies like value pricing and price discrimination.
I got a great deal! That company offers a lot of bang for the buck! Dell provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large. 2-10
I got a lousy deal! That car dealer drives a hard bargain! I almost decided not to buy it! They tried to squeeze the very last cent from me! Total amount paid is close to total value. Consumer surplus is low. 2-11
Consumer Surplus: Discrete Case Price Consumer Surplus: The value received but not paid for. Consumer surplus = (8-2) + (6-2) + (4-2) = $12.
10 8 6 4 2
Consumer Surplus: Continuous Case Price $ 10 Consumer Surplus = $24 - $8 = $16
Value of 4 units = $24
Expenditure on 4 units = $2 x 4 = $8
Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply – The supply curve is upward sloping. Price
Supply Shifters Input prices Technology or government regulations Number of firms – Entry – Exit
Substitutes in production Taxes – Excise tax – Ad valorem tax
Producer expectations 2-15
The Supply Function An equation representing the supply curve: QxS = f(Px , PR ,W, H,) – QxS = quantity supplied of good X. – Px = price of good X. – PR = price of a production substitute. – W = price of inputs (e.g., wages). – H = other variable affecting supply. 2-16
Inverse Supply Function Price as a function of quantity supplied. Example: – Supply Function • Qxs = 10 + 2Px
– Inverse Supply Function: • 2Px = 10 + Qxs • Px = 5 + 0.5Qxs
Change in Quantity Supplied Price
A to B: Increase in quantity supplied S0 B
20 A 10
Change in Supply S0 to S1: Increase in supply
8 6 5
Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. Price
Market Equilibrium The Price (P) that Balances supply and demand – QxS = Qxd – No shortage or surplus
If price is too low… Price
7 6 5 D
Shortage 12 - 6 = 6 6
If price is too high… Surplus 14 - 6 = 8
9 8 7
Price Restrictions Price Ceilings – The maximum legal price that can be charged. – Examples: • Gasoline prices in the 1970s. • Housing in New York City. • Proposed restrictions on ATM fees.
Price Floors – The minimum legal price that can be charged. – Examples: • Minimum wage. • Agricultural price supports. 2-24
Impact of a Price Ceiling Price
P Ceiling D
Full Economic Price The dollar amount paid to a firm under a price ceiling, plus the non-pecuniary price. PF = Pc + (PF - PC) – PF = full economic price – PC = price ceiling – PF - PC = nonpecuniary price
An Example from the 1970s Ceiling price of gasoline: $1. 3 hours in line to buy 15 gallons of gasoline: – Opportunity cost: $5/hr. – Total value of time spent in line: 3 × $5 = $15. – Non-pecuniary price per gallon: $15/15=$1.
Full economic price of a gallon of gasoline: $1+$1=2.
Impact of a Price Floor Price
Comparative Static Analysis How do the equilibrium price and quantity change when a determinant of supply and/or demand change?
Applications: Demand and Supply Analysis Event: The WSJ reports that the prices of PC components are expected to fall by 5-8 percent over the next six months. Scenario 1: You manage a small firm that manufactures PCs. Scenario 2: You manage a small software company.
Use Comparative Static Analysis to see the Big Picture! Comparative static analysis shows how the equilibrium price and quantity will change when a determinant of supply or demand changes.
Scenario 1: Implications for a Small PC Maker Step 1: Look for the “Big Picture.” Step 2: Organize an action plan (worry about details).
Big Picture: Impact of decline in component prices on PC market Price of PCs
Quantity of PC’s 2-33
Big Picture Analysis: PC Market Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase. Use this to organize an action plan: – contracts/suppliers? – inventories? – human resources? – marketing? – do I need quantitative estimates? 2-34
Scenario 2: Software Maker More complicated chain of reasoning to arrive at the “Big Picture.” Step 1: Use analysis like that in Scenario 1 to deduce that lower component prices will lead to – a lower equilibrium price for computers. – a greater number of computers sold.
Step 2: How will these changes affect the “Big Picture” in the software market? 2-35
Big Picture: Impact of lower PC prices on the software market Price of Software
P1 P0 D* D Q0 Q1
Quantity of Software 2-36
Big Picture Analysis: Software Market Software prices are likely to rise, and more software will be sold. Use this to organize an action plan.
Conclusion Use supply and demand analysis to – clarify the “big picture” (the general impact of a current event on equilibrium prices and quantities). – organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).