Managerial Economics & Business

Strategy

Chapter 2
Market Forces:
Demand and Supply

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
 Overview
I. Market Demand III. Market Equilibrium
Curve IV. Price Restrictions
– The Demand Function
– Determinants of Demand
V. Comparative Statics
– Consumer Surplus

II. Market Supply

Curve
– The Supply Function
– Supply Shifters
– Producer Surplus

2-2
 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

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

2-6
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity
2-7
 Change in Demand
Price
D0 to D1: Increase in Demand

6
D1

D0

7 13 Quantity
2-8
 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.

2-9
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:
10 The value received but not
8 paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
6

2
D
1 2 3 4 5 Quantity
2-12
Consumer Surplus: Continuous Case

Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6

4 Expenditure on 4 units =
$2 x 4 = $8

2
D
1 2 3 4 5 Quantity
2-13
 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
S0

Quantity
2-14
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

2-17
Change in Quantity Supplied
Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
2-18
 Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
2-19
 Producer Surplus

The amount producers receive in excess of
the amount necessary to induce them to
produce the good.
Price

S0
P*

Q* Quantity
2-20
 Market Equilibrium

The Price (P) that

Balances supply and
demand
– QxS = Qxd
– No shortage or surplus

Steady-state

2-21
 If price is too low…
Price
S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
2-22
 If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
2-23
 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 S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
2-25
 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

2-26
 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.

2-27
 Impact of a Price Floor
Price Surplus S
PF

P*

Qd Q* QS Quantity
2-28
 Comparative Static Analysis

How do the equilibrium price and quantity
change when a determinant of supply
and/or demand change?

2-29
 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.

2-30
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.

2-31
 Scenario 1: Implications for a
Small PC Maker

Step 1: Look for the “Big Picture.”

Step 2: Organize an action plan (worry
about details).

2-32
Big Picture: Impact of decline in
component prices on PC market
Price S
of
PCs S*

P0
P*

Q0 Q* 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
S
of Software

P1
P0

D*

Quantity of
Q0 Q1 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.

2-37
 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.).

2-38