Cambridge Judge Business School

Session 1
• INTRODUCTION
• DEMAND, SUPPLY AND
ELASTICTY

Dr. Juliana Kozak Rogo

About the Module Leader
• Dr. Juliana Kozak Rogo
• Office: A.301
• Email: [email protected]
• Office Hours: by appointment
Overview of the Module

Market Structure
and Simple Market Failure,
Demand Estimation Game Theory and
Pricing Business and
Consumer Choice Business Strategy
Strategies Government
Chs 3 and 4 Chs 12 and 13
Chs 8 and 9 Chs 15 and 16
Session 2 Session 4 Session 6 Session 8

Session 1 Session 3 Session 5 Session 7

Introduction, Firm's Strategic Pricing Oligopoly and
Demand, Supply Production Ch 10 Uncertainty
and Elasticity Process, Chs 11 and 14
Chs 1, 2 and 3 Technology and
Costs
Chs 5 and 6
Business Economics – Format of the Course

0) Maths Review (sent to you in Summer/23).

1) 8 Lectures
2) Weekly Problem Sets
3) Weekly Tutorials – Henning Zschietzschmann
4) Final Exam Format:
• Question I – a quantitative problem.
• Question II – about 10 multiple choice questions.
• Question III – a more qualitative question.
Business Economics – Overall Goal

1) Learn how to “think like an economist”.

2) Understand and improve managerial decision-making.
3) Explain and predict phenomena related to market and firms.
4) Integrate other business functional areas.
This requires:
i) familiarity with major “models” of economic behavior.
ii) focus on trade-offs and economic incentives of economic
agents (firms, consumers, workers, investors, government).
iii) use of analytical tools to produce consistent and long-lasting
analysis.
Economic Agents Respond to Incentives
• “People respond to
incentives." The rest
is commentary. (The
Armchair Economist,
Landsburg, 2013)
Economics? For Managers?
➢ Managers - direct scarce resources to achieve a stated goal.
• A production manager’s objective is normally to achieve a production target at
the lowest possible cost.
• A human resource manager design compensation systems to encourage
employees to work hard.
• A marketing manager must allocate an advertising budget to promote the product
most effectively.
• The firm’s top manager must coordinate and direct all these activities.
➢ Economics studies the allocation of scarce resources.
• Microeconomics- focuses on individual economic units: consumers, firms,
workers and investors and the markets in which they interact.
• Macroeconomics - focuses economy-wide aggregates including
unemployment, inflation, aggregate economic growth, interest rates.
➢ Managerial Economics - study of decision-making in the presence of
scarce resources to achieve a managerial goal.

7
Outline for Today
1. Supply and Demand Model
• Demand and Demand Shifters
• Supply and Supply Shifters
• Market Equilibrium
• Predicting Changes in Equilibrium
2. Elasticity
• Definition
• Classification
• Netflix Case
• Other Elasticities
Supply and Demand Model
• Most people in business use the supply demand model every day.
• It is one of the basic “mental models” that help us understand the
world around us.
• But using it correctly is not always easy.
Supply and Demand Model
• The supply-demand model can be applied to a wide variety of interesting
and important problems such as:

➢ Understanding and predicting how

changing world economic conditions
affect market price and production
➢ Evaluating the impact of
government interventions (price
controls, minimum wages, taxes)
➢ Create and evaluate firm’s strategy

Marshall was Professor of Political Economy at the University of Cambridge

between 1885 and 1908. An excellent mathematician, Marshall provided new
foundations for the analysis of supply and demand by using calculus to
formulate the workings of markets and firms.
Market Demand Curve
• A demand curve shows the quantity demanded by consumers at each
possible price, holding constant the other factors that influence purchases
(income, prices of other goods, preferences).
• Reflects consumer’s willingness to pay for a product.
• Law of Demand
• “As price falls, quantity demanded rises” → demand curve is downward
sloping. This is an empirical statement. It does not have to be true on
purely logical grounds, but it is usually true in real cases. Exception:
Giffen goods.
The equation describing this demand curve is
given by:
P = (-1/40) Q + 4 (inverse demand equation)
Q = 160 – 40P (direct demand equation)
Shift along the Demand Curve
• Changes in the price of a good lead to a change in the quantity
demanded of that good.
• This corresponds to a movement along a given demand curve.
Good Z

Price
A to B: Increase in
P1 A quantity demanded
of good Z.

P2 B

D
Q1 Q2 Quantity
Shift of the Demand Curve
• A shift of the demand occur when demand increases because of factors
other than price changes.
Good Z
Price D1 to D2: Increase in
the demand for good
Z (entire curve shifts)

P
D2
D1
Q1 Q2 Quantity

• Examples of forces that can shift demand are such things as increased
advertising, changes in the prices of related goods... We will note these
next.
Demand Shifters
• The demand for a product is affect not only by the price of the product itself
but by other factors that can shift, rotate, or change the shape of demand
curve, but none will result in a violation of the law of demand.
✓ Income
• Normal Good (income in(de)creases, demand in(de)creases)
• Inferior Good (income in(de)creases, demand de(in)creases)

✓ Prices of Related Goods

• Substitute Goods (when the price a substitute good goes up (down), the
demand for the good goes up (down))
• Complement Goods (when price a complement good goes up (down),
the demand for the good goes down (up)
✓ Advertising
✓ Population
✓ Consumer expectations
The Demand Curve Shifts Out (to the right) if a
Substitute’s Price Rises

The demand curve for avocados shifts to the right from D1 to D2 as the
price of tomatoes, a substitute, increases by 55¢ per pound. More
avocados are demanded at any given price (assume avocados and
tomatoes are substitute goods for making a salad).
Demand Function x Demand Curve
• The demand function shows the effect of all relevant factors on the
quantity demanded.
• More generally, an equation representing the demand curve:
Qxd = f(Px , PY , M, H,)
• This is the general form of the representation of a demand function
where: Qxd = quantity demand of good X, Px = price of good X, PY = price
of a substitute good Y, M = income, H = any other variable affecting
demand.
• The demand curve shows the relationship between the quantity
demanded and a good’s price, holding other factors constant.
Market Supply Curve
• A supply curve shows the quantity supplied at each possible price,
holding constant the other factors that influence supply decisions.
• Law of Supply:
• “As price increases, the quantity supplied will rise.”
• The supply curve is upward sloping.

The equation describing

this supply curve is given
by:
P = Q/15 - 50/15 (inverse
supply)
Q = 50 + 15P (direct
supply)
Supply Shifters
• A change in a good’s own price causes a shift along the
supply curve.
• What might shift the supply curve?
✓ Changes in the cost of inputs
✓ Changes in technology
✓ Weather, natural disasters...
The Supply Function
• The supply function shows the effect of all relevant factors on the
quantity supplied.
• More generally, an equation representing the supply curve:
Qxd = f(Px , PY , M, H,)
• This is the general form of the representation of a demand function
where: Qxs = quantity supplied of good X, Px = price of good X, PY = price
of a related good, M =price of inputs, H = any other variable affecting
supply (e.g. tax rate, number of firms, producer’s expectations…).
• The supply curve shows the relationship between the quantity supplied
and a good’s price, holding other factors constant.
Market Equilibrium
• Market equilibrium occurs when the quantity supplied equals the
quantity demanded. Diagrammatically, this is where the supply curve
and the demand curve intersect.
Market Equilibrium
• All market participants are able to buy or sell as much as they want (no
participant wants to change its behavior).
• The theory of supply and demand predicts that prices (in free competitive
markets) will equate supply and demand. In other words, the theory
predicts that the price in a market will occur at the intersection of the
supply and demand curves.
• The process that pushes prices toward the equilibrium price is called the
market mechanism (the “invisible hand”). At the equilibrium price the
market clears, so this price is often called the market-clearing pricing.
• Price is the allocating mechanism!
Example

• The equilibrium price and quantity can be computed if we

know the demand and supply curves for the good.
• Example, for the avocado market:
QD = 160 – 40P
QS = 50 + 15P
• You can find the equilibrium using direct or inverse forms,
here we use the direct form.
Discuss

How supply and demand matters for businesses?

Example: Applying the Supply and Demand Model to
Firm’s Strategy
• The FT reports that the prices of PC components are
expected to fall by 5-8 percent over the next three months.

• Scenario 1: You manage a small firm that manufactures

PCs.

• Scenario 2: You manage a small software company.

Use the supply and demand model to design the next

steps for the firm under the two scenarios.
Scenario 1: Small PC Maker
• Step 1: Look for the “Big Picture”
• Step 2: Organize an action plan (worry with details)
• If you are small PC maker your individual actions will not affect
the market much. That is, you can’t set the price you want (if its
too high, consumers will just purchase from someone else), nor
will changes in your supply affect the overall market price (your
supply is just too small relative to the total).
• In this case its best for you to think about how the market price
will change and react to that, to do the best you can.
Managerial Implication
• 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.)
• These actions will certainly affect your profitability.
• The idea here is that an understanding of supply and
demand changes is essential for corporate planning.
• This is true even when your firm is one of many firms in the
market and must simply react to market changes.
Supply and Demand and the Pandemic
Percent
GDP growth
12
Per capita GDP growth

-6

-12
1871 1901 1931 1961 1991 2021
Supply and Demand and the Pandemic
Shock to Supply Shock to Demand Shock
to Supply

Supply bottlenecks have hit developing countries

hard... Ports operating below capacity, pandemic-
related delays in orders for new vessels, and
containers stranded in the “wrong” ports have
increased shipping costs and supply constraints to
unprecedented levels. (World Bank Report, Jan 22)
Oil Prices
Supply, Demand and Government
• It is very common for governments to impose price
restraints on the market such as (i) price ceilings, (ii)
price floors and (iii) taxes (subsidies).
Price Ceiling

Price • The market is in an equilibrium

S at (P* and Q*)
Non-pecuniary

PF • If the government
price

imposes a price ceiling

P* below P*, a shortage will
occur (situation of
excess demand).
Ceiling Price
• For example: you may recall
Shortage D the long line-ups for gasoline
during hurricane crisis.
Qs Q* Qd Quantity

• The long line raised the non-pecuniary costs of gasoline, which increases
the full price of consumption (PF).
Price Floor
• The market is in an equilibrium
Price Surplus
S at (P* and Q*)
Floor Price • If the government imposes
a price floor above P*, a
surplus will occur
P* (situation of excess
supply).
• What happens to this excess
supply?
D • Of course, this depends on the
Qd Q* Qs Quantity specific situation.

• Economist note that high minimum wages create unemployment.

• Price floors in agriculture create excess food. The government stores
much of the excess grains that are produced because of price floors.
DEMAND AND ELASTICITY
Case: Suga Test Instruments

Price of Snow
machine:
$250,000
Price Matters for Business Decisions

What determines a firm’s price?

Demand and Pricing Power
Demand and Pricing Power

“Law of Demand”:
price and quantity
demanded move in
opposite directions.
Elasticity
• One of the most important managerial economics concepts.
Fundamentally related to marketing strategy.
• Elasticity, in general, measures how one variable responds to
changes in another variable.
• The own-price elasticity of demand (𝜺) measures how changes
in the price of a product affect its quantity demanded. It is
computed as the percentage change in the quantity divided by the
percentage change in price.
This can be approximated by
ΔQ the derivative of quantity with
%ΔQ ΔQ P
𝜺= = Q = respect to price, ie. dQ/dP
%ΔP ΔP ΔP Q
P
• Eg. If the elasticity for bread is 𝜀 = −0.5. (This means that a 1%
increase in the price of bread, decreases the demand for bread
by 0.5%).
Classification of Demand relative to Elasticity
• 𝜺 < 1 in absolute value, demand is inelastic
• 𝜺 = 1 in absolute value, demand is Isoelastic/unitary
elastic
• 𝜺 > 1 in absolute value, demand is elastic
• Demand is generally more elastic:
• If there are many similar, close substitutes available.
• If the product comprises a small share of consumers’
budgets.
• If the time horizon is longer (long term).
• Practice Question: Are people more elastic with respect to
toothpaste (product) or Colgate (brand)?
Elasticity is a point concept and varies along a linear demand curve

QD = 160 – 40p

dQ p
=
dp Q
𝑃
𝜀 = −40
𝑄

The Elasticity Varies Along a Linear Demand Curve- the higher the
price, the more elastic the demand curve (ε is larger in absolute value).
Demand is perfectly inelastic (ε = 0) where the demand curve hits the
horizontal axis and is perfectly elastic (ε =∞) where the demand curve hits
the vertical axis.
Example – Elasticities in the Beverage Market
Elasticity, Total Revenue and Marginal Revenue
• Total Revenue is TR(Q)= P(Q)Q
• If demand is linear, P(Q) = a – bQ, then TR(Q) = (a-bQ)Q
• Economic thinking is “at the margin”.
• Marginal Revenue (MR) is the additional revenue from
selling an additional unit of output. It is a very important
concept for profit maximization.
• MR is (approximately) the derivative of total revenue with
respect to quantity, MR = dTR(Q)/dQ
• Practical question: At a certain production point, should the
manager increase or decrease price in order to increase
total revenue?
Total Revenue, Marginal Revenue and Elasticity
Elasticity Test
• Elastic demand→ A 1% increase in
price leads to a greater than 1% drop in
quantity → total revenue falls, MR<0 .
• Inelastic demand, 1% increase in price
results in a less than 1% drop in quantity
→ total revenue rises, MR>0.
• Iso-elastic demand, 1% increase in
MR price results in a 1% drop in quantity→
no effect on total revenue. → Total
revenue stays the same, MR=0.
• TR is maximized when Marginal
Revenue (MR) = 0 or, equivalently,
elasticity=-1.
Case in-point: Netflix and Covid-19

The need to constant entertainment among lock-

down has presented streaming services like
Netflix with a golden opportunity to increase their
prices, according to a new survey.
Mark Billige, CEO of Simon-Kucher & Partners,
said, “The results indicate that price elasticity for
streaming services is at an all-time low… For the
past three years, the calculated price elasticity for
a Netflix subscription was approximately -0.6. But “Consumers are currently
in our June study, we saw elasticity collapse to having a crash course in what
just -0.13. they can (or can’t) live without.
And streaming services are
definitely in the ‘can’t live
without’ bucket,” he added.
Other Elasticities: Cross Price Elasticity of Demand
• Fundamental to managers because they always have to anticipate what
will happen to their own sales if rivals change their prices.
• The cross-price elasticity shows how the price of a related product (PY)
affects the demand for a given product (QX).

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑋 ∆𝑄𝑋 𝑃𝑌

𝜀𝑋𝑌 = =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑌 ∆𝑃𝑌 𝑄𝑋

• If the cross-price elasticity is positive, the products are substitutes.

• If the cross-price elasticity is negative, the products are complements.
Other Elasticities: Income and Advertising Elasticity of
Demand
• The Income Elasticity shows how the demand for a given product (Q) is
affected by changes in income (I) of the product’s consumer base.
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑎 𝑔𝑜𝑜𝑑 ∆𝑄 𝐼
𝜂𝐼 = =
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 ∆𝐼 𝑄
• If positive, then X is a normal good.
• If negative, then X is an inferior good.

• The Advertising Elasticity shows how the demand for a given product
(Q) is affected by changes in the advertising expenditure (A) of the
product’s consumer base.
∆𝑄 𝐴
𝜂𝐴 =
∆𝐴 𝑄
Apple’s iTunes Case

• A few years ago, Apple’s iTunes raised the price of new

songs from $0.99 to $1.29.
• How could Apple predict whether this change would raise
or lower revenue (and profit)?

Start by computing
the price elasticity
of the demand for
iTunes songs.

How?

Next
class!
Important Takeaways
• 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.)
• An understanding of supply and demand shocks is essential for
corporate planning.
• One of the most important and useful microeconomic concepts
for a manager is elasticity.
• Using elasticities, managers can quantify the impact of changes
in prices, income, advertising.
Next…

Session 2 – Demand Estimation and Consumer

Choice