Economics for Managers

Session 2
Introduction to Demand and Supply
Overview
I. Market Demand Curve II. Market Supply Curve
The Demand Function The Supply Function
Determinants of
Supply Shifters
Demand
Consumer Surplus Producer Surplus

III. Market Equilibrium

IV. Price Restrictions
V. Comparative Statics
Market Demand Curve
Shows the amount of a good that will be purchased
at alternative prices.
Law of Demand:
As the price falls, the quantity demanded will rise.
The demand curve is downward sloping.
Price For those of you with a math
background you might wonder why
economists put quantity on the x-
axis and price on the y-axis, when
we talk about quantity as a function
D of price.
This is just an historical anomaly,
Quantity
without explanation.
Market Demand Curve
Price
Now, look at the result of our
on-line sealed bid auction.

What we find is that, by

D
definition, at the winning
price I would see only one
Quantity
unit of the good purchased.
But if I were to continually reduce the price, more of you
would be willing to purchase as the price decreases.

This is just demonstrating the law of demand: increased

quantity demanded as the price falls.
 Change in Quantity Demanded
Price A to B: Increase
in quantity Up till now, we have not
P1 A demanded really differentiated
changes in the quantity
P2 B demanded from changes
in demand.
D We will do that now.
Q1 Q2 Quantity

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.
 Change in Demand
Price D1 to D2: Increase in
Here we illustrate the
Demand
impact of a shift in the
demand curve.
P Demand shifts occur
D2 when demand increases
D1 because of factors other
Q1 Q2
than price changes.
Quantity

We see a shift when, at a given price, we experience a greater

demand for our product.
Examples of forces that can shift demand are such things as
increased advertising, changes in the prices of related goods,
etc. We will note these next.
Shift Factors of Demand
1. Income
All of these factors have
2. Prices of substitutes the ability to shift, rotate,
3. Prices of complements or change the shape of
4. Advertising demand curve, but none
5. Population will result in a violation
of the law of demand.
6. Consumer expectations
For example, a general rise in the population of an area is likely to
shift the demand curve to the right, raising demand for any given price.
If the population increase was purely from low income individuals, the
impact might be to increase demand only at lower price levels. The
demand might rotate out from the bottom.
The Demand Function
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.
H might be advertising level of the firm, or the difference between the
firms advertising level and that of its rivals, etc.
Consumer Surplus:
Up to now we have considered factors that shift or rotate the
demand curve.
But, as we noted at the outset, the demand curve maps out
the quantity sold for any given price.
Whether a consumer purchases a good or not depends
on the surplus the consumer derives from the product.

Consumer surplus:
is the difference between a consumers willingness to
pay for a good (the value they feel they get from the
product) and the price the firm asks for it.
 I got a great deal!
That company offers a lot of bang
for the buck!
Total value greatly exceeds total
amount paid.
Consumer surplus is large.

Think about some products you have purchased recently.

On some you may have felt you got a good deal, while you were less
enxcited with others.
For those you felt good about, it was because the difference between
the value (as you perceived) and the price you had to pay was large.
Firms want to develop products that deliver increased value because
this allows them to raise price and still make sales.
 I got a lousy deal!

That car dealer drives a hard bargain!

They tried to squeeze the very last cent
from me!
Total amount paid is close to total value.
Consumer surplus is low.

Now, for those products that get you less excited to consume, ask
yourself whether you would feel better if you got them for 50% off?
Chances are youd feel better.
The reason you were not excited about these products is that the
difference between the value (as you perceived) and the price you had
to pay was small.
 Consumer Surplus: Discrete
Consumer Surplus: In the diagram the greatest willingness
Price the sum over all consumers to pay for the good by one consumer,
10 that purchase a good or was $8. However, the market price of
each purchaser's own the good was only $2, so the surplus for
8 consumer surplus. that consumer was $6.
For the next consumer the surplus was
6 $6-$2 = $4
4 The fourth consumer receives no
surplus since his/her willingness to pay
2 exactly equals the market price.
D These consumers should be indifferent
between purchasing or not, for
1 2 3 4 5 Quantity convenience we assume indifferent
consumers always purchase.
NOTE: This case can also represent an individual consumers demand curve.
Imagine that wed be willing to pay $8 for a roll of film to take pictures during your
vacation, youd be willing to pay $6 for a second roll, $4 for the third and $2 for a
fourth. If the price at the store was $2, youd buy 4 rolls and probably feel like you
got quite a good deal.
Consumer Surplus: Continuous Case
Price $
We can get surplus in
10 Value the continuous case by
of 4 units imagining that prices
8 can be changed by a
Consumer very small amount and
Surplus 6 that the good being
purchased is infinitely
4 Total Cost of 4 divisible.
units It is often easier to
2 deal with the
D continuous case both
graphically and
1 2 3 4 5 mathematically.
Quantity
Continuous Example: We could imagine that the product is cellular phone airtime.
This product can be sold in very small units (although the unit often chosen are 1
minute intervals) and the price increments could be less that 1 cent (such as 9.5
cents per minute).
Market Supply Curve
The supply curve shows the amount of a good that
will be produced at alternative prices.
Law of Supply:
As price increases, the quantity supplied will rise.
The supply curve is upward sloping

Price
S The Law of Supply
is simply that more product
will be supplied to the
market, the higher is the
market price.
Quantity
Change in Quantity Supplied
Price

S
A to B: Increase in quantity
P2 supplied
B
P1
A

Q1 Q2 Quantity

Changes in the price of a good lead to a change in the

quantity supplied of that good.
This corresponds to a movement along a given supply
curve.
Change in Supply
Price Here we illustrate the
S1
impact of a shift in the
S2 supply curve.
P Supply shifts occur
S1 to S2: Increase in when supply increases
Supply because of factors
other than price
Q1 Q2 Quantity changes.
We see a shift when, at a given price, we produce a greater
supply of our product.
Examples of forces that can shift supply are such things as
changes in input prices, increases in low-cost technologies, etc.
We will note these next.
Supply Shifters
1. Input prices
2. Technology or government All of these factors
regulations have the ability to shift,
rotate, or change the
3. Number of firms shape of supply curve,
4. Substitutes in production but none will result in a
5. Taxes violation of the law of
supply.
6. Producer expectations
For example: when input prices are lower, such as the cost of labor, a
firm will find it attractive to increase the amount it supplies the market
at any given price.
In fact some new firms might enter, further increasing the supply.
The Supply Function
An equation representing the supply curve:
QxS = f(Px , PR ,W, H)
This is a general representation of the amount a
firm or industry supplies to the market, where:
QxS = quantity supplied of good X.
Px = price of good X.
PR = price of a related good
W = price of inputs (e.g., wages)
H = other variable affecting supply
Variable H might be the tax rate, for example.
Producer Surplus
Producer The concept of Producer Surplus
Price Surplus is similar to that of Consumer
Surplus.
S Producer Surplus is the difference
between the market price, and the
P* price at which the producer would
be willing to have sold the product.
A firm should be willing to sell its
products at anything above cost
(all costs including opportunity
costs)
Thus, Producer Surplus is also
Q* economic profit.
Quantity

Look at the supply curve. It would look this way if some firms were
more efficient than others. Those most efficient producers would be
willing to sell at lower prices (they would also make the greatest profit
at the market price). The green area would be industry profits.
Market Equilibrium
Balancing the forces of supply
and demand.
When the quantity supplied
equals the quantity demanded.
(QxS = Qxd)
This is also referred to as a
steady state.
So, the market will be in equilibrium when total supply
meets total demand.
The next slides explain what will happen when we are out
of equilibrium.
If price is too low
Price Here we see that at a price of
S 5, the quantity demanded
exceeds the quantity supplied
(Shortage occurs).
7
6 Price will adjust (rise) to bring
the market into equilibrium.
5
Shortage D As prices rise, the industry is
Qd - Qs willing to supply more, and at
Qs Quantity the same time, the level of
Qd
demand will fall.

In this example, the market will be brought

into equilibrium at a price of $7.
If price is too high
Surplus Here we see that at a price of
Price Qd - Qs S 5, the quantity supplied
5 exceeds the quantity
4 demanded (Surplus occurs).
3
Price will adjust (fall) to bring
the market into equilibrium.

D As prices fall, the industry is

willing to supply less, and at
Quantity the same time, the level of
Qd Qs
demand will increase.
In this example, the Next, we examine government
market will be brought imposed price regulations that will not
into equilibrium at a price allow these price adjustments to bring
of $3. markets into equilibrium.
Price Restrictions
Individuals, firms, or interest groups often lobby government
to impose price restrictions.
Price Ceilings:
The maximum legal price that can be charged, usually
imposed to protect consumers.
Examples: Gasoline prices in the 1970s, Housing in New
York City, and proposed restrictions on ATM fees.
Price Floors:
The minimum legal price that can be charged, usually
imposed to help suppliers of product or services.
Examples: Minimum wage and Agricultural price
supports.
Impact of a Price Ceiling
Price S The market is in an equilibrium
PF at (P* and Q*)
If the government imposes a
P* price ceiling below P*, a
shortage will occur (situation
of excess demand).
Ceiling Price For example: you may recall or
Shortage D have seen in a documentary
the long line ups for gasoline
Qs Q* Qd Quantity during the 1970s energy crisis.
The long line raised the non-pecuniary costs of gasoline, which
increases the full price of consumption (PF), which we will explore next.
Notice, if prices were allowed to rise the lines would disappear, as high
prices cause consumers to substitute away from gas (ex: carpooling).
Full Economic Price
When situations of excess demand happen consumers may
pay low prices, but they often incur other costs, such as
lining up to purchase, or searching around a city to find
store locations which still have the product.
These costs are called the nonpecuniary price of consumption.

The full economic price is the dollar amount paid to a firm

under a price ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC)
PF = full economic price
PC = price ceiling
PF - PC = nonpecuniary price
An Example: 1970s Energy Crisis
We want to find the full economic price of a gallon of
gasoline during the crises.
The ceiling price of gasoline was $1 per gallon.
Suppose you waited 3 hours in line to buy 15 gallons of
gasoline.
Opportunity cost of waiting in line: $5/hr (wage rate)
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
(ceiling price + non-pecuniary price)
 Impact of a Price Floor
Price Surplus
S The market is in an equilibrium
Floor Price at (P* and Q*)
If the government imposes a
price floor above P*, a surplus
P* will occur (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.
Take a break!
In the coming slides we will use comparative statics
to study how businesses and consumers (and
markets in general) respond to changes in price.
Specifically we examine how supply and demand
respond to changes in price.
Before proceeding it would be best to review what
weve completed so far and work the problems
suggested for this section.
Comparative Static Analysis
How does the equilibrium price and quantity
change when a determinant of supply and/or
demand changes?
Using Comparative Static Analysis
Comparative static analysis shows how the equilibrium
price and quantity will change when a determinant of
supply or demand changes.

Why do we call this analysis comparative static?

The reason is that this analysis allows us to compare
an equilibrium before the change to an equilibrium
after the change.
It does not tell us anything about how the market
adjusts after we move from one equilibrium to the
other.
That process is called dynamics.
Application of Demand and Supply
Event: The WSJ 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.
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 cant 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.
Big Picture: Impact of decline in
component prices on PC market
Price S1 We see that lower input
of
PCs S2 prices will cause the supply
curve to shift to the right.
P1
P2
At the new equilibrium the
total supply is higher and the
D market price is lower.
Q1 Q2 Quantity of PCs

So, the Big Picture is:

The decline in PC component prices is likely to decrease PC
prices, and thus, more computers will be sold.
Small Details: Impact of PC price change
on your business decisions
Youre reaction to the price change will affect many of
your strategic decisions despite the fact that your
individual action affects the market little.
Given that more computers will be sold, you will want to rethink
your specific business plan.
Use the big picture information to organize a specific
action plan to make changes to
contracts/suppliers?
inventories? (may want to increase, now that your sales volume
increases).
human resources? (may use more labor as production increases).
marketing? etc

These action will certainly affect your profitability.

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?
Now more people will have computers, so the
demand for software is likely to rise.
 Big Picture: Impact of lower PC prices on
the software market We see that with more
Price S
of Software computers being bought, the
P2 demand will rise for software
P1 (a complement good).

D2 The increase in demand for

software is likely to trigger a
D1 price rise.
Also, this will increase the
Q1 Q2 Quantity of
desire of software producers
Software
to increase production.

At the new equilibrium, there will be a higher price for software, and
more software being bought and sold.
Small Details: Impact of Software price
change on your business decisions
The big picture for the software maker:
Software prices are likely to rise, and more software will
be sold.

Use this to organize an action plan:

In the face of increased demand you may want to hire
new workers.
Perhaps not software writers, but maybe logistics
persons to deal with getting larger amounts of your
product to the market.
You may have to increase the number of blank CDs and
packaging materials you purchase.
etc.
Summary
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.)

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.