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
Demand Shifters
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 PCs
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
