bus_525_me_l2

BUS 525: Managerial Economics

Lecture 2

Demand and Supply

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Overview

III. Market Equilibrium

IV. Price Restrictions

V. Comparative Statics

II. Market Supply Curve
The Supply FunctionSupply ShiftersProducer Surplus
I. Market Demand Curve
The Demand FunctionDeterminants of Demand Consumer Surplus
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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.Need not be a straight line but any downward sloping line.
D

Price

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Price

Quantity

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The big picture, many companies fail because the mangers get bogged down in the day-to-day decisions of business without having a clear picture of market trends and changes that are in the horizon even though they had very hard-working manager, good systems.

Supply and demand analysis is a qualitative tool that allows companies to see the big picture, changes in product and input prices

Ceteris paribus assumption: price of related goods, income, advertising, and other variables held constant

Price and quantity demanded are inversely related

Demand entire curve

Quantity demanded a point on the demand curve

Determinants of Demand
IncomeNormal goodInferior goodPrices of related GoodsPrices of substitutes Prices of complementsAdvertising and consumer tastesPopulationConsumer expectations
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Explain each item.

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, e.g. advertising, patriotism.

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Substitutes: Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in demand for the other good, Coke and Pepsi

Complements: Goods for which an increase (decrease) in the price of one good leads to an decrease (increase) in demand for the other good. Petroleum Car

Normal good: A good for which an increase (decrease) in income leads to an increase (decrease) in demand for that good.

Inferior good: A good for which an increase (decrease) in income leads to an decrease (increase) in demand for that good. Potatoes, Meat, pulses

Advertising and consumer taste: Increase in ad exp. will shift demand curve to the right: Buy same quantity at a higher price or buy greater quantity at the same price draw graph

Informative advertising : Kapersky Internet Security

Persuasive advertising: Anarkoli, Lehenga, cool,fad

Sale of national flags in December and March

Population, Consumer expectations, Higher price lead to stockpiling, doesnt work for perishables.

Sale of national flag in December and March

Inverse Demand Function
Price as a function of quantity demanded.Example:Demand FunctionQxd = 6060 3Px Inverse Demand Function:3Px = 6060 QxdPx = 2020 1/3Qxd
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Please note that independent variable Px is on the vertical axis and on the right hand side of the equation. Qxd the dependent variable is on the horizontal axis and on the left hand side of the equation.

A contradiction with mathematical convention: Q dependent variable in the horizontal axis instead of vertical axis; P independent variable in the vertical axis instead of horizontal axis We get the inverse demand function with price in the LHS.

Y = mx + c

m = slope

= change in Y / change in X

= 2

= rise/run

X is the independent variable

Y is the dependent variable

P

Q

6060

2020

2

1

Y

X

Class Exercise I
Qxd = 12000-3Px+ 4Py 1M + 2AxPx=200, Py=15Ax = 2000, M=10,000Calculate how much X do consumers purchase?Are goods X and Y substitutes or complements? Is good X a normal or an inferior good?
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Qxd = 12000-3Px+ 4Py 1M + 2Ax

Px=200, Py=15

Ax = 2000, M=10,000

Calculate how much X do consumers purchase? 5460

Are goods X and Y substitutes or complements? Substitute (Py Qd ). Since the coefficient of Py is 4>0, we know that Tk.1 increase in price of good Y will increase the consumption of good X by 4 units.

Is good X a normal or an inferior good? Inferior good (Qd M)

Socratic Ignorance: Questions:

# What is war? # What is terrorism? # What is freedom? # What is justice?

# What is peace?

Socrates was executed by poisoning in 399 BC at the age of 71. He died gracefully in the company of friends.

The ancient Greeks had a sacred temple in Delphi. In the temple was a woman who was said to be possessed by the gods and able to get answers from them. Chaerephon traveled to Delphi to ask the Oracle; who is the wisest of men? The answer came back that, no one is wiser than Socrates. Socrates explains to the court: I reflected that if I could only find a man wiser than myself, then I might go to the god with a refutation in my hand. I should say to him, here is a man who is wiser than I am, but you said that I was the wisest.

When I began to talk with him, I could not help thinking that he was not really wise, although he was thought wise by many, and wiser still by himself; and I went and tried to explain to him that he thought himself wise, but was not really wise; and the consequence was that he hated me, and this enmity was shared by several who were present and heard me. So, I left him, saying to myself, as I went away: Well, although I do not suppose that either of us knows anything really beautiful and good, I am better off than he is for he knows nothing, and thinks that he knows.

Change in Quantity Demanded

D0

B

A

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Price

Quantity

4

7

6

A to B: Increase in quantity demanded

10

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Changes in the price of a good lead to a change in the quantity demanded of that good. This corresponds to a movement along the demand curve,

D0 to D1: Increase in Demand

Change in Demand

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Price

Quantity

D0

D1

6

7

13

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Demand Shifters: Variables other than the price of the good such as income or the price of another good, load to a change in demand. This corresponds to a shift in the demand curve

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.
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Eyeglass price, people with bad vision

I got a great deal!
That company offers a lot of bang for the buck!Apple provides good value.Total value greatly exceeds total amount paid.Consumer surplus is large.
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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.
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Price

Quantity

D

10

8

6

4

2

1 2 3 4 5

Consumer Surplus:

The value received but not

paid for. Consumer surplus =

(8-2) + (6-2) + (4-2) = $12.

Consumer Surplus:
The Discrete Case

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Consumer Surplus:
The Continuous Case

Price $

Quantity

D

10

8

6

4

2

1 2 3 4 5

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

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Value

of 4 units = $24

Consumer

Surplus = $24 - $8 = $16

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CS= 1/2x4x8 =16

CS is the area under the demand curve above the price.

CS = x base x height

CS = x Qmrt ( Pmax Pmrt)

CS = Pmax D (P) dp

Pmrt

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. Not necessarily a straight line just upward sloping.
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Price

Quantity

S0

*

Not necessarily a straight line just upward sloping.

Supply Shifters
Input pricesTechnology or government regulationsNumber of firmsEntry ExitSubstitutes in productionTaxesUnit taxAd valorem taxProducer expectations
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Input prices: As the price of an input rises, producers produce less output at each given price- leftward shift in the supply curve

Technology or government regulations: lowering cost- increase in supply; technology that increases costs- leftward shift in the supply curve

Number of firms: entry increase in supply-rightward shift; exit leftward shift

Truck assembly to car assembly-leftward shift in supply

Taxes-increase in costs/input prices

Unit tax

Ad-valorem tax

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.

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Think of some other variables affecting supply, e.g. weather

Inverse Supply Function
Price as a function of quantity supplied.Example:Supply FunctionQxs = 3Px -400 Inverse Supply Function:3Px = Qxs +400Px = 400/3 + 1/3Qxs
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Qxs= 2000 + 3Px - 4Pr - Pw

Linear supply function for TV production

Px= $400 , selling price of TV sets

Pr = $100, selling price of monitor

Pw = $2000, price of an input

Qxs= 800

Change in Quantity Supplied

B

A

A to B: Increase in quantity supplied

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Price

Quantity

S0

20

10

5

10

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Change in the price of a good lead to change in quantity supplied of the good. This corresponds to a movement along the supply curve.

S0 to S1: Increase in supply

Change in Supply

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Price

Quantity

S0

S1

8

7

5

6

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Supply shifters: Variables other than price of the good such as price of input or weather conditions lead to a change in supply. This corresponds to a shift in the supply curve.

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

Quantity

S0

Q*

P*

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Price

Quantity

If price is too low

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S

D

5

6

12

Shortage

12 - 6 = 6

6

7

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Due to shortage price will rise

Price

Quantity

If price is too high

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S

D

9

14

Surplus

14 - 6 = 8

6

8

8

7

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Due to surplus price will fall

Market Equilibrium
The Price (P) that Balances supply and demandQxS = Qxd No shortage or surplusSteady-state
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Qd =10-2P

Qs = 2+2P

Qd =Qs

10-2P = 2+2P

4P = 8

Pe = 2

Qe =6

Price Restrictions
Price CeilingsThe maximum legal price that can be charged.Examples:Gasoline prices in the 1970s.Housing in New York City.Price FloorsThe minimum legal price that can be charged.Examples:Minimum wage.Agricultural price supports.
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Apparently counterintuitive

Price ceiling is below the equilibrium. Price floor above the equilibrium

Paddy/rice procurement price

Price

Quantity

S

D

Impact of a Price Ceiling

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P*

Q*

P Ceiling

Q s

PF

Shortage

Q d

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Loss of welfare due to a price ceiling- graph

Class Exercise II
Qxd = 10-2Px; Qxs = 2+2PxFind out equilibrium Px and QeAssume a price ceiling of $1.5Find Qxd ,Qxs, shortage or surplus, if any Find economic priceFind non-pecuniary price
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Qd = 10 -2P; Qs= 2 +2P

10-2P = 2+2P

4P=8

Equilibrium price = $ 2

Equilibrium quantity Qe = 6

Price ceiling $ 1.50

Qd = 7; Qs= 5

Shortage = 2 units

Economic price

Qspc= Qd

5 = 10 -2P; P=2. 5, $1 is the non-pecuniary price

Full Economic Price
The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC)
PF = full economic pricePC = price ceilingPF - PC = nonpecuniary price
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Fair Price Shop
Ceiling price of Rice: Tk. 20.3 hours in line to buy 5 Kg of RiceOpportunity cost: Tk.10/hr.Total value of time spent in line: 3 Tk.10 = Tk. 30.Non-pecuniary price per Kg: Tk.30/5=Tk.6.Full economic price of a Kg of Rice: Tk.20+Tk.6=Tk. 26.
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Impact of a Price Floor

Price

Quantity

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S

D

P*

Q*

Surplus

PF

Qd

QS

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Qd = 10 -2P; Qs= 2 +2P

Equilibrium price = $ 2

Equilibrium quantity = 6

Price ceiling $ 4

Qd =2; Qs= 10

Surplus = 8 units

Cost of buying the surplus 4x8 =32

Comparative Static Analysis
How do the equilibrium price and quantity change when a determinant of supply and/or demand change?
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Class Exercise III
World cup series being held in DhakaDraw demand and supply curves prior to the gamesNow consider the following:Tigers are on a losing streakTigers are expected to win
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In reality, it is more complicated, e.g. how West Indies played

P

Q

S

D

Applications of Demand and Supply Analysis
Event: The Daily Star 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.
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The big picture, many companies fail bc the mangers get bogged down in the day-to-day decisions of business without having a clear picture of market trends and changes that are in the horizon

Supply and demand analysis is a qualitative tool that allows companies to see the big picture, changes in product and input prices

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.
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Scenario 1: Implications for a Small PC Maker
Step 1: Look for the Big Picture.Step 2: Organize an action plan (worry about details).
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Big Picture: Impact of decline in component prices on PC market

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S

D

Price

of

PCs

Quantity of PCs

S*

P0

P*

Q0

Q*

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Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase.Use this to organize an action plancontracts/suppliers?inventories?human resources?marketing?do I need quantitative estimates?
Big Picture Analysis: PC Market

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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 toa 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?
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Price

of Software

Quantity of

Software

Big Picture: Impact of lower PC prices on the software market

P0

2-*

S

D

Q0

D*

P1

Q1

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PC and software are complements

Software prices are likely to rise, and more software will be sold.Use this to organize an action plan.
Big Picture Analysis: Software Market

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Conclusion
Use supply and demand analysis toclarify 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.).
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