Chapter 2 & 3

CHAPTER 2

Market Forces: Demand and Supply

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Chapter Outline Demand

Factors that change quantity demanded and factors that change demand The demand function Consumer surplus

Supply Factors that change quantity supplied and factors that change supply The supply function Producer surplus

Market equilibrium Price restrictions and market equilibrium

Price ceilings Price floors

Comparative statics Changes in demand Changes in supply Simultaneous shifts in supply and demand

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Chapter Overview

Market demand curve

Illustrates the relationship between the total quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables constant.

Law of demand

The quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises).

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Demand

Demand

Market Demand Curve

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Quantity (thousands per year)

Price ($)

Demand

$40

0

$30

$20

20 40

$10

60 80

Demand

Changing only price leads to changes in quantity demanded.

This type of change is graphically represented by a movement along a given demand curve, holding other factors that impact demand constant.

Changing factors other than price lead to changes in demand.

These types of changes are graphically represented by a shift of the entire demand curve.

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Demand

Changes in Quantity Demanded

Changes in Demand

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Quantity 0

Price

D1

Increase in

demand

Demand

A

B

D0 D2

Decrease in

demand

Demand Shifters

Income Normal good Inferior good

Prices of related goods Substitute goods Complement goods

Advertising and consumer tastes Informative advertising Persuasive advertising

Population Consumer expectations Other factors

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Demand

Advertising and the Demand for Clothing

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Quantity of high-style clothing

0

$50

$40

50,000

Price of high-style clothing

D2

60,000

Due to an increase in advertising

Demand

D1

The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for good X, different prices of a related good Y, different levels of income, and other factors that affect the demand for good X.

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Demand

The Demand Function

One simple, but useful, representation of a demand function is the linear demand function:

= 0 + + + +

, where:

is the number of units of good X demanded;

is the price of good X;

is the price of a related good Y;

is income;

is the value of any other variable affecting demand.

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Demand

The Linear Demand Function

The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X demanded.

= 0 + + +

For example:

< 0 by the law of demand;

> 0 if good Y is a substitute for good X;

< 0 if good X is an inferior good.

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Demand

Understanding the Linear Demand Function

Suppose that an economic consultant for X Corp. recently provided the firms marketing manager with this estimate of the demand function for the firms product:

= 12,000 3 + 4 1 + 2

Question: How many of good X will consumers purchase when = $200 per unit, = $15 per unit, = $10,000 and = 2,000? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good? Answer:

= 12,000 3 200 + 4 15 1 10,000 + 2 2000 =

5,460 units. Goods X and Y are substitutes. Good X is an inferior good.

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Demand

The Linear Demand Function in Action

Inverse Demand Function

By setting = $15 and = $10,000 and = 2,000 the demand function is

= 12,000 3 + 4 15 1 10,000 + 2 2,000

the linear demand function simplifies to

= 6,060 3

Solving this for in terms of results in

= 2,020 1

3

, which is called the inverse demand function. This function is used to construct a market demand curve.

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Demand

Graphing the Inverse Demand Function in Action

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Quantity

Price

= 2,020 1

3

$2,020

0 6,060

Demand

Marketing strategies like value pricing and price discrimination rely on understanding consumer value for products.

Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities.

Total expenditure is the per-unit market price times the number of units consumed.

Consumer surplus is the extra value that consumers derive from a good but do not pay for.

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Consumer Surplus Demand

Quantity in liters

Price per liter

Demand

$5

0

$3

$2

1 2

$1

4 5

2-16

Total Consumer Value: 0.5($5 - $3)x2+(3-0)(2-0) = $8

Expenditures: $(3-0) x (2-0) = $6

Consumer Surplus: 0.5($5 - $3)x(2-0) = $2

Demand

Market Demand and Consumer Surplus in Action

$4

3

Consumer Surplus

Market supply curve

Summarizes the relationship between the total quantity all producers are willing and able to produce at alternative prices, holding other factors affecting supply constant.

Law of supply

As the price of a good rises (falls), the quantity supplied of the good rises (falls), holding other factors affecting supply constant.

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Supply Supply

Changing only price leads to changes in quantity supplied.

This type of change is graphically represented by a movement along a given supply curve, holding other factors that impact supply constant.

Changing factors other than price lead to changes in supply.

These types of changes are graphically represented by a shift of the entire supply curve.

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Supply

Changes in Quantity Supplied

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Change in Supply in Action

Quantity

Price

S2

0

Decrease in supply

Supply

A

B

S0 S1

Increase in supply

Input prices

Technology or government regulation

Number of firms Entry

Exit

Substitutes in production

Taxes Excise tax

Ad valorem tax

Producer expectations

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Supply

Supply Shifters

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Quantity of gasoline per week

Price of

gasoline

0

t = per unit tax of 20

Supply

S0

S0+t

t = 20

$1.20

$1.00

t

Excise tax

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Quantity of backpacks per week

Price of

backpacks

0

Supply

S0

S1 = 1.20 x S0

$24

$10

Ad valorem tax

$12

1,100

$20

2,450

The Supply Function

The supply function for good X is a mathematical representation describing how many units will be produced at different prices for X, different prices of inputs W, prices of technologically related goods, and other factors that affect the supply for good X.

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Supply

The Linear Supply Function

One simple, but useful, representation of a supply function is the linear supply function:

= 0 + + + +

, where:

is the number of units of good X produced;

is the price of good X;

is the price of an input;

is price of technologically related goods;

is the value of any other variable affecting supply.

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Supply

The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X produced.

= 0 + + +

For example:

> 0 by the law of supply.

< 0 increasing input price.

> 0 technology lowers the cost of producing good X.

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Supply

Understanding the Linear Supply Function

Your research department estimates that the supply function for televisions sets is given by:

= 2,000 + 3 4 1

Question: How many televisions are produced when = $400, = $100 per unit, and = $2,000?

Answer:

= 2,000 + 3 400 4 100 1 2,000 =

800 television sets.

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Supply

The Linear Supply Function in Action

Inverse Supply Function

By setting = $2,000 and = $100 in

= 2,000 + 3 4 100 1 2,000

the linear supply function simplifies to

= 3 400

Solving this for in terms of results in

=400

3+

1

3

, which is called the inverse supply function. This function is used to construct a market supply curve.

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Supply

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

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Supply

Producer Surplus

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Producer Surplus in Action

Quantity

Price Supply

$400

0 800

=400

3+

1

3

Supply

$400

3

Producer surplus

Competitive market equilibrium

Price of a good is determined by the interactions of the market demand and market supply for the good.

A price and quantity such that there is no shortage or surplus in the market.

Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change.

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Market Equilibrium Market Equilibrium

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Quantity

Price Supply

0

Demand

Surplus

Shortage

Market Equilibrium

Market Equilibrium I

0 1

Consider a market with demand and supply functions, respectively, as

= 10 2 and = 2 + 2

A competitive market equilibrium exists at a price, , such that = . That is,

10 2 = 2 + 2 8 = 4 = $2

= 10 2 $2 = 6 and = 2 + 2 $2 = 6

= 6 units

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Market Equilibrium II Market Equilibrium

In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply.

Sometimes the government restricts how much prices are permitted to rise or fall.

Price ceiling

Price floor

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Price Restrictions and Market Equilibrium

Price Restrictions

2-34

Quantity

Price Supply

0

Demand Shortage

Priceceiling

No

np

ecu

nia

ry p

rice

Lost social welfare


Price Ceiling in Action I


= 10 2 and = 2 + 2

Suppose a $1.50 price ceiling is imposed on the market. = 10 2 $1.50 = 7 units.

= 2 + 2($1.50) = 5 units.

Since > a shortage of 7 5 = 2 units exists.

Full economic price of 5 unit is 5 = 10 2 , or = $2.50. Of this, $1.50 is the dollar price

$1 is the nonpecuniary price

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Price Ceiling in Action II

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Quantity

Price Supply

0

Demand

Surplus

Pricefloor


Price Floor in Action I

Cost of purchasing excess supply


= 10 2 and = 2 + 2

Suppose a $4 price floor is imposed on the market. = 10 2 $4 = 2 units

= 2 + 2($4) = 10 units

Since > a surplus of 10 2 = 8 units exists

The cost to the government of purchasing the surplus is $4 8 = $32.

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Price Floor in Action II

Comparative static analysis

The study of the movement from one equilibrium to another.

Competitive markets, operating free of price restraints, will be analyzed when:

Demand changes;

Supply changes;

Demand and supply simultaneously change.

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Comparative Statics Comparative Statics

Increase in demand only Increase equilibrium price Increase equilibrium quantity

Decrease in demand only Decrease equilibrium price Decrease equilibrium quantity

Example of change in demand Suppose that consumer incomes are projected to

increase 2.5% and the number of individuals over 25 years of age will reach an all time high by the end of next year. What is the impact on the rental car market?

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Changes in Demand Comparative Statics

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Change in Demand in Action

Quantity (thousands rented per day)

Price Supply

0

$45

104

Demand for Rental Cars

Demand1

$49

Demand0

100

Comparative Statics

108

Increase in supply only Decrease equilibrium price

Increase equilibrium quantity

Decrease in supply only Increase equilibrium price

Decrease equilibrium quantity

Example of change in supply Suppose that a bill before Congress would require

all employers to provide health care to their workers. What is the impact on retail markets?

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Changes in Supply Comparative Statics

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Quantity

Price

Supply0

0 0

Demand

0

Supply1

1

1

Comparative Statics


Suppose that simultaneously the following events occur:

an earthquake hit Kobe, Japan and decreased the supply of fermented rice used to make sake wine.

the stress caused by the earthquake led many to increase their demand for sake, and other alcoholic beverages.

What is the combined impact on Japans sake market?

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Comparative Statics

Simultaneous Shifts in Supply and Demand

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Quantity

Price

Supply0

0

0

Demand1

1

Supply1

Demand0

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Japans Sake Market

0 1

Supply2

2

2

A

B

C

Demand and supply analysis is useful for

Clarifying the big picture (the general impact of a current event on equilibrium prices and quantities).

Organizing an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

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Conclusion

Chapter Outline The elasticity concept Own price elasticity of demand

Elasticity and total revenue Factors affecting the own price elasticity of demand Marginal revenue and the own price elasticity of demand

Cross-price elasticity Revenue changes with multiple products

Income elasticity Other Elasticities

Linear demand functions Nonlinear demand functions

Obtaining elasticities from demand functions Elasticities for linear demand functions Elasticities for nonlinear demand functions

Regression Analysis Statistical significance of estimated coefficients Overall fit of regression line Regression for nonlinear functions and multiple regression

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Chapter Overview

Introduction Chapter 2 focused on interpreting demand

functions in qualitative terms:

An increase in the price of a good leads quantity demanded for that good to decline.

A decrease in income leads demand for a normal good to decline.

This chapter examines the magnitude of changes using the elasticity concept, and introduces regression analysis to measure different elasticities.

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Chapter Overview

The Elasticity Concept

Elasticity

Measures the responsiveness of a percentage change in one variable resulting from a percentage change in another variable.

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The Elasticity Formula

The elasticity between two variables, and , is mathematically expressed as:

, =%

%

When a functional relationship exists, like = , the elasticity is:

, =

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Measurement Aspects of Elasticity

Important aspects of the elasticity:

Sign of the relationship:

Positive.

Negative.

Absolute value of elasticity magnitude relative to unity:

, > 1 is highly responsive to changes in .

, < 1 is slightly responsive to changes in .

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Own Price Elasticity Own price elasticity of demand

Measures the responsiveness of a percentage change in the quantity demanded of good X to a percentage change in its price.

, =%

%

Sign: negative by law of demand. Magnitude of absolute value relative to unity:

, > 1: Elastic.

, < 1: Inelastic.

, = 1: Unitary elastic.

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Own Price Elasticity of Demand

Linear Demand, Elasticity, and Revenue

3-53

Quantity

Price

Demand

$40

0

$20

$10

20 30

$5

40

$15

$30

$25

$35

10 50 60 70 80

Linear Inverse Demand: = 40 0.5 Demand: = 80 2

Revenue = $30 20 = $600

Elasticity: 2 $30

20= 3

Conclusion: Demand is elastic.

Observation: Elasticity varies along a linear (inverse) demand curve


Total Revenue Test

When demand is elastic:

A price increase (decrease) leads to a decrease (increase) in total revenue.

When demand is inelastic:

A price increase (decrease) leads to an increase (decrease) in total revenue.

When demand is unitary elastic:

Total revenue is maximized.

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Extreme Elasticities

3-55

Quantity

Demand

Price

Perfectly Inelastic

, = 0

Demand , =

Perfectly elastic


Factors Affecting the Own Price Elasticity

Three factors can impact the own price elasticity of demand:

Availability of consumption substitutes.

Time/Duration of purchase horizon.

Expenditure share of consumers budgets.

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Demand and Marginal Revenue

3-57

Quantity 0

MR

3

Price

6

Demand


1

6

Unitary

Marginal Revenue (MR)

Cross-Price Elasticity Cross-price elasticity

Measures responsiveness of a percent change in demand for good X due to a percent change in the price of good Y.

, =%

%

If , > 0, then and are substitutes.

If , < 0, then and are complements.

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Cross-Price Elasticity

Cross-Price Elasticity in Action Suppose it is estimated that the cross-price

elasticity of demand between clothing and food is -0.18. If the price of food is projected to increase by 10 percent, by how much will demand for clothing change?

0.18 =%

10 %

= 1.8

That is, demand for clothing is expected to decline by 1.8 percent when the price of food increases 10 percent.

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Cross-Price Elasticity in Action Suppose a restaurant earns $4,000 per week in

revenues from hamburger sales (X) and $2,000 per week from soda sales (Y). If the own price elasticity for burgers is , = 1.5 and the cross-price elasticity of demand between sodas and hamburgers is , = 4.0, what would happen to the firms total revenues if it reduced the price of hamburgers by 1 percent? = $4,000 1 1.5 + $2,000 4.0 1%

= $100 That is, lowering the price of hamburgers 1 percent

increases total revenue by $100.

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Income Elasticity Income elasticity

Measures responsiveness of a percent change in demand for good X due to a percent change in income.

, =%

%

If , > 0, then is a normal good.

If , < 0, then is an inferior good.

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Income Elasticity

Income Elasticity in Action Suppose that the income elasticity of demand for

transportation is estimated to be 1.80. If income is projected to decrease by 15 percent,

what is the impact on the demand for transportation?

1.8 =%

15

Demand for transportation will decline by 27 percent.

is transportation a normal or inferior good? Since demand decreases as income declines,

transportation is a normal good.

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Income Elasticity

Other Elasticities

Own advertising elasticity of demand for good X is the ratio of the percentage change in the consumption of X to the percentage change in advertising spent on X.

Cross-advertising elasticity between goods X and Y would measure the percentage change in the consumption of X that results from a 1 percent change in advertising toward Y.

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Other Elasticities

Conclusion Elasticities are tools you can use to quantify

the impact of changes in prices, income, and advertising on sales and revenues.

Given market or survey data, regression analysis can be used to estimate: Demand functions.

Elasticities.

A host of other things, including cost functions.

Managers can quantify the impact of changes in prices, income, advertising, etc.

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Chapter 2 & 3

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