Managerial Economics & Business Strategy Chapter 2 Market Forces: Demand and Supply

Overview I. Market Demand Curve III. Market Equilibrium The Demand Function Determinants of Demand Consumer Surplus III. Market Equilibrium IV. Price Restrictions V. Comparative Statics II. Market Supply Curve The Supply Function Supply Shifters Producer Surplus

Market Demand Curve Quantity of a good that people are willing and able to buy, at various prices, ceteris paribus. One-to-one relationship willingness and ability all else the same

Market Demand Curve Law of Demand Price and quantity demanded are inversely related See “Lesson from Malawi” The demand curve is downward sloping. Quantity Price D

Determinants of Demand Income Prices of substitutes Prices of complements Advertising/preferences Population Consumer expectations

Qxd = f(Px , PY , PZ, I, A, Pop, Pe) The Demand Function A general equation representing the demand curve Qxd = f(Px , PY , PZ, I, A, Pop, Pe) Qxd = quantity demand of good X. Px = price of good X. PY = price of a substitute good Y. PZ = price of a complementary good Z I = income. A = advertising expenses as a proxy for preferences Pop = population in the relevant area Pe = price expectations

Qxd = a0+a1Px+ a2 PY+a3PZ+a4I+a5A+a6Pop The Demand Function A linear equation representing the demand curve Qxd = a0+a1Px+ a2 PY+a3PZ+a4I+a5A+a6Pop ai is the coefficient on the variable of interest Sign Size Qxd = quantity demand of good X. Px = price of good X. PY = price of a substitute good Y. PZ = price of a complementary good Z. I = income. A = Advertising expense as a proxy for preferences Pop = relevant population Demand Shifters

Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop The Demand Function A linear equation representing the demand curve Numerical example Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop Signs (+ or -), why? a0 (+ or -) a1 (+ or -) a2 (+ or -) a3 (+ or -) a4 (+ or -) a5 (+ or -) a6 (+ or -) Where do we get the numbers?

Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop The Demand Function A linear equation representing the demand curve Numerical example Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop Suppose: a0 = 40 a1 = -33 a2 = 26 and PY = 14 a3 = -16 and PZ = 17 a4 = -0.002 and I = 26,500 a5 = 0.36 and A = 1,356 a6 = 0.0001 and Pop = 32,763

The Demand Function Numerical example: Reduce the values insert non-control variables Qxd = 40-33*PX+26*14-16*17-0.002*26,500+0.36*1,356+0.0001*32,736 Reduce the values Qxd = 40-33*PX+364-272-53+488.16+3.2736 Qxd = 570.4336-33*PX For any value of PX we can get an estimate of sales volume PX = 10 gets Qxd = 570.4336-33*10 = 570.4336-330 = 240.4336 Simple inversion allows us to estimate the price we can charge for a particular volume 33*PX = 570.4336 - Qxd  PX = 17.28587- 0.03030* Qxd If Qxd = 10 then PX = 17.28587- 0.03030* 10 = 16.9828

Change in Quantity Demanded Price Quantity D0 A to B: Increase in quantity demanded A 10 4 B 6 7 a1 = Q/P = (7-4)/6-10) = -3/4 If P = 1 then a1 = Q

Change in Demand ai, i  0,1 Increase in demand At the same price, more is demanded or For the same quantity a higher price can be received Decrease in demand At the same price, less is demanded or For the same quantity a lower price will be received Price Quantity D0 D1 6 7 D0 to D1: Increase in Demand 13 ai, i  0,1

Consumer Surplus The value to consumers above what they paid. Value is determined by the individual - no good has any value except as the possessor or would-be possessor attributes to it Example: willing to pay $20, but only pay $18. You have $2 in consumer surplus.

Consumer Surplus: The Discrete Case Individual C’s Consumer’s Value Individual A’s Consumer’s Value Individual B’s Consumer’s Value Individual D’s Consumer’s Value Price Quantity D 10 8 6 4 2 1 2 3 4 5 Consumer Surplus: The value received but not paid for Amount Spent

Consumer Surplus: The Continuous Case If we arranged all consumers based on maximum willingness and ability to pay we get the demand curve. Area under the demand curve and above the price is total consumer surplus for the market. It represents dollars out the door Price discrimination (pp 410-415) Ability to sort Ability to prevent resale Profitability C.S. P*

Market Supply Curve The supply curve shows the amount of a good that producers (sellers) are willing and able to sell, at various prices, ceteris paribus. One-to-one relationship willingness and ability all else the same

Market Supply Curve The supply curve tends to be upward sloping: S0 Increasingly expensive inputs Diminishing marginal product (we will get there) It is not as consistent as “Law of Demand” Price S0 Quantity

Supply Shifters Input prices Technology government regulations Number of firms Substitutes in production Taxes Producer expectations

QxS = f(Px , Tech, PR ,W, Comp) The Supply Function An equation representing the supply curve: QxS = f(Px , Tech, PR ,W, Comp) QxS = quantity supplied of good X. Px = price of good X. Tech = generation of the production technology PR = price of other good that could be produced W = price of inputs (e.g., wages) Comp = number of firms in the industry (competitors)

The Supply Function Linear equation representing the supply curve: QxS = b0+b1*PX+b2*Tech+b3*PR+b4*W+b5*Comp bi is the coefficient on the variable of interest Sign Size We expect: b0 (+ or -) b1 (+ or -) b2 (+ or -) b3 (+ or -) b4 (+ or -) b5 (+ or -)

The Supply Function QxS = -100+15*PX+60-0.096-1.5825+0.874 A numerical example of a linear supply curve: QxS = b0+b1*PX+b2*Tech+b3*PR+b4*W+b5*Comp We observe: b0 = -100 b1 = 15 b2 = 15, Tech = 4 b3 = -0.06, PR= 1.60 b4 = -0.15, W = 10.55 b5 = 0.038, Comp = 23 Putting values in: QxS = -100+15*PX+15*4-0.06*1.60-0.15*10.55+0.038*23 QxS = -100+15*PX+60-0.096-1.5825+0.874 QxS = -41.6785+15*PX Unless PX > 2.78 there will be no product supplied.

Change in Quantity Supplied Price Quantity S0 20 10 B A 5 A to B: Increase in quantity supplied b1 = Q/P = (10-5)/(20-10) = 1/2 If P = 1 then b1 = Q = 1/2

Change in Supply Increase in supply: Decrease in supply: bi, i  0, 1 At the same price a higher quantity supplied The same quantity will be supplied at a lower price Decrease in supply: At the same price a lower quantity will be supplied The same quantity will be supplied at a higher price Price Quantity S0 S1 8 5 7 S0 to S1: Increase in supply 6 bi, i  0, 1

Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. This is not the same as profit, though it is similar. Price S0 P* Producer Surplus Q* Quantity

Market Equilibrium Balancing supply and demand Opposing responses to the same stimuli Price such that: QxS = Qxd e.g. QD = 570 -33P, QS = -42 + 15P P = 12.7, Q = 148.5 Steady-state Strong tendency to move towards this level

If price is too low… Price S D 7 6 5 6 12 Shortage 12 - 6 = 6 Quantity

If price is too high… Surplus 14 - 6 = 8 Price S D 9 6 14 8 7 8 Quantity

Price Restrictions Price Ceilings Price Floors 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. Minimum wage Agricultural price supports

Impact of a Price Ceiling Quantity S D P* Q* PF Ceiling Price Q s Q d Shortage

Full Economic Price PF = Pc + (PF - PC) The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price. PF = Pc + (PF - PC) PF = full economic price (Black market price) PC = price ceiling PF - PC = nonpecuniary price

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

Common Price Ceiling Results Shortages Black markets Creative non-cash payment schemes Examples Key money Furniture sales Line sitting as an occupation Rent seeking behavior Price distortions NYC real estate value & vacant buildings Santa Monica

Impact of a Price Floor Price Quantity S D P* Q* Surplus PF Qd QS

Impact of a Price Floor - enforced Surplus - increase quantity supplied, reduced quantity demanded Enforcement expenses Compliance expenses Black market operations Example: minimum wage training wages cash only work

Impact of a Price Floor - supported Surplus - increase quantity supplied, reduced quantity demanded Purchases (surplus * price floor) Storage expenses What do you do with it? Examples: Diary products Tobacco Oranges Rubber

Comparative Static Analysis How do the equilibrium price and quantity change when a determinant of supply and/or demand changes?

Comparative Static Analysis- By Steps What happened? value of information; multiple, reliable data sources Does this effect Demand and/or Supply? remember behavioral factors Is it an increase or a decrease? remember the sign on the coefficient What happens to P* and Q*?

Results of greed, understanding and access: “Liar's Poker: Rising Through the Wreckage on Wall Street” by Michael Lewis Event: Cherynobyl Results of greed, understanding and access: early retirement dampened price/quantity movements

Liar's Poker Potato market is in equilibrium Stable demand Stable supply Well developed futures markets Price and volume are constant across time. Arbitrage opportunity - across time and location

Liar's Poker S1 S3 D0 S0 Q0 Q P P0 D2 P1 Q1 Q3 P3 Q2 P2

Applications of 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.

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.

Scenario 1: Implications for a Small PC Maker Step 1: Look for the “Big Picture” Step 2: Organize an action plan (worry about details)

Big Picture: Impact of decline in component prices on PC market PCs Quantity of PC’s S D S* P0 P* Q0 Q*

Use this to organize an action plan So, the Big Picture is: PC prices are likely to fall, and more computers will be sold Use this to organize an action plan contracts/suppliers? inventories? human resources? marketing? do I need quantitative estimates? etc.

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?

Big Picture: Impact of lower PC prices on the software market of Software S D* D P1 Q1 P0 Q0 Quantity of Software

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

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.)