Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Managerial Economics & Business Strategy Chapter 2 Market Forces: Demand and Supply

2-2 Overview I. Market Demand Curve –The Demand Function –Determinants of Demand –Consumer Surplus II. Market Supply Curve –The Supply Function –Supply Shifters –Producer Surplus III. Market Equilibrium IV. Price Restrictions V. Comparative Statics

2-3 Visualizing the Big Picture  Supply and Demand analysis allows the manager to see the big picture.  Predicting market trends are as important as the day to day management decisions.  Specific analytic tools are available to assist with details.

2-4 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. Quantity D Price

2-5 Determinants of Demand and Demand Shifters  Income –Normal good –Inferior good  Prices of Related Goods –Prices of substitutes –Prices of complements  Advertising and consumer tastes  Population  Consumer expectations

2-6 The Demand Function  A general equation representing the demand curve Q x d = f(P x, P Y, M, H,) –Q x d = quantity demand of good X. –P x = price of good X. –P Y = price of a related good Y. Substitute good. Complement good. –M = income. Normal good. Inferior good. –H = any other variable affecting demand.

2-7 Types of Demand Functions  Linear – If the demand for X is a linear function of the variables that affect demand:  Q d x = α 0 + α x P x + α y P y + α M M + α H H  Log-Linear – if the logarithm of demand is a linear function of the logarithms of the influencing variables:  LnQ d x = α 0 + α x lnP x + α y lnP y + α m lnM + α H lnH

2-8 Inverse Demand Function  Price as a function of quantity demanded.  Example: –Demand Function Q x d = 10 – 2P x –Inverse Demand Function: 2P x = 10 – Q x d P x = 5 – 0.5Q x d

2-9 Change in Quantity Demanded Price Quantity D0D A to B: Increase in quantity demanded B 10 A

2-10 Change in Demand Price Quantity D0D0 D1D1 6 7 D 0 to D 1 : Increase in Demand 13

2-11 Consumer Surplus  The value consumers get from a good but do not have to pay for.  Graphically the area under the demand curve and above the price.  Can be termed “psychic profit”.  Used in valuation when a demand curve is not obvious.

2-12 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.

2-13 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.

2-14 Consumer Surplus: Discrete Case Price Quantity D Consumer Surplus: The value received but not paid for. Consumer surplus = (8-2) + (6-2) + (4-2) = $12.

2-15 Consumer Surplus: Continuous Case Price $ Quantity D Value of 4 units = $24 C onsumer Surplus = $24 - $8 = $16 Expenditure on 4 units = $2 x 4 = $8

2-16 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 Quantity S0S0

2-17 Supply Shifters  Input prices  Technology or government regulations  Number of firms –Entry –Exit  Substitutes in production  Taxes –Excise tax –Ad valorem tax  Producer expectations

2-18 The Supply Function  An equation representing the supply curve: Q x S = f(P x, P R,W, H,) –Q x S = quantity supplied of good X. –P x = price of good X. –P R = price of a production substitute. –W = price of inputs (e.g., wages). –H = other variable affecting supply.

2-19 Inverse Supply Function  Price as a function of quantity supplied.  Example: –Supply Function Q x s = P x –Inverse Supply Function: 2P x = 10 + Q x s P x = Q x s

2-20 Change in Quantity Supplied Price Quantity S0S B A 5 A to B: Increase in quantity supplied

2-21 Change in Supply Price Quantity S0S0 S1S S 0 to S 1 : Increase in supply 6

2-22 Producer Surplus  The amount producers receive in excess of the amount necessary to induce them to produce the good. Price Quantity S0S0 Q*Q* P*P*

2-23 Market Equilibrium  The Price (P) that Balances supply and demand –Q x S = Q x d –No shortage or surplus  Steady-state

2-24 If price is too low… Price Quantity S D Shortage = 6 6 7

2-25 If price is too high… Price Quantity S D 9 14 Surplus =

2-26 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.

2-27 Impact of a Price Ceiling Price Quantity S D P* Q* P Ceiling Q s PFPF Shortage Q d

2-28 Full Economic Price  The dollar amount paid to a firm under a price ceiling, plus the non-pecuniary price. P F = P c + (P F - P C ) –P F = full economic price –P C = price ceiling –P F - P C = nonpecuniary price

2-29 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.

2-30 Impact of a Price Floor Price Quantity S D P* Q* Surplus PFPF QdQd QSQS

2-31 Comparative Static Analysis  How do the equilibrium price and quantity change when a determinant of supply and/or demand change?

2-32 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.

2-33 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.

2-34 Scenario 1: Implications for a Small PC Maker  Step 1: Look for the “Big Picture.”  Step 2: Organize an action plan (worry about details).

2-35 Big Picture: Impact of decline in component prices on PC market Price of PCs Quantity of PC’s S D S* P0P0 P* Q0Q0 Q*

2-36 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?

2-37 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?

2-38 Big Picture: Impact of lower PC prices on the software market Price of Software Quantity of Software S D Q0Q0 D* P1P1 Q 1 P0P0

2-39 Big Picture Analysis: Software Market  Software prices are likely to rise, and more software will be sold.  Use this to organize an action plan.

2-40 Simultaneous Shifts in Demand and Supply  Kobe, Japan earthquake in 1995 destroyed the regional sake wine industry.  Demand for alcohol as a stress reliever increased.  What happens to equilibrium P and Q when both S and D shift?

2-41 Ambiguities Nature of ChangeIncrease in DDecrease in D Increase in SP?; Q increasesP decreases; Q? Decrease in SP increases; Q?P?; Q decreases

2-42 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.).