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

2. 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

3. 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

4. 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

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

6. 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

7. 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

8. 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?

9. 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 = and I = 26,500
a5 = 0.36 and A = 1,356
a6 = and Pop = 32,763

10. The Demand Function Numerical example: Reduce the values
insert non-control variables
Qxd = 40-33*PX+26*14-16* *26, *1, *32,736
Reduce the values
Qxd = 40-33*PX
Qxd = *PX
For any value of PX we can get an estimate of sales volume
PX = 10 gets Qxd = *10 = =
Simple inversion allows us to estimate the price we can charge for a particular volume
33*PX = Qxd  PX = * Qxd
If Qxd = 10 then PX = * 10 =

11. 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

12. 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

13. 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.

14. 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
Consumer Surplus:
The value received but not
paid for
Amount Spent

15. 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 )
Ability to sort
Ability to prevent resale
Profitability
C.S. P*

16. 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

17. 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

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

19. 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)

20. 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 -)

21. 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 = *PX+15*4-0.06* * *23
QxS = *PX
QxS = *PX
Unless PX > 2.78 there will be no product supplied.

22. 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

23. 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

24. 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

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

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

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

28. 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

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

30. 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

31. 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

32. 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

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

34. 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

35. 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

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

37. 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*?

38. 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

39. 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

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

41. 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.

42. 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.

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

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

45. 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.

46. 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?

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

48. 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

49. 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.)