1. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Managerial Economics & Business Strategy Chapter 2 Market Forces: Demand and Supply

2. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Overview III. Market Equilibrium IV. Price Restrictions V. Comparative Statics II. Market Supply Curve n The Supply Function n Supply Shifters n Producer Surplus I. Market Demand Curve n The Demand Function n Determinants of Demand n Consumer Surplus

3. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Law of Demand n The demand curve is downward sloping. Quantity D Price

4. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Determinants of Demand Income Prices of substitutes Prices of complements Advertising Population Consumer expectations

5. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 The Demand Function An equation representing the demand curve Q x d = f(P x, P Y, M, H,) n Q x d = quantity demand of good X. n P x = price of good X. n P Y = price of a substitute good Y. n M = income. n H = any other variable affecting demand

6. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Change in Quantity Demanded Price Quantity D0D0 4 7 10 6 A A to B: Increase in quantity demanded B

7. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity D0D0 D1D1 6 7 D 0 to D 1 : Increase in Demand Change in Demand 13

8. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Consumer Surplus: The value consumers get from a good but do not have to pay for.

9. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 I got a great deal! That company offers a lot of bang for the buck! Gateway 2000 provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large.

10. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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.

11. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity D 10 8 6 4 2 1 2 3 4 5 Consumer Surplus: The value received but not paid for Consumer Surplus: The Discrete Case

12. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Consumer Surplus: The Continuous Case Price $ Quantity D 10 8 6 4 2 1 2 3 4 5 Value of 4 units Consumer Surplus Total Cost of 4 units

13. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply n The supply curve is upward sloping Price Quantity S0S0

14. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Supply Shifters Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

15. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 The Supply Function An equation representing the supply curve: Q x S = f(P x, P R,W, H,) n Q x S = quantity supplied of good X. n P x = price of good X. n P R = price of a related good n W = price of inputs (e.g., wages) n H = other variable affecting supply

16. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Change in Quantity Supplied Price Quantity S0S0 20 10 B A 5 A to B: Increase in quantity supplied

17. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity S0S0 S1S1 8 5 7 S 0 to S 1 : Increase in supply Change in Supply 6

18. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. Price Quantity S0S0 Producer Surplus Q*Q* P*P*

19. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Market Equilibrium Balancing supply and demand n Q x S = Q x d Steady-state

20. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity S D 5 6 12 Shortage 12 - 6 = 6 6 If price is too low… 7

21. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity S D 9 14 Surplus 14 - 6 = 8 6 8 8 If price is too high… 7

22. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Restrictions Price Ceilings n The maximum legal price that can be charged n Examples: Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees Price Floors n The minimum legal price that can be charged. n Examples: Minimum wage Agricultural price supports

23. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price Quantity S D P* Q* Ceiling Price Q s PFPF Impact of a Price Ceiling Shortage Q d

24. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Full Economic Price The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price. P F = P c + (P F - P C ) P F = full economic price P C = price ceiling P F - P C = nonpecuniary price

25. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 An Example from the 1970s Ceiling price of gasoline - $1 3 hours in line to buy 15 gallons of gasoline n Opportunity cost: $5/hr n Total value of time spent in line: 3  $5 = $15 n Non-pecuniary price per gallon: $15/15=$1 Full economic price of a gallon of gasoline: $1+$1=2

26. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Impact of a Price Floor Price Quantity S D P* Q* QSQS QdQd Surplus PFPF

27. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Comparative Static Analysis How do the equilibrium price and quantity change when a determinant of supply and/or demand change?

28. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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.

29. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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.

30. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Scenario 1: Implications for a Small PC Maker Step 1: Look for the “Big Picture” Step 2: Organize an action plan (worry about details)

31. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price of PCs Quantity of PC’s S D S* P0P0 P* Q0Q0 Q* Big Picture: Impact of decline in component prices on PC market

32. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 So, the Big Picture is: n PC prices are likely to fall, and more computers will be sold Use this to organize an action plan n contracts/suppliers? n inventories? n human resources? n marketing? n do I need quantitative estimates? n etc.

33. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 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 n a lower equilibrium price for computers n a greater number of computers sold. Step 2: How will these changes affect the “Big Picture” in the software market?

34. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Price of Software Quantity of Software S D Q0Q0 D* P1P1 Q 1 Big Picture: Impact of lower PC prices on the software market P0P0

35. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 The “big picture” for the software maker: n Software prices are likely to rise, and more software will be sold Use this to organize an action plan

36. Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc., 1999 Summary Use supply and demand analysis to n clarify the “big picture” (the general impact of a current event on equilibrium prices and quantities) n organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.)