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

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

3. Market Demand Curve
Shows the amount of a good that will be purchased at alternative prices.
Law of Demand
If the price goes down, the quantity demanded goes up.
Quantity
Price D
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

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

6. Change in Quantity Demanded
Price
Quantity D0
A to B: Increase in quantity demanded A 10 4 B 6 7
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

7. Change in Demand Price D0 to D1: Increase in Demand 6 D1 D0 7 13
Quantity D0
D0 to D1: Increase in Demand D1 6 7 13
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

9. 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.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

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

12. Market Supply Curve
The supply curve shows the amount of a good that will be produced at alternative prices.
Law of Supply
If the price goes up, the quantity supplied will go up.
Price
Quantity S0
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

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

15. Change in Quantity Supplied
Price
Quantity S0
A to B: Increase in quantity supplied B 20 A 10 10 5
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

16. Change in Supply S0 to S1: Increase in supply Price Quantity S0 S1 8 56 7
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

17. Producer Surplus
The amount producers receive in excess of the amount necessary to induce them to produce the good.
Price S0 P*
Producer Surplus Q*
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

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

20. 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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

22. 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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

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

24. Big Picture: Impact of decline in component prices on PC market
PCs
Quantity of PC’s S D S* P0 P* Q0 Q*
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

25. 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.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

26. 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?
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999

27. Big Picture: Impact of lower PC prices on the software market
of Software S D* D P1 Q1 P0 Q0
Quantity of
Software
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999