Download Managerial Economics & Business Strategy

Managerial Economics &
Business Strategy
Chapter 2
Market Forces: Demand and Supply
McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy
Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
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
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.
Price
D
Quantity
2-4
Determinants of Demand
• Income


Normal good
Inferior good
• Prices of Related Goods


Prices of substitutes
Prices of complements
• Advertising and
consumer tastes
• Population
• Consumer expectations
2-5
The Demand Function
• A general 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 related good Y.
• Substitute good.
• Complement good.


M = income.
• Normal good.
• Inferior good.
H = any other variable affecting demand.
2-6
Inverse Demand Function
• Price as a function of quantity
demanded.
• Example:

Demand Function
• Qxd = 10 – 2Px

Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd
2-7
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded
10
A
B
6
D0
4
7
Quantity
2-8
Change in Demand
Price
D0 to D1: Increase in Demand
6
D1
D0
7
13
Quantity
2-9
Consumer Surplus:
• The value consumers get from a good but
do not have to pay for.
• Consumer surplus will prove particularly
useful in marketing and other disciplines
emphasizing strategies like value pricing
and price discrimination.
2-10
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.
2-11
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.
Consumer Surplus:
The Discrete Case
Price
Consumer Surplus:
The value received but not
paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
10
8
6
4
2
D
1
2
3
4
5
Quantity
2-12
Consumer Surplus:
The Continuous Case
Price $
10
Consumer
Surplus =
$24 - $8 =
$16
Value
of 4 units = $24
8
6
Expenditure on 4 units =
$2 x 4 = $8
4
2
D
1
2
3
4
5
Quantity
2-13
2-14
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
S0
Quantity
2-15
Supply Shifters
• Input prices
• Technology or
government regulations
• Number of firms


Entry
Exit
• Substitutes in production
• Taxes


Excise tax
Ad valorem tax
• Producer expectations
2-16
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 production substitute.
W = price of inputs (e.g., wages).
H = other variable affecting supply.
2-17
Inverse Supply Function
• Price as a function of quantity
supplied.
• Example:

Supply Function
• Qxs = 10 + 2Px

Inverse Supply Function:
• 2Px = 10 + Qxs
• Px = 5 + 0.5Qxs
2-18
Change in Quantity Supplied
Price
A to B: Increase in quantity supplied
S0
B
20
A
10
5
10
Quantity
2-19
Change in Supply
S0 to S1: Increase in supply
Price
S0
S1
8
6
5
7
Quantity
2-20
Producer Surplus
• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price
S0
P*
Q*
Quantity
APPLICATION AND SOME DEEPER
INFORMATION ON ECONOMIC
SUPLUS
Economic surplus
A measure of Economic Welfare
Consumer surplus


Consumer surplus is the net gain to
consumers being able to buy a product
through a market
Consumer surplus is the difference between
the highest price someone is willing to pay
for a product and the actual market price
that is paid, then summed over all units that
are demanded and consumed



The highest price that someone is willing to
pay for a unit of a product indicates the
value that the buyer attaches to that unit
In order to measure consumer surplus,
one has to have:
Market price, quantity demanded, and
slope or shape of the demand curve
Consumer surplus can then be measured as the area
below the demand curve and above the market-price line
CONSUMER SURPLUS IS
THE AREA GIVEN BY THE
TRIANGE, C
PRICE
a
a = the
intercept of the
inverse demand
function, while
P = market
price, and Q =
the quantity
consumed at
the price P
C
C
P
Price in the market
DEMAND
Q
QUANTIT
Y
AS DEMAND SHIFTS OUTWARD TO THE RIGHT, GIVEN
THE SAME MARKET PRICE, THEN CONSUMER SURPLUS
INCREASES
PRICE
ALSO RECALL
THAT THE
AREA OF A
TRAINGLE IS
½ TIMES BASE
TIMES
HEIGHT
CONSUMER SURPLUS IS
THE AREA GIVEN BY THE
TRIANGE, C
a
C C
DEMAND
P
Price in the market
Q
QUANTIT
Y
SO CONSUMER SURPLUS IS THEREFORE, ½(a – p)Q
Now we impose an actual supply function and derive the
price as the equilibrium price from the condition that
demand = supply in the market
A PERFECTLY COMPETITIVE
MARKET IS ASSUMED HERE
CONSUMER SURPLUS
TRIANGLE
PRICE
NOW, WE HAVE
ANOTHER
SURPLUS
CALLED
PRODUCERS
SURPLUS --THE
DIFFERENCE
BETWEEN
MARKET PRICE
AND THE
SUPPLY CURVE
a
SUPPLY
E
P
DEMAND
g
Q
QUANTIT
Y
g IS THE INTERCEPT OF THE INVERSE SUPPLY FUNCTION
LET’S USE AN ACTUAL DEMAND FUNCTION AND AN
ACTUAL SUPPLY FUNCTION, BUT WITHOUT ANY INCOME
EFFECT (IN DEMAND) AND WITHOUT ANY PRICE OF
INPUTS (IN SUPPLY)









SUPPOSE THE DEMAND FUNCTION IS THEN GIVEN AS
QD = 18 – 1.2P, FOR QD = QUANTITY AND P = PRICE
LET THE SUPPLY FUNCTION BE GIVEN BY
QS = -2 + 0.6P, FOR QS = QUANTITY AND P = PRICE
WE NOW NEED THE EQUILIBRIUM PRICE AND
QUANTITY IN THE MARKET
SET QD = QS, OR 18 – 1.2P = -2 + 0.6P
SOLVE FOR P BY REARRANGING AS 1.8P = 16, OR
P = 16/1.8 = 8.89
THEN SUBSTITUTE P=8.89 INTO THE DEMAND
FUNCTION TO GET Q = 18 – 1.2(8.89) = 7.33
SO EQUILIBRIUM PRICE IS 8.89 AND EQUILIBRIUM
QUANTITY IN THE MARKET IS 7.33







WE NOW WANT TO CALCULATE THE CONSUMER AND
PRODUCER SURPLUS VALUES
INVERSE DEMAND FROM THE DEMAND FUNCTION Q =
18 – 1.2P IS GIVEN BY P = 18/1.2 – Q/1.2
WHICH IS EQUAL TO P = 15 – 0.83Q
SO OUR INTERCEPT, a, IS NOW a = 15
INVERSE SUPPLY FROM THE SUPPLY FUNCTION Q = 2 + 0.6P IS GIVEN BY P = 2/0.6 + Q/0.6
WHICH IS EQUAL TO P = 3.33 + 1.67Q
SO OUR INVERSE SUPPLY INTERCEPT, g, IS NOW g =
3.33
NOW ON TO CONSUMER SURPLUS AND PRODUCER
SURPLUS GIVEN EQUILIBRIUM PRICE IS P = 8.89;
EQUILIBRIUM QUANTITY IS Q = 7.33; a = 15, AND g =
3.33 (of course we are assuming the product is perfectly
divisible here--- which may not generally be the case)




CONSUMER SURPLUS = ½(15 – 8.89)(7.33)
WHICH IS APPROXIMATELY EQUAL TO 22.39
PRODUCER SURPLUS = ½(8.89 – 3.33)(7.33)
WHICH IS APPROXIMATELY 20.38
PRICE, P
CONSUMER SURPLUS =
22.39
a
Actually Inverse
supply
Equilibrium price,
P
PRODUCER SURPLUS = 20.38
g
Equilibrium quantity Q
Actually inverse demand
QUANTITY, Q
THE AREA UNDER THE SUPPLY CURVE AND UP TO A QUANTITY
SUPPLIED OF Q IS THE PAYMENT TO VARIABLE INPUTS
(VARIABLE COSTS) --- SO THE PRODUCER RECEIVES A
SURPLUS OVER VARIABLE COSTS --- PRODUCERS SURPLUS
CONSUMER SURPLUS =
AREA aEP
PRICE
a
SUPPLY
P IS EQUILIBRIUM
PRICE
E
P
SUPPLY = DEMAND AT POINT E
DEMAND
g
PRODUCERS
SURPLUS =
AREA gPE
Q
QUANTIT
Y
Q IS EQUILIBRIUM QUANTITY
2-31
Market Equilibrium
• The Price (P) that Balances
supply and demand


QxS = Qxd
No shortage or surplus
• Steady-state
2-32
If price is too low…
Price
S
7
6
5
D
Shortage
12 - 6 = 6
6
12
Quantity
If price is too high…
Surplus
14 - 6 = 8
Price
S
9
8
7
D
6
8
14
Quantity
2-33
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.
2-34
2-35
Impact of a Price Ceiling
Price
S
PF
P*
P Ceiling
D
Shortage
Qs
Q*
Qd
Quantity
2-36
Full Economic Price
• The dollar amount paid to a firm under a price
ceiling, plus the nonpecuniary price.
PF = Pc + (PF - PC)
• PF = full economic price
• PC = price ceiling
• PF - PC = nonpecuniary price
2-37
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.
2-38
Impact of a Price Floor
Price
Surplus
S
PF
P*
D
Qd
Q*
QS
Quantity
2-39
Comparative Static Analysis
• How do the equilibrium price and quantity
change when a determinant of supply and/or
demand change?
2-40
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.
2-41
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.
2-42
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
Price
of
PCs
2-43
S
S*
P0
P*
D
Q0
Q*
Quantity of PC’s
2-44
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?
2-45
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
Price
of Software
S
P1
P0
D*
D
Q0 Q1
Quantity of
Software
2-46
2-47
Big Picture Analysis: Software
Market
• Software prices are likely to rise, and more
software will be sold.
• Use this to organize an action plan.
2-48
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.).