CHAPTER 2 Market Forces: Demand and Supply © 2017 by McGraw-Hill Education. All Rights Reserved. Authorized only for instructor use in the classroom. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Learning Objectives 1. Explain the laws of demand and supply, and identify factors that cause demand and supply to shift. 2. Calculate consumer surplus and producer surplus, and describe what they mean 3. Explain price determination in a competitive market, and show how equilibrium changes in response to changes in determinates of demand and supply. 4. Apply supply and demand analysis as a qualitative forecasting tool to see the “big picture” in competitive markets. © 2017 by McGraw-Hill Education. All Rights Reserved. 3 Demand Demand • Market demand curve – Illustrates the relationship between the total quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables constant. • Law of demand – The quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises). – Price and quantity demanded are inversely related. Copyright by the McGraw-Hill Companies, Inc. All rights reserved. © 2017© by2014 McGraw-Hill Education. All Rights Reserved. 2-4 Demand Market Demand Curve Price ($) $40 $30 $20 $10 Demand 0 20 40 60 80 Quantity (thousands per year) © 2017 by McGraw-Hill Education. All Rights Reserved. 2-5 Demand Shift in Quantity Demanded versus a Shift in Demand • Changing only price leads to changes in quantity demanded. – This type of change is graphically represented by a movement along a given demand curve, holding other factors that impact demand constant. • Changing factors other than price lead to changes in demand. – These types of changes are graphically represented by a shift of the entire demand curve. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-6 Changes in Demand Demand Price Increase in demand A Decrease in demand B D1 D2 D0 0 Quantity © 2017 by McGraw-Hill Education. All Rights Reserved. 2-7 Demand Shifters Demand • Income – Normal good – Inferior good • Prices of related goods – Substitute goods – Complement goods • Advertising and consumer tastes – Informative advertising – Persuasive advertising • Population • Consumer expectations • Other factors © 2017 by McGraw-Hill Education. All Rights Reserved. 2-8 Demand Advertising and the Demand for Clothing Price of high-style clothing Due to an increase in advertising $50 $40 D2 D1 0 50,000 60,000 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity of high-style clothing 2-9 The Demand Function Demand • The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a related good Y, income and other factors that affect the demand for good X. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-10 The Linear Demand Function Demand • One simple, but useful, representation of a demand function is the linear demand function: π ππ = πΌ0 + πΌπ ππ + πΌπ ππ + πΌπ π + πΌπ» π» where: – – – – – ππ π is the number of units of good X demanded; ππ is the price of good X; ππ is the price of a related good Y; π is income; π» is the value of any other variable affecting demand. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-11 Demand Understanding the Linear Demand Function • The signs and magnitude of the πΌ coefficients determine the impact of each variable on the number of units of X demanded. ππ π = πΌ0 + πΌπ ππ + πΌπ ππ + πΌπ π • For example: – πΌπ < 0 by the law of demand; – πΌπ > 0 if good Y is a substitute for good X; – πΌπ < 0 if good X is an inferior good. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-12 Demand The Linear Demand Function in Action • Suppose that an economic consultant for X Corp. recently provided the firm’s marketing manager with this estimate of the demand function for the firm’s product: ππ π = 12,000 − 3ππ + 4ππ − 1π + 2π΄π Question: How many of good X will consumers purchase when ππ = $200 per unit, ππ = $15 per unit, π = $10,000 and π΄π = 2,000? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good? Answer: ππ π = 12,000 − 3 200 + 4 15 − 1 10,000 + 2 2,000 = 5,460 units. Goods X and Y are substitutes. Good X is an inferior good. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-13 Inverse Demand Function Demand • By setting ππ = $15 and π = $10,000 and π΄ = 2,000 the demand function is ππ π = 12,000 − 3ππ + 4 15 − 1 10,000 + 2 2,000 the linear demand function simplifies to π ππ = 6,060 − 3ππ Solving this for ππ in terms of ππ π results in 1 π ππ = 2,020 − ππ 3 which is called the inverse demand function. This function is used to construct a market demand curve. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-14 Graphing the Inverse Demand Function in Action Demand Price $2,020 1 ππ = 2,020 − ππ π 3 0 6,060 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 2-15 Supply Supply • Market supply curve – A curve indicating the total quantity of a good that all producers in a competitive market would produce at each price, holding input prices, technology, and other variables affecting supply constant. • Law of supply – As the price of a good rises (falls), the quantity supplied of the good rises (falls), holding other factors affecting supply constant. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-18 Supply Changes in Quantity Supplied versus Changes in Supply • Changing only price leads to changes in quantity supplied. – This type of change is graphically represented by a movement along a given supply curve, holding other factors that impact supply constant. • Changing factors other than price lead to changes in supply. – These types of changes are graphically represented by a shift of the entire supply curve. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-19 Supply Changes in Supply Price S1 S0 B Decrease in supply S2 Increase in supply A 0 Quantity © 2017 by McGraw-Hill Education. All Rights Reserved. 2-20 Supply Shifters Supply • Input prices • Technology or government regulation • Number of firms – Entry – Exit • Substitutes in production • Taxes – Excise tax: a tax on each unit of output sold, where tax revenue is collected from the supplier – Ad valorem tax: percentage tax • Producer expectations © 2017 by McGraw-Hill Education. All Rights Reserved. 2-21 The Supply Function Supply • The supply function for good X is a mathematical representation describing how many units will be produced at alternative prices for X, alternative input prices W, and alternative values of other variables that affect the supply for good X. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-24 The Linear Supply Function Supply • One simple, but useful, representation of a supply function is the linear supply function: π ππ = π½0 + π½π ππ + π½π π + π½π ππ + π½π» π» – – – – – ππ π is the number of units of good X produced; ππ is the price of good X; π is the price of an input; ππ is price of technologically related goods; π» is the value of any other variable affecting supply. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-25 Understanding the Linear Supply Function Supply • The signs and magnitude of the π½ coefficients determine the impact of each variable on the number of units of X produced. ππ π = π½0 + π½π ππ + π½π π + π½π ππ • For example: – π½π > 0 by the law of supply. – π½π < 0 increasing input price. – π½π > 0 technology lowers the cost of producing good X. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-26 Supply The Linear Supply Function in Action • Your research department estimates that the supply function for televisions sets is given by: π ππ = 2,000 + 3ππ − 4ππ − 1ππ Question: How many televisions are produced when ππ = $400, ππ = $100 per unit, and ππ = $2,000? Answer: ππ π = 2,000 + 3 400 − 4 100 − 1 2,000 = 800 television sets. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-27 Inverse Supply Function Supply • By setting ππ = $2,000 and ππ = $100 in π ππ = 2,000 + 3ππ − 4 100 − 1 2,000 the linear supply function simplifies to ππ π = 3ππ − 400 π Solving this for ππ in terms of ππ results in 400 1 π ππ = + ππ 3 3 which is called the inverse supply function. This function is used to construct a market supply curve. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-28 Market Equilibrium Market Equilibrium • Competitive Market Equilibrium – Determined by the intersection of the market demand and market supply curves. – A price and quantity such that there is no shortage or surplus in the market. – Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change. – The equilibrium price is the price that equates quantity demanded with quantity supplied © 2017 by McGraw-Hill Education. All Rights Reserved. 2-31 Market Equilibrium Price Market Equilibrium Supply Surplus ππ» ππ ππΏ Shortage 0 π0 ππ Demand π1 © 2017 by McGraw-Hill Education. All Rights Reserved. 280 Quantity 2-32 Market Equilibrium Market Equilibrium in Action • Consider a market with demand and supply functions, respectively, as ππ = 10 − 2π and π π = 2 + 2π • A competitive market equilibrium exists at a price, ππ , such that ππ ππ = π π ππ . That is, 10 − 2π = 2 + 2π 8 = 4π ππ = $2 ππ = 10 − 2 $2 = 6 and ππ = 2 + 2($2) =6 ππ = 6 units © 2017 by McGraw-Hill Education. All Rights Reserved. 2-33 Comparative Statics Comparative Statics • Comparative static analysis – The study of the movement from one equilibrium to another. • Competitive markets, operating free of price restraints, will be analyzed when: – Demand changes – Supply changes – Demand and supply simultaneously change © 2017 by McGraw-Hill Education. All Rights Reserved. 2-39 Comparative Statics Changes in Demand • Increase in demand only – Increase equilibrium price – Increase equilibrium quantity • Decrease in demand only – Decrease equilibrium price – Decrease equilibrium quantity • Example of change in demand – Suppose that consumer incomes are projected to increase 2.5% and the number of individuals over 25 years of age will reach an all time high by the end of next year. What is the impact on the rental car market? © 2017 by McGraw-Hill Education. All Rights Reserved. 2-40 Comparative Statics Effect of a Change in Demand for Rental Cars Price Supply $49 $45 Demand1 Demand0 0 100 104 © 2017 by McGraw-Hill Education. All Rights Reserved. 108 Quantity (thousands rented per day) 2-41 Comparative Statics Changes in Supply • Increase in supply only – Decrease equilibrium price – Increase equilibrium quantity • Decrease in supply only – Increase equilibrium price – Decrease equilibrium quantity • Example of change in supply – Suppose that a bill before Congress would require all employers to provide health care to their workers. What is the impact on retail markets? © 2017 by McGraw-Hill Education. All Rights Reserved. 2-42 Comparative Statics Effect of a Change in Supply Price Supply1 Supply0 π1 π0 Demand 0 π1 π0 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 2-43 Comparative Statics Simultaneous Shifts in Supply and Demand • Suppose that simultaneously the following events occur: – An earthquake hit Kobe, Japan and decreased the supply of fermented rice used to make sake wine. – The stress caused by the earthquake led many to increase their demand for sake, and other alcoholic beverages. • What is the combined impact on Japan’s sake market? © 2017 by McGraw-Hill Education. All Rights Reserved. 2-44 Comparative Statics Simultaneous Shifts in Supply and Demand in Action Japan’s Sake Market Price Supply2 C π2 Supply1 B π1 Supply0 A π0 Demand1 Demand0 0 π2 π0 π1 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 2-45 Definition of Welfare Economics • Welfare economics – The study of how the allocation of resources affects economic well-being • Benefits that buyers and sellers receive from engaging in market transactions • How society can make these benefits as large as possible • In any market, the equilibrium of supply and demand maximizes the total benefits received by all buyers and sellers combined 46 Basis of Consumer Surplus • Willingness to pay – Maximum amount that a buyer will pay for a good – How much that buyer values the good 47 Link between CS & Demand Curve • Consumer surplus – Measures the benefit buyers receive from participating in a market – Closely related to the demand curve • Demand curve – Derived from the willingness to pay of the possible buyers 48 Consumer Surplus (CS) Demand • Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products. – Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities. – Total expenditure is the per-unit market price times the number of units consumed. – Consumer surplus is the extra value that consumers derive from a good but do not pay extra for. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-49 Demand Market Demand and Consumer Surplus in Action Consumer Surplus Price per liter Consumer Surplus: 0.5($5 - $3)x(2-0) = $2 Total Consumer Value: 0.5($5 - $3)x2+(3-0)(2-0) = $8 $5 $4 Expenditures: $(3-0) x (2-0) = $6 $3 $2 $1 Demand 0 1 2 3 4 © 2017 by McGraw-Hill Education. All Rights Reserved. 5 Quantity in liters 2-50 How CS can be increased? • A lower price raises consumer surplus 1. Existing buyers: increase in consumer surplus • Buyers who were already buying the good at the higher price are better off because they now pay less 2. New buyers enter the market: increase in consumer surplus • Willing to buy the good at the lower price 51 CS & economic well-being • Consumer surplus – Benefit that buyers receive from a good • As the buyers themselves perceive it – Good measure of economic well-being – Exception: illegal drugs • Drug addicts are willing to pay a high price for heroin • Society’s standpoint – Drug addicts don’t get a large benefit from being able to buy heroin at a low price 52 Basis of Producer Surplus (PS) • Cost – Value of everything a seller must give up to produce a good – Measure of willingness to sell • Producer surplus – Amount a seller is paid for a good minus the seller’s cost of providing it – Price received minus willingness to sell 53 Producer Surplus Supply • Producer surplus: the amount producers receive in excess of the amount necessary to induce them to produce the good. © 2017 by McGraw-Hill Education. All Rights Reserved. 2-54 Supply curve & Producer Surplus (PS) • Supply curve – Reflects sellers’ costs – Used to measure producer surplus • Producer surplus in a market – Area below the price and above the supply curve 55 Producer Surplus in Action 400 1 π ππ = + ππ 3 3 Price Supply Supply $400 Producer surplus $400 3 0 800 © 2017 by McGraw-Hill Education. All Rights Reserved. Quantity 2-56 How to increase PS? • A higher price raises producer surplus 1. Existing sellers: increase in producer surplus • Sellers who were already selling the good at the lower price are better off because they now get more for what they sell 2. New sellers enter the market: increase in producer surplus • Willing to produce the good at the higher price 57 Market Efficiency • Total surplus = Consumer surplus + Producer surplus • Consumer surplus = Value to buyers – Amount paid by buyers • Producer surplus = Amount received by sellers – Cost to sellers • Amount paid by buyers = Amount received by sellers • Total surplus = Value to buyers – Cost to sellers 58 Efficiency Vs. Equality • Efficiency – Property of a resource allocation – Maximizing the total surplus received by all members of society • Equality – Property of distributing economic prosperity uniformly among the members of society 59 What is market efficiency? • Market outcomes 1. Free markets allocate the supply of goods to the buyers who value them most highly • Measured by their willingness to pay 2. Free markets allocate the demand for goods to the sellers who can produce them at the least cost 3. Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus 60 How to achieve market efficiency? • Market equilibrium – Efficient allocation of resources • The benevolent social planner – “Laissez faire” = “let people do as they will” 61 What is the best way to organize economic activity? • Adam Smith’s invisible hand – Takes all the information about buyers and sellers into account – Guides everyone in the market to the best outcome – Economic efficiency • Free markets – Best way to organize economic activity 62 References • Baye, Michael R. & Jeffrey T. Prince (2017) Managerial Economics and Business Strategies. 9na. Edición. McGraw Hill. • Mankiw, N. Gregory (2016) Principios de Economía. 7ma Edición: Cengage Learning. © 2017 by McGraw-Hill Education. All Rights Reserved. 63
