ECON528
Managerial Economics
Market
Fundamentals
Outline
• Market Demand
• Market Supply
• Market Equilibrium
• Price Restrictions
• Comparative Statics
What is Managerial Economics?
•
Manager
•
Economics
•
Managerial Economics
And that goal would be…
To maximize Profit.
But what exactly is profit from an economic point of view?
• Accounting Profits:
• Economic Profits:
Opportunity Cost
•
Opportunity Cost is the value of a forgone alternative.
•
An opportunity cost is what you “give up” when making a decision.
•
In business, opportunity cost arises from the use of capital (money) in the
business.
What is an Opportunity Cost?
•
Accounting Costs=(Total Revenue-Costs)
•
Economic Profit=(Total Revenue-Costs-Opportunity Costs)
The Five Forces Framework
·Entry Costs
·Speed of Adjustment
·Sunk Costs
·Economies of Scale
Entry
Power of
Input Suppliers
Power of
Buyers
·Supplier Concentration
·Price/Productivity of
Alternative Inputs
·Relationship-Specific
Investments
·Supplier Switching Costs
·Government Restraints
Sustainable
Industry
Profits
Industry Rivalry
·Concentration
·Price, Quantity, Quality, or
Service Competition
·Degree of Differentiation
·Network Effects
·Reputation
·Switching Costs
·Government Restraints
·Switching Costs
·Timing of Decisions
·Information
·Government Restraints
·Buyer Concentration
·Price/Value of Substitute
Products or Services
·Relationship-Specific
Investments
·Customer Switching Costs
·Government Restraints
Substitutes & Complements
·Price/Value of Surrogate Products
or Services
·Price/Value of Complementary
Products or Services
·Network Effects
·Government
Restraints
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
What determines demand?

Income
– Normal good
– Inferior good

Prices of Related Goods
– Substitutes
– Complements
Advertising and consumer
tastes
 Population
 Consumer expectations

Inverse Demand Function
• Price as a function of quantity demanded.
• Ceteris Paribus, (“all else constant”) is a good way to see
the relationship between the price and the quantity
demanded.
• Example:
– Demand Function
• Qxd = 10 – 2Px
– Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded
10
A
B
6
D0
4
7
Quantity
Change in Demand
Price
D0 to D1: Increase in Demand
6
D1
D0
7
13
Quantity
Consumer Surplus
•
•
The value consumers get from a good but do not have to pay for.
So it’s the difference between the actual price and the price people were
willing to pay
•
Example: Feeling like you got a bargain implies CS was high.
Discrete Look at CS
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
5
2
3
4
Quantity
Continuous Look at CS
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
5
2
3
4
Quantity
Market Supply Curve
 The
supply curve shows the amount of a
good that will be produced at alternative
prices.
Price
 Law
S0
of Supply
– The supply curve is upward sloping.
Quantity
Determinants of Supply






Input prices
Technology or government
regulations
Number of firms
– Entry
– Exit
Substitutes in production
Taxes
– Excise tax
– Ad valorem tax
Producer expectations
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
Change in Quantity Supplied
Price
A to B: Increase in quantity supplied
S0
B
20
10
A
5
10
Quantity
Change in Supply
S0 to S1: Increase in supply
Price
S0
S1
8
6
5
7
Quantity
Producer Surplus

The amount producers receive in excess of the
amount necessary to induce them to produce the
good.
Price
S0
P*
Q*
Quantity
Market Equilibrium
•
The point were Quantity Demanded equals Quantity Supplied
•
Occurs at a single price
•
“Steady-State” – once we reach this equilibrium, the market should stop
changing
Getting to an Equilibrium
•
How does the market get to an equilibrium?
•
Big idea: Prices act as “signals” to buyers and sellers.
•
As the price changes, buyers and sellers change their behavior according
to the Law of Demand and the Law of Supply.
What if Price is too Low?
Price
S
7
6
5
D
Shortage
12 - 6 = 6
6
12
Quantity
What if Price is too High?
Surplus
14 - 6 =
8
Price
9
S
8
7
D
6
8
14
Quantity
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.
Example: Impact of Rent
Control
Price
S
PF
P*
P Ceiling
D
Shortage
Qs
Q*
Qd
Quantity
Example: Impact of Minimum
Wage
Price
Surplus
S
PF
P*
D
Qd
Q*
QS
Quantity
Comparative Static Analysis
•
How do the equilibrium price and quantity change when a determinant of supply
and/or demand change?
•
In other words, what happens when there is a shift of the supply or demand curve?
Application
•
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.
•
In each case, what should you do? Expand or Contract business?
Solution: Impact of Price Decline in PC Components
Price
of
PCs
S
S*
P0
P*
D
Q0
Q*
Quantity of PC’s
Impact of Lower PC Prices on Software
Market
Price
of Software
S
P1
P0
D*
D
Q0 Q1
Quantity of
Software
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.).