Managerial Economic Demand, Supply and Market Equilibrium
DEMAND AND SUPPLY
This chapter presents a brief review of demand and supply analysis.
• The materials covered in this chapter provide the essential background for most of the managerial economic problems to be studied in the coming chapters.
• The model of demand and supply is one of the strongest tools of analysis in economics.
Prices in the Market
• Market
• Money Price
• Relative Price
DEMAND
• Demand
• Market Demand
• Demand and Quantity Demanded • Demand Schedule
• Demand Curve: Willingness-and-ability-to- pay curve.
Managerial Economics Demand and Supply.
Demand Function and Demand Curve:
• Demand function can be expressed as
• Qd= f [ P - ;{ Ps + , Pc -, I +, -, Ex +, -, T +, -, N+, ….}],
where
• Qd: the quantity demanded over a given period of time;
P: the product own price;
Ps: the price of a substitute product;
Pc: the price of a complement product;
I: consumer average income;
Ex: prices, income, and other factors expectations;
T: consumers’ taste or preference; N: number of consumers or buyers.
• Signs above the independent variables show the direction of the relationship between the quantity demanded and each of these variables, when other variables are held constant.
• For example,
if Qd = 1 - 2Px + 0.8Ps - 3Pc +1.5I +1T
• When
Ps=2.5,
Pc=1,
I=4
and T=2,
demand curve is estimated as
Qd = 1 - 2P + 0.8(2.5) – 3(1) +1.5(4) +1(2)
Qd = 8 - 2P ………………
Demand Curve 6
• Change in non-price determinants (for example, ∆I) shift demand curve. If income increases from 4 to 6 then
Qd = 11- 2P P
Qd 8 11 4 5.5 7
• The law of Demand
• Change in the quantity demanded (Qd)
• Changes in Demand
• Non-Price Determinants of Demand:
1. Change in Consumers’ Incomes: 2. The Prices of Related Goods:
3. Expectations about the Future: 4. Tastes and Preferences
5. The Number of Buyers in the Market (Population)
Managerial Rule of Thumb: Demand Considerations
• Managers must
1.Understand what influences demand
2.Determine which factors they can influence
3.Determine how to handle factors they cannot influence
SUPPLY
• supply
• Market supply
• The quantity supplied (Qs)
• Supply curve: "minimum-price-supply" curve - MC
The Implicit Supply Function:
Qs = f [P +; {Ps- , Pc +, Pi -, Ex +, -, T + , N+, ….}]
• Where:
• Qs: the quantity supplied over a given period of time;
P: the product own price;
Ps: the price of a substitute (in production) product;
Pc: the price of a complement (in production) product;
Pi: the price of input
I; Ex: prices, income, and other factors expectations;
T: cost saving technological progress;
N: number of sellers.
• Signs above the independent variables show the direction of the relationship between the quantity supplied and each of these variables, when other variables are held constant.
• The law of Supply
• Changes in the Quantity Supplied • Changes in Supply
• Non-Price Determinants of Supply 1.Prices of productive resources (Cost of Factors of Production) 2.Technology
3.Price of Related Goods: 4.Expectations about the Future: 5.Number of Sellers:
6.Weather conditions
Managerial Rule of Thumb: Supply Considerations
• Managers must
1.Examine technology and costs of production
2.Find ways to increase productivity while lowering production costs
MARKET EQUILIBRIUM
• Equilibrium
• Market equilibrium
• Equilibrium price (P*):
• Equilibrium quantity (Q*):
A. Tabular Illustration of Equilibrium, Surplus, and Shortage
P Qd Qs (Qs – Qd)
Market situation 7 0 600 600 surplus 6 100 500 400
surplus 5 200 400 200
surplus 4 300 300 0
equilibrium 3 400 200 -200 shortage 2 500 100 -400 shortage 1 600 0 -600 shortage.
B. Graphical Illustration of Equilibrium, Surplus, and Shortage Q* = 300200 400 3
P*= 4 5 S Q D
Shortage Surplus P 17
C. Mathematical Illustration of Equilibrium, Surplus, and Shortage
1.Suppose the demand equation is P = 7 – 0.01 Qd, and the supply equation is P = 1 + 0.01 Qs
a.Find Q* and P*
b.Find Q if P = 5 18
2. Given Qd = 65 - 10P and Qs = -35 + 15P
a. Find Q* and P*
b. Find Q if P = 2 19
Comparative Static Analysis:
• Comparative Static Analysis is a commonly used method in economic analysis to compare various points of equilibrium when certain factors change.
• It is a form of sensitivity, or what-if analysis.
• Changes in demand or supply create surplus or shortage and as a result price adjusts towards equilibrium, both in the short-run and the long-run.
Process of comparative static analysis
1. State all the assumptions needed to construct the model.
2. Begin by assuming that the model is in equilibrium.
3. Introduces some event that affects the demand side, the supply side or both sides of the market causing curves to shift. In so doing, a condition of disequilibrium is created.
4. Find the new point at which equilibrium is restored.
5. Compare the new equilibrium point with the original one to assess the impact of that event on the market equilibrium price and quantity.
Question:
• What is the difference between static and dynamic analysis?
SR Market Changes:
The “Rationing Function” of Price The short run is the period of time in which:
• Some factors are variables, others are fixed.
• Sellers already in the market respond to a change in equilibrium price by adjusting variable inputs.
• Buyers already in the market respond to changes in equilibrium price by adjusting the quantity demanded for the good or service. • Price performs its SR rationing function in response to changes in demand or supply.
• The rationing function of price is the change in market price to clear the market of any shortage or surplus.
• SR adjustments are represented as movements along a given demand or supply curve as a result of changes in demand or supply changes in P* and Q*.
• In SR when non-price determinants change, P* and Q*change.
LR Market Analysis:
The “Guiding” or “Allocating” Function
• The long run is the period of time in which:
• All factors are variable.
• New sellers may enter a market
• Existing sellers may exit from a market
• Existing sellers may adjust fixed factors of production
• Buyers may react to a change in equilibrium price by changing their tastes and preferences or buying preferences
• Price perform its guiding or allocating function
• We know that when demand or supply changes due to changes in non-price determinants, Q and P change in SR. But what will happen as a result of changes in P?
• The guiding or allocating function of price is the movement of resources into or out of markets in response to a change in the equilibrium price.
• Guiding is a LR function of price. LR adjustments are represented as shifts in a given demand or supply curve.
• Market mechanism through price adjustments signal to producers and consumers whether to increase or decrease supply or demand.
• It is the use of market prices and sales to signal the desired output (or resource allocation).
This is what Adam Smith refers to as the “invisible hand”, resource allocation through market forces.
Example 1
• Consider the market for apple and orange (substitute goods) where equilibrium price and quantity in both markets are P1 and Q1. Suppose tastes and preferences change in favor of apple and against orange.
Q1Q2Q2Q1
D2 Orange Surplus
P1
D2
P2 PO QO S1
D1 Apple Shortage
P2 D1 P1
PA QA S1
In SR: (The Rationing Function)
• D for apple shortage at original P1 P in apple market to P2 to eliminate shortage.
• While D for orange surplus at original P1 P in orange market to P2 to eliminate surplus.
• This is the rationing function that clears shortage and surplus.
In LR:
The Guiding “Allocating|” Function of
P S2 P1, P3 Q3 S2 Q3 Q1Q2Q2Q1 D2 Orange D2 P2 PO QO S1 D1 Apple P2 D1 P1, P3 PA QA S1 31
• The increase in P of apple will encourage existing producers to produce more, and new firms will enter the market as it seems more profitable than other markets more resources will be devoted to apple production apple supply SC shifts rightward P and Q
• The higher SR price has guided more resources into the market.
• The opposite will happen to orange supply.
• Follow- on adjustment:
• movement of resources into the market
• rightward shift in the supply curve to S2
• Equilibrium price and quantity now P3,Q3
• Thus,
• Apple Market: Q, P S P and Q
• Orange Market: Q, P S P and Q • So, price is fulfilling its guiding or allocating function
Example 2
• Assess the short and long run impacts of the 11Sebtember attack on airline market in USA. P1& P3 Q3 S2 Q1Q2 D2 P2 P Q S1 D1 34
• Before the attack, the market was in initial equilibrium at P1 and Q1.
• Shortly after the attack, insurance premiums for airliners have risen to reflect the higher risk introduced in this industry, causing the supply curve of air trips to shift leftward to S2.
• At the initial price P1 the market then suffered a shortage that pushed air tickets’ price up to P2. 35 In the short-run:
• Responding to the price increase, consumers demanded less air trips by economizing on their consumption, delaying some recreational travel, better planning business trips to make more visits and meetings on the same trip, and by trying other modes of transportation.
• This is the rationing role of price, where the higher price level served to ration the available supply amongst the most valued uses.
• In this example, the rationing function of the price shows as a movement upward along the demand curve. In the long run:
• As the crisis continues to exist, some structural changes in consumers’ tastes and preferences have taken place.
• Some consumers discovered some fun in driving their cars on vocational trips, spending time on the road, enjoying natural sites, making as many stops as they prefer. Others found local tourism to be safer than traveling to distant places.
• All these changes of other factors reduced demand for airline trips causing the demand curve to shift leftward. Eventually, the market reached long run equilibrium at P3 lower than P2 and Q3 less than Q2. • As the production of air trips decreases, some resources have been moved from this industry to the now expanding industries as local hostelling and passengers’ car industry and bussing industry.
• That is the allocation function of the price, where the rise in price, resulted in the long run, in some changes in consumers’ tastes or preferences and then reallocate their resources accordingly.
• In this example, the allocation function of the price shows graphically as a shift of the demand curve to the left. 39 Changes in P and Q when D, S, or both shifts Shift P* Q* Remarks D↑ ↑ ↑ SR shifts (shortage at old P*) D↓ ↓ ↓ SR shifts (surplus at old P*) -Managerial Economics Demand and Supply
Chapter 2
DEMAND AND SUPPLY
This chapter presents a brief review of demand and supply analysis.
• The materials covered in this chapter provide the essential background for most of the managerial economic problems to be studied in the coming chapters.
• The model of demand and supply is one of the strongest tools of analysis in economics.
Prices in the Market
• Market
• Money Price
• Relative Price
DEMAND
• Demand
• Market Demand
• Demand and Quantity Demanded • Demand Schedule
• Demand Curve: Willingness-and-ability-to- pay curve.
Managerial Economics Demand and Supply.
Demand Function and Demand Curve:
• Demand function can be expressed as
• Qd= f [ P - ;{ Ps + , Pc -, I +, -, Ex +, -, T +, -, N+, ….}],
where
• Qd: the quantity demanded over a given period of time;
P: the product own price;
Ps: the price of a substitute product;
Pc: the price of a complement product;
I: consumer average income;
Ex: prices, income, and other factors expectations;
T: consumers’ taste or preference; N: number of consumers or buyers.
• Signs above the independent variables show the direction of the relationship between the quantity demanded and each of these variables, when other variables are held constant.
• For example,
if Qd = 1 - 2Px + 0.8Ps - 3Pc +1.5I +1T
• When
Ps=2.5,
Pc=1,
I=4
and T=2,
demand curve is estimated as
Qd = 1 - 2P + 0.8(2.5) – 3(1) +1.5(4) +1(2)
Qd = 8 - 2P ………………
Demand Curve 6
• Change in non-price determinants (for example, ∆I) shift demand curve. If income increases from 4 to 6 then
Qd = 11- 2P P
Qd 8 11 4 5.5 7
• The law of Demand
• Change in the quantity demanded (Qd)
• Changes in Demand
• Non-Price Determinants of Demand:
1. Change in Consumers’ Incomes: 2. The Prices of Related Goods:
3. Expectations about the Future: 4. Tastes and Preferences
5. The Number of Buyers in the Market (Population)
Managerial Rule of Thumb: Demand Considerations
• Managers must
1.Understand what influences demand
2.Determine which factors they can influence
3.Determine how to handle factors they cannot influence
SUPPLY
• supply
• Market supply
• The quantity supplied (Qs)
• Supply curve: "minimum-price-supply" curve - MC
The Implicit Supply Function:
Qs = f [P +; {Ps- , Pc +, Pi -, Ex +, -, T + , N+, ….}]
• Where:
• Qs: the quantity supplied over a given period of time;
P: the product own price;
Ps: the price of a substitute (in production) product;
Pc: the price of a complement (in production) product;
Pi: the price of input
I; Ex: prices, income, and other factors expectations;
T: cost saving technological progress;
N: number of sellers.
• Signs above the independent variables show the direction of the relationship between the quantity supplied and each of these variables, when other variables are held constant.
• The law of Supply
• Changes in the Quantity Supplied • Changes in Supply
• Non-Price Determinants of Supply 1.Prices of productive resources (Cost of Factors of Production) 2.Technology
3.Price of Related Goods: 4.Expectations about the Future: 5.Number of Sellers:
6.Weather conditions
Managerial Rule of Thumb: Supply Considerations
• Managers must
1.Examine technology and costs of production
2.Find ways to increase productivity while lowering production costs
MARKET EQUILIBRIUM
• Equilibrium
• Market equilibrium
• Equilibrium price (P*):
• Equilibrium quantity (Q*):
A. Tabular Illustration of Equilibrium, Surplus, and Shortage
P Qd Qs (Qs – Qd)
Market situation 7 0 600 600 surplus 6 100 500 400
surplus 5 200 400 200
surplus 4 300 300 0
equilibrium 3 400 200 -200 shortage 2 500 100 -400 shortage 1 600 0 -600 shortage.
B. Graphical Illustration of Equilibrium, Surplus, and Shortage Q* = 300200 400 3
P*= 4 5 S Q D
Shortage Surplus P 17
C. Mathematical Illustration of Equilibrium, Surplus, and Shortage
1.Suppose the demand equation is P = 7 – 0.01 Qd, and the supply equation is P = 1 + 0.01 Qs
a.Find Q* and P*
b.Find Q if P = 5 18
2. Given Qd = 65 - 10P and Qs = -35 + 15P
a. Find Q* and P*
b. Find Q if P = 2 19
Comparative Static Analysis:
• Comparative Static Analysis is a commonly used method in economic analysis to compare various points of equilibrium when certain factors change.
• It is a form of sensitivity, or what-if analysis.
• Changes in demand or supply create surplus or shortage and as a result price adjusts towards equilibrium, both in the short-run and the long-run.
Process of comparative static analysis
1. State all the assumptions needed to construct the model.
2. Begin by assuming that the model is in equilibrium.
3. Introduces some event that affects the demand side, the supply side or both sides of the market causing curves to shift. In so doing, a condition of disequilibrium is created.
4. Find the new point at which equilibrium is restored.
5. Compare the new equilibrium point with the original one to assess the impact of that event on the market equilibrium price and quantity.
Question:
• What is the difference between static and dynamic analysis?
SR Market Changes:
The “Rationing Function” of Price The short run is the period of time in which:
• Some factors are variables, others are fixed.
• Sellers already in the market respond to a change in equilibrium price by adjusting variable inputs.
• Buyers already in the market respond to changes in equilibrium price by adjusting the quantity demanded for the good or service. • Price performs its SR rationing function in response to changes in demand or supply.
• The rationing function of price is the change in market price to clear the market of any shortage or surplus.
• SR adjustments are represented as movements along a given demand or supply curve as a result of changes in demand or supply changes in P* and Q*.
• In SR when non-price determinants change, P* and Q*change.
LR Market Analysis:
The “Guiding” or “Allocating” Function
• The long run is the period of time in which:
• All factors are variable.
• New sellers may enter a market
• Existing sellers may exit from a market
• Existing sellers may adjust fixed factors of production
• Buyers may react to a change in equilibrium price by changing their tastes and preferences or buying preferences
• Price perform its guiding or allocating function
• We know that when demand or supply changes due to changes in non-price determinants, Q and P change in SR. But what will happen as a result of changes in P?
• The guiding or allocating function of price is the movement of resources into or out of markets in response to a change in the equilibrium price.
• Guiding is a LR function of price. LR adjustments are represented as shifts in a given demand or supply curve.
• Market mechanism through price adjustments signal to producers and consumers whether to increase or decrease supply or demand.
• It is the use of market prices and sales to signal the desired output (or resource allocation).
This is what Adam Smith refers to as the “invisible hand”, resource allocation through market forces.
Example 1
• Consider the market for apple and orange (substitute goods) where equilibrium price and quantity in both markets are P1 and Q1. Suppose tastes and preferences change in favor of apple and against orange.
Q1Q2Q2Q1
D2 Orange Surplus
P1
D2
P2 PO QO S1
D1 Apple Shortage
P2 D1 P1
PA QA S1
In SR: (The Rationing Function)
• D for apple shortage at original P1 P in apple market to P2 to eliminate shortage.
• While D for orange surplus at original P1 P in orange market to P2 to eliminate surplus.
• This is the rationing function that clears shortage and surplus.
In LR:
The Guiding “Allocating|” Function of
P S2 P1, P3 Q3 S2 Q3 Q1Q2Q2Q1 D2 Orange D2 P2 PO QO S1 D1 Apple P2 D1 P1, P3 PA QA S1 31
• The increase in P of apple will encourage existing producers to produce more, and new firms will enter the market as it seems more profitable than other markets more resources will be devoted to apple production apple supply SC shifts rightward P and Q
• The higher SR price has guided more resources into the market.
• The opposite will happen to orange supply.
• Follow- on adjustment:
• movement of resources into the market
• rightward shift in the supply curve to S2
• Equilibrium price and quantity now P3,Q3
• Thus,
• Apple Market: Q, P S P and Q
• Orange Market: Q, P S P and Q • So, price is fulfilling its guiding or allocating function
Example 2
• Assess the short and long run impacts of the 11Sebtember attack on airline market in USA. P1& P3 Q3 S2 Q1Q2 D2 P2 P Q S1 D1 34
• Before the attack, the market was in initial equilibrium at P1 and Q1.
• Shortly after the attack, insurance premiums for airliners have risen to reflect the higher risk introduced in this industry, causing the supply curve of air trips to shift leftward to S2.
• At the initial price P1 the market then suffered a shortage that pushed air tickets’ price up to P2. 35 In the short-run:
• Responding to the price increase, consumers demanded less air trips by economizing on their consumption, delaying some recreational travel, better planning business trips to make more visits and meetings on the same trip, and by trying other modes of transportation.
• This is the rationing role of price, where the higher price level served to ration the available supply amongst the most valued uses.
• In this example, the rationing function of the price shows as a movement upward along the demand curve. In the long run:
• As the crisis continues to exist, some structural changes in consumers’ tastes and preferences have taken place.
• Some consumers discovered some fun in driving their cars on vocational trips, spending time on the road, enjoying natural sites, making as many stops as they prefer. Others found local tourism to be safer than traveling to distant places.
• All these changes of other factors reduced demand for airline trips causing the demand curve to shift leftward. Eventually, the market reached long run equilibrium at P3 lower than P2 and Q3 less than Q2. • As the production of air trips decreases, some resources have been moved from this industry to the now expanding industries as local hostelling and passengers’ car industry and bussing industry.
• That is the allocation function of the price, where the rise in price, resulted in the long run, in some changes in consumers’ tastes or preferences and then reallocate their resources accordingly.
• In this example, the allocation function of the price shows graphically as a shift of the demand curve to the left. 39 Changes in P and Q when D, S, or both shifts Shift P* Q* Remarks D↑ ↑ ↑ SR shifts (shortage at old P*) D↓ ↓ ↓ SR shifts (surplus at old P*) ---------------------------------------------------------------------- S↑ ↓ ↑ SR shifts (surplus at old P*) S↓ ↑ ↓ SR shifts (shortage at old P*) ---------------------------------------------------------------------- D↑&S↑ ↑↓− ↑ LR allocation of resources D↓&S↓ ↑↓− ↓ LR allocation of resources ---------------------------------------------------------------------- D↑ & S↓ ↑ ↑↓− LR allocation of resources D↓ & S↑ ↓ ↑↓− LR allocation of resources.
The Managerial Challenge
• In the extreme case, the forces of supply and demand are the sole determinants of the market price.
• This type of market is “perfect competition”
• In other markets, individual firms can exert market power over their price because of their:
• Dominant size
• Ability to differentiate their product through advertising, brand name, features, or services -------------------------------------------------------------------- S↑ ↓ ↑ SR shifts (surplus at old P*) S↓ ↑ ↓ SR shifts (shortage at old P*) ---------------------------------------------------------------------- D↑&S↑ ↑↓− ↑ LR allocation of resources D↓&S↓ ↑↓− ↓ LR allocation of resources ---------------------------------------------------------------------- D↑ & S↓ ↑ ↑↓− LR allocation of resources D↓ & S↑ ↓ ↑↓− LR allocation of resources.
The Managerial Challenge
• In the extreme case, the forces of supply and demand are the sole determinants of the market price.
• This type of market is “perfect competition”
• In other markets, individual firms can exert market power over their price because of their:
• Dominant size
• Ability to differentiate their product through advertising, brand name, features, or services
