Demand Analysis

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

Overview I. Market Demand Curve ■

■

■

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

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.

Price

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

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

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

Change in Quantity Demanded Price A to B: Increase in quantity demanded A

10

B 6

D0 4

7

Quantity

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

Change in Demand Price

D0 to D1: Increase in Demand

6 D1

D0 7

13

Quantity

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

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

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

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

Consumer Surplus: The Continuous Case Price $ 10

Value of 4 units

8 Consu mer Surplu s

6 4

Total Cost of 4 units

2 D 1

2 5

3

4

Quantity

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

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

S0

Quantity

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

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

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

Change in Quantity Supplied Price

A to B: Increase in quantity supplied S0 B

20

A 10

1 Quantity 0 Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 5

1999

Change in Supply S0 to S1: Increase in supply

Price

S0 S1

8 6

5

7

Quantity

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

Producer Surplus • The amount producers receive in excess of the amount necessary to induce them to produce the good. Price

S0 P *

Produce r Surplus

Q*

Quantity

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

If price is too low… Price

S

7 6 5 D

Shortage 12 - 6 = 6 6

12

Quantity

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

If price is too high… Surplu s 14 - 6 =8

Price 9

S

8 7

D

6

8

14

Quantity

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

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

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

Impact of a Price Ceiling Price

S

PF P*

Ceiling Price D

Shortage

Qs

Q*

Qd

Quantity

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

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

Impact of a Price Floor Price

Surplu s

S

PF

P*

D

Qd

Q*

QS

Quantity

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

Big Picture: Impact of decline in component prices on PC market Price of PCs

S S*

P0 P*

D

Q

Q*

Quantity of PC

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

• 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

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

Big Picture: Impact of lower PC prices on the software market

Price of Software

S

P1 P0

D* D

Q0 Q1

Quantity of Software

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