Market Forces: Demand and Supply

1

• Session 2
• Market Forces Demand and Supply

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

3
Market Demand Curve

• Shows the amount of a good that will be purchased
  at alternative prices.
• Law of Demand
• The demand curve is downward sloping.

Price
D
4
Determinants of Demand

• Income
• Prices of substitutes
• Prices of complements
• Advertising
• Population
• Consumer expectations

5
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

6
Change in Quantity Demanded
7
Change in Demand
D0 to D1 Increase in Demand
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Changes in Demand and Quantity Demanded

• Page 2-1 in worksheets

9
Do the following shift the demand curve or not?

• Peanuts are found to increase longevity
• Price of oranges increases
• Income levels double
• Students are seniors who expect to graduate soon

10
Inside Business 2-1

• Asahi Breweries Ltd. and the Asian Recession
• How does this apply to the concept of demand?

11
Demand function faced by a firm

• Q ao a1Px a2N a3M a4Py a5T ...
• as are the coefficients to be estimated by
  regression analysis
• demand will then determine the type quantity of
  inputs firm will use

12
Demo. Problem 2-1, page 40

• Qx 12,000 - 3Px 4Py -1M 2Ax
• If good X sells for 200 per unit, good Y sells
  for 15 per unit, the firm uses 2,000 units of
  advertising and consumer income is 10,000, how
  much of good X do consumers purchase?
• Substitute values to get 5,460 units
• What do the coefficients on the variables
  indicate?

13
Graphing the demand curve

• Demand curve holds everything but price constant
• Qdx 12,000 - 3Px 4(15) - 1(10,000) 2(2,000)
• Simplifies to Qdx 6,060 - 3Px
• To get inverse demand curve, solve for Px
• Px 2020 - (1/3)Qdx
• Graph this line.

14
Consumer Surplus

• The value consumers get from a good but do not
  have to pay for.

15
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.

16
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.

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Consumer Surplus The Discrete Case
Consumer Surplus The value received but not paid
for
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Consumer SurplusThe Continuous Case
Price
10
8
6
4
Total Cost of 4 units
2
D
1 2 3 4 5
Quantity
19
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

20
Supply Shifters

• Input prices
• Technology or government regulations
• Number of firms
• Substitutes in production
• Taxes
• Producer expectations

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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

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Change in Quantity Supplied
A to B Increase in quantity supplied
B
20
A
10
5
10
23
Change in Supply
S0 to S1 Increase in supply
S1
8
6
7
24
Do the following shift the supply curve or not?

• Number of microcomputer suppliers decreases
• Advances in agricultural technology
• Tax is imposed on gasoline
• Workers strike for higher wages and receive them

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Supply and taxes

• Per unit excise tax
• Causes supply curve to shift up by the per unit
  tax
• Ad valorem tax
• percentage tax such as a sales tax
• it is higher for high-priced items than for
  low-priced items
• price goes up by 2 at a quantity of 1,100 and by
  4 at a quantity of 4 so it rotates supply

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Per unit (excise) tax

• P

Q
27
An ad valorem tax

• P

Q
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Supply Function

• Describes how much of a good will be produced at
  alternative prices of that good (Px), alternative
  input prices (Pr W) and alternative values of
  other variables affecting supply (H)
• Qs f(Px, Pr, W, H)
• Linear function Qs bo bxPx brPr bwW bhH
• Coefficients represent given numbers estimated

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Graphing Supply Curve

• Hold everything constant but price
• Insert given values of the supply shifters into
  the supply function, but leave Px in the equation
  to allow for various values.
• Qs 2,000 3Px - 4Pr - Pw
• Qs 2,000 3Px - 4(100) - 1(2,000)
• Qs 3Px - 400.

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Producer Surplus

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

Price
S0
P
Producer Surplus
Q
Quantity
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Market Equilibrium

• Balancing supply and demand
• QS Qd
• Steady-state

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Market Equilibrium

• Supply Demand
• Market clearing price quantity
• Efficient
• MB MC

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Equilibrium using Demand and Supply Functions

• If Qd 10 - 2P
• If Qs 2 2P
• To graph, you need to solve for P
• To find competitive equilibrium and price, set
  the functions equal to each other and solve for P
  and Q.
• P 2
• Q 6

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Equilibrium Price Quantity

• P

SMC
P
DMB
Q
Q
35
Allocative Efficiency

• In equilibrium there are no shortages or
  surpluses
• Price is the allocating device
• Efficiency is when resources are allocated to
  uses where they are most highly valued.

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Five Steps of Market Analysis

• Identify the market
• Identify event as a change in supply, demand or
  both
• Identify the direction of the change
• Identify effects on equilibrium P Q
• Logically explain effects

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Market Analysis

• In the microwave oven market, two events occur
  (1) micro-chip technology cuts production costs
  (2) an ad campaign successfully promotes the
  ovens.
• Use the 5 steps of market analysis (also called
  comparative statics).

38
Microwave Market

• P

S
S1
P
D1
D
Q
Q
Q1
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Market Analysis

• During the past several years the number of
  peanut growers has increased dramatically. At
  the same time peanuts have been found to increase
  longevity.
• Use the 5 steps of market analysis.

40
Market Analysis

• A new machine has been invented which picks
  apples twice as fast. At the same time, the
  Department of Agriculture has announced that
  pesticides used on apples are carcinogenic.
• Use the 5 steps of market Analysis.

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Supply Demand

• Worksheets Pages 2-2 through 2-5 in packet of
  handouts

42
What if a 100 tariff were levied on Japanese
cars?
S
S1

• P

P1
P
D
Q
Japanese luxury cars
Q
Q1
43
Other effects?

• On all other luxury cars in U.S.?
• On all non-U.S. Luxury cars in all other markets?
• Net effect is that all prices rise

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Wage Rate Determination
SL

• W

W
DL
QL
QL
45
Interest Rate Determination

• I

Sm
I
Dm
Qm
Qm
46
Market Disequilibrium

• Occurs whenever there are long-term shortages or
  surpluses in a market
• Result of price ceilings floors

47
If price is too low
Price
Quantity
48
If price is too high
Price
Quantity
49
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

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Impact of a Price Ceiling
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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

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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 15/151
• Full economic price of a gallon of gasoline
  112

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Impact of a Price Floor
PF
54
Comparative Static Analysis

• How do the equilibrium price and quantity change
  when a determinant of supply and/or demand change?

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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.

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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.

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Scenario 1 Implications for a Small PC Maker

• Step 1 Look for the Big Picture
• Step 2 Organize an action plan (worry about
  details)

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Big Picture Impact of decline in component
prices on PC market
59

• 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.

60
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?

61
Big Picture Impact of lower PC prices on the
software market
Price of Software
Quantity of Software
62

• The big picture for the software maker
• Software prices are likely to rise, and more
  software will be sold
• Use this to organize an action plan

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Summary

• 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.)

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Relevant Worksheets Articles

• Disequilibrium Worksheet, page 2-10
• Hot Tickets, pp. 2-11 2-12.
• New Hard Sell on the Internet Buy Our Service,
  Get a Free PC, page 2-15.
• 2 Calif. Banks Curbing ATM Access, pp. 2-18
  2-19.