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. ,

Overview
I. Market Demand III. Market Curve Equilibrium The Demand IV. Price Function Restrictions Determinants of Demand V. Comparative Consumer Surplus 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. ,

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. ,

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. ,

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. ,

Change in Quantity Demanded

Price A to B: Increase in quantity demanded 10 A

B 6

D0 4 7 Quantity

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

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. ,

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. ,

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. ,

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. ,

Consumer Surplus: The Continuous Case

Price $ 10 8
Consu mer Surplu s

Value of 4 units

6 4 2 D 1 5 2 3 4 Quantity Total Cost of 4 units

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

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. ,

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. ,

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. ,

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

Change in Supply
Price S0 to S1: Increase in supply S0 S1

8 6

Quantity

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

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. ,

If price is too low

Price S

7 6 5 Shortage 12 - 6 = 6 6 12 D

Quantity

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

If price is too high

Price 9 8 7 Surplu s 14 - 6 =8 S

14

Quantity

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

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. ,

Impact of a Price Ceiling

Price S

PF P*

Ceiling Price Shortage D

Qs

Q*

Qd

Quantity

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

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. ,

Impact of a Price Floor

Price P
F

Surplu s

P*

Qd

Q*

QS

Quantity

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

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

Price of PCs S S*

P0 P*

Q
0

Q*

Quantity of P

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

 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. ,

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. ,

Price of Software P1 P0

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

S

D* D

Q0 Q1

Quantity of Software

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