Managerial Economics and Business Strategy:

Ch. 2 - Market Forces: Demand and Supply

Rayhan Gunaningrat, SE., MM.
Department of Management
Faculty of Law and Business
Universitas Duta Bangsa
headLine:
Samsung and Hynix Semiconductor to Cut Chip Production
Mr. Edy Krisnadi, owner and CEO of ELS Computer, arrived at the office and glanced at
the front page of Koran KOMPAS waiting on his desk. One of the articles contained
statements from executives of two of South Korea’s largest semiconductor
manufacturers—Samsung Electronic Company and Hynix Semiconductor—indicating
that they would suspend all their memory chip production for one week. The article
went on to say that another large semiconductor manufacturer was likely to follow suit.
Collectively, these three chip manufacturers produce about 30 percent of the world’s
basic semiconductor chips.
headLine:
Samsung and Hynix Semiconductor to Cut Chip Production (2)
ELS Computer is a small but growing company that assembles PCs and sells them in
the highly competitive market for “clones.” ELS Computer experienced 100 percent
growth last year and is in the process of interviewing recent graduates in an attempt to
double its workforce.

After reading the article, Sam picked up the phone and called a few of his business
contacts to verify for himself the information contained in the newspaper. Satisfied that
the information was correct, he called the director of personnel, Mr. Joni. What do you
think Mr. Edy and Mr. Joni discussed?
INTRODUCTION
As suggested in this chapter’s opening headline, supply and demand analysis is a tool
that managers can use to visualize the “big picture.” Many companies fail because
their managers get bogged down in the day-today decisions of the business without
having a clear picture of market trends and changes that are on the horizon.

Absent a view of the big picture, you are likely to negotiate the wrong prices with
suppliers and customers, carry too much inventory, hire too many employees, and—if
your business spends money on informative advertising—purchase ads in which your
prices are no longer competitive by the time they reach print.
INTRODUCTION (2)
Supply and demand analysis is a qualitative forecasting tool you can use to predict
trends in competitive markets, including changes in the prices of your firm’s products,
related products (both substitutes and complements), and the prices of inputs (such as
labor services) that are necessary for your operations.
DEMAND
DEMAND (2)
The market research reveals that, holding all other things constant, the quantity of
jeans consumers are willing and able to purchase goes down as the price rises. This
fundamental economic principle is known as the law of demand: Price and quantity
demanded are inversely related. That is, as the price of a good rises (falls) and all other
things remain constant, the quantity demanded of the good falls (rises).

Figure 2–1 plots the data in Table 2–1. The straight line connecting those points, called
the market demand curve, a curve indicating the total quantity of a good all consumers
are willing and able to purchase at each possible price, holding the prices of related
goods, income, advertising, and other variables constant.
DEMAND (3): Demand Shifters
Economists recognize that variables other than the price of a good influence
demand. For example, the number of pairs of jeans individuals are willing and
financially able to buy also depends on the price of shirts, consumer income,
advertising expenditures, and so on. Variables other than the price of a good that
influence demand are known as demand shifters.

When we graph the demand curve for good X, we hold everything but the price of X
constant. A representative demand curve is given by D0 in Figure 2–2. The
movement along a demand curve, such as the movement from A to B, is called a
change in quantity demanded.
DEMAND (4): Demand Shifters (cont.)
Whenever advertising, income, or the price of related goods changes, it leads to a
change in demand; the position of the entire demand curve shifts. A rightward
shift in the demand curve is called an increase in demand, since more of the good
is demanded at each price. A leftward shift in the demand curve is called a
decrease in demand.

Now that we understand the general distinction between a shift in a demand curve
and a movement along a demand curve, it is useful to explain how five demand
shifters—consumer income, prices of related goods, advertising and consumer
tastes, population, and consumer expectations—affect demand.
Demand Shifters: Consumer Income
Because income affects the ability of consumers to purchase a good, changes in
income affect how much consumers will buy at any price. Whether an increase in
income shifts the demand curve to the right or to the left depends on the nature of
consumer consumption patterns. Accordingly, economists distinguish between
two types of goods: normal and inferior goods.

Normal good: a good for which an increase (decrease) in income leads to an

increase (decrease) in the demand for that good.

Inferior good: A good for which an increase (decrease) in income leads to a

decrease (increase) in the demand for that good.
Demand Shifters: Prices of Related Goods
Changes in the prices of related goods generally shift the demand curve for a
good. For example, if the price of a KFC increases, most consumers will begin to
substitute McD because the relative price of KFC is higher than before. This is
illustrated by a shift in the demand for McD to the right. Goods that interact in this
way are known as substitutes.

Not all goods are substitutes; in fact, an increase in the price of a good such as
computer software may lead consumers to purchase fewer computers at each
price. Goods that interact in this manner are called complements.
Demand Shifters: Advertising and Consumer Tastes
Another variable that is held constant when drawing a given demand curve is the level
of advertising. An increase in advertising shifts the demand curve to the right. Why?

Advertising often provides consumers with information about the existence or quality
of a product, which in turn induces more consumers to buy the product. These types of
advertising messages are known as informative advertising.

Advertising can also influence demand by altering the underlying tastes of consumers.
These types of advertising messages are known as persuasive advertising.
Demand Shifters: Population
The demand for a product is also influenced by changes in the size and
composition of the population. Generally, as the population rises, more and more
individuals wish to buy a given product, and this has the effect of shifting the
demand curve to the right.

It is important to note that changes in the composition (age, gender, etc.) of the
population can also affect the demand for a product. To the extent that a greater
proportion of the population ages, the demand for medical services will tend to
increase.
Demand Shifters: Consumer Expectations
Changes in consumer expectations also can change the position of the demand
curve for a product. If consumers expect future prices to be higher, they will
substitute current purchases for future purchases. This type of consumer behavior
often is referred to as stockpiling and generally occurs when products are durable
in nature.

For example, if consumers suddenly expect the price of automobiles to be

significantly higher next year, the demand for automobiles today will increase. In
effect, buying a car today is a substitute for buying a car next year.
Demand Shifters: Other Factors
In concluding our list of demand shifters, we simply note that any variable that
affects the willingness or ability of consumers to purchase a particular good is a
potential demand shifter. Health scares affect the demand for cigarettes. The birth
of a baby affects the demand for diapers.
The Demand Function
By now you should understand the factors that affect demand and how to use graphs
to illustrate those influences. The final step in our analysis of the demand side of the
market is to show that all the factors that influence demand may be summarized in
what economists refer to as a demand function. Then the demand function for good X
may be written as

Thus, the demand function explicitly recognizes that the quantity of a good consumed
depends on its price and on demand shifters.
The Demand Function (2)
Different products will have demand functions of different forms. One very simple
but useful form is the linear representation of the demand function:

The αi are fixed numbers that the firm’s research department or an economic
consultant typically provides to the manager. (Chapter 3 provides an overview of
the statistical techniques used to obtain these numbers.) The information
summarized in a demand function can be used to graph a demand curve. For
instance, see demonstration problem 2-1.
The Demand Function (3)
Since a demand curve is the relation between price and quantity, a representative
demand curve holds everything but price constant. This means one may obtain the
formula for a demand curve by inserting given values of the demand shifters into the
demand function, but leaving Px in the equation to allow for various values. If we do
this for the demand function in Demonstration Problem 2–1, we get
The Demand Function (4)
Because we usually graph this relation with the price of the good on the vertical
axis, it is useful to represent Equation 2–1 with price on the left-hand side and
everything else on the right-hand side. This relation is called an inverse demand
function. For this example, the inverse demand function is

It reveals how much consumers are willing and able to pay for each additional unit
of good X. This demand curve is graphed in Figure 2–4.
Consumer Surplus
We now show how a manager can use the demand curve to ascertain the value a
consumer or group of consumers receives from a product. Consumer surplus is
the value consumers get from a good but do not have to pay for. It will prove
particularly useful in marketing and other disciplines emphasizing strategies like
value pricing and price discrimination.

For more details: https://www.youtube.com/watch?v=oL20S7c0ZJE

SUPPLY
In the previous section we focused on demand, which represents half of the forces
that determine the price in a market. The other determinant is market supply. The
market supply curve summarizes the total quantity all producers are willing and
able to produce at alternative prices, holding other factors that affect supply
constant.

The fact that the market supply curve slopes upward reflects the inverse law of
supply: As the price of a good rises (falls) and other things remain constant, the
quantity supplied of the good rises (falls). Producers are willing to produce more
output when the price is high than when it is low.
While the market supply of a good generally
depends on many things, when we graph
a supply curve, we hold everything but
the price of the good constant. The movement
along a supply curve, such as the one from A to B
is called a change in quantity supplied.
Supply Shifters
Variables that affect the position of the supply curve are called supply shifters,
and they include the prices of inputs, the level of technology, the number of firms
in the market, substitutes in production, taxes, and producer expectations.
Whenever one or more of these variables change, the position of the entire supply
curve shifts. Such a shift is known as a change in supply.
The shift from S0 to S2 in Figure 2–6 is called
an increase in supply since producers sell more
output at each given price. The shift from S0 to S1
in Figure 2–6 represents a decrease in supply
since producers sell less of the product
at each price.
Supply Shifters: Taxes
A Per Unit (Excise) Tax

An excise tax is a tax on each unit of output

sold, where the tax revenue is collected from the
supplier. An excise tax shifts the supply curve up
by the amount of the tax, as in Figure 2–7.

Note that at any given price, producers are

willing to sell less gasoline after the tax than
before. Thus, an excise tax has the effect of
decreasing the supply of a good.

For more details:

https://www.investopedia.com/terms/e/excisetax.asp
https://klc.kemenkeu.go.id/pusbc-filosofi-cukai/
Supply Shifters: Taxes (2)
Ad Valorem Tax (PPN, PPn, PBB)

Ad valorem literally means “according to the

value.” An ad valorem tax is a percentage tax;
the sales tax is a well-known example. Because
an ad valorem tax is a percentage tax, it will be
higher for high-priced items.

An ad valorem tax will rotate the supply curve

counterclockwise, and the new curve will shift
farther away from the original curve as the price
increases.

For more details:

https://www.finansialku.com/ad-valorem/
The Supply Function
The final step in our analysis of supply is to show that all the factors that influence
the supply of a good can be summarized in a supply function. The supply function
of a good describes how much of the good will be produced at alternative prices
of the good, alternative prices of inputs, and alternative values of other variables
that affect supply.

Thus, the supply function explicitly recognizes that the quantity produced in a
market depends not only on the price of the good but also on
all the factors that are potential supply shifters.
The Supply Function (2)
While there are many different functional forms for different types of products, a
particularly useful representation of a supply function is the linear relationship:

The coefficients (the βis) ) represent given numbers that have been estimated by
the firm’s research department or an economic consultant. The information
summarized in a supply function can be used to graph a supply curve. For
example, see demonstration problem 2–3.
The Supply Function (3)
Since a supply curve is the relationship between price and quantity, a
representative supply curve holds everything but price constant. If we do this for
the supply function in Demonstration Problem 2–3, we get
The Supply Function (4)
Since we usually graph this relation with the price of the good on the vertical axis,
it is useful to represent Equation 2–2 with price on the left-hand side and
everything else on the right-hand side. This is known as an inverse supply function.

which is the equation for the supply curve graphed in Figure 2–9. This curve
reveals how much producers must receive to be willing to produce
each additional unit of good X.
Producer Surplus
Just as consumers want price to be as low as possible, producers want price to be
as high as possible. The supply curve reveals the amount producers will be willing
to produce at a given price. Alternatively, it indicates the price firms would have to
receive to be willing to produce an additional unit of a good.

Producer surplus is the amount of money producers receive in excess of the

amount necessary to induce them to produce the good. Geometrically, producer
surplus is the area above the supply curve but below the market price of the good.

For more details:

https://www.youtube.com/watch?v=ECz2hEbEagw
MARKET EQUILIBRIUM
The equilibrium price in a competitive market is determined by the interactions of
all buyers and sellers in the market. The interaction of supply and demand
ultimately determines a competitive price, Pe, such that there is neither a shortage
nor a surplus of the good. This price is called the equilibrium price and the
corresponding quantity, Qe, is called the equilibrium quantity for the competitive
market.

Once this price and quantity are realized, the market forces of supply and demand
are balanced; there is no tendency for prices either to rise or to fall.
PRICE RESTRICTIONS AND MARKET EQUILIBRIUM
The previous section showed how prices and quantities are determined in a free
market. In some instances, government places limits on how much prices are
allowed to rise or fall, and these restrictions can affect the market equilibrium.

➔ Price Ceilings
➔ Price Floors
Price Ceilings
Suppose that, for whatever reason, the
government views the equilibrium price of Pe in
Figure 2–11 as “too high” and passes a law
prohibiting firms from charging prices above Pc.
Such a price is called a price ceiling.

Price ceiling is the maximum legal price that can

be charged in a market.

In fact, if a ceiling were imposed above the

equilibrium price, it would be ineffective; the
equilibrium price would be below the maximum
legal price.
Price Floors
In contrast to the case of a price ceiling,
sometimes the equilibrium competitive price
may be considered too low for sellers. Price
floors is the minimum legal price that can be
charged in a market.

If the equilibrium price is above the price floor,

the price floor has no effect on the market. But if
the price floor is set above the competitive
equilibrium level, such as Pf in Figure 2–12, there
is an effect.

The dollar value of the lost social welfare

“deadweight loss” is given by the blue triangle in
Figure 2–12.
Price Floors (2)
When a price floor is a minimum wage, the
deadweight loss that results is fully captured by the
blue triangle in Figure 2–12. However, when the
price floor applies to a product, the deadweight loss
can be even greater as indicated by the red
trapezoid.

How much additional deadweight loss there is

depends on what happens to the unsold inventories.
One possibility is that the government purchases
and discards the surplus. This type of price floor,
where the government purchases the surplus, is
called a price support. If the government discards
the surplus it purchases, this results in additional
deadweight loss.
COMPARATIVE STATICS
Now, we learn how managers can use supply and demand to analyze the impact of
changes in market conditions on the competitive equilibrium price and quantity. The
study of the movement from one equilibrium to another is known as comparative static
analysis.

Throughout this analysis, we assume that no legal restraints, such as price ceilings or
floors, are in effect and that the price system is free to work to allocate goods among
consumers.

➔ Changes in Demand
➔ Changes in Supply
➔ Simultaneous Shifts in Supply and Demand
COMPARATIVE STATICS: Changes in Demand
Suppose that Statistics Indonesia (BPS) reports that consumer incomes are
expected to rise by about 2.5 percent over the next year, and the number of
individuals over 25 years of age will reach an all-time high by the end of the year.

We can use our supply and demand apparatus to examine how these changes in
market conditions will affect car rental agencies like DOcar, TRAC, and Golden
Bird.

It seems reasonable to presume that rental cars are normal goods: A rise in
consumer incomes will most likely increase the demand for rental cars. The
increased number of consumers aged 25 and older will also increase demand
since at many locations those who rent cars must be at least 25 years old.
COMPARATIVE STATICS: Changes in Demand (2)
The initial equilibrium in the market for rental
cars is at point A, where demand curve D0
intersects the market supply curve S.

The changes reported by Statistics Indonesia

suggest that the demand for rental cars will
increase over the next year, from D0 to some
curve like D1.

The equilibrium moves to point B, where car

rental companies rent more cars and charge
a higher price than before the demand
increase.
COMPARATIVE STATICS: Changes in Supply
Consider a bill before Congress that would require all employers, small and large
alike, to provide health care to their workers. How would this bill affect the prices
charged for goods at retailing outlets?

This health care mandate would increase the cost to retailers and other firms of
hiring workers. These higher labor costs, in turn, would decrease the supply of
retail goods. The final result of the legislation would be to increase the prices
charged by retailing outlets and to reduce the quantity of goods sold there.
COMPARATIVE STATICS: Changes in Supply (2)
We can see this more clearly in Figure 2–14.
The market is initially in equilibrium at point
A, where demand curve D intersects the
market supply curve, S0.

Higher input prices decrease supply from S0

to S1, and the new competitive equilibrium
moves to point B.

In this instance, the market price rises from

P0 to P1, and the equilibrium quantity
decreases from Q0 to Q1.
COMPARATIVE STATICS: Simultaneous Shifts in Supply and Demand

A tragic example occurred at the end of the last century when an earthquake hit
Kobe, Japan. The earthquake did considerable damage to Japan’s dorayaki
pancake industry, and the nation’s supply of dorayaki pancake decreased as a
result. Unfortunately, the stress caused by the earthquake led many to increase
their demand for dorayaki and other sweet desserts.
COMPARATIVE STATICS: Simultaneous Shifts in Supply and Demand (2)

In Figure 2–15, the market is initially in

equilibrium at point A, where demand curve D0
intersects market supply curve S0.

Since the earthquake led to a simultaneous

decrease in supply and increase in demand for
dorayaki, suppose supply decreases from S0 to
S1 and demand increases from D0 to D1.

In this instance, a new competitive equilibrium

occurs at point B; the price of dorayaki increases
from P0 to P1, and the quantity consumed
increases from Q0 to Q1.
COMPARATIVE STATICS: Simultaneous Shifts in Supply and Demand (3)

But what if, instead of shifting from S0 to S1, the

supply curve shifted much farther to the left to S2 so
that it intersected the new demand curve at point C
instead of B?

In this instance, price would still be higher than the

initial equilibrium price, P0. But the resulting quantity
would be lower than the initial equilibrium (point C
implies a lower quantity than point A).

Thus, we have seen that when demand increases

and supply decreases, the market price rises, but
the market quantity may rise or fall depending on
the relative magnitude of the shifts.
ANSWERING THE headLINE
Mr. Edy recognized that a cut in chip production will
ultimately lead to higher chip prices. Since chips are
a key input in the production of PCs, an increase in
the price of chips would in turn lead to a decrease in
the market supply of PCs, as indicated by the
change in supply from S0 to S1 in Figure 2–16.

Notice that total quantity of PCs sold in the market

falls as the equilibrium moves from point A to point
B. In light of this anticipated decline in PC sales, Mr.
Edy and Mr. Joni discussed the wisdom of going
ahead with their plan to double ELS Computer’s
workforce at this time.