MANAGERIAL

ECONOMICS
AND BUSSINESS
STRATEGY
PREPARED BY:
 CHAPTER TWO

MARKET FORCES
DEMAND AND SUPPLY

BOOK BY: Michael R. Baye

 Market Demand
is the total quantity demanded
by all Consumers at different
prices of certain good or service
(Other things being equal)
The market demand reflects the\
willingness and ability to buy
certain good at alternative prices
Law of demand:
states that there is a negative relationship between
the quantity demanded and the market price
(other things being equal).
* Any increasing of market prices leads to
decreasing of quantity demanded (other things
being equal) and declining market price leads to
increasing of quantity demanded.
This reason reflects the negative slope of demand
curve.
Note: the demand curve reflects the marginal
benefit of consuming different amount of
certain good or service.
 WHAT ARE THE DETERMINANTS OF DEMAND?

1- Income (normal good – inferior good).

2- Price of related goods:
* Price of substitutes. Positive relation
* Price of complements. Negative relation
3- Advertise and consumer tastes. Positive relation
4- Population. Positive relation
5- Consumer expectation. (optimistic - pessimistic)
Note: the relationship between each previous
factor and the quantity demanded supposing
other things being equal.
Shifting up of demand:
1- Increasing of income.
2- Increasing of price of
substitute goods.
3- Decreasing of price of
complements goods.
4- Increasing of population.
5- High effectiveness of
advertising campaign.
6- Transfer of consumers tastes
in favour of the good.
7- Optimistic expectation.
Shifting down of demand:
1- Decreasing of income.
2- Decreasing of price of
substitute goods.
3- Increasing of price of
complements goods.
4- Decreasing of population.
5- Low effectiveness of
advertising campaign.
6- Transfer of consumers tastes
against the good.
7- Pessimistic expectation.
Note: There is negative relationship between income
and quantity demanded in case of inferior goods
(other things being equal).
 THE DEMAND FUNCTION
The demand function reflects the relationship
between quantity demand (Qxd) and all factors
could affect on the quantity demand.
General formula of the demand function:
QX = F (PX, PS, PC, M, H)
Qx: quantity demanded of good X
PX: price of good X (+ or - )
PS: price of substitute goods (+)
PC: price of complements goods
M: individuals income ( + or -)
H: any other variable affecting demand.
Other things being equal.
 INVERSE DEMAND FUNCTION

Suppose the demand function on good X is :

Q x = F (Px, Y, PS, PC….. )

Q is the quantity demanded , Px is the price of x , Y is
consumers income, Ps the price of alternatives and
Pc the price of complementary goods . For
simplicity suppose:
Qx = α + b px
α: the quantity demanded if the price is zero , b is a
coefficient of the independent variable PX.
 NOTE:
1- The value of b will be negative if the X is normal
good, but it will be positive if X is inferior good.
2- According to the demand function, the quantity
demanded is called dependent variable and other
variables affect the quantity demanded are called
independent variables.
Suppose the demand function is QX = 10 – 2 PX.
Determine the QX if the market price is $4.
Qx = 10 – 2*4 = 2 units
2PX = 10 - Qx
PX = 5 – 0.5 Q ( inverse function)
 CHANGES OF QUANTITY DEMANDED & CHANGES
OF DEMAND

Changes of quantity demanded:

It means changes from point to other point on
the same demand curve as a result of
changing in the market price of certain
good or service (other things being equal).
Only one factor leads to the changes of quantity
demanded ,this factor is: the changes in the market
price of good X.
Changes in demand: \\
are shifting of the demand curve
of certain good or service X up
or down at all prices of good x.
All factors that could affect on
the quantity demanded except
the price of good( non- price factor),
lead to changes of demand
(consumers income, consumers
tastes, price of alternatives, price
of complementary Advertising, and
population ),,
Demonstration problem:
Suppose an economic consultant to the manger in the
computer company, this consultant includes an
estimation to the demand function for the company
products as:
QX = 12000 - 3PX + 4PY - 1M + 2AX
Where QX represents the amount consumed of good
X, PX is the price of good X, PY is the price of good
Y, M is income and A represents the amount of
advertising on good X. if the price of X $200 per
unit, PY is $15 per unit, the amount of advertising
2000 units and consumer income is $10000.
According to these data and information:
1- How much quantity of good X does consumer
purchase?
2- Are good X and Y substitutes or complements.
3- Is good X a normal or inferior good.

Answer
1- To determine how much the consumers purchase
from good X, substitute the given values in the
demand function.
QX = 12000 - 3(200) + 4(15) – 1(10000) + 2(2000)
= 5460 units
2- Coefficient of the price Y is positive 4, it means an
increase in the price by $1 leads to increase of the
quantity demanded of X by 4 units. (for this reason,
X and Y are substitutes).
3- Coefficient of income is negative one ( -1), it means
increasing of the consumers income by $1 leads to
decreasing of quantity demanded of x by one unit .
(for this reason, the good X is inferior good).
Note:
Depending on the previous values for PX, M, and
advertising AX, we can determine the demand
function formula as follows:
QX = 12000 - 3 PX + 4(15) – 1(10000) + 2(2000)
QX = 6060 - 3PX
The inverse demand function will be:
3PX = 6060 - QX
PX = 2020 – 1/3 QX
 CONSUMER SURPLUS:

It is the value or the consumer benefit from good A

but doesn’t have to pay for.
- The difference between the
total benefit of consuming
certain quantity and the
total payment for Q, if the price
is P, CS will be the shaded area
(iep).If the price of good X is zero,
all area under demand consider
consumer surplus.
How much i am happy, i got a great deal.
* I got a special discount (25%) from computer
company.
* I increase my surplus where the total benefit (value)
exceeds total money paid.
Demonstration problem:
If the consumer demand curve for Pepsi company
product as is presented in figure (A), and the firm
charges $2 per litres of Pepsi.

According to these data and information:

1- How much revenue will the company earn?
2- How much the consumer surplus will the consumer
enjoy?
3- What is the most, the consumer would be willing to
pay for a bottle containing 3 litres of Pepsi?
 Answer
1- Revenue = Q * P
= 3 * 2 = $6
2- Consumer surplus if the price is $2, is the triangle
area (1/2 * B * H) = ½ * 3 * 3 = $4.5
3- The consumer will purchase 3 units, by $2 per unit.
The total value of the consumption (3 units) equal
$10.5 (consumer spending + consumer surplus)
Total value( consumer willing to pay) =
= consumer spending + consumer surplus
Consumer willing to pay= (3*2) + 4.5 = $10.5
 SUPPLY SIDE
To determine market price, there are two forces:
* demand power
* supply power

In the previous section we focused on demand but in

this section we will concern on the supply.

In a competitive market, there are many producers

produce similar products.
Market supply:
Represents the total quantity that all producers in the
market desire and able to produce at alternative
prices (other things being equal).
- The quantity supplied from certain good by all
producers at different market prices (other things
being equal).
What is the relationship between market price and
quantity supplied?
Other things being equal there is a positive
relationship between market prices and quantity
supplied of certain good.
High price reflects
high profit (other things
being equal), this profit
induces the producers to
produce and supply more,
and low price, low profit,
produce and supply less
Quantity, for this reason
the supply curve will be
Positive slope as represented
In the figure.
Changes of quantity supplied:
Reflects the changes of quantity
supplied of good X as a result
of changes of the market price of
(other things being equal).
- The changes of the quantity
supplied reflects movements
on the same supply curve
from point to point , only the
changes of the market price
leads to these movements.
What are the variables that lead to shifting of supply??
1- Input prices.
2- Technology or
G regulations.
3- Number of firms.
4- Substitutes in
production.
5- Taxes.
6- Producer
expectations.
* The changes of any one of the previous
variables lead to changes of supply
curve downward or upward.
Any change of one or more of non- price factor leads
to changes of supply (shifts of supply)

Q. Determine the variables

that lead to shifting of the
supply up and down?
 THE SUPPLY FUNCTION

The supply function represents the relationship

between the quantity supplied of the good
(demand variable) and all the variables that
affect on the quantity supplied.

In general, the supply function of 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 on the supply.
General formula:

QX = F (PX, Pw, Pt, H)

Qx = quantity supplied of good X
Pw: price of inputs.
Pt: price of technology related to good X.
H: any other variable affecting supply (taxes,
number of firms, producers` expectation, existing
technology).
Other things being equal.
 QsX = B0 + BXPX + BnPn + BtPt + BHH
B0 > 0, B2 < 0, Bt < 0,
BH may be positive or negative depends on the type of
these factors (variables).
Demonstration problem:
Suppose the supply function on television sets is given
by:

QsX = 2000 + 3PX - 4Pt - Pw

Where PX is the price of good X and PW is the price of

an input in TV. If the price of each set is $400 and
the computer monitors are sold by $100 per unit and
the price of an input is $2000, how much TV
sets are produced?
 Answer

QsX = 2000 + 3(400) - 4(400) – 1( 2000)

= 800 units
 PRODUCER SURPLUS:
the difference between
the money received by
the producer at certain
Q of production and the
minimum money( price)
is accepted to induce him
to produce Q of good x.
Note:; The supply curve
reflects the minimum
price to produce.
Suppose: the market price is $1.5,at this price the
producers produce 15 units as represented in
figure below.
Producer surplus =
received price – minimum price
L
to produce
E1
1- The money received by
producers at Q1 (15)
Q
= 15 * 1.5 = $22.5 N

2- Minimum money to accept, equals the area under

the supply curve at Q (15) = Triangle area E1NQ
= ½ * 15 * 1.5 = $11.25
Producer surplus = 22.5 – 11.25 = $11.25
= LE1N = ½ * 1.50 * 15 =$11.5

Graphically PS equals the area above the supply

curve and below the market price.

Other things being equal, less

price less producer surplus.
 MARKET EQUILIBRIUM
Equilibrium price in the competitive market is
determined by the interaction between market
demand (buyers) and market supply (sellers).
 At the equilibrium, the quantity
demanded equals quantity supplied.
At Equilibrtium:
* QS = Q D
* Interaction between D and S
* Producer price = consumer price

Producers desire to receive consumers desire to pay

Minimum price to receive Maximum price to pay

** No surplus and
no shortage. B
A
** Steady state.
M N

* If the market price is more than EP, the quantity

supplied will be greater than the quantity demanded
by AB. the difference is called (consumer surplus /
producer surplus).
* If the market price is less than EP, the quantity
demanded will be more than the quantity supplied
by MN. The difference is called surplus or shortage.
Problem:
Suppose the demand function for certain type of fruits
is: QD = 10 – 2P
And the supply function is: QS = 2 + 2P
According to these data and information:
Determine the market price and the quantity sold.
Answer
QD = Q S
10 – 2P = 2 + 2P
8 = 4P
P=2
QD = 10 – 2*2 = 6 units.
 GOVERNMENT INTERVENTION IN THE
MARKET
** Sometimes, the equilibrium price in the free market
system is not convenient from government point of
view. It wants to introduce some goods and services
(especially very essential goods and services) with low
price less than the market
price to support poor
individuals (price ceiling).

** In other cases, the government wants to encourage

producers (farmers) to produce more than the quantity
produced locally to reduce the imported quantity from
the products, to achieve this target; the government
interferes in the free market by determining price more
than the free market price (price floor).

Price ceiling:
1- What is the price ceiling ?
2- What are the targets of price ceiling?
3- What are the main results of applying price ceiling ?
PRICE CEILING:
Is imposed by
government in the free
market for very essential
goods or services.

It will be less than the

market price as is
represented in figure
Below.
Targets:

** In some cases, the market price in the free

markets prevents the poorest people from
consuming some goods and services because the
price of these goods is out of their ability to pay.

** To internalize this type of consumer

(individuals) in the market of these goods,
government imposes a ceiling price of the
market.
 P2

P*

P1

Q*

Results: From figure above:

1- Free market will determine P* as equilibrium price
(1000), and the equilibrium quantity is at Q* (80 units).
2- Government imposes P1 as a price ceiling, this price
is less than the market price P*, At the ceiling price:
 Quantity demanded (100) more than the quantity
supplied (60)
 There is demand surplus (excess demand – shortage)

Demand surplus = QD – QS
= 100 – 60 = 40 units
 At the ceiling price, the consumers desire to
purchase more, but the producers want to produce
less, they produce (60 units) instead of (80 units).
 At p1 (800), ceiling price, the consumers are paying
p1 which is low, but they are willing to pay p2 (1200).
 The difference between the ceiling price and the
price that consumers willing to pay (p2 - p1 ) reflects
the opportunity cost of waiting in time.
 The quantity supplied not enough to satisfy the
consumers, as they need (80 units) (QD > QS ).
 Without government intervention in the distribution
system of this good, it will allocate based on the
base or rule “first come – first take (served”, long
time of people want to get this good.
 Government may be interfering in distributing this
good by using cards or quota system.
 The full economic price paid by the consumers equals
the explicit price paid to producers P1 (800), and the
implicit price that reflects the opportunity cost (cost
of waiting to get the good) is measured by the
difference between the price consumers is willing to
pay and the price paid by them (P1P3)
Economic price = 800 + (1200 – 800) = $1200
 Loss of social welfare equals vertical distance
between demand curve and supply curve:
LSW = triangle NBE = shaded area
= ½ * (1200 – 800) * (80 – 60) = $4000
 One of the main results of applying the price ceiling
policy is a black market that will appear in the goods
and services market that subject to the ceiling price.
Q1: What do you think about the price in the black
market??
Q2: What is your point of view of the price ceiling
policy, what are your recommendations to
activate this policy?
Problem:
Suppose demand function and supply function are
as follows:
QD = 20 – ½ P QS = 5 + 2 P
If the government puts a price ceiling at $6 per unit.

1- What is the quantity demanded and supplied at

this price?
2- How much is demand surplus at this price ?
3- What is the economic price at this price?
4- How much is the lost of social welfare at the
price ceiling policy?
 Answer
Market equilibrium: QD = QS
20 – ½ P = 5 + 2 P
2.5 P = 15
P = $6
And Q = 5 + 2*6 = 17 units
Ceiling price = $4
At the ceiling price:
QD = 20 – ½ * 4 = 18 units
QS = 5 + 2 * 4 = 13 units
Demand surplus = QD - QS = 18 – 13 = 5 units
Economic price at 13 units (supplied Q)
QD = 20 – ½ P
13 = 20 – ½ * P
½ P=7
Economic price P = $14
Economic price = explicit price – implicit price
Explicit price = the price paid at the ceiling price = $4
Implicit price = opportunity cost
= willing to pay price – ceiling price
= 14 – 4 = $10
Economic price = $14
Lost of social welfare =
= ½ * (change in Q) * opportunity cost
= ½ * (17 – 13) * 10
= 4 * 5 = $ 20
PRICE FLOOR:
It is the minimum price
that consumers can
legally pay for a good.
It is sometimes referred
to price support.

If the price floor is above the pre control price

competitive equilibrium price, it is said to be
binding.