MANAGERIAL ECONOMICS - Material No.

5
Chapter 3 – DEMAND AND SUPPLY
Reference:
MANAGERIAL ECONOMICS 14TH EDITION BY: HIRSCHEY AND BENTZEN (2016)

Introduction

Gasoline demand in the USA grows roughly 2% per year, primarily as a result of rising
economic activity. Also contributing to the trend is the US consumer’s strong preference
for fuel-less-efficient vehicles, like mini vans. SUV’s and light duty trucks.

Supply-demand imbalances can become acute when gasoline consumption rises by

nearly 10% during summer driving season. Recent increases in gas prices have been
blamed on the growing demand from emerging economies India, and on fears of oil
supply restrictions tied to political instability in Iran, Nigeria and Venezuela.

High pump prices are directly tied to the escalating cost of crude. For every $1 increase
in the cost of a barrel of oil, there is an average increase about 2.5% in the gallon in the
price of gasoline. In addition to restrictions tied to political instability and bad weather,
gasoline supplies in the USA have tightened because of scarce refining capacity. Nobody
wants a new refinery built in the own backyard. For example, if a refinery bottleneck
occurs in California, consumers must rely on tankers to ship gasoline from the half-
dozen refineries around the world that can produce the state’s cleaning-burning
gasoline. Even the closest refinery in the state of Washington, is 7 to 10 days away. In
the meantime, even temporary supply disruptions lead to skyrocketing gasoline prices.

In short, do not merely blame Exxon for high gas prices. Blame worsening demand and
supply conditions.

BASIS OF DEMAND

Goods and services have ready markets if they directly satisfy wants, or help firms to
produce products that satisfy consumer wants.

Direct Demand

Demand is the quantity of good or services that customers are willing and able to
purchase during a specified period under a given set of economic conditions. The time
frame might be an hour, a day, a month, or a year. Conditions to be considered include
the price of the good in question, prices and availability of related goods, expectations
of price changes, consumer incomes, consumer tastes and preferences, advertising
expenditures, and so on. The amount of that product consumers are prepared to
purchase, its demand, depends on all of these factors. According to the law of demand,

1
the lower the price of a good, the larger the quantity consumers wish to purchase, all
other things held constant.

For managerial decision-making, a prime focus is on market demand. Market demand

is the aggregate of individual, personal, demand. Insight into market demand relations
requires an understanding of the nature of individual demand.

Individual demand is determined by the value associated with acquiring and using any
good or service and the ability to acquire it. Both necessary for effective individual
demand. Desire without purchasing power may lead to want, but not demand. There are
two basic models of individual demand. One, known as the theory of consumer behavior,
relates to the direct demand for personal consumption of products. This model is
appropriate for analyzing individual demand for goods and services that directly satisfy
consumer desires. The value or worth of good or service, its utility, is the prime
determinants of direct demand. Individuals are viewed as attempting to maximize the
total utility or satisfaction provided by the goods and services they acquire and consume.
This optimization process requires that consumers focus on the marginal utility (gain in
satisfaction) of acquiring additional units of a given product. Product characteristics,
individual preferences (tastes), and the ability to pay are all important determinants of
direct demand.

Derived Demand

Goods and services are sometimes acquired because they are important inputs in the
manufacture and distribution of other products. The outputs of engineers, production
workers, sales staff, managers, lawyers, office business machines, production facilities
and equipment, natural resources, and commercial airplanes are all examples of goods
and services demanded not for direct consumption but rather for their use in providing
services. Their demand is derived from the demand for the products they are used to
provide. Input demand is called as derived demand.

The demand for air transportation to resort areas is not direct demand but is derived
from the demand for recreation. Similarly, the demand for producer’s goods and
services used to manufacture products for final consumption is derived.

Aggregate demand for consumer goods and services determines demand for capital
equipment, materials, labor, and energy used to manufacture them. For example, the
demands for steel, aluminum, and plastics are all derived demands, as are demands for
machine tools and labor. None of these producer’s goods are demanded because of their
direct value to consumers but because of the role they play in production.

Demand for producer’s goods and services are closely related to final product’s demand.
An examination of final product demand is an important part of demand analysis for
intermediate, or producers’ goods. For products whose demand is derived rather than

2
direct, demand seems stems from their value in the manufacture and sale of other
product. They have value because their employment has the potential to generate profits.
Key components in the determination of derived demand are marginal benefits and
marginal costs associated with using a given input or factor of production. The amount
of any good or service used rises when marginal benefit, measured in terms of the value
of resulting output, is greater than the marginal costs of using the input, measured in
terms of wages, interest, raw material costs, or related expenses. Conversely, the
amount of any input used in production falls when resulting marginal benefits are less
than the marginal cost for employment. In short, derived demand is related to the
profitability of using a good or service.

Regardless of whether a good or service is demanded by individuals for final

consumption (direct demand) or as an input used in providing other goods and services
(derived demand), the fundamentals of economic analysis offer a basis for investigating
demand characteristics.

• For final consumption products, utility maximization as described by the theory

of consumer behavior explains the basis for direct demand.
• For inputs used in production of other products, profit maximization provides the
underlying rationale for derived demand.

Because both demand models are based on the optimization concept, fundamental direct
demand and derived demand relations are essentially the same.

MARKET DEMAND FUNCTION

The demand function for a product is a statement of the relation between the aggregate
quantity demanded and all factors that affect this quantity.

Demand Function and Demand Curve

A demand function is a mathematical equation which expresses the demand of a product

or service as a function of the its price and other factors such as the prices of the
substitutes and complementary goods, income, etc.

A demand functions creates a relationship between the demand (in quantities) of a

product (which is a dependent variable) and factors that affect the demand such as the
price of the product, the price of substitute and complementary goods, average income,
etc., (which are the independent variables).

Determinants of Demand

The quantity demanded of a consumer is the amount of goods or services consumers

are willing and able to buy/purchase as a given price, place, and at a given period of

3
time. How do you decide how much quantity of a good, and what factors affect your
decision? The following are the determinants of demand:

1. Price of the good itself – as the price of certain goods and services increases,
the demand for these goods and services decreases or vice versa.

2. Consumers’ income – a change in income will cause a change in demand.

Consumer tends to buy more goods and acquire more services when their
income increases. On the hand, demand for such goods and services declines
once their income decreases. Thus, changes on the consumers’ income
likewise change their demand for goods and services. The direction in which
the demand will shift in response to change in income depends on the type of
goods, to wit:

a) Normal Good – refers to a good for which quantity demand at every

price increase when income rises.
b) Inferior Good – refers to a good for which quantity demand falls when
income rises. For example: In public transportation, as the income of
passengers increase, they stop riding the public mode of transportation
and instead they buy and drive their own car.

3. Consumers’ expectation of Future Prices – the quantity of a good demanded

within any period depends not only on prices in that period but also on prices
expected in future periods. When someone expects higher prices in the future
especially for basic commodities, the tendency is to buy more of these goods
today. In same manner, demand for such goods decreases if consumers
expect prices to decline in the future.

4. Prices of Related Commodities/Goods – the quantity demanded for any

particular good will be affected by changes in the prices of related good.
Changes in the prices of alterative goods such as pork and chicken will affect
the quantity of fish demanded. All other commodities may be either:

a) Substitute goods are goods that can be used in place of other goods.
They are related in such a way that an increase in the price of one good,
will cause an increase in the demand for the other good or vice versa.
For example, coffee substitute for tea.
b) Complementary goods are goods that go together. They are related in
such a way that an increase in the price of one good will cause a
decrease the demand for the other good. For example: gasoline and
car.

5. Consumers’ Taste and Preferences – consumers’ tastes and preferences are

a major factor determining the quantity of any good demanded. An increase in

4
 the preference and taste for a certain good will certainly increase the demand
for that particular good. For example: a change in preference from scooter to
big bike will increase the demand for big bikes and decrease the demand for
scooters.
6. Population – an increase in the population means more demand for goods and
services. Inversely, less population means less demand for goods and
services.

The Demand Curve

The Demand Curve shows graphically the relationship between the quantity of good
demanded and its corresponding price, with other variables held constant. A demand
curve is shown in the form of graph, all variables in the demand function except the
price and quantity of the product are held fixed. The demand curve is typically downward
sloping. It describes the negative relation between the price of a good and the quantity
that consumers want to buy a given price. The law of demand can be expressed into a
graph, with the price on Y axis and the quantity demanded on the X axis. In economics,
price is on the vertical axis and the quantity demanded on the horizontal axis. This is
shown in Fig. 1.

Price (Php ‘000)

1
1

0 200 400 600 800 1000 QD (Quantity Demanded)

Fig. 1 - Demand Curve for Shoes

Notice that the demand curve shows a downward sloping. The position of the demand curve indicates the
inverse relationship between the price and the quantity demanded. This is “the law of downward sloping.”
Thus, the greater quantity will be demanded when the price is lower, and when the price of goods increase,
buyers tends to buy less of it.

Changes Involving Demand

Changes in demand may be:

5
 1. Change in quantity demanded is the movement along a demand curve, which
indicates movement from one point to another point of the same demand curve.
This is due to a change in the price of goods and services. This is shown below in
Fig. 2.

Price (Php ‘000)

0 200 400 600 800 1000 QD (Quantity Demanded)

Fig. 2 - Change in Quantity Demanded (Movement along the Demand Curve)

2. Change in demand - a shifting from one demand curve to another is known as

change in demand. This is brought by the changes in all or other determinants of
demand (non-price) except price.

Fig. 3 - Change in Demand (Shift in the Demand Curve)

0 200 400 600 800 1000 QD (Quantity Demanded)

Relationship Between Demand Curve and Demand Function

The relationship between the demand curve and the demand function is important and
worth considering. The demand function specifies relationship between quantity
demanded of a product with many independent variables, whereas, demand curve of a
product is a graphic representation of only a part of the demand function with price of

6
the product as the only independent variable. The effects of change in variables other
than price, as explained above, are shown through a shift in the demand curve.

A change in quantity demanded is defined as a movement along a single demand curve.

A change in quantity demanded refers to the effect on sales of a change in price, holding
constant the effects of all other demand-determining factors. This effect is shown in a
demand curve.

A shift in demand, or switch from one demand to another demand curve following a
change in a non-price determinant of demand. It reflects a change in one or more non-
price variables in product demand function.

Industry Demand versus Company Demand

Demand is classified into two types, namely: (a) Industry demand and (b) Company
demand.

a) Company demand refers to the demand for the products of a particular company
in an industry. An industry consists of different companies producing a
commodity with different brand names and trade marks. For instance, the soap
industry consists of several soaps manufactured by different companies Unilever
Limited, Godrej etc. are some of the leading companies which manufacture
different varieties of soaps.

b) Industry demand means the total or aggregate demand for the products of a
particular industry. For instance, the total demand for sugar is fulfilled by the
sugar industry. The various sugar mills in sugar industry produce such quantity
of sugar which can be demanded by the people at a particular time.

Industry demand consists of the aggregate demand made for the product of
different companies. Industry covers all the firms or companies which produce
close substitutes for a single product with different brand names.

For instance, there are several companies manufacturing toothpaste like Close-Up,
Colgate, Promise, Neem etc. All these companies come under the category of single
industry namely tooth paste industry. Industry demand schedule can he constructed on
the basis of the total quantity of a commodity bought from all firms at a given price and
time. It can be divided into several groups like customer group wise or area wise.

The manager of each firm estimates the share of’ the product of a company in the total
industry demand. However, he has to consider industry demand for estimating and
forecasting the sales of the company. The nature of competition prevailing in the market
determines the relationship between the industry demand and company demand.

7
THE CONCEPT OF SUPPLY

Supply Function

A supply function is a tool used by economists to measure the relationship between

price and quantity of goods supplied. The supply function describes the effect that
changes in one variable have on another. Supply function can be described with three
variables: Price, Quantity Supplied, and Marginal Cost. The supply function is also known
as Supply Curve. The Supply Curve is a graphical representation of the Law of Supply.

It shows the relationship between price and quantity supplied at a given point in time.
The curve slopes upward because as price increases, producers are able to sell more
units of the good or service. The marginal cost curve intersects the supply curve at the
equilibrium point. This is where quantity supplied equals quantity demanded. The
marginal cost curve measures the change in total costs associated with producing one
more unit of output. At the equilibrium point, marginal cost is equal to price.

Importance of Supply Function

The supply function is important to study because it shows the relationship between two
variables. The supply function can be used to illustrate how demand changes when the
price is altered, and vice versa. Supply functions are often depicted graphically with a
supply curve that slopes upward because as prices increase producers will be able to
sell more units of goods or services. Supply curves serve an important role in economic
theory by showing what happens to overall production levels based on current market
conditions such as supply & demand trends, technology improvements, etc.

Supply Curve

The term supply refers to the quantity of good or service that producers are willing and
able to sell under a given set of conditions.

The supply curve expresses the relation between price charged and quantity supplied,
holding constant the effects of all other variables.

The Law of Supply states that as price increases, quantity supplied also increases; and
as price decreases, quantity supplied also decreases. This means that the higher price
of certain good and service, the higher the quantity supplies. This is because it could give
them more profit. This law is valid of there is no change in the other non-price
determinants

The quantity supplied refers to the amount or quantity and services producers are willing
and able to supply at a given price, at a given period of time.

8
The Determinants of supply are the following:

1. Change in technology – state of the art technology that uses high-tech

machines increases the quantity supply of goods which causes the reduction
of cost of production.
2. Costs of inputs used – an increase in the price of an input or the cost of
production decreases the quantity supplies because the profitability of certain
business decreases.
3. Expectation of future price – when producers expect higher prices in the
future commodities, the tendency is to keep their good and release them when
the price rises. Inversely, supply for goods decreases if producers expect
prices to decline in the future.
4. Change in the price of related goods – changes in the price of goods have a
significant effect in the supply of such goods. For instance, an increase in the
price of pork may likely encourage poultry raisers to shift into piggery farm if
this gives them more profit.
5. Government regulation and taxes – it is expected that taxes imposed by the
government increases cost of production which in turn discourages
production because it reduces producers’ earnings. A higher degree of
regulation and tax will translate to lower supply in the market.
6. Government subsidies – subsidies or the financial assistance given by the
government reduces cost of production which encourages more supply.
7. Number of firms in the market – an increase in the number of firms in the
market leads to an increase in supply of goods and services.

The Supply Curve shows graphically the quantity of good supplied at each price, with
other factors that affecting quantity supplied held constant. The supply curve is typically
upward-sloping, as shown in Fig. 4 below:

Price (Php ‘000)

0 200 400 600 800 1000 Quantity Supplied (QS)

9
 Supply Curve for Shoes

Changes involving Supply

1. Change in quantity supplied – movement along a supply curve is known as a

change in quantity supplied, which shows the movement from one point to
another point on the same supply curve. This is due to a change in the price of
goods and services.

Fig. 5 - Change in Quantity Supplied (Movement along the Supply Curve)

0 200 400 600 800 1000 Quantity Supplied (QS)

2. Change in supply – shifting from one supply curve to another is known as

change in supply. This is brought about by a change in any or of the all
determinants. A shifting of the supply curve to the right indicates decrease in
supply.

Fig. 6 – Change in Supply (Shift in the Supply Curve)

0 200 400 600 800 1000 Quantity Supplied (QS)

2

10

1
Market Supply versus Individual Supply

Just as market demand is the sum of the demands of all buyers, market supply is the
sum of the supplies of all sellers. The market supply is the sum of the two individual
supplies. Market supply depends on all those factors that influence the supply of
individual sellers, such as the prices of inputs used to produce the good, the available
technology, and expectations. In addition, the supply in a market depends on the number
of sellers.

THE MARKET EQUILIBRIUM

Consumers demand the amount or quantity of goods and services at each corresponding
price. Similarly, producers are willing and able to supply the amount or quantity of goods
and services at each price. Hence, the law of demand and supply stipulate that when
demand is greater than demand, price decreases, and when demand is equal to supply,
price remains constant. What will happen when supply and demand intersect?

It is noted that there is a contradiction between the consumers and producers as to the
price. The consumers dislike higher price while producers like high price. Consumers
are willing and able to buy goods or services at a lower price (the law of demand). On
the other hand, producers are willing and able to offer or sell more goods and services
at a higher price (law of supply). This force in the market place creates equilibrium price
and equilibrium quantity, or the market equilibrium.

Market equilibrium is a state which implies a balance between the opposing forces, a
situation in which quantity demanded and quantity supplied are equal. Market is in
equilibrium when quantity demanded equals quantity supplied or the QD intersect with
QS at particular point. Given the demand function and supply function, the equilibrium
price and quantity can be derived.

The Equilibrium of Supply and Demand

The equilibrium is found where the supply and demand curves intersect. At the
equilibrium price, the quantity supplied equals the quantity demanded. Figure 10 shows
the market supply curve and market demand curve together.

11
 Fig. 7 – Equilibrium of Supply and Demand
P

0
200 400 600 800 1000 QS and QD

Notice that there is one point at which the supply and demand curves intersect; this point
is called the market’s equilibrium. The price at which these two curves cross is called
the equilibrium price, and the quantity is called the equilibrium quantity. Here the
equilibrium price is P3,000 per shoes, and the equilibrium quantity is 600. At the
equilibrium price, the quantity of the good that buyers are willing and able to buy exactly
balances the quantity that sellers are willing and able to sell. The equilibrium price is
sometimes called the market-clearing price because, at this price, everyone in the
market has been satisfied: Buyers have bought all they want to buy, and sellers have
sold all they want to sell.

THE MARKET FORCES OF SUPPLY AND DEMAND

Surplus

What happens when the market price is not equal to the equilibrium price? Suppose first
that the market price is above the equilibrium price - There is a surplus of the good:
Suppliers are unable to sell all they want at the going price. Surplus is a situation in
which quantity supplied is greater than quantity demanded. When there is a surplus in
the market of shoes for instance, sellers of shoes find it difficult to sell it, they would
like to sell but cannot. They respond to the surplus by cutting their prices. Prices
continue to fall until the market reaches the equilibrium.

Shortage

Suppose now that the market price is below the equilibrium price - There is a shortage
of the good: Demanders are unable to buy all they want at the going price. Shortage is a

12
situation in the market in which quantity demanded is greater than quantity supplied.
When a shortage occurs in the shoe market, for instance, buyers have to wait in long
lines for a chance to buy one or few that are available. With too many buyers chasing
too few goods, sellers can respond to the shortage by raising their prices without losing
sales. As prices rise, the market once again moves toward the equilibrium.

Thus, the activities of the many buyers and sellers automatically push the market price
toward the equilibrium price. When there is shortage in the market there is an upward
pressure on the price. Whereas, when there is surplus there is a downward pressure
on the price. Once the market reaches its equilibrium, all buyers and sellers are
satisfied, and there is no upward or downward pressure on the price. How quickly
equilibrium is reached varies from market to market, depending on how quickly prices
adjust. In most free markets, however, surpluses and shortages are only temporary
because prices eventually move toward their equilibrium levels.

Indeed, this phenomenon is so pervasive that it is sometimes called the Law of

Equilibrium of Supply and Demand: The price of any good adjusts to bring the supply and
demand for that good into balance.

The above discussion about forces of supply and demand can be summarized in Table
No. 1 illustrated below:

Table 1 - Demand and Supply Schedule of Shoes

Pt. P Qd Qs State of Market Pressure on Price

A 1 1000 200 Shortage Upward
(-800)
B 2 800 400 Shortage Upward
(-400)
C 3 600 600 Equilibrium Neutral/Equal
(0)
D 4 400 800 Surplus Downward
(400)
E 5 200 1000 Surplus Downward
(800)

13