MBA I602

Economics and Business Statistics

(Fall 2022)
 Economics

Supply and Demand

Demand
• When consumers decide whether to buy a particular good
or service, they must decide how much to buy, generally
based on its own price and on other factors.

• Own Price: To determine how a change in price affects the

quantity demanded, economists ask what happens to
quantity when price changes and other factors are held
constant.

• Other Factors: The list of other factors usually includes

income, the price of related goods, tastes, information,
government regulation.
Regression Analysis
• Demand relationships can be estimated by data driven
models which approximate its sensitivity to various factors.

• Empirical estimation of these sensitivities requires an

understanding of the modelling process, careful scrubbing of
data, and an appreciation for the uncertainty of estimates.
• Although frequently over-looked, each equation includes a residual
term which captures the impact of all factors not explicitly included
in the model.
• Accordingly, we must recognize the “fuzziness” of such estimates and
always proceed with caution in real applications.
The Demand Function
 
The Demand Curve
• A demand curve shows the quantity demanded at each
possible price, holding constant the other factors that
influence purchases.
• This is just like a regression coefficient – the sensitivity of
demand is estimated assuming all the other factors are constant.
Effects of a Price Change
• The Law of Demand states that consumers demand more of
a good if its price is lower or less when its price is higher.
• Accordingly, demand curves slope downward except under
extraordinary circumstances (asset bubbles).

• The demand curve is a concise summary of the answer to

the question: What happens to the quantity demanded as
the price changes, when all other factors are held constant?

• Changes in the quantity demanded in response to changes

in price are movements along the demand curve.
Effects of Other Factors
• Only own-price and quantity appear on a two-dimensional
graph but other factors still affect the quantity demanded.
• To capture the impact of these others factors graphically, a
change in any relevant factor other than own-price causes
a shift of the demand curve.
The Demand Function
• Assume the quantity demanded of coffee is a function of
its price p and income Y.
• Other factors are constant: Q = 8.5 - p + 0.1Y

• This specific linear form reflects empirical evidence; p is

negative and Y is positive. The constant (8.5) represents the
impact of all other factors.

• Where Y = 35 (an arbitrary choice for now), the demand

curve is : Q = 12 – p
• Notice that ∆Q = -∆p. So, if ∆p = −$2, then ∆Q = –(­−2) = 2 million
tons per year.
Calibrating Demand Models
• To calibrate a demand (or supply) model as a function of
several variables, we generally rely on historical data and
regression analysis.

• Using this technique, the sensitivity of demand to each

factor, in isolation, can be estimated.

• Recall that regression coefficients should be interpreted as

the rate of one variable changing as another does, holding
any other factors constant.
Regression Coefficients
• The magnitude of the coefficients are estimates of the
magnitude of a change in demand to a change in price,
part of what economists call the elasticity of demand.
• Own-price elasticity, Cross-price elasticity, Income elasticity, etc
• Elasticities are (regression coefficient * P/Q)

• While regression models are a good framework for

understanding the relationship that is being described, the
relationship is not defined by any given sample of data.
• Nonetheless, if you understand the idea of sensitivity to various
factors, you understand elasticity.

• Although price elasticities are negative for own-price and

complements, we typically report their absolute value,
noting whether something is a substitute or complement.
Price Elasticity of Demand
• The price elasticity of demand (or demand elasticity) is the
percentage change in quantity demanded, Q, divided by
the percentage change in price, p.

• Regression produces coefficient estimates of the first term

in the calculation of Point Elasticity:

ε = (∆Q /∆p) (p/Q)

Estimating Demand Elasticities
• While valuable, the data required to make regression
estimates may be empirically prohibitive to obtain.

• Instead, managers can estimate the elasticity (slope) by

comparing quantities just before and just after a price
change, assuming one can be reasonably sure that other
variables, such as income, have not changed appreciably.

• This estimate is called the arc-price elasticity of demand.

Arc Price Elasticity: ε = .

Elasticity Along the Demand
Curve
• There are 3 types of linear demand curves: horizontal,
vertical, or most commonly, downward-sloping
• The shape of the demand curve determines whether the
elasticity of demand varies or is the same at every price along
the demand curve.
• Price and quantity for certain products (c) may be functionally
impervious to changes but there is usually a limit this behaviour.
Elasticity Extremes
• Horizontal Demand Curves: ε = -∞ at every point
• If the price increases even slightly, demand falls to zero.
• Even a small increase in prices causes an infinite drop in quantity.
• Consumers view this good as identical to another good and do not
care which they buy.

• Vertical Demand Curves: ε = 0 at every point

• If the price goes up, the quantity demanded is unchanged, so ∆Q=0.
• A demand curve is vertical (perfectly inelastic) for essential goods—
goods that people feel they must have and will pay anything for it.
Elasticity: Downward Sloping
Demand
The higher the price, the more elastic demand becomes.
A 1% increase in price causes a larger percentage fall in
quantity near the top of the curve than near the bottom.
Cross-Price Elasticity
• Related goods are sorted as complements and substitutes,
depending on the sign of their regression coefficient.

• Complements are items which generally “go together

with” item X and thus when their prices move down,
quantity demanded of X goes up (a negative regression
coefficient).

• Substitutes are (imperfect) replacement items whose

prices move in the opposite direction as demand for X,
which is to say, when their prices rise, people which to X
and demand for it rises (a positive regression coefficient).
Income Elasticity
• Income Elasticity of Demand is defined as: (∆Q/∆Y) (Y/Q)

• Depending on the sign of the coefficient, a good may be

classified as normal or inferior
• Normal goods have positive income elasticity (coffee).
• Inferior goods have negative income elasticity (instant soup)
• https://www.dailymail.co.uk/femail/article-2287532/Helena-Rubinstein-She-revolutionised
-cosmetics-new-book-reveals-success-came-terrible-emotional-cost.html

• Since the same good may be considered normal to one

income level but not another, it is important to recall that
the sign may switch depending on the income level of the
person or group under study.
• Kraft Dinner may be upmarket for the poor but inferior for the rich.
Elasticity over Time
• The shape of a demand curve depends on the time period
under consideration.

• In general, it is easier to substitute between products in the

long run than in the short run (switching costs, information
costs, supplier loyalty, etc)

• Liddle (2012) estimated gasoline demand elasticities across

many countries and found that the short-run elasticity was
–0.16, and the long-run elasticity was –0.43.
Supply
• Firms determine how much to supply on the basis of the
price of that good and on other factors, including the costs
of producing the good.
• Many factors influence the supply produced including own-price,
production costs, technological change, government regulations, etc

• Costs of Production: labor, machinery, fuel and other direct and

indirect costs. As a firm’s cost falls it is usually willing to supply more
(holding price and other factors constant) and vice-versa
• Technological Change: the firm can produce at lower cost, allowing it to
supply more of that good at any given price (other factors constant).
• Government Regulations: can affect supply directly without working
through costs. For example, retailers may not sell most goods and
services on particular days of religious significance.
The Supply Function
 
The Supply Curve
A supply curve shows the quantity supplied at each possible
price, holding constant the other factors that influence firms’
supply decisions.
The Supply Function
• Assume the following supply function for coffee where p is
own-price:
Q = 9.0 + 0.5p
• This specific linear form reflects empirical evidence; p is
positive. The constant term, 9.0, represents all other factors

• Thus, a $1 increase in price causes the quantity supplied to

increase by 0.5 million tons per year.

• This change in q, induced by a change in p, is a movement

along the supply curve.
Effects of a Price Change
• The supply curve is usually upward sloping but can also be
vertical or flat.
• There is no “Law of Supply” requiring supply curves to slope upward
• A flat curve implies that firms faces a constant marginal cost while a
vertical supply curve indicates a hard cap of their capacity,
regardless of price.

• An increase in the own-price of a good causes a movement

along the supply curve, with more coffee being supplied.
• As the price increases (all other factors being equal), firms
will supply more to the market.
Effects of Other Factors
• As with demand, a change in any relevant factor other than
the good’s own-price causes the entire supply curve to shift
rather than a movement along the supply curve.
 Inverted D&S Functions
• An inverted supply/demand function solves for P rather than Q
• If Qd = 25 – 5P, and Qs = - 5 + 10P

• Then the inverted functions would be:

• P = 5 - 0.2Qd, and P = 0.5 + 0.1 Qs respectively

• These reformulations don’t include any new information but

can be useful in certain applications.
• In particular, most D&S diagrams are presented with price on the
vertical axis and thus correspond to inverse functions.

27
Aggregate Demand and Supply
• The overall demand and supply is composed of the demand
of many individual consumers.

• Total quantity demanded at a given price is the sum each

consumer’s quantity demanded at that price.

• Similarly, total quantity supplied at a given price is the sum

of what each firm supplies at that price.

• We can generalize this approach to look at the total demand

and supply across a whole market
• In macroeconomics, entire industries or countries.
Market Equilibrium
• Taken together, the aggregate demand and supply curves
from a market jointly determine the price and quantity at
which a good or service is bought and sold.

• The market is in equilibrium when all market participants

are able to buy or sell as much as they want.
• There is no excess supply or demand.

• By setting the quantity demanded equal to the quantity

supplied, we can solve the equilibrium price and the
equilibrium quantity.
• By allowing prices to float up and down, markets encourage suppliers
to bring their production into equilibrium with demand.
Market Equilibrium
Qd = Qs; 12 - p = 9 + 0.5p; p = $2.
Using Demand: Q = 12 – 2 = 10
 General vs. Partial Equilibrium
• When we concentrate on price and quantity, leaving other factors in
the residual, we are conducting a partial equilibrium analysis.
• We assume that exogenous factors do not correlate or feedback substantially
into prices and quantities.

• While this may seem naïve, this assumption greatly simplifies the
analysis and can sometimes be appropriate, as in small sub-markets
that aren’t large enough to influence aggregate prices and quantities
• In practice, feedback almost always occurs but the effect may not be significant
enough to affect local results.

• When such an assumption is not appropriate, we conduct a general

equilibrium analysis which considers all such interactions (prices of
substitute goods, wages level, etc).
• A constrained multivariate optimization – which is beyond this class
The Price Mechanism
• The price mechanism works by allowing buyers and sellers
to attach their own valuation to the product sold.
• Transactions are assumed to operate on a purely voluntary basis.
• If the market is transparent, prices also provide information about
the value of a particular good or factor to other market participants.

• In theory, prices should reflect ALL costs and benefits

associated with a good or service.
• When some costs or benefits do not accrue directly to a market
participant, they are called externalities and their lack of price can
lead to sub-optimal behaviour.
• Public goods like the environment often suffer from this problem as
access is frequently mispriced (if priced at all) in the name of
ensuring access to all.
Market Frictions
• In practice markets are rarely (if ever) AT equilibrium.
Rather, equilibrium is the point to which prices and
quantities will gravitate in the absence of market frictions.
• Costs related to searching for counterparties, negotiating with them,
contracting and monitoring, as well as those from agency costs and
asymmetric information.

• Due to the presence of so many active agents, market

equilibrium can be a “moving target” which can, at best,
only be approximated.
• Our models for supply and demand are derived from regression
analysis of historical data.
• Be cautious about equilibrium forecasts. The more “frictional” the
market, the more likely reality is to deviate from the estimate.
Shocks to the Equilibrium
The equilibrium changes only if a shock occurs that shifts the
demand and/or supply curves.
Shocks to the Equilibrium
Some events shift both the supply curve and the demand curve.
If both shift, the effect on the equilibrium price and quantity
may be difficult to predict.