Managerial Economics

Understanding market demand

Understanding market forces – Demand,
supply, equilibrium

Term I

Sumit Sarkar, XLRI Jamshedpur

Understanding market demand
Maximum WtP function = Demand function
Maximum
Price WtP
Consumers’ Surplus (CS) is the
difference between the consumer’s
80 willingness to pay and what she actually
is paying.
70 E.g., at P=40, the shaded area is CS.
60 With continuity, the white triangles
reduce.
50 CS = Area under the demand fn above
the price.
40
30
20
10
0 Cumulative
Quantity
100 190 305 400 530 690
830 1000 frequency
demanded
Demand function for bourbon biscuits in Sec-A
Demand function for bourbon biscuits in Sec-B
Demand function for nachos in Sec-C
Demand function for nachos in Sec-D
Change in quantity demanded for a change in price
of the product (other factors remaining constant)

p1

p0

X
X1 X0
Shift of the demand curve – change in demand

For all prices demand increases (or decreases) due to

change(s) in exogenous factor(s)

p With economic growth

and industrialization,
energy demand
increases.

p0

X0 X1 X
Shift of the demand curve – change in price of
substitutes (or availability of new substitutes)
Demand for gasoline is expected to reduce with the adoption
of electric vehicles (EVs)

px

p0

X0 X1 X
Shift of the demand curve – change in price of
complements
With an increase in the price of gasoline vehicles (GVs),
demand for gasoline reduces.

px

p0

X1 X0 X
Understanding market forces
Excess supply

At price $20 p($)

consumers demand
80 units, but
S
producers want to 20 The demand
supply 240 units. and the
supply
schedules
So, if the price is at are put in the
$20, there will be same graph.
160 units unsold in
D
the market.

80 240 X
Price must fall.
Excess demand

At price $10 p($)

consumers demand
240 units, but
producers want to S
supply 100 units.

So, if the price is at

10
$10, there will be
excess demand of
140 units. D

Price must rise. 100 240 X

Market Equilibrium

Price must be p($)

something between
$10 and $20.
S
20
At price $14, the
14
consumers
demand 160 unit 10
and the producers
want to supply D
160 units.
80 160 240 X
Market clears
 Price convergence to equilibrium
There is excess supply
of 160 units at p = 20. p($)
To sell 240, price must
be reduced to $10.
S
Market closes 20
At price $10, there
excess demand of 14
140 units. Price rises. 10
But does not go to 20.
D
Price fluctuates but
converges to the 200
80 100 X
equilibrium. 160 240
Price divergence
(Different demand and supply schedules)
Suppose there is excess
supply at p = 16. p($)
To sell 200, price must
be reduced to $4.
Market closes S

At price $4, there is

excess demand of 16
164 units. Price rises.

Price fluctuates and 4 D

diverges away from
36 100 200 X
the equilibrium.
 Case: Global Crude Oil Market

 Who demands?
◦ The world

 Who supplies?
◦ 80% of the supply comes
from 12 countries.

 How is the price

determined?
◦ Through the forces of
demand and supply.
 Demand side effect on price

 Increase in demand
shifts the demand p
S1
schedule from D1
to D2
 Supply being more
inelastic price p2
increases sharply. P0
 Not much change in
equilibrium output.
p1
 This explains D1
D2
general increasing
trend of oil price. X1 QX
02
X
Demand shock – effect on price
Supply response
Supply response to demand shock and
effect on price
Initially price was
p S2
p0
S1
Demand reduces to
D2
Price reduces to p1.
Equilibrium qty p00
P
reduces to X1 p2
Supply gets adjusted p1
As supply is D1
D2
contracted price
increases. X2 X00
Q X
X1
Oil price movement since the financial crisis
Why oil price dropped between
2014-16?
• Reduced demand?
◦ No. Demand increased.
◦ Average daily demand increased by approximately 2 million
barrels per day in 2014 as compared to previous year.
• Supply side explanation
◦ Supply increased.
◦ US production increased steadily.
 Fishbone fracking in North Dakota and Texas.
 In general cost of fracking reduced.
◦ OPEC could not reduce supply.
Increase in supply results in price fall

Supply schedule p
shifts right. The new
supply schedule is S1
S

Price falls from p0 S1

p0
to p1

p1
X1 quantity is D
demanded and
sold. X0 X1 X
Oil price movement since the financial crisis
Supply-demand gap
Problem 1 – Set 1
Suppose that the market supply and demand curves for wheat are,
respectively,

Prices are in ₹ per KG, and quantities in KG.

Government decided to buy enough wheat retain the price at ₹2
higher than the equilibrium price. The wheat bought by the
government will be used in the National Rural Employment
Program, which is outside the market system.
How much wheat (in KG) will the government buy?
Solution to Problem 1
In eqlm:
Govt. sets
At price of 22, and
Govt. buys the difference, i.e., 3000
Problem 2 – Set 1

Suppose that the government decided NOT to buy any wheat.

Instead, they offer a subsidy per KG of wheat sold. How much
subsidy (per KG) is required to retain the price at ₹2 higher than
the equilibrium price derived in Problem 1?

Which policy is more expensive for the government, the one

given in Problem 1 or this one?
Solution to Problem 2
Farmers get (inclusive of subsidy),
At , how much is the supply?

At what price will 11000 KGs be demanded?

Let it be
Using the demand function:
11000 KGs will be demanded at = 19
Subsidy required = 22 – 19 = 3
Govt. exp = 11000*3 = ₹ 33,000
Govt. exp in Prob 1 = 3000*22 = ₹ 66,000
Reading and problems
• Besanko & Braeutigam.
• Ch. 1 (Section 1.2)
• Problems 1.12, 1.13 and 1.14
• Ch. 2 (Section 2.1)
• Problems 2.1, 2.3, 2.6a, 2.7.