Transcript Managerial Economics in a Global Economy

Department of Business Administration
FALL 2007-08
Demand, Supply, and Equilibrium
by
Asst. Prof. Sami Fethi
Ch 3: Demand Theory
Demand, Supply and Equilibrium

Economics begins and ends with the
“Law” of supply and demand. The laws of
supply and demand are an important
beginning in the attempt to answer vital
questions about the working of a market
system.
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Ch 3: Demand Theory
Demand, Supply and Equilibrium

Demand for a good or service is defined as
quantities of a good or service that people
are ready (willing and able) to buy at
various prices within some given time
period, other factors besides price held
constant.
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Ch 3: Demand Theory
Demand, Supply and Equilibrium

The supply of a good or service is defined
as quantities of a good or service that
people are ready to sell at various prices
within some given time period, other factors
besides price held constant.
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Ch 3: Demand Theory
Demand, Supply and Equilibrium

Every market has a demand side and a supply side.
The demand side can be represented by a market
demand curve which shows the amount of
commodity buyers would like to purchase at
different prices.
 Demand curves are drawn on the assumption that
buyers’ tastes, income, the number of consumers
in the market and the price of related commodities
are unchanged.
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Ch 3: Demand Theory
Law of Demand

The inverse relationship between the price of the
commodity and the quantity demanded per period
is referred to as the law of demand.
 A decrease in the price of a good, all other things
held constant (ceteris paribus), will cause an
increase in the quantity demanded of the good.
 An increase in the price of a good, all other things
held constant, will cause a decrease in the quantity
demanded of the good.
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Ch 3: Demand Theory
Change in Quantity Demanded
Price
An increase in price
causes a decrease in
quantity demanded.
P1
P0
Q1
Q0
Quantity
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Ch 3: Demand Theory
Change in Quantity Demanded
Price
A decrease in price
causes an increase in
quantity demanded.
P0
P1
Q0
Q1
Quantity
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Ch 3: Demand Theory
Changes in Demand

Changes in price result in changes in the
quantity demanded.
– This is shown as movement along the demand
curve.

Changes in nonprice determinants result in
changes in demand.
– This is shown as a shift in the demand curve.
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Ch 3: Demand Theory
Changes in Demand

Nonprice determinants of demand
– Tastes and preferences
– Income
– Prices of related products
– Future expectations
– Number of buyers
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Ch 3: Demand Theory
Changes in Demand






Change in Buyers’ Tastes
-Today’ consumer purchases leaner meats compared to old generations
-due to the level of blood cholesterol and body weight
Change in Buyers’ Incomes
– Normal Goods
i.e., shoes, steaks, travel, automobiles, education
– Inferior Goods
– i.e., potatoes, hotdogs, hamburger
Change in the Number of Buyers
Change in the Price of Related Goods
– Substitute Goods
i.e., Carrots can be replaced by cabbage
– Complementary Goods
i.e., cars and gasoline or electric stove and electricity.
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Ch 3: Demand Theory
Change in Demand
An increase in demand
refers to a rightward shift
in the market demand
curve.
Price
P0
Q0
Q1
Quantity
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Ch 3: Demand Theory
Change in Demand
A decrease in demand
refers to a leftward shift
in the market demand
curve.
Price
P0
Q1
Q0
Quantity
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Ch 3: Demand Theory
Demand, Supply and Equilibrium

Every market has a demand side and a
supply side. The Supply side can be
represented by a market supply curve which
shows the amount of commodity sellers
would offer a sale at various prices.
 Supply curves are drawn on the assumption
of technology and input or resources (as
such labor, capital and land) and prices.
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Ch 3: Demand Theory
Law of Supply

The direct relationship between the price of the
commodity and the quantity supplied per period is
referred to as the law of supply.
 A decrease in the price of a good, all other things
held constant (ceteris paribus), will cause a
decrease in the quantity supplied of the good.
 An increase in the price of a good, all other things
held constant, will cause an increase in the
quantity supplied of the good.
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Ch 3: Demand Theory
Change in Quantity Supplied
A decrease in price
causes a decrease in
quantity supplied.
Price
P0
P1
Q1
Q0
Quantity
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Ch 3: Demand Theory
Change in Quantity Supplied
An increase in price
causes an increase in
quantity supplied.
Price
P1
P0
Q0
Q1
Quantity
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Ch 3: Demand Theory
Changes in Supply

Nonprice determinants of supply
– Costs and technology
– Prices of other goods or services offered by the
seller
– Future expectations
– Number of sellers
– Weather conditions
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Ch 3: Demand Theory
Changes in Supply




Change in Production Technology
- An improvement in the technology and a reduction in input prices would
make it possible to produce a commodity at a lower cost. This indicates that
sellers would be willing to sell more the goods at each price
Change in Input Prices
-↓ in agriculture product, ↓ price of lamb meat, ↑ quantity supplied so
rightward shift in the market supply curve
Change in the Number of Sellers
- ↑ in no of sellers, the market supply curve shifts to right or ↓ in no of sellers,
the market supply curve shifts to left
Prices of other goods or services offered by the seller
- i.e., BMW, Mercedes, Woswagen (Subs. Goods)
- i.e., lamp meat and lamp leather (comp. Goods)
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Ch 3: Demand Theory
Change in Supply
An increase in supply
refers to a rightward shift
in the market supply curve.
Price
P0
Q0
Q1
Quantity
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Ch 3: Demand Theory
Change in Supply
A decrease in supply refers
to a leftward shift in the
market supply curve.
Price
P0
Q1
Q0
Quantity
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Ch 3: Demand Theory





Market Equilibrium
Market equilibrium is determined at the
intersection of the market demand curve and the
market supply curve.
Equilibrium price: The price that equates the
quantity demanded with the quantity supplied.
Equilibrium quantity: The amount that people
are willing to buy and sellers are willing to offer
at the equilibrium price level.
The equilibrium price causes quantity demanded
to be equal to quantity supplied.
An increase or decrease in the demand or supply
curve, it defines a new equilibrium point.
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Ch 3: Demand Theory
Market Equilibrium

Price
D
S

P
Q
If the quantity
supplied of a
commodity exceeds
the quantity
demanded, this is
called excess supply
or surplus between D
and S over point p.
If the quantity
demanded of a
commodity exceeds
the quantity supplied,
this is called excess
demand or shortage
between D and S
below point p.
Quantity
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Ch 3: Demand Theory
Market Equilibrium

Shortage: A market situation in which the
quantity demanded exceeds the quantity
supplied.
– A shortage occurs at a price below the
equilibrium level.

Surplus: A market situation in which the
quantity supplied exceeds the quantity
demanded.
– A surplus occurs at a price above the
equilibrium level.
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Ch 3: Demand Theory
Market Equilibrium
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Ch 3: Demand Theory
Market Equilibrium
Price
D0
D1
S0
An increase in demand
will cause the market
equilibrium price and
quantity to increase.
P1
P0
Q0 Q1
Quantity
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Ch 3: Demand Theory
Market Equilibrium
Price
D1
D0
S0
A decrease in demand
will cause the market
equilibrium price and
quantity to decrease.
P0
P1
Q1 Q0
Quantity
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Ch 3: Demand Theory
Market Equilibrium
Price
D0
S0
P0
P1
Q0 Q1
S1
An increase
in supply
will cause
the market
equilibrium
price to
decrease and
quantity to
increase.
Quantity
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Ch 3: Demand Theory
Market Equilibrium
Price
D0
S1
P1
P0
Q1 Q0
S0
A decrease in
supply will
cause the
market
equilibrium
price to
increase and
quantity to
decrease.
Quantity
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Ch 3: Demand Theory
The Demand Schedule and the demand curve
Example

How can the relationship between quantity
demanded and price be portrayed?

Demand schedule

Demand curve
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Ch 3: Demand Theory
Table 1: A demand schedule for carrots

P (price per ton)
D (quantity demanded)
Thousands ton per months
U
$ 20
110
V
40
90
W
60
77.5
X
80
67.5
Y
100
62.5
Z
120
60
Av income:$
Table
1
is
a
hypothetical demand
schedule for carrots.
It shows the quantity
of carrots that would
be demanded at
various prices on the
assumption
that
average household
income is fixed at $
20000 and all other
price do not change.
(i.e. if the price of
carrots were $60 per
ton,
consumers
would
desire
to
purchase
$77,500
tons of carrots per
month.
20000
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Ch 3: Demand Theory
A demand curve for carrots

A second method of showing the relation between
quantity demanded and price is to draw a graph. It is a
downward slope which indicates quantity demanded
increases as price falls.
140
120
Price
100
80
60
40
20
0
60
62.5
67.5
77.5
90
110
Quantity
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Ch 3: Demand Theory
Shifts in the demand curve-Example


A demand curve or line is drawn on the assumption that
everything except the commodity’s own price is held
constant. A change in any of variables previously held
constant will shift the demand curve or line to a new
position. (i.e. A rise in household income has shifted the
demand curve or line to the right.
A demand curve can shift in mainly two ways: If more
bought at each price, the demand curve shift right so that
each price corresponds to a higher quantity than before. If
less is bought at each price, the demand curve shifts left so
that each price represents to a lower quantity than before.
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Ch 3: Demand Theory
Table 2: Two Alternative Demand Schedule for
 An
increase
carrots
P
Q (D)
Q1 (D1)
$ 20
110
140
40
90
116
60
77.5
100.8
80
67.5
87.5
100
62.5
81.3
120
60
78
Av in:
$ 20000
$ 24000
in
average income will
rise the quantity
demanded at each
price. When AV
income rises from
$20000 to $ 24000
per year, quantity
demanded at price of
$60 per ton increases
from 77500 tons per
month to 100800
tons per month.
Similar rise occurs at
every other price.
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Ch 3: Demand Theory
Table 2: Two Alternative Demand Schedule for
carrots

Put differently, A rise in av household income shifts
the demand curve for most commodities to right so
this indicates that more will be demanded at each
possible price. Ultimately, the demand schedule
relating columns P and D is replaced by one relating
columns P and D1 in the previous table. The
graphical presentation of the two functions are seen
in the following graph.
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Ch 3: Demand Theory
Shifts in the demand curve-Example
Q (D)
Q1 (D1)
$ 20
110
140
40
90
116
60
77.5
100.8
80
67.5
87.5
100
62.5
81.3
120
60
78
160
140
120
100
80
60
40
20
0
price
P
Q1D1
QD
60 80 90 100 120 140
Quantity
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Ch 3: Demand Theory
Other Prices

Earlier, we saw that the downward slope of a
commodity’s demand curve occurs because the lower
its price, the cheaper the commodity is relative to
other commodities that can satisfy the same needs or
desires. Those other commodities are called
substitutes (i.e. Carrots can be made cheap relative to
cabbage either by lowering the price of carrots or
raising the price of cabbage).
 A rise in the price of a substitute for a commodity
shifts the demand curve for the commodity to the
right.
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Ch 3: Demand Theory
Other Prices

Another class of commodities is called complements.
These are the commodities that tend to be used
jointly each other. Such as cars and gasoline or
electric stove and electricity.
 A fall in the price of a complementary commodity
will shift a commodity’s demand curve to the right.
 For example, a fall in the price of airplane trips to
Paris will lead to a rise in the demand for Disney
Land tickets at paris even though their price is
unchanged.
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Ch 3: Demand Theory
Tastes

Tastes have a large effect on people’s
desired purchased. A change in tastes may
be long-lasting such as the shift from
fontain pens to ball-point pens. In this case,
a change in tastes in favor of a commodity
shifts the demand curve to the right.
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Ch 3: Demand Theory
Distribution of Income

A change in the distribution of income will shift to the
right the demand curves for commodities bought most by
those gaining income. On the other hand, it will shift to the
left the demand curves for commodities bought most by
those losing income.
 If, for example, the government increases the deductions
for children on the income tax and compensates by raising
basic taxes, income will be transferred from childness
persons to the large familes. So commodity more heavily
bought by families with no child decline in demand.
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Ch 3: Demand Theory
Population

Population growth does not by itself create new
demand. The additional people must have
purchasing power before demand is changed.
 Extra people of working age, however, usually
means extra output and if they produce, they will
earn income.
 When this happens, the demand for all the
commodities purchased by the new income earners
will rise. Thus a rise in population will shift the
demand curves to the right.
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Ch 3: Demand Theory
Individual Demand function

The demand for a commodity arises from the
consumers’ willingness and ability to purchase the
commodity. Consumer demand theory postulates
that the quantity demanded of a commodity is a
function of / or depends on the price of the
commodity, the consumers’ income, the price of
related commodities, and the tastes of the
consumer.
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Ch 3: Demand Theory
Functional form

Qdx= (Px, I, Py, T)

An inverse relationship is expected between
the quantity demanded of a commodity and
its price (law of demand). That is, when the
price rises, the quantity purchased declines,
and when the price falls, the quantity sold
increases.
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Ch 3: Demand Theory
Functional form
Qdx= (Px, I, Py, N,T)
QdX/PX < 0
QdX/I > 0 if a good is normal
QdX/I < 0 if a good is inferior
QdX/PY > 0 if X and Y are substitutes
QdX/PY < 0 if X and Y are complements
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Ch 3: Demand Theory
Recall: Consumer Demand Theory


Consumer demand theory postulates that the quantity
demanded of a commodity per time period increases with a
reduction in its price, with an increase in the consumer’s
income, with an increase in the price of substitute
commodities and a reduction in the price of complementary
commodities, and with an increased taste for the commodity.
On the other hand, the quantity demanded of a commodity
declines with the opposite changes.
Consumer demand theory postulates that the quantity
demanded of a commodity is a function of / or depends on
the price of the commodity, the consumers’ income, the price
of related commodities, the number of consumers in the
market, and the tastes of the consumer.
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Ch 3: Demand Theory
Relating Concepts



The increase in Qx when Px falls occurs because in
consumption, the individual consumer substitutes commodity x
for other commodities which are now relatively expensive. This
is called the substitution effect.
In addition, when Px falls, a consumer can purchase more of x
with a given amount of money (i.e., the consumer’s real income
increases). This is called the income effect.
The movement along a given demand curve resulting from a
change in the commodity price is referred to as a change in the
quantity demanded, while a shift in the demand curve resulting
from a change in any of the factors that affect demand, other
than the commodity price, is referred to as a change in demand.
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Ch 3: Demand Theory
Individual and Market Demand Curve
Example
Horizontal Summation: From Individual to Market
Demand
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Ch 3: Demand Theory
Individual and Market Demand Curve
Example

Given the following data: Pdx=$4 and Qdx=4 and
Qddx=400, while at Px=$3, Qdx=6 and Qdd=600,
construct the relevant individuals and market curves
Market
8
6
4
2
0
Px
Px
Individuals
0
2
4
6
Qdx
8
10
12
8
6
4
2
0
0
200
400
600
800
1000
1200
Qdx
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Ch 3: Demand Theory
Price Elasticity of Demand

The price elasticity of demand (Ep) is
measured by the percentage change in the
quantity demanded of the commodity
divided
by the percentage change in
commodity’s price, holding constant all
other variables in the demand function.
Q / Q Q P
EP 


P / P P Q
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Ch 3: Demand Theory
Price Elasticity of Demand
Point Definition
Or Elasticity at
given point
Linear Function
Q / Q Q P
EP 
 
P / P P Q
P
EP  a1 
Q
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Ch 3: Demand Theory
Price Elasticity of Demand

Arc Definition
Q2  Q1 P2  P1
EP 

P2  P1 Q2  Q1
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Ch 3: Demand Theory
Marginal Revenue and Price Elasticity of
Demand

1 
MR  P 1 

E

P 
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Ch 3: Demand Theory
Price Elasticity of Demand- Example

Market

Px

8
A
6
4
2
0
0

B
200

C
400
D
600
E
800

F
G
1000 1200

Find Ep at point A, B, C
and G
Ep=(ΔQ/ ΔP) (P/Q)
At point A, Ep=(200-0/ 56) (6/0)
Ep=-200 (6/0)= - indefinite
At point B, Ep= (-200/1)
(5/200)=-5
At point C, Ep=(-200)
(4/400)=-2
At point G, Ep=(-200)
(0/1200)=0
Qdx
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Ch 3: Demand Theory
Price Elasticity of Demand- Example

Find Ep at point A, B, C and G
 Ep=(ΔQ/ ΔP) (P/Q)
 At point A, Ep=(200-0/ 5-6) (6/0)
 Ep=-200 (6/0)= - indefinite
 At point B, Ep= (-200/1) (5/200)=-5
 At point C, Ep=(-200) (4/400)=-2
 At point G, Ep=(-200) (0/1200)=0
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Ch 3: Demand Theory
Arc Elasticity of Demand- Example







Find arc Ep between points B and C
Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1)
Ep= (400-200)/(4-5) (4+5)/(400+200)
Ep=-3
Market
Absolute value of Ep
8
A
6
B
Greater than 1- elastic
C
4
D
2
Equals 1- unit elastic
0
Less than 1- inelastic
0
200
400
600
Px

E
800
F
G
1000
1200
Qdx
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Ch 3: Demand Theory
MR and TR based on Elasticity- Example
P
1
$6
5
4
3
2
1
0
Q
2
0
200
400
600
800
1,000
1,200
Ep
3
- indefinite
-5
-2
-1
-1/2
-1/5
0
TR
2
$0
1,000
1,600
1,800
1,600
1,000
0
MR
5
5
3
1
-1
-3
-5
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Ch 3: Demand Theory
MR and TR based on Elasticity- Example








Find MR by using P and Ep at Px =$4 and $3
MR= P{1+(1/Ep)}
At Px =$4 MR=4{1+(1/-2)=$2
At Px =$3 MR=3{1+(1/-1)=0
Based on the previous table:
P decreases TR increases when Ep is elastic
TR max or unchanged when Ep is unitary elastic
TR decreases when Ep is inelastic
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Ch 3: Demand Theory
Graphically Showing Elasticities and MR-TR
MR>0 MR<0
EP  1 E  1
TR
P
0
600
1200
EP  1 MR=0
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Ch 3: Demand Theory
Graphically Showing Elasticities and MR-TR
PX
6
EP  1
EP  1
EP  1
0
600
1200
QX
MR
X
Managerial Economics
59
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income Elasticity of Demand

Point
Definition

Linear
Function
EI 
Q / Q Q I


I / I
I Q
EI  a3 
I
Q
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income Elasticity of Demand
Arc Definition
Q2  Q1 I 2  I1
EI 

I 2  I1 Q2  Q1
Normal Good
E
I
E
I
EI  0
 0
Luxuries Good
 1
Inferior Good
necessities Good
0 <I E < 1
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Ch 3: Demand Theory
Cross-Price Elasticity of Demand
Point Definition
Linear Function
E XY
QX / QX QX PY



PY / PY
PY QX
E XY  a4 
PY
QX
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Cross-Price Elasticity of Demand
Arc Definition
Substitutes
EXY  0
QX 2  QX 1 PY 2  PY 1
EXY 

PY 2  PY 1 QX 2  QX 1
Complements
EXY  0
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Income, Cross and Arc Elasticises- Example

Px
Find arc EI between two levels of income i.e I=$10000 and
I=$ 11000
Market
 Ep=(Q2-Q1)/(I2-I1) (I2+I1)(Q2+Q1)
8
A
6
B
C
 Ep= (600-400)/(11-10) (11+10)/(600+400) 4
D
E
2
F
0
 EI= 4.2
0
200 400 600 800 1000
Qdx
 Thus commodity x is normal and luxury.
 Find arc Exy between two levels of price y i.e Py=$ 1 and Py
=$ 2
 Ep=(Q2-Q1)/(P2-P1) (P2+P1)(Q2+Q1)
 Ep= (600-400)/(2-1) (2+1)/(600+400)
 EI= 0.
 Thus commodity y is substitute compared to commodity X
G
1200
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticises In Managerial Decision MakingExample

A firm selling coffee brand X and estimated
relevant demand regression as follows:
 Qx=1.5-3.0 Px+0.8 I+2.0 Py-0.6 Ps+1.2 A
 Qx is sales of coffee brand X, I is disposable
income, Py is price of competitive coffee brand,
Ps is price of sugar and A is advertising
expenditures for coffee brand X.
 Suppose: Px=$2, I=$2.5, Py=$1.80, Ps=$0.50 and
A=$1
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticities In Managerial Decision
Making-Example





Calculate Qx and the elasticities of sales with respect
to each variable in the relevant demand function
Qx=1.5-3.0(2)…1.2(1)=2 mn pounds coffee
Ep=-3(2/2)=-3, Ei=0.8(2.5/2)=1, Exy=2(1.8/2)
Exs=-0.6(0.5/2)=-0.15, Ea=1.2(1/2)=0.6
RECALL the Formulae
EP
P
 a1 
Q
E XY
PY
 a4 
QX
EI  a3 
I
Q
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Managerial Economics
© 2007/08, Sami Fethi, EMU, All Right Reserved.
Ch 3: Demand Theory
Using Elasticises In Managerial Decision Making-Example





Next year, the firm would like to increase Px by 5%,
A by 12%, I by 4%, and Py 7% whereas Ps fall by
8%.
Determine sales of coffee brand X in the next year.
Qxx=Qx+Qx(DPx/Px)Ep……+Qx(DA/A)Ea
Qxx=2+2(5%)(-3)…..+2(5%)(0.6)
Qxx=2.2 or 2,200,000 pounds
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Managerial Economics
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Ch 3: Demand Theory
The End
Thanks
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© 2007/08, Sami Fethi, EMU, All Right Reserved.