Transcript managerial-economics-Lecture2

Managerial Economics
Lecture 2:
The Market System
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Learning Objectives
 Demand and Supply
 The Market Forces of Supply and Demand
 Markets and Competition
 Market Equilibrium
 Price Control
 Comparative Static Analysis
1-2
Demand and Supply
1-3
Market Forces of Supply and Demand
 A market is made up of two parties- the buyer and the seller.
 The buyer represents demand and the seller supply.
 Supply and Demand are the two words that economists use often.
 Supply and Demand are the forces that make market economies
work.
 They are referred as forces because they act in different ways and
cause prices to change.
 They determine the quantity of each good produced and the price at
which it is sold.
1-4
Markets and Competition
 Market is a group of sellers and buyers of a particular good or
service.
 The sellers as a group determine the supply of the product and the
buyers as a group that determine the demand for the product.
 Markets take many forms.
– Sometimes markets are highly organized such as, the markets for auctioning
many commodities.
– More often markets are less organized such as, the market for perfumes.
• Firms manufacturing and selling perfume are varied and seek to offer
different products for sale which they hope will be distinctive.
1-5
Markets and Competition
• The market for perfume, like most market in the economy, is competitive.
 Competition exist when two or more firms are rivals. Each firm strives
to gain the attention and custom of buyers in the market.
 A competitive market is a market in which they are many buyers
and many sellers so that each has a negligible impact on the market
price.
 In the perfume market, sellers may have some limited control over
price because of the way they can differentiate their product from
competitors.
1-6
Markets and Competition
 Basically, there are four main types of markets.
– Perfect competitive market: In this market,
• the goods being offered for sale are all the same (homogenous)
• many buyers and sellers and as a result no single buyer or seller can
influence the market price.
– Monopoly: in this market, there is only one seller and this seller sets
the price.
– Oligopoly: in this market, there are few sellers that do not always
compete aggressively.
– Monopolistic competition: it contains many sellers but each offers
slightly different product. For example: mobile telephony market.
1-7
Demand
.
1-8
Demand

Demand is the amount of goods and services that a consumer is willing
and able to buy at alternative prices at a given period of time.

The quantity demanded of any good is the amount of the good that buyers
are willing and able to purchase.

Consumers are willing to buy more when the prices of products and
services are low and vice versa.

This relationship between price and quantity demanded is called the law of
demand :
–
All other things being equal, when the price of a good falls the quantity
consumers are willing to buy (quantity demanded) rises and the reverse is true.
1-9
Demand
Demand Curve
 Demand curve is the curve that relates price to quantity demanded.
 It slopes downwards because, other things being equal, a higher price
means a lower quantity demanded and the reverse is true.
Price
An
decrease
in price..
Increases in the
quantity demanded
Quantity demanded
1-10
Demand
Market Demand versus Individual Demand.
 Market demand is the sum of demands of all consumers.
 We sum the individual demand curves horizontally to obtain the market
demand curve.
Market demand
Ama’s demand
Kofi’s demand
P
P
D Kofi
Qty dd
P
D Market
D Ama
Qty dd
Qty ss
Qty dd
1-11
Demand
Determinants of Demand (Shift In The Demand Curve)
 Income – lower incomes mean that people have less to spend in total, so
they are likely to spend less on some- and probably most – goods.
– if the demand for a good falls when income falls and vice versa, the good is
called a normal good.
– If the demand for a good rises when income falls and vice versa, the good is
called an inferior good.
 Prices of related goods- prices of related goods such as substitutes and
complements
– When a fall in the price of one good reduces the demand for the other and vice
versa, the two goods are called substitutes. Example Pepsi and Coca- Cola.
1-12
Demand
Determinants of Demand (Shift In The Demand Curve)
– When a fall in the price of one good increases the demand for the other and vice
versa, the two goods are called complements. Example flash light and battery.
 Tastes and Preferences- if people enjoy more of or prefer one product to
the other, they end up demanding more of the preferred (enjoyed) product.
 Expectations - if consumers anticipate an increment in the price of a
product in the future, they end up demanding more of such product now and
vice versa. However, this depends on the perishability of the product.
 Population – the size and composition of population also affect demand.
– A larger population, other things being equal will demand for all goods and
services and vice versa.
1-13
Demand
Determinants of Demand (Shift In The Demand Curve)
– If the population is an ageing one then there will be high demand for health care
services and retirement homes.
 Advertising- both informative advertising and persuasive advertising
influence the level of demand for a product.
– Informative advertising tends to create awareness about the existence of a
product and its quality.
– Persuasive advertising is used by companies to lure consumers to patronize their
products.
1-14
Demand
Demand Equation
 A general equation representing the demand curve
Qxd = βo + β1Px + β2Py + β3M + β4H
– Qxd = quantity demand of good X.
– Px = price of good X (coefficient is negative)
– PY = price of a related good Y.
• Substitute good. (coefficient is positive)
• Complement good (coefficient is negative)
– M = income.
• Normal good (coefficient is positive)
• Inferior good (coefficient is negative)
– H = any other variable affecting demand
1-15
Demand
Demand Equation
Problem:
An economic consultant for Despite Group of Companies recently provided the
firm’s marketing manager with this estimate of the demand function for the
firm’s product:
Qxd =12,000 - 3Px + 4Py - 1M + 2Ax
where Qxd 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 Ax represents the amount of
advertising spent on good X. Suppose good X sells for $200 per unit, good Y
sells for $15 per unit, the company utilizes 2,000 units of advertising, and
consumer income is $10,000. How much of good X do consumers
purchase? Are goods X and Y substitutes or complements? Is good X a
normal or an inferior good?
1-16
Demand
Inverse Demand Function
 Price as a function of quantity demanded.
 Example:
– Demand Function
• Qxd = 10 – 2Px
– Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd
1-17
Demand
Shifts vs Movements along the Demand
Curve
1-18
Demand
Shifts vs Movements along the Demand Curve
 A distinction must be made between a shift in the demand curve and the
movement along the demand curve.
 A shift in the demand curve is caused by a factor affecting demand other than
a change in price.
 If any of these factors change, then the amount consumers are willing to
purchase for consumption changes, whatever the price.
 The shift in the demand curve refers to as an increase or decrease in demand
 On the other hand, a movement along a demand curve occurs when there is a
change in price.
 This movement along the demand curve is referred to as a change in quantity
demanded.
1-19
Change in Quantity Demanded
Price
Changes in the price
of a good lead to a
change in the quantity
demanded of that
good.
This
corresponds
to
a
movement along a
given demand curve.
A to B: Increase in
quantity demanded
10
A
B
6
D0
4
7
Quantity
1-20
Change in Demand
Price
Changes in variables other
than the price of a good,
such as income or the
price of another good, lead
to a
change in demand. This
corresponds to a shift of
the entire demand curve.
D0 to D1: Increase in
Demand
6
D1
D0
7
13
Quantity
1-21
Supply
.
1-22
Supply
 Supply is the amount of goods and services a producer is willing
and capable to offer/produce at alternative prices at a given time
period.
 The quantity supplied of any good or service is the amount that
sellers are willing and able to sell.
 Suppliers are willing to supply more when prices of their products and
services are high and vice versa.
 This relationship between price and quantity supplied is called the
law of supply :
– All other things being equal, when the price of a good rises the quantity
producers are willing to supply rises and the reverse is true.
1-23
Supply
Supply curve
 Supply curve is a curve that relates price to quantity.
 It slopes upwards because, other things being equal, a higher price means a
greater quantity supplied and the reverse is true.
Price
An
Increase
in price..
Increases in the
quantity supplied
Quantity Supplied
1-24
Supply
Market Supply versus Individual Supply.
 Market supply is the sum of supplies of all sellers.
 We sum the individual supply curves horizontally to obtain the market supply
curve.
Market supply
Geisha supply
Delay supply
P
S Delay
P
Qty ss
S Market
S Geisha
P
Qty ss
Qty ss
Qty ss
1-25
Supply
Determinants of Supply (Shift In The Supply Curve)
 There are many variables that can shift the supply curve. Some of which are:
– Input prices- if input prices rise substantially, some firms might shut down or cut
down on supply and the reverse is true.
– Technology- advances in technology increase productivity allowing more to be
produced using fewer factor input. As a result costs, both total and unit, may fall
and supply increases.
– Expectations – if producers expect the price of their goods to rise in the future,
they may put some of their current stock into storage and supply less to the
market today.
– The number of sellers- if there are more producers of a product, then the
amount of that product would be likely to rise.
1-26
Supply
Determinants of Supply (Shift In The Supply Curve)
– Natural/ social factors- there are often many natural or social factors that affect
supply. These include such things as
• The weather affecting crops
• Natural disasters
• Pestilence and disease
• Changing attitudes and social expectations ( eg. reducing carbon emissions)
• Christmas, Valentine’s day, Eid and so on.
1-27
Supply
Supply Equation

An equation representing the supply curve:
Qxs = βo + β1Px +β2Py + β3S + β4T+ β5E+ β6IP + β7H
– QxS = quantity supplied of good X.
– Px = price of good X (coefficient is positive)
– PY = price of a substitute good Y (coefficient is negative)
– S= Season
• Favorable (coefficient is positive)
• Unfavorable (coefficient is negative)
– T = Technology(coefficient is positive)
– E= Expectation
• Rise in price in the future(coefficient is negative)
• Decrease in price in the future(coefficient is positive)
– IP=Input prices
• High prices (coefficient is negative)
• Low prices (coefficient is positive)
– H= Other Variable
1-28
Supply
Supply Equation
 Problem:
Your research department estimates that the supply function for
television sets is given by
Qxs = 2,000 + 3Px - 4Pr - Pw
where Px is the price of TV sets, Pr represents the price of a
computer monitor, and Pw is the price of an input used to make
television sets. Suppose TVs are sold for $400 per unit, computer
monitors are sold for $100 per unit, and the price of an input is
$2,000. How many television sets are produced?
1-29
Supply
Inverse Supply Function
 Price as a function of quantity supplied.
 Example:
– Supply Function
• Qxs = 10 + 2Px
– Inverse Supply Function:
• 2Px = 10 + Qxs
• Px = -5 + 0.5Qxs
1-30
Supply
Shifts vs Movements along the Supply
Curve
1-31
Supply
Shifts vs Movements along the Supply Curve
 A distinction must be made between a shift in the supply curve and the
movement along the supply curve.
 A shift in the supply curve is caused by a factor affecting supply other than a
change in price.
 If any of these factors change, then the amount sellers are willing to offer for
sale changes, whatever the price.
 The shift in the supply curve refers to as an increase or decrease in supply
 On the other hand, a movement along a supply curve occurs when there is a
change in price.
 This movement along the supply curve is referred to as a change in quantity
supplied.
1-32
Change in Quantity Supplied
A to B: Increase in
quantity supplied
Price
Changes in the price
of a good lead to a
change
in
the
quantity
supplied of that good.
This corresponds to a
movement along a
given supply curve.
S0
B
20
A
10
5
10
Quantity
1-33
Change in Supply
S0 to S1: Increase in supply
Price
Changes in variables
other than the price
of a good, such as
input
prices
or
technological
advances, lead to a
change in supply.
This corresponds to
a shift of the entire
supply curve
S0
S1
8
6
5
7
Quantity
1-34
Market Equilibrium
.
1-35
Market Equilibrium

Market equilibrium is a situation in which the price has reached the level where
quantity supplied equals quantity demanded.

The price at this intersection (where quantity supplied equals quantity demanded) is
called the equilibrium price and the quantity is called the equilibrium quantity.

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
– Sellers have sold all they want to sell
– There is neither a shortage nor a surplus
1-36
Market Equilibrium
 The Price (P) that
Balances supply and
demand
– QxS = Qxd
– No shortage or surplus
 Steady-state
– Quantity supplied equals
quantity demanded
1-37
Market Equilibrium
Price
E= Equilibrium
Pe= Equilibrium Price
Qe= Equilibrium Quantity
E
Pe
Qe
Quantity bought
and sold
1-38
Market Equilibrium
If price is too low…
Price
S
7
6
5
D
Shortage
12 - 6 = 6
6
12
Quantity
1-39
Market Equilibrium
If price is too high…
Surplus
14 - 6 = 8
Price
S
9
8
7
D
6
8
14
Quantity
1-40
Market Equilibrium
Problem
According to an article in Daily Graphic, Ghana recently accelerated its
plan to privatize certain state-owned firms. Imagine that you are a
business economist, and you have been asked to help the committee
to determine the price and quantity that will prevail when competitive
forces are allowed to equilibrate the market. The best estimates of
the market demand and supply for the good (in U.S. dollar equivalent
prices) are given by
Qd =10 - 2P and Qs = 2 + 2P, respectively.
Determine the competitive equilibrium price and
quantity.
1-41
Price Control/Restrictions
Government’s intervention in the free market
1-42
Price Control
Price Ceiling
 The economic doctrine of scarcity is that there are not enough goods to
satisfy the desires of all consumers at a price of zero.
 Corollary to this, some method must be used to determine who gets to
consume goods and who does not.
 People who do not get to consume goods are essentially discriminated
against.
 One way to determine who gets a good and who does not is to allocate the
goods based on the following:
– If you are left-handed, you get the good; if you are not left-handed, you don’t get
the good.
1-43
Price Control
Price Ceiling
 Often persons who are discriminated against by the price system attempt to
lure the government to intervene in the market by requiring producers to sell
the good at a lower price.
 This is only natural, for if we were unable to own a house because we are
right-handed, then the government has to step in to allow us own a house.
 But then there would be too few houses to go around, and some other
means would have to be used to allocate houses to people.
 That brings in the price ceiling- maximum legal price of a product in the
market.
1-44
Impact of a Price Ceiling
Lost of social
welfare due to
price ceiling
Price
PF
S
F
P*
Under the price ceiling of Pc, only
Qs units of the good are available.
Since this quantity corresponds to
point F on the demand curve, we
see that consumers are willing to
pay PF for another unit of the good.
By law, however, they cannot pay
the firm more than Pc. The
difference, PF - Pc, reflects the price
per unit consumers are willing to pay
by waiting in line.
PC
ceiling
D
Shortage
Qs
Q*
Qd
Quantity
1-45
Price Control
Price Ceiling
Full Economic Price
 The cedi amount paid to a firm under a price ceiling, plus the non-pecuniary
price.
PF = Pc + (PF - PC)
– PF = full economic price
– PC = price ceiling
– PF - PC = nonpecuniary price (implicit amount paid by waiting in line)
Note: nonpecuniary price is paid not in cedis but through opportunity cost.
1-46
Price Control
Price Ceiling
Full Economic Price
Problem
one of the parliamentarians in Ghana raises a concern that the
free market price for a bag of cement might be too high for the
typical Ghanaian citizen to pay. Accordingly, she asks you to
explain what would happen if the Ghanaian government
privatized the market, but then set a price ceiling at the
Ghanaian equivalent of $1.50. How do you answer? Assume
that the market demand and supply curves (in U.S. dollar
equivalent prices) are still given by
Qd= 10 -2P and Qs= 2 + 2P
1-47
Price Control
Price Ceiling
Reasons and consequences for price ceiling
Reasons
 It helps to ensure fairness (equity).
Consequences
 It results in long lines such as those created in 1983 due to price ceiling.
 price ceilings discriminate against people who have a high opportunity
cost of time and do not like to wait in lines.
1-48
Price Control
Price Ceiling
Lessons to Managers
 First come, first serve
 Sell products to loyal customers
 Bank managers may allocate money only to consumers who
are relatively well-to-do.
1-49
Price Control
Price Ceiling
Problem
Consider the following demand and supply equations for the product of a perfectly
competitive industry.
QD = 300-3P
Qs = 100 + 5P
Where Q is quantity and P is price.
a. Determine the market equilibrium price and quantity algebraically.
b. Suppose that an increase in consumer income resulted in the new demand
equation
QD = 420 -3P
What are the new equilibrium price and quantity?
c. Suppose the government enacts legislation that imposes a price ceiling
equivalent to the original equilibrium price. What is the result of this
legislation?
1-50
Price Control
Price Floor
 Sometimes the equilibrium competitive price may be considered too low for
producers.
 Individuals may lobby for the government to legislate a minimum legal price
for a good.
 Such a price is called a price floor. For instance, the minimum wage.
1-51
Impact of a Price Floor
Price
Surplus
S
PF
P*
D
Qd
Q*
QS
Price floor is set above the
competitive equilibrium level, such as
Pf, there is an effect. Specifically,
when the price floor is set at Pf,
quantity supplied is Qs and quantity
demanded is Qd . In this instance,
more is produced than consumers
are willing to purchase at that price,
and a surplus develops. In the
context of the labor market, there are
more people looking for work than
there are jobs at that wage, and
unemployment results. In the context
of a product market, the surplus
translates into unsold inventories.
Quantity
1-52
Price Control
Price Floor
Problem
Consider the following demand and supply equations for a product
QD = 25-3P
Qs = 10 + 2P
a.
Determine the market equilibrium price and quantity.
b.
Suppose that government regulatory authorities imposed a ‘price floor’ on
this product of P = Ȼ4. What would be the quantity supplied and quantity
demanded of this product? How would you characterize the situation in this
market?
1-53
Comparative Static Analysis
1-54
Comparative Static Analysis
 How do the equilibrium price and quantity
change when a determinant of supply and/or
demand change?
1-55
Comparative Static Analysis
Three Steps to Analyzing Changes in Equilibrium
 Decide whether the event shifts the supply or demand curve (or perhaps
both).
 Decide in which direction the curve shifts.
 Use the supply and demand diagram to see how the shift changes the
equilibrium price and quantity.
1-56
Comparative Static Analysis
Example: A Change in Demand
 Suppose that a government-sponsored research projects finds that
using soymilk helps reduce the risk of heart disease and strokes.
– How does this event affect the market for soymilk?
1-57
Comparative Static Analysis
Answer
 This news has a direct effect on the demand curve, by changing
people’s taste for soymilk.
– That is, the report changes the amount of soymilk that people want to buy at any
given price.
1-58
Comparative Static Analysis
1) Because the report incentivizes
people to use more soymilk, the
demand curve shifts to the right
(D1 - D2)
1) Report on positive
effects of soymilk
increases demand…..
Price of
Soymilk
per crate
2) This shift indicates that the
quantity of soymilk demanded is
higher at every price.
S1
4)….
Resulting
in a
higher
price…
3)…. Which puts
pressure on prices to
rise which encourages
suppliers to offer more
4
3
2) …. Which
causes a
shortage in the
market….
D2
D1
6
8
12
Quantity Bought and Sold
5)… and a higher quantity
bought and sold.
3) The shift in demand has led to a
shortage of soymilk in the market.
4) At a price of GHC3.00 buyers
now want to buy 12 crates of
soymilk, but sellers are only
offering 6 crates ( a shortage of 6
crates).
5) The shortage starts to force up
prices and encourages suppliers
to supply more soymilk.
6) The additional production incurs
extra costs and so a higher price
is required to compensate the
suppliers. Thus the equilibrium
price and quantity moves from 3 to
4 and 6 to 8 respectively.
1-59
Comparative Static Analysis
Example: A Change in Supply
 Suppose that, during another dry season, bad weather destroys
soybeans and drives up the world price of soybeans.
 How does this event affect the market for soymilk ?
1-60
Comparative Static Analysis
Price of
Soymilk
per crate
1) An increase in the
price of soybean
reduces the supply of
soymilk…..
S2
S1
4)….
Resulting
in a
higher
price…
3)…. Which puts
pressure on
prices to rise
4
3
2) …. Which
causes a
shortage in the
market….
D1
6
8
12
5)… and a lower quantity
bought and sold.
Quantity Bought and Sold
1) The change in the price of
soybean, an input needed to
produce soymilk, affects the
supply curve.
2) By raising the cost of
production, it reduces the amount
of soymilk firms produce and sell
at any given price.
3) The supply curve shifts to the
left (S1 – S2), because, at every
price, the total amount that firms
are willing and able to sell is
reduced.
4) At a price of GHC3.00 sellers
are now able to offer 6 crates, but
demand is still 12 crates leading to
a shortage of 6 crates.
5) The shortage starts to force up
prices as buyers look to buy
soymilk.
6) The shortage raises the
equilibrium price form 3 to 4 and
lowers the equilibrium quantity
from 12 to 8
1-61
Comparative Static Analysis
Example: A Change in both Supply and Demand
 Now suppose that the report and the bad weather occur during the
same dry season.
 How does it affect the equilibrium price and quantity?
 Answer
– There will be two scenarios
Scenario 1: If the increment in demand for soymilk is more than the decrement
in the supply for soymilk, then both equilibrium price and equilibrium quantity
bought and sold will rise.
Scenario 2: If the increment in demand for soymilk is less than the decrement
in supply for soymilk, then the equilibrium price rises whiles the equilibrium
quantity sold and bought falls.
1-62
Comparative Static Analysis
Scenario 1
Price
of
soymil
k per
crate
Large
increase
in
demand
New
equilibrium
Price and
quantity
rises
S2
S1
P2
Small
decrease
in supply
P1
D2
Initial equilibrium
D1
Q1
Q2
Quantity bought and sold
1-63
Comparative Static Analysis
Scenario 2
Price of
soymilk
per
crate
Small
increase in
demand
Price rises
and
quantity
falls
S2
S1
New
equilibrium
P2
Large
decrease
in supply
P1
Initial
equilibrium
D2
D1
Q2
Q1
Quantity bought and sold
1-64
Comparative Static Analysis
Example: A Change in both Supply and Demand
 Now suppose that the report and the good weather occur during the same
season.
 How does it affect the equilibrium price and quantity?
 Answer
– There will be two scenarios
Scenario 1: If the increment in demand for soymilk is more than the increment
in the supply for soymilk, then both equilibrium price and equilibrium quantity
bought and sold will rise.
Scenario 2: If the increment in demand for soymilk is less than the increment
in supply for soymilk, then the equilibrium price falls whiles the equilibrium
quantity sold and bought rises.
Scenario 3: If the increment in demand for soymilk is equal to the increment in
supply for soymilk, then the equilibrium price remains constant whiles the
equilibrium quantity sold and bought rises.
1-65
Comparative Static Analysis
Scenario 1
Price
of
soymil
k per
crate
Small
Large
increase in
supply
increase in
demand
S0
S1
P2
P1
Price and
quantity
rises
New
equilibrium
Initial
equili
brium
D1
D0
Q1
Q2
Quantity bought and sold
1-66
Comparative Static Analysis
Scenario 2
Price of
soymilk
per
crate
Initial
equilibrium
S0
Large increase
in supply
Price falls
and
quantity
rises
S1
New
equilibrium
P1
P2
D1
D0
Q1
Q2
Small
increase in
demand
Quantity bought and sold
1-67
Comparative Static Analysis
Scenario 3
Price of
soymilk
per
crate
S0
Equal
increase
in supply
Price
constant
and
quantity
rises
S1
P1
New
equilibrium
Initial
equili
brium
D1
D0
Q1
Q2
Equal
increase in
demand
Quantity bought and sold
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Comparative Static Analysis
Problem:
Suppose you are the manager of a chain of computer stores. For obvious
reasons you have been closely following developments in the computer
industry, and you have just learned that Parliament has passed a twopronged program designed to further enhance the Ghanaian computer
industry’s position in the global economy. The legislation provides increased
funding for computer education in primary and secondary schools, as well as
tax breaks for firms that develop computer software. As a result of this
legislation, what do you predict will happen to the equilibrium price and
quantity of software?
Quick Quiz … Analyse what happens to the market for
‘Gari and Beans’ if the price of beans rises. Analyse what
happens to the market for ‘Fufu’ if the price of cassava falls.
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Conclusion
 Use supply and demand analysis to
– clarify the “big picture” (the general impact of a current event
on equilibrium prices and quantities).
– organize an action plan (needed changes in production,
inventories, raw materials, human resources, marketing
plans, etc.).
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End of Lecture 2
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