Managerial Economics

1. Chapter 2
Market Forces: Demand and
Supply

2. Apply Apply supply and demand analysis as a qualitative forecasting tool to see the “big picture” in competitive markets.
Explain 1.Explain and illustrate how excise taxes, ad valorem taxes, price floors and price ceilings impact the functioning of a market.
Explain
Explain price discrimination in a competitive market and show how equilibrium changes in response to changes in determinants of demand
and supply.
Calculate Calculate consumer surplus and producer surplus and describe what they mean.
Explain Explain the laws of demand and supply and identify factors that cause demand and supply to shift.
© 2022 by McGraw-Hill Education. All Rights Reserved.
Learning Objectives

3. Market demand curve
–Illustrates the relationship between the total quantity and price per unit of a good
all consumers are willing and able to purchase, holding other variables constant.
Law of demand
–The quantity of a good consumers are willing and able to purchase increases
(decreases) as the price falls (rises).
–Price and quantity demanded are inversely related.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-3
Demand

4. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-4
Market Demand Curve (Figure 2-1)
Quantity
(thousands per year)
Price ($)
Demand
$40
0
$30
$20
20 40
$10
60 80

5. Changing only price leads to changes in quantity demanded.
–This type of change is graphically represented by a movement along a given
demand curve, holding other factors that impact demand constant.
Changing factors other than price leads to changes in demand.
–These types of changes are graphically represented by a shift of the entire
demand curve.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-5
Shift in Quantity Demanded versus a Shift in Demand

6. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-6
Changes in Demand (Figure 2-2)
Quantity
0
Price
D1
Increase
in
demand
A
B
D0
D2
Decrease
in
demand

7. 1. Income
• Normal good
• Inferior good
2. Prices of related goods
• Substitute goods
• Complement goods
3. Advertising and consumer tastes
• Informative advertising
• Persuasive advertising
4. Population
5. Consumer expectations
6. Other factors
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-7
Demand Shifters

8. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-8
Advertising and the Demand for Clothing (Figure 2-3)
Quantity of
high-style
clothing
0
$50
$40
50,000
Price of
high-style
clothing
D2
60,000
Due to an
increase in
advertising
D1

9. The demand function for good X is a mathematical representation
describing how many units will be purchased at different prices for X,
the price of a related good Y, income and other factors that affect the
demand for good X.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-9
The Demand Function

10. One simple, but useful, representation of a demand function is the linear
demand function:
𝑄𝑋
𝑑
= 𝛼0 + 𝛼𝑋𝑃𝑋 + 𝛼𝑌𝑃𝑌 + 𝛼𝑀𝑀 + 𝛼𝐻𝐻
where:
–𝑄𝑋
𝑑
is the number of units of good X demanded;
–𝑃𝑋 is the price of good X;
–𝑃𝑌 is the price of a related good Y;
–𝑀 is income;
–𝐻 is the value of any other variable affecting demand.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-10
The Linear Demand Function

11. The signs and magnitude of the 𝛼 coefficients determine the impact of
each variable on the number of units of X demanded.
𝑄𝑋
𝑑
= 𝛼0 + 𝛼𝑋𝑃𝑋 + 𝛼𝑌𝑃𝑌 + 𝛼𝑀𝑀
For example:
–𝛼𝑋 < 0 by the law of demand;
–𝛼𝑌 > 0 if good Y is a substitute for good X;
–𝛼𝑀 < 0 if good X is an inferior good.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-11
Understanding the Linear Demand Function

12. Suppose that an economic consultant for X Corp. recently provided the firm’s marketing
manager with this estimate of the demand function for the firm’s product:
𝑄𝑋
𝑑
= 12,000 − 3𝑃𝑋 + 4𝑃𝑌 − 1𝑀 + 2𝐴𝑋
Question: How many of good X will consumers purchase when 𝑃𝑋 = $200 per unit, 𝑃𝑌 =
$15 per unit, 𝑀 = $10,000 and 𝐴𝑋 = 2,000? Are goods X and Y substitutes or
complements? Is good X a normal or an inferior good?
Answer:
𝑄𝑋
𝑑
= 12,000 − 3 200 + 4 15 − 1 10,000 + 2 2,000 = 5,460 units. Goods X and
Y are substitutes. Good X is an inferior good.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-12
The Linear Demand Function in Action

13. By setting 𝑃𝑌 = $15 and 𝑀 = $10,000 and 𝐴 = 2,000 the demand function is
𝑄𝑋
𝑑
= 12,000 − 3𝑃𝑋 + 4 15 − 1 10,000 + 2 2,000
the linear demand function simplifies to
𝑄𝑋
𝑑
= 6,060 − 3𝑃𝑋
Solving this for 𝑃𝑋 in terms of 𝑄𝑋
𝑑
results in
𝑃𝑋 = 2,020 −
1
3
𝑄𝑋
𝑑
which is called the inverse demand function. This function is used to
construct a market demand curve.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-13
Inverse Demand Function

14. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-14
Graphing the Inverse Demand Function in Action (Figure 2-4)
Quantity
Price
𝑃𝑋 = 2,020 −
1
3
𝑄𝑋
𝑑
$2,020
0 6,060

15. Marketing strategies – like value pricing and price discrimination – rely on
understanding consumer value for products.
–Total consumer value is the sum of the maximum amount a consumer is willing to
pay at different quantities.
–Total expenditure is the per-unit market price times the number of units
consumed.
–Consumer surplus is the extra value that consumers derive from a good but do
not pay extra for.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-15
Consumer Surplus

16. Quantity
in liters
Price per
liter
Demand
$5
0
$3
$2
1 2
$1
4 5
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-16
Market Demand and Consumer Surplus in Action (Figure 2-5)
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8
Expenditures:
$(3-0) x (2-0) = $6
Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
$4
3
Consumer Surplus

17. Market supply curve
–A curve indicating the total quantity of a good that all producers in a competitive
market would produce at each price, holding input prices, technology, and other
variables affecting supply constant.
Law of supply
–As the price of a good rises (falls), the quantity supplied of the good rises (falls),
holding other factors affecting supply constant.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-17
Supply

18. Changing only price leads to changes in quantity supplied.
–This type of change is graphically represented by a movement along a given
supply curve, holding other factors that impact supply constant.
Changing factors other than price leads to changes in supply.
–These types of changes are graphically represented by a shift of the entire supply
curve.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-18
Changes in Quantity Supplied
versus Changes in Supply

19. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-19
Changes in Supply (Figure 2-6)
Quantity
Price
S2
0
Decrease
in supply
A
B
S0
S1
Increase
in supply

20. 1. Input prices
2. Technology or government regulation
3. Number of firms
• Entry
• Exit
4. Substitutes in production
5. Taxes
• Excise tax: a tax on each unit of output sold, where tax revenue is collected from the
supplier
• Ad valorem tax: percentage tax
6. Producer expectations
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-20
Supply Shifters

21. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-21
A Per Unit (Excise) Tax (Figure 2-7)
Quantity of
gasoline per
week
Price
of
gasoline
0
t = per unit tax of 20¢
S0
S0+t
t = 20¢
$1.20
$1.00
t

22. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-22
An Ad Valorem Tax (Figure 2-8)
Quantity of
backpacks per
week
Price
of
backpacks
0
S0
S1 = 1.20 x S0
$24
$10
Ad valorem tax
$12
1,100
$20
2,450

23. The supply function for good X is a mathematical representation
describing how many units will be produced at alternative prices for X,
alternative input prices W, and alternative values of other variables that
affect the supply for good X.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-23
The Supply Function

24. One simple, but useful, representation of a supply function is the linear
supply function:
𝑄𝑋
𝑠
= 𝛽0 + 𝛽𝑋𝑃𝑋 + 𝛽𝑊𝑊 + 𝛽𝑟𝑃𝑟 + 𝛽𝐻𝐻
–𝑄𝑋
𝑠
is the number of units of good X produced;
–𝑃𝑋 is the price of good X;
–𝑊 is the price of an input;
–𝑃𝑟 is price of technologically related goods;
–𝐻 is the value of any other variable affecting supply.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-24
The Linear Supply Function

25. The signs and magnitude of the 𝛽 coefficients determine the impact of
each variable on the number of units of X produced.
𝑄𝑋
𝑠
= 𝛽0 + 𝛽𝑋𝑃𝑋 + 𝛽𝑊𝑊 + 𝛽𝑟𝑃𝑟
For example:
–𝛽𝑋 > 0 by the law of supply.
–𝛽𝑊 < 0 increasing input price.
–𝛽𝑟 > 0 technology lowers the cost of producing good X.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-25
Understanding the Linear Supply Function

26. Your research department estimates that the supply function for high
definition televisions (HDTVs)is given by:
𝑄𝑋
𝑠
= 2,000 + 3𝑃𝑋 − 4𝑃𝑡 − 1𝑃𝑊
Question: How many televisions are produced when 𝑃𝑋 = $400, 𝑃𝑡 =
$250 per unit, and 𝑃𝑊 = $1,400?
Answer:
𝑄𝑋
𝑠
= 2,000 + 3 400 − 4(250) − 1 1,400 = 800 HDTVs.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-26
The Linear Supply Function in Action

27. By setting 𝑃𝑊 = $2,000 and 𝑃𝑡 = $250 in
𝑄𝑋
𝑠
= 2,000 + 3𝑃𝑋 − 4 250 − 1 1,400
the linear supply function simplifies to
𝑄𝑋
𝑠
= 3𝑃𝑋 − 400
Solving this for 𝑃𝑋 in terms of 𝑄𝑋
𝑠
results in
𝑃𝑋 =
400
3
+
1
3
𝑄𝑋
𝑠
which is called the inverse supply function. This function is used to
construct a market supply curve.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-27
Inverse Supply Function

28. Producer surplus: the amount producers receive in excess of the amount
necessary to induce them to produce the good.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-28
Producer Surplus

29. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-29
Producer Surplus in Action (Figure 2-9)
Quantity
Price Supply
$400
0 800
𝑃𝑋 =
400
3
+
1
3
𝑄𝑋
𝑆
$400
3
Producer surplus

30. Competitive Market Equilibrium
–Determined by the intersection of the market demand and market supply curves.
–A price and quantity such that there is no shortage or surplus in the market.
–Forces that drive market demand and market supply are balanced, and there is no
pressure on prices or quantities to change.
–The equilibrium price is the price that equates quantity demanded with quantity
supplied
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-30
Market Equilibrium

31. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-31
Market Equilibrium (Figure 2-10)
Quantity
Price Supply
0
𝑃𝐻
280
Demand
Surplus
Shortage
𝑃𝑒
𝑃𝐿
𝑄0 𝑄𝑒
𝑄1

32. Consider a market with demand and supply functions, respectively, as
𝑄𝑑 = 10 − 2𝑃 and 𝑄𝑠 = 2 + 2𝑃
A competitive market equilibrium exists at a price, 𝑃𝑒, such that 𝑄𝑑 𝑃𝑒 = 𝑄𝑠 𝑃𝑒 .
That is,
10 − 2𝑃 = 2 + 2𝑃
8 = 4𝑃
𝑃𝑒 = $2
𝑄𝑒 = 10 − 2 $2 = 6 and 𝑄𝑒 = 2 + 2($2) =6
𝑄𝑒 = 6 units
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-32
Market Equilibrium in Action

33. In a competitive market equilibrium, price and quantity freely adjust to
the forces of demand and supply.
At times, government restricts how much prices are permitted to rise or
fall.
–Price ceiling- the maximum legal price that can be charged in a market.
–Price floor- the minimum legal price that can be charged in a market.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-33
Price Restrictions and Market Equilibrium

34. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-34
A Price Ceiling (Figure 2-11)
Quantity
Price Supply
0
𝑃𝐹
𝑃𝑐
𝑄𝑠
𝑄𝑒 𝑄𝑑
280
Demand
Shortage
𝑃𝑒
Priceceiling
Nonpecuniary
price
Lost social welfare

35. Consider a market with demand and supply functions, respectively, as
𝑄𝑑
= 10 − 2𝑃 and 𝑄𝑠
= 2 + 2𝑃
Suppose a $1.50 price ceiling is imposed on the market.
–𝑄𝑑 = 10 − 2 $1.50 = 7 units.
–𝑄𝑠 = 2 + 2($1.50) = 5 units.
–Since 𝑄𝑑 > 𝑄𝑠 a shortage of 7 − 5 = 2 units exists.
–Full economic price of 5𝑡ℎ unit is 5 = 10 − 2𝑃𝑓𝑢𝑙𝑙, or 𝑃𝑓𝑢𝑙𝑙 = $2.50. Of this,
• $1.50 is the dollar price
• $1 is the nonpecuniary price
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-35
Price Ceiling in Action

36. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-36
A Price Floor (Figure 2-12)
Quantity
Price Supply
0
𝑃𝑓
𝑄𝑑
𝑄𝑒 𝑄𝑠
280
Demand
Surplus
𝑃𝑒
Pricefloor
Cost of
purchasing
excess supply

37. Consider a market with demand and supply functions, respectively, as
𝑄𝑑
= 10 − 2𝑃 and 𝑄𝑠
= 2 + 2𝑃
Suppose a $3.50 price floor is imposed on the market.
–𝑄𝑑 = 10 − 2 $3.50 = 3 units
–𝑄𝑠 = 2 + 2($3.50) = 9 units
–Since 𝑄𝑠 > 𝑄𝑑 a surplus of 9 − 3 = 6 units exists
–The cost to the government of purchasing the surplus is $3.50 × 6 = $21.
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-37
Price Floor in Action

38. Comparative static analysis
–The study of the movement from one equilibrium to another.
Competitive markets, operating free of price restraints, will be analyzed
when:
–Demand changes
–Supply changes
–Demand and supply simultaneously change
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-38
Comparative Statics

39. Increase in demand only
–Increase equilibrium price
–Increase equilibrium quantity
Decrease in demand only
–Decrease equilibrium price
–Decrease equilibrium quantity
Example of change in demand
–Suppose that consumer incomes are projected to increase 2.5% and the number
of individuals over 25 years of age will reach an all time high by the end of next
year. What is the impact on the rental car market?
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-39
Changes in Demand

40. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-40
Effect of a Change in Demand for Rental Cars (Figure 2-13)
Quantity
(thousands
rented per day)
Price Supply
0
$45
104
Demand1
$49
Demand0
100 108

41. Increase in supply only
–Decrease equilibrium price
–Increase equilibrium quantity
Decrease in supply only
–Increase equilibrium price
–Decrease equilibrium quantity
Example of change in supply
–Suppose that a bill before Congress would require all employers to provide health
care to their workers. What is the impact on retail markets?
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-41
Changes in Supply

42. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-42
Effect of a Change in Supply (Figure 2-14)
Quantity
Price
Supply0
0 𝑄0
Demand
𝑃0
Supply1
𝑃1
𝑄1

43. Suppose that simultaneously the following events occur:
–An earthquake hits Kobe, Japan and decreased the supply of fermented rice used
to make sake wine.
–The stress caused by the earthquake led many to increase their demand for sake,
and other alcoholic beverages.
What is the combined impact on Japan’s sake market?
© 2022 by McGraw-Hill Education. All Rights Reserved. 2-43
Simultaneous Shifts in Supply and Demand

44. © 2022 by McGraw-Hill Education. All Rights Reserved. 2-44
Simultaneous Shifts in Supply and Demand in Action
(Figure 2-15)
Quantity
Price
Supply0
𝑃0
0
Demand1
𝑃1
Supply1
Demand0
Japan’s Sake Market
𝑄0
𝑄1
Supply2
𝑃2
𝑄2
A
B
C