1) This document discusses demand and supply analysis, which provides the essential background for managerial economic problems. It covers the model of demand and supply, which is a key tool in economics. 2) The document outlines demand, supply, and market equilibrium. It explains how equilibrium price and quantity are determined by the intersection of supply and demand curves. It also discusses how non-price factors can shift the curves and change equilibrium. 3) The roles of price in the short-run (rationing function) and long-run (guiding/allocating function) are explained. In the short-run, price adjusts to clear surpluses and shortages, while in the long-run it guides

1. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
1
Chapter Three
DEMAND AND SUPPLY
1
• This chapter presents a brief review of
demand and supply analysis.
• The materials covered in this chapter
provide the essential background for most
of the managerial economic problems to be
studied in the coming chapters.
• The model of demand and supply is one of
the strongest tools of analysis in
economics.
2
Prices in the Market
• Market
• Money Price
• Relative Price
3
DEMAND
• Demand
• Market Demand
• Demand and Quantity Demanded
• Demand Schedule
• Demand Curve: Willingness-and-ability-to-
pay curve - MB
4

2. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
2
Demand Function and Demand Curve:
• Demand function can be expressed as
• Qd= f [ P - ;{ Ps
+
, Pc
-, I +, -, Ex +, -, T +, -, N+,
….}], where
• Qd: the quantity demanded over a given
period of time; P: the product own price;
Ps: the price of a substitute product; Pc: the
price of a complement product; I: consumer
average income; Ex: prices, income, and
other factors expectations; T: consumers’
taste or preference; N: number of
consumers or buyers.
5
• Signs above the independent variables
show the direction of the relationship
between the quantity demanded and each of
these variables, when other variables are
held constant.
• For example, if
Qd = 1 - 2Px + 0.8Ps - 3Pc +1.5I +1T
• When Ps=2.5, Pc=1, I=4 and T=2,
demand curve is estimated as
Qd = 1 - 2P + 0.8(2.5) – 3(1) +1.5(4) +1(2)
Qd = 8 - 2P ……………… Demand Curve
6
• Change in non-price determinants (for
example, ∆I) shift demand curve. If income
increases from 4 to 6 then
Qd = 11- 2P
P
Qd
8 11
4
5.5
7
• The law of Demand
• Change in the quantity demanded (Qd)
• Changes in Demand
• Non-Price Determinants of Demand:
1. Change in Consumers’ Incomes:
2. The Prices of Related Goods:
3. Expectations about the Future:
4. Tastes and Preferences
5. The Number of Buyers in the Market
(Population)
8

3. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
3
Managerial Rule of Thumb: Demand
Considerations
• Managers must
1.Understand what influences demand
2.Determine which factors they can influence
3.Determine how to handle factors they
cannot influence
9
SUPPLY
• supply
• Market supply
• The quantity supplied (Qs)
• Supply curve: "minimum-price-supply" curve
- MC
10
The Implicit Supply Function:
Qs = f [P +; {Ps-
, Pc
+, Pi
-, Ex +, -, T + , N+, ….}]
• Where:
• Qs: the quantity supplied over a given
period of time; P: the product own price;
Ps: the price of a substitute (in production)
product; Pc: the price of a complement (in
production) product; Pi: the price of input I;
Ex: prices, income, and other factors
expectations; T: cost saving technological
progress; N: number of sellers.
11
• Signs above the independent variables
show the direction of the relationship
between the quantity supplied and each of
these variables, when other variables are
held constant.
12

4. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
4
• The law of Supply
• Changes in the Quantity Supplied
• Changes in Supply
• Non-Price Determinants of Supply
1.Prices of productive resources (Cost of
Factors of Production)
2.Technology
3.Price of Related Goods:
4.Expectations about the Future:
5.Number of Sellers:
6.Weather conditions
13
Managerial Rule of Thumb: Supply
Considerations
• Managers must
1.Examine technology and costs of
production
2.Find ways to increase productivity while
lowering production costs
14
MARKET EQUILIBRIUM
• Equilibrium
• Market equilibrium
• Equilibrium price (P*):
• Equilibrium quantity (Q*):
15
A. Tabular Illustration of Equilibrium, Surplus,
and Shortage
P Qd Qs (Qs – Qd) Market situation
7 0 600 600 surplus
6 100 500 400 surplus
5 200 400 200 surplus
4 300 300 0 equilibrium
3 400 200 -200 shortage
2 500 100 -400 shortage
1 600 0 -600 shortage
16

5. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
5
B. Graphical Illustration of Equilibrium,
Surplus, and Shortage
Q* = 300200 400
3
P*= 4
5
S
Q
DShortage
Surplus
P
17
C. Mathematical Illustration of Equilibrium,
Surplus, and Shortage
1.Suppose the demand equation is
P = 7 – 0.01 Qd,
and the supply equation is
P = 1 + 0.01 Qs
a.Find Q* and P*
b.Find Q if P = 5
18
2. Given Qd = 65 - 10P and Qs = -35 + 15P
a. Find Q* and P*
b. Find Q if P = 2
19
Comparative Static Analysis:
• Comparative Static Analysis is a commonly
used method in economic analysis to
compare various points of equilibrium when
certain factors change.
• It is a form of sensitivity, or what-if
analysis.
• Changes in demand or supply create
surplus or shortage and as a result price
adjusts towards equilibrium, both in the
short-run and the long-run.
20

6. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
6
Process of comparative static analysis
1. State all the assumptions needed to
construct the model.
2. Begin by assuming that the model is in
equilibrium.
3. Introduces some event that affects the
demand side, the supply side or both sides
of the market causing curves to shift. In so
doing, a condition of disequilibrium is
created.
4. Find the new point at which equilibrium is
restored.
21
5. Compare the new equilibrium point with the
original one to assess the impact of that
event on the market equilibrium price and
quantity.
Question:
• What is the difference between static and
dynamic analysis?
22
SR Market Changes: The “Rationing
Function” of Price
The short run is the period of time in which:
• Some factors are variables, others are
fixed.
• Sellers already in the market respond to a
change in equilibrium price by adjusting
variable inputs.
• Buyers already in the market respond to
changes in equilibrium price by adjusting
the quantity demanded for the good or
service.
23
• Price performs its SR rationing function in
response to changes in demand or supply
• The rationing function of price is the change
in market price to clear the market of any
shortage or surplus.
• SR adjustments are represented as
movements along a given demand or supply
curve as a result of changes in demand or
supply  changes in P* and Q*.
• In SR when non-price determinants change,
P* and Q*change.
24

7. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
7
LR Market Analysis: The “Guiding” or
“Allocating” Function
• The long run is the period of time in which:
• All factors are variable.
• New sellers may enter a market
• Existing sellers may exit from a market
• Existing sellers may adjust fixed factors of
production
• Buyers may react to a change in equilibrium
price by changing their tastes and
preferences or buying preferences
• Price perform its guiding or allocating
function
25
• We know that when demand or supply
changes due to changes in non-price
determinants, Q and P change in SR. But
what will happen as a result of changes in
P?
• The guiding or allocating function of price is
the movement of resources into or out of
markets in response to a change in the
equilibrium price.
• Guiding is a LR function of price. LR
adjustments are represented as shifts in a
given demand or supply curve.
26
• Market mechanism through price
adjustments signal to producers and
consumers whether to increase or decrease
supply or demand.
• It is the use of market prices and sales to
signal the desired output (or resource
allocation). This is what Adam Smith refers
to as the “invisible hand”, resource
allocation through market forces.
27
Example 1
• Consider the market for apple and orange
(substitute goods) where equilibrium price
and quantity in both markets are P1 and Q1.
Suppose tastes and preferences change in
favor of apple and against orange.
28

8. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
8
Q1Q2Q2Q1
D2
Orange
Surplus
P1
D2
P2
PO
QO
S1
D1
Apple
Shortage
P2
D1
P1
PA
QA
S1
29
In SR: (The Rationing Function)
• D for apple shortage at original P1 P in
apple market to P2 to eliminate shortage.
• While D for orange surplus at original
P1 P in orange market to P2 to eliminate
surplus.
• This is the rationing function that clears
shortage and surplus.
30
In LR: The Guiding “Allocating|” Function of P
S2
P1, P3
Q3
S2
Q3 Q1Q2Q2Q1
D2
Orange
D2
P2
PO
QO
S1
D1
Apple
P2
D1
P1, P3
PA
QA
S1
31
• The increase in P of apple will encourage
existing producers to produce more, and
new firms will enter the market as it seems
more profitable than other markets  more
resources will be devoted to apple
production  apple supply   SC shifts
rightward  P and Q
• The higher SR price has guided more
resources into the market.
• The opposite will happen to orange supply.
32

9. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
9
• Follow- on adjustment:
• movement of resources into the market
• rightward shift in the supply curve to S2
• Equilibrium price and quantity now P3,Q3
• Thus,
• Apple Market: Q, P  S P and Q
• Orange Market: Q, P  S P and Q
• So, price is fulfilling its guiding or allocating
function
33
Example 2
• Assess the short and long run impacts of
the 11Sebtember attack on airline market in
USA.
P1& P3
Q3
S2
Q1Q2
D2
P2
P
Q
S1
D1
34
• Before the attack, the market was in initial
equilibrium at P1 and Q1.
• Shortly after the attack, insurance
premiums for airliners have risen to reflect
the higher risk introduced in this industry,
causing the supply curve of air trips to
shift leftward to S2.
• At the initial price P1 the market then
suffered a shortage that pushed air tickets’
price up to P2.
35
In the short-run:
• Responding to the price increase,
consumers demanded less air trips by
economizing on their consumption,
delaying some recreational travel, better
planning business trips to make more
visits and meetings on the same trip, and
by trying other modes of transportation.
• This is the rationing role of price, where
the higher price level served to ration the
available supply amongst the most valued
uses.
36

10. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
10
• In this example, the rationing function of the
price shows as a movement upward along
the demand curve.
In the long run:
• As the crisis continues to exist, some
structural changes in consumers’ tastes
and preferences have taken place.
• Some consumers discovered some fun in
driving their cars on vocational trips,
spending time on the road, enjoying natural
sites, making as many stops as they prefer.
Others found local tourism to be safer than
traveling to distant places. 37
• All these changes of other factors reduced
demand for airline trips causing the demand
curve to shift leftward. Eventually, the
market reached long run equilibrium at P3
lower than P2 and Q3 less than Q2.
• As the production of air trips decreases,
some resources have been moved from this
industry to the now expanding industries as
local hostelling and passengers’ car
industry and bussing industry.
38
• That is the allocation function of the price,
where the rise in price, resulted in the long
run, in some changes in consumers’ tastes
or preferences and then reallocate their
resources accordingly.
• In this example, the allocation function of
the price shows graphically as a shift of the
demand curve to the left.
39
Changes in P and Q when D, S, or both shifts
Shift P* Q* Remarks
D↑ ↑ ↑ SR shifts (shortage at old P*)
D↓ ↓ ↓ SR shifts (surplus at old P*)
----------------------------------------------------------------------
S↑ ↓ ↑ SR shifts (surplus at old P*)
S↓ ↑ ↓ SR shifts (shortage at old P*)
----------------------------------------------------------------------
D↑&S↑ ↑↓− ↑ LR allocation of resources
D↓&S↓ ↑↓− ↓ LR allocation of resources
----------------------------------------------------------------------
D↑ & S↓ ↑ ↑↓− LR allocation of resources
D↓ & S↑ ↓ ↑↓− LR allocation of resources
40

11. ECON340 : Managerial Economics Demand and Supply Dr. Mohammed Alwosabi
11
Supply, Demand, and Price: The Managerial
Challenge
• In the extreme case, the forces of supply
and demand are the sole determinants of
the market price.
• This type of market is “perfect competition”
• In other markets, individual firms can exert
market power over their price because of
their:
• Dominant size
• Ability to differentiate their product through
advertising, brand name, features, or
services
41 42