Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Managerial Economics &
Business Strategy
Chapter 2
Market Forces,Demand and Supply
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Overview
III,Market Equilibrium
IV,Price Restrictions
V,Comparative Statics
II,Market Supply Curve
? The Supply Function
? Supply Shifters
? Producer Surplus
I,Market Demand Curve
? The Demand Function
? Determinants of Demand
? Consumer Surplus
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Market Demand Curve
? Shows the amount of a good that will be
purchased at alternative prices,
? Law of Demand
? The demand curve is downward sloping,
Quantity
D
Price
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Determinants of Demand
? Income
? Prices of substitutes
? Prices of complements
? Advertising
? Population
? Consumer expectations
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Demand Function
? An equation representing the demand curve
Qxd = f(Px,PY,M,H,)
? Qxd = quantity demand of good X,
? Px = price of good X,
? PY = price of a substitute good Y,
? M = income,
? H = any other variable affecting demand
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Change in Quantity Demanded
Price
Quantity
D0
4 7
10
6
A
A to B,Increase in quantity demanded
B
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
D0
D1
6
7
D0 to D1,Increase in Demand
Change in Demand
13
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Surplus,
? The value consumers get from a good but
do not have to pay for,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
I got a great deal!
? That company offers a lot
of bang for the buck!
? Gateway 2000 provides
good value,
? Total value greatly exceeds
total amount paid,
? Consumer surplus is large,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
I got a lousy deal!
? That car dealer drives a
hard bargain!
? I almost decided not to
buy it!
? They tried to squeeze the
very last cent from me!
? Total amount paid is
close to total value,
? Consumer surplus is low,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
D
10
8
6
4
2
1 2 3 4 5
Consumer Surplus,
The value received but not
paid for
Consumer Surplus,
The Discrete Case
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Consumer Surplus,
The Continuous Case
Price $
Quantity
D
10
8
6
4
2
1 2 3 4 5
Value
of 4 units
Consumer
Surplus
Total Cost of 4 units
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Market Supply Curve
? The supply curve shows the amount of a good
that will be produced at alternative prices,
? Law of Supply
? The supply curve is upward sloping
Price
Quantity
S0
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Supply Shifters
? Input prices
? Technology or
government
regulations
? Number of firms
? Substitutes in
production
? Taxes
? Producer expectations
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
The Supply Function
? An equation representing the supply curve,
QxS = f(Px,PR,W,H,)
? QxS = quantity supplied of good X,
? Px = price of good X,
? PR = price of a related good
? W = price of inputs (e.g.,wages)
? H = other variable affecting supply
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Change in Quantity Supplied
Price
Quantity
S0
20
10
B
A
5 10
A to B,Increase in quantity supplied
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
S0
S1
8
5 7
S0 to S1,Increase in supply
Change in Supply
6
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Producer Surplus
? The amount producers receive in excess of the amount
necessary to induce them to produce the good,
Price
Quantity
S0
Producer
Surplus
Q*
P*
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Market Equilibrium
? Balancing supply and
demand
? QxS = Qxd
? Steady-state
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
S
D
5
6 12
Shortage
12 - 6 = 6
6
If price is too low…
7
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
S
D
9
14
Surplus
14 - 6 = 8
6
8
8
If price is too high…
7
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price Restrictions
? Price Ceilings
? The maximum legal price that can be charged
? Examples,
? Gasoline prices in the 1970s
? Housing in New York City
? Proposed restrictions on ATM fees
? Price Floors
? The minimum legal price that can be charged,
? Examples,
? Minimum wage
? Agricultural price supports
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
Quantity
S
D
P*
Q*
Ceiling
Price
Q s
PF
Impact of a Price Ceiling
Shortage
Q d
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Full Economic Price
? The dollar amount paid to a firm under a price
ceiling,plus the nonpecuniary price,
PF = Pc + (PF - PC)
? PF = full economic price
? PC = price ceiling
? PF - PC = nonpecuniary price
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
An Example from the 1970s
? Ceiling price of gasoline - $1
? 3 hours in line to buy 15 gallons of gasoline
? Opportunity cost,$5/hr
? Total value of time spent in line,3 ? $5 = $15
? Non-pecuniary price per gallon,$15/15=$1
? Full economic price of a gallon of gasoline,
$1+$1=2
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Impact of a Price Floor
Price
Quantity
S
D
P*
Q* QS Qd
Surplus
PF
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Comparative Static Analysis
? How do the equilibrium price and quantity
change when a determinant of supply and/or
demand change?
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Applications of Demand and
Supply Analysis
? Event,The WSJ reports that the prices of
PC components are expected to fall by 5-8
percent over the next six months,
? Scenario 1,You manage a small firm that
manufactures PCs,
? Scenario 2,You manage a small software
company,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Use Comparative Static
Analysis to see the Big Picture!
? Comparative static analysis shows how the
equilibrium price and quantity will change
when a determinant of supply or demand
changes,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Scenario 1,Implications for a
Small PC Maker
? Step 1,Look for the,Big Picture”
? Step 2,Organize an action plan (worry
about details)
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
of
PCs
Quantity of PC’s
S
D
S*
P0
P*
Q0 Q*
Big Picture,Impact of decline in
component prices on PC market
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
? So,the Big Picture is,
? PC prices are likely to fall,and more computers will be
sold
? Use this to organize an action plan
? contracts/suppliers?
? inventories?
? human resources?
? marketing?
? do I need quantitative estimates?
? etc,
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Scenario 2,Software Maker
? More complicated chain of reasoning to
arrive at the,Big Picture”
? Step 1,Use analysis like that in Scenario 1
to deduce that lower component prices will
lead to
? a lower equilibrium price for computers
? a greater number of computers sold,
? Step 2,How will these changes affect the
“Big Picture” in the software market?
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Price
of Software
Quantity of
Software
S
D
Q0
D*
P1
Q1
Big Picture,Impact of lower PC
prices on the software market
P0
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
? The,big picture” for the software maker,
? Software prices are likely to rise,and more software
will be sold
? Use this to organize an action plan
Michael R,Baye,Managerial Economics and Business Strategy,3e,?The McGraw-Hill Companies,Inc.,1999
Summary
? 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.)