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econ563_module2.pdf
.. ECON 563Managerial Economics
Module 2: Market Equilibrium, Demand and Supply Model
Copyright 2017 Montclair State University
.. ECON 563Managerial Economics
Module 2a: Brief Overview
Learning Objectives
(1) Explain the laws of demand and supply, and identify fac- tors that cause shift in demand and supply.
(2) Define and calculate consumer surplus and producer surplus.
(3) Explain price determination in a competitivemarket, and show how equilibrium changes in response to changes in determinants of demand and supply.
Learning Objectives
(4) Explain and illustrate how excise taxes, ad valorem taxes, price floors, and price ceilings impact the functioning of a market.
(5) Apply supply and demand analysis as a qualitative fore- casting tool to see the big picture in competitive mar- kets.
.. ECON 563Managerial Economics
Module 2b: Demand
Demand Market demand curve
• Describes 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.
Price $/lb
$6
$4
$2
Quantity (lbs)742
D
0
Market demand curve
Movement Along Demand Curve
Change in quantity demanded • Changing only price leads to changes in quantity de- manded.
• Graphically represented by a movement along a given demand curve, holding other factors that impact demand constant.
Shift in Demand Curve
Shift in demand • Changing factors other than price lead to changes in demand.
• Graphically represented by a shift of the entire demand curve.
Price
Quantity
Shift to the right
Shift to the left
Changes in Demand
Demand Shifters Income
• Normal good • Inferior good
Prices of related goods • Substitute goods • Complement goods
Advertising and consumer tastes • Informative advertising • Persuasive advertising
Population, Consumer expectations, Other factors
Price
Quantity
D
D′
0
Figure : Advertising and Increase in Market Demand Curve
.. ECON 563Managerial Economics
Module 2c: Demand Function
The Demand Function
The demand function for good X (say, apples) is a mathe- matical representation describing how many units (pounds, lbs) will be purchased at different prices for X ($ per lb), the price of a related good Y (say, orange), income and other factors that affect the demand for good X.
The Linear Demand Function One simple, but useful, representation of a demand function is the linear demand function.
QdX = α0 + αXPX + αY PY + αMM + αHH
where QdX 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 ; and H is the value of any other variable affecting demand.
Understanding the Linear Demand Function
The signs and magnitude of the α coefficients determine the impact of each variable on the number of units of X demanded
QdX = α0 + αXPX + αY PY + αMM + αHH.
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.
Example
Suppose demand function for a firm's product X is :
QdX = 12000− 3PX + 4PY −M + 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
QdX = 12000− 3(200) + 4(15)− 10000 + 2(2000)
QdX = 12000− 600 + 60− 10000 + 4000 = 5460.
X and Y are substitutes. X is an inferior good.
Inverse Demand Function In the example, if we set PY = $15 per unit, M = $10, 000 and AX = 2, 000, the demand function is
QdX = 12000− 3PX +4(15)− 10000+ 2(2000) = 6060− 3PX .
We can solve for PX in terms of QdX to obtain
PX = 6060
3 − Q
d X
3 = 2020− Q
d X
3 .
It is called inverse demand function and is used to construct market demand curve.
Price
$2020
Quantity6060
PX = 2020− Q d X
3
0
Graphing Inverse Demand Function
.. ECON 563Managerial Economics
Module 2d: Supply
Supply Market supply curve
• A curve indicating the total quantity of a good that all producers in a competitivemarket would produce at each price, holding input prices, technology, and other va- riables 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.
Movement Along Supply Curve
Change in quantity supplied • Changing only price leads to changes in quantity sup- plied.
• Graphically represented by a movement along a given supply curve, holding other factors that impact supply constant.
Shift in Supply Curve
Shift in supply • Changing factors other than price lead to changes in supply.
• Graphically represented by a shift of the entire supply curve.
Price
Quantity
Increase in supply
Decrease in supply
Changes in Supply
Supply Shifters • Input prices • Technology or government regulation • Number of firms
• Entry • Exit
• Substitutes in production • Taxes
• Excise tax : a tax on each unit of output sold, where tax reve- nue is collected from the supplier
• Ad valorem tax : percentage tax
• Producer expectations
Price
1.10
1.00
Quantity
t = $0.1
Excise tax = $0.10 per unit
A per unit (Excise) Tax
Price
1.10
1.00
Quantity
Ad Valorem tax = 10%
An Ad Valorem Tax
.. ECON 563Managerial Economics
Module 2e: Supply Function
The Supply Function
The supply function for goodX is a mathematical represen- tation describing how many units will be produced at alter- native prices for X, alternative input pricesW , and alterna- tive values of other variables that affect the supply for good X.
The Linear Supply Function A simple representation of a supply function is the linear supply function.
QsX = β0 + βXPX + βWW + βrPr + βHH
where QsX is the number of units of good X supplied ; PX is the price of good X ; W is the price of an input ; Pr is price of technologically related goods ; and H is the value of any other variable affecting supply.
Understanding the Linear Supply Function The signs and magnitude of the β coefficients determine the impact of each variable on the number of units of X supplied
QsX = β0 + βXPX + βWW + βrPr + βHH
For example βX > 0 by the law of supply ; βW < 0 increasing input prices ; βr > 0 technology lowers the cost of producing good X.
Example
Suppose supply function for a firm's product X is :
QsX = 2000 + 3PX − 4Pr − PW .
Question How many units of good X will be produced when PX = $400 per unit, Pr = $100 per unit and PW = 2, 050?
Answer
QsX = 2000 + 3(400)− 4(100)− 1(2050)
QsX = 2000 + 1200− 400− 2050 = 750.
Inverse Supply Function In the example, if we set PW = $2050 per unit and Pr = 100, the supply function is
QsX = 2000 + 3PX − 4(100)− 1(2050) = 3PX − 450.
We can solve for PX in terms of QsX to obtain
PX = 450
3 +
QdX 3
= 150 + QdX 3
.
It is called inverse supply function and is used to construct market supply curve.
Price
Quantity 150
PX = 150 + QsX 3
0
Graphing Inverse Supply Function
.. ECON 563
Managerial Economics
Module 2f: Consumer and Producer Surplus
Consumer Surplus Marketing strategies - like value pricing and price discrimi- nation - rely on the concept of consumer value for the pro- ducts.
• Total consumer value is the sumof themaximumamount 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.
Priceper litre $8
$4
8 Quantity in litres40
Market Demand and Consumer Surplus
Consumer Surplus
Total Consumer Value = 1
2 (8 + 4) · 4 = 24,
Total Expenditure = 4 · 4 = 16,
Consumer Surplus = 1
2 (4 · 4) = 8.
Producer Surplus
The amount producers receive in excess of the amount ne- cessary to induce them to produce the good.
Price
Quantity900
150
450
0
Producer Surplus
Producer Surplus
Producer Surplus = 1
2 (450− 150) · (900) = 135000.
.. ECON 563Managerial Economics
Module 2g: Market Equilibrium
Market Equilibrium 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 drivemarket demand andmarket supply are balanced, and there is no pressure on prices or quanti- ties to change.
• The equilibrium price is the price that equates quantity demanded with quantity supplied.
Price
QuantityQ∗ 15
P ∗
60
0
Market Equilibrium
Example Consider a market with demand and supply functions for good X given as :
QdX = 100− PX , QsX = 20 + PX .
A competitive market equilibrium exists at a price P ∗ such that
QdX(P ∗) = QsX(P
∗), or .100− PX = 20 + PX ,
2PX = 80, or PX = 40, , and QX = 100− 40 = 60.
Equilibrium is PX = 40 and QX = 60.
.. ECON 563Managerial Economics
Module 2h: Market Interventions
Price Restrictions and Market Equilibrium
• In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply.
• Sometime government restricts how much prices are permitted to rise or fall,
• Price ceiling, • Price floor.
Price
QuantityQ∗ 20
P ∗
P c
100
0 Price ceiling
A Price Ceiling
Price Ceiling in Action
Consider the market with demand and supply functions for good X given as :
QdX = 100− PX , QsX = 20 + PX .
Suppose a price ceiling of $30 is imposed in this market.
QdX = 100−30 = 70, QsX = 20+30 = 50, shortage = 70−50 = 20.
Full economic price of the 50th unit is PX = 100 − 50 = 50 where $30 is the dollar price and $30 is the non-pecuniary price.
Price
QuantityQ∗ 15
P ∗
60
0
Price Floor
Price Floor in Action
Consider the market with demand and supply functions for good X given as :
QdX = 100 − PX , QsX = 20 + PX . Suppose a price floor of $50 is imposed in this market.
QdX = 100−50 = 50, QsX = 20+50 = 70, surplus = 70−50 = 20.
.. ECON 563Managerial Economics
Module 2i: Comparative Statics
Comparative Static Analysis
• The study of the movement from one equilibrium to ano- ther.
• Competitivemarket equilibrium outcome, operating free of price restraints, could change when
• Demand changes • Supply changes • Demand and supply simultaneously change.
Change in Demand • 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 in- crease 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 ?
Price
Quantity0
Effect of change in demand
Both price and quantity increase
Change in Supply • 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 ?
Price
Quantity0
Effect of increase in supply
Price goes down and quantity goes up
