Managerial Economics

PGDM : 2013 15 Term 1 (June September, 2013) (Lecture 3)

Market forces of Demand & Supply

Key Concepts
Law of Demand Individual and Market Demand Curve Shifters/Determinants of Demand Law of Supply Individual and Market Supply Curve Shifters/Determinants of Supply Movement along the Demand (Supply) Curve vs. Shift of the Demand (Supply) Curve Market Equilibrium Elasticity of Demand Own Price, Cross Price and Income Elasticity of Demand Determinants of Elasticity Relationships b/w Elasticity and Revenue and its implication Comparative Statics use the tools of Demand Supply Government Intervention Price Ceiling and Price Floor: Concept and Implication Incidence of Tax: Consequences and Implications

Markets and Competition

a15

A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. In a perfectly competitive market: All goods exactly the same Buyers & sellers so numerous that no one can affect market price each is a price taker We assume markets are perfectly competitive throughout the demand supply analysis.
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Slide 3 a15 In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties including burger, the example you would find here. And there are many markets in which the number of firms is small enough that some of them have the ability to affect the market price. For now, though, we look at supply and demand in perfectly competitive markets, for two reasons: First, its easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicated analysis of imperfectly competitive markets. Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will see many times in the topics that follow.
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Why is Demand important?

An important contributor to firm risk arises from sudden shifts in demand for the product or service. Demand analysis serves two managerial objectives: it provides the insights necessary for effective management of demand, and it aids in forecasting sales and revenues.

Demand
What is Demand? The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase at a certain price. Law of Demand a18 The quantity demanded of a good falls when the price of the good rises or vice-versa, other things being equal (Ceteris Paribus). Following Law of Demand there is an inverse relationship between price and quantity demanded.
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Slide 5 a18 Note that this Law is applicable to Normal good. For giffen or Veblen goods there exists a direct relationship between price and quantity demanded.
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Demand Schedule (Individual)

Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded Example: Demand for Burgers. Price of Burger 0.00 1.00 2.00 3.00 4.00 5.00 6.00 Quantity of Burgers demanded 16 14 12 10 8 6 4
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Notice that the preferences of the

consumer obey the Law of Demand.

Demand Schedule & Demand Curve (Individual)a19

Price of Burgers Price Quantity of of Burgers Burger demanded $0.00 1.00 2.00 3.00 4.00 5.00 6.00 Quantity of Burgers 16 14 12 10 8 6 4

$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10

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Slide 7 a19 Each point on the demand curve represents the maximum willingness to pay (WTP) of the consumerfor each unit of quantity demanded. So this willingness to pay is then the buyer's price (which is determined by how the consumer is valuing the good) for each unit of quantity demanded.
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Market Demand versus Individual Demand

The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose A and B are the only two buyers in the Burger market. (Qd = quantity demanded) a2
Price Consumer1s Qd Consumer2s Qd

Market Qd 24 21 18 15 12 9 6
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$0.00 1.00 2.00 3.00 4.00 5.00 6.00

16 14 12 10 8 6 4

+ + + + + + +

8 7 6 5 4 3 2

= = = = = = =

Slide 8 a2 This example violates the many buyers condition of perfect competition. Yet, we are merely trying to show here that, at each price, the quantity demanded in the market is the sum of the quantity demanded by each buyer in the market. This holds whether there are two buyers or two million buyers. But it would be harder to fit data for two million buyers on this slide, so we settle for two.
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The Market Demand Curve for Burgers a9

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20
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P $0.00 1.00 2.00 3.00 4.00 5.00 6.00

Qd (Market) 24 21 18 15 12 9 6

Q
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Slide 9 a9 Whenever there is a price change while everything else remaining constant, there will be a movement along the Demand Curve
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Demand (Curve) Shifters a5

The demand curve shows how price affects quantity demanded, other things being equal. These other things are non-price determinants of demand (i.e., things that determine buyers demand for a good, other than the goods price). Changes in them shift the D curve

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Slide 10 a5 We are talking about Market Demand Curve

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Demand (Curve) Shifters

Income Number of Buyers: Change in the Size of population can change the number of buyers Price of Related Goods: Price of substitute goods and Price of Complementary goods Taste or Preference : Both Advertising for the product and Advertising by competitors can change the preference or taste of the consumer Future Expectation
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Demand (Curve) Shifters: Income

Demand for a normal good is positively related to income. Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. Decrease in income causes decrease in quantity demanded at each price, shifts D curve to the left. Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.

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Demand Curve Shifters: Income

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30
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Suppose the income of the consumers increases. Then, at each P, Qd will increase (by 5 in this example).

Demand Curve Shifters: Number of Buyers

Increase in number of buyers leads to an increases in quantity demanded at each price and D curve shifts to the right. Decrease in number of buyers leads to an decrease in quantity demanded at each price and D curve shifts to the left. For example, suppose there is a sudden influx of foreign immigrants into our country. Each immigrant is a consumer. Therefore, this sudden change in the number of consumers will definitely increase the demand for certain goods immediately like food, clothes, medicines etc.
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Demand Curve Shifters: Prices of Related Goods (Substitutes)

Two goods are substitutes to each other if consumption of either good gives more or less the same level of satisfaction to the consumer. Example: Tea and Coffee. An increase in the price of coffee increases demand for tea, shifting the demand curve to the right. Other examples: a10 Coke and Pepsi; Laptops and Desktop computers; CDs and Music downloads; Book (Hard Cover) and e-Book; Brown Rice and White Rice; Foreign Tour and Local Tour; Private car and Public Transportation; Metro Ride and Bus Ride; Smartphone and Ordinary Phone15

Slide 15 a10 When a consumer is indifferent between two goods, the goods are perfect substitute to each other. In a scale of 0 to 1, you can think for perfect substitutes the degree of substitutability is 1. However, in reality it is hard to find perfect substitutes.Since each good is different from other a consumer cannot be indifferent between two good. Therefore, all the example I gave here are examples of close substitutes. However, for our purpose of understanding the basic principles of demand and supply it is innocuous to assume perfect substitutability between two goods.
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Demand Curve Shifters: Price of Related Goods (Substitutes) a7

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30

Suppose the price of Tea increases. Then, at each P, Qd for coffee will increase (by 5 in this example).

Q
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Slide 16 a7 Suppose Qd = 10 when P = $5 for Coffee. Now suppose tea becomes more expensive, but price of coffee does not change, what would happen to the quantity of coffee demanded? Would it remain at 10, would it increase, or would it decrease? Since Tea and Coffee are substitutes to each other, whenever there is an increase in the price of Tea, the consumers (not all though; why?) will switch from tea to coffee. Thus given the fact that price of coffee does not change the demand for coffee will go up and the demand curve shifts to the right.
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Demand Curve Shifters: Prices of Related Goods (Complements)

Two goods are complements if consumption of both goods are required to obtain a certain level of satisfaction consumer desires. Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. Other examples: Left Shoe and Right Shoe (the classic example) Coffee and Sugar; College education and textbooks, Bread and Butter, Pizza and Chili Flakes; Computer and Printer; i-pod and i-tune downloads; Smartphone and apps; Movie Ticket and Popcorn; Paper and Pen
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Demand Curve Shifters: Price of Related Goods (Complement)a8

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30
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Suppose the price of computer decreases. Then, at each P, Qd for software will increase (by 5 in this example).

Slide 18 a8 Suppose Qd = 10 when P = $5 for Computer. Now suppose computer becomes less expensive, but price of price of software does not change, what would happen to the quantity of software demanded? Would it remain at 10, would it increase, or would it decrease? Since Computer and Software are complement to each other, whenever there is an decrease in the price of software, the quantity demanded for computers will increase. Therefore, the need for software will also rise. Thus given the fact that price of software remains the same, the demand for software will go up and the demand curve shifts to the right.
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Demand Curve Shifters: Preferences/Tastes

Anything that causes a shift in preference/tastes toward a good will increase demand for that good and shift its D curve to the right and vice-versa Examples: The Atkins diet became popular in the 90s, caused an increase in demand for eggs, shifted the egg demand curve to the right. The IT boom caused an increase in demand for IT education and shifted the demand curve to the right. New findings on the usefulness of drinking energy drink increases the demand for the drink and shifts the demand curve to the right. Good advertisement for a product can change the taste of a consumer and subsequently shifts the demand curve to the right.

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Demand Curve Shifters: Future Expectations

Expectations affect consumers buying decisions Inter-temporal Choice of Consumption Examples: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now shifting the demand curve to the right. If the economy sours and people worry about their future job security, demand for new autos may fall now and demand curve shifts to the left. If it is expected that the price of a product (say, rice) would rise too much in next month the demand for that product increases now shifting the demand curve to the right. Also, if it is expected that a product might not be available after two months the demand for the product increases now shifting the demand curve to the right. It is safe to conclude that future expectations force the consumers to make a choice between todays and tomorrows consumptions accordingly shift the demand curve to the right or left.
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Supply
What is Supply The quantity supplied of any good is the amount that sellers are willing and able to sell at a certain price. Law of supply The Law states that the quantity supplied of a good rises when the price of the good rises, other things equal

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The Supply Schedule (Individual)

Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Example: Starbucks supply of lattes. Price of lattes $0.00 1.00 2.00 3.00 4.00 5.00 6.00 Quantity of lattes supplied 0 3 6 9 12 15 18
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Notice that Starbucks supply

schedule obeys the Law of Supply.

Starbucks Supply Schedule & Curve (Individual)a20

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00

Price of lattes $0.00 1.00 2.00 3.00 4.00 5.00 6.00

Quantity of lattes supplied 0 3 6 9 12 15 18

Q
0 5 10 15

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Slide 23 a20 Each point on the supply curve represents the minimum willingness to accept (WTA) of the seller for each unit of quantity supplied. So this willingness to accept is then the sellers's price (which is determined by cost of producing each additional unit of the product) for each unit of quantity supplied.
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Market Supply versus Individual Supply

The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and CCD are the only two sellers in this market. (Qs = quantity supplied) Price $0.00 1.00 2.00 3.00 4.00 5.00 6.00 Starbucks 0 3 6 9 12 15 18 + + + + + + + Jitters 0 2 4 6 8 10 12 = = = = = = = Market Qs 0 5 10 15 20 25 30
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The Market Supply Curve

P

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35

QS (Market) 0 5 10 15 20 25 30

$0.00 1.00 2.00 3.00 4.00 5.00 6.00

Q
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Supply Curve Shifters

The supply curve shows how price affects quantity supplied, other things being equal. These other things are non-price determinants of supply. Non-price determinants of supply simply means the things other than the price of a good that determine sellers supply of the good. Changes in them shift the S curve

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Supply Curve Shifters

Cost of Production: Input Prices, Costs of regulatory compliance, taxes or subsidies Technology Future Expectation Number of Sellers Accidental supply interruptions from fires, floods, etc

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Supply Curve Shifters: Cost of Production (Input Price)

Examples of input prices: wages, prices of raw materials. A fall (rise) in input prices makes production more (less) profitable at each output price, so firms supply a larger (smaller) quantity at each price. The S curve shifts to the right (left).

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Supply Curve Shifters: Input Prices

P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
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Suppose the price of milk falls. At each price, the quantity of Lattes supplied will increase (by 5 in this example). Q

Supply Curve Shifters

Technology
Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right.

Number of Sellers
Existence of profit (loss) make s new (existing) firms to enter (leave) the market for a good or service. An increase (decrease) in the number of sellers increases (decreases) the quantity supplied at each price, shifts S curve to the right (left).

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Supply Curve Shifters: Expectations

Example: Events in the Middle East lead to expectations of higher oil prices. In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. S curve shifts left. In general, sellers may adjust supply* when their expectations of future prices change. (*If good not perishable)

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Summary: Shift vs. Movement Along Curve

Change in the quantity demanded: a movement along a fixed D curve occurs when P changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity supplied: a movement along a fixed S curve occurs when P changes Change in supply: a shift in the S curve occurs when a nonprice determinant of supply changes (like technology or costs)