Managerial Economics &

Business Strategy
Chapter 2
Market Forces: Demand and Supply

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Overview

I. Market Demand Curve III. Market Equilibrium

Q The Demand Function IV. Price Restrictions
Q Determinants of Demand
Q Consumer Surplus V. Comparative Statics

II. Market Supply Curve

Q The Supply Function
Q Supply Shifters
Q Producer Surplus

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Market Demand Curve
• Shows the amount of a good that will be
purchased at alternative prices, holding
other factors constant.
• Law of Demand
Q The demand curve is downward sloping.
Price

D
Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Determinants of Demand
• Income
Q Normal good
Q Inferior good
• Prices of Related Goods
Q Prices of substitutes
Q Prices of complements
• Advertising and
consumer tastes
• Population
• Consumer expectations

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Demand Function
• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

Q Qxd = quantity demand of good X.

Q Px = price of good X.
Q PY = price of a related good Y.
• Substitute good.
• Complement good.
Q M = income.
• Normal good.
• Inferior good.
Q H = any other variable affecting demand.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Inverse Demand Function

• Price as a function of quantity

demanded.
• Example:
Q Demand Function
• Qxd = 10 – 2Px
Q Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Change in Demand
Price D0 to D1: Increase in Demand

6
D1

D0

7 13 Quantity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Surplus:

• The value consumers get from a good but

do not have to pay for.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 I got a great deal!

• That company offers a lot

of bang for the buck!
• Dell provides good value.
• Total value greatly exceeds
total amount paid.
• Consumer surplus is large.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Surplus:
The Discrete Case
Price
Consumer Surplus:
10 The value received but not
8 paid for. Consumer surplus =
(8-2) + (6-2) + (4-2) = $12.
6

2
D
1 2 3 4 5 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Consumer Surplus:
The Continuous Case
Price $

10
Value
Consumer 8 of 4 units = $24
Surplus =
$24 - $8 =
$16
6

4 Expenditure on 4 units =
$2 x 4 = $8

2
D
1 2 3 4 5 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Market Supply Curve
• The supply curve shows the amount of a good
that will be produced at alternative prices.
• Law of Supply
Q The supply curve is upward sloping.

Price
S0

Quantity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Supply Shifters
• Input prices
• Technology or
government regulations
• Number of firms
Q Entry
Q Exit
• Substitutes in production
• Taxes
Q Excise tax
Q Ad valorem tax
• Producer expectations

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 The Supply Function
• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

Q QxS = quantity supplied of good X.

Q Px = price of good X.
Q PR = price of a production substitute.
Q W = price of inputs (e.g., wages).
Q H = other variable affecting supply.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Inverse Supply Function

• Price as a function of quantity

supplied.
• Example:
Q Supply Function
• Qxs = 10 + 2Px
Q Inverse Supply Function:
• 2Px = 10 + Qxs
• Px = 5 + 0.5Qxs

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Change in Quantity Supplied
Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Producer Surplus
• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price

S0
P*

Q* Quantity

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Market Equilibrium
• Balancing supply and
demand
Q Q
x = Qx
S d

• Steady-state

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 If price is too low…
Price S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Price Restrictions
• Price Ceilings
Q The maximum legal price that can be charged.
Q Examples:
• Gasoline prices in the 1970s.
• Housing in New York City.
• Proposed restrictions on ATM fees.
• Price Floors
Q The minimum legal price that can be charged.
Q Examples:
• Minimum wage.
• Agricultural price supports.

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
Impact of a Price Ceiling
Price S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 An Example from the 1970s
• Ceiling price of gasoline: $1.
• 3 hours in line to buy 15 gallons of gasoline
Q Opportunity cost: $5/hr.

Q Total value of time spent in line: 3 × $5 = $15.

Q 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Impact of a Price Floor
Price Surplus S
PF

P*

Qd Q* QS Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
Big Picture: Impact of decline in
component prices on PC market
Price S
of
PCs S*

P0
P*

Q* Quantity of PC’s
Q0
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Big Picture Analysis: PC Market
• Equilibrium price of PCs will fall, and
equilibrium quantity of computers sold will
increase.
• Use this to organize an action plan
Q contracts/suppliers?
Q inventories?
Q human resources?
Q marketing?
Q do I need quantitative estimates?

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 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
Q a lower equilibrium price for computers.
Q 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
Big Picture: Impact of lower PC
prices on the software market
Price S
of Software

P1
P0

D*

Q0 Q1 Quantity of
Software
Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Big Picture Analysis: Software
Market
• 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, 5e. ©The McGraw-Hill Companies, Inc., 2006
 Conclusion
• Use supply and demand analysis to
Q clarify the “big picture” (the general impact of a current
event on equilibrium prices and quantities).
Q organize an action plan (needed changes in production,
inventories, raw materials, human resources, marketing
plans, etc.).

Michael R. Baye, Managerial Economics and Business Strategy, 5e. ©The McGraw-Hill Companies, Inc., 2006