Managerial Economics: The Two Sides of A Market

Managerial Economics
MBACatólica
Fernando Branco
2006-2007
Fall Quarter
Session 1
2nd Part
The two sides of a market

♦Any market has two sides:
– The demand: resulting from the behavior of the buyers
in the market;
– and the supply: resulting from the behavior of the
sellers in the market.
♦The behavior of either side can be described with
appropriate curves:
– The Demand Curve and the Supply Curve.
Managerial Economics MBACatólica
2006-2007 • Fall Quarter • Session 1 ©Fernando Branco
The Demand in a market

♦In general, the quantity of a good or service that
the customers are willing to buy decreases with
the level of the price.
♦The demand curve is just the description of the
relationship between quantity and price.
♦Example.
♦Changes in the demand.

1
The market Demand: Example
Average
Quantity of Advertising Average price
Price of jeans consumer
jeans sold expenditures of shirts
income
0 80000 25000 50000 20
5 70000 25000 50000 20
10 60000 25000 50000 20
15 50000 25000 50000 20
20 40000 25000 50000 20
25 30000 25000 50000 20
30 20000 25000 50000 20
35 10000 25000 50000 20
40 0 25000 50000 20

The Demand curve

45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

Changes in the Demand:

Changes in price
♦A change in the sale price of a good implies a
movement along its demand curve.
45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

2
Changes in the Demand:
Shifting of the curve
♦A change in another relevant variable implies a
shift of the curve.
45
40
35
30
Price
25
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

Demand shifters
♦Tastes
♦Income
♦Information
♦Expectations
♦Other prices

Demand shifters
♦ “Gostos não se discutem”;
♦Tastes
♦ Tastes evolve through the life
♦Income cycle: food, clothing, music;
♦ Collective tastes change: fashion.
♦Information
♦ Advertising is often used to
♦Expectations change tastes.
♦Other prices

3
Advertising and tobacco consumption
Advertising is a documented important shifter in the
demand for tobacco, through changes in tastes.
A study for the US (Keeler et al., Applied
Economics, 2004) showed that while cigarette
demand, between 1990 and 2000, was down 8.3%
due to price increases, the increase in advertising
over the period partially offset that effect by 2.7% to
4.7%.

Demand Shifters
♦ Income influences people’s
♦Tastes purchasing power;
♦ The demand for most goods
♦Income and services increase as
income increases (normal
♦Information and superior goods).
♦ The demand for some other
♦Expectations goods and services decrease
as income increases (inferior
♦Other prices goods).

Income Effect
It is common to measure the effect that an increase
of 1% in income has on the demand of goods and
services.
It has been estimated that, in Portugal, an increase
of 1% in income:
– Increases the demand for food in 0.75%;
– Increases the demand for clothing in 1.40%.
Leonor Modesto et al., “Allocation of Private Consumption in Portugal: a Multi-stage Application of
the Rotterdam Model,” Economia, XVII(3), October 1993.

4
Distribution and recessions
While in the early 90s and 2000s the American
economy was in downturn, the US retail giant Wal-
Mart experienced strong growth rates.
Even controlling for other effects (e.g., prices,
advertising), the service provided by Wal-Mart
could be classified as an inferior good.
Finding for the 1990s mentioned in Baye (1997), second edition, while numbers for the 2000s can be
found in the web (e.g., http://news.bbc.co.uk/2/low/business/1829736.stm)

Demand Shifters
♦ Information may have a
strong effect on demand.
♦Tastes
♦ In some cases consumers
actively look for
♦Income
information: cars.
♦Information ♦ In some other cases firms
actively provide information
♦Expectations through advertising.
♦ Example: Online search
♦Other prices costs for wine.

Online search costs for wine

Electronic shopping reduces the search costs for
products over other channels.
Results of a study for wine (Lynch and Ariely,
Marketing Science, 2000) suggest that retailers
carrying differentiated goods have incentives to
make information transparent, but avoid price
competition by carrying more unique merchandise.

5
Demand Shifters
♦ Expectations on relevant
variables influence
♦Tastes demand;
♦ Among the most important
♦Income
variables are technological
innovations and changes in
♦Information prices;
♦Expectations
♦ Example: Sales of four-
♦Other prices wheel drive cars in
Portugal.
Sales of four-wheel drive cars in

Portugal
At the end of 1998, in Portugal there was a rumor
that some special fiscal treatment of four-çwheel
drive cars would disappear in 1999.
The sales of those vehicles had a strong increase:
160% in January 1999 over January 1998 (while the
demand in motor-cars increased 30% only).
The special fiscal treatment ended in 2001, only!

Demand Shifters
♦ Changes in the price of
♦Tastes some goods may influence
the demand for other goods;
♦Income ♦ Sometimes the increase in
the price of some good
♦Information increases the demand of one
good (substitutes) and
♦Expectations decreases the demand of
other good (complements).
♦Other prices
♦ Example.
6
The effect of other prices
It is common to determine the effects of a change in
1% of the price of a good on the demand of another
good.
In Portugal if has been estimated that:
– The demand of meat raises 0.12% when the price of
fish increases in 1%;
– The demand of coffee and tea drop 0.13% when the
price of sugar increases 1%.
Revisiting the Demand curve
♦An inverted reading of the demand curve:

– Highest price the consumers are willing to pay for a
given quantity to be sold.
♦Consumer surplus:
– Money measure of the value the consumers get from a
good or service, net of the amount paid.

Consumer surplus
45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

7
The Supply in a market
♦In general, the quantity of a good or service that
the producers wish to sell increases with an
increase in price.
♦The relationship between the amount supplied and
the price can be described by the Supply curve.
♦Example.
♦Changes in supply.

The market Supply: Example

Quantity of Cost of Number of
Price of jeans Salary rate
jeans sold capital competitors
0 0 10000 15000 10
5 10000 10000 15000 10
10 20000 10000 15000 10
15 30000 10000 15000 10
20 40000 10000 15000 10
25 50000 10000 15000 10
30 60000 10000 15000 10
35 70000 10000 15000 10
40 80000 10000 15000 10

A Supply curve
45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

8
Changes in the supply:
Changes in price
♦A change in the price decided for a good implies a
movement along its supply curve.
45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

Changes in the Supply:

Shifting of the curve
♦A change in another relevant variable implies a
shift of the curve.
45
40
35
30
Price
25
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

Supply shifters
♦Technology
♦Input prices
♦Regulation
♦Expectations

9
Supply shifters
♦ The technology summarizes
♦Technology the production process;
♦ Technology evolution can be
♦Input Prices conduct through in a direct
way (R&D) ou an indirect
♦Regulation way (M&A).
♦ Example: R&D and
♦Expectations technology change.

R&D and technology change

Many writers have claimed that R&D has two faces:
in addition to the conventional role of stimulating
innovation, it enhances technology transfer. This
thus effects have recently been documented by a
study of a panel of industries in twelve OECD
countries (Griffith, Redding and Van Reenen,
Review of Economics and Statistics, 2006).

Supply shifters
♦ Production costs affect
♦Technology the supply;
♦ Changes in salary, the
♦Input Prices cost of capital, or raw
materials affect
♦Regulation production costs;
♦ Example: Oil prices and
♦Expectations
the PPI.

10
Oil prices and the PPI
The producer price index for finished goods in the
US rose 0,1% on July 2006. But, excluding food and
energy costs it fell 0.3%, matching the largest drop
since April 2003.
In the 12 months ending in July, overall wholesale
prices climbed 4.%, while the core rate was uo
1.3%.
Adpated from Economist’s View, August 15, 2006.

Supply shifters
♦ Taxes affect the supply;
♦Technology ♦ Other regulations (for
example, environmental
♦Input Prices regulation) affect the
supply.
♦Regulation
♦Expectations ♦ Example: Opening
hours of
“hypermarkets”.

Opening hours of “hypermarkets”

In 1996 the Portuguese government placed
restrictions to the opening hours of large
commercial stores on Sundays and Holydays
(Portaria 153/96), arguably to protect small
traditional stores.
That had an immediate impact on supply. New
medium size chain stores flourished. In same case,
large stores were renovated to reduce their
commercial area.

11
Supply shifters
♦ Expectations on future
♦Technology prices of inputs and
intermediate goods
♦Input Prices affect supply;
♦ Expectations about
♦Regulation technological changes
affect supply.
♦Expectations
♦ Example: Supply of
shares in the stock
market.
Revisiting the Supply curve
♦An inverted reading of the supply curve:

– Lowest price the providers require to receive for a
given quantity to be sold.
♦Producers surplus:
– Money measure of the profit the producers get from a
good or service.

Producer surplus
45
40
35
30
25
Price
20
15
10
5
0
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

12
Market equilibrium
♦Price at which the quantities demanded and
supplied are equal.
♦Disequilibrium situations:
– Higher price: excess supply;
– Lower price: excess demand.
♦Example.
♦Application: The world market for copper.

The market of jeans

45
40
Excess supply
35
30
25
Price
20
15
10
5
0
Excess demand
0 10000 20000 30000 40000 50000 60000 70000 80000 90000
Quantity

The world market for copper

1.3
(US dollars per pound)
1.2
Price
1.1 S
1.0
D
0.9
9 10 11 12 13
Quantity
(Millions of Metric Tons per years)
Extracted from Mansfield et al., 2002 (pp. 20-25).

13
Changes in the market equilibrium
♦Movements of the demand:

– Changes in demand shifters.
♦Movements of the supply:
– Changes in the supply.
♦Application: Increase of the VAT rate.

Changes in demand shifters

1.3
1.2
Price
1.1 S
D'
1.0
D
0.9
9 10 11 12 13
Quantity

Changes in supply shifters

1.3
1.2 S'
Price
1.1 S
D'
1.0
D
0.9
9 10 11 12 13
Quantity

14
Increase of the VAT rate
S'
The standard VAT rate in S
Portugal is 21%, having
p
increased from 17% since 2002.
D
What is the impact on prices?
q
 ad + bc dp
 p = a − bq  p = d + b(1 − t )
 ⇔ dt =
b
≤1
 ⇔
 p(1 − t ) = c + dq q = c(1 − t ) − c p b+d
 d + b(1 − t ) t =0

Restrictions on Prices
♦Sometimes the government imposes restrictions to
the value of prices.
♦Price floor:
– Example: Minimum wage.
♦Price ceiling:
– Example: Price ceilings for energy.

A price floor
p
pmin
qD qS q
At the price floor, supply exceeds demand, generating an

excess supply in the market.
15
Minimum wage
Many countries have minimum wage legislation.
One of the simple effects of such legislation is an
increase in the unemployment.
This is a reason why the minimum wage in Portugal
should not approach the European average to
quickly.

A price ceiling
p
S
pmax
qS qD q
At the price ceiling the quantity demanded exceeds

the quantity supplied, and there is excess demand.
Price ceilings for energy

Energy prices are often caped.
The gasoline in Portugal was subject to price
ceilings for many years.
At the time, some claimed that the ceilings were not
really protecting consumers.

16

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Managerial Economics

The two sides of a market

The Demand in a market

Managerial Economics MBACatólica

Managerial Economics MBACatólica

The Demand curve

Managerial Economics MBACatólica

Changes in the Demand:

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Online search costs for wine

Managerial Economics MBACatólica

Sales of four-wheel drive cars in

Managerial Economics MBACatólica

Revisiting the Demand curve

♦An inverted reading of the demand curve:

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

The market Supply: Example

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Changes in the Supply:

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

R&D and technology change

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Opening hours of “hypermarkets”

Managerial Economics MBACatólica

Revisiting the Supply curve

♦An inverted reading of the supply curve:

Managerial Economics MBACatólica

Managerial Economics MBACatólica

Managerial Economics MBACatólica

The market of jeans

Managerial Economics MBACatólica

The world market for copper

Extracted from Mansfield et al., 2002 (pp. 20-25).

Managerial Economics MBACatólica

♦Movements of the demand:

♦Application: Increase of the VAT rate.

Managerial Economics MBACatólica

Changes in demand shifters

Extracted from Mansfield et al., 2002 (pp. 20-25).

Managerial Economics MBACatólica

Changes in supply shifters

Extracted from Mansfield et al., 2002 (pp. 20-25).

Managerial Economics MBACatólica

Portugal is 21%, having

Managerial Economics MBACatólica