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# ECONOMICS

## Chapter 2 .Managerial Economics & Business Strategy

Market Forces: Demand and Supply

Overview 1. Market Demand Curve o The Demand Function o Determinants of Demand o Consumer Surplus 2. Market Supply Curve o The Supply Function o Supply Shifters o Producer Surplus 3. Market Equilibrium 4. Price Restrictions 5. Comparative Statics Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Law of Demand o The demand curve is downward sloping.

Determinants of Demand o Income o Prices of substitutes o Prices of complements o Advertising o Population o Consumer expectations

The Demand Function An equation representing the demand curve Qxd = f(Px , PY , M, H,) o o o o o 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

## Change in Quantity Demanded

Change in Demand

Consumer Surplus: The value consumers get from a good but do not have to pay for. 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. 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. Consumer Surplus: The Discrete Case

## Consumer Surplus:The Continuous Case

Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply o The supply curve is upward sloping

Supply Shifters Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

The Supply Function An equation representing the supply curve: QxS = f(Px , PR ,W, H,) o o o o o 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

## Change in Quantity Supplied

Change in Supply

Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good.

## If price is too high

Price Restrictions Price Ceilings o The maximum legal price that can be charged o Examples: Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees Price Floors o The minimum legal price that can be charged. o Examples: Minimum wage Agricultural price supports

## Impact of a Price Ceiling

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

An Example from the 1970s Ceiling price of gasoline - \$1 3 hours in line to buy 15 gallons of gasoline o Opportunity cost: \$5/hr o Total value of time spent in line: 3 \$5 = \$15 o Non-pecuniary price per gallon: \$15/15=\$1 Full economic price of a gallon of gasoline: \$1+\$1=2

## Impact of a Price Floor

Comparative Static Analysis How do the equilibrium price and quantity change when a determinant of supply and/or demand change? 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.

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.

Scenario 1: Implications for a Small PC Maker Step 1: Look for the Big Picture Step 2: Organize an action plan (worry about details) Big Picture: Impact of decline in component prices on PC market

So, the Big Picture is: o PC prices are likely to fall, and more computers will be sold Use this to organize an action plan o contracts/suppliers? o inventories? o human resources? o marketing? o do I need quantitative estimates? o etc.

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 o a lower equilibrium price for computers o a greater number of computers sold. Step 2: How will these changes affect the Big Picture in the software market?

## Big Picture: Impact of lower PC prices on the software market

The big picture for the software maker: o Software prices are likely to rise, and more software will be sold Use this to organize an action plan

Summary Use supply and demand analysis to o clarify the big picture (the general impact of a current event on equilibrium prices and quantities) o organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.)

## The Concept of Elasticity:

Elasticity is a measure of the responsiveness of one variable to another. The greater the elasticity, the greater the responsiveness.

Laugher Curve Q. Whats the difference between an economist and a befuddled old man with Alzheimers? A. The economist is the one with a calculator.

Price Elasticity The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price. Percentage change in quantity demanded ED = Percentage change in price

Sign of Price Elasticity According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative. Because it is always negative, economists usually state the value without the sign.

What Information Price Elasticity Provides Price elasticity of demand and supply gives the exact quantity response to a change in price.

Classifying Demand and Supply as Elastic or Inelastic Demand is elastic if the percentage change in quantity is greater than the percentage change in price. E >1 Classifying Demand and Supply as Elastic or Inelastic Demand is inelastic if the percentage change in quantity is less than the percentage change in price. E <1

Elastic Demand Elastic Demand means that quantity changes by a greater percentage than the percentage change in price. Inelastic Demand Inelastic Demand means that quantity doesn't change much with a change in price.

Defining elasticities When price elasticity is between zero and -1 we say demand is inelastic. When price elasticity is between -1 and - infinity, we say demand is elastic. When price elasticity is -1, we say demand is unit elastic.

Elasticity Is Independent of Units Percentages allow us to have a measure of responsiveness that is independent of units. This makes comparisons of responsiveness of different goods easier.

Calculating Elasticities To determine elasticity divide the percentage change in quantity by the percentage change in price.

The End-Point Problem The end-point problem the percentage change differs depending on whether you view the change as a rise or a decline in price. Economists use the average of the end points to calculate the percentage change.

(Q2 - Q1)

Elasticity =

Q2 Q1 P1 + P2

(P2 - P1)

Graphs of Elasticities

## Calculating Elasticities: Price elasticity of Demand

Price Elasticity: Supply Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in

Price Elasticity: Supply Supply is elastic if the percentage change in quantity is greater than the percentage change in price Elastic supply is when ES > 1 Supply is inelastic if the percentage change in quantity is less than the percentage change in price Inelastic supply is when ES < 1

## Calculating Elasticities: Price elasticity of Supply

Graphs of Elasticities

Calculating Elasticity

Q2 Q1 (Q1 Q2 ) %Q E P2 P %P 1 1 1 2 2 (P P )
1 2

## Calculating Elasticity of Supply Between Two Points

Calculating Elasticity at a Point Let us now turn to a method of calculating the elasticity at a specific point, rather than over a range or an arc. To calculate elasticity at a point, determine a range around that point and calculate the arc elasticity. Calculating Elasticity at a Point

## Calculating Elasticity at a Point

Elasticity and Demand Curves Two important points to consider: Elasticity is related (but is not the same as) slope. Elasticity changes along straight-line demand and supply curves.

## Calculating Elasticity at a Point

Elasticity Is Not the Same as Slope The steeper the curve at a given point, the less elastic is supply or demand. There are two limiting examples of this. When the curves are flat, we call the curves perfectly elastic. The quantity changes enormously in response to a proportional change in price (E = innfinity). When the curves are vertical, we call the curves perfectly inelastic. The quantity does not change at all in response to an enormous proportional change in price (E = 0). Perfectly Inelastic Demand Curve

## Perfectly Elastic Demand Curve

Demand Curve Shapes and Elasticity Perfectly Elastic Demand Curve The demand curve is horizontal, any change in price can and will cause consumers to change their consumption. Perfectly Inelastic Demand Curve The demand curve is vertical, the quantity demanded is totally unresponsive to the price. Changes in price have no effect on consumer demand. In between the two extreme shapes of demand curves are the demand curves for most products. Demand Curve Shapes and Elasticity

Elasticity Changes Along Straight-Line Curves Elasticity is not the same as slope. Elasticity changes along straight line supply and demand curvesslope does not. Elasticity Along a Demand Curve

## The Price Elasticity of Demand Along a Straight-line Demand Curve

Substitution and Elasticity As a general rule, the more substitutes a good has, the more elastic is its supply and demand. Substitution and Demand The less a good is a necessity, the more elastic its demand curve. Necessities tend to have fewer substitutes than do luxuries. Demand for goods that represent a large proportion of one's budget are more elastic than demand for goods that represent a small proportion of one's budget. Goods that cost very little relative to your total expenditures are not worth spending a lot of time figuring out if there is a good substitute. The larger the time interval considered, or the longer the run, the more elastic is the goods demand curve. There are more substitutes in the long run than in the short run. The long run provides more options for change. Determinants of the Price Elasticity of Demand The degree to which the price elasticity of demand is inelastic or elastic depends on: How many substitutes there are How well a substitute can replace the good or service under consideration The importance of the product in the consumers total budget The time period under consideration.