Lecture 2 Adj

ECF2731 Managerial Economics - Lecture 2: Demand & Supply

ECW2731 Managerial Economics

Lecture 2: Demand & Supply

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Lecture objectives:

Demand Supply

Market Equilibrium Comparative Statics

Unit objectives:

Recognize and evaluate the various theories of the organisation Understand and analyze firm pricing strategies

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Outline

Economic Optimization (CH. 1-2)

Demand/Consumer (Ch. 4)

Supply/Firm

(Ch. 7,8, 10, 12- 13)

General equilibrium & Role of Gov. (Ch. 15, 19, Ch. 12 other book)

Demand and Supply (Ch. 3)

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Roadmap

Management

Market entry/exit decision

Marketing

Evaluate effect of advertisement expenditure

Management accounting

Financial planing and forecasting

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Areas of application

Demand and Supply - Setting the stage

The market for automobiles.

Demand and supply are driven by various factors.

Some of these factors are beyond the control of the consumers and producer (exogenous e.g. Prices of related products).

Other factors can be controlled by the consumers and producer (endogenous e.g. Advertising).

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Market Demand

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Demand is the quantity of a good or service that customers are willing and able to purchase during a specified period under a given set of economic conditions.

Determinants of Demand

Demand is determined by price, prices of other goods, income, expectations of price changes, consumer tastes and preferences , advertising expenditures and so on.

Basis for Demand

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Direct Demand

Direct demand is demand for consumption.

Derived Demand

Derived demand is input demand.

Firms demand inputs that can be profitably employed.

Industry Demand Versus Firm Demand

Industry demand is subject to general economic conditions.

Firm demand is determined by economic conditions and competition.

Market Demand function

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Demand Curve

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Demand Curve Determination

Demand curve shows price and quantity relation holding everything else constant.

Change in Quantity Demanded

Quantity demanded falls if price rises.

Quantity demanded rises if price falls.

Role of Non-Price Variables

Change in non-price variables will define a new demand curve.

Relation between the demand curve and demand function

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Movements Along Demand Curve

A rise in price causes upward movement along a given demand curve.

A price decline causes downward movement along a given demand curve.

Demand Curve Shifts

Demand increases if a non-price change allows more to be sold at every price.

Demand decreases if a non-price change causes less to be sold at every price.

Market Demand Function - Roadmap

1

We apply tools:

Equations and Functions Graphs

to isolate one factor that influence demand/supply and,

evaluate the effect of this isolated factor on demand and supply.

Market Equilibrium

Comparative Statics

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2

3

4

5

Market Demand Function

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EXAMPLE

Let us analyse the market of automobiles

What are the variables in this demand function ?

P Average price of new domestic cars ($)

Px Average price of new imported cars ($)

I Disposable income per household ($)

Pop Population (millions)

i Average interest rate (%)

A Industry advertising expenditure (million $)


Demand Function (specific form):

If we are more precise about the functional form

Q = a1P + a2PX + a3I + a4Pop + a5i + a6A

(1)

an - parameters of the demand function

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Assume that the parameters of the demand function are known:

Q = 500P + 250PX + 125I + 20, 000Pop - 1, 000, 000i + 600A(2)

Interpretation of equation (2):

The demand for cars falls by 500 for each $1 increase in the average price.

The demand for cars . . . by . . . for each $1 increase in the average price of imported cars.

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Independent VariableParameterEst. Value for Ind. Variable during coming yearEstimated demandAv. price of new domestic cars ($)-50030,000-15,000,000Av. price of new imported cars ($)25060,00015,000,000Disp. income per household ($)12556,0007,000,000Pop. (millions)20,0003006,000,000Av. interest rate (%)-1,000,0008-8,000,000Advertising exp. (million $)6005,0003,000,000Total demand for cars8,000,000

Demand Curve


Demand curve shows price and quantity relation holding everything else constant.

Hold income, population, interest rates . . . constant to identify the effect of domestic automobile prices on quantity demanded.

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Hold income, population, interest rates . . . constant to identify the effect of domestic automobile prices on quantity demanded.

Q = 500P + 250(60, 000) + 125(56, 000) + 20, 000(300)

+ 1, 000, 000(8) + 600(5, 000)(3)

= 23, 000, 000 500P

Rearranging equation (4) allows us to express prices as a function of output.

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P = 46, 000 0.002Q

(4)

Demand Curve

Figure 1. Hypothetical Industry demand for New Domestic Automobiles

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Demand Curve

Change in Quantity Demanded

Quantity demanded falls if price rises.

Quantity demanded rises if price falls.

Role of Non-Price Variables

Change in non-price variables will define a new demand curve.

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Shift in Demand

Figure 2. Shifts in Hypothetical Industry demand for New Domestic Automobiles due to changes in interest rates

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Basis for Supply

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Firms Offer Supply To Make Profits

When prices rise, firms boost the quantity supplied.

When prices fall, firms cut the quantity supplied.

Remember from a previous lecture: A profits maximizing firm will increase production (supply) as far as Marginal Profit (MP) is positive (the profit obtained from the last unit produced increases total profit). And since MP=MR-MC the firm will produce up to the point in which MR=MC and MP=0.

Everything That Affects Marginal Production Costs or Marginal Revenue Affects Supply

If MC falls supply rises.

If MC rises supply falls.

If MR falls supply falls.

If MR rises supply rises.

Market Supply Function

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Determinants of Supply

Supply is determined by price, prices of other goods, technology, and so on.

Industry Supply Versus Firm Supply

Firm supply is determined by economic conditions and competition.

Industry supply is the sum of firm supply.


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Supply Curve

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Supply Curve Determination

Supply curve shows price and quantity relation holding everything else constant.

The Price-quantity Supplied Relation

A rise in price will increase the quantity supplied.

A fall in price will decrease the quantity supplied.

Along a supply curve, all non-price variables are held constant

Relation between supply curve and supply function

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Movements Along Supply Curve

A rise in price causes upward movement along a given supply curve.

A price decline causes downward movement along a given supply curve.

Supply Curve Shifts

Supply increases if a non-price change allows more to be profitably produced and sold.

Supply decreases if a non-price change causes less to be profitably produced and sold.


Supply Function:

Q = b1P + b2PSUV + b3W + b4S + b5E + b6i

Where:

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(5)

P PSUV

W

SE

i bn

Average price of new domestic cars (in $) Average price of new SUV (in $)

Hourly price of labour (wages in $ per hour) Average cost of steel ($ per ton)

Average cost of energy ($ per mcf natural gas) Average interest rate (in %)

parameters of the demand function

Supply Function

Assume that the parameters of the supply function are known:

Q = 2000P 500PSUV 100, 000W 15, 000S 125, 000E 1, 000, 000i (6)

Interpretation of equation (6):

The supply for cars . . .

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Supply is determined by price, prices of other goods, technology, and so on.

Industry Supply Versus Firm Supply

Firm supply is determined by economic conditions and competition. Industry supply is the sum of firm supply.

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Supply Curve Determination

Hold all else constant, to identify the effect of domestic automobile prices on quantity demanded.

Q = 2, 000P 500(42, 500) 100, 000(100) 15, 000(800)

125, 000(6) 1, 000, 000(8)

= 52, 000, 000 + 2, 000P

(7)

Rearranging equation (7) allows us to express prices as a function of output.

P = 26, 000 + 0.0005Q(8)

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Supply Curve

Figure 3. Hypothetical Industry Supply Curve for New Domestic Automobiles

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Relation Between Supply Curve and Supply Function

Movements Along Supply Curve

A rise in price causes upward movement along a given supply curve. A price decline causes downward movement along a given supply curve.

Supply Curve Shifts

Supply increases if a non-price change allows more to profitably produced and sold.

Supply decreases if a non-price change causes less to be profitably produced and sold.

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Shifts in Supply

Figure 4. Shifts in Hypothetical Industry Supply Curve for New Domestic

Automobiles due to changes in interest rate.

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Market Equilibrium

Demand and Supply Balance

Equilibrium exists if perfect balance exists in the quantities demanded and supplied.

Equilibrium reflects productive and allocative efficiency.

Surplus and Shortage

Surplus is excess supply. Shortage is excess demand.

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Surplus, Shortage, and Market Equilibrium

Figure 5. Surplus, Shortage, and Market Equilibrium

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Comparative Statics

Changes in Equilibrium

Equilibrium exists when there is no economic incentive for change in demand or supply.

Changing demand or supply affects equilibrium.

Comparative Statics

Study of how equilibrium changes with changing demand or supply. Change continues until a new equilibrium is established.

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Comparative Statics 1

Figure 6a. Comparative Statics 1

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Figure 6b. Comparative Statics 2

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Figure 7. Comparative Statics of Changing Supply AND Demand

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Until next class . . .

Prepare tutorial exercises

Moodle/Tutorials

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Supply Function. A review of industry wide data for the jelly and jam manufacturing

industry suggests the following industry supply function:

Q = -59,000,000 + 500,000P - 125,000PL - 500,000PK + 2,000,000W,

where Q is cases supplied per year, P is the wholesale price per case ($), PL is the

average price paid for unskilled labor ($), PK is the average price of capital (in percent),

and W is weather measured by the average seasonal rainfall in growing areas (in

inches).

A. Determine the industry supply c urve for a recent year when PL = $8, PK = 10

percent, and W = 20 inches of rainfall. Show the industry supply curve with

quantity expressed as a function of price and price expressed as a function of

quantity.

B. Calculate the quantity supplied by the indu stry at prices of $50, $60, and $70 per

case.

C. Calculate the prices necessary to generate a supply of 4 million, 6 million, and 8

million cases.

A vegetable fibre is traded in a competitive world market, and the world price is $9 per

pound. Unlimited quantities are available for import into the United States at this price.

The U.S. domestic supply and demand for various price levels are shown below.

PRICE U.S. SUPPLY

(MILLION LBS)

U.S. DEMAND

(MILLION LBS)

3 2 34

6 4 28

9 6 22

12 8 16

15 10 10

18 12 4

a) What is the equation for demand? What is the equation for supply?

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Lecture 2 Adj