MANAGERIAL ECONOMICS Introduction Demand and Supply

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MANAGERIAL ECONOMICSIntroductionDemand and
Supply

• POLONA DOMADENIK, PhD
• E-mail polona.domadenik_at_ef.uni-lj.si

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Outline of the lecture

• Demand Supply
• The Consumer Problem
• Network externalities
• Characteristics approach

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Demand Supply

• Applications of Supply and Demand Analysis
• Understanding and predicting how world economic
  conditions affect market price
• Analyzing the impact of price controls
• Analyzing the impact of production incentives on
  price and output
• Analyzing the impact of taxation, subsidies, and
  import restrictions on prices and output

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Market Demand

• The demand for a good or service is defined as
• Quantities of a good or service that people are
  ready (willing and able) to buy at various prices
  within some given time period, other factors
  besides price held constant.

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• Market demand is the sum of all the individual
  demands.

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The demand curve slopes downward demonstrating
that consumers are willing to buy more at a
lower price as the product becomes relatively
cheaper and the consumers real income
increases.

• The inverse relationship between price and the
  quantity demanded of a good or service is called
  the Law of Demand.

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• Changes in nonprice determinants result in
  changes in demand.
• Nonprice determinants of demand
• Tastes and preferences
• Income
• Prices of related products
• Future expectations
• Number of buyers
• This is shown as a shift in the demand curve.

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Market Supply

• The supply of a good or service is defined as
• Quantities of a good or service that people are
  ready to sell at various prices within some given
  time period, other factors besides price held
  constant.

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The supply curve slopes upward demonstrating
that at higher prices firms will increase output
Price ( per unit)
S
Changes in price result in changes in the
quantity supplied. Movement along the supply
curve.
Quantity
10

• Changes in nonprice determinants result in
  changes in supply.
• Nonprice determinants of supply
• Costs and technology
• Prices of other goods or services offered by the
  seller
• Future expectations
• Number of sellers
• Weather conditions
• This is shown as a shift in the supply curve.

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Market Equilibrium

• We are now able to combine supply with demand
  into a complete analysis of the market.

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The curves intersect at equilibrium, or
market- clearing, price. At P0 the quantity
supplied is equal to the quantity demanded at Q0
.
Price ( per unit)
S
P0
P0 4 Q0 300
D
Quantity
Q0
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The Market Mechanism

• Characteristics of the equilibrium or market
  clearing price
• QD QS
• No shortage
• No excess supply
• No pressure on the price to change

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ExampleThe case of surplus Price Floors
Price ( per unit)
S
Surplus
P1
Assume the price is P1 , then 1) Q2 gt Q1 2)
Excess supply is Q2-Q1 3) Producers lower price
D
Quantity
Q1
Q2
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How does the market mechanism work?
4) Quantity supplied decreases and quantity
demanded increases.
Price ( per unit)
S
Surplus
P1
D
Quantity
Q1
Q2
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ExampleThe case of shortage Price Ceilings
Price ( per unit
S
If price is below equilibrium 1) Price is below
the market clearing price 2) Qd gt Qs 3)
Price rises to the market-clearing price
P0
P2
Shortage
D
Quantity
Q0
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Price ( per unit)
S
Assume the price is P1 , then 1) Q2 gt Q1 2)
Shortage is Q2-Q1. 3) Producers raise price. 4)
Quantity supplied increases and quantity demanded
decreases.
P2
Shortage
D
Quantity
Q1
Q2
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Comparative Statics Analysis

• A common method of economic analysis used to
  compare various points of equilibrium when
  certain factors change.
• A form of sensitivity or what-if analysis.

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The procedure

• State all the assumptions needed to construct the
  model.
• Begin by assuming that the model is in
  equilibrium.
• Introduce a change in the model.In doing so, a
  condition of disequilibrium is created.
• Find the new point at which equilibrium is
  restored.
• Compare the new equilibrium point with the
  original one.

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New Equilibrium FollowingShifts in Supply and
Demand

• Consider a market where consumers disposable
  income increases and raw material prices fall.
• Both supply and demand will increase.

P
S
D
P1
Q1
Q
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P
S
D
D
S

• In this example, the increase in demand is
  greater than the increase in supply.
• This creates a shortage of (Q4 -Q3) at price P1.

P1
Q3
Q4
Q
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Both the equilibrium price and quantity
increase.
P
S
D
D
S
When supply and demand change simultaneously,
the impact on the equilibrium price and quantity
is determined by 1) The relative size and
direction of the change 2) The shape of the
supply and demand models
P2
P1
Q2
Q1
Q
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Example The Price of Eggs

• The real price of eggs fell by 68 from 1970 to
  1995.
• Supply increased due to the increased
  mechanization of poultry farming and the reduced
  cost of production.
• Demand decreased due to the increasing consumer
  concern over the health and cholesterol
  consequences of eating eggs.

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Market for Eggs
P (1970 dollars per dozen)
S1970
0.61
D1970
Q (million dozens)
5,300
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P (1970 dollars per dozen)
S1970
0.61
D1970
D1995
Q (million dozens)
5,300
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Prices fell until a new equilibrium was reached
at 0.24 and a quantity of 5,100 million dozen
P (1970 dollars per dozen)
S1970
S1995
0.61
0.24
D1970
D1995
Q (million dozens)
5,300
5,100
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Example The Price of a College Education

• The real price of a college education rose by 68
  percent from 1970 to 1995.
• Supply decreased due to higher costs of equipping
  and maintaining modern classrooms, laboratories
  and libraries, and higher faculty salaries.
• Demand increased due a larger percentage of a
  larger number of high school graduates attending
  college.

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Market for a College Education
P (annual cost in 1970 dollars)
S1970
2,530
D1970
Q
8.6
(millions of students enrolled))
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P (annual cost in 1970 dollars)
S1970
2,530
D1995
D1970
Q
8.6
(millions of students enrolled))
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Prices rose until a new equilibrium was reached
at 4,248 and a quantity of 14.9 million students
P (annual cost in 1970 dollars)
S1995
4,248
S1970
2,530
D1995
D1970
Q
8.6
(millions of students enrolled))
14.9
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Example The Long-Run Behavior of Mineral Prices

• Facts
• Consumption of iron has increased 20 times from
  1880 through 1995 indicating a large increase in
  demand.
• Real prices for iron has remained relatively
  constant.

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Long-Run Movements of Supply and Demand for
Mineral Resources
Price
S1900
D1900
Quantity
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Price
Increase in demand decrease in costs of
production
S1900
S1950
D1900
D1950
Quantity
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Price
S1900
S1950
S1995
D1900
D1950
D1995
Quantity
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Price
S1900
S1950
S1995
Long-Run Path of Price and Consumption
D1900
D1950
D1995
Quantity
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• Conclusion
• Decreases in the costs of production have
  increased the supply by more than enough to
  offset the increase in demand.
• Observation
• To accurately predict the future price of a
  product or service, it is necessary to consider
  the potential change in supply and demand.
• 1970 predictions for oil and other minerals
  proved incorrect because they only considered the
  demand side of the market.

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The Theory of Individual Behaviour

• Consumer preferences
• Constraints
• Consumer equilibrium
• Comparative statics
• Applications of indifference curve analysis
• Attribute approach to consumer problem

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Consumer Preferences

• Completeness
• The consumer is capable of expressing a
  preference for all bundles of goods.
• Transitivity
• Given 3 bundles of goods A, B C.
• If A ? B and B ? C, then A ? C.
• If A ? B and B ? C, then A ? C.
• More is Better
• Continuity

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Indifference Curve Analysis
Clothing (units per week)
The consumer prefers A to all combinations in the
blue box, while all those in the pink box are
preferred to A.
B
50
E
H
40
A
30
D
G
20
10
Food (units per week)
10
20
30
40
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Indifference Map
Indifference Curve A curve that defines the
combinations of 2 or more goods that give a
consumer the same level of satisfaction.
Good Y
III.
II.
I.

• An indifference map is a set of indifference
  curves that describes a persons preferences for
  all combinations of two commodities.

Good X
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Marginal Rate of Substitution
Marginal Rate of Substitution The rate at which a
consumer is willing to substitute one good for
another and stay at the same satisfaction level.
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Along an indifference curve there is a
diminishing marginal rate of substitution.
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The Budget Constraint

• Preferences do not explain all of consumer
  behavior.
• Budget constraints also limit an individuals
  ability to consume in light of the prices they
  must pay for various goods and services.
• The budget line indicates all combinations of
  two commodities for which total money spent
  equals total income.

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• Opportunity Set
• The set of consumption bundles that are
  affordable.
• PxX PyY ? M.
• Budget Line
• The bundles of goods that exhaust a consumers
  income.
• PxX PyY M.
• Market Rate of Substitution
• The slope of the budget line
• -Px / Py

The Opportunity Set
Y
Budget Line
Px
Py
X
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Effects of a Change in Income on the Budget Line
Clothing (units per week)
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An increase in income shifts the budget
line outward
60
40
20
L2
L1
(I 160)
(I 80)
Food (units per week)
80
120
160
40
0
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Effects of a Change in Income on the Budget Line
Clothing (units per week)
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A decrease in income shifts the budget line inward
60
40
L3
20
L2
L1
(I 80)
(I 160)
(I 80)
Food (units per week)
80
120
160
40
0
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Effects of a Change in Price on the Budget Line
Clothing (units per week)
A decrease in the price of food from 1 to 0.50
changes the slope of the budget line and rotates
it outward.
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L1
L2
(PF 1)
(PF 1/2)
Food (units per week)
80
120
160
40
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Effects of a Change in Price on the Budget Line
Clothing (units per week)
An increase in the price of food to 2.00
changes the slope of the budget line and rotates
it inward.
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L1
L2
L3
(PF 1)
(PF 1/2)
(PF 2)
Food (units per week)
80
120
160
40
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Consumer Equilibrium
Clothing (units per week)
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Does point B maximize consumer satisfaction?
B
30
A
20
U1
Budget Line
Food (units per week)
40
80
20
0
50
Maximizing Consumer Satisfaction
Clothing (units per week)
Point B does not maximize satisfaction because
the MRS (-(-10/10) 1 is greater than the
price ratio (1/2).
40
B
30
-10C
A
20
10F
U1
Budget Line
Food (units per week)
40
80
20
0
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Clothing (units per week)
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Does point D maximize consumer satisfaction?
D
30
20
U3
Budget Line
Food (units per week)
40
80
20
0
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Equilibrium
Clothing (units per week)
At market basket A the budget line and
the indifference curve are tangent and no
higher level of satisfaction can be attained.
40
30
A
20
U2
Budget Line
Food (units per week)
40
80
20
0
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• Recall, the slope of an indifference curve is
• Further, the slope of the budget line is

Equilibrium
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A Corner Solution
Clothing (units per week)
A corner solution exists at point B.
A
U2
U3
U1
A corner solution exists if a consumer buys in
extremes, and buys all of one category of good
and none of another.
Food (units per week)
B
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Example A College Trust Fund

• Suppose Jane Does parents set up a trust fund
  for her college education.
• Originally, the money must be used for education.
• If part of the money could be used for the
  purchase of other goods, her consumption
  preferences change.

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The budget line that Jane is faced with prior to
being awarded the trust is shown by line PQ.
Other Consumption ()
P
Jane initially consumes at point A.
A
U1
Education ()
Q
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Other Consumption ()
The trust fund shifts the indifference
curve outward, but the trust fund, PB, must
be spent on education
Corner Solution
P
B
A
U2
U1
Education ()
Q
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Other Consumption ()
If the trust could be used on other consumption,
the student would be better off at C.
C
P
B
A
U2
U1
Education ()
Q
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Comparative Statics
Changes in prices

• Substitute Goods
• An increase (decrease) in the price of good X
  leads to an increase (decrease) in the
  consumption of good Y.
• Complementary Goods
• An increase (decrease) in the price of good X
  leads to a decrease (increase) in the consumption
  of good Y.

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Complementary Goods
Pretzels (Y)
When the price of good X falls, the consumption
of complementary good Y rises.
B
Y2
II
A
Y1
I
0
X1
X2
Beer (X)
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Changes in income

• Normal Goods
• Good X is a normal good if an increase
  (decrease) in income leads to an increase
  (decrease) in its consumption.
• Inferior Goods
• Good X is a inferior good if an increase
  (decrease) in income leads to an decrease
  (increase) in its consumption.

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Normal Goods
Y
An increase in income increases the consumption
of normal goods.
B
II
A
I
X
0
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Example 1 A Classic Marketing Application
A buy-one, get-one free pizza deal.
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Example 1a Too Efficient Marketing Application
The Case of Hoover

• In Autumn 1992, the British home appliance
  manufacturer offered two free air tickets to
  every costumers who purchased an appliance with a
  price of 100 GBP or more
• The market value of two tickets exceed 400 GBP
• Effective Hoovers price was negative!!!
• 250-person task force was established to deal
  with fight bookings.
• Promotion costed more than 48 million GBP.

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Example 2 What should we buy for birthday
present?
A Gift of One Fruitcake
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A Cash Gift
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A Gift Certificates
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Example 3 Gasoline Rationing

• In 1974 and again in 1979, the government imposed
  price controls on gasoline.
• This resulted in shortages and gasoline was
  rationed.
• Nonprice rationing is an alternative to market
  rationing.

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• This can be seen in the following model.
• It applies to a woman with an annual income of
  20,000.
• The horizontal axis shows her annual consumption
  of gasoline at 1/gallon.
• The vertical axis shows her remaining income
  after purchasing gasoline.

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Without rationing, up to 20,000 gallons of
gasoline are available for consumption (B).
Spending on other goods ()
A
20,000
Without rationing, the consumer chooses point C.
C
15,000
U1
B
20,000
5,000
Gasoline (gallons per year)
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Spending on other goods ()
A
With a limit of 2,000 gallons, the consumer
moves to a lower indifference curve (lower level
of utility).
20,000
18,000
D
C
15,000
U1
U2
B
20,000
5,000
2,000
Gasoline (gallons per year)
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Individual Demand Curve

• An individuals demand curve is derived from each
  new equilibrium point found on the indifference
  curve as the price of good X is varied.

P0
P1
X0
X1
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Market Demand

• The market demand curve is the horizontal
  summation of individual demand curves.
• It indicates the total quantity all consumers
  would purchase at each price point.

Individual Demand Curves
Market Demand Curve


50
40
D2
D1
DM
Q
1 2 3
Q
1 2
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Network externalities

• The positive network externality exists if the
  quantity of the good demanded by a consumer
  increases in response to an increase in purchases
  by other consumers.
• The negative network externality exists if the
  quantity of the good demanded by a consumer
  decreases in response to an increase in purchases
  by other consumers.

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• BANDWAGON EFFECT the desire to be in style, to
  have a good because almost everyone else has it,
  or to indulge in a fad
• SNOB EFFECT (negative) refers to the desire to
  own exclusive or unique goods
• VEBLEN EFFECT consumers are willing to buy more
  products if price increases high price is more
  attractive

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Characteristics Approach
What is it?
The satisfaction the customers desire is
provided by the attributes or characteristics of
goods, not by the products themselves.
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Summer Holidays in Slovenia
Possibility Price/day Swimming
Nature Ratio No. of days A 9.700
88 30 2,93 5,15 B 9.500
76 39 1,95 5,26 C 9.300
68 45 1,51 5,37 D 7.000
30 55 0,54 7,14 E 8.000
12 85 0,14 6,25
M 50.000
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Swimming
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Budget Constraints and Efficiency Frontier
Swimming
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Optimal Selection
Swimming
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Optimal Selection with Indivisible Brands
Economy
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Effect of Price Change
? Price of brand B
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Effect of Price Change
? Price of brand C
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Effect of Income Change
? Income
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Change in Perceptions and Preferences
Size
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Introduction of New Brand