Managerial Economics & Business Strategy

1. Managerial Economics & Business Strategy Chapter 2 Market Forces: Demand and Supply

2. Overview II. Market Supply Curve • The Supply Function • Supply Shifters • Producer Surplus I. Market Demand Curve • The Demand Function • Determinants of Demand • Consumer Surplus III. Market Equilibrium IV. Price Restrictions V. Comparative Statics

3. Quantity of a good that people are willing and able to buy, at various prices, ceteris paribus. One-to-one relationship willingness and ability all else the same Market Demand Curve

4. Law of Demand Price and quantity demanded are inversely related See “Lesson from Malawi” The demand curve is downward sloping. Quantity Market Demand Curve Price D

5. Determinants of Demand • Income • Prices of substitutes • Prices of complements • Advertising/preferences • Population • Consumer expectations

6. The Demand Function • A general equation representing the demand curve Qxd = f(Px ,PY , PZ, I, A, Pop, Pe) • Qxd = quantity demand of good X. • Px = price of good X. • PY = price of a substitute good Y. • PZ = price of a complementary good Z • I = income. • A = advertising expenses as a proxy for preferences • Pop = population in the relevant area • Pe = price expectations

7. The Demand Function • A linear equation representing the demand curve Qxd = a0+a1Px+ a2 PY+a3PZ+a4I+a5A+a6Pop • ai is the coefficient on the variable of interest • Sign • Size • Qxd = quantity demand of good X. • Px = price of good X. • PY = price of a substitute good Y. • PZ = price of a complementary good Z. • I = income. • A = Advertising expense as a proxy for preferences • Pop = relevant population Demand Shifters

8. The Demand Function • A linear equation representing the demand curve • Numerical example Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop • Signs (+ or -), why? • a0 (+ or -) • a1 (+ or -) • a2 (+ or -) • a3 (+ or -) • a4 (+ or -) • a5 (+ or -) • a6 (+ or -) • Where do we get the numbers?

9. The Demand Function • A linear equation representing the demand curve • Numerical example Qxd = a0+a1PX+ a2 PY+a3PZ+a4I+a5A+a6Pop • Suppose: • a0 = 40 • a1 = -33 • a2 = 26 and PY = 14 • a3 = -16 and PZ = 17 • a4 = -0.002 and I= 26,500 • a5 = 0.36 and A= 1,356 • a6 = 0.0001 and Pop= 32,763

10. The Demand Function • Numerical example: • insert non-control variables • Qxd = 40-33*PX+26*14-16*17-0.002*26,500+0.36*1,356+0.0001*32,736 • Reduce the values • Qxd = 40-33*PX+364-272-53+488.16+3.2736 • Qxd = 570.4336-33*PX • For any value of PX we can get an estimate of sales volume • PX = 10 gets Qxd = 570.4336-33*10= 570.4336-330 = 240.4336 • Simple inversion allows us to estimate the price we can charge for a particular volume • 33*PX = 570.4336 - Qxd  PX = 17.28587- 0.03030* Qxd • If Qxd = 10 then PX = 17.28587- 0.03030* 10 = 16.9828

11. Price A to B: Increase in quantity demanded A 10 B 6 D0 4 7 Quantity Change in Quantity Demanded a1 = Q/P = (7-4)/6-10) = -3/4 If P = 1 then a1 = Q

12. Change in Demand Price D0 to D1: Increase in Demand 6 D1 D0 13 Quantity 7 • Increase in demand • At the same price, more is demanded or • For the same quantity a higher price can be received • Decrease in demand • At the same price, less is demanded or • For the same quantity a lower price will be received ai, i  0,1

13. Consumer Surplus • The value to consumers above what they paid. • Value is determined by the individual - no good has any value except as the possessor or would-be possessor attributes to it • Example: willing to pay $20, but only pay $18. You have $2 in consumer surplus.

14. Individual B’s Consumer’s Value Individual C’s Consumer’s Value Price Individual A’s Consumer’s Value Individual D’s Consumer’s Value 10 8 Consumer Surplus: The value received but not paid for 6 4 Amount Spent 2 D 1 2 3 4 5 Quantity Consumer Surplus: The Discrete Case

15. C.S. P* Consumer Surplus:The Continuous Case • If we arranged all consumers based on maximum willingness and ability to pay we get the demand curve. • Area under the demand curve and above the price is total consumer surplus for the market. • It represents dollars out the door • Price discrimination (pp 410-415) • Ability to sort • Ability to prevent resale • Profitability

16. Market Supply Curve • The supply curve shows the amount of a good that producers (sellers) are willing and able to sell, at various prices, ceteris paribus. • One-to-one relationship • willingness and ability • all else the same

17. Market Supply Curve • The supply curve tends to be upward sloping: • Increasingly expensive inputs • Diminishing marginal product (we will get there) • It is not as consistent as “Law of Demand” Price S0 Quantity

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

19. The Supply Function • An equation representing the supply curve: QxS = f(Px ,Tech,PR ,W, Comp) • QxS = quantity supplied of good X. • Px = price of good X. • Tech = generation of the production technology • PR = price of other good that could be produced • W = price of inputs (e.g., wages) • Comp = number of firms in the industry (competitors)

20. The Supply Function Linear equation representing the supply curve: QxS = b0+b1*PX+b2*Tech+b3*PR+b4*W+b5*Comp bi is the coefficient on the variable of interest Sign Size We expect: b0 (+ or -) b1 (+ or -) b2 (+ or -) b3 (+ or -) b4 (+ or -) b5 (+ or -)

21. The Supply Function A numerical example of a linear supply curve: QxS = b0+b1*PX+b2*Tech+b3*PR+b4*W+b5*Comp We observe: b0 = -100 b1 = 15 b2 = 15, Tech = 4 b3 = -0.06, PR= 1.60 b4 = -0.15, W = 10.55 b5 = 0.038, Comp = 23 Putting values in: QxS = -100+15*PX+15*4-0.06*1.60-0.15*10.55+0.038*23 QxS = -100+15*PX+60-0.096-1.5825+0.874 QxS = -41.6785+15*PX Unless PX > 2.78 there will be no product supplied.

22. Price A to B: Increase in quantity supplied S0 B 20 A 10 Quantity 5 10 Change in Quantity Supplied b1 = Q/P = (10-5)/(20-10) = 1/2 If P = 1 then b1 = Q = 1/2

23. S0 to S1: Increase in supply Price S0 S1 8 6 7 5 Quantity Change in Supply • Increase in supply: • At the same price a higher quantity supplied • The same quantity will be supplied at a lower price • Decrease in supply: • At the same price a lower quantity will be supplied • The same quantity will be supplied at a higher price bi, i  0, 1

24. Producer Surplus • The amount producers receive in excess of the amount necessary to induce them to produce the good. • This is not the same as profit, though it is similar. Price S0 P* Producer Surplus Q* Quantity

25. Market Equilibrium • Balancing supply and demand • Opposing responses to the same stimuli • Price such that: QxS = Qxd • e.g. QD = 570 -33P, QS = -42 + 15P • P = 12.7, Q = 148.5 • Steady-state • Strong tendency to move towards this level

26. If price is too low… S 7 6 5 D Shortage 12 - 6 = 6 6 12 Price Quantity

27. If price is too high… Surplus 14 - 6 = 8 S 7 8 9 D 6 8 14 Price Quantity

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

29. Impact of a Price Ceiling Price S PF P* Ceiling Price D Shortage Quantity Q* Q s Q d

30. 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 (Black market price) • PC = price ceiling • PF - PC = nonpecuniary price

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

32. Common Price Ceiling Results • Shortages • Black markets • Creative non-cash payment schemes • Examples • Key money • Furniture sales • Line sitting as an occupation • Rent seeking behavior • Price distortions • Examples • NYC real estate value & vacant buildings • Santa Monica

33. Surplus Price S P* D Quantity Qd Q* QS Impact of a Price Floor PF

34. Impact of a Price Floor - enforced • Surplus - increase quantity supplied, reduced quantity demanded • Enforcement expenses • Compliance expenses • Black market operations • Example: minimum wage • training wages • cash only work

35. Impact of a Price Floor - supported • Surplus - increase quantity supplied, reduced quantity demanded • Purchases (surplus * price floor) • Storage expenses • What do you do with it? • Examples: • Diary products • Tobacco • Oranges • Rubber

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

37. Comparative Static Analysis- By Steps • What happened? • value of information; multiple, reliable data sources • Does this effect Demand and/or Supply? • remember behavioral factors • Is it an increase or a decrease? • remember the sign on the coefficient • What happens to P* and Q*?

38. “Liar's Poker: Rising Through the Wreckage on Wall Street”by Michael Lewis • Event: Cherynobyl • Results of greed, understanding and access: • early retirement • dampened price/quantity movements

39. Liar's Poker • Potato market is in equilibrium • Stable demand • Stable supply • Well developed futures markets • Price and volume are constant across time. • Arbitrage opportunity - across time and location

40. S3 S1 P1 P2 P3 P P P0 S0 S0 D2 Q1 Q2 Q3 D0 D0 Q Q Q0 Q0 Liar's Poker

41. 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.

42. Comparative static analysis shows how the equilibrium price and quantity will change when a determinant of supply or demand changes. Use Comparative Static Analysis to see the Big Picture!

43. Scenario 1: Implications for a Small PC Maker • Step 1: Look for the “Big Picture” • Step 2: Organize an action plan (worry about details)

44. Big Picture: Impact of decline in component prices on PC market Price of PCs S S* P0 P* D Quantity of PC’s Q* Q0

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

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

47. Big Picture: Impact of lower PC prices on the software market S P1 P0 D* D Q0 Q1 Price of Software Quantity of Software

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

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