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Finance 30210: Managerial Economics

Finance 30210: Managerial Economics. Supply, Demand, and Equilibrium. Suppose that you are the “Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible. Farmer #1. Farmer #2. Farmer #3.

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Finance 30210: Managerial Economics

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  1. Finance 30210: Managerial Economics Supply, Demand, and Equilibrium

  2. Suppose that you are the “Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible. Farmer #1 Farmer #2 Farmer #3 You decide that farmers 1 and 3 are the cheapest so you have them produce as much as possible and then have farmer 2 make up the rest. Could you do better?

  3. Suppose that you are the “Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible. Farmer #1 Farmer #2 Farmer #3 The same 15 bushels are produced at a net $3 savings! By having farmer #3 scale back by one bushel, you save $7 By having farmer #2 scale up by one bushel, you spend $4

  4. Average Cost vs. Marginal Cost Average Cost is simply the total cost divided by quantity produced Marginal Cost refers to the additional costs incurred by producing on more unit Consider the following farmer:

  5. Suppose that you are the ‘Wheat Czar”. You are asked to use the three farmers to produce 15 bushels of wheat as cheaply as possible. The efficient (lowest cost solution) is where marginal costs are equal across all producers. Farmer #1 Farmer #2 Farmer #3

  6. Suppose that rather than choosing what each farmer grows you make the offer ‘I will buy any wheat produced for $6”. Farmer #1 At a $6 price, Farmer #1 would choose to produce 5 bushels as a profit maximizing decision. (P=MC) Farmer #1’s decision is not only individually optimal, but socially optimal (efficient) as well!! Further, this solution requires no information on individual farmers’

  7. At a stated market price of $4, each farmer chooses to produce up to the point where P=MC Farmer #1 Farmer #2 Farmer #3 Market Supply The market supply function simply adds up the decisions of each farmer at each potential market price

  8. A Supply Function represents the rational decisions made by a representative firm(s) “Is a function of” Quantity Supplied Market Price (+) Market Supply Price S $6.00 $4.00 Bushels of Wheat 9 15

  9. Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your citizens. To whom do you give the wheat? Citizen #1 Citizen #2 Citizen #3 Note: Marginal value is the dollar amount each citizen is willing to pay for each additional bushel of wheat Total Value = $84 Total Value = $10 Total Value = $56 Total = $150 Suppose we started out with citizens 1 and 3 getting 7 bushels each and citizen 2 getting one. We could do better, right?

  10. Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your citizens. To whom do you give the wheat? Citizen #1 Citizen #2 Citizen #3 Note: Marginal value is the dollar amount each citizen is willing to pay for each additional bushel of wheat Total Value = $84 Total Value = $18 Total Value = $54 Total = $156 By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss of $2 by #3 and a gain of $8 by #2)

  11. Now, as “Wheat Czar” you have 15 bushels of wheat to distribute amongst your citizens. To whom do you give the wheat? Citizen #1 Citizen #2 Citizen #3 As with the farmers, the best allocation is where values by all citizens (at the margin) are equal. Total Value = $84 Total Value = $24 Total Value = $50 Total = $158 By taking a bushel from #3 and giving it to #2, we get a net gain of $6 (A loss of $2 by #3 and a gain of $8 by #2) – As with the producers, announcing “I will sell wheat at $6/ bushel” would accomplish the same thing!

  12. At a market price of, say $6, each buyer decides how much to purchase Citizen #1 Citizen #2 Citizen #3 The market demand function simply adds up the decisions of each citizen at each potential market price

  13. A Demand Function represents the rational decisions made by a representative consumer(s) “Is a function of” Quantity Demanded Market Price (-) Price $10 $6 D Quantity 9 15

  14. Farmer #1 Farmer #2 Farmer #3 Market Supply An announcement of “ I will buy and sell at $6” Gets the job done! Citizen #1 Citizen #2 Citizen #3 Market Demand

  15. There is no need to even set the price. The market will find the $6 price on its own! Market Demand Market Supply Price $6 Quantity 15 We would call the $6 price the equilibrium price

  16. A market price below the equilibrium price would create a shortage! Market Supply Market Demand Price $2.00 At a price of $2.00, total supply is 3, but demand is at least 19 Quantity 3 19

  17. A market price above the equilibrium price would create a surplus! Market Supply Market Demand Price $8.00 At a price of $8.00, total supply is 20, but demand is less than 12 Quantity 12 20

  18. Note that citizen #1 would’ve paid up to $14 for the third bushel of wheat, but was only charged $6 in the marketplace. The $8 difference is referred to as consumer surplus Citizen #1 Price $14 $8 $6 Total = $42 Quantity 3 15

  19. Also, note that Farmer #1 would’ve sold that 3rd bushel of wheat for as low as $4. The difference a producers marginal cost and the market price is referred to as producer surplus. Farmer #1 Price $6 Total = $10 $2 $4 Quantity 3 15

  20. Farmer #1 Farmer #2 Farmer #3 Total = $10 Total = $6 Total = $15 Citizen #1 Citizen #2 Citizen #3 Total = $42 Total = $6 Total = $20

  21. A competitive marketplace maximizes the total consumer plus producer surplus. An efficient outcome! Price Total = $68 Total = $31 Total = $99 $68 $31 Quantity 15

  22. Example: Suppose we have the following petroleum firms. Further suppose that there is pressure from the public to reduce pollution levels. How would you go about reducing emissions by 50%

  23. The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms to reduce their emissions completely and let the other four firms continue as in the past $ Per Unit Pollution Reduction Hess $54 Gulf $48 First $42 Exxon $36 • Problems: • Unfair • Requires information on abatement costs Devon $30 Chevron $24 BP $18 Apache $12 Quantity of Emissions Reduction

  24. We could follow an “across the board” emission reduction program (note: pollution taxes would have the same basic effect)

  25. Let markets work for you!!! Example: Cap and Trade as a solution to pollution reduction. Could BP profit from selling a pollution permit to Gulf? What should the selling price be?

  26. The Market for pollution permits $ Per Unit Pollution Reduction Hess Hess S $54 Gulf Gulf $48 First First $42 Exxon Exxon $36 Equilibrium price range $33 Devon Devon $30 Chevron Chevron $24 BP BP $18 Apache Apache $12 D Quantity of Emissions Reduction

  27. The cap and trade program lowered the cost of pollution reduction by $2,400 (from $6,600 to $4,200).

  28. Note that cost of purchasing permits equals revenues from selling permits and so add so additional costs. Lets set the equilibrium permit price at $33.

  29. The consumer/producer surplus represents the gains by all firms $ Per Unit Pollution Reduction Hess Hess S $54 Gulf Gulf $48 $525 First First $42 $375 $225 Exxon Exxon $36 $75 $33 Devon Devon $30 $225 $375 $525 Chevron Chevron $24 $75 BP BP $18 Apache Apache $12 D Quantity of Emissions Reduction

  30. So far, we have the following: “Is a function of” “Is a function of” Quantity Supplied Quantity Demanded Market Price (+) Market Price (-) Price Consumer surplus represents all the gains to buyers in the market CS We can find an equilibrium price where demand equals supply P* Producer surplus represents all the gains to buyers in the market PS Quantity Q*

  31. We could do this numerically as well… Every $1 increase in price lowers demand by 2 units Every $1 increase in price raises supply by 4 units In Equilibrium Price S $15 D Quantity 70

  32. Consumer and producer surplus give us a numerical value of a marketplace… Note: a $50 price will set quantity demanded equal to zero. Price S $50 Consumer Surplus $1225 $15 Producer Surplus $525 D $0 Quantity 70

  33. Demand is not simply a function of price, but is, instead, a function of many variables “Is a function of” • Income • Prices of other goods (Substitutes vs. Compliments) • Tastes • Future Expectations • Number of Buyers Price Demand Shifters Example At the initial price of $10, but with a new value for one of the demand shifters, quantity demanded has risen to 120 (An increase in demand) Price Holding all the demand shifters constant at some level, quantity demanded at a price of $10 is 100 $10 D(.’.) D(…) Quantity 100 120

  34. Supply is not simply a function of price, but is, instead, a function of many variables “Is a function of” Price Supply Shifters Example At the initial price of $10, but with a new value for one of the supply shifters, quantity demanded has fallen to 80 (A decrease in supply) • Technology • Input prices • Number of sellers Marginal costs S(.’.) Price S(…) Holding all the supply shifters constant at some level, quantity supplied at a price of $10 is 100 $10 Quantity 80 100

  35. Example: How would the loss in income during the last recession impact the hotel industry? Rate per night At the current $150 market price, supply is still 50,000, but with a lower level of income, demand has fallen to 40,000 $150 # of Rooms 40,000 50,000 At the new income level of $50,000, $150 can no longer be the equilibrium price

  36. Example: How would the loss in income during the last recession impact the hotel industry? Rate per night $150 $125 # of Rooms 45,000 50,000 The decrease in income (which causes a decrease in demand) causes a drop in sales and a drop in market price

  37. Example: How would a drop in the wage rate in Columbia influence the price of coffee? Price per pound $5 At the current $5 market price, supply has risen to 18,000, but demand is still at 10,000 Pounds 10,000 18,000 At the wage level of $6, $5 can no longer be the equilibrium price

  38. Example: How would a drop in the wage rate in Columbia influence the price of coffee? Price per pound $5 $4 Pounds 10,000 16,000 The lower wage (which causes an increase in supply) , results in a lower price and higher sales

  39. We could do this numerically as well… Income in thousands Suppose that average income is $60,000 Price S $20 D( I =$60,000) 90

  40. Suppose that income rose to $72,000… Suppose that average income is $72,000 Price S $21 $20 D( I =$72,000) D( I =$60,000) 90 94

  41. Demand curves slope downwards – this reflects the negative relationship between price and quantity. Elasticity of Demand measures this effect quantitatively Price $2.75 $2.50 Quantity 4 5

  42. Consider the following demand curve We have the elasticity formula Every dollar increase in price lowers quantity demanded by 5 units A little rearranging gives us: Price $30 Change in quantity per dollar change in price Quantity 50

  43. Note that elasticities vary along a linear demand curve We have the elasticity formula Every dollar increase in price lowers quantity demanded by 5 units Price $30 $20 $10 Quantity 50 100 150

  44. Total revenue equals price times quantity. If you want to increase revenues, should you raise price or lower price? Revenues = $1500 Revenues = $2000 Price $30 Revenues = $1500 $20 $10 Quantity 50 100 150

  45. Supply curves slope upwards – this reflects the positive relationship between price and quantity. Elasticity of Supply measures this effect quantitatively Price $3.00 $2.00 Quantity 200 250

  46. Consider the following supply curve We have the elasticity formula Every dollar increase in price raises quantity supplied by 6 units A little rearranging gives us: Price Change in quantity per dollar change in price $25 Quantity 170

  47. Example: What effect would a shutdown of oil production in Iran have on oil prices? PDVSA Strike Iraq War Asian Expansion Iranian Revolution/ Iran Iraq War OPEC Cuts Yom Kippur war oil embargo 911 Gulf War

  48. It would be foolish to consider the entire oil market as perfectly competitive, but perhaps considering the non-OPEC market as perfectly competitive market is not entirely crazy There are around 100 Non-OPEC countries producing collectively 55M Bar/D.

  49. Suppose that we consider the following supply demand model: Demand Competitive Supply OPEC Supply Parameters to be estimated Parameters to be estimated To estimate four parameters, we need four pieces of information

  50. Let’s start with the demand side first. We can relate the equilibrium elasticity to the parameter ‘b’ The parameter ‘b’ represents the change in quantity demanded per dollar change in price A little rearranging…

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