Managerial Economics &

Business Strategy
Chapter 2
Market Forces: Demand and Supply

McGraw-Hill/Irwin
Michael R. Baye, Managerial Economics and
Business Strategy
 2-2

Overview

I. Market Demand Curve III. Market Equilibrium


The Demand Function IV. Price Restrictions

Determinants of Demand

Consumer Surplus V. Comparative Statics

II. Market Supply Curve


The Supply Function

Supply Shifters

Producer Surplus
 2-3

Market Demand Curve

• A curve indicating the total quantity of a
good all consumers are willing and able to
purchase at each possible price, holding the
prices of related goods, income, advertising,
and other variables constant.
• Law of Demand

The demand curve is downward sloping.

D
price

Quantity
 2-5

Determinants of Demand or
Demand shifters
• Income

Normal good

Inferior good
• Prices of Related Goods

Prices of substitutes

Prices of complements
• Advertising and
consumer tastes
• Population
• Consumer expectations
 2-6

The Demand Function

• A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X.

Px = price of good X.

PY = price of a related good Y.
• Substitute good.
• Complement good.

M = income.
• Normal good: A good for which an increase (decrease) in
income leads to an increase (decrease) in the demand for that
good.
• Inferior good.

H = any other variable affecting demand.
 2-8

Inverse Demand Function

• Price as a function of quantity

demanded.
• Example:

Demand Function
• Qxd = 10 – 2Px

Inverse Demand Function:
• 2Px = 10 – Qxd
• Px = 5 – 0.5Qxd
 2-9

Change in Quantity Demanded

Price
A to B: Increase in quantity demanded

A
10

B
6

D0

4 7 Quantity
 2-10

Change in Demand
Price
D0 to D1: Increase in Demand

6
D1

D0
7 13 Quantity
 2-11

Consumer Surplus:
• The value consumers get from a good but
do not have to pay for.
• Consumer surplus will prove particularly
useful in marketing and other disciplines
emphasizing strategies like value pricing
and price discrimination.
• is important to managers because it tells
how much extra money consumers would
be willing to pay for a given amount of a
purchased product.
 2-12

I got a great deal!

• That company offers a lot
of bang for the buck!
• Dell provides good value.
• Total value greatly exceeds
total amount paid.
• Consumer surplus is large.
 2-13

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: 2-14

Price
Consumer Surplus:
10 The value received but not
8 paid for. It is the area of the rectangle
Above the 2$
6

2
D
1 2 3 4 5 Quantity
An economic consultant for X Corp. recently provided the
firm’s marketing manager with this estimate of the
demand function for the firm’s product:
Qx = 12,000 - 3Px + 4Py -1M +2Ax

where Qx represents the amount consumed of good X, Px

is the price of good X, Py is the price of good Y, M is
income, and Ax represents the amount of advertising
spent on good X. Suppose good X sells for $200 per unit,
good Y sells for $15 per unit, the company utilizes 2,000
units of advertising, and consumer income is $10,000.
How much of good X do consumers purchase? Are goods
X and Y substitutes or complements? Is good X a normal
or an inferior good?
To find out how much of good X consumers will purchase,
we substitute the given values of prices, income, and
advertising into the linear demand equation to get:

Qx = 12,000 -3(200) +4(15) -1(10,000)+ 2(2,000)

Adding up the numbers, we find that the total

consumption of X is 5,460 units. Since the coefficient of Py
in the demand equation is 4 > 0, we know that a $1
increase in the price of good Y will increase the
consumption of good X by 4 units. Thus, goods X and Y
are substitutes. Since the coefficient of M in the demand
equation is 1 0, we know that a $1 increase in income will
decrease the consumption of good X by 1 unit. Thus, good
X is an inferior good.
Holding Px constant and graphing
the inverse demand function:
• where Py= $15, M =$10,000, and Ax =
2,000), we get:
• Qx d = 12,000 - 3Px + 4(15) - 1(10,000)
+2(2,000)
• which simplifies to
• Qx d = 6,060 - 3Px(2–1)
• the inverse demand function is:
• Px = 2,020 - 1/3 Qx d
 2-19

Market Supply Curve

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

Price
S0

Quantity
 2-20

Supply Shifters
• Input prices
• Technology or
government regulations
• Number of firms

Entry

Exit
• Substitutes in production
• Taxes

Excise tax

Ad valorem tax
• Producer expectations
 2-21

The Supply Function

• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

 QxS = quantity supplied of good X.

 Px = price of good X.
 PR = price of a production substitute.

W = price of inputs (e.g., wages).

H = other variable affecting supply.
 2-22

Inverse Supply Function

• Price as a function of quantity

supplied.
• Example:

Supply Function
• Qxs = 10 + 2Px

Inverse Supply Function:
• 2Px = 10 + Qxs
• Px = 5 + 0.5Qxs
 2-23

Change in Quantity Supplied

Price A to B: Increase in quantity supplied

S0
B
20

A
10

5 10 Quantity
 2-24
Change in Supply
S0 to S1: Increase in supply
Price

S0

S1

5 7 Quantity
Excise tax effect
Advalorem tax
 2-27

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

S0
P*

Q* Quantity
• Geometrically, producer surplus is the area
above the supply curve but below the
market price of the good.
 2-29

Market Equilibrium
• The Price (P) that Balances
supply and demand
 Qx S = Q x d

No shortage or surplus
• Steady-state
 2-30

If price is too low…

Price S

7
6

Shortage D
12 - 6 = 6
6 12 Quantity
 2-31
If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
 Demonstration Problem 2–4
According to an article in China Daily, China recently accelerated
its plan to privatize tens of thousands of state-owned firms.
Imagine that you are an aide to a senator on the Foreign Relations
Committee of the U.S. Senate, and you have been asked to help the
committee determine the price and quantity that will prevail when
competitive forces are allowed to equilibrate the market. The best
estimates of the market demand and supply for the good (in U.S.
dollar equivalent prices) are given by:

Qd = 10 - 2P and Qs 2 + 2P, respectively.

Determine the competitive equilibrium price and quantity.

 Answer:
• Competitive equilibrium is determined by
the intersection of the market demand and
supply curves. Mathematically, this simply
means that Qd = Qs . Equating demand and
supply yields:
• 10-2P = 2+ 2P
• 8=4P
• Pe =2
• Qe= 2+2(2)= 6
 2-34
Price Restrictions
• Price Ceilings

The maximum legal price that can be charged.

Examples:
• Gasoline prices in the 1970s.
• Price Floors

The minimum legal price that can be charged.

Examples:
• Minimum wage.
• Agricultural price supports.
 Price Ceiling
• Suppose that, for whatever reason, the
government views the equilibrium price of
Pe in Figure 2–11 as “too high” and passes
a law prohibiting firms from charging prices
above Pc . Such a price is called a price
ceiling
• A shortage of units will occur. The reason
is:
• First, producers are willing to produce less
at the lower price, so the available quantity
is reduced from Qe to Qs .
• Second, consumers wish to purchase more
at the lower price; thus, quantity demanded
increases from Qe to Qd .
 2-37

Impact of a Price Ceiling

Lost social welfare
Price S

PF

P* e

P Ceiling d

Shortage D

Qs Qd Quantity
Q*
 2-38

Example

• Suppose a senator raises a concern that the free

market price might be too high for the typical
Chinese citizen to pay. Accordingly, she asks you
to explain what would happen if the Chinese
government privatized the market, and set a price
ceiling of $1.50 , where the equilibrium price is of
$2, Assume that the market demand and supply
curves are given by:
• Qd = 10 - 2P and Qs= 2 + 2P
 Answer
• Since the price ceiling is below the
equilibrium price of $2, a shortage will
result. More specifically, when the price
ceiling is $1.50, quantity demanded is 7:
• Qd = 10 - 2(1.50) = 7
• Quantity supplied:
• Qs= 2 + 2(1.50)= 5
• Thus, there is a shortage of 7 - 5 =2 units
• To determine the full economic price, we
simply determine the maximum price
consumers are willing to pay for the five
units produced. To do this, we first set
quantity equal to 5 in the demand formula:
• 5= 10 - 2PF
• PF = $2.50.
• Thus, consumers pay a full economic price
of $2.50 per unit
 Price floor
• It is the minimum legal price that can be
charged in a market. for example: the
minimum wage
• If the equilibrium price is above the price
floor, the price floor has no effect on the
market.
• if the price floor is set above the
competitive equilibrium level, such as Pf in
Figure 2–12, there is an effect. Specifically,
when the price floor is set at Pf , quantity
supplied is Qs and quantity demanded is
Qd. In this instance, more is produced than
consumers are willing to purchase at that
price, and a surplus develops.
 2-43

Impact of a Price Floor

Price Surplus S
PF

P*

Qd Q* QS Quantity
 A problem
• One of the members of the Senate Foreign
Relations Committee has studied your
analysis of Chinese privatization ,but is
worried that the free market price might be
too low to enable producers to earn a fair
rate of return on their investment. He asks
you to explain what would happen if the
Chinese government privatized the market,
• but agreed to purchase the good from
suppliers at a floor price of $4. What do you
tell the senator?
• Answer: Since the price floor is above the
equilibrium price of $2, the floor results in a
surplus. More specifically, when the price is
$4, quantity demanded is:
• Qd= 10 - 2(4) = 2
• and quantity supplied is :
• Qs = 2 + 2(4) = 10
• Thus, there is a surplus of:
• 10 - 2 = 8 units.
• Consumers pay a higher price ($4), and
producers have unsold inventories of 8
units. However, the Chinese government
must purchase the amount consumers are
unwilling to purchase at the price of $4.
Thus, the cost to the Chinese government of
buying the surplus of 8 units is $4 * 8= $32.
 2-47

Comparative Static Analysis

• How do the equilibrium price and quantity
change when a determinant of supply
and/or demand change?
• The study of the movement from one
equilibrium to another is known as
comparative static analysis
 2-48

Applications of Demand and

Supply Analysis
• Event: The WSJ reports that consumer
incomes are expected to rise by about 2.5
percent over the next year, and the number
of individuals over 25 years of age will
reach an all-time high by the end of the
year.
• A rise in consumer incomes will most likely
increase the demand for rental cars. (normal
good)
 2-50

Changes in supply
Price S*
of
PCs S

P*
P0

Quantity of PC’s
Q* Q0
 2-51

Conclusion
• 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.).