Lecture 3 - Market Forces of Demand and Supply

7/30/2019 Lecture 3 - Market Forces of Demand and Supply

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Managerial Economics

PGDM : 2013 15Term 1 (June September, 2013)

(Lecture 3)

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Market forces of Demand & Supply

Key Concepts

Law of Demand

Individual and Market DemandCurve

Shifters/Determinants of Demand

Law of Supply

Individual and Market SupplyCurve

Shifters/Determinants of Supply

Movement along the Demand(Supply) Curve vs. Shift of theDemand (Supply) Curve

Market Equilibrium Elasticity of Demand

Own Price, Cross Price andIncome Elasticity of Demand

Determinants of Elasticity

Relationships b/w Elasticity andRevenue and its implication

Comparative Statics use the tools ofDemand Supply

Government Intervention Price Ceiling and Price Floor:

Concept and Implication

Incidence of Tax:Consequences and Implications

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Markets and Competition

A market is a group of buyers and sellers of a particular product.

A competitive market is one with many buyers and sellers, each

has a negligible effect on price.

In a perfectly competitive market:

All goods exactly the same

Buyers & sellers so numerous that no one can affect marketprice each is a price taker

We assume markets are perfectly competitive throughout thedemand supply analysis.

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a15


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Slide 3

a15 In the real world, there are relatively few perfectly competitive markets. Most goods come in lots of different varieties includingburger, the example you would find here. And there are many markets in which the number of firms is small enough that some ofthem have the ability to affect the market price.

For now, though, we look at supply and demand in perfectly competitive markets, for two reasons:

First, its easier to learn. Understanding perfectly competitive markets makes it a lot easier to learn the more realistic but complicatedanalysis of imperfectly competitive markets.

Second, despite the lack of realism, the perfectly competitive model can teach us a LOT about how the world works, as we will seemany times in the topics that follow.arnab, 7/8/2013


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Why is Demand important?

An important contributor to firm risk arises from sudden shifts

in demand for the product or service.

Demand analysis serves two managerial objectives: it provides the insights necessary for effective

management of demand, and

it aids in forecasting sales and revenues.

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Demand

What is Demand?

The quantity demanded of any good is the amount of the

good that buyers are willing and able to purchase at a

certain price.

Law of Demand

The quantity demanded of a good falls when the price of

the good rises or vice-versa, other things being equal(Ceteris Paribus).

Following Law of Demand there is an inverse relationship

between price and quantity demanded.5

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Slide 5

a18 Note that this Law is applicable to Normal good. For giffen or Veblen goods there exists a direct relationship between price andquantity demanded.arnab, 7/8/2013


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Demand Schedule (Individual)

Demand schedule:

a table that shows the relationship

between the price of a good and the

quantity demanded

Example:

Demand for Burgers.

Notice that the preferences of the

consumer obey the Law of

Demand.

Price

of

Burger

Quantity

of Burgers

demanded

0.00 161.00 14

2.00 12

3.00 10

4.00 8

5.00 6

6.00 4

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7

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15

Price of

Burgers

Quantity

of

Burgers

Demand Schedule & Demand Curve (Individual)

Priceof

Burger

Quantityof Burgers

demanded

$0.00 16

1.00 14

2.00 12

3.00 10

4.00 8

5.00 6

6.00 4

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Slide 7

a19 Each point on the demand curve represents the maximum willingness to pay (WTP) of the consumerfor each unit of quantitydemanded. So this willingness to pay is then the buyer's price (which is determined by how the consumer is valuing the good) for eachunit of quantity demanded.arnab, 7/8/2013


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Market Demand versus Individual Demand

The quantity demanded in the market is the sum of the quantities

demanded by all buyers at each price.

Suppose A and B are the only two buyers in the Burger market.

(Qd= quantity demanded)

4

6

8

10

12

14

16

Consumer1s Qd

2

3

4

5

6

7

8

Consumer2s Qd

+

+

+

+

=

=

=

=

6

9

12

15

+ = 18

+ = 21

+ = 24Market Qd

$0.00

6.00

5.00

4.00

3.00

2.00

1.00

Price

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Slide 8

a2 This example violates the many buyers condition of perfect competition. Yet, we are merely trying to show here that, at each price,the quantity demanded in the market is the sum of the quantity demanded by each buyer in the market. This holds whether there aretwo buyers or two million buyers. But it would be harder to fit data for two million buyers on this slide, so we settle for two.arnab, 7/6/2013


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9

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25

P

Q

The Market Demand Curve for Burgers

P Qd

(Market)

$0.00 24

1.00 21

2.00 183.00 15

4.00 12

5.00 9

6.00 6

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Slide 9

a9 Whenever there is a price change while everything else remaining constant, there will be a movement along the Demand Curvearnab, 7/8/2013


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Demand (Curve) Shifters

The demand curve shows how price affects quantity

demanded, other things being equal.

These other things are non-price determinants of

demand (i.e., things that determine buyers demand

for a good, other than the goods price).

Changes in them shift theD curve

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Slide 10

a5 We are talking about Market Demand Curvearnab, 7/6/2013


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Income

Number of Buyers: Change in the Size of population can

change the number of buyers

Price of Related Goods: Price of substitute goods and Price of

Complementary goods

Taste or Preference : Both Advertising for the product and

Advertising by competitors can change the preference or tasteof the consumer

Future Expectation

Demand (Curve) Shifters

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Demand for a normal good is positively related to income.

Increase in income causes increase in quantity demanded at

each price, shiftsD curve to the right.

Decrease in income causes decrease in quantity demanded

at each price, shiftsD curve to the left.

Demand for an inferior good is negatively related to income.

An increase in income shiftsD curves for inferior goods to theleft.

Demand (Curve) Shifters: Income

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30

P

Q

Suppose the income of

the consumers

increases.

Then, at eachP,

Qdwill increase(by 5 in this example).

Demand Curve Shifters: Income

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Demand Curve Shifters: Number of Buyers

Increase in number of buyers leads to an increases in quantity

demanded at each price andD curve shifts to the right.

Decrease in number of buyers leads to an decrease in quantity

demanded at each price andD curve shifts to the left.

For example, suppose there is a sudden influx of foreign

immigrants into our country. Each immigrant is a consumer.

Therefore, this sudden change in the number of consumers willdefinitely increase the demand for certain goods immediately

like food, clothes, medicines etc.

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15

Two goods are substitutes to each other if consumption of either good gives

more or less the same level of satisfaction to the consumer.

Example: Tea and Coffee.

An increase in the price of coffee increases demand for tea, shifting the

demand curve to the right.

Other examples:

Coke and Pepsi;

Laptops and Desktop computers;

CDs and Music downloads;

Book (Hard Cover) and e-Book; Brown Rice and White Rice;

Foreign Tour and Local Tour;

Private car and Public Transportation;

Metro Ride and Bus Ride;

Smartphone and Ordinary Phone

Demand Curve Shifters: Prices of Related

Goods (Substitutes)

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Slide 15

a10 When a consumer is indifferent between two goods, the goods are perfect substitute to each other. In a scale of 0 to 1, you can thinkfor perfect substitutes the degree of substitutability is 1. However, in reality it is hard to find perfect substitutes.Since each good isdifferent from other a consumer cannot be indifferent between two good. Therefore, all the example I gave here are examples of closesubstitutes.However, for our purpose of understanding the basic principles of demand and supply it is innocuous to assume perfect substitutability

between two goods.arnab, 7/8/2013


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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30

P

Q

Suppose the price ofTea increases.

Then, at eachP,

Qdfor coffee will

increase(by 5 in this example).

Demand Curve Shifters: Price of Related

Goods (Substitutes)

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Slide 16

a7 Suppose Qd = 10 when P = $5 for Coffee.

Now suppose tea becomes more expensive, but price of coffee does not change, what would happen to the quantity of coffeedemanded? Would it remain at 10, would it increase, or would it decrease?

Since Tea and Coffee are substitutes to each other, whenever there is an increase in the price of Tea, the consumers (not all though;why?) will switch from tea to coffee. Thus given the fact that price of coffee does not change the demand for coffee will go up and thedemand curve shifts to the right.arnab, 7/8/2013


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Two goods are complements if consumption of both goods are required to obtaina certain level of satisfaction consumer desires.

Example: computers and software.If price of computers rises, people buy fewer computers, and therefore less

software. Software demand curve shifts left. Other examples:

Left Shoe and Right Shoe (the classic example) Coffee and Sugar; College education and textbooks, Bread and Butter, Pizza and Chili Flakes; Computer and Printer; i-pod and i-tune downloads; Smartphone and apps; Movie Ticket and Popcorn; Paper and Pen

Demand Curve Shifters: Prices of Related

Goods (Complements)

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30

P

Q

Suppose the price ofcomputer decreases.

Then, at eachP,

Qdfor software will

increase(by 5 in this example).

Demand Curve Shifters: Price of Related Goods

(Complement)

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Slide 18

a8 Suppose Qd = 10 when P = $5 for Computer.

Now suppose computer becomes less expensive, but price of price of software does not change, what would happen to the quantity ofsoftware demanded? Would it remain at 10, would it increase, or would it decrease?

Since Computer and Software are complement to each other, whenever there is an decrease in the price of software, the quantitydemanded for computers will increase. Therefore, the need for software will also rise. Thus given the fact that price of softwareremains the same, the demand for software will go up and the demand curve shifts to the right.arnab, 7/6/2013


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Anything that causes a shift in preference/tastes towarda good will increase

demand for that good and shift itsD curve to the right and vice-versa

Examples:

The Atkins diet became popular in the 90s, caused an increase in demand

for eggs, shifted the egg demand curve to the right.

The IT boom caused an increase in demand for IT education and shifted the

demand curve to the right.

New findings on the usefulness of drinking energy drink increases the

demand for the drink and shifts the demand curve to the right.

Good advertisement for a product can change the taste of a consumer and

subsequently shifts the demand curve to the right.

Demand Curve Shifters: Preferences/Tastes

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Expectations affect consumers buying decisions Inter-temporal Choice of

Consumption

Examples:

If people expect their incomes to rise, their demand for meals at expensive

restaurants may increase now shifting the demand curve to the right.

If the economy sours and people worry about their future job security, demand

for new autos may fall now and demand curve shifts to the left.

If it is expected that the price of a product (say, rice) would rise too much in next

month the demand for that product increases now shifting the demand curve to

the right.

Also, if it is expected that a product might not be available after two months thedemand for the product increases now shifting the demand curve to the right.

It is safe to conclude that future expectations force the consumers to make a choice

between todays and tomorrows consumptions accordingly shift the demand curve to

the right or left.

Demand Curve Shifters: Future Expectations

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Supply

What is Supply

The quantity supplied of any good is the amount that

sellers are willing and able to sell at a certain price.

Law of supply

The Law states that the quantity supplied of a good rises

when the price of the good rises, other things equal

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The Supply Schedule (Individual)

Supply schedule:

A table that shows the relationship

between the price of a good and the

quantity supplied.

Example:Starbucks supply of lattes.

Notice that Starbucks supply

schedule obeys theLaw of Supply.

Price

of

lattes

Quantity

of lattes

supplied

$0.00 0

1.00 3

2.00 6

3.00 9

4.00 12

5.00 15

6.00 18

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15

Starbucks Supply Schedule & Curve (Individual)

Priceof

lattes

Quantityof lattes

supplied

$0.00 0

1.00 32.00 6

3.00 9

4.00 12

5.00 15

6.00 18

P

Q

23

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Slide 23

a20 Each point on the supply curve represents the minimum willingness to accept (WTA) of the seller for each unit of quantity supplied. Sothis willingness to accept is then the sellers's price (which is determined by cost of producing each additional unit of the product) foreach unit of quantity supplied.arnab, 7/8/2013


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Market Supply versus Individual Supply

The quantity supplied in the market is the sum of

the quantities supplied by all sellers at each price.

Suppose Starbucks and CCD are the only two sellers in this

market. (Qs = quantity supplied)

18

15

12

9

6

3

0Starbucks

12

10

8

6

4

2

0Jitters

+

+

+

+

=

=

=

=

30

25

20

15

+ = 10

+ = 5

+ = 0Market Q

s

$0.00

6.00

5.00

4.00

3.00

2.00

1.00

Price

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

The Market Supply Curve

P

QS

(Market)

$0.00 0

1.00 5

2.00 10

3.00 15

4.00 20

5.00 25

6.00 30

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Supply Curve Shifters

The supply curve shows how price affects quantity supplied,

other things being equal.

These other things are non-price determinants of supply.

Non-price determinants of supply simply means the things

other than the price of a good that determine sellers supply

of the good.

Changes in them shift theScurve

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Cost of Production: Input Prices, Costs of regulatory

compliance, taxes or subsidies

Technology

Future Expectation

Number of Sellers

Accidental supply interruptions from fires, floods, etc

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Supply Curve Shifters: Cost of Production

(Input Price)

Examples of input prices: wages, prices of raw materials.

A fall (rise) in input prices makes production more (less)

profitable at each output price, so firms supply a larger(smaller) quantity at each price. TheScurve shifts to the right

(left).

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$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

0 5 10 15 20 25 30 35

P

Q

Suppose the price

of milk falls.

At each price, the

quantity of

Lattes suppliedwill increase

(by 5 in this

example).

Supply Curve Shifters: Input Prices

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Technology

Technology determines how much inputs are required to produce a unit

of output.

A cost-saving technological improvement has the same effect as a fall

in input prices, shiftsScurve to the right.

Number of Sellers

Existence of profit (loss) make s new (existing) firms to enter (leave)

the market for a good or service.

An increase (decrease) in the number of sellers increases (decreases)

the quantity supplied at each price, shiftsScurve to the right (left).

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Supply Curve Shifters: Expectations

Example:

Events in the Middle East lead to expectations of higher oil

prices.

In response, owners of Texas oilfields reduce supply now,

save some inventory to sell later at the higher price. Scurve shifts left.

In general, sellers may adjust supply* when their expectations

of future prices change.(*If good not perishable)

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Summary: Shift vs. Movement Along Curve

Change in the quantity demanded: a movement along a

fixedD curve occurs whenPchanges

Change in demand: a shift in theD curve

occurs when a non-price determinant of demand changes (likeincome or # of buyers)

Change in the quantity supplied:

a movement along a fixedScurve occurs whenPchanges

Change in supply: a shift in theScurve occurs when a non-price determinant of supply changes (like technology or costs)

Documents

Lecture 3 - Market Forces of Demand and Supply