CHAPTER 2 Market Forces: Demand and Supply Copyright © 2014 McGraw-Hill Education. All rights...

CHAPTER 2

Market Forces: Demand and Supply

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Chapter Outline• Demand

– Factors that change quantity demanded and factors that change demand – The demand function– Consumer surplus

• Supply– Factors that change quantity supplied and factors that change supply– The supply function– Producer surplus

• Market equilibrium• Price restrictions and market equilibrium

– Price ceilings– Price floors

• Comparative statics– Changes in demand– Changes in supply– Simultaneous shifts in supply and demand

2-2

Chapter Overview

• Market demand curve– Illustrates the relationship between the total

quantity and price per unit of a good all consumers are willing and able to purchase, holding other variables constant.

• Law of demand– The quantity of a good consumers are willing and

able to purchase increases (decreases) as the price falls (rises).

2-3

Demand

Demand

Market Demand Curve

2-4

Quantity(thousands per year)

Price ($)

Demand

$40

0

$30

$20

20 40

$10

60 80

Demand

• Changing only price leads to changes in quantity demanded.– This type of change is graphically represented by a

movement along a given demand curve, holding other factors that impact demand constant.

• Changing factors other than price lead to changes in demand.– These types of changes are graphically

represented by a shift of the entire demand curve.

2-5

Demand

Changes in Quantity Demanded

Changes in Demand

2-6

Quantity0

Price

D1

Increase in

demand

Demand

A

B

D0D2

Decrease in

demand

Demand Shifters• Income– Normal good– Inferior good

• Prices of related goods– Substitute goods– Complement goods

• Advertising and consumer tastes– Informative advertising– Persuasive advertising

• Population• Consumer expectations• Other factors

2-7

Demand

Advertising and the Demand for Clothing

2-8

Quantity of high-style clothing

0

$50

$40

50,000

Price of high-style clothing

D2

60,000

Due to an increase in advertising

Demand

D1

• The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for good X, different prices of a related good Y, different levels of income, and other factors that affect the demand for good X.

2-9

Demand

The Demand Function

• One simple, but useful, representation of a demand function is the linear demand function:

, where:– is the number of units of good X demanded;– is the price of good X;– is the price of a related good Y;– is income;– is the value of any other variable affecting demand.

2-10

Demand

The Linear Demand Function

• The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X demanded.

• For example:– by the law of demand;– if good Y is a substitute for good X;– if good X is an inferior good.

2-11

Demand

Understanding the Linear Demand Function

• Suppose that 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:

Question: How many of good X will consumers purchase when per unit, per unit, and ? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good?

2-12

Demand

The Linear Demand Function in Action

Inverse Demand Function• By setting and and the demand function is

the linear demand function simplifies to

Solving this for in terms of results in

, which is called the inverse demand function. This function is used to construct a market demand curve.

2-13

Demand

Graphing the Inverse Demand Function in Action

2-14

Quantity

Price

𝑃 𝑋=2,020−13𝑄𝑋

𝑑

$2,020

0 6,060

Demand

• Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products. – Total consumer value is the sum of the maximum

amount a consumer is willing to pay at different quantities.

– Total expenditure is the per-unit market price times the number of units consumed.

– Consumer surplus is the extra value that consumers derive from a good but do not pay for.

2-15

Consumer SurplusDemand

Quantity in liters

Price per liter

Demand

$5

0

$3

$2

1 2

$1

4 5

2-16

Total Consumer Value:0.5($5 - $3)x2+(3-0)(2-0) = $8

Expenditures: $(3-0) x (2-0) = $6

Consumer Surplus: 0.5($5 - $3)x(2-0) = $2

Demand

Market Demand and Consumer Surplus in Action

$4

3

Consumer Surplus

• Market supply curve – Summarizes the relationship between the total

quantity all producers are willing and able to produce at alternative prices, holding other factors affecting supply constant.

• Law of supply– As the price of a good rises (falls), the quantity

supplied of the good rises (falls), holding other factors affecting supply constant.

2-17

SupplySupply

• Changing only price leads to changes in quantity supplied.– This type of change is graphically represented by a

movement along a given supply curve, holding other factors that impact supply constant.

• Changing factors other than price lead to changes in supply.– These types of changes are graphically

represented by a shift of the entire supply curve.

2-18

Supply

Changes in Quantity Supplied

2-19

Change in Supply in Action

Quantity

Price

S2

0

Decrease in supply

Supply

A

B

S0S1

Increase in supply

• Input prices• Technology or government regulation• Number of firms– Entry– Exit

• Substitutes in production• Taxes– Excise tax (Levied on each unite of output sold)– Ad valorem tax (percentage tax: sales tax)

• Producer expectations2-20

Supply

Supply Shifters

2-21


Quantity of gasoline per week

Price of

gasoline

0

t = per unit tax of 20¢

Supply

S0

S0+t

t = 20¢

$1.20

$1.00

t

Excise tax

2-22


Quantity of backpacks per week

Price of

backpacks

0

Supply

S0

S1 = 1.20 x S0

$24

$10

Ad valorem tax

$12

1,100

$20

2,450

The Supply Function• The supply function for good X is a

mathematical representation describing how many units will be produced at different prices for X, different prices of inputs W, prices of technologically related goods, and other factors that affect the supply for good X.

2-23

Supply

The Linear Supply Function

• One simple, but useful, representation of a supply function is the linear supply function:

, where:– is the number of units of good X produced;– is the price of good X;– is the price of an input;– is price of technologically related goods;– is the value of any other variable affecting supply.

2-24

Supply

• The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X produced.

• For example:– by the law of supply.– increasing input price.– technology lowers the cost of producing good X.

2-25

Supply

Understanding the Linear Supply Function

• Your research department estimates that the supply function for televisions sets is given by:

Question: How many televisions are produced when , per unit, and ?

2-26

Supply

The Linear Supply Function in Action

Inverse Supply Function• By setting and in

the linear supply function simplifies to

Solving this for in terms of results in

, which is called the inverse supply function. This function is used to construct a market supply curve.

2-27

Supply

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

2-28

Supply

Producer Surplus

2-29

Producer Surplus in Action

Quantity

Price Supply

$400

0 800

𝑃 𝑋=4003

+13𝑄𝑋

𝑆

Supply

$ 4003

Producer surplus

• Competitive market equilibrium– Price of a good is determined by the interactions

of the market demand and market supply for the good.

– A price and quantity such that there is no shortage or surplus in the market.

– Forces that drive market demand and market supply are balanced, and there is no pressure on prices or quantities to change.

2-30

Market EquilibriumMarket Equilibrium

2-31

Quantity

Price Supply

0

𝑃𝐻

Demand

Surplus

Shortage

𝑃𝑒

Market Equilibrium

Market Equilibrium I

𝑃 𝐿

𝑄0 𝑄𝑒 𝑄1

• Consider a market with demand and supply functions, respectively, as

and • A competitive market equilibrium exists at a

price,

2-32

Market Equilibrium IIMarket Equilibrium

• In a competitive market equilibrium, price and quantity freely adjust to the forces of demand and supply.

• Sometimes the government restricts how much prices are permitted to rise or fall. – Price ceiling (rental control for tenants)– New York City’s rent control program, which began

in 1943, is among the oldest in the country– Price floor (minimum wage)– 7.25 dollar/hour in TX (Jan. 1st 2014)

2-33

Price Restrictions and Market Equilibrium

Price Restrictions

2-34

Quantity

Price Supply

0

𝑃 𝐹

𝑃𝑐

𝑄𝑠 𝑄𝑒 𝑄𝑑

DemandShortage

𝑃𝑒

PriceceilingNon

pecu

niar

y pr

ice

Lost social welfare


Price Ceiling in Action I


and • Suppose a $1.50 price ceiling is imposed on the

market.

– Full economic price of unit is , or . Of this, • $1.50 is the dollar price• $1 is the nonpecuniary price

2-35


Price Ceiling in Action II

2-36

Quantity

Price Supply

0

𝑃 𝑓

𝑄𝑑 𝑄𝑒 𝑄𝑠

Demand

Surplus

𝑃𝑒

Pricefloor


Price Floor in Action I

Cost of purchasing excess supply


and • Suppose a $4 price floor is imposed on the

market. – units– units– Since a surplus of units exists– The cost to the government of purchasing the

surplus is ?

2-37


Price Floor in Action II

• Comparative static analysis– The study of the movement from one equilibrium

to another.• Competitive markets, operating free of price

restraints, will be analyzed when:– Demand changes;– Supply changes;– Demand and supply simultaneously change.

2-38

Comparative StaticsComparative Statics

• Increase in demand only– Increase equilibrium price– Increase equilibrium quantity

• Decrease in demand only– Decrease equilibrium price– Decrease equilibrium quantity

• Example of change in demand – Suppose that consumer incomes are projected to

increase 2.5% and the number of individuals over 25 years of age will reach an all time high by the end of next year. What is the impact on the rental car market?

2-39

Changes in DemandComparative Statics

2-40

Change in Demand in Action

Quantity (thousands rented per day)

Price Supply

0

$45

104

Demand for Rental Cars

Demand1

$49

Demand0

100

Comparative Statics

108

• Increase in supply only– Decrease equilibrium price– Increase equilibrium quantity

• Decrease in supply only– Increase equilibrium price– Decrease equilibrium quantity

• Example of change in supply– Suppose that a bill before Congress would require

all employers to provide health care to their workers. What is the impact on retail markets?

2-41

Changes in SupplyComparative Statics

2-42

Quantity

Price

Supply0

0 𝑄0

Demand

𝑃0

Supply1

𝑃1

𝑄1

Comparative Statics


• Suppose that simultaneously the following events occur:– an earthquake hit Kobe, Japan and decreased the

supply of fermented rice used to make sake wine.– the stress caused by the earthquake led many to

increase their demand for sake, and other alcoholic beverages.

• What is the combined impact on Japan’s sake market?

2-43

Comparative Statics

Simultaneous Shifts in Supply and Demand

2-44

Quantity

Price

Supply0

𝑃0

0

Demand1

𝑃1

Supply1

Demand0

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Japan’s Sake Market

𝑄0𝑄1

Supply2

𝑃2

𝑄2

A

B

C

• Demand and supply analysis is useful for– Clarifying the “big picture” (the general impact of

a current event on equilibrium prices and quantities).

– Organizing an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

2-45

Conclusion

Market Demand Curve

2-46

Quantity(Millions of Barrels)

Price(Dollars per Barrel)

Demandoil

$140

0

$100

$60

80 160

$20

240 280

International Oil Market

Demand

Changes in Quantity Demanded

2-47



Demandoil

$140

0

$100$90

80 100 280


Increase in quantity demanded

Demand

Change in Demand

2-48



Demandoil1

$140

0

$100$90

80 100 280


Demandoil2

120 140

Increase in demand

$160

Demand

2-49



Supplyoil

0

$65$60

80 90

$20


Increase in quantity supplied

Supply

Change in Quantity Supplied

2-50



Supplyoil

$140

0

$100

$60

80 160

$20

240


Supply

The Market Supply Curve

2-51




Supplyoil1

$140

0

$100

180

$20

240

International Oil MarketSupplyoil2

100 160

$50

Decrease in supply

Supply

2-52



Supplyoil

$140

0

$120

$40

40 Qe = 120

$20

200 280


Demandoil

Surplus 160 million barrels

Forces of demand and supply put downward pressure on price.

Shortage160 million barrels

Forces of demand and supply put upward pressure on price.

Pe = $80 Competitive market equilibriumQd(Pe) = Qs(Pe)

Market Equilibrium

Competitive Market Equilibrium I

2-53



Supplyoil

$140

0

Pf = $120

Pc = $40

40 Qe = 120

$20

200 280


Demandoil

Shortage160 million barrels

Pe = $80 Competitive market equilibriumQd(Pe) = Qs(Pe)

PriceceilingNon

pecu

niar

y pr

ice

Lost social welfare


Price Ceiling in Action I

• Increase in demand only– Increase equilibrium price– Increase equilibrium quantity

• Decrease in demand only– Decrease equilibrium price– Decrease equilibrium quantity

• Example of change in demand – Suppose that worldwide demand for automobiles

is projected to decrease by 30% next year. What is the impact on the international crude oil market?

2-54

Changes in DemandComparative Statics

2-55

Change in Demand in Action



Supplyoil

$140

0

Pe2 = $54

Qe1 = 120

$20

280


Demandoil1

Pe1 = $80

Demandoil2

Qe2 = 68

Comparative Statics

• Increase in supply only– Decrease equilibrium price– Increase equilibrium quantity

• Decrease in supply only– Increase equilibrium price– Decrease equilibrium quantity

• Example of change in supply– Suppose that war breaks out in a major oil-

producing country in the Middle East. What is the impact on the international crude oil market?

2-56

Changes in SupplyComparative Statics

2-57



Supplyoil1

$140

0 Qe1 = 120

$20

280


Demandoil

Pe1 = $80

Supplyoil2

Pe2 = $100

Qe2 = 80

Comparative Statics


• Suppose that simultaneously the following two events occur:– worldwide demand for automobiles is projected

to decrease by 30% next year. – war breaks out in a major oil-producing country in

the Middle East. • What is the combined impact on the

international crude oil market?

2-58

Comparative Statics

Simultaneous Shifts in Supply and Demand

2-59



Supplyoil1

$140

Pe2 = $65

Qe2 = 10 Qe1 = 120

$20

280


Demandoil1

Pe1 = $80

Supplyoil2

Demandoil2

The equilibrium price increases or decreases depending on themagnitude of the demand and supply changes.

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

CHAPTER 2 Market Forces: Demand and Supply Copyright © 2014 McGraw-Hill Education. All rights...

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Transcript of CHAPTER 2 Market Forces: Demand and Supply Copyright © 2014 McGraw-Hill Education. All rights...