Chapter 2
Market Forces: Demand And Supply analysis
• This chapter discusses Demand and supply sides of a
market :
• The Demand Function
• Determinants of Demand
• Consumer Surplus
• The Supply Function
• Determinants of supply
• Producer Surplus
• Market Equilibrium
2.1 Demand Analysis
DEMAND:
Desire to buy
+
Ability to pay
+
Willingness to pay
1. Market Demand
Law of Demand
• Other things being equal, the demand varies with the
price, more is demanded at a low price or less is
demanded at a high price.
• The demand curve is downward sloping.
Price
Quantity
Assumptions of the Law
•The size of income of a consumer remain
unchanged
•The size & composition of population remains
unchanged
•Tastes & preferences remain the same
•Prices of other goods remain same
•No expectation of price change
• No change in government policy
Determinants/shifters of Demand
• Income
• Prices of substitutes
• Prices of complements
Taste, habit and preferences
• Advertising
• Population
• Consumer expectations
• Invention and innovation
• Fashion
• climate
Types of Demand
• Direct demand
Demand is the quantity customers are willing to buy
under current market conditions.
Direct demand is demand for consumption.
• Derived or indirect demand
Derived demand is input demand.
Firms demand inputs that can be profitably employed.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
EXCEPTIONS OF DEMAND LAW
» Giffen goods
» Ignorance
» Luxury goods
» Superior goods
» Medicine
» Speculation
» Demonstration
» Fashion
Individual & Market Demand
The quantity demanded by an individual
purchaser at a given price is known as
individual demand whereas the total
quantity demanded by all the purchaser
together is known as market demand.
That is market demand shows the amount of
a good that will be purchased at alternative
prices.
The Demand Function
• An equation representing the demand curve
Qxd = f(Px , PY ,T, M, Ep,EM, U)
Qxd = quantity demand of good X.
Px = price of good X.
Ep = Consumer’s expectation about future price
EM = consumer’s expected future income
PY = price of a substitute good Y.
M = income.
T = tastes & Pref. of the
U = any other variable affecting demand
Demand Curve
• Demand Curve Determination
Demand curve shows price and quantity relation
holding everything else constant.
• Change in Quantity Demanded
Quantity demanded falls if price rises.
Quantity demanded rises if price falls.
• Role of Non-Price Variables
Change in non-price variables will define a new
demand curve.
Relation Between the Demand Curve and
Demand Function
• Movements Along Demand Curve
A rise in price causes upward movement along a given
demand curve.
A price decline causes downward movement along a
given demand curve.
• Demand Curve Shifts
Demand increases if a non-price change allows more to
be sold at every price.
Demand decreases if a non-price change causes less to
be sold at every price
Industry/Market Demand Versus Firm Demand
Industry demand is subject to general economic
conditions.
• Cyclical factors
• Systemic factors
• Political decisions
Firm demand is determined by
• economic conditions and competition.
Change in Quantity Demanded
Price
A to B: Increase in quantity demanded
A
10
B
6
D0
4 7 Quantity
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Change in Demand
Price
D0 to D1: Increase in Demand
6
D1
D0
7 13 Quantity
Consumer Surplus
• The value consumers get from a good but
do not have to pay for.
• It is the value received but not paid for a
good or services
Fig. Consumer Surplus
Price $
10 Value
of 4 units
8
Consumer
Surplus 6
4 Total Cost of 4 units
2
D
1 2 3 4 5 Quantity
2. 2 Supply Analysis
• 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
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Basis For Supply
• Firms Offer Supply To Make Profits
When prices rise, firms boost the quantity supplied.
When prices fall, firms cut the quantity supplied.
• Everything That Affects Marginal
Production Costs Affects Supply
If MC falls, supply rises.
If MC rises, supply falls.
Supply Shifters/determinants
• Input prices
• Technology or
government
regulations
• Number of firms
• Substitutes and
complements in
production
• Taxes
• Producer expectations
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
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 related good
W = price of inputs (e.g., wages)
H = other variable affecting supply
• Anything that affects the cost of doing business
will impact the firm’s decision to supply.
Labor costs
Materials costs
Overhead
Advertising
Productivity
Technology
Taxes
Also, changes in the number of suppliers.
• Determinants of Supply
Supply is determined by price, prices of
other goods, technology, and so on.
• Industry Supply Versus Firm Supply
Firm supply is determined by economic
conditions and competition.
Industry supply is the sum of firm supply.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Relation Between Supply
Curve and Supply Function
• Movements Along Supply Curve
A rise in price causes upward movement along a given
supply curve.
A price decline causes downward movement along a
given supply curve.
• Supply Curve Shifts
Supply increases if a non-price change allows more to
profitably produced and sold.
Supply decreases if a non-price change causes less to
be profitably produced and sold.
Michael R. Baye, Managerial Economics and Business Strategy, 3e. ©The McGraw-Hill Companies, Inc. , 1999
Change in Quantity Supplied
Price A to B: Increase in quantity supplied
S0
B
20
A
10
5 10 Quantity
Change in Supply
S0 to S1: Increase in supply
Price
S0
S1
5 7 Quantity
Producer Surplus
• The amount producers receive in excess of the amount
necessary to induce them to produce the good.
Price
S0
P*
Producer
Surplus
Q* Quantity
4. Market Equilibrium
• Balancing supply and
demand
Q S= Q d
x x
• Steady-state
Cont…
• Demand and Supply Balance
Equilibrium exists if perfect balance
exists in the quantities demanded and
supplied.
Equilibrium reflects productive and
allocative efficiency.
• Surplus and Shortage
Surplus is excess supply.
Shortage is excess demand.
If price is too low…
Price S
7
6
Shortage D
12 - 6 = 6
6 12 Quantity
If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7
6 8 14 Quantity
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
Impact of a Price Ceiling
Price
S
PF
P*
Ceiling
Price
Shortage D
Q* Quantity
Qs Qd
Impact of a Price Floor
Price Surplus S
PF
P*
Qd Q* QS Quantity
Cont…
• Changes in Equilibrium
Equilibrium exists when there is no economic incentive
for change in demand or supply.
Changing demand or supply affects equilibrium.
• Comparative Statics
Study of how equilibrium changes with changing
demand or supply.
Change continues until a new equilibrium is
established.
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