# Ch02: Demand, Supply, and Equilibrium Prices Managerial Economics Prof. R. Michelfelder, Ph.D. Outline 2 Demand, Supply, Price, Revenues, Estimation of Demand Function and Prediction of Revenues 2.1 Outline 2 2.1 Theory of Demand 2.2 Theory of Supply 2.3 Demand, Supply & Price 2.4 Demand, Price Elasticity & Revenue Prediction

2.2 2.1 Theory of Demand The functional relationship between the price of a good or service and other variables and the quantity demanded or sales in units by consumers in a given time 2.3 Non-Price Factors Influencing Demand 1. Tastes and preferences Affected by socioeconomic factors

such as age, sex, race, marital status, and education level 2. Income The level of income (e.g. GDP) affects demand for normal goods and inferior goods 2.4 Non-Price Factors Influencing Demand 3. Prices of related goods Substitute goods when one good can be used in the place of another Complementary goods two or more

goods that consumers use together 4. Future expectations Number of consumers 6. Others (weather for electricity sales) 5. 2.5 Demand Function Q = f (P , T, Y, P , P , EXC, NC, where QXD XD = f (PXX, T, Y, PYY, PZZ, EXC, NC, where

QXD = sales in unit s or quantity demanded for good X PX = price of good X T = variables representing tastes and preferences Y = income (continued on next slide) 2.6 The Demand Function Q = f (P , T, I, P , P , EXC, NC, where QXD XD = f (PXX, T, I, PYY, PZZ, EXC, NC, where PY and PZ = prices of goods Y and Z, which relate to consumption of good X

EXC = consumer expectations about future prices NC = number of consumers 2.7 Demand Curves Price Figure 2.1 P1 P2 A B

The demand curve shows the relationship between price of a good and quantity demanded, all else constant Demand 0 Q1 Q2 Quantity 2.8 More About Demand Curves

Demand shifters: variables held constant when defining a demand curve but would shift if their values changed Negative (inverse) relationship: where an increase in one variable causes a decrease in another 2.9 Increase in Demand Price Figure 2.2 A change in demand

occurs when one or more of the factors are held constant in defining a given demand curve change D2 D1 P1 0 Q1 Q2 Quantity

2.10 Individual Versus Market Demand Curve Horizontal summation of individual demand curves: for every price, the quantity that each person demands at that price determines market quantity demanded at that price The market demand curve, D , M considers quantities demand at other prices 2.11

Price Individual Versus Market Demand Curve Figure 2.3 P1 DB DM = DA + DB DA 0 Q1 Q2

Q3 Q4 Quantity 2.12 Demand Function as an Equation (for copper) Q QDD == 10 10 -- 50P 50PCC ++ 0.31 0.31 ++ 1.5TC 1.5TC ++ 0.5E 0.5E where where

QD = sales of copper in pounds PC = price of copper per pound I = consumer income index TC = index showing uses for copper E = expectations index 2.13 Managerial Rule of Thumb: Demand Considerations Managers must Understand what influences demand Determine which factors they can influence Determine how to handle factors

they cannot influence 2.14 2.2 Theory of Supply The functional relationship between the price of a good or service and other variables that affect cost and the quantity that producers are willing to supply in a given time 2.15 Non-Price Factors Influencing Supply State of technology Input prices (labor, capital)

Prices of goods related in production Future expectations Number of producers 2.16 The Supply Function Q = f (P , TX, P , P , P , EXP, NP, where QXS XS = f (PXX, TX, PII, PAA, PBB, EXP, NP, where QXS = quantity supplied of good X PX = price of good X TX = state of technology

PI = prices of the inputs of production (continued on next slide) 2.17 The Supply Function Q = f (P , TX, P , P , P , EXP, NP, where QXS XS = f (PXX, TX, PII, PAA, PBB, EXP, NP, where PA, PB = price of goods A and B, related to good X EXP = producer expectations about future prices NP = number of producers

2.18 Price Supply Curve for a Product B P2 P1 0 Supply Relationship between price of a good and

quantity supplied A Q1 Figure 2.4 Q2 Quantity 2.19 Supply Relationships Not all supply curves are linear Supply curve does not show actual

price of product but the relationship of alternative prices and quantities A positive relationship is shown as upward line where increase in one variable causes increase in another variable 2.20 Price Changes (Increase) in Supply Figure 2.5 S1 S2 P1

0 Q1 Q2 A change in supply occurs when one or more of the factors held constant in defining a given supply curve change Quantity 2.21

Change in Quantity Supplied A price change causes movement from one point to another An increase in price of a substitute good causes the supply curve to shift to the left; a decreases shifts it to the right If the price of a complementary good increases, the supply increases An increase in the number of producers shifts it to the right 2.22 Managerial Rule of Thumb:

Supply Considerations Managers must Examine technology and costs of production Find ways to increase productivity while lowering production costs Supply curve is actually a portion the marginal cost curve 2.23 2.3 Demand, Supply, and Price A price for a good or service is determined when the market

reaches equilibrium The quantity demanded of good X equals the quantity producers are willing to supply An upset in equilibrium pushes the price back toward equilibrium 2.24 Market Equilibrium Price Figure 2.6 Supply PE

Market equilibrium occurs where demand equals supply Demand 0 QE Quantity QE = equilibrium quantity 2.25 PE = equilibrium price

Lower-ThanEquilibrium Prices Consumers demand more of a good than producers are willing to supply at that price Supply and demand become unstable An adjustment process begins which seeks to again bring equilibrium 2.26 Changes in Equilibrium Prices and Quantities Change in demand Change in supply Changes on both sides of the

market 2.27 4. Demand, Price Elasticity, Revenues & Prediction Mature & Start-up Firms Predict Income Statements and Cash Flows in a Business Plan Revenues are Driven by Sales: (predicted from demand function) 2012 2013

2014 2015 2016 Revenues Expenses Oper. Cash Flow 2.28 Price Elasticity The percentage change in the quantity demanded of a given good relative to a percentage change in its price

eP = % QQx % QPx where eP = price elasticity of demand Q = the absolute change Qx= quantity demanded of good X Px= the price of good X 2.29 Price Elasticity Price Figure 3.1

P1 A P B P2 0 Measured as a movement along a demand curve Q Q1

Demand Q2 Quantity 2.30 Price Elasticity and Decision Making Tells managers what will happen if product prices change Helps firms to develop pricing strategies Helps to develop pricing strategies in the public sector 2.31

Elasticity Elastic demand: change in quantity demanded is greater than the change in price Inelastic demand: change in quantity demanded is less than the change in price Unitary elasticity: change in quantity demand is equal to change in price 2.32 Elasticity and Total Revenue If demand is elastic, higher prices

result in lower total revenue. Lower prices result in higher total revenue Changes in price and the resulting total revenue are inversely proportionate (see Figure 3.2 on next slide) 2.33 Demand Elasticity Demand elasticity shows the percentage change in quantity demanded of a product relative to the percentage change in both variables

The coefficient represents the ratio of the two percentage changes 2.34 Elastic Demand and Total Revenue Figure 3.2 If prices decrease, revenue increases. If prices increase, revenue decreases. 12 (P1) 10 Price

(P2) 9 A Y B C X 0 2 3 (Q1) (Q2) Area X = Q1CBQ2

Area Y = P1ACP2 12 Demand Quantity 2.35 Inelastic Demand When units are sold at a lower price, the quantity demanded has not increased proportionately Total revenue decreases Changes in price and the resulting total revenue move in the same direction

(See Figure 3.3 on next slide) 2.36 Price Inelastic Demand and Total Revenue Figure 3.3 If prices decrease, revenue decrease. If prices increase, revenue increases. 12 (P1) 4 (P2) 3

0 A Y B Area X = Q1CBQ2 Area Y = P1ACP2 C X 8 9 12 (Q1) (Q2) Demand Quantity

2.37 Managerial Rule of Thumb: Estimating Price Elasticity Managers can estimate price elasticity by asking customers: 1. What do you currently pay for my product? 2. At what price would you stop buying my product altogether? Managers should ask themselves: 3. How much will revenue increase as a result of higher sales? 4. How much will revenue decrease as a result of lower prices for each unit?

2.38 Determinants of Price Elasticity of Demand 1. Number of substitute goods 2. Percent of a consumers income that is spent on the product 3. Time period under consideration 4. Nature of the good (durable or non-durable) 2.39 Calculating Price Elasticities Arc price elasticity: base quantity

(or price) is the average value of the starting and ending points Point price elasticity: measurement of the price elasticity of demand calculated at a point on the curve using infinitesimal changes in prices and quantities 2.40 Numerical Examples Demand function Shows relationship between quantity demanded and price

Q = 12 P or P = 12 Q Total revenue function Shows total revenue received by producer as a function of the level of output TR = (P) (Q) = (12 Q) (Q) = 12Q Q2 2.41 Numerical Examples Average revenue function: shows how average revenue is related to level of output AR = TR / Q = [(P) (Q)] / Q = P Marginal revenue function: shows the additional revenue a producer receives by

selling an additional unit of output at different levels MR = (TR) / (Q) = (TR2 TR1) / (Q2 Q1) MR = dTR / dQ = 12 2Q 2.42 Demand and Marginal Revenue Firms are always constrained by demand curve Top half of the demand curve in Figure 3.4 indicates when managers lower price, total revenue increases Bottom half indicates a price decrease causes total revenue

to fall 2.43 Demand and Marginal Revenue 12 |eP| > 1 6 0 |eP| = 1 6 Figure 3.4

Demand, marginal revenue, and total revenue functions are related |eP| < 1 Demand Marginal 12 Quantity Revenue 2.44 The Total Revenue

Function Figure 3.5 Total Revenue 36 18 Total Revenue 0 6 12 2.45

Extreme Demand Curves Vertical demand curve Represents perfectly inelastic demand Example might be insulin for diabetics Horizontal demand curve Represents perfectly elastic demand Example would be a bushel of wheat from an agricultural producer 2.46 Extreme Demand Curves Price 0

Price Vertical demand curve Demand Q1 Quantity Horizontal demand curve P1 Demand 0

Quantity 2.47 Elasticities of Demand Income elasticity of demand: percentage change in quantity demanded of a given good relative to percentage change in consumer income Necessities elasticity between 0 and 1 Luxuries elasticity greater than 1 2.48

Managerial Rule of Thumb: Calculating Income Elasticity Calculating income elasticity of demand is based on two questions for a consumer: 1. What fraction of your total budget do you spend on Product X? 2. If you earned a bonus of \$1000, what part of that bonus would you spend on Product X? 2.49 Elasticities of Demand

Cross-price elasticity of demand: measures how demand for Good X varies with changes in the price of Good Y Substitute goods have positive cross elasticity Complementary goods have negative cross elasticity Defines relevant market in which different products compete 2.50 Managerial Rule of Thumb:

Price Elasticity Decision Making Which demand elasticity should be used in making appropriate decisions: the one for the entire product or the one for the individual producer? (The answer depends upon how other firms react to price changes) 2.51 Marketing Literature Regarding Elasticity Issues Advertising elasticity of demand: the percentage change in quantity demanded of a good relative to the percentage change in advertising

dollars spent on that good Marketing studies Tellis, 1988 Sethuraman and Tellis, 1991 Hoch, et al, 1995 2.52