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

Chapter Overview

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

Demand

Demand

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

Market Demand Curve

Price ($)
$40

$30

$20

$10

Demand
0

20

40

60

80

Quantity
(thousands per year)
2-4

Changes in Quantity Demanded

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 Demand
Price

Increase
in
demand

Decrease
in
demand

D1

D2
0

D0
Quantity

2-6

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

Price of
high-style
clothing
Due to an
increase in
advertising

$50
$40

D2
D1
0

50,000 60,000

Quantity of
high-style
clothing
2-8

The Demand Function

Demand

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

The Linear Demand Function

Demand

One simple, but useful, representation of a

demand function is the linear demand function:

= 0 + + + +
, 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

Understanding 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.
= 0 + + +
For example:
< 0 by the law of demand;
> 0 if good Y is a substitute for good X;
< 0 if good X is an inferior good.

2-11

Demand

The Linear Demand Function in Action

Suppose that an economic consultant for X Corp. recently
provided the firms marketing manager with this estimate of the
demand function for the firms product:
= 12,000 3 + 4 1 + 2
Question: How many of good X will consumers purchase when
= $200 per unit, = $15 per unit, = $10,000 and
= 2,000? Are goods X and Y substitutes or complements? Is
good X a normal or an inferior good?

Answer:
= 12,000 3 200 + 4 15 1 10,000 + 2 2000 =
5,460 units. Goods X and Y are substitutes. Good X is an inferior
good.

2-12

Inverse Demand Function

Demand

By setting = $15 and = $10,000 and

= 2,000 the demand function is

= 12,000 3 + 4 15 1 10,000 + 2 2,000

the linear demand function simplifies to

= 6,060 3
Solving this for in terms of results in
1
= 2,020
3
, 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

Price
$2,020

1
= 2,020
3

6,060

Quantity

2-14

Demand

Consumer Surplus
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

Demand

Market Demand and Consumer Surplus in Action

Consumer Surplus
Price per
liter

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

$5
$4

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

$3
$2
$1

Demand
0

Quantity
in liters
2-16

Supply

Supply

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

Changes in Quantity Supplied

Supply

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

Change in Supply in Action

Supply

Price
S1

S0
B

Decrease
in supply

S2

Increase
in supply

Quantity

2-19

Supply Shifters

Supply

Input prices
Technology or government regulation
Number of firms
Entry
Exit

Substitutes in production
Taxes
Excise tax
Ad valorem tax

Producer expectations
2-20

Change in Supply in Action

Supply

Excise tax

Price
of
gasoline

S0+t

$1.20

S0
t = 20

t
$1.00

t = per unit tax of 20

Quantity of
gasoline per
week
2-21

Change in Supply in Action

Price Ad valorem tax
of
backpacks

Supply

S1 = 1.20 x S0

$24

S0
$20
$12
$10

1,100

2,450

Quantity of
backpacks per
week
2-22

The Supply Function

Supply

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

The Linear Supply Function

Supply

One simple, but useful, representation of a

supply function is the linear supply function:

= 0 + + + +
, 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

Understanding the Linear Supply Function

The signs and magnitude of the coefficients
determine the impact of each variable on the
number of units of X produced.
= 0 + + +
For example:
> 0 by the law of supply.
< 0 increasing input price.
> 0 technology lowers the cost of producing
good X.

2-25

Supply

The Linear Supply Function in Action

Your research department estimates that the
supply function for televisions sets is given by:
= 2,000 + 3 4 1

Question: How many televisions are produced

when = $400, = $100 per unit, and
= $2,000?
Answer:
= 2,000 + 3 400 4 100 1 2,000 =
800 television sets.
2-26

Inverse Supply Function

Supply

By setting = $2,000 and = $100 in

= 2,000 + 3 4 100 1 2,000

the linear supply function simplifies to
= 3 400

Solving this for in terms of results in

400 1
=
+
3
3
, which is called the inverse supply function.
This function is used to construct a market
supply curve.
2-27

Producer Surplus

Supply

The amount producers receive in excess of the

amount necessary to induce them to produce
the good.

2-28

Producer Surplus in Action

400 1
=
+
3
3

Price

Supply

Supply

$400
Producer surplus

$400
3
0

800

Quantity

2-29

Market Equilibrium

Market Equilibrium

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 Equilibrium I
Price

Market Equilibrium

Supply
Surplus

Shortage
0

Demand
1

Quantity

2-31

Market Equilibrium

Market Equilibrium II
Consider a market with demand and supply
functions, respectively, as
= 10 2 and = 2 + 2
A competitive market equilibrium exists at a
price, , such that = . That is,
10 2 = 2 + 2
8 = 4
= $2
= 10 2 $2 = 6 and = 2 + 2 $2 = 6
= 6 units
2-32

Price Restrictions and Market Equilibrium

Price Restrictions
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
Price floor

2-33

Price Restrictions and Market Equilibrium

Price Ceiling in Action I

Price

Supply

Nonpecuniary price

Lost social welfare

Priceceiling
Shortage
0

Demand

Quantity

2-34

Price Restrictions and Market Equilibrium

Price Ceiling in Action II

Consider a market with demand and supply
functions, respectively, as
= 10 2 and = 2 + 2
Suppose a $1.50 price ceiling is imposed on the
market.

= 10 2 $1.50 = 7 units.
= 2 + 2($1.50) = 5 units.
Since > a shortage of 7 5 = 2 units exists.
Full economic price of 5 unit is 5 = 10 2 , or
= $2.50. Of this,
$1.50 is the dollar price
$1 is the nonpecuniary price
2-35

Price Restrictions and Market Equilibrium

Price Floor in Action I

Price

Supply
Surplus

Pricefloor

Cost of
purchasing
excess supply

Demand
0

Quantity

2-36

Price Restrictions and Market Equilibrium

Price Floor in Action II

Consider a market with demand and supply
functions, respectively, as
= 10 2 and = 2 + 2
Suppose a $4 price floor is imposed on the
market.
= 10 2 $4 = 2 units
= 2 + 2($4) = 10 units
Since > a surplus of 10 2 = 8 units
exists
The cost to the government of purchasing the
surplus is $4 8 = $32.
2-37

Comparative Statics

Comparative Statics
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 Statics

Changes in Demand
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

Comparative Statics

Change in Demand in Action

Demand for Rental Cars
Price

Supply

$49

$45

Demand1
Demand0
0

100

104

108

Quantity
(thousands
rented per day)
2-40

Comparative Statics

Changes in Supply
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

Comparative Statics

Change in Supply in Action

Price

Supply1

Supply0

1
0

Demand

Quantity

2-42

Comparative Statics

Simultaneous Shifts in Supply and Demand

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 Japans sake

market?

2-43

Comparative Statics

Simultaneous Shifts in Supply and Demand in Action

Japans Sake Market

Price

Supply2

Supply1

Supply0

Demand1

Demand0
0

2 0

Quantity

2-44

Conclusion
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

CHAPTER 3
Quantitative Demand
Analysis

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

Chapter Outline

Chapter Overview

The elasticity concept

Own price elasticity of demand
Elasticity and total revenue
Factors affecting the own price elasticity of demand
Marginal revenue and the own price elasticity of demand

Cross-price elasticity
Revenue changes with multiple products

Income elasticity
Other Elasticities
Linear demand functions
Nonlinear demand functions

Obtaining elasticities from demand functions

Elasticities for linear demand functions
Elasticities for nonlinear demand functions

Regression Analysis
Statistical significance of estimated coefficients
Overall fit of regression line
Regression for nonlinear functions and multiple regression
3-47

Introduction

Chapter Overview

Chapter 2 focused on interpreting demand

functions in qualitative terms:
An increase in the price of a good leads quantity
demanded for that good to decline.
A decrease in income leads demand for a normal
good to decline.

This chapter examines the magnitude of

changes using the elasticity concept, and
introduces regression analysis to measure
different elasticities.
3-48

The Elasticity Concept

The Elasticity Concept

Elasticity

Measures the responsiveness of a percentage

change in one variable resulting from a
percentage change in another variable.

3-49

The Elasticity Concept

The Elasticity Formula

The elasticity between two variables, and ,

is mathematically expressed as:
%
, =
%
When a functional relationship exists, like
= , the elasticity is:

, =

3-50

The Elasticity Concept

Measurement Aspects of Elasticity

Important aspects of the elasticity:
Sign of the relationship:
Positive.
Negative.

Absolute value of elasticity magnitude relative to

unity:
, > 1 is highly responsive to changes in .

, < 1 is slightly responsive to changes in .

3-51

Own Price Elasticity of Demand

Own Price Elasticity

Own price elasticity of demand
Measures the responsiveness of a percentage change
in the quantity demanded of good X to a percentage
change in its price.

%
=
%

Sign: negative by law of demand.

Magnitude of absolute value relative to unity:

> 1: Elastic.
< 1: Inelastic.

= 1: Unitary elastic.

3-52

Own Price Elasticity of Demand

Linear Demand, Elasticity, and Revenue

Linear Inverse Demand: = 40 0.5
Demand: = 80 2
Revenue = $30 20 = $600

Price

$40
$35

$30

Elasticity: 2
= 3
20
Conclusion: Demand is elastic.

$30
$25

Observation: Elasticity
varies along a linear
(inverse) demand curve

$20

$15
$10
$5

Demand
0

10 20 30

40

50

60

70

80

Quantity

3-53

Own Price Elasticity of Demand

Total Revenue Test

When demand is elastic:
A price increase (decrease) leads to a decrease
(increase) in total revenue.

When demand is inelastic:

A price increase (decrease) leads to an increase
(decrease) in total revenue.

When demand is unitary elastic:

Total revenue is maximized.

3-54

Own Price Elasticity of Demand

Extreme Elasticities
Price
Demand

Perfectly
elastic

=0

Demand
, =

Perfectly Inelastic

Quantity

3-55

Own Price Elasticity of Demand

Factors Affecting the Own Price Elasticity

Three factors can impact the own price
elasticity of demand:
Availability of consumption substitutes.
Time/Duration of purchase horizon.
Expenditure share of consumers budgets.

3-56

Own Price Elasticity of Demand

Demand and Marginal Revenue

Price
6
Unitary

MR

Demand
0

Quantity

Marginal Revenue (MR)

3-57

Cross-Price Elasticity

Cross-Price Elasticity
Cross-price elasticity
Measures responsiveness of a percent change in
demand for good X due to a percent change in the
price of good Y.

If

If

%
=
%

> 0, then and are substitutes.

< 0, then and are complements.

3-58

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose it is estimated that the cross-price
elasticity of demand between clothing and
food is -0.18. If the price of food is projected
to increase by 10 percent, by how much will
demand for clothing change?

0.18 =
% = 1.8
10
That is, demand for clothing is expected to decline
by 1.8 percent when the price of food increases
10 percent.

3-59

Cross-Price Elasticity

Cross-Price Elasticity in Action

Suppose a restaurant earns $4,000 per week in
revenues from hamburger sales (X) and $2,000
per week from soda sales (Y). If the own price
elasticity for burgers is , = 1.5 and the
cross-price elasticity of demand between sodas
and hamburgers is , = 4.0, what would
happen to the firms total revenues if it reduced
the price of hamburgers by 1 percent?
= $4,000 1 1.5 + $2,000 4.0 1%
= $100
That is, lowering the price of hamburgers 1 percent
increases total revenue by $100.

3-60

Income Elasticity

Income Elasticity
Income elasticity
Measures responsiveness of a percent change in
demand for good X due to a percent change in
income.

%
=
%

If

> 0, then is a normal good.

If

< 0, then is an inferior good.

3-61

Income Elasticity

Income Elasticity in Action

Suppose that the income elasticity of demand for
transportation is estimated to be 1.80. If income
is projected to decrease by 15 percent,
what is the impact on the demand for
transportation?

%
1.8 =
15
Demand for transportation will decline by 27 percent.

is transportation a normal or inferior good?

Since demand decreases as income declines,
transportation is a normal good.

3-62

Other Elasticities

Other Elasticities
Own advertising elasticity of demand for good X
is the ratio of the percentage change in the
consumption of X to the percentage change in
advertising spent on X.
Cross-advertising elasticity between goods X
and Y would measure the percentage change in
the consumption of X that results from a 1
percent change in advertising toward Y.

3-63

Conclusion
Elasticities are tools you can use to quantify
the impact of changes in prices, income, and
advertising on sales and revenues.
Given market or survey data, regression
analysis can be used to estimate:
Demand functions.
Elasticities.
A host of other things, including cost functions.

Managers can quantify the impact of changes

in prices, income, advertising, etc.
3-64