Managerial Economics

Module 2: Analysis of Market

Demand and Supply
Module 2: Analysis of Market
Demand and Supply
Today’s Lecture:
 Determinants of Supply
 Supply Function and Law of Supply
 Supply Curve and shifts
 Demand and Supply Equilibrium
 Adjustments in Market Equilibrium
 Elasticities of Demand and Its Determinants
 The Supply Function

 A supply function is a causal

relationship between a dependent
variable (i.e., quantity supplied) and
various independent variables (i.e.,
factors which are believed to influence
quantity supplied)
 Again, this is just a behavior function.
 Lets consider a market supply function,
and list the factors.

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 Factors which you believe influence
quantity supplied
 Your list:
 price of good
 technology
 price of inputs
 Price of related* goods
(*Other goods which could be
produced)
 number of suppliers
 expectations
 Government through excise taxes or subsidies,
regulation

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 Supply Functions
 General Functional Form
QSX= f (PX, Pinput, POther, Tech., Expect., No. of
Sellers, Govt. Influences, µ )
 µ is a random term.
 Suppliers may behave randomly.
 There are random events (disasters, etc.)
which influence supply.
 Again, red variables are held constant
for a given supply curve.

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 Supply
 Suppose that sellers are
P/unit
initially willing and able
to supply Q1 units per
period when the price
per unit is P1.
P2
 If, for some reason, the
market price rises to p2
P1
then these sellers are
now willing and able to
supply Q2 units to the Q
Q1 Q2
market per period of
time
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 Supply

 Connecting these P/unit

two behavioral S
points gives the
supply curve.
 It describes the P2
voluntary behavior of
producers.
P1

Q
Q1 Q2

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 The Law of Supply

The higher the price of the

good or service, ceteris
paribus, the larger the
quantity supplied.
 A Change in Supply

 The supply curve

shows producers’ P/unit
willingness and ability S
to produce these
alternative units at
alternative prices P2
when everything else
remains constant.
 Suppose something P1
else does change!
Q
Q1 Q2

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 A Change in Supply

 If one of the ceteris

paribus assumptions P/unit
S S’
changes, this shifts
the entire supply
curve.
 Suppose Pinputs falls. P2
 Supply increases or
shifts right!
P1
 Q increases at every
price.

Q1 Q’1Q2 Q’2 Q

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 Review
 Supply is a behavior function describing
the behavior of producers.
 At given values of the supply shifters
(i.e., cet. par.), there is a supply curve.
 Movement along curve is caused by change
in price.
 Changes in cet. par. assumptions shift
curve
 (e.g., price of inputs, technology, price
other goods, expectations, government,
etc.)
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 What is an Equilibrium?

 A situation where there is no

tendency for change.
 Think of equilibrium in traffic flow.
 Why assume equilibrium?
 Economists frequently talk about a
stable equilibrium.
 What does this mean?
 Why assume stable equilibrium?

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Look at Equilibrium in Markets

We focus on output markets,

although input markets can also
be considered.
 Stable Market Equilibrium
 If prices exceed
equilibrium, price
Price
movements restore
S equilibrium.
 Invisible Hand
P1
Pe

D
QD Qe QS Q
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Market Adjustments to
Changes

We believe Markets adjust to

disturbances, and establish a
new equilibrium.
 Stable Market Equilibrium
 Look at comparative
Price Statics
 Suppose demand
S decreases.
 i.e., decreased quantity
demanded at every price.
 What could cause this
change?
Pe
P’e
 Puts downward pressure
on prices until new
equilibrium.
D’ D
Q’e Qe Q
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 Some Examples
(Note: Your book has some excellent examples)

Market Event
 Music CD sales in US  U.S. courts shut down Napster.
 Delhi High Court’s ruling to ban
 CNG buses and petrol/diesel operated public
auto/ taxi in Delhi transport vehicles.
 No. of reasons –
 Mobile services  Policy Regulation - Universal
licensing; More operators allowed
per circle; More bandwidth;
 Tariff restructuring - No charges for
incoming incoming calls;
rationalization of interconnectivity
charges
 Technology – CDMA arrives
 Cheaper handset - reduced import
duty on knocked down handsets

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 Hints and Suggestions
 Always remember which market you are
analyzing.
 Try to determine whether a cet. par.
assumption is changing.
 If so, show which curve is shifting and why.
 Don’t start with a preconceived notion as
to what will happen to P and Q.
 Let your logic determine the outcome.
 Always label graphs.

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 Deriving Equilibrium Mathematically

 Suppose demand function

QDX=15000 - 25PX + 10PY+2.5*I
 Can derive demand curve by holding PY and I
constant (e.g., at PY=100, and I=1000)
giving: QDX=18500-25PX
 Suppose supply function
QSX= -12000+75PX-10Pinput+250*NFIRM
 Can derive supply curve by holding (Pinput and
NFIRM constant (e.g., Pinput=100, and NFIRM
=50) giving: QSX=-500 +75PX
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 Solving for equilibrium
 Solve two equations and two unknowns:
 QDX=18500-25PX =-500 +75PX =QSX
 Solve for PX: 19000=100PX
 PX=190
 Plug value of PX into demand:
 Q=18500 - 25*190 = 18500-4750=13750

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 Market Equilibrium

Price
S

190

D
13,750 QUANTITY
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 Comparative Statics Mathematically
 Suppose the Pinput falls giving new supply
curve.
 QSX=-12000+75PX-10Pinput+250*NFIRM
 Now suppose Pinput falls from 100 to 75.
 Suppose NFIRM =50 as before.
 Old Supply Curve: QSX=-500 +75PX
 New Supply Curve: QSX=-250 +75PX
 Thus, supply increased.

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 Re-Solving for equilibrium

 Solve two equations and two unknowns:

QDX=18500-25PX =-250 +75PX =QSX
 Solve for PX: 18750=100PX
 PX=187.50
 Plug value of PX into supply:
Q=-250+75*187.50 = 13812.5
 Compare to old values

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 New Market Equilibrium

Price  Supply increases.

S  i.e., increased
quantity at every
price.
S’
 What could cause
this change?
 Puts downward
190
pressure on prices
187.5 until new
equilibrium.

D
13,750 13,812.5
Quantity
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 Demand Elasticities
 Look at the demand function:
QD=f(P, PY, I, Tastes, Expect., Buyers,
Govt, ε )
 Causality goes from right to left in function.
 Can examine responsiveness along the
demand curve.
 Price elasticity: ε =%∆ Q/%∆ P
 In words, this is the percent change in
quantity demanded brought about by the
percent change in price.

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 Price elasticity: ε =%∆ Q/%∆ P

 Causality: denominator numerator!

 An elastic response is one where
numerator is greater than denominator.
 i.e., %∆ Q>%∆ P so ε < −1
 Imagine extreme example.
 An inelastic response is one where
numerator is smaller than denominator.
i.e., %∆ Q<%∆ P so ε > −1
 Again, imagine extreme example.

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 Look at the Extremes
 Perfectly Elastic D  Perfectly Inelastic D
ε = −infinite

P P D
ε =0
D

Q
Q

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 Relatively Elastic vs. Relatively
Inelastic Demand Curves

P
D’ is relatively more elastic
than D

P1

P2
D’
D
Q
Q1 Q2 Q2’
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 Determinants of ε
 Number of close substitutes
 Market vs. brand level
 Nature of goods – Necessities/ Luxuries
 Importance of goods in budget
 Time taken to readjust habit, usage
behaviour, etc.
 No. of uses of a product
 Price Level

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