MANAGERIAL ECONOMICS Market Forces: Demand and Supply

Demand

Introduction
In every market, there are buyers and sellers. The buyers' willingness to buy a particular good (at various prices) is referred to as the buyers' demand for that good. The sellers' willingness to supply a particular good (at various prices) is referred to as the sellers' supply of that good.
2

Demand
Demand is the quantity of a product that purchasers are willing and able to purchase in a specified period. Holding all other factors constant, the price of a good or service increases as its demand increases and vice versa.

Demand, Explained
Think of demand as your willingness to go out and buy a certain product.  Market demand is the total of what everybody in the market wants.


Note: Businesses spend a considerable amount of money to determine the amount of demand that the public has for its products and services. Incorrect estimations will either result in money left on the table if its underestimated or losses if its overestimated.
4

Demand Theory
A theory relating to the relationship between consumer demand for goods and services and their prices.  Demand theory forms the basis for the demand curve, which relates consumer desire to the amount of goods available. As more of a good or service is available, demand drops and therefore so does the equilibrium price.


Demand Theory, Explained

Demand theory is one of the core theories of microeconomics. It aims to answer basic questions about how badly people want things, and how demand is impacted by income levels and satisfaction (utility). Based on the perceived utility of goods and services by consumers, companies adjust the supply available and the prices charged.

Demand Schedule
Economists record demand on a Demand Schedule and plot it on a graph as an inverse (downward sloping) demand curve. The Demand Schedule shows the quantity of goods that a consumer would be willing and able to buy at specific prices under the existing circumstances.

Demand Schedule
This kind of behavior on the part of buyers is in accordance with the Law of Demand.

Law of Demand: As price increases, demand decreases.

The Law of Demand

 There is an inverse relationship between the price of  
a good and the quantity of the good demanded per time period. As the price of a good goes up, buyers demand less of that good. This inverse relationship is more readily seen using the graphical device known as the demand curve, which is nothing more than a graph of the demand schedule. Demand curves are negatively sloped.

The Law of Demand, Explained

 Why is the Law of Demand True? Because of how 
humans behave. Economist have 3 explanations: 1. Diminishing Marginal Benefit 2. Income Effect 3. Substitution effect

Factors Affecting Demand

1. Price of the good 2. Price of related goods (complements/substitutes) 3. Tastes and preferences 4. Income (normal good/inferior good) 5. Consumer expectations (future prices and supply conditions) 6. Others Can you think of other factors?

Answer
Other factors: 1. Advertising 2. Interest rates 3. Credit availability 4. Population (number of expected consumers)

The Demand Curve



The relationship of price and quantity demanded can be exhibited graphically as the demand curve. A demand curve
Downward sloping; negatively sloped The demand curve shows the quantity that would be bought at each price, for some fixed combination of all other factors

Price

Quantity Demanded

13

The Demand Curve

y-axis
Price

2 dimensional, relationship bet. 2 variables only price and quantity demanded.

x-axis
Quantity Demanded

The vertical axis (yaxis) depicts the price per unit of good X, while the horizontal axis (x-axis) depicts the quantity demanded of good X.

Figure 1

The Demand Curve

Linear regression puts the dependent variable on the y-axis and the independent variable on the x=axis.

Independent variable Dependent variable

The Demand Curve

Explanation: Typically, the y-axis is the dependent variable while the x=axis is the independent variable. However, the demand equation is inversed the y-axis (price of goods) is the independent variable while the x-axis (quantity demanded) is the dependent variable.

The Demand Equation

In addition to the demand schedule and the demand curve, the buyers' demand for a good can also be expressed a third way algebraically, using a Demand Equation. The Demand Equation relates the price of the good, denoted by P, to the quantity of the good demanded, denoted by Q.

P = 10 2Q

Demand Equation for the table

The Demand Equation

From the demand equation, you can determine the intercept value where the quantity demanded is zero, as well as the slope of the demand curve. In the example given, the intercept value is 10 and the slope of the demand curve is 2. In order to satisfy the law of demand, the slope of the demand equation must be negative so that there is an inverse relationship between the price and quantity demanded.

The Demand Equation

 Price as a function of quantity demanded, i.e. Qxd = f(P) demand function P = f(Qxd) inverse demand function  Example: Demand Function Qxd = 10 2Px linear demand function Inverse Demand Function: 2Px = 10 Qxd Or linear demand function Px = 5 0.5Qxd

Graphing the Inverse Demand Function

Price

Qxd = 10 2Px 5

10

Quantity

Change in Quantity Demanded

Price A to B: Increase in quantity demanded 10 6 A B Movement from A to B

D0 4 8 Quantity

Change in Quantity Demanded

A change in the quantity demanded is a movement along the demand curve due to a change in the price of the good being demanded. Ex.: In the previous figure the price for good X is $10 so that the quantity demanded is 4 units. If the price decreases to $6, the quantity demanded moves along the demand curve to the right, resulting in new quantity demanded of 8 units. The change in the quantity demanded due to the $4 decrease in the price of good X is 4 more units of good X. Similarly, an increase in the price of good X from $6 to $10 would induce a movement along the demand curve to the left, and the change in the quantity demanded would be 4 less units of good X.

Change in Quantity Demanded

Change in Demand
A change in demand is represented by a shift of the demand curve. As a result of this shift, the quantity demanded at all prices will have changed.

Change in Demand

Shift from the left means decrease of numbers in the schedule.

Movement and Shift, Explained



The demand curve moves (change in quantity demanded) when own-price change.
Price

10 6

A B

D0 4 8 Quantity 26

Movement and Shift, Explained



The demand curve shifts (change in demand) when anything except own-price changes
Price

9 5 D1 4.5 10 D0 Quantity 27

Reasons for a Change in Demand

There is only one reason for a change in the quantity demanded of good X a change in the price of good X; however, there are several reasons for a change in demand for good X (ex. income, advertising, prices of other goods). Demand Shifters are variables other than the price of a good that influence demand.


Reasons for a Change in Demand

Good's own price: The basic demand relationship is between the price of a good and the quantity supplied. Generally the relationship is negative or inverse and is embodied in the downward slope of the consumer demand curve.
Ex. If the price of a new novel is high, a person might decide to borrow the book from the public library rather than buy it. Or if the price of a new equipment is high a firm may decide to repair existing equipment rather than replacing it.

Reasons for a Change in Demand

Changes in the price of related products: The demand for good X may be changed by increases or decreases in the prices of other, related goods. Related products: The principal related goods are complements and substitutes.
Explanation: Related products are classified as either complements or substitutes according to the effect of a price increase in one product on the demand for the other.

The Substitution Effect

Complements and substitutes, distinguished: Complements. Two products are complements if an increase in the price of one causes a decrease in the demand for the others. Ex. Coffee and coffee creamer. Substitutes. Two products are substitutes if an increase in the price of one causes an increase in the demand for the others. Ex. Movies and pirated DVDs.

Complement and Substitute

Good X Complement Substitute Price Demand Demand Price Demand Demand

Complements
A complement is a good that is used with the primary good (ex. automobiles and gasoline). Close complements behave as a single good. If the price of the complement goes up the quantity demanded of the other good goes down.

A complement to good X is any good that is consumed in some proportion to good X. Example: If good X is automobile, then a complement good Y might be gasoline. Since automobile and gasoline are complements, then as the price of gasoline rises, the demand for automobiles decreases; the demand curve for automobiles shifts to the left. Conversely, as the price of the gasoline falls, the demand for automobiles increases; the demand curve for automobiles shifts to the right.

Complements
Mathematically, the variable representing the complementary good would have a negative coefficient. Equation sample: Qd = P Pg Where: Qd = quantity (of automobiles) demanded P = price (of automobiles) Pg = price (of gasoline)

Individual demand curve with a more expensive complement, ex. Movies and popcorn.

Demand curve with $1 popcorn

20

Demand curve with $2 popcorn

20

Qty (Movies a month)

As the price of popcorn increases, the demand curve shifts toward the left.

Substitutes
Substitutes are goods that can be used in place of the primary good. A substitute for good X is any good Y that satisfies most of the same needs as good X. The mathematical relationship between the substitute and the good in question is negative. If the price of the substitute goes down the demand for the good in question goes up.

For example, if good X is butter, a substitute good Y might be margarine. Since butter and margarine are substitutes, then as the price of margarine rises, the demand for butter increases; demand curve for butter shifts to the right. Conversely, as the price margarine falls, the demand for butter decreases; the demand curve for butter shifts to the left.

Complements and Substitutes

A

demand curve will shift to the right if there is either a decrease in the price of a complement or an increase in the price of a substitute.

A

demand curve will shift to the left if there is either an increase in the price of a complement or a decrease in the price of a substitute.

The Income Effect

Changes in Income: The more money you have the more likely you are to buy a good The demand for good X may also be affected by changes in the incomes of buyers. Typically, as incomes rise, the demand for a good will usually increase at all prices and the demand curve will shift to the right. Similarly, when incomes fall, the demand for a good will decrease at all prices and the demand curve will shift to the left.

Demand and Income

An individual's demand, say movies, may depend on other factors (in addition to the price of such movies). If one gets a raise, an individual might spend more on movies. Other factors would depend on the price of other alternative forms of entertainment such as video rentals. Note: The individual demand curve shows how the quantity that a person buys depends on the price of the item. The demand curve, however, does not display the effect of changes in income and other factors.

Demand and Income

Price $ Per Movie
20 19 ... 10 9 8 ... 1

Quantity Movies/mo.
0 0 ... 0 2 4 ... 18

An income change, say a diminution from $50,000 to $40,000.

Individual Demand Curve with Lower Income

20 Demand curve with $50,000 income

Demand curve with $40,000 income 10 8

As income falls, the entire demand curve shifts toward the left.

12

20

Qty (Movies a month)

Normal Good vs. Inferior Good

Goods can be categorized according to the effect of changes in income on demand.  If the demand for an item increases as the buyer's income increases, the good is considered a normal good.  The demand for inferior good is negatively related to changes in the buyer's income. Explanation: As the buyer's income increases, demand decreases for inferior products. As the buyer's income decreases, demand increases for the inferior products.


Normal Good vs. Inferior Good

Explanation: Put it in another way  Normal good when an increase in income causes an increase in demand.  Inferior good when an increase in income causes a decrease in demand.

Normal and Inferior Goods

Income Normal Inferior Demand Demand Income Demand Demand

Normal and Inferior Products, Examples



Transportation services a normal product, since the higher a person's income, the more he tends to spend on transportation. Public transportation an inferior product, since with a higher income, the typical commuter switches from public transportation to a private car.

Note: The distinction between normal and inferior products is important for business strategy. When the economy is growing and incomes are rising, the demand for normal products will rise, while the demand for inferior products will fall. This reverses when the economy is in recession and incomes are falling.

Activity
Is pizza a normal or inferior good? Learning: Whether a good is normal or inferior is a matter of fact, not theory.

Normal and Inferior Products in International Business

 The

demand for normal products is relatively higher in richer countries.  The demand for inferior products is relatively higher in poorer countries. Example. In developed countries, relatively more people commute to work by car than bicyle.

Durable Goods
Durable Goods provide a stream of services over an extended period of time (ex. automobiles, home appliances, and machinery). 3 Significant Factors in the Demand for Durable goods: 1. Expectations about future prices and incomes A client who is pessimistic about his future income may postpone replacing his car. 2. Interest rates Consumers may defer purchase if interest rates are higher. 3. Price of used models Used cars may be substitute for new cars.

Changes in Taste or Preference

Changes in Taste or Preferences: The greater the desire to own a good the more likely you are to buy the good. As peoples' preferences for goods and services change over time, the demand curve for these goods and services will also shift. For example, as the price of gasoline has risen, automobile buyers have demanded more fuel-efficient, economy cars and fewer gas-guzzling, luxury cars. This change in preferences could be illustrated by a shift to the right in the demand curve for economy cars and a shift to the left in the demand curve for luxury cars.

Changes in Taste or Preference

The procedure for constructing a demand curve relies completely on the consumer's individual taste or preference the individual decides how much it wants to buy at each possible price. The demand curve displays information in a graphical way.

Changes in Taste or Preference

2 Implications: 1. The demand curve will change with changes in the consumer's preferences. Ex. As a person grows older, his demand for rock videos and junk food may decline, while the demand for adult contemporary music and meals in stylish restaurant may increase. 2. Different consumers may have different preferences and hence different demand curves. Ex. One may like red meat while another is a vegetarian.

Changes in Expectations
Changes in Expectations: Demand curves may also be shifted by changes in expectations. For example, if buyers expect that they will have a job for many years to come, they will be more willing to purchase goods such as cars and homes that require payments over a long period of time, and therefore, the demand curves for these goods will shift to the right. If buyers fear losing their jobs, perhaps because of a recessionary economic climate, they will demand fewer goods requiring long-term payments and will therefore cause the demand curves for these goods to shift to the left.

Changes in Expectations
Consumer expectations about future prices and income: If a consumer believes that the price of the good will be higher in the future he is more likely to purchase the good now, ex. Real estate, foreign currencies. If the consumer expects that her income will be higher in the future the consumer may buy the good now. Positive expectations about future income may encourage present consumption (demand increases).

Advertising
Advertising is another factor in demand. Ex. An individual's demand for, say shampoo, may depend on advertising by the manufacturer. 2 Types of Advertising 1. Informative communicates information to potential buyers and seller. 2. Persuasive aims to influence consumer choice. Advertising depends on the medium, i.e., tri-media. Note: An increase in advertising may increase demand, while a reduction in advertising may cause demand to fall.

An increase in advertising shifts the demand curve to the right from D1 to D2. Two perspectives: 1) Buyers will buy 500 units for $40, after advertising buyers will buy 100 more units (or 600 units) for $40. 2) Buyers will buy 500 units for $40, after advertising buyers will buy 500 units even if they pay $10 more or ($50).

$50 $40

D2 D1
500 600

Other Factors in Demand

 The

individual demand for an item may depend on other factors which include population, expectation, durability, season, weather, and location.

Desire vs. Demand

There is a basic distinction between desire and demand. Desire is a measure of the willingness to buy a good. Demand is the willingness and ability to affect one's desires. Note: It is assumed that tastes and preferences are relatively constant.

The Demand Function

Demand function is a behavioral relationship between quantity consumed and a person's maximum willingness to pay for incremental increases in quantity. It is usually an inverse relationship where at higher (lower) prices, less (more) quantity is consumed. Other factors which influence willingness-to-pay are price of the good, price of substitutes, income, and others.

The Demand Function

 A general equation representing the demand curve Qxd = f(Px , PY , M, H,) Qxd = quantity demand of good X. Px = price of good X. PY = price of a related good Y. Substitute good. Complement good. M = income. Normal good. Inferior good. H = any other variable affecting demand.

QXd = f(PX,PY, M,H) (QXd/(PX < 0 (QXd/(M > 0 if a good is normal (QXd/(M < 0 if a good is inferior (QXd/(PY > 0 if X and Y are substitutes (QXd/(PY < 0 if X and Y are complements

Problem Illustration:
A manager receives the following demand function for the firm's product Qxd = 12,000 3Px +4PY 1M +2A Where: Qxd = Amount consumed of good X Px= Price of good X PY= Price of good Y M = Income A = Amount of advertising Suppose good X sells for $200/unit, good Y sells $15/unit, the company utilizes 2,000 units of advertising, and consumer income is $10,000. How much of good X do consumers purchase? Are good X and Y substitute or complements? Is good X a normal or inferior product?

Answer:
How much of good X do consumers will purchase? Answer: 5,460 units Qxd = 12,0003(200) +4(15) 1(10,000)+2(2,000) = 5,460 Are good X and Y substitute or complement? Answer: Substitutes. Sol. Since the coefficient of P is 4>0, a price increase of $1 in good Y increases the consumption of good X by 4 units. Is good X a normal or inferior product? Answer: Inferior product. Since the coefficient of M is 1<0, a $1 increase in income will decrease the consumption of good X by 1 unit.

The Principle of Diminishing Marginal Benefit

Any item that a consumer is willing to buy must provide some benefit, which may be psychic or monetary. The marginal benefit of the first movie is the benefit from one movie a month. (The marginal benefit of the second movie is the additional benefit from seeing a second movie each month.) The Principle of Diminishing Marginal Benefit is the benefit provided by an additional unit of an item.

The Principle of Diminishing Marginal Benefit, Explained

Utility (benefit or satisfaction) is the reason we consume a good or service. Ex. Eating pizza (the first slice). Marginal means additional or extra. Diminishing marginal benefit is like eating a few more slices (after the first slice) until you get sick of it. Consumers will only buy the second (third or more) slice if it has a lower price (since they get less additional benefit from it).

From Individual to Market Demand



The market demand curve is the horizontal summation of individual consumer demand curves. Aggregation introduces three additional non price determinants of demand - (1) the number of consumers (2) the distribution of tastes among the consumers, and (3) the distribution of incomes among consumers of different taste. Thus if the population of consumers increases, ceteris paribus, the demand curve will shift out. If the proportion of consumers with a strong preference for a good increases, ceteris paribus, the demand for the good will change.

From Individual to Market Demand



Finally if the distribution of income changes is favor of those consumer with a strong preference for the good in question the demand will shift out. Factors that affect individual demand can also affect aggregate demand. However, net effects must be considered. For example, a good that is a complement for one person is not necessarily a complement for another. Further the strength of the relationship would vary among persons.

Market Demand Schedule

Businesses that deal with many different customers may determine their strategy on the basis of the entire market rather than individual customers.. Market Demand Curve is a graph showing the quantity that all buyers will purchase at every possible price.

Market Demand Curve

To do a horizontal summation, add the demand curves in the horizontal direction.

Sample Problem for Market Demand

Pedro is selling his action figures collection. 3 friends expressed interest in buying them. Their individual demand equation are as follows: Q1 = 30 1P Q2 = 22.5 0.75P Q3 = 37.5 1.25P What is the market demand for Pedro's action figures? Sol. Qm = Q1+Q2+Q3= (301P)+(22.50.75P)+(37.51.25P) Qm = 903P

Sample Problem for Market Demand

If he has 60 action figures, how much should he charge the entire collection? Answer: $600 ($10x60). Sol. Because P is price, a 1 dollar decrease will increase quantity demanded by 3. The equation would be Qm= 60, so that 60 = 90 3P P = $10 Substituting the price to individual demand equations give Q1 = 301(10) = 20 Q2 = 22.50.75(10) = 15 Q3 = 37.51.25(10) = 25

Elasticity, Defined
Elasticity is the ratio of the % change in one variable to the percent change in another variable.


Inelastic: price elasticity < 1 Unit elastic: price elasticity = 1 Elastic: price elasticity > 1

Elasticity, Examples


When the price of gasoline rises by 1% the quantity demanded falls by 0.2%, so gasoline demand is not very price sensitive. Price elasticity of demand is -0.2 . When the price of gold jewelry rises by 1% the quantity demanded falls by 2.6%, so jewelry demand is very price sensitive. Price elasticity of demand is 2.6. When the price of beef increases by 1% the quantity supplied increases by 5%, so beef supply is very price sensitive. Price elasticity of supply is 5.

Price Elasticity of Demand



Price Elasticity of Demand (or simply Price elasticity or PED) is a measure of how much the quantity demanded of a good responds to a change in the price of that good. PED is a measure of the sensitivity of the quantity demanded, Q, to changes in price, P. PED answers the question of how much the quantity will change in percentage terms for a 1% change in the price.

Price Elasticity of Demand, Explained



The extent to which demand changes with price is known as "Price Elasticity of Demand." Inelastic products tend to be those that people must have, but they use only a fixed quantity of it. Electricity is an example: if power companies lower the price of electricity, consumers may be happy, but they probably won't use a lot more power in their homes, because they don't need much more than they already use. However, demand for luxury goods, such as restaurant meals, is extremely elastic consumers quickly choose to stop going to restaurants if prices go up.

Price Elasticity of Demand

The PED formula is

PED = %(Q %(P PED=(% Change in Quantity demanded) (%

Change in Price) Note: The percentage change in quantity demanded given a percent change in price.

Ex.: Price(Old) = 9 Price(New) = 10 Qdemand(Old) = 150 Qdemand(New) = 110

Using the information above, calculate % change in quantity demanded and price, together with PED. Answers:
110  150 % (Q ! ! 0.2667 150 10  9 % (P ! ! 0.1111 9

(110  150) / 150 PED ! (10  9) / 9 ! 2.4

We are concerned with absolute value, so we ignore the (-) value. We conclude that the price elasticity of demand when the price increases from $9 to $10 is 2.4 (240%).

Price Elasticity of Demand



If PED > 1 then demand is price elastic (demand is sensitive to price changes) If PED = 1 then demand is unit elastic (it means the 2 variables change by the same proportion, e.g., a 5% increase determines a 5% increase). If PED < 1 then demand is price inelastic (demand is not sensitive to price changes). Note: Elasticity of 1 means the 2 variables goes into opposite direction but in the same proportion.

Perfectly Inelastic Demand

(a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price . . .

100

Quantity

2. . . . leaves the quantity demanded unchanged.

Copyright2003 Southwestern/Thomson Learning

Inelastic Demand
(b) Inelastic Demand: Elasticity Is Less Than 1 Price

$5 4 1. A 22% increase in price . . . Demand

90

100

Quantity

2. . . . leads to an 11% decrease in quantity demanded.

Unit Elastic Demand

(c) Unit Elastic Demand: Elasticity Equals 1 Price

$5 4 1. A 22% increase in price . . . Demand

80

100

Quantity

2. . . . leads to a 22% decrease in quantity demanded.

Elastic Demand
(d) Elastic Demand: Elasticity Is Greater Than 1 Price

$5 4 1. A 22% increase in price . . . Demand

50

100

Quantity

2. . . . leads to a 67% decrease in quantity demanded.

Perfectly Elastic Demand

(e) Perfectly Elastic Demand: Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 2. At exactly $4, consumers will buy any quantity. Demand

0 3. At a price below $4, quantity demanded is infinite.

Quantity

Elasticity and Decision Making

Demand tends to be less elastic if: There are few good substitutes available Expenditures on the good accounts for only a small portion Consumers have not yet had time to adjust fully to changes in price.  If demand is price-elastic, revenue increases with lower prices.  If demand is price-inelastic, revenue decreases with lower prices.


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Determinants of Own-Price Elasticity



Demand tends to be more elastic : the larger the number of close substitutes. if the good is a luxury. the more narrowly defined the market. the longer the time period.

86

Consumer Surplus


An economic measure of consumer satisfaction calculated by analyzing the difference between what consumers are willing to pay for a good or service relative to its market price. A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.

Ex. Pedro goes out shopping for a CD player and is willing to pay P500 for a rare Elvis Presley Hawaii Concert. When he finds out that a CD is on sale for P300, Pedro has a consumer surplus of P200.

Consumer Surplus
Compute the consumer surplus in the given example. Formula: (Base x height)/2 Answer: (40 x (3600 2000))/2 = 32,000

Problem Illustration:
Given the following graph, if Beverage Co. X charges a price of $2 per liter (of beverage), how much revenue will the firm earn and how much consumer surplus will the typical consumer enjoy? What is the most a consumer would be willing to pay for a bottle containing exactly 3 liters of the firm's beverage?
$5

$2

Answer:
Consumer surplus: CS = (3x(5 2))/2 = $4.50 At $2/liter a typical consumer will buy 3 liters, thus, the firm's revenue is $6 ($2x3). The total value of the 3 liters to a consumer is thus, $10.50 ($6+$4.50) The maximum amount a consumer would be willing to pay for 3 liters is also $10.50. If the company sold 3 liters at $10.50 means it would earn higher revenues and extract all consumer surplus.

Other Factors Related to Demand Theory

International Convergence of Tastes
Globalization of Markets Influence of International Preferences on Market Demand

Growth of Electronic Commerce

Cost of Sales Supply Chains and Logistics Customer Relationship Management