Demand, Supply and Equilibrium Prices

Chapter 2

Why Should Managers Study Supply and Demand?

Managers need to understand supply and demand to develop their own competitive strategies and to respond to the actions of their competitors. Managers need to understand how the structure of the market that their firm operates in impacts supply and demand. Managers need to understand how public policy will impact supply and demand.
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Demand

The functional relationship between the price of a good or service and the quantity demanded by consumers in a given period of time, all else held constant.

7 6 5 4 3 2 1 0 0 5 10 15 Quantity

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Price

Nonprice Factors Influencing Demand

Tastes and preferences Income Prices of goods related in consumption Future expectations Number of potential consumers

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Tastes and Preferences

Tastes and preferences are how potential consumers feel about a good or service and how well a good or service meets a consumers desire.

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Tastes and Preferences in Action

In the aftermath of the September 11, 2001, terrorist attacks on New York and Washington, D.C., the tastes and preferences of U.S. consumers for airline travel changed dramatically. In spring, 2006, the National Chicken Council waged a campaign to prevent fears of the avian flu in Asia from impacting the demand for chicken in the United States.
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Income

The level of a persons income also affects demand, because demand incorporates both willingness and ability to pay for the good. If an increase (decrease) in income causes a person to buy more (less) steak, then for that person, steak is said to be a normal good. If an increase (decrease) in income causes a person to buy less (more) hamburger, then for that person, hamburger is said to be an inferior good.
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Income in Action

Firms selling normal goods, like, jewelry, automobiles and clothing experience increases in sales when the general economy is booming, like, in the late 1990s. Firms selling inferior goods, like, hamburger, used clothing and generic bleach experience increases in sales when the general economy is in recession, like, in the second half of 2008.
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Prices of Related Goods

Prices of related goods will also affect the demand for a good or service. Products or services are substitute goods for each other if one can be used in place of another. Complementary goods are products or services that consumers use together.

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Prices of Related Goods in Action

By 2006 the abundance and relatively low prices of cell phones, iPods, and laptop computers resulted in many teens and young adults no longer purchasing wristwatches. These all serve as substitutes for watches. As prices of personal computers have dropped over time, there has been an increased demand for printers and printer cartridges. Personal computers and printers are complementary products.
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Future Expectations

Expectations about future prices also play a role in influencing current demand for a product.

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Future Expectations in Action

In summer, 2004, many consumers responded to high lumber prices by waiting to purchase until fall when a normal seasonal decline was expected to occur. One developer in Maryland bought only as much wood as he needed week-by-week because the high summer prices had increased the cost of wood for a typical apartment by 50 percent.
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Number of Potential Consumers

The number of consumers in the marketplace influences the demand for a product.

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Number of Potential Consumers in Action

The effect of growing populations on demand and grain prices can be seen as both increases in the size of the population in Asian and Latin American economies and growth in the middleclass segments of these economies had a stimulating effect on the demand for many types of grain from US farmers.

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Expressing Demand Functions

7 6 5 4 3 2 1 0 0 5 10 15 Quantity

Qxd = f(Px,T,I,Py,Pz,EXP,N)
where

Qxd = quantity of good x demanded Px = price of good x T = variables representing tastes and preferences I = income Py = price of related good y Pz = price of related good z EXP = expected future prices N = number of consumers

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Price

Demand

Demand curves are generally portrayed as downward sloping, suggesting an inverse or negative relationship between the price of the good and the quantity demanded, all else equal. When the price of a good rises the quantity demanded falls, all else equal.

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Individual vs. Market Demand

P

Market demand is the horizontal sum of individual demand curves.

D1

D2

D1 + D2 Q

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Demand Curve Shift vs. Movement Along a Demand Curve

P P

D2

A to B: change (increase) in demand

D1

A to B: change (increase) in quantity demanded A B

D1 P1 A B P1 P2

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Q1

Q2

Q
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Q1 Q2

Supply

The functional relationship between the price of a good or service and the quantity supplied by producers in a given time period, all else help constant.

Price

Quantity

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Nonprice Factors Influencing Supply

Technology Input prices Prices of goods related in production Future expectations Number of producers

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Technology

The state of technology, or the body of knowledge about how to combine the inputs of production, affects what output producers will supply because technology influences how the good or service is actually produced, which, in turn, affects the costs of production.

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Technology in Action

In the nickel industry, most of the worlds production has come from deposits that were relatively easy to exploit. However, these deposits comprise only about 40 percent or less of the worlds remaining reserves. During the 1990s companies tried to develop a process called high pressure acid leaching to remove nickel from other rock deposits. This new technology could fundamentally alter the supply of nickel on world markets.

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Input Prices

Input prices are the prices of all the inputs or factors of productionlabor, capital, land, and raw materialsused to produce the given product. These input prices affect the costs of production and, therefore, the prices at which producers are willing to supply different amounts of output.

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Input Prices in Action

For broiler chickens, feed costs represent 70 to 75 percent of the costs of growing a chicken to a marketable size. Thus, changes in feed costs are so important that market analysts often use them as a proxy to forecast broiler prices and returns to broiler processors.

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Prices of Related Goods

The prices of other goods related in production can also affect the supply of a particular good.

Two goods are substitutes in production if the same inputs can be used to produce either of the goods, such as land for different agricultural crops. Two goods are complementary in production if the production of one is a by-product of the production of the other.

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Prices of Related Goods in Action

Switching from corn to tobacco, a farmer in Illinois netted $1,800 per acre from his 150 acres of tobacco compared with $250 per acre for corn and that planting tobacco had increased his annual income by 35 percent over the previous three years.

As more oil and natural gas are produced, the supply of sulfur, which is removed from the products, also increases. Sixty-foot-high blocks of unwanted sulfur were reported in Alberta, Canada, and Kazakhstan in 2003.

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Future Expectations

If producers expect prices to increase in the future, they may supply less output now than without those expectations. The opposite could happen if producers expect prices to decrease in the future.

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Number of Producers

The number of producers influences the total supply of a product at any given price. The number of producers may increase because of perceived profitability in a given industry or because of changes in laws or regulations such as trade barriers.

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Number of Producers in Action

For example, the lumber market was reported to be exceedingly strong in January 1999, largely due to demand from the booming U.S. housing market. However, quotas on the amount of wood that Canada could ship into the United States also played a role in keeping the price of lumber high in the United States in January of that year.
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Supply

Supply curves are generally portrayed as upward sloping, suggesting a direct or positive relationship between the price of the good and the quantity supplied, all else equal. When the price of a good rises the quantity supplied rises, all else equal.

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Expressing Supply Curves

Qxs=f(Px,TX,Pi,Pa,Pb,EXP,N)
where

Price

Quantity

Qxs = quantity of good x supplied Px = price of good x T = variables representing tastes and preferences I = income Py = price of related good y Pz = price of related good z EXP = expected future prices N = number of consumers

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Supply Curve Shift vs. Movement Along a Supply Curve

P S1 P S2 B P2 A P1 B P1 A to B: change (increase) in demand A A to B: change (increase) in quantity demanded S1

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Q1

Q2

Q
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Q1

Q2

Market Equilibrium
Price
PE

The market equilibrium price and quantity is that price for which the quantity supplied is equal to the quantity demanded.

QE

Quantity

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Surplus Disequilibrium

At prices where the quantity supplied exceeds the quantity demanded there exists a surplus in that market at that price.

P P1 surplus

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Shortage Disequilibrium

At prices where the quantity demanded exceeds the quantity supplied there exists a shortage in that market at that price.

P2

shortage
D

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Changes in Equilibrium Demand Induced

When nonprice demand factors change, the demand curve shifts and produces a change in the equilibrium price and quantity.

S P3 P2 P1 D1 D2 D3 Q

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Q1 Q2 Q1

Changes in Equilibrium Supply Induced

When nonprice factors change, the supply curve shifts and produces a change in the equilibrium price and quantity.

S1 S2 S3

P1 P2 P3

D1

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Q1 Q2 Q3

Changes in Equilibrium Changes in Demand and Supply

P When nonprice factors change, the supply and demand curves may both shift P1 and produce a P2 change in the equilibrium price and quantity. Q1
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S1

S2

D2 D1 Q2 Q

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