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ECONOMICS
Chapter 2 .Managerial Economics & Business Strategy
Market Forces: Demand and Supply
Overview1. Market Demand Curve
o The Demand Functiono Determinants of Demando Consumer Surplus
2. Market Supply Curveo The Supply Functiono Supply Shifterso Producer Surplus
3. Market Equilibrium4. Price Restrictions5. Comparative Statics
Market Demand Curve
Shows the amount of a good that will be purchased at alternative prices. Law of Demand
o The demand curve is downward sloping.
Determinants of Demand
o Incomeo Prices of substituteso Prices of complementso Advertisingo Populationo Consumer expectations
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The Demand Function
An equation representing the demand curve
Qxd = f(Px ,PY , M, H,)o Qxd = quantity demand of good X.o Px = price of good X.o PY = price of a substitute good Y.o M = income.o H = any other variable affecting demand
Change in Quantity Demanded
Change in Demand
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Consumer Surplus:
The value consumers get from a good but do not have to pay for.
I got a great deal!
That company offers a lot of bang for the buck! Gateway 2000 provides good value. Total value greatly exceeds total amount paid. Consumer surplus is large.
I got a lousy deal!
That car dealer drives a hard bargain! I almost decided not to buy it! They tried to squeeze the very last cent from me! Total amount paid is close to total value. Consumer surplus is low.
Consumer Surplus: The Discrete Case
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Consumer Surplus:The Continuous Case
Market Supply Curve
The supply curve shows the amount of a good that will be produced at alternativeprices.
Law of Supplyo The supply curve is upward sloping
Supply Shifters
Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations
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The Supply Function
An equation representing the supply curve: QxS = f(Px ,PR ,W, H,)
o QxS = quantity supplied of good X.o Px = price of good X.o PR = price of a related goodo W = price of inputs (e.g., wages)o H = other variable affecting supply
Change in Quantity Supplied
Change in Supply
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Producer Surplus
The amount producers receive in excess of the amount necessary to induce them toproduce the good.
Market Equilibrium
Balancing supply and demando QxS = Qxd
Steady-state
If price is too low
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If price is too high
Price Restrictions
Price Ceilingso The maximum legal price that can be chargedo Examples:
Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees
Price Floorso The minimum legal price that can be charged.o Examples:
Minimum wage Agricultural price supports
Impact of a Price Ceiling
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Full Economic Price
The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price. PF = Pc + (PF - PC) PF = full economic price PC = price ceiling PF - PC = nonpecuniary price
An Example from the 1970s
Ceiling price of gasoline - $1 3 hours in line to buy 15 gallons of gasoline
o Opportunity cost: $5/hro Total value of time spent in line: 3 $5 = $15o Non-pecuniary price per gallon: $15/15=$1
Full economic price of a gallon of gasoline: $1+$1=2
Impact of a Price Floor
Comparative Static Analysis
How do the equilibrium price and quantity change when a determinant of supplyand/or demand change?
Applications of Demand and Supply Analysis
Event: The WSJreports that the prices of PC components are expected to fall by 5-8percent over the next six months.
Scenario 1: You manage a small firm that manufactures PCs. Scenario 2: You manage a small software company.
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Use Comparative Static Analysis to see the Big Picture!
Comparative static analysis shows how the equilibrium price and quantity willchange when a determinant of supply or demand changes.
Scenario 1: Implications for a Small PC Maker
Step 1: Look for the Big Picture Step 2: Organize an action plan (worry about details)
Big Picture: Impact of decline in component prices on PC market
So, the Big Picture is:o PC prices are likely to fall, and more computers will be sold
Use this to organize an action plano contracts/suppliers?o inventories?o human resources?o marketing?o do I need quantitative estimates?o etc.
Scenario 2: Software Maker More complicated chain of reasoning to arrive at the Big Picture Step 1: Use analysis like that in Scenario 1 to deduce that lower component prices
will lead too a lower equilibrium price for computerso a greater number of computers sold.
Step 2: How will these changes affect the Big Picture in the software market?
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Big Picture: Impact of lower PC prices on the software market
The big picture for the software maker:o Software prices are likely to rise, and more software will be sold
Use this to organize an action planSummary
Use supply and demand analysis too clarify the big picture (the general impact of a current event on equilibrium
prices and quantities)o organize an action plan (needed changes in production, inventories, raw
materials, human resources, marketing plans, etc.)
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Chapter 7. The Elasticity of Demand
The Concept of Elasticity:Elasticity is a measure of the responsiveness of one variable to another.
The greater the elasticity, the greater the responsiveness.
Laugher Curve
Q. Whats the difference between an economist and a befuddled old man with Alzheimers?
A. The economist is the one with a calculator.
Price Elasticity
Theprice elasticity of demandis the percentage change in quantity demandeddivided by the percentage change in price.
Sign of Price Elasticity
According to the law of demand, whenever the price rises, the quantity demandedfalls. Thus the price elasticity of demand is always negative.Because it is always negative, economists usually state the value without the sign.
What Information Price Elasticity Provides
Price elasticity of demand and supply gives the exact quantity response to a change inprice.
Classifying Demand and Supply as Elastic or Inelastic
Demand is elasticif the percentage change in quantity is greater than the
percentage change in price.E >1
Classifying Demand and Supply as Elastic or Inelastic
Demand is inelasticif the percentage change in quantity is less than the percentagechange in price.
E
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Elastic Demand
Elastic Demand means that quantity changes by a greater percentage than the percentagechange in price.
Inelastic Demand
Inelastic Demand means that quantity doesn't change much with a change in price.
Defining elasticities
When price elasticity is between zero and -1 we say demand is inelastic.When price elasticity is between -1 and - infinity, we say demand is elastic.When price elasticity is -1, we say demand is unit elastic.
Elasticity Is Independent of Units
Percentages allow us to have a measure of responsiveness that is independent of units.This makes comparisons of responsiveness of different goods easier.
Calculating Elasticities
To determine elasticity divide the percentage change in quantity by the percentage changein price.
The End-Point Problem
The end-point problem the percentage change differs depending on whether you viewthe change as a rise or a decline in price.Economists use the average of the end points to calculate the percentage change.
2112
12
12
P+P)P-(P
QQ)Q-(Q
=Elasticity
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Graphs of Elasticities
Elasticity of demand between A and B = 1.27
Calculating Elasticities: Price elasticity of Demand
Price Elasticity: SupplyPrice elasticity of supply is the percentage change in quantity supplied divided by thepercentage change in
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Price Elasticity: Supply
Supply is elastic if the percentage change in quantity isgreater than the percentage changein price
Elastic supply is when ES > 1
Supply is inelastic if the percentage change in quantity is less than the percentage changein price
Inelastic supply is when ES < 1
Calculating Elasticities: Price elasticity of Supply
Graphs of Elasticities
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Calculating Elasticity
Calculating Elasticity of Demand Between Two Points
Calculating Elasticity of Supply Between Two Points
)(
)(
P%
Q%
2121
12
2121
12
PP
PP
QQ
QQ
E
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Calculating Elasticity at a Point
Let us now turn to a method of calculating the elasticity at a specific point, rather than overa range or an arc.To calculate elasticity at a point, determine a range around that point and calculate the arc
elasticity.
Calculating Elasticity at a Point
Calculating Elasticity at a Point
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Elasticity and Demand Curves
Two important points to consider:Elasticity is related (but is not the same as) slope.Elasticity changes along straight-line demand and supply curves.
Calculating Elasticity at a Point
Elasticity Is Not the Same as Slope
The steeper the curve at a given point, the less elastic is supply or demand.There are two limiting examples of this.When the curves are flat, we call the curves perfectly elastic.
The quantity changes enormously in response to a proportional change in price (E =innfinity).When the curves are vertical, we call the curves perfectly inelastic.The quantity does not change at all in response to an enormous proportional change inprice (E = 0).
Perfectly Inelastic Demand Curve
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Perfectly Elastic Demand Curve
Demand Curve Shapes and Elasticity
Perfectly Elastic Demand Curve
The demand curve is horizontal, any change in price can and will cause consumersto change their consumption.
Perfectly Inelastic Demand Curve
The demand curve is vertical, the quantity demanded is totally unresponsive to theprice. Changes in price have no effect on consumer demand.
In between the two extreme shapes of demand curves are the demand curves for mostproducts.
Demand Curve Shapes and Elasticity
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Elasticity Changes Along Straight-Line Curves
Elasticity is not the same as slope. Elasticity changes along straight line supply and demand curvesslope does not.
Elasticity Along a Demand Curve
The Price Elasticity of Demand Along a Straight-line Demand Curve
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Substitution and Elasticity
As a general rule, the more substitutes a good has, the more elastic is its supply anddemand.
Substitution and Demand
The less a good is a necessity, the more elastic its demand curve.Necessities tend to have fewer substitutes than do luxuries.Demand for goods that represent a large proportion of one's budget are more elastic thandemand for goods that represent a small proportion of one's budget.Goods that cost very little relative to your total expenditures are not worth spending a lotof time figuring out if there is a good substitute.The larger the time interval considered, or the longer the run, the more elastic is the goods
demand curve.
There are more substitutes in the long run than in the short run.The long run provides more options for change.
Determinants of the Price Elasticity of Demand
The degree to which the price elasticity of demand is inelastic or elastic depends on:How many substitutes there areHow well a substitute can replace the good or service under considerationThe importance of the product in the consumers total budgetThe time period under consideration.