Lecture 2
Market Forces: Demand and Supply
Guernsey Organic Milk Production Suspended
• Following increased demand for organic dairy products and Guernsey
dairy products in particular, Lakenham Creamery, a small rapidly
growing company that supplies ice cream to major stores in London
and East Anglia, has initiated plans to expand its Norfolk County ice
cream selections by introducing organic ice cream made entirely from
imported Guernsey milk and cream. Lakenham Creamery’s current
Guernsey Organic Milk Production
• Workforce is not large enough to produce the new ice cream
selections. As a result, Nigel Stewart, the company’s Human Resource
Director has taken proper measures by interviewing a large number of
candidates in an attempt to increase the company’s workforce by
25%. The company owner, Mary Hatchins, while watching the BBC
News, learned that weather conditions, which involved strong winds,
heavy rain, and poor crop harvests resulted in a drastic reduction in
cattle feed, prompting Guernsey Diary, the
Guernsey Organic Milk Production
• Primary diary producer in the British Chanel Island of Guernsey, to
suspend its production of organic milk. Mary immediately contacted
Nigel to ask him to postpone the company’s plans to increase the
workforce. Did Mary make the right call?
• Market demand curve
• Demand
• Law of demand
• The quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises).
• Demand can be represented by tables, graphs and equations
Demand
Demand Table
Price of Pepsi (cedis per can)
3 4 5 6 7
Quantity Sold (cans per day)
240
200
160
120
80
Demand Graph
P
3 6 9
40 120 200 280
Quantity (Cans per day price
Market Demand Curve
• Law of Demand explains individual behaviour to the expected change in price.
Interested in market demand rather.
• Market Demand Curve: horizontal summation of the individual demand curves.
• Hypothetically, we consider three individual demand functions for product in question
QD,1 = a1 + b1 P (1) QD,2 = a2 + b2 P (2) QD,3= a3 + b3 P (3)
Factors that affect Demand
• Controllable factors
—Price
—Product
—Promotion (communication by a firm)
—Place
• Uncontrollable Factors
—Income
—Price of other products
Factors that affect Demand
—Government Policy
—Macroeconomic factors
—Institutional Factors
—Demographic Factors
—Expectations
• 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.
Changes in Quantity Demanded
Changes in Demand
Quantity 0
Price
D1 Increase
in demand A
B
D0 D2
Decrease in demand
Demand Shifters
• Income
• Normal good
• Inferior good
• Prices of related goods
• Substitute goods
• Complement goods
• Advertising and consumer tastes
• Population
• Consumer expectations
• Other factors
Advertising and the Demand for Clothing
Quantity of high-style clothing 0
$50
$40
50,000 Price of
high-style clothing
D2
60,000 Due to an increase in advertising
D1
• The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a
related good Y, income and other factors that affect the demand for good X.
The Demand Function
Demand Equations
• Symbolically, this can be summarised as QD = f(P) and dQD <0
dP
Q =f(P,A,Y, PS, ....), where A represents
Advertising expenditure, Y represents average Income of the market and PS represents price of a substitute product.
In the two- variable case the demand function can be expressed in a linear form: Q=a + bP
Understanding the linear demand function
• Q=a + bP
a represents the maximum sales that will occur if the price is zero, and b represents the effect of a unit rise in price on the quantity demanded
(marginal effect) .
Q= a+bP +cY + dP
S; b , c and d represent
marginal effects.
• One simple, but useful, representation of a demand function is the linear demand function:
, 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.
•
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.
• For example:
• by the law of demand;
• if good Y is a substitute for good X;
• if good X is an inferior good.
•
Understanding the Linear Demand
Function
• Suppose that an economic consultant for X Corp. recently provided the firm’s marketing manager with this estimate of the demand function for the firm’s product:
Question: How many of good X will consumers purchase when per unit, per unit, and ? Are goods X and Y substitutes or
complements? Is good X a normal or an inferior good?
Answer:
units. Goods X and Y are substitutes. Good X is an inferior good.
•
The Linear Demand Function in Action
Inverse Demand Function
• By setting and and the demand function is
the linear demand function simplifies to Solving this for in terms of results in
, which is called the inverse demand function. This function is used to construct a market demand curve.
•
Graphing the Inverse Demand Function in Action
Quantity Price
��=2,020 − 1
3 ���
$2,020
0 6,060
Non- Linear Demand Function
• Q=aP
b, b represents price elasticity of demand; for every 1% rise in price, quantity demanded rises by b%.
• Q =aP
bY
c,b represents price elasticity of demand and c represents
income elasticity of demand.
Quantity in liters Price per
liter
Demand
$5
0
$3
$2
1 2
$1
4 5
Total Consumer Value:
0.5($5 - $3)x2+(3-0)(2-0) = $8 Expenditures:
$(3-0) x (2-0) = $6 Consumer Surplus:
0.5($5 - $3)x(2-0) = $2
Market Demand and Consumer Surplus in Action
$4
3 Consumer Surplus
• 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 extra for.
Consumer Surplus
• 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.
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.
Changes in Quantity Supplied
Change in Supply in Action
Quantity Price
S2
0
Decrease in supply
A
B
S0 S1
Increase in supply
• Input prices
• Technology or government regulation
• Number of firms
• Entry
• Exit
• Substitutes in production
• Taxes
• Excise tax (tax on each unit of output sold)
• Ad valorem tax (percentage tax eg.sales tax)
• Producer expectations
Supply Shifters
Change in Supply in Action
Quantity of gasoline per week
Price of gasoline
0
t = per unit tax of 20¢
S0 S0+t
t = 20¢
$1.20
$1.00 t
Excise tax
Change in Supply in Action
Quantity of Price
of backpacks
S0 S1 = 1.20 x S0
$24
$10
Ad valorem tax
$12
1,100
$20
2,450
The Supply Function
• The supply function for good X is a mathematical representation describing how many units will be
produced at different prices for X, prices of inputs W, prices of technologically related goods, and other
factors that affect the supply for good X.
The Linear Supply Function
• One simple, but useful, representation of a supply function is the linear supply function:
, 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.
•
• The signs and magnitude of the coefficients
determine the impact of each variable on the number of units of X produced.
• For example:
• by the law of supply.
• increasing input price.
• technology lowers the cost of producing good X.
•
Understanding the Linear
Supply Function
• Your research department estimates that the supply function for televisions sets is given by:
Question: How many televisions are produced when , per unit, and ?
Answer:
television sets.
•
The Linear Supply Function
in Action
Inverse Supply Function
• By setting and in
the linear supply function simplifies to Solving this for in terms of results in
, which is called the inverse supply function. This function is used to construct a market supply curve.
•
Producer Surplus in Action
Price Supply
$400
��= 400
3 + 1
3 ���
$ 400 3
Producer surplus
Quantity
Price Supply
0
��
280
Demand Surplus
Shortage
��
Market Equilibrium
Market Equilibrium I
��
�0 �� �1
• Consider a market with demand and supply functions, respectively, as
and
• A competitive market equilibrium exists at a price, , such that . That is,
and
•
Market Equilibrium II
• In a competitive market equilibrium, price and
quantity freely adjust to the forces of demand and supply.
• Sometime government restricts how much prices are permitted to rise or fall.
• Price ceiling
• Price floor
Price Restrictions
• Consider a market with demand and supply functions, respectively, as
and
• Suppose a $1.50 price ceiling is imposed on the market.
• units.
• units.
• Since a shortage of units exists.
•
Price Ceiling in Action II
Quantity
Price Supply
0
��
�� �� �� 280
Demand Surplus
��
Price floor
Price Floor in Action I
Cost of purchasing excess supply
• Consider a market with demand and supply functions, respectively, as
and
• Suppose a $4 price floor is imposed on the market.
• units
• units
• Since a surplus of units exists
• The cost to the government of purchasing the surplus is .
•
Price Floor in Action II
• 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?
Changes in Demand
Change in Demand in Action
Price Supply
$45
Demand for Rental Cars
Demand1
$49
Demand0
• Increase in supply only
• Decrease equilibrium price
• Increase equilibrium quantity
• Decrease in supply only
• Increase equilibrium price
• Decrease equilibrium quantity
• Example of change in demand
• Suppose that a bill before Congress would require all
employers to provide health care to their workers. What is the impact on retail markets?
Changes in Supply
Price
Supply0
�0
Demand
�0
Supply1
�1
�1
Change in Supply in Action
• 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 Japan’s sake market?
Simultaneous Shifts in Supply
and Demand
• 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.).
