ECW2731 Managerial Economics

Lecture 2: Demand & Supply

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Outline

Lecture objectives:
Demand
Supply
Market Equilibrium
Comparative Statics
Unit objectives:
Recognize and evaluate the various theories of the organisation
Understand and analyze firm pricing strategies

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Roadmap
Supply/Firm

Demand/Consumer

(Ch. 7,8, 10, 12-

(Ch. 4)

13)
Demand and

General
equilibrium &
Role of Gov. (Ch.
15, 19, Ch. 12
other book)

Supply (Ch.
3)

Economic Optimization
(CH. 1-2)

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Areas of application

Management
Market entry/exit decision

Marketing
Evaluate effect of advertisement expenditure

Management accounting
Financial planing and forecasting

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Demand and Supply - Setting the

stage

The market for automobiles.

Demand and supply are driven by various factors.

Some of these factors are beyond the control of the

consumers and producer (exogenous e.g. Prices of related
products).
Other factors can be controlled by the consumers and
producer (endogenous e.g. Advertising).

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Market Demand
Demand is the quantity of a good or service
that customers are willing and able to purchase
during a specified period under a given set of
economic conditions.
Determinants of Demand
Demand is determined by price, prices of
other goods, income, expectations of
price changes, consumer tastes and
preferences , advertising expenditures
and so on.

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Basis for
Demand
Direct Demand
Direct demand is demand for
consumption.
Derived Demand

Derived demand is input demand.

Firms demand inputs that can be
profitably employed.
Industry Demand Versus Firm Demand
Industry demand is subject to general
economic conditions.
Firm demand is determined by economic
conditions and competition.
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Market Demand function

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Demand Curve
Demand Curve Determination
Demand curve shows price and quantity
relation holding everything else constant.
Change in Quantity Demanded
Quantity demanded falls if price rises.
Quantity demanded rises if price falls.
Role of Non-Price Variables
Change in non-price variables will define
a new demand curve.

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Relation between the demand curve and demand function

Movements Along Demand Curve
A rise in price causes upward movement
along a given demand curve.
A price decline causes downward
movement along a given demand curve.
Demand Curve Shifts
Demand increases if a non-price change
allows more to be sold at every price.
Demand decreases if a non-price change
causes less to be sold at every price.

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Market Demand Function Roadmap

We apply tools:
Equations and Functions
Graphs

to isolate one factor

that influence
2
demand/supply and,
3
evaluate the effect of this isolated factor on demand and
4
supply.
5 Market Equilibrium
Comparative Statics

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Market Demand
Function
EXAMPLE
Let us analyse the market of automobiles
What are the variables in this demand function ?

P
Average price of new domestic cars ($)
Px Average price of new imported cars ($)
I
Disposable income per household ($)
Pop Population (millions)
i
Average interest rate (%)
A Industry advertising expenditure (million $)

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Market Demand
Function

Demand Function (specific form):

If we are more precise about the functional form

Q = a1 P + a2 PX + a3 I + a4 Pop + a5 i +
a6 A

(1)

an - parameters of the demand function

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Market Demand
Function

Assume that the parameters of the demand function are known:

Q = 500P + 250PX + 125I + 20, 000Pop - 1, 000, 000i + 600A (2)

Interpretation of equation (2):

The demand for cars falls by 500 for each $1 increase in the average
price.
The demand for cars . . . by . . . for each $1 increase in the average
price of imported cars.

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Market Demand
Function

Independent Variable

Parameter

Av. price of new domestic cars ($)

Av. price of new imported cars ($)
Disp. income per household ($)
Pop. (millions)
Av. interest rate (%)
Advertising exp. (million $)
Total demand for cars

-500
250
125
20,000
-1,000,000
600

Est. Value
for Ind. Variable
during coming
year
30,000
60,000
56,000
300
8
5,000

Estimated
deman
d
-15,000,000
15,000,000
7,000,000
6,000,000
-8,000,000
3,000,000
8,000,000

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Demand
Curve

Demand Curve Determination

Demand curve shows price and quantity relation holding
everything else constant.

Hold income, population, interest rates . . . constant to identify

the effect of domestic automobile prices on quantity
demanded.

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Demand Curve
Determination

Hold income, population, interest rates . . . constant to identify

the effect of domestic automobile prices on quantity
demanded.
Q = 500P + 250(60, 000) + 125(56, 000) + 20, 000(300)
+ 1, 000, 000(8) + 600(5, 000)
(3)
= 23, 000, 000 500P

P = 46, 000 0.002Q

Rearranging equation (4) allows us to express prices as a
function of output.

(4)

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Demand
Curve
Figure 1. Hypothetical Industry demand for New Domestic
Automobiles

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Demand
Curve

Change in Quantity Demanded

Quantity demanded falls if price
rises.
Quantity demanded rises if price
falls.

Role of Non-Price Variables

Change in non-price variables will define a
new demand curve.

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Shift in
Demand Figure 2. Shifts in Hypothetical Industry demand for
New Domestic Automobiles due to changes in
interest rates

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Basis for Supply

Firms Offer Supply To Make Profits

When prices rise, firms boost the quantity supplied.
When prices fall, firms cut the quantity supplied.

Remember from a previous lecture: A profits maximizing firm will increase

production (supply) as far as Marginal Profit (MP) is positive (the profit obtained
from the last unit produced increases total profit). And since MP=MR-MC the firm
will produce up to the point in which MR=MC and MP=0.

Everything That Affects Marginal Production Costs or Marginal Revenue

Affects Supply
If MC falls supply rises.
If MC rises supply falls.
If MR falls supply falls.
If MR rises supply rises.
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Market Supply Function

Determinants of Supply
Supply is determined by price, prices of other goods,
technology, and so on.
Industry Supply Versus Firm Supply
Firm supply is determined by economic conditions and
competition.
Industry supply is the sum of firm supply.

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Market Supply Function

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Supply Curve

Supply Curve Determination

Supply curve shows price and quantity relation
holding everything else constant.
The Price-quantity Supplied Relation
A rise in price will increase the quantity
supplied.
A fall in price will decrease the quantity
supplied.
Along a supply curve, all non-price variables are
held constant

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Relation between supply curve and supply function

Movements Along Supply Curve
A rise in price causes upward movement along
a given supply curve.
A price decline causes downward movement
along a given supply curve.
Supply Curve Shifts
Supply increases if a non-price change allows
more to be profitably produced and sold.
Supply decreases if a non-price change causes
less to be profitably produced and sold.

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Determinants of Supply

Supply Function:

P
Where:
PSUV

W
S
E
i
bn

Q = b1 P + b2 PSUV + b3 W + b4 S + b5 E +
b6 i
Average price of new domestic cars (in $)
Average price of new SUV (in $)
Hourly price of labour (wages in $ per hour)
Average cost of steel ($ per ton)
Average cost of energy ($ per mcf natural gas)
Average interest rate (in %)
parameters of the demand function

(5)

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Supply Function

Assume that the parameters of the supply function are known:

Q = 2000P 500PSUV 100, 000W 15, 000S 125, 000E 1, 000, 000i
(6)

Interpretation of equation (6):

The supply for cars . . .

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Market Supply Function

Determinants of Supply
Supply is determined by price, prices of other goods, technology, and
so on.

Industry Supply Versus Firm Supply

Firm supply is determined by economic conditions and competition.
Industry supply is the sum of firm supply.

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Supply Curve
Determination

Hold all else constant, to identify the effect of domestic

automobile prices on quantity demanded.
Q = 2, 000P 500(42, 500) 100, 000(100) 15, 000(800)
125, 000(6) 1, 000, 000(8)
(7)
= 52, 000, 000 + 2, 000P

Rearranging equation (7) allows us to express prices as a

function of output.
P = 26, 000 + 0.0005Q
(8)

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Supply Curve
Figure 3. Hypothetical Industry Supply Curve for New
Domestic Automobiles

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Relation Between Supply Curve and Supply

Function

Movements Along Supply Curve

A rise in price causes upward movement along a given supply curve. A
price decline causes downward movement along a given supply curve.

Supply Curve Shifts

Supply increases if a non-price change allows more to profitably
produced and sold.
Supply decreases if a non-price change causes less to be profitably
produced and sold.

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Shifts in Supply
Figure 4. Shifts in Hypothetical Industry Supply Curve for
New Domestic
Automobiles due to changes in interest rate.

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Market
Equilibrium

Demand and Supply Balance

Equilibrium exists if perfect balance exists in the quantities
demanded and supplied.
Equilibrium reflects productive and allocative efficiency.

Surplus and Shortage

Surplus is excess supply.
Shortage is excess demand.

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Surplus, Shortage, and Market

Equilibrium
Figure 5. Surplus, Shortage, and Market
Equilibrium

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Comparative
Statics

Changes in Equilibrium
Equilibrium exists when there is no economic incentive for change in
demand or supply.
Changing demand or supply affects equilibrium.

Comparative Statics
Study of how equilibrium changes with changing demand or supply.
Change continues until a new equilibrium is established.

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Comparative Statics
1
Figure 6a. Comparative
Statics 1

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Comparative Statics
2
Figure 6b. Comparative
Statics 2

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Comparative Statics
3
Figure 7. Comparative Statics of Changing Supply
AND Demand

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Until next class . .

.

Prepare tutorial exercises

Moodle/Tutorials

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