Overview Market Forces Demand and Supply (Baye Chapter 2) I. Market Demand Curve The Demand Function Determinants of Demand Consumer Surplus II. Market Supply Curve The Supply Function Supply Shifters Producer Surplus III. Market Equilibrium - The equilibrium - Social Value - Mechanics of S&D IV. Price Restrictions

Economic models Functional relationships coefficient restrictions (like positive quantities) equilibrium conditions Demand = Qd(P) Supply = Qs(P) Supply=Demand used to demonstrate/predict effects of changes in key paramaters

Economic models P S D Q

Economic models P S P1 P0 D1 D0 Q

Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Law of Demand The demand curve is downward sloping. Quantity Price D

Determinants of Demand Income Prices of substitutes Prices of complements Advertising Population Consumer expectations

The Demand Function An 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 substitute good Y. M = income. H = any other variable affecting demand

Change in Quantity Demanded Price Quantity D0 A to B: Increase in quantity demanded A 10 4 B 6 7

Change in Demand Price D0 to D1: Increase in Demand 6 D1 D0 7 13 Quantity D0 D0 to D1: Increase in Demand D1 6 7 13

Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply The supply curve is upward sloping Price Quantity S0

Supply Shifters Input prices Technology or government regulations Number of firms Substitutes in production Taxes Producer expectations

The Supply Function An equation representing the supply curve: QxS = f(Px , PR ,W, H,) QxS = quantity supplied of good X. Px = price of good X. PR = price of a related good W = price of inputs (e.g., wages) H = other variable affecting supply

Change in Quantity Supplied Price Quantity S0 A to B: Increase in quantity supplied B 20 A 10 5 10

Change in Supply S0 to S1: Increase in supply Price Quantity S0 S1 8 5 6 7

Market Equilibrium Balancing supply and demand QxS = Qxd Steady-state

The value to an individual of consumption Recall the demand curve definition: demand at given prices for a consumer An interpretation: marginal movement gives us the individual’s value assigned to an additional unit of consumption Under this interpretation, if we sum across consumption values (in other words under the demand curve) we can get a measure of the value of total consumption

The value to an individual of consumption Q0 P0 At P0, an individual is willing to buy Q0. D Q0+1 P1 Our consumer is only willing to pay up to P1 for an extra unit of Q. This is what this extra unit is worth to him

The value to an individual of consumption Note that, at P1, the consumer saves ( P0-P1)*Q0. This is a gain to the consumer As we drop the price (with demand increasing), the consumer gain increases. Conceptually, we generalize this by focusing on the area between price and the demand curve. This is CONSUMER SURPLUS. D Q0 P0 P1 Q0+1

The value to an individual of consumption Conceptually, the initial value to the consumer is the triangle. When price falls to P1, the increase in consumer surplus is then the shaded area. Algebraically, this is calculated as follows: D Q0 P0 P1 Q0+1

The value to society of consumption Recall that the total demand curve is equal to the sum of private demand curves In the same way, the sum of individual consumer surplus values gives us the social value of consumption, or total consumer surplus. For society, the value of consumption is thus the area under the total demand curve.

The value to society of consumption Here, we have the supply function (a measure of the cost to society of producing Q), while the demand function tells us the social value in consumption. The difference is the benefit to society D S

The value to society of consumption The supply curve represents marginal changes in the social cost of producing Q. For competitive markets, this is considered to be a schedule of social opportunity cost P D S Q

The value to society of consumption Here, the area between the price line and the demand curve is the gain to consumers (consumer surplus). The area between the price line and the supply curve (in a competitive market) is called producer surplus. P D S Q

An example -- a new cost-saving technology Here, the area between the demand curve and the supply curve (A+B) is total social surplus. This is split between producers and consumers. With a cost-saving innovation, this grows to area (C+D). P D C D A B S0 S1 Intellectual property protection can be viewed as an incentive to firms (by boosting their share, temporarily, in the surplus) to produce innovations. Q

If price is too low… Price S D 7 6 5 6 12 Shortage 12 - 6 = 6 Quantity

If price is too high… Price S D 9 6 14 8 7 8 Quantity Surplus 14 - 6 = 8 Price S D 9 6 14 8 7 8 Quantity

Price Restrictions Price Ceilings Price Floors The maximum legal price that can be charged Examples: Gasoline prices in the 1970s Housing in New York, Philadelphia, &tc (sublets….) Medical services in managed health care systems Price Floors The minimum legal price that can be charged. Minimum wage Agricultural price supports (Rice in India…..)

Impact of a Price Ceiling Quantity S D P* Q* PF Ceiling Price Q s Q d Shortage

Who pays a commodity tax? With no tax, market equilibrium is at P0, Q0 S' Q1 P1 With the tax, supply is S'S' and equilibrium is P1Q1 Price S P0 …but who pays the tax? See Box 4-2 in the main text. S D Q0 Quantity

Who pays a commodity tax? Area A is borne by consumers S B Area B is borne by producers P1 C Area C is a welfare loss. P0 See Box 4-2 in the main text. S' The incidence of the tax depends upon the elasticities of demand and supply. S D Q1 Q0

` Managerial Economics Quantifying Demand (Baye Chapter 3)

Overview I. Demand Functions II.Elasticities of Demand Own Price Elasticity Elasticity and Total Revenue Cross-Price Elasticity Income Elasticity Linear and Log-Linear Demand III. Regression Analysis

Elasticities of Demand How responsive is variable “G” to a change in variable “S” + S and G are directly related - S and G are inversely related

Own Price Elasticity of Demand Negative according to the “law of demand” Elastic: Inelastic: Unitary:

Perfectly Elastic & Inelastic Demand Price Price D D Quantity Quantity Perfectly Elastic Perfectly Inelastic

Own-Price Elasticity and Total Revenue Increase (a decrease) in price leads to a decrease (an increase) in total revenue. Inelastic Increase (a decrease) in price leads to an increase (a decrease) in total revenue. Unitary Total revenue is maximized at the point where demand is unitary elastic.

Elasticity, TR, and Linear Demand Price Quantity D 10 8 6 4 2 1 2 3 4 5 Elastic Inelastic

Factors Affecting Own Price Elasticity Available Substitutes The more substitutes available for the good, the more elastic the demand. Time Demand tends to be more inelastic in the short term than in the long term. Time allows consumers to seek out available substitutes. Expenditure Share Goods that comprise a small share of consumer’s budgets tend to be more inelastic than goods for which consumers spend a large portion of their incomes.

Summary on own-price elasticities Elasticities depend on expenditure shares Elasticities depend on the availability of substitutes Elasticities depend on the time-frame Revenue will go up/down with an increase is price of demand is inelastic/elastic. Elastic means Ep<-1.

Cross Price Elasticity of Demand + Substitutes - Complements

Income Elasticity + Normal Good - Inferior Good

Income elasticities Inferior and Normal goods EI<0 or EI>0 Luxuries and Necessities EI>1 1>EI

Elasticity and revenue When price is changed, the impact on a firm’s total revenue (TR) will depend upon the price elasticity of demand. See Section 5-2 in the main text, and Figure 5-4.

Uses of Elasticities Pricing Managing cash flows Impact of changes in competitors’ prices Impact of economic booms and recessions Impact of advertising campaigns And lots more!

example elastic inelastic

example Our example: lemonade is a luxury (consider a 25% boost in incomes) Note: D0 and D1 are the two sets of inverse demand curves.

Our example Our example: lemonade is a substitute for Cindy’s coffee (consider a 100% boost in Cindy’s price) Note: D0 and D1 are the two sets of inverse demand curves.

Our example Our example: lemonade is a substitute for Cindy’s coffee (consider a 100% boost in Cindy’s price)

Demand Functions Mathematical representations of demand curves Example: X and Y are substitutes (coefficient of PY is positive) X is an inferior good (coefficient of M is negative)

Specific Demand Functions Linear Demand Own Price Elasticity Cross Price Elasticity Income Elasticity

Example of Linear Demand Qd = 10 - 2P Own-Price Elasticity: (-2)P/Q If P=1, Q=8 (since 10 - 2 = 8) Own price elasticity at P=1, Q=8: (-2)(1)/8= - 0.25

Log-Linear Demand