1. 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

2. 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

3. Economic models P S D Q

4. Economic models P S P1 P0 D1 D0 Q

5. 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

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

7. 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

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

9. 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

10. 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

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

12. 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

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

14. Change in Supply S0 to S1: Increase in supply Price Quantity S0 S1 8 56 7

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

16. 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

17. The value to an individual of consumptionQ0 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

18. 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

19. 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

20. 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.

21. 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

22. 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

23. 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

24. 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

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

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

27. 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…..)

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

29. 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

30. 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

31. ` Managerial Economics
Quantifying Demand
(Baye Chapter 3)

32. 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

33. 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

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

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

36. 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.

37. Elasticity, TR, and Linear Demand
Price
Quantity D 10 8 6 4 2
Elastic
Inelastic

38. 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.

39. 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.

40. Cross Price Elasticity of Demand
+ Substitutes
- Complements

41. Income Elasticity
+ Normal Good
- Inferior Good

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

43. 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.

44. 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!

45. example
elastic
inelastic

49. 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.

50. 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.

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

52. 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)

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

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

55. Log-Linear Demand