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Managerial Economics and Business Strategy - Ch. 2 - Market Forces - Demand and Supply PDF
Managerial Economics and Business Strategy - Ch. 2 - Market Forces - Demand and Supply PDF
After reading the article, Sam picked up the phone and called a few of his business
contacts to verify for himself the information contained in the newspaper. Satisfied that
the information was correct, he called the director of personnel, Mr. Joni. What do you
think Mr. Edy and Mr. Joni discussed?
INTRODUCTION
As suggested in this chapter’s opening headline, supply and demand analysis is a tool
that managers can use to visualize the “big picture.” Many companies fail because
their managers get bogged down in the day-today decisions of the business without
having a clear picture of market trends and changes that are on the horizon.
Absent a view of the big picture, you are likely to negotiate the wrong prices with
suppliers and customers, carry too much inventory, hire too many employees, and—if
your business spends money on informative advertising—purchase ads in which your
prices are no longer competitive by the time they reach print.
INTRODUCTION (2)
Supply and demand analysis is a qualitative forecasting tool you can use to predict
trends in competitive markets, including changes in the prices of your firm’s products,
related products (both substitutes and complements), and the prices of inputs (such as
labor services) that are necessary for your operations.
DEMAND
DEMAND (2)
The market research reveals that, holding all other things constant, the quantity of
jeans consumers are willing and able to purchase goes down as the price rises. This
fundamental economic principle is known as the law of demand: Price and quantity
demanded are inversely related. That is, as the price of a good rises (falls) and all other
things remain constant, the quantity demanded of the good falls (rises).
Figure 2–1 plots the data in Table 2–1. The straight line connecting those points, called
the market demand curve, a curve indicating the total quantity of a good all consumers
are willing and able to purchase at each possible price, holding the prices of related
goods, income, advertising, and other variables constant.
DEMAND (3): Demand Shifters
Economists recognize that variables other than the price of a good influence
demand. For example, the number of pairs of jeans individuals are willing and
financially able to buy also depends on the price of shirts, consumer income,
advertising expenditures, and so on. Variables other than the price of a good that
influence demand are known as demand shifters.
When we graph the demand curve for good X, we hold everything but the price of X
constant. A representative demand curve is given by D0 in Figure 2–2. The
movement along a demand curve, such as the movement from A to B, is called a
change in quantity demanded.
DEMAND (4): Demand Shifters (cont.)
Whenever advertising, income, or the price of related goods changes, it leads to a
change in demand; the position of the entire demand curve shifts. A rightward
shift in the demand curve is called an increase in demand, since more of the good
is demanded at each price. A leftward shift in the demand curve is called a
decrease in demand.
Now that we understand the general distinction between a shift in a demand curve
and a movement along a demand curve, it is useful to explain how five demand
shifters—consumer income, prices of related goods, advertising and consumer
tastes, population, and consumer expectations—affect demand.
Demand Shifters: Consumer Income
Because income affects the ability of consumers to purchase a good, changes in
income affect how much consumers will buy at any price. Whether an increase in
income shifts the demand curve to the right or to the left depends on the nature of
consumer consumption patterns. Accordingly, economists distinguish between
two types of goods: normal and inferior goods.
Not all goods are substitutes; in fact, an increase in the price of a good such as
computer software may lead consumers to purchase fewer computers at each
price. Goods that interact in this manner are called complements.
Demand Shifters: Advertising and Consumer Tastes
Another variable that is held constant when drawing a given demand curve is the level
of advertising. An increase in advertising shifts the demand curve to the right. Why?
Advertising often provides consumers with information about the existence or quality
of a product, which in turn induces more consumers to buy the product. These types of
advertising messages are known as informative advertising.
Advertising can also influence demand by altering the underlying tastes of consumers.
These types of advertising messages are known as persuasive advertising.
Demand Shifters: Population
The demand for a product is also influenced by changes in the size and
composition of the population. Generally, as the population rises, more and more
individuals wish to buy a given product, and this has the effect of shifting the
demand curve to the right.
It is important to note that changes in the composition (age, gender, etc.) of the
population can also affect the demand for a product. To the extent that a greater
proportion of the population ages, the demand for medical services will tend to
increase.
Demand Shifters: Consumer Expectations
Changes in consumer expectations also can change the position of the demand
curve for a product. If consumers expect future prices to be higher, they will
substitute current purchases for future purchases. This type of consumer behavior
often is referred to as stockpiling and generally occurs when products are durable
in nature.
Thus, the demand function explicitly recognizes that the quantity of a good consumed
depends on its price and on demand shifters.
The Demand Function (2)
Different products will have demand functions of different forms. One very simple
but useful form is the linear representation of the demand function:
The αi are fixed numbers that the firm’s research department or an economic
consultant typically provides to the manager. (Chapter 3 provides an overview of
the statistical techniques used to obtain these numbers.) The information
summarized in a demand function can be used to graph a demand curve. For
instance, see demonstration problem 2-1.
The Demand Function (3)
Since a demand curve is the relation between price and quantity, a representative
demand curve holds everything but price constant. This means one may obtain the
formula for a demand curve by inserting given values of the demand shifters into the
demand function, but leaving Px in the equation to allow for various values. If we do
this for the demand function in Demonstration Problem 2–1, we get
The Demand Function (4)
Because we usually graph this relation with the price of the good on the vertical
axis, it is useful to represent Equation 2–1 with price on the left-hand side and
everything else on the right-hand side. This relation is called an inverse demand
function. For this example, the inverse demand function is
It reveals how much consumers are willing and able to pay for each additional unit
of good X. This demand curve is graphed in Figure 2–4.
Consumer Surplus
We now show how a manager can use the demand curve to ascertain the value a
consumer or group of consumers receives from a product. Consumer surplus is
the value consumers get from a good but do not have to pay for. It will prove
particularly useful in marketing and other disciplines emphasizing strategies like
value pricing and price discrimination.
The fact that the market supply curve slopes upward reflects the inverse law of
supply: As the price of a good rises (falls) and other things remain constant, the
quantity supplied of the good rises (falls). Producers are willing to produce more
output when the price is high than when it is low.
While the market supply of a good generally
depends on many things, when we graph
a supply curve, we hold everything but
the price of the good constant. The movement
along a supply curve, such as the one from A to B
is called a change in quantity supplied.
Supply Shifters
Variables that affect the position of the supply curve are called supply shifters,
and they include the prices of inputs, the level of technology, the number of firms
in the market, substitutes in production, taxes, and producer expectations.
Whenever one or more of these variables change, the position of the entire supply
curve shifts. Such a shift is known as a change in supply.
The shift from S0 to S2 in Figure 2–6 is called
an increase in supply since producers sell more
output at each given price. The shift from S0 to S1
in Figure 2–6 represents a decrease in supply
since producers sell less of the product
at each price.
Supply Shifters: Taxes
A Per Unit (Excise) Tax
Thus, the supply function explicitly recognizes that the quantity produced in a
market depends not only on the price of the good but also on
all the factors that are potential supply shifters.
The Supply Function (2)
While there are many different functional forms for different types of products, a
particularly useful representation of a supply function is the linear relationship:
The coefficients (the βis) ) represent given numbers that have been estimated by
the firm’s research department or an economic consultant. The information
summarized in a supply function can be used to graph a supply curve. For
example, see demonstration problem 2–3.
The Supply Function (3)
Since a supply curve is the relationship between price and quantity, a
representative supply curve holds everything but price constant. If we do this for
the supply function in Demonstration Problem 2–3, we get
The Supply Function (4)
Since we usually graph this relation with the price of the good on the vertical axis,
it is useful to represent Equation 2–2 with price on the left-hand side and
everything else on the right-hand side. This is known as an inverse supply function.
which is the equation for the supply curve graphed in Figure 2–9. This curve
reveals how much producers must receive to be willing to produce
each additional unit of good X.
Producer Surplus
Just as consumers want price to be as low as possible, producers want price to be
as high as possible. The supply curve reveals the amount producers will be willing
to produce at a given price. Alternatively, it indicates the price firms would have to
receive to be willing to produce an additional unit of a good.
Once this price and quantity are realized, the market forces of supply and demand
are balanced; there is no tendency for prices either to rise or to fall.
PRICE RESTRICTIONS AND MARKET EQUILIBRIUM
The previous section showed how prices and quantities are determined in a free
market. In some instances, government places limits on how much prices are
allowed to rise or fall, and these restrictions can affect the market equilibrium.
➔ Price Ceilings
➔ Price Floors
Price Ceilings
Suppose that, for whatever reason, the
government views the equilibrium price of Pe in
Figure 2–11 as “too high” and passes a law
prohibiting firms from charging prices above Pc.
Such a price is called a price ceiling.
Throughout this analysis, we assume that no legal restraints, such as price ceilings or
floors, are in effect and that the price system is free to work to allocate goods among
consumers.
➔ Changes in Demand
➔ Changes in Supply
➔ Simultaneous Shifts in Supply and Demand
COMPARATIVE STATICS: Changes in Demand
Suppose that Statistics Indonesia (BPS) reports that consumer incomes are
expected to rise by about 2.5 percent over the next year, and the number of
individuals over 25 years of age will reach an all-time high by the end of the year.
We can use our supply and demand apparatus to examine how these changes in
market conditions will affect car rental agencies like DOcar, TRAC, and Golden
Bird.
It seems reasonable to presume that rental cars are normal goods: A rise in
consumer incomes will most likely increase the demand for rental cars. The
increased number of consumers aged 25 and older will also increase demand
since at many locations those who rent cars must be at least 25 years old.
COMPARATIVE STATICS: Changes in Demand (2)
The initial equilibrium in the market for rental
cars is at point A, where demand curve D0
intersects the market supply curve S.
This health care mandate would increase the cost to retailers and other firms of
hiring workers. These higher labor costs, in turn, would decrease the supply of
retail goods. The final result of the legislation would be to increase the prices
charged by retailing outlets and to reduce the quantity of goods sold there.
COMPARATIVE STATICS: Changes in Supply (2)
We can see this more clearly in Figure 2–14.
The market is initially in equilibrium at point
A, where demand curve D intersects the
market supply curve, S0.
A tragic example occurred at the end of the last century when an earthquake hit
Kobe, Japan. The earthquake did considerable damage to Japan’s dorayaki
pancake industry, and the nation’s supply of dorayaki pancake decreased as a
result. Unfortunately, the stress caused by the earthquake led many to increase
their demand for dorayaki and other sweet desserts.
COMPARATIVE STATICS: Simultaneous Shifts in Supply and Demand (2)