Markets:  Demand and Supply

Demand Analysis

 

Reading Assignment: What Do Markets Do? (posted)

 

Market:  Demand and Supply

    Markets ration scarce resources to the highest bidder.  Revealed preferences in markets are provided to suppliers by consumers either buying or not buying a good at a given price.

    Remember -- that consumers drive everything in markets -- demand and supply.

Let's start with demand:

The Demand Curve: A curve indicating varying quantities of a good or service that consumers are willing and able to purchase at varying prices, per unit of time, other things constant.  Demand is downward-sloping due to the diminishing marginal utility of consumption and changes in ability to buy as the price drops - plus, everything is a potential substitute for everything else.

 

There are a number of important components in the decision buyers make to buy something or not:

a. Price/Quantity relationship: Price is the most important determinant of Quantity in the model.  Do you think this is realistic in most cases?

 

b.  Willing and able:  Defines the market.

            Willing - desires the good.

                        Motivation:  a good has to satisfy the subjectively valued ends of the consumer.  And they have to recognize that the good will do this. 

                        (So part of your job as an entrepreneur or manager is to show consumers how their ends can be met by buying your good or service)!!

 

Diminishing marginal utility: People will rank order their wants or ends -- starting with the end that gives them their highest utility.  As they obtain more and more of something - they can move down their list of ends - move to lower valued ends.  Therefore, we have diminishing marginal utility.

So this means that as someone has more of a good - they will value it less (use it for lower valued ends) - and thus will not be willing to pay as much for it (ceteris paribus).

 

            Able - has the wherewithal.  Usually this means - has the money!

 

c.  Per unit of time: Time must be specified, as it affects diminishing marginal utility.  People change their rank orders through time.  Plus other things change as well.

 

d.  Other things constant.  A number of things aside from the price affect qty purchased (including substitutes, complements, and advertising, etc.)

 

Determinants of Demand.  Things that affect the Marginal Utility of purchasers and their ability and willingness to buy in the market. In addition to price, determinants include:

 Ps        Price of substitutes     

 Pc        Price of complements

 I          Income (Normal goods or Inferior goods)

 E         Expectations (regarding relative future prices and income)

 B         Number of buyers (population)

 T         Taste (the relationship between P and Q reflects this)

 Changes in demand vs. changes in qty demanded.  When one of the non-price determinants of demand changes, it is necessary to draw a new demand schedule.  This is known as a change in demand (schedule).  When there is a change in price, other things held constant, this is called a change in quantity demanded (a movement along a schedule)

 Example, consider 

Qd = f(P, Ps, Pc, I)

This is a demand function.  It is a relationship between quantity demanded, and the collection of elements that determine sales quantity.  The demand curve is a relationship between price and quantity alone, holding all other elements constant.

Suppose income increases.  Then it would be necessary to shift the demand schedule.

 Note: The one thing that CANNOT change the demand (curve) is a change in the price of  the good!

 Graphs:

 

 

 

 

The Notion of Consumer Surplus       In markets where all consumers pay a uniform price for a good,  the consumers who purchase the good place a higher value on the product than the purchase price.  This difference between purchase price and value is termed consumer surplus. 

For example, a consumer who values unit Q1 at $8 and pays $5 for the unit enjoys a consumer surplus of $3.  Notice that the entire consumer surplus for the market is the area between the demand curve and the price.

Graph:

 

 

 

 

In Class Exercise Three

 An analytical example

Consider the following, simple demand function.   A linear function - where Y = a - bx; a is the intercept and bx is the slope of the line.  We will assume our demand curves to be linear -- although in the real world, they often are not.  If we collect data from past sales, we can fit the data to a line that the data fits best.  So assume:

Qd = 10 - 2P

 What does this mean in everyday language to you as a manager?  It means that the data you have collected tells you that when the Price of your good is zero, you will sell 10 units.  Graph this:

 

 

Now -- as the price increases, the -2P indicates the slope of your demand curve.  If the price increases to $1, what will your quantity demanded be?  10 - 2(1) = 8, etc.

What if your demand function were:

Qd = 10 - 5P

How would this demand curve look relative to the one above?  At what price would you no longer have a market for your good?  Graph this:

 

 

 

What if you knew quantity demanded (and the equation) but not price (called inverse demand).  Could you determine the price at which you would sell a given quantity?

Example:  Let's say 6 = 10 - 6P, at what price would the firm sell 6 units?

6 - 10 = -6P

 -4 = -6P

P = -4/-6

P = .66 cents

What about income, price of a substitute, etc.?  Now let's change another variable that would shift your curve. 

Suppose Income = 30, then the demand curve or function can be written as

Qd = 20 - 2P + .25I or 20 - 2P +.25(30)

If the price is $1.00 - then 20 - 2 + 7.5 = 25.5. 

If Income increases to 60 -- what will happen to the demand curve?

Qd = 20 - 2P + .25I or 20 - 2P +.25(60)

If the price is $1.00 - then 20 - 2 + 15 = 33  (Does this make sense -- that at the same price the firm would sell more?  What kind of good is this - normal or inferior?  How would the equation change if it were an inferior good?

But would a change in income also change the slope of the curve?  It might or it might not.  Depends --

If we wanted to show how the price of a substitute would change the equation -- just add it in (after getting the data to determine the relationship) - so would adding in a positive price of a substitute increase or decrease demand?  That is would it be positive or negative?  What about a complement? Answer:  for a substitute it would be positive and for a complement it would be negative - why?  The higher the price of the substitute, the higher the demand for our good.  The higher price of a complement, the lower the demand for our good.

In Class Exercise Three A

So how would a manager use information regarding a demand function for a given product?

    If the data is good (as always), then this can tell them something about how a change in price will change demand -- and therefore revenue streams.

    Data regarding shifts in the curve can tell the manager about how all of the variables in the function effect the demand for their product. 

 

Consumer Surplus:  Now assume the following demand function:

Qd = 30 - 2P

Suppose that the price is $5.  How much consumer surplus will consumers receive at that price? 

So the area of the C.S. triangle is = 1/2 base x height 

Determine your triangle first - when the price is $5, Qd = 20, when Qd = 0 then 0 = 30 - 2P, so -30 = -2P, 15 = P.

Now you can plug into the formula for the C.S. triangle -

(.5)(15-5)(20) = 100

This is the triangle illustrated below

Price

                                                                                                         Quantity Demanded

 How might a manager use this information?

    Again, if there is a lot of consumer surplus, that means there are a lot of consumers who are willing and able to pay a higher price for the good.  A manager might want to capture some of this surplus by using different pricing strategies - such as price discrimination, etc. (that we will discuss later).

    Or -- if the consumer surplus is very low, this means the firm is selling their product for a price very close to the reservation price (the highest price consumers will pay).  In order to be able to get more - the firm might want to change its advertising and promotion strategies -- designed to shift the demand curve to the right -- so that they can sell more at any price and/or make the slope of the demand curve steeper -- so that an increase in price will not change demand by much.

In Class Exercise Three B