You are on page 1of 79

Managerial Economics

PGDM : 2013 15 Term 1 (June September, 2013) (Lecture 4)

Market Equilibrium
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
2

Equilibrium: P has reached the level where quantity supplied equals quantity demanded

Equilibrium Price: The price that equates quantity supplied with quantity demanded (Max WTP = Min WTA)
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
3

P $0 1 2 3 4 5

QD 24 21 18 15 12 9 6

QS 0 5 10 15 20 25 30

Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
4

P $0 1 2 3 4 5

QD 24 21 18 15 12 9 6

QS 0 5 10 15 20 25 30

Surplus (excess supply):When quantity supplied is greater than quantity demanded


P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
5

Surplus

Example: If P = $5, then QD = 9 lattes and QS = 25 lattes resulting in a surplus of 16 lattes Q

Surplus (excess supply):When quantity supplied is greater than quantity demanded


P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
6

Surplus

Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall which reduces the surplus. Q

Surplus (excess supply):When quantity supplied is greater than quantity demanded


P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
7

Surplus

Facing a surplus, sellers try to increase sales by cutting price. This causes QD to rise and QS to fall. Prices continue to fall until market reaches equilibrium. Q

Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5

Example: If P = $1, then QD = 21 lattes and QS = 5 lattes resulting in a shortage of 16 lattes Q


8

Shortage
10 15 20 25 30 35

Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
9

Facing a shortage, sellers raise the price, causing QD to fall and QS to rise, which reduces the shortage.

Shortage

Shortage (excess demand): when quantity demanded is greater than quantity supplied
P
$6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 0 5 10 15 20 25 30 35
10

Facing a shortage, sellers raise the price, causing QD to fall and QS to rise. Prices continue to rise until market reaches equilibrium.

Shortage

EXAMPLES

11

Demand Curve
Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?
A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls

12

A. Price of iPods falls


Price of music downloads

Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right.
D1 Q1 Q2 D2
Quantity of music downloads
13

P1

B. Price of music downloads falls


Price of music downloads

The D curve does not shift. Move down along curve to a point with lower P, higher Q.

P1 P2 D1 Q1 Q2

Quantity of music downloads


14

C. Price of CDs falls


Price of music downloads

CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left.
D2 Q2 Q1 D1
Quantity of music downloads
15

P1

Supply Curve
Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios?
A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide.
16

A. Fall in price of tax return software


Price of tax return software

S1

S curve does not shift. Move down along the curve to a lower P and lower Q.

P1 P2

Q2 Q1

Quantity of tax return software


17

B. Fall in cost of producing the software


Price of tax return software

S1

S2

S curve shifts to the right: at each price, Q increases.

P1

Q1

Q2

Quantity of tax return software


18

C. Professional preparers raise their price


Price of tax return software

S1

This shifts the demand curve for tax preparation software, not the supply curve.

Quantity of tax return software


19

Three Steps to Analyze Changes in Equilibrium


To determine the effects of any event,
1. Decide whether event shifts S curve,

D curve, or both.
2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see

how the shift changes eqm P and Q.

Example 1: The Market for Diesel Cars


price of hybrid cars P S1

P1

D1 Q1 Q quantity of hybrid cars

Example 1:A Shift in Demand


Event to be analyzed:

P S1 P2

Increase in price of Petrol.


STEP 1:

D curve shifts because P1 STEP 2: price of gas affects demand for D shifts right hybrids. because high gas price STEP 3: S curvehybrids does not shift, makes more The shift causes an increase because price of gas attractive relative to in price and quantity of does not affect cost of other cars. hybrid cars. producing hybrids.

D1 Q1 Q2

D2 Q

Example 1:A Shift in Demand


Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. Always be careful to distinguish b/w a shift in a curve and a movement along the curve.
P S1 P2 P1

D1 Q1 Q2

D2 Q

Example 2:A Shift in Supply


Event: New technology reduces cost of producing diesel cars.
STEP 1:

P S1 S2

S curve shifts because P1 STEP 2: event affects cost of production. P2 S shifts right D curve event does not shift, because reduces STEP 3: production because cost, The shift causes price technology is not of makes productionone more to fall and quantity to the factors that affect profitable at any given rise. demand. price.

D1 Q1 Q2 Q

Example3: A Shift in Both Supply and Demand


Events: price of fuel rises AND new technology reduces production costs
STEP 1:

P S1 P2 P1 S2

Both curves shift.


STEP 2:

Both shift to the right.


STEP 3:

Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises.
25

D1 Q1 Q2

D2 Q

Example3: A Shift in Both Supply and Demand


EVENTS: price of fuel rises AND new technology reduces production costs
STEP 3, cont.

P S1 S2

But if supply increases more than demand, P falls.

P1 P2 D1 Q1 Q2 D2 Q

Shifts in Supply and Demand


Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads.

Event A: Event B: Event C:

A fall in the price of CDs Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Events A and B both occur.

A. Fall in price of CDs


STEPS The market for music downloads
S1 P1 P2

1. D curve shifts 2. D shifts left 3. P and Q both fall.

D2 Q2 Q1

D1

B. Fall in cost of royalties a1


STEPS The market for music downloads
S1 S2

1. S curve shifts (Royalties are part of 2. S shifts right sellers costs) P1 3. P falls, P2 Q rises.

D1 Q1 Q2

Slide 29 a1 The royalties that sellers must pay the artists are part of sellers costs of production. Typically, this royalty is a fixed amount each time one of the artists songs is downloaded. Event B, therefore, describes a reduction in sellers costs of production. Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. This event causes a fall in costs of production for sellers of music downloads. Hence, the S curve shifts to the right.
arnab, 7/7/2013

C. Fall in price of CDs and fall in cost of royalties a2


Results P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q; The increase in supply increases Q.

Slide 30 a2 Verify the result by a graphical analysis as discussed in the class.


arnab, 7/7/2013

A Problem
In Rolling Stone magazine, several fans and rock stars, including Pearl Jam, were bemoaning the high price of concert tickets. One superstar argued, It just isnt worth $75 to see me play. No one should have to pay that much to go to a concert. Assume this star sold out arenas around the country at an average ticket price of $75. a) b) How would you evaluate the arguments that ticket prices are too high? Suppose that due to this star s protests, ticket prices were lowered to $50. In what sense is this price too low? Draw a diagram using supply and demand curves to support your argument. Suppose Pearl Jam really wanted to bring down ticket prices. Since the band controls the supply of its services, what do you recommend they do? Explain using a supply and demand diagram. Suppose the bands next CD was a total flop. Do you think they would still have to worry about ticket prices being too high? Why or why not? Draw a supply and demand diagram to support your argument. Suppose the group announced their next tour was going to be their last. What effect would this likely have on the demand for and price of tickets? Illustrate with a supply and demand diagram.
31

c)

d)

e)

A Funny Exercise

Explain the story told by this image with the help of Demand Supply Tools..
32

Market Equilibrium: Algebraic Approach


Quantity Demanded Q d is function of price P d

\ Q d = f P d = a - bP d .(1)
An inverse demand function or price function is \ P d = f -1 Q d = a - bQ d .(1.1)

( )

( )

Quantity Supplied Q s is function of P s

a 1 where, a = and b = b b

\ Q s = f P s = c + dP s ....(2)
An inverse supply function is

( )

\ P s = f -1 Q s = c + dQ s ..(2.1) where, c = c 1 and d = d d


33

( )

Market Equilibrium: Algebraic Approach


e When the market is in equilibrium, P d = P s = P e , where, P is the Equilibrium Price

\ a - bQ = c + dQ
e

where, Q is the Equilibrium Quantity

a -c Q = b+d
e

a -c and , P = a - b b+d
e

Since, Price cannot be negative a f c Alternatively, you can obtain the equilibrium price and quantity just by equating equations (1) and (2)

34

Example
Demand is given by QD = 620 - 10P and supply is given by QS = 100 + 3P. What is the price and quantity when the market is in equilibrium? Answer: In equilibrium, QD = QS, 620 - 10P = 100 + 3P So, the equilibrium Price is 40 And the equilibrium quantity is 220.

35

A note on Equilibrium Price


a3

The objective of Demand supply analysis is to find a price at which the market is clear. We know it is the equilibrium price. Other than Market clearing explanation of equilibrium price what else can you say about this price? In the simplest manner, equilibrium price can be defined as the market value of a product or service and at this value the willingness to accept (WTA) of the sellers matches with willingness to pay (WTP) of the buyers. Now the question is why does equilibrium price differ across different markets? It was thought by the economists, that intrinsic use value of a commodity is the reason for this difference . However, the concepts of production cost and scarcity value better explain this difference. It should be noted that scarcity is also responsible for increasing the production cost. The following examples help you to 36 understand this concept:

Slide 36 a3 Comments and Arguments are very much welcome...


arnab, 7/11/2013

A note on Equilibrium Price (contd.)


Diamond and Water Paradox Real Diamond and Cubic Zicronium Diamond (artificial) Hand Written Bible and Printed Bible Whale Oil Lubricant and Lubricant made from Jojoba Beans

37

Suggested Readings
Shuttlecock Production in Uluberia, West Bengal (http://articles.economictimes.indiatimes.com/2012-1228/news/36036532_1_shuttlecocks-duck-feathers-badmintonplayers) Discovery of Jojoba Beans caused a collapse of Whale Oil Lubricant Price ( MMH, Chapter 2, Page 29) Depreciation of Rupee and Impact on Product Market (The article sent through e-mail) Atkins Diet and Demand for Egg (The article sent through e-mail)
38

Elasticity
Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.

39

Price Elasticity of Demand


Price elasticity of demand Percentage change in Qd
=

Percentage change in P

Price elasticity of demand measures how much Qd responds to a change in P.

Loosely speaking, it measures the price-sensitivity of


buyers demand.

40

Price Elasticity of Demand


Price elasticity of demand Percentage change in Qd
=

Percentage change in P
P P rises by 10% P2 P1 D Q2 Q falls by 15%
41

Example:
Price elasticity of demand equals 15% 10%
= 1.5

Q1

Price Elasticity of Demand


Price elasticity of demand Percentage change in Qd
=

Percentage change in P
P P2 P1 D Q2 Q1 Q

Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers.

42

Calculating Percentage Changes


Standard method of computing the percentage (%) change: end value start value start value x 100%

Demand for your websites


P $250 $200 B A D 8 12 Q

Going from A to B, the % change in P equals ($250$200)/$200 = 25%

43

Calculating Percentage Changes


Problem: The standard method gives different answers depending on where you start. From A to B, P rises 25%, Q falls 33%, elasticity = 33/25 = 1.33
D 8 12

Demand for your websites


P $250 $200 B A

From B to A, P falls 20%, Q rises 50%, Q elasticity = 50/20 = 2.50


44

Calculating Percentage Changes


So, we instead use the midpoint method:

end value start value x 100% midpoint

The midpoint is the number halfway between the


start & end values, the average of those values.

It doesnt matter which value you use as the start


and which as the end you get the same answer either way!

45

Calculating Percentage Changes


Using the midpoint method, the % change in P equals

$250 $200 x 100% = 22.2% $225

The % change in Q equals


12 8 x 100% = 40.0% 10

The price elasticity of demand equals


40/22.2 = 1.8
46

What determines price elasticity?


To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: Suppose the prices of both goods rise by 20%. The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity of demand?
47

The Determinants of Price Elasticity The price elasticity of demand depends on:
the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon elasticity is higher in the long run than the short run

48

EXAMPLE 1: Insulin vs. Caribbean Cruises


The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?

To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities.

EXAMPLE 2: Breakfast cereal vs. Sunscreen

The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: Price elasticity is higher when close substitutes are available.

EXAMPLE 3: Blue Jeans vs. Clothing


The prices of both goods rise by 20%. For which good does Qd drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (black jeans, khakis, Grey Jeans). There are fewer substitutes available for broadly defined goods. Actually, there is no substitutes for clothing. Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.

EXAMPLE 4: Car Fuel in the Short Run vs. Car Fuel in the Long Run
The price of petrol rises 20%. Does Qd drop more in the short run or the long run? Why? Theres not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run.

The Variety of Demand Curves


The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves.

53

Perfectly inelastic demand (one extreme case)


Price elasticity = of demand % change in Q % change in P
P P1 P2 P falls by 10%

a4

=
D

0% 10%

=0

D curve: vertical Consumers price sensitivity: none Elasticity: 0

Q1 Q changes by 0%

54

Slide 54 a4 If Q doesnt change, then the percentage change in Q equals zero, and thus elasticity equals zero. It is hard to think of a good for which the price elasticity of demand is literally zero. Take insulin, for example. A sufficiently large price increase would probably reduce demand for insulin a little, particularly among people with very low incomes and no health insurance. However, if elasticity is very close to zero, then the demand curve is almost vertical. In such cases, the convenience of modeling demand as perfectly inelastic probably outweighs the cost of being slightly inaccurate.
arnab, 7/12/2013

Inelastic demand
Price elasticity = of demand

a5

% change in Q % change in P
P P1 P2 P falls by 10%

< 10% 10%

<1

D curve: relatively steep Consumers price sensitivity: relatively low Elasticity: <1

Q1 Q2 Q rises less than 10%

55

Slide 55 a5 An example: Student demand for textbooks that their professors have required for their courses. Here, its a little more clear that elasticity would be small, but not zero. At a high enough price, some students will not buy their books, but instead will share with a friend, or try to find them in the library, or just take copious notes in class. Another example: Gasoline in the short run.
arnab, 7/12/2013

Unit elastic demand


Price elasticity = of demand % change in Q % change in P
P P1 P2 P falls by 10% Q

10% 10%

=1

D curve: intermediate slope Consumers price sensitivity: intermediate Elasticity: 1

Q1

Q2

Q rises by 10%
56

Elastic demand
Price elasticity = of demand

a6

% change in Q % change in P
P P1 P2 P falls by 10%

> 10% 10%

>1

D curve: relatively flat Consumers price sensitivity: relatively high Elasticity: >1

Q1

Q2

Q rises more than 10%


57

Slide 57 a6 A good example here would be breakfast cereal, or nearly anything with readily available substitutes. An elastic demand curve is flatter than a unit elastic demand curve (which itself is flatter than an inelastic demand curve).
arnab, 7/12/2013

Perfectly elastic demand (the other extreme)


Price elasticity = of demand % change in Q

a7

Very Large = infinity = % change in P Very Low(almost 0%)


P P2 = P1 D

D curve: horizontal Consumers price sensitivity: extreme Elasticity: infinity

P changes by 0%

Q1

Q2 Q changes by any %

58

Slide 58 a7 Heres a good real-world example of a perfectly elastic demand curve, which foreshadows an upcoming chapter on firms in competitive markets. Suppose you run a small family farm in Jodhpur. Your main crop is Bazra. The demand curve in this market is downward-sloping, and the market demand and supply curves determine the price of Bazra. Suppose that price is Rs. 50/Kg. Now consider the demand curve facing you, the individual Bazra farmer. If you charge a price of Rs.50, you can sell as much or as little as you want. If you charge a price even just a little higher than Rs. 50, demand for YOUR Bazra will fall to zero: Buyers would not be willing to pay you more than Rs.50 when they could get the same Bazra elsewhere for Rs. 50. Similarly, if you drop your price below Rs. 50, then demand for YOUR Bazra will become enormous (not literally infinite, but almost infinite): if other Bazra farmers are charging Rs.50 and you charge less, then EVERY buyer will want to buy Bazra from you. Why is the demand curve facing an individual producer perfectly elastic? Recall that elasticity is greater when lots of close substitutes are available. In this case, you are selling a product that has many perfect substitutes: the wheat sold by every other farmer is a perfect substitute for the wheat you sell.
arnab, 7/12/2013

Problem
Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Qd = 5000 if P = $90, Qd = 3000

59

Answers
Use midpoint method to calculate % change in Qd (5000 3000)/4000 = 50% % change in P ($90 $70)/$80 = 25% The price elasticity of demand equals 50% = 2.0 25%
60

A scenario
You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you wont sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase?
61

Price Elasticity and Total Revenue

a8

Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand.
62

Slide 62 a8 It should be clear that making the best possible decision would require information about the likely effects of the price increase on revenue. That is why elasticity is so helpful, as we will now see.
arnab, 7/12/2013

Price Elasticity and Total Revenue


Price elasticity of demand
=

Percentage change in Q Percentage change in P

Revenue = P x Q

If demand is elastic, then


price elast. of demand > 1 % change in Q > % change in P

The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls.
63

Price Elasticity and Total Revenue


Elastic demand (elasticity = 1.8) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 8 and revenue = $2000. When D is elastic, a price increase causes revenue to fall.
64

Demand for your websites

$250 $200

increased revenue due to higher P

lost revenue due to lower Q 8 12

Price Elasticity and Total Revenue


Price elasticity of demand
=

Percentage change in Q Percentage change in P Revenue = P x Q

If demand is inelastic, then price elast. of demand < 1 % change in Q < % change in P

The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250.
65

Price Elasticity and Total Revenue


Now, demand is inelastic: elasticity = 0.82 If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 10 and revenue = $2500. When D is inelastic, a price increase causes revenue to rise.
66

$250 $200

increased revenue due to higher P

lost reven ue due to lower Q

D Q

10

12

Demand for your websites

Problem
A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall?

67

Answers
A. Pharmacies raise the price of insulin by 10%. Does

total expenditure on insulin rise or fall? Expenditure = P x Q Since demand is inelastic, Q will fall less than 10%, so expenditure rises.

68

Answers
B. As a result of a fare war, the price of a luxury cruise

falls 20%. Does luxury cruise companies total revenue rise or fall? Revenue = P x Q The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger? Since demand is elastic, Q will increase more than 20%, so revenue rises.

69

Other Types of Elasticity of Demand


Income elasticity of demand: measures the response of Qd to a change in consumer income Income elasticity of demand Percent change in Qd = Percent change in income

Recall : An increase in income causes an increase in demand


for a normal good.

Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0.
70

Other Types of Elasticity of Demand


Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good Cross-price elast. of demand % change in Qd for good 1 = % change in price of good 2

For substitutes, cross-price elasticity > 0


(e.g., an increase in price of mutton causes an increase in demand for chicken)

For complements, cross-price elasticity < 0


(e.g., an increase in price of computers causes decrease in demand for software)
71