Managerial Economics

2. Demand, Supply and Market Equilibrium

Solomon K.(PhD)

Lunar International College

December, 2020
 Table of Contents

 Demand and Demand Function

1
 Determinants of Demand
 Elasticity of Demand
2

 Demand Analysis and Optimal Pricing

 Supply and Supply Function
 Determinants of supply
 Market Equilibrium
 Basic Concepts: Demand side of the market

Quantity Demanded:- refers to various amounts of a product or

service consumers are willing and able to buy at each of a series of
possible prices during a specified period, given other things
unchanged (ceteris paribus).

Law of demand is the principle of demand, which states

that, "price of a commodity and its quantity demanded are
inversely related, ceteris paribus".

All else equal/cetris paribus, as price falls, the quantity

demanded rises, and as price rises, the corresponding quantity
demanded falls.
 Demand Function

Demand function is a mathematical relationship between price and

quantity demanded, all other things remaining the same.

1. General demand function: Quantity demand as a function of the

independent variables that influence the quantity demanded.
Qd = f (Px , Y , Pr , T, E, Nb )

2. Direct demand: The direct relationship between the quantity

demanded and price (other independent variables held constant).
Qd = f (Px )

3. Inverse demand: The direct relationship between price and quantity

demanded.
Px = f (Qd )
 The relation between quantity demanded and the six factors that
affect quantity demanded.

General Demand Function Qd = f (Px , Y , Pr , T , E, Nb )

Qd = β 0 + β1Px + β 2 Y + β3Pr + β 4 T + β5E + β6Nb

(1)

β0 is the intercept
β 1 , β 2 , β 3 , β 4 , β 5 , and β 6 are slope parameters
Measure effect on Qd of changing one of the variables while
holding the others constant.
Sign of parameter shows how variable is related to Qd
Positive sign indicates direct relationship
Negative sign indicates inverse relationship
 Determinants of Demand

The demand for a product (say X) is in uenced by many factors.

1 Price of the product (Px )
2
Income of the consumers (Y )
3
Price of related goods (Pr )
4
Taste or preference of consumers ( T )
5
Consumers expectation of income and price (E )
6
Number of buyers in the market (Nb )
 Different types of goods and services
Normal good: A good or service for which an increase (decrease) in
income causes consumers to demand more (less) of the good, holding all
other variables in the general demand function constant.

Inferior good: A good or service for which an increase (decrease) in

income causes consumers to demand less (more) of the good, all other
factors held constant.

Substitutes: Two goods are substitutes if an increase (decrease) in the

price of one of the goods causes consumers to demand more (less) of the
other good, holding all other factors constant.

Complements: Two goods are complements if an increase (decrease) in

the price of one of the goods causes consumers to demand less (more) of
the other good, all other things held constant.
 General Demand Determinants

Variables Relation to Qd Sign of slope Parameter

Px Inverse β 1 = △Q d /△Px is negative
Direct for normal goods β 2 = △Q d /△Y is positive
Y Inverse for inferior goods β 2= △Q d /△Y is negative
Direct for substitute goods β 3 = △Q d /△Pr is positive
Pr Inverse for complements β 3= △ Q d / △Pr is negative
T Direct β 4 = △Qd /△T is positive
Direct β 5 = △Q d / △ E is positive
E β 6 = △Q d / △ Nb is positive
N Direct
b
 Example 1: Demand for Car

Qd = f (Px , Y ,
Pr )

Qd = 50 − 0.45Px + 0.15Y + 0.12Pr (2)

d d d
△Q / △ Px = −0.45; △ Q / △ Y = 0.15; △ Q / △ Pr = 0.12

If Pr = 100; Y = 200, then Qd = 115 − 45Px

 Example 2
Demand function
Given a general demand function:
Qd = 3200 -10P +0.05 Y-24 Pr

Drive the demand function, Qd = f(P) if inclcome Y = 60,000, Pr= 200

Qd = 3200 -10P +0.05 Y-24 Pr

= 3200-10P+0.05(60,000)-24(200)
Qd = 1400-10P

Intercept Parameter= 1400 (Horizontal intercept)

Slope = △Qd/ △P= -10 (indicate that a one Birr increase in price
causes quantity demanded to decrease by 10 units).
Inverse Demand Functions: P = f (Qd)-express price as a function of
quantity demanded:
P= 140- 1/10 Qd
 Demand Schedule

A demand schedule (or table) shows a list of several prices and

the quantity demanded per period of time at each of the prices,
again holding all variables other than price constant.

Price Quantity demanded

14o 0

120 200

100 400

80 600

60 800

40 1000

20 1200
 Demand Curve
A graph showing the relation between quantity demanded and
price when all other variables influencing quantity demanded
are held constant.
 Movements Vs Shift of the Demand Curve
Change in quantity demanded
• movement along the same demand curve
• It is caused by change in price of the good
Change in demand =
• shift of the demand curve and
• Caused by changes in other factors that affect
demand
 Out ward shift  increase in demand
 Inward shift  decrease in demand.
Movements Vs Shift of the Demand Curve

Figure: Shift in demand curve

 Elasticity of Demand
Elasticity of Demand: percentage change in the dependent
variables due to the percentage change in the independent
variables.
It is a measure of the responsiveness or sensitivity of
customers to change in one of factors that affect demand.
Price Elasticity of Demand: Measures responsiveness or
sensitivity of consumers to changes in the price of a good.
E=
%△Q = − △Q * P
%△P △P Q
Since P & Q are inversely related (the law of demand), then
E
is always negative.
 Elasticity of Demand

The price elasticity is calculated for movements along a

given demand curve (or function) as price changes and all
other factors affecting quantity demanded are held constant.
Suppose a 10 percent price decrease causes consumers to
increase their purchases by 30 percent. The price elasticity
is equal to -3 in this case.
In contrast, if the 10 percent decrease in price causes only a
5 percent increase in sales, the price elasticity would equal
-0.5.
The larger the absolute value of E, the more
sensitive buyers are to a change in price.
Price Elasticity of Demand
Price Elasticity of Demand-Graphically
 Predicting the Percentage Change in Quantity Demanded

Suppose a manager knows the price elasticity of demand for a

company’s product is equal to -2.5 over the range of prices currently
being considered by the firm’s marketing department. The manager is
considering decreasing price by 8 percent and wishes to predict the
percentage by which quantity demanded will increase.
From the definition of price elasticity, it follows that
-2.5= % △ Q
-8%
% △ Q = +20%
Thus, the manager can increase sales by 20 percent by
lowering price 8 percent.
 Price elasticity and Total revenue
Total revenue (TR): The total amount paid to
producers for a good or service.
TR=P*Q
The change in price and the change in quantity have
opposite effects on total revenue. The relative strengths
of these two effects will determine the overall effect on
TR.
Price effect: The effect on total revenue of changing
price, holding output constant.

Quantity effect: The effect on total revenue of

changing output, holding price constant.
Price Elasticity, Revenue, and Marginal Revenue
Elasticity and Total Revenue
Price Elasticity, Revenue, and Marginal Revenue

Marginal revenue (MR): is the change in total revenue

per unit change in output.
MR =
△TR
△Q
Since MR measures the rate of change in total
revenue as quantity changes, MR is the slope of the
total revenue (TR) curve.
Marginal Revenue
Maximizing Revenue
Maximizing Revenue
 Basic Concepts: Supply side of the market

Supply indicates various quantities of a product that

sellers (producers) are willing and able to provide at
different prices in a given period of time, other things
remaining unchanged.
T h e law of supply : states that, ceteris paribus, it tells us
there is a positive relationship between price and quantity
supplied.
 Supply Function
Supply function is a mathematical relationship between price and
quantity supplied, all other things remaining the same.

Figure: Individual supply function

 Aggregate Supply

Market supply: It is derived by horizontally adding the quantity

supplied of the product by all sellers at each price.
Suppose the individual supply function of a product is
given
by: P = -10 + Q / 2 and there are about 100 identical sellers in
the market. What is the market supply function?
P = -10 + Q / 2
Q / 2 =10+P
Q = 20 + 2P and
Qm = (20 + 2P) 100 = 2000+200P
 Determinats of supply

The supply of a particular product is determined by:

1
Price of the good itself (P x )
2
Prices of related goods (P r )
3
Price of inputs (cost of inputs) (P i )
4
Technology (T )
5
Sellers` expectation of price of the product (E )
6
Taxes & subsidies (TS )
7
Number of sellers in the market (NS )
 Market Equilibrium

The equilibrium price in a competitive market is determined by

the interactions of all buyers and sellers in the market.
More precisely,the price of a good in a competitive market is
determined by the interaction of market supply and market
demand for the good.
Thus, market equilibrium occurs when market demand equals
market supply.
Graphically

Figure: Market equilibrium

 Example

It is reported that Ethiopian government has a plan to privatize state-

owned firms. Imagine that you are an advisor to the Ethiopian state-
owned enterprises, and you have been asked to help the enterprise
determine the price and quantity that will prevail when competitive
forces are allowed to equilibrate the market. The best estimates of
the market demand and supply for the good are given by Qd = 100 −
2P, and: P = Qs/2 + 10, respectively.
1 Calculate the market equilibrium price and quantity
2 What happens to the market at P = 25 and P = 35.
 Example

Solution :
1 At equilibrium., Qd= Qs ↔100 -2P = 2P-20 ↔P =30 & Q
= 40
2 Qd(P = 25) = 100-2(25) =50 and Qs(P = 25 ) = 2(25) -20
=30 ⇒there is a shortage of: 50 -30 =20 units
Qd( at P=35) = 100-2(35) = 30 and Qs (at p = 35) =
2(35)-20 = 50 (a surplus of 20 units)
 References

Thomas et al. (2016) Managerial Economics: Foundations of

Business Analysis and Strategy, Chapter 2 and 6.
Baye (2010).Managerial Economics and Business Strategy,
Chapter 2.
Webster ,Thomas J. (2003)Managerial Economics: Theory
and Practice, Chapter 3 and 4.
Other microeconomics text books.
Thomas et al. (2016) Managerial Economics: Foundations of Business
Analysis and Strategy, Chapter 2 and 6.

Page 76 Question #1, 6, 7, 11,13,15,17

Page 226. Question # 1,3,6,8,16

Date submission: December 28, 2020