Managerial Economics (Fall Semester 2022)- Session 3

Section 3 - Demand in the Market

Session 3.1- Introduction

Learning Outcomes
• Assess the importance of different influences on demand
• Compare own-price, cross-price and income elasticities of demand for a range of goods
• Demonstrate how demand and supply interact to create the market equilibrium
• Distinguish between own-price elastic and inelastic goods in how revenue changes as we move
along a demand curve
• Demonstrate how the values of the own-price elasticities affect the relative variation in price
and quantity to a market shock.

Additional Notes: Maths Primer: Solving simultaneous equations (Session 1)

Finance Primer: The idea of linear regression (Session 5).

Session 3.2: Thinking about demand

Only Exercises in this section- Attempt them

Session 3.3: Exploring the demand curve

Exercise on the Cumulative Demand Curve

Exercise on the buyer’s response to price changes

A demand curve shows what happens to the amount that buyers want to purchase as the good's own
price changes, but if there is a change to something else, then the demand curve itself will shift. In the
next activity, we will look at some examples of this.

Session 3.4: Shifting the demand curve

Video Lecture:
We need to remember that the demand curve is drawn on the assumption that everything apart from
the goods own price is held constant.- Ceteris Paribus Assumption
Substitutes and Complements
The first Example asked how the price of bread might affect the demand for rice. They're similar foods,
and while they are not perfect substitutes, if rice became very expensive, you might have fewer meals
based on rice and more based on bread. You'd be substituting bread for rice and that's the term
economists use. Bread and rice are substitutes. In the example you were given, the price of the
substitute for rice went up and so the demand curve for rice shifted outwards. You could see it as the
demand curve shifting right since people would buy more rice at any given price, or is the curve shifting
up for the highest price you could get while still selling a particular amount of rice goes up.

However, if the shape of the curve is more complex than a straight line, it's quite possible the shape
willchange as well as the position. The opposite of a substitute is a complement, something that you
tend to buy as well as the product we're interested in. A substitute is something we buy instead.

Session 3.5- Market Equilibrium

• Economists define an equilibrium as a situation where everyone who is making a decision is
doing as well as they can (in terms of what that person wants), given the options available to
them. Those options will depend on the decisions made by other people, and the general
environment.
• When we are studying an individual market, that environment would include people's incomes,
the costs of production and the prices of other goods.
• As long as the environment stays the same, there is no reason for any of the decision-makers to
change their decision, since they would be no better off (and might well be worse off) if they did
change.

Market equilibrium
Think about the intersection of a supply curve and a demand curve. The supply curve shows the amount
that sellers wish to sell at every possible price, and the demand curve shows the amount that buyers
wish to purchase. The curves intersect at a price where the amount being offered (at that price) is just
equal to the amount wanted (at that price).

In the diagram below, Q1 is offered if the price is Price1 and the same amount is demanded. This is the
market equilibrium.
Everyone in the market has a choice between 'trade at the market price' and 'don't trade'.
Firms and consumers to the left of Q1 have chosen 'trade at the market price'. Firms and
consumers to the right of Q1 have chosen 'don't trade'.

When the market is not in equilibrium

Think about a situation that is not an equilibrium; what would happen if the supply curve had
shifted to the left? Perhaps the cost of oil production has increased, or some oil fields are
unable to produce.
Nothing has happened to change the underlying relationship between the price of oil and the
amount that people want to buy, and so the demand curve does not shift.
If the market price remained at Price1, would the amount that buyers are willing to trade still be the
same as the amount sellers want?

All the buyers who previously chose 'trade' would still want the same choice. But fewer sellers would
choose to trade, and so some buyers would effectively be forced into 'do not trade'. The red arrow
shows how much oil would be wanted but not supplied if the price remained at Price1.

These buyers might be better off with a new choice: 'try to find a seller willing to accept a higher price
that you are willing to pay'. Those to the left of Q2 should succeed, for they are willing to pay Price2,
which enough sellers are willing to accept. Would-be buyers between Q1 and Q2 would not be able to
find a seller willing to accept a price lower than their own willingness to pay (which is less than Price2).

The sellers who might have accepted Price1 if that was the only price being offered will realise that
others will be able to receive Price2. Because of that, they would no longer be willing to trade at Price1.
The market price will have to rise to Price2, and this is the new equilibrium.

Buyers and sellers to the left of Q2 choose 'trade at the (new) market price'. Those to the right choose
'do not trade'.

In the oil market, there are many traders in a range of markets, all trying to find the best price to buy
and sell at, and so prices change quickly in response to events (and sometimes to rumours of events).

Other markets are less transparent, and so suppliers try to set the highest price they can get for the
amount they want to sell. If their costs rise, they eventually have to raise prices, losing some sales. If the
supply curve shifted in because some suppliers left the market, the others would see that they now have
more customers (unable to go to their normal seller). That would encourage them to raise prices, and
we would then move towards equilibrium again.
Reading – Supply and Demand

Alfred Marshall Supply and Demand

At the end of the nineteenth century, the economist Alfred Marshall introduced his model of supply and
demand.

Example:

Most English towns had a corn exchange (also known as a grain exchange)—a building where farmers
met with merchants to sell their grain. Marshall described how the supply curve of grain would be
determined by the prices that farmers would be willing to accept, and the demand curve by the
willingness to pay of merchants. Then he argued that, although the price ‘may be tossed hither and
thither like a shuttlecock’ in the ‘higgling and bargaining’ of the market, it would never be very far from
the particular price at which the quantity demanded by merchants was equal to the quantity the
farmers would supply.

Marshall called the price that equated supply and demand the equilibrium price. If the price was
above the equilibrium, farmers would want to sell large quantities of grain. But few merchants would
want to buy—there would be excess supply. Then, even the merchants who were willing to pay that
much would realize that farmers would soon have to lower their prices and would wait until they did.

Similarly, if the price was below the equilibrium, sellers would prefer to wait rather than sell at that
price. If, at the going price, the amount supplied did not equal the amount demanded, Marshall
reasoned that some sellers or buyers could benefit by charging some other price (in modern
terminology, we would say that the going price was not a Nash equilibrium). So the price would tend to
settle at an equilibrium level, where demand and supply were equated.

Marshall’s Contributions
• Provided new foundations for the analysis of supply and demand by using calculus to formulate
the workings of markets and firms, and express key concepts such as marginal costs and
marginal utility.
• The concepts of consumer and producer surplus are also due to Marshall.
• His observation that large firms could produce at lower unit costs than small firms was integral
to his thinking, but it never found a place in the neoclassical school. This may be because if the
average cost curve is downward-sloping even when firms are very large, there will be a kind of
winner-takes-all competition in which a few large firms emerge as winners with the power to set
prices, rather than taking the going price as a given.
Supply and Demand Curves
Example

To apply the supply and demand model to the textbook market, we assume that all the books are
identical (although in practice some may be in better condition than others) and that a potential seller
can advertise a book for sale by announcing its price on a local website. As at the Corn Exchange, we
would expect that most trades would occur at similar prices. Buyers and sellers can easily observe all the
advertised prices, so if some books were advertised at $10 and others at $5, buyers would be queuing to
pay $5, and these sellers would quickly realize that they could charge more, while no one would want to
pay $10 so these sellers would have to lower their price.

We can find the equilibrium price by drawing the supply and demand curves on one diagram, as in
Figure 8.3. At a price P* = $8, the supply of books is equal to demand: 24 buyers are willing to pay $8,
and 24 sellers are willing to sell. The equilibrium quantity is Q* = 24.

The market-clearing price is $8—that is, supply is equal to demand at this price, so all buyers who want
to buy and all sellers who want to sell can do so. The market is in equilibrium.

Price Taking
A price-taker is an individual or company that must accept prevailing prices in a market, lacking the
market share to influence market price on its own. Due to market competition, most producers are
also price-takers.

• In this unit, we study market equilibria where both buyers and sellers are price-takers.
• On both sides of the market, competition eliminates bargaining power. We will describe the
equilibrium in such a market as a competitive equilibrium.
 • A competitive market equilibrium is a Nash equilibrium, because given what all other actors are
doing (trading at the equilibrium price), no actor can do better than to continue what he or she
is doing (also trading at the equilibrium price).

Session 3.6- Limits on Price

Price Ceilings

Sometimes, governments decide that they are not happy with the equilibrium in a particular market. If
they believe that buyers are paying too much, the government could set a price ceiling which is a legal
maximum price

Price Floors

In other situations, the government may believe that suppliers are receiving too little and might respond
by setting a price floor. To have any impact, a price ceiling would have to be below the equilibrium price,
and a price floor above it.

Session 3.7- Shifts in Demand and Supply

An increase in demand
Example
In the market for second-hand textbooks, demand comes from new students enrolling on the course,
and supply comes from students who took the course in the previous year. In Figure 8.11 we have
plotted supply and demand for textbooks when the number of students enrolling remains stable at 40
per year. The equilibrium price is $8 and 24 books are sold, as shown by point A. Suppose that in one
year the course became more popular. Figure 8.11 shows what would happen.
The increase in demand leads to a new equilibrium, in which 32 books are sold for $10 each. At the
original price, there would be excess demand and sellers would want to raise their prices. At the new
equilibrium, both price and quantity are higher. Some students who would not have sold their books at
$8 will now sell at a higher price.

When we say ‘increase in demand’, it’s important to be careful about exactly what we mean:

• Demand is higher at each possible price, so the demand curve has shifted.
• In response to this shift there is a change in the price.
• This leads to an increase in the quantity supplied.
• This change is a movement along the supply curve.

But the supply curve itself has not shifted (the number of sellers and their reserve prices have not
changed), so we do not call this ‘an increase in supply’.

After an increase in demand, the equilibrium quantity rises, but so does the price. You can see in Figure
8.11 that the steeper (more inelastic) the supply curve, the higher the price will rise and the lower the
quantity will increase. If the supply curve is quite flat (elastic), then the price rise will be smaller and
the quantity sold will be more responsive to the demand shock.

An increase in supply due to improved productivity

Example

In contrast, as an example of an increase in supply, think again about the market for bread in one city.
Remember that the supply curve represents the marginal cost of producing bread. Suppose that
bakeries discover a new technique that allows each worker to make bread more quickly. This will lead to
a fall in the marginal cost of a loaf at each level of output. In other words, the marginal cost curve of
each bakery shifts down.
Figure 8.12 shows the original supply and demand curves for the bakeries. When the MC curve of each
bakery shifts down, so does the market supply curve for bread. Look at Figure 8.12 to see what happens
next.

The improvement in the technology of breadmaking leads to:

• an increase in supply
• a fall in the price of bread
• a rise in the quantity sold

NOTE: READ Leibniz: Shifts in demand and supply

As in the example of an increase in demand, an adjustment of prices is needed to bring the market into
equilibrium. Such shifts in supply and demand are often referred to as shocks in economic analysis. We
start by specifying an economic model and find the equilibrium. Then we look at how the equilibrium
changes when something changes—the model receives a shock. The shock is called exogenous because
our model doesn’t explain why it happened: the model shows the consequences, not the causes.

Another reason for a change in market supply is the entry of more firms or the exit of existing firms. If
economic profits in a product’s market are greater than zero, firms are receiving an economic rent, so
other firms might want to invest in the same business. There will be some costs of entry, for example,
acquiring and equipping the premises, but provided these are not too high (or if premises and equipment
can be easily sold if the venture doesn’t work out) it will be worthwhile to do so.
In the case of bakeries, when more bakeries have entered, more bread will be supplied at each price level.
Although the reason for the supply increase is different from the previous one, the effect on the market
equilibrium is the same: a fall in price and a rise in bread sales.
Complete the Exercises at the end of this reading. Also Complete the Quiz and other exercises in this
section.

Session 3.8: The Own-Price Elasticity of Demand

Video Lecture
If the percentage increase in quantity is smaller than the percentage price cut, your revenues have just
fallen. And that's unlikely to be a good idea. If the percentage increase in quantity is bigger, on the other
hand, then you'll be increasing your total revenue. And the price cut might make sense.

And the measure we're going to use, the elasticity of demand, is the ratio of the percentage change in
quantity demanded to the percentage change in price. Strictly speaking, I should call it the own-price
elasticity of demand, for economists find elasticity such a useful concept that we also apply it to several
other things that can change demand or supply. But if you hear someone talk about just the elasticity of
demand, they almost certainly mean this version, the own-price elasticity.

Definition of Price Elasticity

Price elasticity of demand is the ratio of the percentage change in quantity demanded of a product to
the percentage change in price. Economists employ it to understand how supply and demand change
when a product's price changes.
NOTES: THIS IS AN IMPORTANT [Link] THE EXPLANATION ON REGRESSION AND DO THE
EXCERCISES.

Session 3.9: Elasticity and Revenue

Video Lecture 1
NOTES: ATTEMPT THE QUIZ IN THIS SECTION
Session 3.10: Other Demand Elasticities

Reading 1-Walmart Case Study

Abstract: Wal-Mart’s revenues increase during bad times, whereas Target’s revenues decrease,
consistent with Wal-Mart selling “inferior goods” in the technical sense of the term. An upper
bound on the aggregate income elasticity of demand for Wal-Mart’s wares is −0.5.

The cross-price elasticity of demand

We’ve seen that income elasticity can be positive or negative, and the same is true for the
cross-price elasticity of demand. This is equal to the percentage change in the quantity
demanded of one good, divided by the percentage change in the price of the second good.
Estimating the cross-price elasticity of demand is one way to tell whether two goods are
actually substitutes or complements in practice (or have little effect on each other's demand).

Notes: Work on the exercises in this section

Session 3.11: Elasticity of supply

• The own-price elasticity of supply is defined in a similar way to all the other elasticities that
you've seen. It is equal to the percentage change in quantity supplied as you move along the
supply curve, divided by the percentage change in price that would bring about that change.

• Since the supply curve always slopes upwards (or at worst is flat), this elasticity is always going
to be positive. In principle, we could define some other elasticities related to supply; the cross-
price elasticity of the supply of petrol/gasoline with respect to the price of diesel, for example.
However, economists so rarely use these variants that we can just say 'elasticity of supply' and it
would practically always be clear that we meant the own-price elasticity.

• As before, we can define elastic supply as the case when the percentage change in quantity is
greater than the percentage change in price, giving an elasticity of greater than (plus) one.
Inelastic supply means that the percentage change in quantity is smaller, with a value of less
 than one. Since both are positive, most people find 'greater than' and 'less than' a lot easier to
keep on top of with the elasticity of supply than with the own-price elasticity of demand.

NOTE: Work on the two activities in this section

Session 3.12: Why is the oil price so volatile?

The demand curve and the supply curve are inelastic hence the proportional change in price is large
compared to the proportional change in price.
When the demand curve is more elastic, with a small change in price there is a larger change in the
quantity demanded.

When the supply curve is also made more elastic, there is an even smaller change in price
because that’s all that is required to get the required change in supply.

At a less elastic demand curve and a relatively elastic supply curve the price rises substantially compared
to the quantity.
Notes: Attempt the exercise.

Session 3.13: Live tutorial: Elasticities and equilibrium-October 5th