ABM71 Chapter 2 Market Forces - Demand and Supply.pdf
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ABM71 Managerial Economics CHAPTER 2. Market Forces: Demand and Supply 2 Objectives In this module, you will learn the supply and demand function in the market and this will help you to achieve the following module outco...
ABM71 Managerial Economics CHAPTER 2. Market Forces: Demand and Supply 2 Objectives In this module, you will learn the supply and demand function in the market and this will help you to achieve the following module outcomes: 1. What is the law of demand and law of supply? 2. What are the important factors that cause demand and supply curve to shift? 3. What is the consumer surplus and producer surplus? 4. Explain the difference between price floor and price ceilings? 5. Distinguish excise taxes and ad valorem taxes, how these taxes impact the market functions.profits? Lesson Roadmap Effective Time Value of Management Money Understand Use of Incentive Marginal Understand Analysis Market Economics of Recognize the ABM 71 Chapter 2: Market Forces: Demand and Law Supply of Market Demand ABM 71 Chapter 2: Market Forces: Demand and Supply How to derive Market Demand? ❑ What is a “Market demand curve”? o It shows the relationship between the quantity and price per unit of a good that consumers are willing and able to purchase, holding other variables constant. o Figure on the next slide shows the straight line connecting those points called the market demand curve interpolates the quantities consumers would be willing and able to purchase at the market prices. ABM 71 Chapter 2: Market Forces: Demand and Supply ABM 71 Chapter 2: Market Forces: Demand and Supply What is the “Law of Demand” ❑ The Law of Demand states that the quantity of a good consumers are willing and able to purchase increases (decreases) as the price falls (rises). ❑ The law of demand says that o consumers will buy more when the price falls and; o consumers will buy less when the price increase. ABM 71 Chapter 2: Market Forces: Demand and Supply ABM 71 Chapter 2: Market Forces: Demand and Supply Other factors can also leads changes in Quantity Demanded ❑ Changing factors other than price (such as advertising, increase in income, increase of price of related goods) also lead to changes in demand. ❑ These types of changes are graphically represented by a shift of the entire demand curve either rightward or leftward. ❑ This will be covered in the next section. ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts ABM 71 Chapter 2: Market Forces: Demand and Supply Changes in Quantity Demand ❑ Figure: Changes in Demand. ❑ The movement along a demand curve, such as the movement from A to B is called a change in quantity demanded. ABM 71 Chapter 2: Market Forces: Demand and Supply ABM 71 Chapter 2: Market Forces: Demand and Supply Changes in Demand ❑ Figure: Changes in Demand. ❑ Whenever advertising, income or the price of related goodschanges, 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. ABM 71 Chapter 2: Market Forces: Demand and Supply ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts? ❑ How Five Demand Shifters Affect Consumer Demand? ❑ 1. Consumer’s Income: Normal good, Inferior good o Normal good: A good for which an increase (decrease) in income leads to an increase (decrease) in the demand for that good. o Inferior good: A good for which an increase (decrease) in income leads to a decrease (increase) in the demand for that good. ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts? ❑ How Five Demand Shifters Affect Consumer Demand? ❑ 2. Prices of related goods: Substitute goods, Complement goods o Substitutes: Goods for which an increase (decrease) in the price of one good leads to an increase (decrease) in the demand for the other good. o Complements: Goods for which an increase (decrease) in the price of one good leads to a decrease (increase) in the demand for the other good. ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts? ❑ How Five Demand Shifters Affect Consumer Demand? ❑ 3. Advertising and Consumer tastes o Informative advertising: Advertising often provides consumers with information about the existence or quality of a product, which in turn induces more consumers to buy the product. o Persuasive advertising: Advertising can also influence demand by altering the underlying tastes of consumers. ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts? ❑ How Five Demand Shifters Affect Consumer Demand? ❑ 4. Population o The demand for a product is also influenced by changes in the size and composition of the population ❑ 5. Consumer Expectations o 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. ABM 71 Chapter 2: Market Forces: Demand and Supply Why Demand Curve Shifts? ❑ How Five Demand Shifters Affect Consumer Demand? ❑ 6. Other Factors o Any variable that affects the willingness or ability of consumers to purchase a particular good is a potential demand shifter. o Take a look at the figure in the next slide. You may see how advertising can influence demand by altering the underlying tastes of consumers. ABM 71 Chapter 2: Market Forces: Demand and Supply Effect of Advertising to Demand Curve ❑ Figure: Advertising and the Demand for Clothing o Advertising done by firms causes the demand curve for clothing to shift from D1 to D2 o The old demand curve D1 shows that at Price (P) of $40 the Quantity Demanded (Q) is at 50,000. o But, when the demand curve move from D1 to D2 due to advertising, at Price (P) of $40 the Quantity Demanded (Q) increases from 50,000 to 60,000 ABM 71 Chapter 2: Market Forces: Demand and Supply ABM 71 Chapter 2: Market Forces: Demand and Deman Supply d Function ABM 71 Chapter 2: Market Forces: Demand and Supply The Demand Function ❑The demand function for good X is a mathematical representation describing how many units will be purchased at different prices for X, the price of a related good Y, income and other factors that affect the demand for good X. ABM 71 Chapter 2: Market Forces: Demand and Supply The Linear Demand Function ❑One simple, but useful, representation of a demand function is the linear demand function: ❑, where: o is the number of units of good X demanded; o is the price of good X; o is the price of a related good Y; o is income; o is the value of any other variable affecting demand. ABM 71 Chapter 2: Market Forces: Demand and Supply Understanding the Linear Demand Function ❑ The signs and magnitude of the coefficients determine the impact of each variable on the number of units of X demanded. ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ Dear students, now you know what is "Manager", "Managerial Economics". Managerial ❑ Now we need to understand how Economics a managerial economics is a Valuable Tool valuable tool for analyzing "Economics" and business situations ABM 71 Chapter 2: Market Forces: Demand and Supply Economics of Effective Management ❑ What are the basic Economic Principles for Effective Management? ❑ We will go through each principle to understand what can influence the economic decisions. ❑ It begins with identify goals and constraints ▪ Sound decisions must have well-defined goals. ▪ The decision maker often faces constraints that affect the ability to achieve a goal. ▪ For example, if your goal is to maximize your grade in this course rather than maximize your overall grade point average, your study habits will differ accordingly. ABM 71 Chapter 2: Market Forces: Demand and Supply The Goal of Maximizing Profits ❑The goal of maximizing profits requires a decision about the optimal price for a product. ▪ Total Sales (Revenue) = Price x Unit of Product/Services Sold ▪ Profit = Sales – Cost ❑The managers should decide how much to produce, use of technology, input use, and how to react to the decision made by competitors. ABM 71 Chapter 2: Market Forces: Demand and Supply Accounting Profit vs. Economic Profit ❑Accounting Profit ▪ cost of producing goods and services. The total amount of money ▪ Accounting Profit = Sales taken in from sales (total – Cost of Producing revenue) minus the dollar Goods and Services services. ❑Economic Profit ▪ Economic Profit = Total Revenue – Total Opportunity ▪ The difference between the Cost of Producing Goods and total revenue (sales) and the Services total opportunity cost of producing the firm's goods or ABM 71 Chapter 2: Market Forces: Demand and Supply Opportunity Cost ❑ The opportunity cost of using a resource includes both explicit (or accounting cost) and implicit cost of giving up the best alternative use of the resource. ❑ Implicit costs are very hard to measure and therefore managers often overlook them. ABM 71 Chapter 2: Market Forces: Demand and Supply Opportunity Cost ❑ The opportunity cost of using a resource includes both explicit (or accounting cost) and implicit cost of giving up the best alternative use of the resource. ❑ Implicit costs are very hard to measure and therefore managers often overlook them. ABM 71 Chapter 2: Market Forces: Demand and Supply Explicit Cost vs. Implicit Cost ❑For example, an employee could take a vacation and travel. ❑The implicit costs ❑The explicit costs relate to the tradeoff, would include travel namely the wages that expenses, the cost of a the employee could hotel room, and costs have earned if the related to entertainment. vacation was not taken. ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ Profitssignal to resource holders where Opportunity resources are most Cost highly valued by society. ABM 71 Chapter 2: Market Forces: Demand and Supply Framework for Sustainable Industry Profits ABM 71 Chapter 2: Market Forces: Demand and Supply Framework for Sustainable Industry Profits ❑ Michael Porter’s “five forces” framework organizes many complex managerial economics issues into five categories or “forces” that impact the sustainability of industry profits: A. Entry B. Power of Input suppliers C. Power of buyers D. Industry rivalry E. Substitutes and Complements ABM 71 Chapter 2: Market Forces: Demand and Supply Five Forces and Industry ❑ A. Entry Profitabili ty ▪ More competition and reduces the margins of existing firms in the wide variety of industry settings. ▪ Sustainable profits of existing firms depend on barriers to entry. ❑ B. Power of Input Suppliers ▪ Industry profits tend to be lower when suppliers have the power to negotiate favorable terms for their inputs. ABM 71 Chapter 2: Market Forces: Demand and Supply Five Forces and Industry Profitability ❑ C. Power of Buyers ▪ Industry profits tend to be lower when customers have the power to negotiate favorable terms for the products or services produced in the industry. ❑ D. Industry Rivalry ▪ Sustainability of industry profits depends on the nature and intensity of rivalry among firms. The rivalry is less in the concentrated industries. ABM 71 Chapter 2: Market Forces: Demand and Supply Five Forces and Industry Profitability ❑ E. Substitutes and Complements ▪ Industry profits also depend on the price and value of interrelated products and services. ABM 71 Chapter 2: Market Forces: Demand and Supply Understanding Incentives ❑ Changes in profits (growth in profit) provide an incentive to how resource holders use their resources. ❑ Economic incentives are what motivates you to behave in a certain way, while preferences are your needs, wants and desires. Economic incentives provide you the motivation to pursue your preferences. ABM 71 Chapter 2: Market Forces: Demand and Supply Understanding Incentives ❑ Within a firm, incentives impact how resources are used and how hard workers work. ❑ One role of a manager is to construct incentives to induce maximal effort from employees. o Salary o Commission o Bonus ❑ Many professionals and owners of small establishments have difficulties because they do not fully comprehend the importance of the role incentives play in guiding the decisions of others ABM 71 Chapter 2: Market Forces: Demand and Supply What is a Market? ❑ Market transaction has two sides: o Buyer. o Seller. ❑ Bargaining position of consumers and producers is limited by three rivalries in economic transactions: o Consumer-producer rivalry. o Consumer-consumer rivalry. o Producer-producer rivalry. ABM 71 Chapter 2: Market Forces: Demand and Supply Market Interactions Producer ▪ Consumers C-P ❑ Consumer - Rivalry attempt to locate low prices, while ▪ Scarcity of goods Producer producers attempt to charge high reduces the negotiating power Rivalry G ▪ Scarcity of prices. of consumers as consumers they compete for ❑ The Role of C-C the right to those causes producers to Governmen goods. compete with t ❑ Consumer - one another ▪ Disciplines the Consumer P-P for the right to service market process. Rivalry customers. ❑ Producer - ABM 71 Chapter 2: Market Forces: Demand and Supply Role of Government in a Market ❑ What is the role of the government to regulate the market? ❑ When agents on either side of the market findthemselves disadvantaged in the market process, they attempt to induce the government to intervene on their behalf. ABM 71 Chapter 2: Market Forces: Demand and Supply The Time Value of Money ABM 71 Chapter 2: Market Forces: Demand and Supply The Time Value of Money ❑ Managers can use present value analysis to properly account for the timing of many decisions involves a gap between the time when the costs of a project are borne and the time when the benefits of the project are received. ❑ Managers can use present value analysis to properly account for the timing of receipts and expenditures. ABM 71 Chapter 2: Market Forces: Demand and Supply Present Value Analysis ❑ The amount that would have to be invested today at the prevailing interest rate to generate the given future value. ❑ Present value of a future value o The amount that would have to be invested today at the prevailing interest rate to generate the given future value: FV ( ) PV = 1+ in o Present value reflects the difference between the future value and the opportunity cost of waiting: o = − ABM 71 Chapter 2: Market Forces: Demand and Supply The Time Value of Money ❑ Consider a project that returns the following income stream: o Year 1, $10,000; Year 2, $50,000; and Year 3, $100,000. o At an annual interest rate of 3 percent, what is the present value of this income stream? ABM 71 Chapter 2: Market Forces: Demand and Supply Present Value Analysis ❑ The higher the interest rate, the higher the opportunity cost of waiting to receive a future amount and thus the lower the present value of the future amount. ABM 71 Chapter 2: Market Forces: Demand and Supply Net Present Value ❑ The present value of the income stream generated by a project minus the current cost of the project: ❑ Given the present value of the income stream that arises froma project, one can easily compute the net present value of the project. ❑ Profit maximization principle o Maximizing profits means maximizing the value of the firm, which is the present value of current and future profits. ABM 71 Chapter 2: Market Forces: Demand and Supply Marginal Analysis ABM 71 Chapter 2: Market Forces: Demand and Supply Understanding Marginal Analysis ❑ What is marginal analysis? o The marginal analysis states that optimal managerial decisions involve comparing the marginal (or incremental) benefits of a decision with the marginal (or incremental) costs. ❑ Given a control variable, , denote the o total benefit as , total benefits derived from Q units. o total cost as , representing the total costs of correspondinglevel of Q. ABM 71 Chapter 2: Market Forces: Demand and Supply Understanding Marginal Analysis ❑ Marginal benefit refers to what people are willing to give up in order to obtain one more unit of a good, while; ❑ marginal cost refers to the value of what is given up in order to produce that additional unit. ❑ Additional units of a good should be produced as long as marginal benefit exceeds marginal cost. ❑ Manager’s objective is to maximize net benefits (produce goods at maximum profit) Marginal Analysis ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ How can the manager maximize net benefits? ❑ Use marginal analysis o Marginal benefit: The change in total benefits arising from a change in the managerial control variable,. o Marginal cost: The change in the total costs arising from a change in the managerial control variable,. o Marginal net benefits: = − ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ Change in total benefits arising from a change in B Marginal MB Benefit the control variable, Q: Δ = (calculus Δ (MB) ❑ Slope Q derivative) of the total benefit curve. ABM 71 Chapter 2: Market Forces: Demand and Supply Cost Marginal (MC) ❑Change in total costs Q arising from a change in the control variable, Q: ❑Slope (calculus derivative) of the total CMC Δ cost curve Δ = Marginal Analysis Principle ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ Marginal principle o To maximize net benefits, the manager should increase the managerial control variable up to the point where marginal benefits equal marginal costs. o At this level (MB = MC) marginal net benefits are zero; nothing more can be gained by further changes in that variable. ABM 71 Chapter 2: Market Forces: Demand and Supply ❑ To maximize net benefits, the managerial control variable should be increased up to the of the control variable Marginal increased benefits more than it increased costs. ❑ MB < MC means the last unit Principle of the control variable increased costs more than it increased benefits. point where MB = MC. ❑ MB > MC means the last unit ABM 71 Chapter 2: Market Forces: Demand and Supply ❑Net Benefits = ▪ Total Benefits - Total Net Costs ❑Profits = Benefits Total Benefits Costs Revenue - Costs & Total Costs Benefits Slope =MB B CSlope = MC The Geometry of Optimization: Total Benefit and Cost Q Q* ABM 71 Chapter 2: Market Forces: Demand and Supply Maximum Total Benefits ❑ At the level Q where the marginal benefit curve intersects the marginal cost curve, marginal net benefits are zero. That level Q maximizes net benefits. benefits Net Benefits The Geometry of Optimization: Net Benefits Maximum net Slope = MNB Q Q* ABM 71 Chapter 2: Market Forces: Demand and Lesso Supply n Recap ABM 71 Chapter 2: Market Forces: Demand and Supply Conclusio n ❑Economics ❑Trade offs ❑Opportunity costs ❑Implicit costs and explicit costs ❑Economic profits and accounting profits ❑Marginal benefits and marginal costs ❑Present value and net present value ❑Time value of money ❑Porter’s five forces Thank you for listening!
