Business Economics Lecture 2 PDF

Business Economics Lecture 2 Esther Boler Assistant Professor of Economics Aysha sat at her desk in front of her laptop, her head in her hands. She’d had such a good start to the day, but didn’t make it further than lunch time before the thought of the decision in front of her was weighing heavil...

Business Economics Lecture 2 Esther Boler Assistant Professor of Economics Aysha sat at her desk in front of her laptop, her head in her hands. She’d had such a good start to the day, but didn’t make it further than lunch time before the thought of the decision in front of her was weighing heavily on her shoulders. She had built this company from scratch. When they launched her innovation – a smart bottle that adjusts the amount of recommended water intake based on the weather forecast – six months ago, it had gained a lot of attention and got glowing reviews in the press. She had been so proud and excited about what was to come. But sales were slower than anticipated, and there were numerous complaints on social media saying that the bottle was too expensive. Max, the newly appointed Marketing Director, was arguing they should cut the price and reach a bigger consumer segment. Aysha was sceptical. She had invested a lot of money in developing this product, and the reality was they really needed to recoup some of the cost. She slammed her laptop shut and decided to go buy herself a croissant and yet another cup of coffee. Surely the decision could wait another day. Imperial College Business School Imperial means Intelligent Business 2 Imperial College Business School Imperial means Intelligent Business 3 The Nature of Markets A market is an arrangement through which buyers and sellers are brought together and transactions are made There are many different types of markets: – product markets – labour markets – financial markets – marriage markets There are two sides to a market: – Demand: arising from those who want to buy the product or service – Supply: arising from those who want to sell the product or service Imperial College Business School Imperial means Intelligent Business 4 The Nature of Markets Why is it important to understand the nature of product markets? The characteristics of the market will affect: – How easy it is to enter the market – How much a firm can sell – The price a firm can charge – Whether the actions of one firm will impact other firms – Incentives for innovation We will spend quite a bit of time exploring how the nature of markets affect decision-making for entrepreneurs and managers Imperial College Business School Imperial means Intelligent Business 5 The Nature of Markets We will start by exploring some general concepts – We will focus on markets for products – Much will be the same for services Market dimensions to consider – Location: the market may or may not have a specific geographical location – Price: the unit price at which the product is bought and sold – Quantity: the amount of the product which is bought and sold – Time: the period of time over which the market transactions are made – Size: how much potential revenue is there – Structure: how many firms are active, how easy is it to enter and exit Imperial College Business School Imperial means Intelligent Business 6 Market Demand In a product market, demand is the amount that consumers (households) want to buy over a given period in time For an entrepreneur or a manager, it is crucial – and very challenging – to understand the demand pattern in the market Lecture 3 will dig deeper into – How to predict demand – Which factors affect demand Today, we will introduce some key concepts – Demand curve – Elasticity of demand Imperial College Business School Imperial means Intelligent Business 7 Market Demand Demand will depend on many factors, mainly: – The price of the product – The price of other products – Household incomes – Consumer tastes/preferences Changes in any of these factors will cause demand to change Which of these can a manager possibly affect? Imperial College Business School Imperial means Intelligent Business 8 Analysing the Factors Influencing Demand The ceteris paribus assumption: we examine changes in each factor, assuming other factors do not change Suppose there is a fall in the price of apples – Demand for apples goes up Suppose household incomes rise – Demand for apples goes up Suppose there is an increase in the price of pears – Demand for apples goes up Suppose we learn that apples are bad for your health – Demand for apples goes down Imperial College Business School Imperial means Intelligent Business 9  The Demand Curve £/unit If something other than the good’s own price changes, the whole curve shifts (left or right) Move along the curve to show how people respond to a DꞋ(p) (cold weather) change in the good’s Economists often use a prime to show that a own price D(p) variable or function has changed Units per period Imperial College Business School Imperial means Intelligent Business 10 Market Supply In a product market, supply is the amount that producers (firms) want to sell over a given period in time For an entrepreneur or a manager, it is crucial – and again challenging – to understand how much to supply to the market Lectures 4 and 5 will dig deeper into – The different types of costs that firms incur – Which factors affect supply Today, we will introduce some concepts – Supply curve – Elasticity of supply Imperial College Business School Imperial means Intelligent Business 11 Market Supply Supply depends on several factors, mainly: – The price of the product – Production costs and technology – The number of firms operating in the market Changes in any of these factors will cause supply to change Which of these can a manager possibly affect? Imperial College Business School Imperial means Intelligent Business 12 Analysing the Factors Influencing Supply The ceteris paribus assumption: we examine changes in each factor, assuming other factors do not change Suppose there is an increase in the price of wheat – Supply of wheat goes up Suppose that wage costs fall – Supply of wheat goes up Suppose technological progress causes an increase in crop yields – Supply of wheat goes up Imperial College Business School Imperial means Intelligent Business 13  The Supply Curve £/unit S(p) Move along the curve to SꞋ(p) show how firms respond to a change in the good’s (lower input costs) own price If something other than the good’s own price changes, the whole curve shifts Units per period Imperial College Business School Imperial means Intelligent Business 14 Market equilibrium £/unit S(p) Economists often use a star to show that a variable is at its equilibrium level P* D(p) Q* Units per period Imperial College Business School Imperial means Intelligent Business 15 Market Equilibrium Thinking about the equilibrium price An Equilibrium is a situation in which there is no reason for things to change Every decision-maker is taking (one of) the best action(s) available to them, given the environment and what they know about the actions of other people and firms If the environment changes, we would normally expect at least some people to have an incentive to change their decision, and we would move to a new equilibrium Imperial College Business School Imperial means Intelligent Business 16 Market Equilibrium Thinking about the equilibrium price At the equilibrium price, everyone who wants to buy the good at that price can find a seller willing to sell it What would happen if the price was higher? What would happen if the price was lower? Imperial College Business School Imperial means Intelligent Business 17 Excess supply £/unit S(p) P D(p) Units per period QD QS Imperial College Business School Imperial means Intelligent Business 18 Excess demand £/unit S(p) P D(p) Units per period QS QD Imperial College Business School Imperial means Intelligent Business 19 Numerical example Market equilibrium is the solution to a simultaneous equation problem We are looking at the market for haircuts in Central London The demand is like this: – if the price of a haircut is £30, 50 haircuts per week will be sold – For each £1 price increase, 3 fewer haircuts per week will be sold We can write this as: D = 50 – 3 (P – 30) Imperial College Business School Imperial means Intelligent Business 20 Numerical example Now over to the supply side Supply is like this: – If the price is £30 per haircut, supply is 40 haircuts per week – For each £1 price increase, supply rises by 2 haircuts per week We can write this as S = 40 + 2 (P – 30) Imperial College Business School Imperial means Intelligent Business 21 Numerical example Questions to figure out: a) What is the equilibrium price of a haircut in Central London? b) In equilibrium, how many haircuts will be performed each week? How can we go about solving this? 1. Simplify expressions 2. Set supply (S) equal to demand (D) 3. Solve for P 4. Insert the solution for P into either S or D 5. Always a good idea to double check by solving for the other one too! Imperial College Business School Imperial means Intelligent Business 22 Numerical example How confident are you in solving mathematical problems like this? Or go to menti.com and enter code 8605 4638 Imperial College Business School Imperial means Intelligent Business 23 Numerical example 1. Simplify expressions: D = 50 – 3 (P – 30) = 140 – 3P S = 40 + 2 (P – 30) = 2P – 20 2. The equilibrium condition is that D = S, giving us: 140 – 3P = 2P – 20 140 + 20 = 2P + 3P 3. Solve for P 160 = 5P  P = 32 Imperial College Business School Imperial means Intelligent Business 24 Numerical example 4. Insert into either S or D S = 2 ×32 – 20 = 64 – 20 = 44 5. Verify by inserting into the other one D = 140 – 3×32 = 140 – 96 = 44 Equilibrium in this market is 44 haircuts per week at £32 each This holds until “something” changes. What is “something”? Imperial College Business School Imperial means Intelligent Business 25 Market equilibrium when demand shifts £/unit S(p) P*Ꞌ P* DꞋ(p) (tourist season) D(p) Q* Q*Ꞌ Units per period Imperial CollegeCollege © Imperial BusinessBusiness School School Imperial means Intelligent Business 26 26 Market equilibrium when supply shifts £/unit S(p) SꞋ(p) (Central London rent prices drop) P* P*Ꞌ D(p) Q* Q*Ꞌ Units per period Imperial CollegeCollege © Imperial BusinessBusiness School School Imperial means Intelligent Business 27 27 Characteristics of shifting equilibria If something affecting demand changes (apart from the good’s own price)… – The demand curve will shift and the equilibrium involves a movement along the supply curve – Price and quantity change in the same direction If something affecting supply changes (apart from the good’s own price)… – The supply curve will shift and the equilibrium involves a movement along the demand curve – Price and quantity change in opposite directions Imperial College Business School Imperial means Intelligent Business 28 Characteristics of shifting equilibria It is of course possible that whatever is changing will affect both supply and demand It is also possible for something affecting demand and something affecting supply to change at the same time It is useful to be able to talk about how responsive demand or supply is when something changes, without having to worry about the units we are using Which is why we will spend a few slides on the concept of… Imperial College Business School Imperial means Intelligent Business 29 Elasticity Elasticity is a measure that is independent of units and so is “scale free” It is often used in the context of supply and demand models, but can be applied to many other issues We are going to focus on the following: – Own-price elasticity of demand – Cross-price elasticity of demand – Income elasticity of demand – Price elasticity of supply Imperial College Business School Imperial means Intelligent Business 30 Own-price elasticity of demand A relative measure of how the quantity demanded responds to price changes Why is this useful to know? It tells the firm how demand responds to changes in prices! % change in quantity demanded % change in price DQ DP DQ P ¶Q P ¸ = = Q P DP Q ¶P Q Imperial College Business School Imperial means Intelligent Business 31 Own-price elasticity of demand Let’s go back to our haircut example. We had this demand curve: D = 140 – 3P And we had D* = 44 P* = 32 What is the own-price elasticity of demand at the equilibrium? 𝜕𝑄 𝑃 32 Note that the elasticity = −3 ≈ −2.18 depends on where on the 𝜕𝑃 𝑄 44 curve you are! Imperial College Business School Imperial means Intelligent Business 32 Classes of elasticity These vertical bars represent absolute values DQ DP Elastic demand > : elasticity >1 Q P DQ DP elasticity