Unit 2 Market Demand, Supply, And Prices (Ch. 2) Input Suppliers to Cut Production Sam, the CEO of PC Solutions, recently read a WSJ article that quoted executives of Samsung and of Hyundia indicating those companies would be reducing their production of PC memory chips. The article went on to say a third company, LG Semicon, would likely follow suit. Collectively, these three companies produce about one-third of the worlds basic semiconductor chips. As part of their operations, PC Solutions buys PC memory chips. The company is relatively small but has been growing (e.g. 100% last year) and is in the process of deciding whether or not to double its workforce. Should PC Solutions plans be impacted by the WSJ article? Using S & D Projections Sue, a commodity merchandiser for KonAgra, is aware that the current market price of a commodity she trades is $1.50 per unit. Her company has just projected for this commodity a new near-term market supply of P =.01Q and market demand of P = Q. What should she expect to happen to the price of this commodity near term? Should her merchandising actions be impacted by this new, updated information? A Shortage? In recent years, there has been a significant increase in the amount of corn-based ethanol produced in the state of Iowa. As a result, numerous popular press articles have questioned whether or not the state will see a shortage of corn production. What would this mean and is it likely to happen? Demand of Microsofts Dos In the late 1970s, Microsoft developed the DOS operating system, initially designed for IBM computers. Microsoft pursued a relatively low pricing strategy for its DOS product to encourage consumers to buy more DOS computers. Were there any other controllable factors that Microsoft used to its advantage to increase the demand for its product? S & D Managerial Implications Understand how Ps are determined in order to anticipate P changes Understand how P changes impact consumers & producers (i.e. coordinate economic activities) Understand how to capitalize on anticipated P changes buying selling producing maintaining inventory contracting staff ing Why Prices are Important to Firms 1. Influence $ sales if a firm is a seller e.g.total revenue = TR = P Q 2.Influence $ expenses if a firm is a buyer e.g. Total cost = TC = P Q =>Firms want to Buy low, sell high! Market Demand Curve Shows the amount of a good that will be purchased at alternative prices. Law of Demand The demand curve is downward sloping. Demand Curves are associated with a given: 1. Product (specified dimensions) quality or type location time period 2. Number of buyers one consumer/buyer all customers of a given firm all customers in a given geographic area (i.e. market) Output or Product Markets Households D Outputs S Inputs Input or Factor Markets Firms D Inputs S Outputs Note: Physical items flow clockwise; payments flow counter clockwise. General Demand Function An equation representing the demand curve =quantity demand of good X. P x= price of good X. P Y= price of a related good Y (substitute or complement). M=income. H=any other variable affecting demand. Factors That Affect D for X (controllable and non controllable) 1. P x = P of that product (or item) (note P could be caused by supply) 2. P and/or availability of another item (e.g. Y) a.Substitutes ( P => D for X) b.Complements ( P Y => D for X) 3. Income (I) a.Inferior ( I => D for X) b.Normal ( I => D for X) 4. Type of Item a.Luxury b.Necessity 5. Buyer concerns or expectations a.Safety and/or health b.Quality (warranty ?) c.Future cost/availability d.Service 6. Advertising 7. Tastes and preferences 8. No. of buyers or alternative uses 9. Govt. policy (e.g. tax) 10. Seasonality 11. Interest rates 12. Profitability of an input (i.e. = derived demand) Specific Demand Function inverse demand equation would be the above equation solved for P x given the values of all the other demand factors Effects of D Factor Changes Change in Demand (due to P of THAT product) Change in Demand (Due to a other than P of THAT product) Quote of the Day In this world, there are two ways to get rich: #1.Produce something valuable and sell it to others. #2.Steal from those who are successful at pursuing the first strategy. N. Gregory Mankiw Fortune (June 12, 00) The Progression of Economic Value ProductActivityBuyer CommodityExtractMarket GoodsProduceCustomer ServicesDeliverClient ExperiencesStageGuest TransformationGuideAspirant Mass Customization (by Pine, 93) Specific D Function Example Q x = 20 P x + 2P y If P y = 5, => P x = 30-Q x (= inverse D function equation) If P y = 10, => P x = 40-Q x Note, an increase in the price of Y has increased The vertical axis intercept without changing the Slope of the original D curve. Thus, there has Been a parallel shift to the right of the D curve for X. Consumer Surplus The value consumers get from a good but do not have to pay for. Market Supply Curve The supply curve shows the amount of a good that will be produced at alternative prices. Law of Supply The supply curve is upward sloping. General Supply Function An equation representing the supply curve: Q X S =f(P X, P R, W, H,) Q X S = quantity supplied of good X. P X = price of good X. P R = price of a related good. W = price of inputs (e.g. wages) H = other variable affecting supply Factors that Affect S of X (controllable and non controllable) 1. P x = P of that product or item (note P could be caused by D) 2. P or profitability of an alternative production item (e.g. Y) ( P Y => S of X) 3. P or cost of an input (e.g. Z) ( P Z => S of X) 4. Taxes 5. Interest rates 6. Govt policies/regulations 7. Technology 8. Producer expectations 9. Weather 10. Number of producers Q X S = a+bP X +cP Y +dW+eH inverse supply equation would be the above equation solved for P X given the values of all the other supply factors Specific Supply Function Effects of S Factor Changes Change in Supply (Due to P of THAT product) A to B: Increase in quantity supplied Change in Supply (Due to other than P of THAT product) S 0 to S 1 : Increase in supply Specific S Function Example Q X = 2P X W if W = 5, Q X = 2P X 5 P X = Q X if W = 10, P X = 5 +.5Q X Producer Surplus The amount producers receive in excess of the amount necessary to induce them to produce the good. Market Equilibrium Balancing supply and demand Q X S = Q X D Steady-state If price is too high... If price is too low... Equilibrium Price = That price for which the amount buyers are willing and able to buy equals the amount producers are willing and able to sell Solving for Equil P Equil S price = D price Q = Q .02Q = 4 Q = 200 P = (200) P = 2.00 Equilibrium Over Time Equilibrium Changes CasePQ 1. D 2. D 3. S 4. S 5. D, S ? 6. D, S ? 7. D, S ? 8. D, S ? S and D Observations 1.A shift of a D curve P Q S (movement along S curve) S and D Observations 2. A shift of a S curve P Q D (movement along D curve) S and D Observations 3. A P in ONE market may shift in S or D in ANOTHER market (e.g. all products if they become too expensive, are likely to have substitutes) Favorite Trading Rules The reaction of the market to news is more important than the news itself. People who buy headlines end up selling newspapers. Facts are priceless opinions are worthless. Rich Felthaus, Refco, July 2004 Big Picture: Impact of decline in component prices on PC market Big Picture: Impact of lower PC prices on the software market Market Equilibrium & NSW NSW=net social welfare =PS + CS Max NSW P = P e NSW Impacts: Q & P NSW= net social welfare = PS + CS =(a-c) + (-a-b) =-c b =net welfare loss (deadweight loss) Price Restrictions Price Ceilings The maximum legal price that can be charged Examples: Gasoline prices in the 1970s Housing in New York City Proposed restrictions on ATM fees Price Floors The minimum legal price that can be charged Examples: Minimum wage Agricultural price supports Impact of a Price Ceiling Impact of a Price Floor Incidence of a Tax P b is the price (including the tax) paid by buyers. P s is the price that sellers receive, net of the tax. Here the burden of the tax is split about evenly between buyers and sellers. Buyers lose A + B, sellers lose D + C, and the government earns A + D in revenue. The deadweight loss is B + C.