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CHAPTER 2

Market Forces: Demand and Supply

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Chapter Outline

• Demand

Chapter Overview

– Factors that change quantity demanded and factors that change demand – The demand function – Consumer surplus

• Supply

– Factors that change quantity supplied and factors that change supply – The supply function – Producer surplus

• Market equilibrium • Price restrictions and market equilibrium

– Price ceilings – Price floors

• Comparative statics

– Changes in demand – Changes in supply – Simultaneous shifts in supply and demand

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2-9

The Linear Demand Function

• One simple, but useful, representation of a demand function is the linear demand function: ������ ������������ = ������0 + ������������ ������������ + ������������ ������������ + ������������ ������ + ������������ ������ , where:

– – – – –

Demand

������������ ������ is the number of units of good X demanded; ������������ is the price of good X; ������������ is the price of a related good Y; ������ is income; ������ is the value of any other variable affecting demand.

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Demand

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. ������������ ������ = ������0 + ������������ ������������ + ������������ ������������ + ������������ ������ • For example:

– ������������ < 0 by the law of demand; – ������������ > 0 if good Y is a substitute for good X; – ������������ < 0 if good X is an inferior good.

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The Linear Demand Function in Action

• Suppose that an economic consultant for X Corp. recently provided the firm’s marketing manager with this estimate of the demand function for the firm’s product: ������������ ������ = 12,000 − 3������������ + 4������������ − 1������ + 2������������ Question: How many of good X will consumers purchase when ������������ = $200 per unit, ������������ = $15 per unit, ������ = $10,000 and ������������ = 2,000? Are goods X and Y substitutes or complements? Is good X a normal or an inferior good?

Demand

Answer: ������������ ������ = 12,000 − 3 200 + 4 15 − 1 10,000 + 2 2000 = 5,460 units. Goods X and Y are substitutes. Good X is an inferior good.

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Inverse Demand Function

• By setting ������������ = $15 and ������ = $10,000 and ������ = 2,000 the demand function is

Demand

������������ ������ = 12,000 − 3������������ + 4 15 − 1 10,000 + 2 2,000

the linear demand function simplifies to ������ ������������ = 6,060 − 3������������ Solving this for ������������ in terms of ������������ ������ results in 1 ������ ������������ = 2,020 − ������������ 3 , which is called the inverse demand function. This function is used to construct a market demand curve.

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Demand

Graphing the Inverse Demand Function in Action

Price $2,020

1 ������������ = 2,020 − ������������ ������ 3

0

6,060

Quantity

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Demand

Consumer Surplus

• Marketing strategies – like value pricing and price discrimination – rely on understanding consumer value for products.

– Total consumer value is the sum of the maximum amount a consumer is willing to pay at different quantities. – Total expenditure is the per-unit market price times the number of units consumed. – Consumer surplus is the extra value that consumers derive from a good but do not pay for.

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Demand

Market Demand and Consumer Surplus in Action

Consumer Surplus Price per liter $5 $4 $3 $2 $1 0 1

Consumer Surplus: 0.5($5 - $3)x(2-0) = $2 Total...

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