APPENDIX

To accompany

Lecture Notes 2

I. A CASUAL MODEL TO PREDICT MARKET

EQUILIBRIUM

II. SELF-REVIEW EXERCISES

 I. A CASUAL MODEL TO PREDICT
MARKET EQUILIBRIUM

(We will not go over this appendix. However, students are required
to read and digest the contents.)
(1) Introduction
Here, we apply previously discussed concepts and show how simple causal models help
managers determine the association between changes in market variables and firm
performance.

We also examine normative aspects of simple supply and demand models. That is, how can
managers use the models to form beliefs about future changes in market conditions?

Managerial decision making is characterized by two conditions - incomplete information and

a strategic nature. Incomplete information simply means that managers do not possess all the
relevant information. For example, a manager does not know with certainty how new
capacity coming on-stream will affect market price. Because of their uncertainty, managers
must form beliefs about what will occur. In forming these beliefs, managers use causal
models (either explicit or implicit ones). Today we will examine one causal model – a basic
economic one about changes in market equilibrium.

(2) Theory

Our causal model is simple and is based on two sets of numbers:

- The current market price and quantity.

- (We assume this price and quantity “clears the market” – it is the market equilibrium.
Managers usually use one of several simple models to form their beliefs about the
market’s equilibrium conditions. For example, analyzing historical market performance
and taking the simple average. Or, if the market is growing or declining, a manager
might use the moving average (depending on her causal model). Keep in mind that the
true “objective” price and quantity level does not exist. For example, even if a manager
knew all the “true” numbers (which she won’t) different definitions of the relevant
market may exist. )

- The own market price elasticities of demand and supply at the equilibrium price. (The
manager must consider the elasticities at the current market price and quantity levels
since elasticities generally change as one moves up and down demand and supply
curves.)

Assume linear demand and supply curves. Thus,

Supply: QS = a0 +a1PS

Demand: QD = b0 – b1PD

Now, the manager needs to “fill in the blanks”; she must choose the values of the
variables a0, a1, b0 and b1.
Step 1: Recall that own price elasticity of demand is equal to:

eD = (PD/QD)(dQD/dPD)

and that dQD/dPD is constant for linear demand curves and that own price elasticity of supply
is equal to:

eS = (PS/QS)(dQS/dPS)

and that dQS/dPS is constant for linear supply curves.

Now if we take the supply curve QS = a0 + a1PS and differentiate quantity with respect to
price, we have

dQS/dPS = a1

and if we do the same for the demand curve, we have

dQD/dPD = -b1

Now substitute those into the own price elasticity formula:

Supply: eS = a1(PS*/QS*)
Demand: eD = -b1(PD*/QD*)

Where the * indicates the price and quantity at market equilibrium, i.e., QD* =QS* =Q* and PD*
= PS* = P*.

Thus, a1 = eSQS*/PS* = eSQ*/ P*

and b1 = -eDQD*/PD* = -eDQ*/P*

Step 2: Now, our causal model can approximate constants for 2 of the 4 variables (a1 and b1,
so the next step is to solve for the last 2 variables (a0 and b0).

We can change the supply equation to:

Supply = QS = a0 +a1PS = Q* = a0 +a1P*

or a0 = Q* - a1P* = Q* - eSQ* = Q*(1 - eS)

and the demand equation to:

Demand = QD = b0 – b1PD = Q* = b0 – b1P*

or b0 = Q* + b1P* = Q* - eDQ* = Q*(1- eD)

Now we have solved for our 4 variables.

(3) Numerical Example

An example:
Assume your summer internship is in the analysis group of a major diversified industrial
goods corporation. You are asked to analyze the implications of a downward shift in the
demand for shipping fasteners.

You believe that the following market conditions are approximately true:

Quantity = Q* = 2 million a year

Demand = P* = $0.50 per fastener
Own price elasticity of supply = eS = (P*/Q*)(dQS/dPS) = 1.3
Own price elasticity of demand = eD = (P*/Q*)(dQD/dPD) = -0.9

You are willing to believe that a linear approximation will describe the market supply and
demand curves.

Step 1: Substitute these numbers to determine a1

Own price elasticity of supply = eS = a1(P*/Q*)

i.e., 1.3 = a1(0.5/2) = 0.25a1 or a1 = 5.2

Step 2: determine a0

Supply = QS = a0 + a1PS = Q* = a0 + a1P*

i.e., 2 = a0 + 5.2*0.5 = a0 + 2.6 or a0 = -0.6

Step 3: Write the supply curve

QS = -0.6 + 5.2PS

Step 4: Substitute these numbers to determine b1

Own price elasticity of demand = eD = -b1(P*/Q*)

i.e., -0.9 = -b1(0.5/2) = -0.25b1 or b1 = 3.6

Step 5: Determine b0

Demand = QD = b0 – b1PD = Q* = b0 – b1P*

i.e., 2= b0 – 3.6*0.5 = b0 – 1.8 or b0 = 3.8

Step 6: Write the demand curve

QD = 3.8 – 3.6PD

We can check out our calculations by setting quantity supplied equal to quantity demanded:

QS = -0.6 + 5.2PS = 3.8 – 3.6PD = QD

or Q* = -0.6 + 5.2P* = 3.8 – 3.6P* = Q*
or 8.8P* = 4.4
or P* = 0.50

Shock #1: We believe that there might be a 30% decline in demand, i.e., quantity demanded
will fall by 30% at each price. So multiply the demand quantity through by 0.7 or:

QDNew = 0.7QD = 0.7(3.8 –3.6PD)

= 2.66 – 2.52PD

Now equate quantity supplied and the new quantity demanded

QS = -0.6 + 5.2P* = 2.66 – 2.52P* = QDNew

or 7.72P* = 3.26
or P* = 0.422

So a 30% decrease in demand causes approximately a 16% (= 0.078/0.5 = 15.6%) decrease in

price.

Shock #2: what will occur if the own price supply elasticity changes?

You believe the following market conditions are approximately true:

Quantity = Q* = 2 million a year

Price = P* = $0.50 per fastener

Own price elasticity of supply = eS = (P*/Q*)(dQS/dPS) = 1.1

Own price elasticity of demand = eD = (P*/Q*)(dQD/dPD) = -0.9

You are willing to believe that a linear approximation will describe the market demand and
supply curves.
Step 1: Substitute these numbers to determine a1

Own price elasticity of supply = eS = a1(P*/Q*)

i.e., 1.1 = a1(0.5/2) = 0.25a1 or a1 = 4.4

Step 2: Determine a0

Supply = QS = a0 + a1PS = Q* = a0 + a1P*

i.e., 2 = a0 + 4.4*0.5 = a0 + 2.2 or a0 = -0.2

Step 3: Write the supply curve

QS = -0.2 + 4.4PS

Step 4: Since the demand information didn’t change, we have the demand curve, which we
estimated previously

QD = 3.8 – 3.6PD

We can check out our calculations by setting quantity supplied equal to quantity demanded:

QS = -0.2 + 4.4PS = 3.8 – 3.6PD = QD

or Q* = -0.2 + 4.4P* = 3.8 – 3.6P* = Q*
or 8P* = 4
or P* = 0.50

We believe that there might be a 30% decline in demand. So multiply the demand quantity
through by 0.7 or:

QDNew = 0.7QD = 0.7(3.8 –3.6PD)

= 2.66 – 2.52PD

Now equate quantity supplied and the new quantity demanded

QS = -0.2 + 4.4P* = 2.66 – 2.52P* = QDNew

or 6.92P* = 2.86
or P* = 0.413

So a 30% decrease in demand causes approximately a 17% (= 0.087/0.5 = 17.34%) decrease

in price.
Shock # 3: What are the effects of a change in own price demand elasticity?

You believe that the following market conditions are approximately true:

Quantity = Q* = 2 million a year and Price = P* = $0.50 per fastener

Own price elasticity of supply = eS = (P*/Q*)(dQS/dPS) = 1.3

Own price elasticity of demand = eD = (P*/Q*)(dQD/dPD) = -0.7

You are willing to believe that a linear approximation will describe the market demand and supply
curves.

Step 1: Since the supply information didn’t change, we have the supply curve, which we estimated
previously
QS = -0.6 + 5.2PS

Step 2: Substitute these numbers to determine b1

Own price elasticity of demand = eD = -b1(P*/Q*)

i.e., -0.7 = -b1(0.5/2) = -0.25b1 or b1 = 2.8

Step 3: Determine b0
Demand = QD = b0 – b1PD = Q* = b0 – b1P*

i.e., 2 = b0 – 2.8*0.5 = b0 – 1.4 or b0 = 3.4

Step 4: Write the demand curve

QD = 3.4 – 2.8PD

We can check out our calculations by setting quantity supplied equal to quantity demanded:

QS = -0.6 + 5.2PS = 3.4 – 2.8PD = QD

or Q* = -0.6 + 5.2P* = 3.4 – 2.8P* = Q*
or 8P* = 4 or P* = 0.50

We believe that there might be a 30% decline in demand. So multiply the demand quantity through by
0.7 or:

QDNew = 0.7QD = 0.7(3.4 – 2.8PD)

= 2.38 – 1.96PD

Now equate quantity supplied and the new quantity demanded

QS = -0.6 + 5.2P* = 2.38 – 1.96P* = QDNew

or 7.16P* = 2.98
or P* = 0.416

So a 30% decrease in demand causes approximately a 17% (= 0.084/0.5 = 16.76%) decrease in price.
II. SELF-REVIEW EXERCISES
EXERCISE 1

Let’s see how demand and supply curves can help managers better understand
markets. You receive a summer internship with P&G. The group’s assignment is to
determine whether P&G should enter a new market. The group has to estimate future
market potential and they ask you to estimate the post-entry market price. The
forecasting group estimates the market demand curve as:

QD = 5,230 – 350P

If P&G decides to enter the market, the estimated market supply curve is

QS = 2,500 + 300P

a. What is your estimate of market price?

Step 1- Equate market quantity demanded with market quantity supplied

QD = 5,230 – 350P = 2,500 + 300P = QS

Step 2- Solve for P

5,230 – 350P = 2,500 + 300P

or 650P = 2,730
or P = $4.20

b. Now let’s put some more economics in. Let’s view the annual world market of
coffee beans.

Suppose market demand was PD = 10 – QD

and market supply was PS = 4 + QS

Thus, at equilibrium

PD =10 – QD = 4 + QS = PS or 2Q = 6 or Q = 3

Then,
P = 10 –3 = 4 + 3 = 7

Now, suppose that Columbia and Brazil agreed to pull Q = 2 from the world
market in an attempt to drive up the price). How would it affect the equilibrium
price?
Rewrite the original supply as

QS = -4 + PS

If 2 is taken out of the market, then the new supply becomes:

QSNEW = -4 + PS – 2 = - 6 + PS

Rewrite demand as

QD = 10 – PD

Equating demand with the new supply:

QD = 10 – PD = -6 + PS = QSNEW or 2P = 16 or P = 8

Then Q = 10 – 8 = -6 + 8 = 2

So the impact of the Columbia and Brazil action of withholding 2 units of coffee from the
market is to raise price from 7 to 8 and to decrease coffee consumed from 3 to 2. Note that
the coffee consumption does not decrease by the amount that they’ve taken out of the market
because the increase in price stimulates other coffee producers to produce and because the
increase in price causes demanders to want to consume less.

Shifted Supply Curve

$

10 Supply Curve

8
7
6

4 Demand Curve

2 3 10 Quantity

Adding a reality:

Now suppose that the market was about daily supply and demand for coffee beans and
suppose that daily supply curve is perfectly price-inelasitic. Can you compare it to the above
case? How about the case of the demand and supply over 10 years?
EXERCISE 2

Suppose the market for widgets can be described by the following equations:
Demand: P  10  Q Supply: P  Q  4
where P is the price in dollars per unit and Q is the quantity in thousands of units.

a. What is the equilibrium price and quantity?

Equate supply and demand and solve for Q: 10  Q  Q – 4. Therefore Q  7 thousand
widgets.
Substitute Q into either the demand or the supply equation to obtain P.
P  10  7  $3.00,
or
P  7  4  $3.00.

b. Suppose the government imposes a tax of $1 per unit to reduce widget consumption
and raise government revenues. What will the new equilibrium quantity be? What
price will the buyer pay? What amount per unit will the seller receive?

With the imposition of a $1.00 tax per unit, the price buyers pay is $1 more than the price
suppliers receive. Also, at the new equilibrium, the quantity bought must equal the
quantity supplied. We can write these two conditions as
Pb  Ps  1
Qb  Qs.
Let Q with no subscript stand for the common value of Qb and Qs. Then substitute the
demand and supply equations for the two values of P:
(10  Q)  (Q  4)  1
Therefore, Q  6.5 thousand widgets. Plug this value into the demand equation, which is
the equation for Pb, to find Pb  10  6.5  $3.50. Also substitute Q  6.5 into the supply
equation
to get Ps  6.5  4  $2.50.
The tax raises the price in the market from $3.00 (as found in part a) to $3.50. Sellers,
however, receive only $2.50 after the tax is imposed. Therefore the tax is shared equally
between buyers and sellers, each paying $0.50.
c. Suppose the government has a change of heart about the importance of widgets to
the happiness of the American public. The tax is removed and a subsidy of $1 per
unit granted to widget producers. What will the equilibrium quantity be? What
price will the buyer pay? What amount per unit (including the subsidy) will the
seller receive? What will be the total cost to the government?

Now the two conditions that must be satisfied are

Ps  Pb  1
Qb  Qs.
As in part b, let Q stand for the common value of quantity. Substitute the supply and
demand curves into the first condition, which yields
(Q  4)  (10  Q)  1.
Therefore, Q  7.5 thousand widgets. Using this quantity in the supply and demand
equations, suppliers will receive Ps  7.5  4  $3.50, and buyers will pay Pb  10  7.5 
$2.50. The total cost to the government is the subsidy per unit multiplied by the number of
units. Thus the cost is ($1)(7.5)  $7.5 thousand, or $7500.
EXERCISE 3

Suppose the demand curve for a product is given by Q = 10  2P + PS, where P is the price
of the product and PS is the price of a substitute good. The price of the substitute good is
$2.00.

a. Suppose P = $1.00. What is the (point) price elasticity of demand? What is the (point)
cross-price elasticity of demand?

Find quantity demanded when P = $1.00 and PS = $2.00. Q = 10  2(1) + 2 = 10.

P Q 1 2
Price elasticity of demand =  (2)    0.2 .
Q P 10 10

PS Q 2
Cross-price elasticity of demand =  (1)  0.2 .
Q PS 10

b. Suppose the price of the good, P, goes to $2.00. Now what is the (point) price elasticity
of demand? What is the (point) cross-price elasticity of demand?

When P = $2.00. Q = 10  2(2) + 2 = 8.

P Q 2 4
Price elasticity of demand =  (  2 )    0 . 5 .
Q P 8 8

PS Q 2
Cross-price elasticity of demand =  (1)  0.25 .
Q PS 8
EXERCISE 4

Among the tax proposals regularly considered by Congress is an additional tax on distilled
liquors. The tax would not apply to beer. The price elasticity of supply of liquor is 4.0, and
the price elasticity of demand is –0.2. The cross-elasticity of demand for beer with respect
to the price of liquor is 0.1.

a. If the new tax is imposed, who will bear the greater burden – liquor suppliers or liquor
consumers? Why?
Supply is more price-elastic than Demand, thus buyers will bear more tax burden than
sellers.

b. Suppose that the market price increased by 30% after the tax. Assuming that
beer supply is infinitely elastic, how will the new tax affect the beer market ?
With an increase in the price of liquor (from the large pass-through of the liquor tax),
some consumers will substitute away from liquor to beer because the cross-elasticity
is positive. This will shift the demand curve for beer outward by 3% (=30% x 0.1) .
With an infinitely elastic supply for beer (a horizontal supply curve), the equilibrium
price of beer will not change, and the quantity of beer consumed will increase by 3%.

END OF APPENDIX