CHAPTER 2

DEMAND AND SUPPLY, ANALYSIS, ESTIMATION AND FORECASTING

A fundamental understanding of demand and supply concepts is essential to the successful

operation of any economic organization.

Lesson 1.Basis of Demand

Demand is the quantity of a good or service that customers are willing and able to purchase
under a given set of economic conditions.

Direct demand is the demand for the products that directly satisfy consumer desires. The value
or worth of a good or service, its utility, is the prime determinant of direct demand. Demand for
consumption of products.

Derived demand is a demand for all inputs and determined by the profitability of using various
inputs to produce output. Demand for inputs used in production.

Law of Demand:

“As price goes up, the quantity demanded by consumers goes down.

As the price falls, the quantity demanded by consumers rises.”

If everything else remains the same, people will demand more of something at a lower price than they
will at a higher price.

Demand Schedule- a list of how many units are willing to buy at different prices.

Demand

Lesson 2.Market Demand Function

The market demand function for a product is a statement of the relation between the aggregate
quantity demanded and all factors that affect this quantity.

Determinants of demand: Increase Demand: Decrease Demand:

1. Change in buyer tastes. Favorable change. Unfavorable

2. Change in number of buyers. Increase number decrease number

3. Change in income. Increase if normal/ A rise if inferior good’

superior good A fall if normal/superior

Fall if inferior good good
4. Change in prices of related goods .An increase of related good An increase of good
If Y is s ubstitute to X; If Y is complementary to X;

A decrease of related goods. A decrease of related goods

If Y is complementary good to X. If Y is substitute to X

5. Change in expectations. Increase expectations of Decline in future price

Future increase in income and income & prices

Lesson 3.Demand Curve

The demand curve expresses the relation between the price charged for a product and the
quantity demanded, holding constant the effects of all other variables.

A change in the quantity demanded is a movement along a single demand curve.

A shift in demand, or shift from one demand curve to another, reflects a change in one or more
of the non-price variables in the product demand function.

Lesson 4.Basis of Supply

Supply refers to the quantity of a good or service that produces are willing and able to sell under
a given set of conditions.

Law of Supply:

“ If everything else remain the same, business will supply more of a product or service at a higher price
than they will at a lower price”

Supply Schedule- a list of how many units of a product sellers are willing to supply at different
prices.
Lesson 5.Market Supply Function

Market supply function for a product is a statement of the relation between the quantity
supplied and all factors affecting that quantity.

Determinants of supply:

1. Resources prices.

2. Technology

3. Taxes and subsidies

4. Prices of other goods.

5. Future price expectation.

6. Number of Sellers

Lesson 6.Supply Curves

Supply curve expresses the relation between the price charged and the quantity supplied,
holding constant the effects of all other variables.

Movement along supply curve reflects change in the quantity supplied. A shift in supply, or a
switch from one supply curve to another, indicates a change in one or more of the non-price variables in
the product supply function.

Lesson 7. Market Equilibrium

Market is an institution or mechanism which brings together buyer and sellers(suppliers of particular
goods and services.

A market is in equilibrium when the quantity demanded and the quantity supplied is in perfect balance
at a given price. Surplus describes a condition of excess supply. Shortage is created when buyers
demand more of a product at a given price than producers are willing to supply. The market equilibrium
price or market clearing price just clears the market of all supplied product.

Lesson 8. Demand Analysis

Managerial Economics provides a useful framework for understanding how consumers make
trade-offs. Every consumer decision involves trade-offs between price, quantity, quality, timeliness, and
a host of related factors. The consideration of such trade-offs,, and the methods used by consumers to
make consumption decisions, is called the study of consumer behavior. Its obvious practical relevance
when considering the pricing, and production decisions made by businesses, also of practical relevance
when considering public policy decisions that directly or indirectly affect consumers. Consumer behavior
theory is useful for both describing and predicting consumer decisions.

In a comparative static analysis, the role of factors influencing demand and supply is analyzed
while holding all else equal.

UTILITY THEORY

The ability of goods and services to satisfy consumer wants is the basis for consumer demand.

Utility-Satisfaction tied to consumption. Utils- Unit of utility or satisfaction.

Three Basic Assumptions

With these basic assumptions, the foundation exists for a more detailed examination of the
benefits tied to consumption.

1st. NONSATIATION PRINCIPLE-“More is better”, consumers always prefer more to less of any good or
service at any specific place and time, and consumers do become sated. It is best considered within the
context of money income where more money brings additional satisfaction or well-being.

2nd.INDIFFERENCE-“Preference are complete”, consumers are able to compare and rank the benefits
tied to consumption. Indifference implies equivalence in the eyes of the consumer, it yields the same
amount of satisfaction.
3rd.PREFERENCES ARE TRANSITIVE, consumers are able to rank the desirability of various goods and
services. Ordinal utility, rank ordering of preferences (A is better than B). Cardinal utility, understanding
of the intensity of preferences (A=2B).

UTILITY FUNCTIONS

It is a descriptive statement that relates satisfaction or well-being to the consumption of goods

and services and can be written in general form: Utility= f(goods/services)

Market baskets-bundles of items desired by consumers.

Total Utility- measures the consumers overall level of satisfaction derived from consumption

Marginal Uitility-measures the added satisfaction derived from a 1-unit increase in consumption
of a particular good or service, holding consumption of other goods and services constant. It tends to
diminish as consumption increase within a given time interval.

LAW OF DIMINISHING MARGINAL UTILITY:

“As an individual increases consumption of a given product within a set of period of time, the marginal
utility gained from consumption eventually declines.

Lesson 9. DEMAND ESTIMATION

Interview And Experimental Methods

Effective means of finding out What do customers want.

1. Consumer interview (or survey) method-requires questioning customers or potential customers to

estimate demand relation and or a variety of underlying factors.

2. Market Experiments-demand estimation in a controlled environment. It is an alternative technique for

obtaining useful product demand information. Firms study one or more markets with specific prices,
packaging, ads, and then vary controllable factors over time or between markets. This is expensive,
undertaken on short periods, low level of confidence in the results.

Simple Demand Curve Estimation

 It can give useful insight for pricing and promotion decisions.

Simple Demand Curve-sophisticated demand estimation and cost effective. Offering discounts
that will increase sales and thereby yielding maximum profits.

Simple Market Demand Curve Estimation

Market Demand is the firm’s total demand from various customer proups.

Market Demand Curve shows the total amount customers are willing to buy at various prices
under current market conditions. Total amount of demand=sum of demand curve of every group(class
a,b,c or local,foreign). Evaluate the market demand in every group in every specific price.

Identification problem

Firms sometimes face problems in estimating demand relations because of the interplay
between demand and supply conditions.

Simultaneous relation-concurrent association, market price-output equilibrium at any point in

time is determined by the forces of demand and supply.

Identification problem-difficulty of estimating an economic relation in the presence of

simultaneous relations.

Regression Analysis

It is a powerful statistical technique used to describe the ways in which important economic
variables are related.

Deterministic relation is an association between variables that is known with certainty. Ex: Total
Revenue=PricexQuantity.

Statistical relation exists between two economic variables if the average is related to another
but it is impossible to predict with certainty the value of one based on the value of another. Imprecise
link between two variables.
 Time Series of data-daily weekly, monthly, or annual sequence of economic data.

Cross-section of data-a group of observation on an important economic variable atany given

point of time.

Scatter diagram-is a plot of data where the dependent variable is plotted on the vertical axis(Y)
and the independend variable on horizontal axis (X).

Lesson10. Forecasting

Predicting trends in macroeconomic conditions and their impact on costs or demand for
company goods and services is one of the most difficult responsibilities facing management however
Forecasting is a necessary task because, for better or worse, all decisions are made on the basis of future
expectations. A number of forecasting techniques have proven successful in forming accurate
expectations in a wide variety of real-world applications.

Macroeconomic forecasting –prediction of aggregate economic activity at the international, national,

regional, or state levels. Prediction of gross domestic products (GDP), unemployment,interest
rates.GDP-is the value of final point of sale of all goods and services produced in the domestic economy
during a given period by both domestic and foreign-owned enterprises. GNP- is the value of final point
of sale of all goods and services produced bydomestic firms.

Microeconomic forecasting-prediction of partial economic data, involves the prediction of economic

data at the industry, firm,plant, or product levels.

Forecast Techniques:

1. Qualitative analyses

2. Trend analysis and projection

3. Exponential smoothing

4. Econometric methods
1. Qualitative analyses –an intuitive judgmental approach to forecasting based on opinion.

Expert Opinion:

a. Personal insight-method based on personal or organizational experience.

b. Panel consensus- method based on the informed opinion of several individuals.

c. Delphi method- method that uses forecasts derived from an independent analysis of expert
opinion.

Survey Techniques

Generally use interviews or mailed questionnaire approach to forecasting.

2. Trend analysis and projection-is based on the premise that future economic performance follows
anestablished historical pattern

Trends in Economic Data:

a.Secular Trend-long run pattern of increase or decrease.

b.Cyclical Fluctuation- Rythmic fluctuation in an economic series due to expansion or contraction

in the overall economy.

c.Seasonality- Rythmic annual patterns in sales or profits.

d. Irregular or random Influences-Unpredictable shocks to the economic system and the paced
of economic activity such as wars, strikes, natural catastrophes and the like.

Linear Trend Analysis –assumes a constant period-by-period unit change in an important

economic variable over time.

Growth Trend Analysis- assumes constant period-by-period percentage change in an important

economic variable over time.

3. Exponential smoothing-averaging techniques to predict unit sales growth, revenue, costs and profit
performance
 a. Exponential smoothing or averaging is a method of forecasting trends in unit sales, unit costs,
wage expenses, and so on. Identifies historical patterns of trend or seasonality in the data and then
extrapolates these patterns forward into the forecast data. Most widely used techniques.

b. One-parameter (Simple) Exponential Smoothing- the sole regular component is the level of
the forecast data series, ppropriate for forecasting sales in mature markets with stable activity

c. Two-parameter (HOLT) Exponential Smoothing- by C.C.Holt, appropriate for forecasting sales

in established markets with stable growth.

d. Three-parameter (Winters) Exponential Smoothing – by P.R.Winters, economic data involve

both growth trend, and seasonal considerations, best suited for forecasting problems that involve rapid
and/or changing rates of growth combined with seasonal influences.

4. Econometric methods- combined economic theory with statistical tools topredict economic relations.

Advantage:

a. Force the forecaster to make explicit assumptions about the linkages among the variables on the
economic system being examined, forecaster must deal with causal relations to produce logical
consistency and increase reliability.

b. Forecaster can compare forecasts with actual results and use insights gained to improve the forecast
model.

c. Output offers estimates of actual values for forecasted variables that includes direction and
magnitude of change.

d. Their ability to explain economic phenomena.

Judging Forecast Reliability

Forecast Reliability, or predictive consistency must be adequately assessed prior to the

implementation of any successful forecasting program. A given forecast model is often estimated by
using test group of data and evaluated by using forecast group data. No forecasting assignment is
complete until reliability has been quantified and complete. The sample mean forecast error is one
useful measure of predictive capability.

Choosing the best forecast technique

 The best forecast technique is one that carefully balances marginal costs and marginal benefits
and depends on:

a. data requirements

b. time horizon considerations

c. role of judgment

The Law of Demand

There is an inverse relationship between price and quantity demanded

Example:

When the price goes down for milk, the quantity consumers buy will increase

1. Substitution Effect

2. Income Effect

3. Law of Diminishing Marginal Utility

1. Substitution Effect

Changes in price motivate consumers to buy relatively cheaper substitutes goods

2. Income Effect

Changes in price affect the purchasing power of consumers' income

3. The Law of Diminishing Marginal Utility

As you continue to consume a given product, you will eventually get less additior utility (satisfaction)
from each unit you consume

5 Shifters of Demand

1. Tastes/Preferences

2. Number of Consumers

3. Price of Related Good

4. Income

5. Expectations

Normal Goods

Income and the demand for the product are directly related.

Inferior Goods

Income and the demand for the product are inversely related.

What happens to the demand for a product when the price decreases?

Demand stays the same, but the quantity demanded increases

Price changes the quantity demanded (moves along the curve)

The 5 shifters change the demand (moves the entire curve)

CHAPTER 1

INTRODUCTION: ECONOMICS AND MANAGERIAL DECISION MAKING

Managerial Economics is one of the most important and useful courses in your curriculum of studies.

-Economics is "the study of the behavior of human beings in producing, distributing and consuming
material goods and services in a world of scarce resources."

-Management is the discipline of organizing and allocating a firm's scarce resources to achieve its
desired objectives.

-These two definitions clearly point to the relationship between economics and managerial decision
making.

-Managerial Economics is the use of economic analysis to make business decisions involving the best use
of an organization's scarce resources.

-Joel Dean, author of the first managerial economics textbook, defines managerial economics as "the
use of economic analysis in the formulation of business policies."

-William Baumol, a highly respected economist and industry consultant, stated that an economist can
use his or her ability to build theoretical models and apply them to any business problem, no matter
how complex, break it down into essential components, and describe the relationship among the
components, thereby facilitating a systematic search for an optimal solution.
-William H. Meckling, the former dean of the Graduate School of Management at the University of
Rochester, expressed a similar sentiment in an interview conducted by The Wall Street Journal. In his
view, "economics is a discipline that can help students solve the sort of problems they meet within the
firm."

As it has evolved in undergraduate and graduate programs over the past half century, managerial
economics is essentially a course in applied microeconomics that includes selected quantitative
techniques common to other disciplines such as linear programming (management science), regression
analysis (statistics, econometrics, and management science), capital budgeting (finance), and cost
analysis (managerial and cost accounting).

Examples of disciplines in business studies drawn from the core of microeconomics:

1. The economic analysis of demand and price elasticity

2. The division of markets into four types-perfect competition, pure monopoly, monopolistic
competition, and oligopoly.

There are a number of other examples to be found:

1. The economic concept of opportunity cost.

2. Theme of strategy and human resources in managerial economics.

Figure 1.1 illustrates our view that managerial economics is closely linked with many other disciplines in
a business curriculum.

- Managerial Accounting

- Strategy

- Management Science

- Finance

- Marketing

Our approach in this text is to show linkages of economics with other business functions, while
maintaining a focus on the heart of managerial economics-the microeconomic theory of the behavior of
consumers and firms in competitive markets.

In making these decisions, managers must essentially deal with the following questions listed in
abridged form:
1. What are the economic conditions in a particular market in which we are or could be competing? In
particular:

a. Market structure?

b. Supply and demand conditions?

c Technology?

d. Government regulations?

e. International dimensions?

f. Future conditions?

g. Macroeconomic factors?

2. Should our firm be in this business?

3. If so, what price and output levels should we set in order to maximize our economic profit or minimize
our losses in the short run?

4. How can we organize and invest in our resources (land, labor, capital, managerial skills) in such a way
that we maintain a competitive advantage over other firms in this market?

A Cost leader?

b. Product differentiation?

C Focus on market niche?

d. Outsourcing, alliances, mergers, acquisitions?

E. International dimensions-regional or country focus or expansion?

5. What are the risks involved?

Perhaps the most fundamental management question is question 2, which concerns whether a firm
should be in the business in which it is operating.

Note that question 5 has to do with a firm's risk.

However, when it comes to future impacts, few things are certain. We can define risk or uncertainty as a
chance or possibility that actual future outcomes will differ from those expected today.

Typical of the types of risk that businesses face include:

> Changes in demand and supply conditions

> Technological changes and the effect of competition

> Changes in interest rates and inflation rates

> Exchange rate changes for companies engaged in international trade

➤ Political risk for companies with foreign operations

You may not literally see the term risk in many of the topics that we will study in this course. However,
we really know that risk is present in most situations.

For purposes of study and teaching, economics is divided into two broad categories: microeconomics
and macroeconomics.

Microeconomics concerns the study of individual consumers and producers in specific markets.

Macroeconomics deals with the aggregate economy.

Topics in microeconomics include supply and demand in individual markets, the pricing of specific
outputs and inputs (also called factors of production, or resources), production and cost structures for
individual goods and services, and the distribution of income and output in the population.

Topics in macroeconomics include analysis of the gross domestic product (also referred to as "national
income analysis"), unemployment, inflation, fiscal and monetary policy, and the trade and financial
relationships among nations.

Microeconomics is the category that is used in managerial economics.

However, certain aspects of macroeconomics must also be included because decisions by managers of
firms are influenced by their views of the current and future conditions of the macroeconomy.

However, for the most part, managerial economics is based on the variables, models, and concepts that
embody microeconomic theory.

As defined in the previous section, economics is the study of how choices are made regarding the use of
scarce resources in the production, consumption, and distribution of goods and services. The key term is
scarce resources.
Scarcity can be defined as a condition in which resources are not available to satisfy all the needs and
wants of a specified group of people.

A BRIEF REVIEW OF IMPORTANT ECONOMIC TERMS AND CONCEPTS

The relative nature of scarcity is represented in Figure 1.2. as seen in Figure 1.2, the supply of resources
is used to meet the demand for these resources by the population.

In an introductory economics course, the concept of scarcity is usually discussed in relation to an entire
country and its people.

The intent of the "guns versus butter" example is to illustrate that scarcity forces a country to choose
the amounts of resources that it wants to allocate between defense and peacetime goods and services.
In doing so, its people must reckon with the opportunity cost of their decision.

Opportunity cost can be defined as the amount of subjective value that must be sacrificed in choosing
one activity over the next best alternative.

In the presence of a limited supply relative to demand, countries must decide how to allocate their
scarce resources.

In fact, economics has been defined as "the science which studies human behavior as a relationship
between ends and scarce means which have alternative uses.

Essentially, the allocation decision can be viewed as comprising three separatenchoices:

1. What goods and services should be produced and in what quantities?

2. How should these goods and services be produced?

3. For whom should these goods and services be produced?

All countries must deal with these three basic questions because all have scarce resources.

There are essentially three ways a country can answer the questions of what, how, and for whom. These
ways, referred to as processes, are as follows:

1. Market process: The use of supply, demand, and material incentives to answer the questions of what,
how, and for whom.

2. Command process: The use of the government or some central authority to answer the three basic
questions. (This process is sometimes referred to as the political process.)

3. Traditional process: The use of customs and traditions to answer the three basic questions.

Countries generally employ a combination of these three processes to allocate their scarce resources.

A BRIEF REVIEW OF IMPORTANT ECONOMIC TERMS AND CONCEPTS

Table 1.1 compares the three basic questions from the standpoint of a country and from the standpoint
of a company, where they form the basis of the economic decisions for the firm.

Table 1.1 The Three Basic Economic Questions

-1. What goods and services should be produced?

2. How should these goods and services be produced?

3. For whom should these goods and services be produced?

From the Standpoint of a Company

1. The product desicion

2. The hiring, staffing, procurement and capital budgeting decisions

3. The market segmentation decision

A BRIEF REVIEW OF IMPORTANT

ECONOMIC TERMS AND CONCEPTS

Perhaps one of the best ways to link the economic problem of making choices under conditions of
scarcity with the tasks of a manager is to consider the view put forth by Professor Robert Anthony that a
manager is essentially a person who is responsible for the allocation of a firm's scarce resources.

It is interesting to note that "managers" or "management skills" was not delineated as a separate factor
of production by early economic theorists. the four traditional categories of resources are land, labor,
capital, and entrepreneurship. The last category can be treated as broad enough to include
management, but the two classifications do involve different characteristics in skills.

A BRIEF REVIEW OF IMPORTANT ECONOMIC TERMS AND CONCEPTS

The term entrepreneurship is generally associated with the ownership of the means of production. In
addition, it implies willingness to take certain risks in the pursuit of goals (e.g. starting a new business,
producing a new product, or providing a different kind of service).

Management, in contrast, involves the ability to organize and administer various tasks in pursuit of
certain objectives. An important part of a manager's job is to monitor and guide people in an
organization.

A BRIEF REVIEW OF IMPORTANT ECONOMIC TERMS AND CONCEPTS

In the words of Peter Drucker, who has been called "the founding father of the science of management,"
It is "management" that determines what is needed and what has to be achieved [in an organization]....
Management is work. Indeed, it is the specific work of a modern society, the work that distinguishes our
society from all earlier ones... As work, management has its own skills, its own tools, its own techniques.