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NOTES TO MODULE III

HOW MARKETS WORK

DR. TULSI JAYAKUMAR

LESSONS 1- 3

DEMAND FUNCTION

 Demand function for a hypothetical automobile industry:


Q=-500P+250Px+125I+20,000Pop-1,000,000i+600A

ESTIMATING INDUSTRY DEMAND FOR NEW AUTOMOBILES


INDEPENDENT PARAMETER ESTIMATED VALUE ESTIMATED
VARIABLE ESTIMATE OF THE INDEP VAR DEMAND
(1) (2) DURING THE
COMING YEAR (4)= (2)*(3)
(3)
Av price of new cars -500 30,000 -15,000,000
(P) (Rs.)
Average Price of a 250 60,000 15,000,000
new imported car
(Px) (Rs.)
Disposable income 125 56,000 7,000,000
per household (I)
(Rs.)
Population (millions) 20000 300 6,000,000
(Pop)
Av interest rate (i) % -1000,000 8 -8,000,000
Advertising exp(Rs. 600 5000 3,000,000
Crore)
TOTAL DEMAND 8,000,000
(cars)

In this case, the relationship between Qd and price of new cars is given by-

Q=-500P+250* (60,000)+125*(56000)+20,000*(300)-1,000,000*(8)+600*(5000)

Q=23,000,000-500P.................................................. (1)

OR

P=46,000-0.002 Q............................................(2)

Equations (1) and (2) represent the demand curve.

REMEMBER-

Failure to understand the causes of changes in demand (whether due to price or other factors)
for a company’s products can lead to costly, even disastrous mistakes in managerial decision
making.

The task of demand analysis is made especially difficult by the fact that under normal
circumstances, not only prices but also prices of other goods, incomes, population, interest
rates and other dd-related factors keep changing from time to time.

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Sorting out the impact of each factor makes demand analysis one of the most challenging
aspects of managerial economics.

SUPPLY FUNCTION

A hypothetical automobile supply function could be-

Q=2000P-500PSUV-100,000W-15,000S-125,000E-1,000,000i

ESTIMATING INDUSTRY SUPPLY FOR NEW AUTOMOBILES


INDEPENDENT PARAMETER ESTIMATED VALUE ESTIMATED
VARIABLE ESTIMATE OF THE INDEP VAR DEMAND
(1) (2) DURING THE
COMING YEAR (4)= (2)*(3)
(3)
Av price of new cars 2000 30,000 60,000,000
(P) (Rs.)
Average Price for -500 42,500 -21,250,000
SUV’s (PSUV) (Rs.)
Av hourly wage rate, -100,000 100 -10,000,000
including fringe
benefits (W) (Rs.)
Av. Cost of steel per -15,000 800 -12,000,000
ton (S) (Rs.)
Av cost of energy -125,000 6 -750,000
input (E) (Rs.)
Av interest rate (i) % -1,000,000 8 -8,000,000
TOTAL DEMAND 8,000,000
(cars)

The relationship between price and quantity supplied of new cars would be given by-

Q= 2000P-500*(42,500)-100,000*(100)-15,000*(800)-125,000*(6)-1000,000*(8)

Q= -52,000,000+2000P...................................... (3)

OR

P=26,000+0.0005Q.............................................(4)

Equations 3 or 4 describe a supply curve.

Note- There is no explicit term describing technology. The current state of technology is an
implicit (or underlying) factor in the industry supply function.

Firms within an industry can use different production methods, different equipment of different
vintage, employ L of varying skill and compensation levels.

Thus, individual firm supply level can be affected quite differently by different factors.

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Chinese automakers , e.g. may be able to offer sub-compacts in the US profitably at an average
industry price as low as say 15,000 per automobile. On the other hand, US auto manufacturers who
have a labor cost disadvantage, may only be able to offer supply of sub-compacts at average industry
prices in excess of $26,000.

This means that at a relatively high average prices for the industry above 26,000 per unit, both
Chinese (foreign) and domestic (US) auto manufacturers would be actively engaged in auto
production. At prices below 26,000, only Chinese producers would offer cars.

This would be reflected in the different parameters describing the relationship between P and Qs in
the individual supply functions of Chinese and US auto manufacturers.

MARKET EQUILIBRIUM, SURPLUSES AND SHORTAGES

The market is in equilibrium when Qd=Qs.

Equate (1) and (3)

23,000,000-500P=-52,000,000+2000P

P=30,000

Q=8,000,000 (8 million cars)

What happens when Mkt price rises to 32,000?

Plug in figures to see Qd=7 m cars, while Qs=12 m cars. Surplus= 5 m cars.

What would happen to market prices? They fall? How? ( Happens from both the demand and supply
side.)

Producers cut back production as inventories build up..

The auto industry uses rebate programs and dealer-subsidized low-interest rate financing on new
cars to effectively combat the problem of periodic surplus production.

What happens when prices fall to say 28,000?

Qd=9m cars; Qs=4m cars.

Shortage= 5m cars.

Shortages exert a powerful upward force on both market price and output levels.The increase in Qs
and decrease in Qd with a rise in price eliminates shortages.

The market is in equilibrium when P=30,000 and Q= 8 m cars.

APPLICATION

Read the article http://www.hul.co.in/Images/10April12-HULFightsBack_tcm114-215016.pdf to


understand the challenges on the demand and supply front for companies.

What are the challenges facing HUL on the demand and supply front?

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Price Elasticity formula

Q1. Assume that the management of PVR is interested in analyzing movie ticket demand.

Also suppose the monthly data for the past year suggests the following demand function-

Q= 7000-5000P+6000PDVD+150I+1000A

Let PDVD =4, I=60,000 and A=20,000

Calculate the price elasticity of demand by movie-goers when price per movie ticket is Rs. 8.
What happens if the price is raised to Rs. 10? Also calculate the arc elasticity for a price range
berween 8-10. Explain your findings.

SOLUTION

Q= 7000-5000P+6000*(4)+150*(60)+1000*(20)

Q =60,000-5000P----------------------------------- Demand function

At P=8, Q= 20,000; dQ/dP=-5000

E= -5000*(8/20,000)= -2

At P=10, E= -5000*(10/10000)=-5

Means when P=8 per ticket, a 1% increase (decrease) in the price of the ticket will lead to a 2%
decrease(increase) in Qd; while at a price of 10 per ticket, a 1% increase (decrease) in the price will
lead to a 5% decrease (increase) in Qd.

The price demand becomes more negative at higher prices because the price sensitivity of
consumers tends to grow as prices increase.

Next, calculate arc elasticity for the range of price between 8-10.

P=8, Q=20,000; P=10, Q=10,000

E(Arc)=-(10,000/2)*(18/30,000)=-3

i.e. a 1% change in price leads to a 3% change in Qd when movie-ticket prices lie in the range from 8-
10 per ticket.

Remember: Point elasticity measures the impact of small changes, while arc elasticity is used
to measure the impact of large changes in the independent variable (more than 5%).

OPTIMAL PRICE FORMULA

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Q2. Suppose the manager of Big Bazaar notes a 2% increase in the weekly sales of ‘ Big
Tissue paper’ following a 1% discount on the price of the product.What is the optimal price he
should charge given a MC of Rs. 25? What are the managerial implications of his finding?

SOLUTION

The point price elasticity is:

Ep= % change in Qd/ % change in price

= (2)/ (-1)

=-2

If the relevant marginal costs are Rs. 25 per unit and given Ep=-2,

The profit maximising price would be

P*= MC/ (1+1/Ep)

= 25/ (1+1/ (-2)

=25/ (1/2)

P*=50

Thus, optimal price is 50.

How to use this formula for planning purposes?

Suppose the manager orders these tissues from another distributor at MC=24, (reduces the MC)

P= 24/ (1+1/-2)

= 48

Thus, a Re. 1 reduction in MC can allow the Big Bazaar manager to reduce his prices by Rs. 2 per
unit.

Income Elasticity

Q. When income increases from Rs. 80,000 to Rs. 81,000, the quantity demanded of a good
increases from 3000 to 3050. Compute the income elasticity of demand. What is the nature of
the good?

Ans. Ei= (∆Q/∆I)* I/Q

= (50/1000)* 80,000/3000

=1.33

The good is relatively income elastic.(Ei>1)

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