Fundamental Economic Concepts. Chapter 2. Fundamental Economic Concepts. Demand, Supply, and Equilibrium Review Total, Average, and Marginal Analysis Finding the Optimum Point Present Value, Discounting & Net Present Value Risk and Expected Value Probability Distributions
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Chapter 2
Price
An increase in price causes a decrease in quantity demanded.
P1
P0
Quantity
Q1
Q0
Price
A decrease in price causes an increase in quantity demanded.
P0
P1
Quantity
Q0
Q1
$/Q
$5
20
Q /time unit
4 3 7
Q = f( P, Ps, Pc,Y, N PE)
 +  ? + +
P is price of the good
PS is the price of substitute goods
PC is the price of complementary goods
Y is income, N is population,
PE is the expected future price
i. price, P
ii. price of substitute goods, Ps
iii. price of complementary goods, Pc
iv. income, Y
v. advertising, A
vi. advertising by competitors, Ac
vii. size of population, N,
viii. expected future prices, Pe
xi. adjustment time period, Ta
x. taxes or subsidies, T/S
An increase in demand refers to a rightward shift in the market demand curve.
Price
P0
Quantity
Q0
Q1
A decrease in demand refers to a leftward shift in the market demand curve.
Price
P0
Quantity
Q1
Q0
A decrease in price causes a decrease in quantity supplied.
Price
P0
P1
Quantity
Q1
Q0
An increase in price causes an increase in quantity supplied.
Price
P1
P0
Quantity
Q0
Q1
$/Q
Q/time unit
Acme Inc. + Universal Ltd. = Market
4 3 7
Q = g( P, PI, RC,T, T/S)
+   + ?
Determinants of the Supply Function
i. price, P
ii. input prices, PI, e.g., sheet metal
iii. Price of unused substitute inputs, PUI, such as fiberglass
iv. technological improvements, T
v. entry or exit of other auto sellers, EE
vi. Accidental supply interruptions from fires, floods, etc., F
vii. Costs of regulatory compliance, RC
viii. Expected future changes in price, PE
ix. Adjustment time period, TA
x. taxes or subsidies, T/S
Note: Anything that shifts supply can be included and varies for different industries or products.
An increase in supply refers to a rightward shift in the market supply curve.
Price
P0
Quantity
Q0
Q1
A decrease in supply refers to a leftward shift in the market supply curve.
Price
P0
Quantity
Q1
Q0
S
P
Willing
& Able
in cross
hatched
Pe
D
Q
P
S
P1
e1
D
Q
P
S
e2
D’
e1
D
Q
D1
P1
Q1
Market EquilibriumPrice
D0
S0
An increase in demand will cause the market equilibrium price and quantity to increase.
P0
Quantity
Q0
D1
P0
P1
Q1
Q0
Market EquilibriumPrice
D0
S0
A decrease in demand will cause the market equilibrium price and quantity to decrease.
Quantity
S0
S1
P1
Q1
Market EquilibriumPrice
An increase in supply will cause the market equilibrium price to decrease and quantity to increase.
D0
P0
Quantity
Q0
S1
S0
P1
P0
Q1
Q0
Market EquilibriumPrice
A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.
D0
Quantity
profit
GLOBAL
MAX
MAX
A
quantity B
PROFITS
MAX
C
B
profits
quantity
Q
dY/dX = limit DY/DX
DX B
D
Y
DY
DX
C
X
__ _______ ___ __ ___ __ ___ ______
Functions dY/dX = 0
dY/dX = 5
Functions dY/dX = 10•X
Name Function Derivative Example
Functions
example Y = 5•X + 5•X2 dY/dX = 5 + 10•X
Two FunctionsdY/dX = (dG/dX)H + (dH/dX)G
exampleY = (5•X)(5•X2 )
dY/dX = 5(5•X2 ) + (10•X)(5•X) = 75•X2
dY/dX = (dG/dX)•H  (dH/dX)•G H2
Y = (5•X) / (5•X2) dY/dX = 5(5•X2) (10•X)(5•X) (5•X2)2
= 25X2 / 25•X4 =  X2
dY/dX = (dG/dH)•(dH/dX) Y = (5 + 5•X)2
dY/dX = 2(5 + 5•X)1(5) = 50 + 50•X
TC a function of Q
Problem 1Problem 2
Problem 1 Problem 2
S/X = 200  20X + 20Y= 0
S/Y = 100  40Y + 20X = 0
Examples: Roulette Wheel or Dice
Uncertainty if probabilities and/or payouts are unknown
States of Nature
StrategyRecessionEconomic Boom
p = .30p = .70
Expand Plant 40 100
Don’t Expand  10 50
_
_

expand = SQRT{ (40  58)2(.3) + (10058)2(.7)}
= SQRT{(98)2(.3)+(42)2 (.7)}
= SQRT{ 4116} =64.16
don’t = SQRT{(10  32)2 (.3)+(50  32)2 (.7)}
= SQRT{(42)2 (.3)+(18)2 (.7) }
= SQRT{ 756 } = 27.50
Expanding has a greater standard deviation (64.16), but also has the higher expected return (58).
_
Coefficient of Variation is good for comparing projects of different sizes
Example of Two Gambles
A: Prob X } R = 15
.5 10 } = SQRT{(1015)2(.5)+(2015)2(.5)]
.5 20 } = SQRT{25} = 5
C.V. = 5 / 15 = .333
B: Prob X } R = 30
.5 20 } = SQRT{(2030)2 ((.5)+(4030)2(.5)]
.5 40 } = SQRT{100} = 10
C.V. = 10 / 30 = .333