MBA 773, Week 1:

Demand and Supply

Professor Jesse Davis, Fall 2022
Who am I?
Education:
– Miami University (BS/BA, 2001), University of Chicago (MBA,
2007), Northwestern University (PhD, 2016)

Employment:
– Pre-MBA: Habitat for Humanity, Connections for the Homeless,
– Post-MBA: Lehman Brothers/Neuberger Berman (buy-side)

Research:
– Theorist: Information Economics & Corporate Finance

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How is the course structured?
• Grading:
– The process matters more than the result.
– Don’t lose hope! You have multiple opportunities.
• Participation:
– Asynchronous participation emphasizes completion
– Be an active participant in class (and in your group)
• Review Sessions/Office Hours:
– “Open door” policy
• Wall Street Journal/Other Materials

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How does microeconomics help you?
You should expect to learn the foundations of how to …
• Utilize market conditions to predict future prices/revenue
• Influence consumer behavior
• Allocate resources within the firm
• Optimally produce your product
• Choose which product markets to enter/exit
• Price your product to maximize your firm’s value
• Predict the impact of taxes/subsidies on your business

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Agenda: Supply and Demand
1. Demand
1. Determinants
2. La Croix
3. Exceptions to the Law of Demand?
2. Supply
1. Determinants
2. Barbecue
3. Exceptions to the Law of Supply?
3. Market Clearing
1. Equilibrium
2. Forecasting Prices

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 - Luxury products don’t go against the law of demand
because all else isn’t held equal (ceteris paribus), that
is, persons want to pay high prices for them. Price
falling will no longer incentivize the type of buyers
because they associate the products with status.

Prices Matter: Demand

- At the individual level, consumption won’t be
reduced as price falls.
- At the market level, the law of demand holds strictly,
that is, prices fall = incr. qty.

As the price decreases,

the quantity demanded increases.
• Generally referred to as the “Law of Demand”
• Intuitively, a reduction in the price should make us more
likely to buy a good.
• How does this apply at the individual level? Market level?
– Examples: Oranges & Milk, Tesla Model S & MacBook Pro

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 - Substitute: any good that if it’s price falls, the demand for a - Complement: goods consumed with another. If the price
similar/reference good also falls (persons will switch to increases of one, then the demand for the other will
cheaper alternative). Eg. almond and cows milk. If the price decrease. Eg. PB&J, cars & gasoline, milk & cereal.
of almond milk falls then the demand for regular milk will fall
because consumers can get more almond milk instead.

Prices matter, but they’re not the only thing

• What are the alternatives/what else am I buying?
– What’s the price of a potential substitute?
– Or a potential complement to the good?
• How much money do I have?
– Do we always buy more when our income increases?
• What other uses are there for the good?
– What is the demand for products which use our good?
• What is the impact of consumer preference?
– How do advertising, reputation, and fads factor in?

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Consumer demand for LaCroix
• What are the alternatives?
Water, Milk, Perrier, Soda, Cheaper Sparkling Water.

• How much money do I have?

Mid-range people - eg. college students may have it in social settings etc.

• How does consumer taste/preference factor?

Mostly for the hype of it?

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 - Supply is the willingness to supply a good or service.
- Only applies in a competitive market because otherwise
(eg. monopoly) the company can just dictate the price and
customers just have to go with it.

Prices Matter: Supply

- In a competitive market, the customers/market set the price
because firms are price takers. No one firm has meaningful
pricing power.
- There is no formal definition of perfect competition because it
differs by industry/company.

As the price decreases,

the quantity supplied decreases.
• Generally referred to as the “Law of Supply”
• Intuitively, if you were willing to sell 10 units of the good
for $4, you will not sell less if the price is $5.
• Applicable in competitive markets, our current focus
• Why does this only apply in competitive markets?
• How does this apply at the firm level? Market level?

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- Anything utilized to make a good or service is the input to production.
- As the price of the inputs increase, the willingness to supply decreases.
- Supply willingness example: someone is willing to supply their labour services for $500/hr, but that doesn’t mean that someone out there is
willing to pay at that rate.

Prices matter, but they’re not the only thing (II)

• What do I utilize to produce the good?
– What are the prices of inputs, i.e., factors of production?
– Do weather conditions matter?
• What technology is available? Any efficient change in the process, eg. automation. It is any sort
of innovation that changes how the good is made.

– How productive is my capital and/or labor?

– What is their capacity? Limit in what can be supplied due to constraints. Eg. size of the factory. In the
short-term it is generally capped at how many units can be produced.

• Is the good a byproduct of other production?

– How does the supply of good A impact production of good B?
If supply of A decreases, the production of B also decreases.

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Supply of barbecue (pork)
• What do I utilize to produce the good?

• What technology is available?

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Is it really the “Law” of Demand?
Can you think of any potential exceptions?
Giffen good - as prices increase, quantity demanded increases. The are generally staples (eg. rice in China).
This is the exception to the law of demand.

1. Jensen, Robert T. and Nolan H. Miller. 2008. "Giffen Behavior

and Subsistence Consumption." American Economic Review, 98(4):
1553-77.

2. What about luxury items (e.g. a Veblen good)?

Luxury items are exceptions because the price is viewed to reveal quality. Therefore, a lower price gives the perception
of lower quality - customer perception of the product will change if prices are reduced.

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Is it really the “Law” of Supply?
Can you think of any potential exceptions?
P

1. Backward-bending labor supply q

After some time people will prioritize leisure and family over getting more money. As real wages increase beyond a certain level,
people will substitute leisure for paid worktime and so higher wages lead to a decrease in the labour supply and so less labour-time
being offered for sale.

2. Long-run supply in decreasing cost industry

If there are breakthroughs in technology - as quantity demanded increases then prices can fall.

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Example: Demand for Iced Coffee

Suppose that demand for iced coffee in Chapel Hill is captured by

the following equation:

(Demand) qd = 4,000*(26 – 2p + 5piced tea)

Please write (and then graph) the demand equation, given that
you forecast the price of iced tea (piced tea) will be $4. Please label
the y-intercept and provide the slope of the demand curve.

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Example: Demand for Iced Coffee

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Example: Supply of Iced Coffee

Suppose that the supply of iced coffee in Chapel Hill is captured

by the following equations:

(Supply) qs = 16,000*(2 + 3p – pbeans)

Please write (and graph) the supply equation, given that you
forecast the price of coffee beans (pbeans) will be $8. Please label
the y-intercept and provide the slope of the supply curve.

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Example: Supply of Iced Coffee

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How are prices determined?
• We understand now how the quantity varies as (i) the price
and (ii) other factors change
• What determines the price/quantity pair we observe?
– Market clearing: the quantity demanded (qd) equals the
quantity supplied (qs) There is a buyer for every seller and vise versa. The price of the good/service
will adjust until the market clears > where qd=qs.

– This defines the equilibrium in each market

• Essentially, the price adjusts until this relationship holds.
• Given the price, buyers have purchased all they want to buy
(there’s no shortage) and sellers have sold all they would
want to sell (no excess inventory)

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Market clearing, graphically
Supply • First, we plot demand
Price

– P = 20 – 0.6Q
Demand • Second, we plot supply
– P = 2 + 0.8Q
p* • At the intersection of the
supply and demand curves
the quantity supplied equals
the quantity demanded.
– This is the equilibrium!
q* Quantity

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 If prices exceed equilibrium, firms will produce excess supply because demand decreased.
There will be increased inventory so prices will need to fall to retain equilibrium.

When the market doesn’t clear …

Demand
Price

Excess • Suppose the price > p*

Supply
– Then the quantity
Supply demanded will fall (qd < q*)
p
– But the quantity supplied
p*
will increase (qs > q*)
• As a result, there is excess
supply (i.e., qs – qd>0)!

qd q* qs Quantity

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Changes in Inventory & Future Prices
Demand
Price

Excess • Suppose the price > p*

Supply
• As a result, there is excess
Supply supply (i.e., qs – qd>0)!
p
p* – You can think of this as a
buildup in inventory
– Expect prices to decrease
when inventory increases

qd q* qs Quantity

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 If prices fall below equilibrium, it will trigger excess demand and the quantity supplied will decrease. This creates excess demand.
There will be an decrease in inventory, aka a shortage. This will cause the equilibrium price to increase.

Prices will adjust until supply exactly equal demand (equilibrium). NB: This is the case for a competitive market.

When the market doesn’t clear …

Demand
Price

• Suppose the price < p*

Excess – Then the quantity supplied
Demand will fall (qs < q*)
Supply – But the quantity demanded
p*
p
will increase (qd > q*)
• As a result, there is excess
demand (i.e., qd – qs>0)!!

qs q* qd Quantity

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Changes in Inventory & Future Prices
Demand
• Suppose the price < p*
Price

• As a result, there is excess

Excess demand (i.e., qd – qs>0)!!
Demand
– This will lead to (i) a
Supply decrease in inventory and
p*
p (ii) potentially a product
shortage
– Expect prices to increase
when inventory falls
qs q* qd Quantity

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Market clearing, mathematically
We can solve for the equilibrium using our demand/supply equations.

Suppose we’re given the following equations for the natural gas market:

Supply: qs = 2,000,000*(3 - 4plabor + 2p)

Demand: qd = 4,000,000*(7 + 3pcoal – 1.5p)

Initially, you believe that plabor = 12 and pcoal = 16:

qs = 2,000,000*(3 - 4(12) + 2p) = 2,000,000*(-45+ 2p)

qd = 4,000,000*(7 + 3(16) – 1.5p) = 4,000,000*(55 – 1.5p)

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Market clearing, mathematically
Applying our market-clearing conditions (qs = qd):
(Supply) 2,000,000*(-45+ 2p) = 4,000,000*(55 – 1.5p) (Demand)
-45 + 2p = 110 – 3p
5p = 155
p* = 31
We can substitute p* into either the supply or demand equation:
q* = 2,000,000*(-45+ 2p*)
q* = 2,000,000*(-45+2(31))
q* = 34,000,000

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Example: Market for Iced Coffee
Suppose that the supply and demand for iced coffee in Chapel
Hill is captured by the following equations:

(Demand) qd = 4,000*(26 – 2p + 5piced tea)

(Supply) qs = 16,000*(2 + 3p – pbeans)

If the price of iced tea (piced tea) will be $4 and the price of coffee
beans (pbeans) will be $8, what is the market-clearing price and
quantity of iced coffee?

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Example: Market for Iced Coffee

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Microeconomics in the News
• “The Place with the Most Lithium”, 8/10/22

• “Covid-19 Fuels Best-Ever Commercial Real Estate Sales”, 1/25/22

• “Coronavirus is Causing a Can Shortage”, 8/25/20

• “Dealers Dangle Deals to Move Outgoing Models”, 8/15/19

• “Apple’s Troubles Extend Beyond China”, 1/3/19

• “The Next Big Bet in Fracking: Water”, 8/22/18

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