DEMAND & SUPPLY

Aims & Objectives

After studying this lesson, you will be able to understand:

The concept of demand Determinants of demand Law of demand Elasticity of demand Process of demand estimation Understand the concept of supply and supply function Explain determinants of supply Describe elasticity of supply

Demand defined

Demand is the desire, want or need to purchase a good or service at a given price backed up by the willingness and ability to pay for it Quantity demanded (normally denoted as Qo) is the amount of a particular good or service that consumers are willing or able to purchase at a given price, during a given period of time.

Types of Demand

Individual vs Market demand Company vs Industry demand Market segment vs Total market demand Domestic vs National demand Direct vs Indirect demand Autonomous vs induced demand New vs replacement demand Household vs Corporate vs Government demand

Determinants of Demand

Price of the commodity Income of the consumer Price of related goods - Price of substitutes & Price of complements Wealth of the consumer Price/Income Expectation Advertisement expenditure Taste & preferences Other factors

Demand function

A demand function is given as: Dx = f (Px, Py, Pz, I, W, E, A, T, O)

Where, Px price of good X Py price of substitute Pz price of complement I income of the consumer W wealth of the consumer E price/income expectation of the consumer A advertisement expenditure on the good T taste & preference of the consumer O other exogenous factors

Market demand function

Market demand function is the summation of all the individual demand functions

Law of Demand

All other factor affecting demand for a commodity remaining constant, if price of the good rises then quantity demanded of the good falls and viceversa.

Demand schedule & Demand curve

A tabular representation of quantity purchased of a good at corresponding prices is referred to as a demand schedule.

Price/unit P1 P2 p3

Quantity (unit) Q1 Q2 Q3

A graphical representation of the demand schedule is the demand curve P

D O Q

Slope of a demand curve

The demand curve, each point on which shows the quantity purchased of a good at various prices, is downward sloping as quantity demanded of a good is inversely related to its price This inverse price-quantity relationship may be explained with the help of the following two concepts: Income effect Substitution effect

Income effect

When the price of a commodity falls less has to be spent on the purchase of the same quantity of the commodity. This leads to an increase in purchasing power of the money with the buyer. This is referred to an increase in real income of the consumer. The increase in real income leads to an increase in purchase of the commodity whose price has fallen. This is referred to as income effect of a price change.

Px Real income Qx

Income effect negative or positive?

Px Real income Qx income effect is positive X is a normal good Px Real income Qx income effect is negative X is an inferior good

Substitution Effect

When price of a commodity falls, its becomes cheaper relative to other commodities. This leads to substitution of other commodities( which are now relatively more expensive) by this commodity. Thus the demand for the cheaper good rises. This is called the substitution effect.

Py it is relatively cheaper and hence attractive Qx

Substitution effect negative or positive?

Substitution effect is always positive.

Inferior good vs Giffen good

A good with negative income effect is referred to as inferior good A good whose negative income effect dominates the positive substitution effect is a Giffen good. Thus, all Giffen goods are inferior goods but all inferior goods are not Giffen goods

Exception to Law of Demand

Giffen paradox: when negative income effect of an inferior good dominates its positive substitution effect, the total effect of a price change of the good on its quantity demanded tends to be positive. That is, as price falls, demand for its falls too & if price rises then demand for its rises too. This results in an upward sloping demand curve. D P

Other exceptions are: Snob/Veblen effect, Share Market, Demonstration effect

Shifts & movement along demand curve

Movement along demand curve

P1 P2 A B

Q1 Q2 The change in demand is due to change in price of the good all other factors affecting demand being constant. This is referred to as change in quantity

Shift of demand curve

Q1Q2 Q3 The change in demand is due to change in any one of the other factors affecting demand (say, income), price of the good remaining the same. This is referred to as change in demanded. If quantity demanded increases

Elasticity of demand

This measures the responsiveness of quantity demanded of a good or a service to change in factors like price, income, price of related products etc. The three main types of elasticity of demand are: Price elasticity Income elasticity Cross elasticity

Price elasticity of demand

This measures the responsiveness of quantity demanded of a good or service to a change in its own price. It is defined as
Ep = (% change in quantity demanded)/(% change in price of the good or service)

= [(Q/Q) * 100]/[(P/P )*100]

Where, Q denotes change in quantity P denotes change in price Q denotes original quantity P denotes original price

Elastic vs Inelastic price elasticity of demand

Products with price elasticity of demand less than 1 are said to be price inelastic. This usually the case of necessary goods Products with price elasticity greater than one are said to be elasticity. This is usually the case for luxury goods Some extreme case are: Perfectly elastic: when any quantity of the product can be sold at a given price. Demand curve is horizontal Perfectly inelastic: when demand is unresponsiveness to changes in price. Demand curve is vertical Unit elasticity: When proportional change in quantity is exactly equal to 1. Demand curve is rectangular hyperbolic in shape Normally, elasticity varies between 0 to infinity as one moves up along an demand curve with elasticity being 1 at the mid point of the demand curve

Arc vs Point elasticity

Arc elasticity measures the responsive of demand to large changes in prices as measured over an arc of the demand curve. The formula for arc price elasticity is given as, Ep = [(Q2-Q1)/1/2(Q2+Q1) /[(P2-P1)/1/2(P2+P1)

Point elasticity measures the responsive of demand to very small changes in prices . The formula for arc price elasticity is given as, Ep = [(Q/Q) * 100]/[(P/P )*100]

Income elasticity of demand

This measures the responsiveness of quantity demanded of a good or service to a change in the consumers income. It is defined as
EI = (% change in quantity demanded)/(% change in income of the consumer)

= [(Q/Q) * 100]/[(I/PI)*100] Where, Q denotes change in quantity I denotes change in price Q denotes original quantity I denotes original price

Classification of goods on basis of income elasticity value

Inferior good: income elasticity of demand is negative Normal good: income elasticity of demand is positive Necessities : income elasticity is less than 1 Luxuries: income elasticity is greater than 1

Cross price elasticity of demand

This measures the responsiveness of quantity demanded of a good or service to a change in price of a related good It is defined as
Exy = (% change in quantity demanded of X )/(% change in price of Y)

= [(Qx/Qx) * 100]/[(Py/Py )*100] Where, Qx denotes change in quantity of good X Py denotes change in price of good Y Qx denotes original quantity of X Py denotes original price of Y

Classification of goods on basis of cross elasticity value

Substitute goods: cross elasticity of demand is positive Complementary goods: cross elasticity of demand is negative Unrelated goods: cross elasticity of demand is zero

Estimation of demand

Involves estimating demand relationship and forecasting demand. Steps involved are: Collecting information: consumer surveys, Market information Data Analysis by statistical estimation of demand relationships

Supply

Quantity supplied of any good or service is the amount that sellers are willing and able to sell for a price

Determinants of supply

Input prices Technology Expectation of future prices Number of sellers in the market Price of substitute or complementary goods

Supply function

Sx = S (Px, Pw, Pv, C, T, E, N, In, Dr) Where Px denotes price of X Pw denotes price of substitute Pv denotes price of complement C denotes input prices or cost T denotes technology E denotes price expectation N denotes number of sellers In denotes inventory demand Dr denotes reservation demand

Supply schedule & Supply curve

A tabular representation of quantity supplied of a good at corresponding prices is referred to as a supply schedule.

Price/unit P1 P2 p3

Quantity (unit) Q1 Q2 Q3

A graphical representation of the supply schedule is the supply curve. The supply curve is upward rising as quantity supplied of a good is directly related to its own price O P S

Shifts & movement along supply curve

Movement along supply curve

P1 P2

A B

Shift of supply curve

Q1Q2 Q3

Q1 Q2 The change in supply is due to change in price of the good all other factors affecting supply being constant. This is referred to as change in quantity

The change in supply is due to change in any one of the other factors affecting supply(say, technology), price of the good remaining the same. This is referred to as change in supply. If quantity supplied increases it is

Law of Supply

All other factor affecting supply of a commodity remaining constant, if price of the good rises then quantity supplied of the good also rises.

Elasticity of supply

This measures the responsiveness of quantity supplied of a good or a service to change in factors like price, input prices, technology etc. The different types of elasticity of supply may be: Input elasticity Production elasticity

Market equilibrium

Aims and Objectives

After studying this lesson, you will be able to understand

Concept of market equilibrium Effect of changes in demand on equilibrium Effect of changes in supply on equilibrium

Market equilibrium/Demand-supply equilibrium & its stability

P P2 P1 P3 Excess demand Q1 E D Excess supply Market equilibrium occurs when demand for a good matches its supply and the market gets cleared. An equilibrium is said to be equilibrium stable when following any deviation from the equilibrium there are some automatic forces which bring the system back to equilibrium S Q

Effect on equilibrium when demand changes

P D E P2 P1 E S Let demand increase for some reason. New demand curve is D now. With same supply there is excess demand at each price. This pushes up the price and the new equilibrium occurs at E at a higher price and higher quantity Q

Q1 Q2

Effect on equilibrium when supply changes

P D S S E P1 P 2 E Let supply increase for some reason. New supply curve is S now. With same demand there is excess supply at each price. This pushes down the price and the new equilibrium occurs at E at a higher quantity and lower price Q

Q1 Q2

Exercise
Work out effect on equilibrium in the following situations:

When When When When

there is a technological up gradation income of consumer increases input prices rise price of substitute rises

Price controls

These are of two types: Price ceiling and Price floor

Price Ceiling

When the Regulator (government) feels that the market price (Pm) of a good is too high and the consumer welfare is at stake then the government can fix the price at a level lower than the market equilibrium price. This is referred to as price ceiling. At the ceiling price (Pc)there is excess demand trying to push the price back to the higher level determined by market equilibrium. So to sustain the price ceiling the government increases the supply to match the increased demand and thereby eliminate the pressure of excess demand. To enable suppliers to supply more at lower price, the government provides subsidies to the suppliers.
Demand Curve Original market supply curve Supply curve after subsidy

Pm Pc
Excess demand

Price Floor

When the Regulator (government) feels that the market price (Pm) of a good is too less and the producer welfare is at stake then the government can fix the price at a level higher than the market equilibrium price. This is referred to as price floor. At the floor price (Pf)there is excess supply trying to push the price back to the lower level determined by market equilibrium. So to sustain the price floor the government increases the demand to match the excess supply and thereby eliminates the pressure of excess supply. To increase the demand to match the excess supply, the government procures these goods and takes initiatives to sell these procured products itself
Excess supply Supply curve

Pf Pm

Demand curve when gov procures Original demand curve

Thank you