Demand and Supply

Concept of Individual Demand

Demand Desire to buy backed by ability and willingness to pay. it should containthe quantity demanded, price at which quantity is demanded, time period over which a commodity is demanded, market area in which it is demanded

Demand Distinction

Consumer and producers goods demand Durable and nondurable demand Derived and autonomous demand Company and industry demand Short run and long run demand

Determinants of demand

Price of product (own price) Buyers income Taste and preferences of consumer Availability and price of substitutes or competing products Advertising and sales promotion Population

Conti.

Availability of credit Season of the year Consumers future expectations distribution of income and wealth Govt. taxation policy Patterns of saving Climatic conditions

Conti..

Inventions and discoveries Quantity of money in circulation Demonstration effect Business cycle- prosperity and depression international trade

Demand function

Dx= f (Px,Y, PO, T, v) Dx = Demand for product X Px= PRICE OF x PO= PRICE OF OTHER PRODUCTS

Y = INCOME OF CONSUMER
T= Taste and preference

v = other factors

Law of Demand

Law simply expresses the functional relationship between the quantity demanded of a particular product and its price in the market It states that higher the price, lower the demand and vice versa, other things remaining same.

Assumptions of the Law

consumers income should not change Consumers tastes and preferences should remain constant Price of other products (substitute and compliments) should not change Consumers customs and habits should not change No discovery of new product

Demand Schedule

Price (Rs.)

quantity demanded (units)

5 4 3 2

80 100 150 200

The Demand curve

The curve slopes downward from left to right

Chief Characteristics of Law of Demand

Inverse relationship- b/w price and quantity demanded Price an independent variable, and demand as dependent variable other things remaining same

Reason underlying the law of demand- (why does the Demand curve
slopes downward from left to right)

Income Effect-

the fall in the price of a commodity leads to an equivalent increase in the income of the consumer because now he has to spend less for purchasing the same quantity as before. A part of money so gained can be used for purchasing some more units of the commodity. vice versa

Substitution effect-

when the price of the commodity falls, the consumer tends to substitute that commodity for other commodities which have not become relatively dear. Conversely, when the price of a commodity rises, other commodities will be used in its place at least to some extent. therefore, a fall in the price of a commodity increases demand a rise in price reduces demand.

Reason underlying the law of demand- (why does the Demand curve
slopes downward from left to right)

Operation of the law of diminishing marginal utility- According to this law, as a consumer
consumes more and more units of a particular product, the marginal utility of that product goes on diminishing. Therefore the consumer will consume more units of that product only as its price falls.

Change in no. of consumers or price

effect

Change in number of uses

Exceptions to law of Demand

Snob appeal or ostentation or conspicuous consumption- when price of

such goods rises, their snob appeal increases and they are purchased in larger quantities.

Speculative market Giffen Paradox- in it the demand curve slopes upward from left to right. inferior good
eg: meat and potatoes

Conti..

Ones status Geographic location of buyers Expected future trend in price Change in consumer tastes, needs and preferences.

EFFECTS OF CHANGE IN REST OF THE

DEMAND DETERMINANTS- Change in Income

The effects of changes in income vary depending on the type of product demanded. When income rises, all else equal, the demand for normal goods increases, while the demand for inferior goods decreases.

If income rises, the demand for a normal good increases and the demand for an inferior good decreases.
Price P2 S Price S NORMAL GOOD P 1 P2 INFERIOR GOOD

P1

D1
Q 1 Q2

D2
Q2 Q1

D2 D1
Quantity

Quantity

Prices of Related Goods

When two goods are related (as substitutes or complements), a change in the price of one good may either increase or decrease the demand for the other product.

A substitute good is one that can be used in place of another good. A complementary good is one that is used together with another good.

Prices of Related Goods

If two goods are substitutes, an increase in the price of one will increase the demand for the other. If two goods are complements, an increase in the price of one will decrease the demand for the other. Most goods are unrelated to one another. For these independent goods, a change in the price of one will have virtually no effect on the demand for the other.

Basis of consumer demand:utility

Utility- can be looked from two angles Commodity angel- utility is want satisfying property of a commodity consumers angle- utility is psychological feeling of satisfaction, pleasure, happiness or wellbeing which a consumer derives, from the consumption, possession or use of a commodity.

Utility- property

It is a post consumption phenomenon Varies from person to person and from time to time it is sense of satisfaction

Two approaches to utility

Cardinal Utility Approach- this approach was advocated by Alfred Marshall. According to this approach, utility can be measured in monetary units. Two fundamental laws have been developed under this approach to theory of consumer behavior- law of diminishing marginal utility, law of equi marginal utility

Total Utility versus Marginal Utility

Marginal utility is the utility a consumer derives from the last unit of a consumer good she or he consumes (during a given consumption period), ceteris paribus. Total utility is the total utility a consumer derives from the consumption of all of the units of a good or a combination of goods over a given consumption period, ceteris paribus. Total utility = Sum of marginal utilities

Law of diminishing marginal utility

It states that as the consumer goes on consuming more units of a particular product, the marginal utility will go on diminishing According to Alfred Marshall- The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in stock that he already has

Total and Marginal Utility for Ice Cream

Q 0 1 2 3 4 5 6 7 8 9 10 ($) TU 0 40 85 120 140 150 157 160 160 155 145 ($) MU 40 45 35 20 10 7 3 0 -5 -10 145

Total Utility
200 150 100 50 0 1 2 3 4 5
($) M U

10 11

50 40 30 20 10 0 1 -10 -20 2 3 4 5 6 7 8 9 1 11

Q 0 1 2 3 4 5 6 7 8 9 10

($) TU 0 40 85 120 140 150 157 160 160 155 145

($) MU 40 45 35 20 10 7 3 0 -5 -10 145

Assumptions of law

1. 2. 3. 4. 5. 6.

rationality cardinal utility constant marginal utility of money homogeneity of product Continuity Ceteris Paribus

Law of Equi Marginal utility or law of substitution (multiple commodity

case)

It states that other things remaining the same, a consumer gets maximum total utility by spending his money income between different products in such a way that the marginal utility derived from the last unit of money spent on each product is equal. Alfred Marshall contended that if a consumer has limited income and if he has freedom to choose among various commodities, he would maximize total utility derivable from all such commodities by allocating the given income such that the marginal utilities in respect of all commodities are equal.

Consumer Equilibrium

So far, we have assumed that any amount of goods and services are always available for consumption In reality, consumers face constraints (income and prices):

Limited consumers income or budget Goods can be obtained at a price

Some simplifying assumptions

Consumers objective: to maximize his/her utility subject to income constraint 2 goods (X, Y) Prices Px, Py are fixed Consumers income (I) is given

Consumer Equilibrium

Optimizing condition:

MU X MU Y PX PY

If

MU X MUY PX PY

spend more on good X and less of Y

Simple Illustration

Suppose:

X = hot dog Y = burger

Assume: PX = 2 PY = 10

Numerical Illustration
Qx 1 2 3 4 5 6 TUX 30 39 45 50 54 56 MUX 30 9 6 5 4 2 MUx Px 15 4.5 3 2.5 2 1 QY 1 2 3 4 5 6 TUY 50 105 148 178 198 213 MUY 50 55 43 30 20 15 MUy Py 5 5.5 4.3 3 2 1.5

2 potential optimum positions Combination A: X = 3 and Y = 4

TU = TUX + TUY = 45 + 178 = 223

Combination B: X = 5 and Y = 5

TU = TUX + TUY = 54 + 198 = 252

Presence of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination. Expenditure per combination

Total expenditure = PX X + PY Y Combination A: 3(2) + 4(10) = 46 Combination B: 5(2) + 5(10) = 60

Scenarios:

If consumers income = 46, then the optimum is given by combination A. .Combination B is not affordable If the consumers income = 60, then the optimum is given by Combination B.Combination A is affordable but it yields a lower level of utility

Ordinal utility approach

Rationality Ordinal utility Transitivity and consistency of choice- if he prefers A to B, B to C then hell prefer A to C No satiety Diminishing MRS

Ordinal approach to utilityScale of preferences

Indifference curve analysis- propounded by J.R.Hicks The tools of this approach are- budget line, IC Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction

Indifference Curves
x
2

x x

x ~ x ~ x

x x1

I1

x
2

x I2
y z

All bundles in I1 are strictly preferred to all in I2.

I3

All bundles in I2 are strictly preferred to all in I3. x1

Marginal Rate of Substitution-The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. The slope of IC curve is called MRS.

Marginal Rate of Substitution

x
2

MRS at x is the slope of the indifference curve at x

x1

Indifference Curves: Slope

The slope or steepness of indifference curves is determined by consumer preferences.

It reflects the amount of one good that a consumer must give up to get an additional unit of the other good while remaining equally satisfied. This relationship changes according to diminishing marginal utilitythe more a consumer has of a good, the less the consumer values an additional value of that good. This is shown by an indifference curve that bows in toward the origin

PROPERTIES OFINDIFFERENCE CURVES

IC slopes downward to the right-negative slope. (consumer can remain indifferent to various combinations of IC is convex to the origin-

X and Y only when for increasing the stock of X he is required to forgo certain units of Y or vice versa)

(this implies that along an IC the consumer is prepared to forgo only diminishing quantities of Y for each given increment in the quantity of X) MRS is diminishing=-dy/dx

IC never intersectHigher IC is always preferred to a lower one

Quantity of Pepsi 14

MRS = 6
8 1 A

People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little

4 3 0 2 3

MRS = 1

1
6

Indifference curve Quantity of Pizza

Indifference Map

Budgetary constraint and the budget line

The Budget Line

A budget line describes the limits to consumption choices and depends on a consumers budget and the prices of goods and services. It indicates the various combination of product X and Y that a consumer can choose, given his income and market prices. It is also called income line.

Quantity of Pepsi
500
.

250

C
Consumers Budget line A 100

50

Quantity of Pizza

Consumer equilibrium

The consumer is said to be in equilibrium when he gets the maximum possible satisfaction from his consumption, given his money income and market prices of both the commodities. Given the indifference map and the budget line of the consumer, the equilibrium is defined by the point of tangency of the budget line with the highest possible IC

Consumer equilibrium
Quantity of Pepsi Optimum B A

I3

I1
Budget constraint 0

I2

Quantity of Pizza

At optimum point, the slope of the IC (MRS of X and Y) and the slope of budget line (ratio of price of X and Y) are exactly equal. MRSXY= MUX/MUY= PX/PY

CONSUMER SURPLUS

According to Marshall the excess of the price which a person would be willing to pay rather than go without the thing, over that which he actually does pay is the economic measure of this surplus satisfaction. It may be called consumers surplus Or the difference between the potential price and the actual price. Where potential price means- the total amt. of money the consumer would be willing to pay for the product while the actual price is the amount he actually does pay for the product.- it is based on the law of diminishing MU.

Tabular Explanation of Consumer Surplus

Consumer Surplus= total utility- (price* quantity)

Product X
(units)

Potential Price (MU) (Rs.)

Actual Consumers Market price Surplus (Rs.) (Rs.)

1 2 3 4 5 6
Total units consumed = 6

80 70 55 50 40 25
Total utility=320

25 25 25 25 25 25
Total money actually spent=

55 45 30 25 15 0.
Total consumer surplus= 170

Consumer surplus= 320- (25*6) = 320-150 = 170

Consumer Surplus
Price
Consumer Surplus

Maximum Willingness to Pay for Qo

Po

What is paid

D
Qo

Quantity

Change in Consumer Surplus: Price Increase

Price
New Consumer Surplus
Original Consumer Surplus

Loss in Surplus: Consumers paying more P1 Po

D
Qo

Q1

Quantity

supply
Supply is a schedule or curve showing the amounts of a product that producers will make available for sale at each of a series of possible prices during a specific period.

The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

The Law of Supply

Curve slopes upward left to right and is positively sloped.
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Factors affecting supply

Determinants of supply are those factors that cause supply to change.

The basic determinants of supply are (1) resources prices, (2) technology, (3) taxes and subsidies, (4) price of other goods, (5) expected prices, and (6) the number of sellers in the market.

Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded.

Disequilibrium
Excess supplyIf the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

Disequilibrium
Excess Demand Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

Shifts vs. Movement

Movements
A movement refers to a change along a curve.

On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Movement along the supply curve

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

Movement along the supply curve

Shifts

A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same.

Shift in the demand curve

if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption

Shift in Supply curve

if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price

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