DEMAND & SUPPLY

AIMS & OBJECTIVES

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

The concept of demand Determinants of demand Law of demand Demand Curve & its slope 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 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
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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

Price/unit P1

Quantity (unit) Q1

corresponding prices is
referred to as a demand schedule.

P2
p3

Q2
Q3

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

D O
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SLOPE OF DEMAND CURVE: EXPLAINED WITH

UTILITY ANALYSIS

The demand curve, each point on which shows the quantity purchased of a good at a given prices, is downward sloping as quantity demanded of a good is inversely related to its price Qs. Why does quantity demanded move in the opposite direction to that of price? Answer to this lies in utility analysis.

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UTILITY ANALYSIS

Utility refers to the usefulness of a good Two important concepts of utility are: Total Utility (TU) and Marginal Utility (MU) TU sum total of utility derived from all units of a good consumed MU additional utility derived from each additional unit of a good consumed

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RELATION BETWEEN TU & MU

MU measures the rate of change in TU. It gives the change in utility with an additional unit of the good consumed TU rises at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU diminishes, becomes zero and becomes negative thereafter TU may sometimes rise initially at an increasing rate, then at a diminishing rate reaching its maximum and falling thereafter. Accordingly, MU rises at first, then diminishes, then becomes zero and becomes negative thereafter

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LAW OF DIMINISHING MARGINAL UTILITY

Marginal utility usually diminishes throughout or may rise briefly at first and then diminish throughout. This tendency leads to a very important law the Law of Diminishing Marginal Utility (LDMU) The Law states - As a consumer consumes more and more units of a particular good, the Marginal utility derived from each additional unit diminishes

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SLOPE OF DEMAND CURVE EXPLAINED BY LDMU

Let a consumer buying/consuming good X be initially in equilibrium i.e. MUx = Px i.e. what he is receiving as utility is exactly balanced by what he is foregoing as price. He is making the best use of his resources to reach the maximum satisfaction/value Now let Px MUx > Px equilibrium disturbed. The consumer is now getting more value than he is foregoing. So he would want to get more and increase his consumption Qx . As Qx, MUx (LDMU works) and the system starts moving back to MUx = Px . The consumer reaches equilibrium once again. In the process Qx . Thus as Px Qx which explains the inverse prices quantity relationship for a product.

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LAW OF EQUI-MARGINAL UTILITY (LEMU)

In the real world a consumer takes his consumption decision not with respect to one product but with respect to a number of products he purcahes/consumes. Thus, he does not quite reach his equilibrium when MUx = Px He reaches his equilibrium when marginal utility of his expenditure in all directions of his purchases are equalized i.e. if he is buying two goods X & Y at prices Px & Py then he is in equilibrium when MUx/Px = MUy/Py = MUm where Mum denotes marginal utility from total money he has. This is referred to as consumers equilibrium as per law of equimarginal utility

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SLOPE OF DEMAND CURVE EXPLAINED BY LEMU

Let a consumer buying/consuming two goods X & Y be initially in equilibrium i.e. MUx/Px = MUy/Py i.e. the marginal utility of expenditure on X is equal to the marginal utility of expenditure on Y. Hence he consumes both and maximizes his utility. Now let Px MUx/Px > MUy/Py equilibrium disturbed. The consumers MU of expenditure on X is greater than MU of expenditure on Y and hence he wants buy more of X with his scarce money Qx . As Qx, MUx (LDMU works) and the system starts moving back to MUx/Px = MUy/Py . The consumer reaches equilibrium once again. In the process Qx . Thus as Px Qx which explains the inverse prices quantity relationship for a product

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SLOPE OF A DEMAND CURVE REVISITED

The inverse price-quantity relationship and hence the downward slope of a demand curve may also be explained with the help of the following two concepts: Income effect Substitution effect

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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

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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

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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.

Px it is relatively cheaper and hence attractive Qx

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SUBSTITUTION EFFECT NEGATIVE OR POSITIVE?

Substitution effect is always positive.

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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

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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

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

FURTHER BEHIND THE DEMAND CURVE

Consumers equilibrium can also be explained using the two concepts of: Indifference curve Budget Line

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INDIFFERENCE CURVES

An indifference shows various combinations of two goods that fetches the same level of utility/satisfaction to the consumer Basic Characteristics of Indifference Curves Higher indifference curves represent higher levels of utility Indifference curves do not intersect. Indifference curves slope downward. Indifference curves are concave to origin.

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SLOPE OF AN INDIFFERENCE CURVE & MRSXY

Slope of an Indifference Curve = - dY/dX = the Marginal rate of technical substitution between X & Y (MRSxy) = -MUX/MUY The Marginal rate of technical substitution between X & Y (MRSxy) represents the rate at which X gets substituted for Y as a consumer moves down an indifference curve The MRSxy diminishes as one moves down an indifference curve. This is the Law of Diminishing Marginal Rate of substitution. This explains the concave to the origin (or convex from the origin) property of an indifference curve

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BUDGET CONSTRAINTS

Budget constraint shows the various combinations of two goods that a consumer can have for a given money outlay

If a consumer is buying only two goods X and Y in quantities x & y respectively and at prices Px and Py respectively with his entire income M then
M = xPx + yPy This represents the consumers budget constraint or budget line

Basic Characteristics of Budget Constraints Shows affordable combinations of X and Y. Slope of PX/PY reflects relative prices.
Effect of increase in relative prices Slope of Budget line changes. It shifts outward/inward with one of its points either on Y axis(when Px changes) or on X axis (when Py changes) remaining fixed Effects of Changing Income with prices constant Income increase causes parallel outward shift. Income decrease causes parallel inward shift.
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PRICE CONSUMPTION CURVE, INCOME CONSUMPTION CURVE, ENGLE CURVE

Price-consumption Curve Shows how consumption is affected by price changes (movement along demand curve). Income-consumption Curve Shows how consumption is affected by income changes (shifts from one demand curve to another).

Engle Curves Plot between income and quantity consumed. Consumption of normal goods rises with income. Consumption of inferior goods falls with income (rare).

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OPTIMAL CONSUMPTION/CONSUMERS
EQUILIBRIUM

A consumer does his optimal consumption at the point where his utility is maximized subject to this budget constraint i.e. he reaches the highest possible indifference curve given the budget constraint Mathematically, this Utility Maximization happens when the budget line becomes tangent to the highest possible indifference curve for the consumer. At this point slope of budget line becomes equal to slope of indifference curve (IC) i.e. -PX/PY = - MRSxy = - MUX/MUY. i.e. MUX/PX = MUY/PY.

Condition for Consumers equilibrium. This same as obtained from Law of equi-marginal utility
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Each of A, B, C represents consumers Equilibrium for different budget constraint faced by the consumer.

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SHIFTS & MOVEMENT ALONG DEMAND CURVE

Movement along demand curve

P1 A P2 B

Shift of demand curve

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 demanded. If quantity demanded increases it is called expansion of demand. If

Q1 Q2 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 it is 35 called increase of demand. If quantity demanded decreases it is called decrease of demand

CONSUMERS SURPLUS

This refers to the difference between what a consumer is willing to pay and what he actually pays

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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

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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

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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
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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]

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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

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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

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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

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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

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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

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SUPPLY

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

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DETERMINANTS OF SUPPLY

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

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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
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SUPPLY SCHEDULE & SUPPLY CURVE

A tabular representation of quantity supplied of a good at

Price/unit P1

Quantity (unit) Q1

corresponding prices is
referred to as a supply schedule.

P2
p3

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 P S

own price
O
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SHIFTS & MOVEMENT ALONG SUPPLY CURVE

Movement along supply curve

P1 A P2 B

Shift of supply curve

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 supplied. If quantity supplied increases it is called expansion of supply. If

Q1 Q2 Q3 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 50 it is called increase of supply. If quantity supplied decreases it is called

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.

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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

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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

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MARKET EQUILIBRIUM/DEMAND-SUPPLY EQUILIBRIUM & ITS STABILITY

P
P2 P1 P3 E

Excess supply

Market equilibrium occurs when demand for a good matches its supply and the market gets cleared. An equilibrium is said to be stable when following any deviation from the equilibrium equilibrium there are some automatic forces which bring the system back to equilibrium

Excess demand O Q1 Q

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EFFECT ON EQUILIBRIUM WHEN DEMAND

CHANGES
P
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

D
E

P2 P1

Q1 Q2

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EFFECT ON EQUILIBRIUM WHEN SUPPLY

CHANGES
P
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

S
S E

P1 P2

Q1 Q2

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EXERCISE
Work out effect on equilibrium in the following situations: When there is a technological up gradation When income of consumer increases When input prices rise When price of substitute rises

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