Demand and Supply

1. Demand Schedule and Demand

Curve
2. Supply Schedule and the Supply
Curve
3. Elasticity of demand and supply
 Demand - Total quantity customers are
willing and able to purchase.
 A demand function is a behavior function for
consumers.
 A supply function is a behavior function for
producers.
 We describe market behavior using these two
functions.
Direct Demand and Derived
Demand
 Direct Demand-for consumption goods
Goods and services that satisfy consumer
desires.
 Derived Demand-These are sometimes
called intermediate goods.
For example, demand for steel (an
intermediate good) is derived from the
demand for final goods (e.g., automobiles).
 Quantity Demanded – amount of a good
that the consumer is willing to buy and able to
buy at a given price over a period of time.
 Law of Demand :All other things remaining
unchanged, the quantity demanded of a good
increases when its price decreases and vice
versa.
 This relationship can be shown by a demand
schedule, a demand curve or a demand
function.
Demand Schedule
 Demand Schedule Prices Quantity
shows the different
quantities of goods that 4 28
a consumer is willing to
buy at various prices. 8 15
 Prices and quantities 12 5
normally move in
opposite directions 16 1

20 0
 Demand Curve : A curve showing the
relationship between the price of a good and
the quantity demanded.
price

quantity
 Demand Function:

 A demand function is a causal relationship

between a dependent variable (i.e., quantity
demanded) and various independent
variables (i.e., factors which are believed to
influence quantity demanded)
 Q = f(P)
Where Q= quantity and P = price of a good.
Example Q = 2 – 4P
Determinants of Demand
 Own Price
 Income of the consumer
 Price of other goods- 1. complements
2. substitutes
 Tastes and preferences
 Expectations of future prices
 Advertising
 Distribution of income
Types of goods
 Complementary goods are a pair of goods
consumed together. As the price of one goes
up the demand for the other falls.
Example- car and petrol
 Substitute goods are alternatives to each
other. As the price of one goes up the
demand for the other also goes up.
Example – pepsi and coke
 Normal goods are those goods whose
demand goes up when the consumer’s
income increases.
 Inferior goods are those goods whose
demand falls when the consumer’s income
increases.
Example : autotravel, kerosene
 Giffen goods are those goods whose demand
moves in same direction as price
 Snob or Veblen goods are those goods
whose demand falls when price falls
Shift of the Demand Curve
 A change in demand is reflected by shift of
the Demand curve and is caused by a
change in any of the non price determinants
of demand
price

Here, the curve shifts due to an

increase in income or an
increase in price of a substitute
good etc

qty
 A change in quantity demanded is however
reflected in a movement along the demand
curve and is called an extension or
contraction in demand.
 The movement from A to B is due to the
change in price of the good all other factors
remaining unchanged

B
Supply
 The quantity supplied is the number of units
that sellers want to sell over a specified
period of time at a particular price.
 Law of Supply states that all other factors
remaining unchanged the supply of a good
increases as its price increases. This can be
shown by a supply schedule, a supply curve
or a supply function.
 Supply schedule price quantity

1 2
 There exists a positive
relation between 5 10
quantity and price
8 15

13 25

20 35
 Supply Curve: price

qty

• Supply function shows the relation between quantity

and price.
It is a positive relation. Example : q= 4+3p
Determinants Of Supply
 Price
 Cost of production
 Technological progress
 Prices of related outputs
 Govt policy

All factors other than price cause a shift of the

supply curve and is called a change in supply
EQUILIBRIUM
 Equilibrium - perfect balance in supply and
demand
 Determines market output and price

p
p s

eqm

dem
q
Market forces drive market to
equilibrium
 at prices < equilibrium level: excess demand
(amount by which quantity demanded
exceeds quantity supplied at the specified
price)
 at price > equilibrium level: excess supply
 equilibrium price is market clearing price: no
excess demand or excess supply
Equilibrium in a Market

Demand Price Supply

800 $3,000 2,900
1,150 $2,500 2,550
1,500 $2,000 2,200
1,850 $1,500 1,850
2,200 $1,000 1,500
2,550 $500 1,150
2,900 $0 0
Surplus and Shortage
 Any price above the equilibrium causes an excess
supply and any price below the equilibrium causes a
shortage.
 The market if uncontrolled will automatically arrive at
the equilibrium price at which supply equals
demand.
 Any shift in demand and supply curves will result in
a new equilibrium
 Comparison of equilibrium is called comparative -
statics
Price Rationing
 A decrease in supply
creates a shortage at
P0. Quantity
demanded is greater
than quantity supplied.
Price will begin to rise.
• The lower total supply
is rationed to those
who are willing and
able to pay the higher
price.
Alternative Price- Control
Mechanisms

• A price ceiling is a maximum price

that sellers may charge for a good,
usually set by government.
• Example: rent control
• A price floor is a price above
equilibrium price that the buyers have
to pay.
• Example : agricultural support price,
minimum wages
Elasticity
 Elasticity: A measure of the
responsiveness of one variable to changes
in another variable; the percentage change
in one variable that arises due to a given
percentage change in another variable.
 By converting each of these changes into
percentages, the elasticity measure does
not depend on the units in which we
measure the variables.
ELASTICITY
Sensitivity of the quantity
demanded to price is
called: price elasticity of
demand:

% change in quantity demanded  Q / Q

EP  
% change in price P/P
Arc Elasticity
To get the average elasticity
between two points on a demand
curve we take the average of the two
end points (for both price and
quantity) and use it as the initial
value:
q2-q1/(q2+q1)/2

p2-p1/(p2+p1)/2
Own Price Elasticity of
Demand
 Own price elasticity: A measure of the
responsiveness of the quantity demanded of a
good to a change in the price of that good; the
percentage change in quantity demanded
divided by the percentage change in the price
of the good.
 Elastic demand: Demand is elastic if the
absolute value of the own price elasticity is
greater than 1.
Types of elasticities
 elastic: the quantity demanded changes more
than in proportion to a change in price

 inelastic: the quantity demanded changes

less than in proportion to a change in price
Elasticity and slope
Price
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded
Slope of the Demand Curve
 P is the
change in P
Price Demand

price. (P<0) slope 

Q
 Q is the P
change in P
P+ P
quantity. Q

 slope =
P/ Q

Q Q + Q Quantity
 Elastic demand : Demand is elastic if the
absolute value of own price elasticity is
greater than 1.
 Inelastic demand: Demand is inelastic if the
absolute value of the own price elasticity is
less than 1.
 Unitary elastic demand: Demand is unitary
elastic if the absolute value of the own price
elasticity is equal to 1.
 Perfectly elastic demand : e= infinity
 Perfectly inelastic demand : e = 0
Linear Demand Curve:
price
E = infinity e=lower segment/upper segment

E=1

E=0
Qty
Determinants of Elasticity
 Number and closeness of substitutes –
the greater the number of substitutes,
the more elastic

 The proportion of income taken up by the product – the smaller

the proportion the more inelastic

 Price of the product- lower the price, lower the elasticity

 Luxury or Necessity - for example,

addictive drugs

 Time period – the longer the time under consideration the more
elastic a good is likely to be
Cross-Price Elasticity
 Cross-price elasticity: A measure of the
responsiveness of the demand for a good to
changes in the price of a related good; the
percentage change in the quantity demanded
of one good divided by the percentage change
in the price of a related good.
 The cross-price elasticity is positive whenever
goods are substitutes.
 The cross-price elasticity is negative whenever
goods are complements.
Cross-price elasticity of
demand
how quantity of one good
changes as price of
another good increases

%change in quantity demanded

%change in price of another good
Q / Q Q Po
EQ , Po  
Po / Po Po Q
Income elasticity of demand

% change in quantity demanded

EI 
% change in income
Q / Q Q I
 
Y / Y Y Q
Income Elasticity
 Income elasticity: A measure of the
responsiveness of the demand for a good to
changes in consumer income; the percentage
change in quantity demanded divided by the
percentage change in income.
 The income elasticity is positive whenever the
good is a normal good.
 The income elasticity is negative whenever the
good is an inferior good.
Factors affecting Income elasticity:

 Nature of the good:

 inferior goods have negative income elasticity
 Normal goods have positive income elasticity
 Luxury goods have income elasticity greater
than one
 Necessary goods have income elasticity less
than one
Elasticity and Total Revenue
 If demand is elastic, an increase (decrease)
in price will lead to a decrease (increase) in
total revenue.
 If demand is inelastic, an increase (decrease)
in price will lead to an increase (decrease) in
total revenue.
 Total revenue is maximized at the point
where demand is unitary elastic.
price revenue elasticity

Increases increases E< 1

increases decreases E>1

decreases decreases E<1

decreases increases E>1

Increases/ constant E=1

decreases
Elasticity of Supply
 Price Elasticity of Supply:
 The responsiveness of supply to changes
in price
 If es is inelastic (<1)- it will be difficult for suppliers to react
swiftly to changes in price
 If es is elastic(>1) – supply can react quickly to changes
in price

% Δ Quantity Supplied
____________________
es =
% Δ Price
Paradox of the Bumper harvest
 When prices of food crops increase, the
demand does not increase proportionally.
 Hence the revenue earned by farmers fall.
 The Govt announces a floor price for the
farmers- agricultural price subsidy.
 This interference with prices comes at a cost
to the Govt in form of storage costs of Govt
granaries.
Supply And Demand Together:
Equilibrium

 There is one point at which supply and demand

curves intersect.
 This point is called the market’s equilibrium.
 The price at this intersection is called the
equilibrium price.
 The quantity at this point is called the
equilibrium quantity.

42
Supply And Demand Together:
Equilibrium (Cont.)

 At the equilibrium price, the quantity demanded

exactly balances the quantity supplied.
 Equilibrium price is also called market-clearing
price because at this price, everyone in the
market is satisfied:
 Buyers have bought all they wanted to buy.
 Sellers have sold all they wanted to sell.

43
Demand Schedule Supply Schedule

At $2.00, the quantity demanded

is equal to the quantity supplied!
44
Equilibrium of Supply and Demand

Price

Supply

Equilibrium price Equilibrium

$2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity
45