Law of Demand&

Law of Supply

Foundation EconomicsBIMTECHJune 2009

Demand

Economics is the study of the ordinary activities of human life. Economic activities take place to satisfy human wants and desires. In order to satisfy human wants consumers make demand for goods and services. People desire goods and services as they derive utility or satisfaction or pleasure or benefit from the consumption of a commodity.

Prof. Benham : “Demand for anything, at a given price, is the amount of it which will be bought per unit of time at that price”. Thus demand is an effective desire backed by purchasing power i.e. there should be a want for the commodity in the consumers mind which should be backed by the ability and the willingness to pay for it.

Demand Function

Determinants of Demand / Demand Function:

Qd =f(Pn, Pr, Y, T, U) Price of the commodity. Price of related commodities i.e. substitutes or

complementary goods. Level of Income and Wealth Tastes and preferences of consumers Size and composition of population Distribution of income Wealth conditions Other factors

Price of a commodity and quantity demanded are inversely related.

Price of related commodities : Price of complementary goods and quantity demanded are inversely related . Eg : Car and Petrol. Change in the price of one inversely affects the demand for the complimentary commodity. Prices of substitutes and quantity demanded for original good are positively related.

Income of the household : There are three types of commoditites : a) Necessities : With an increase in income, the demand for necessities initially increases and becomes inelastic thereafter. b) Comforts and Luxuries : Demand for commodities and luxuries is positively related to income . Eg : Scooters etc. c) Inferior goods : Eg : Coarse grain, rough cloth etc. Demand for inferior goods is inversely related to income. At very low levels of income, it is possible that the demand for inferior goods may increase with an increase in household income, but beyond a certain level of income, demand for the good decreases with an increase of income.

Tastes and Preferences of household: Positive change in tastes and preferences will lead to an increase in demand and vice versa.

Other factors : Size of population – Larger the size of population, larger the demand

on the whole.

Composition of population : If number of children in the age composition of society is large, larger the demand for toys and vice versa.

Distribution of Income : Equitable distribution of income leads to an increase in demand, unequal distribution leads to a fall in demand.

Weather conditions : Cold spell, rainy season would accordingly have a bearing on quantity demanded for woolens, umbrellas etc.

Paul Samuelson : “When the price of a good is raised (at the same time that all other things are held constant), less of it is demanded”. In brief, the law of demand states that the other things being equal, at a higher price consumers will buy less of a commodity and at a lower price, consumers will buy more of it. As the price of the good rises so does the opportunity cost of purchasing the good increase, therefore either the consumers will have to forego buying other goods or purchase lesser quantity of the good whose price has increased.

Demand Schedule is a numerical tabulation which shows the quantity that is demanded at selected prices.

Individual Demand Schedule

Market Demand Schedule states the quantity of a commodity that the households in the market will buy at selected prices.

Law of Demand

Demand Curve

It shows the complete relation between quantity demand and price.

Demand Curves Slopes Downwards :

Traditional Approach was propagated by Alfred Marshall and is based on the Utility Analysis..

Law of diminishing Marginal Utility states as a consumer has more of a commodity, the utility derived from the successive units goes on decreasing. Consumer will continue consuming a commodity until the marginal utility of the commodity becomes equal to it’s price. This is the equilibrium position of the consumer.MUx=Px.

Changes in the number of consumers: As price falls, more consumers can afford to purchase the same commodity.

Diverse uses of a commodity : For goods which have diverse uses, increase in price leads to decrease in demand.

Demand Curve

Modern Approach : Income Effect Substitution Effect

Income Effect in the price of a commodity affects the purchasing power (real income) of a household. A fall in the price causes an increase in the real income and vice versa.

Substitution Effect : When the price of a commodity falls, the relative price of it’s substitute automatically increases ie when price of a commodity falls, it becomes relatively cheaper than other commodities.

Exception to Law of Demand

Giffen goods : Giffen goods are special type of inferior goods. According to Sir Giffen, when the price of cheap foodstuff like bread increased, people bought more and consumed more and not less of it. Eg: A rise in the price of bread caused a decline in the purchasing power of the poor such that they were forced to cut down the consumption of other items like meat, vegetables etc as bread even though its price had increased was cheaper than other items.

Conspicuous Necessities : Commodities like TV, fridge as through their constant use they have become necessities of life.

Conspicuous consumption : Goods like diamond etc. where with an increase in price of the good, Quantity demanded increases.

Future changes in price : Households act as speculators. Eg: Realty prices etc.

Emergencies : Like war, flood negate the operation of law of demand. Change in fashion Ignorance

Expansion and Contraction of demand :If the demand changes due to a change in price the Law of Demand operates wherein expansion of demand is due to larger quantity of commodity demanded at a lower price and contraction of demand is lower quantity demanded at a higher price. Expansion and contraction of demand are shown by movements on the same demand curve.

Shift In Demand Curve The change in demand or effect on demand for a

commodity due to a change in factors other than the price. Change in demand can be the result of factors like income, tastes, prices of related goods, weather conditions etc.

Increase or Decrease in Demand Curve

Increase in Demand : More is demanded at the same price or same quantity is demanded at a higher price.

Elasticity of DemandMeasures the rate of change in the quantity demanded due to a given change in any of the determinants of demand such as price of the good, price of related commodities, money income of the consumer etc.

Alfred Marshall stated “Elasticity (or responsiveness) of demand in a market is great or small accordingly as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price.

Price Elasticity of Demand Income Elasticity of Demand Cross Elasticity of Demand

Price Elasticity of demand is defined as the percentage of change in quantity demanded divided by the percentage change in price.

Ed = Proportionate change in quantity demanded Proportionate change in price

Ed = change in quantity demanded * price ------------------------------------ --------------------- Quantity demand change in price

0<=Ed<=infinity.

Demand is generally very inelastic in the case of necessities or luxuries or when the price of the commodity is very high or very low, while elasticity is high when price is moderate.

Factors affecting Elasticity of Demand1. Nature of commodity : Necessities have inelastic demand

while for luxuries it is relatively elastic.2. Availability of substitutes : Commodity which has number

of substitutes to it will have elastic demand while commodity which has no substitutes has inelastic demand.

3. Share in total expenditure : Commodities which have a higher share in total expenditure will generally have elastic demand while those with lesser share have inelastic demand.

4. Possibility of postponing the consumption5. Several uses of a commodity6. Consumer habits7. Range of prices : At very high and low range of prices,

demand for the goods is inelastic.

Income Elasticity of Demand : Ey = Proportionate change in quantity demanded

------------------------------------------------------ Proportionate change in Income

Prof. Engel demonstrated that the quantity of a commodity demanded is directly related to his money income.

Superior Good Ey>1 Inferior Good Ey<0 Normal Good Ey>0

Cross Elasticity of DemandEc= Proportionate change in quantity demanded of X

------------------------------------------------------------ Proportionate change in price of Y

Infinite Elasticity : Two commodities are perfect substitutesGreater than zero but less than infinity : Commodity Y is a substitute for Commodity XZero : Commodities X and Y are not relatedNegative : Commodities X and Y are complementary

Importance of Elasticity of Demand :

Importance for indirect taxation: If the elasticity is less than unity, the increase in the tax rate will not affect the quantity demanded of the good and total tax revenue will increase.

Importance to a monopolist: A monopolist cannot determine the price of his product arbitrarily. He considers the demand in the market while fixing the price of the product. In case where the demand for the product is inelastic, he can fix a higher price, while in case the demand is elastic he would not fix a higher price.

Important in regulating prices especially of agricultural products: As demand for certain products especially agricultural products is inelastic, the government in order to increase the income of farmers, may regulate the supply and increase the price.

International Trade: If the demand for the country’s exports is elastic, a fall in their prices would cause an increase in their demand and thus improve the foreign exchange earnings of the county.

Paradox of Poverty amongst plenty: A bumper crop instead of being a cause of prosperity may spell disaster if demand for the product is inelastic especially if the commodity is perishable. A rich harvest implies increased supply of produce which if perishable leads to a fall in price ie a rich harvest might fetch less money than a poor crop.

Supply

Accd. To Prof. Mc Connell : “Supply may be defined as a schedule which shows the various amounts of a product which a producer is willing and able to produce and make available for sale in the market at each specific price in a set of possible prices during some given period.

Supply refers to what producers offer for sale at a given price and it is a flow concept ie quantity supplied is so much per unit of time, per day, per week…..

The supply schedule is the relationship between the quantity of items supplied by the producers of a good and the current market price. It is commonly represented as directly proportional to price.

Determinants of Supply

Sn=fn (Pn, Pr, G, F, T)

Price of the commodity Price of related goods : If price of substitute goes up, firms will be

tempted to divert the resources to the production of the substitutes. Price of factors of production: With increase in cost of factor of

production, supply tends to fall and vice versa. State of Technology: As technology progresses, it becomes

cheaper to produce commodities and the firms could be willing to supply more quantity at lower price.

Goal of firms: Some firms aim at maximization of profits, while other believe in lower margins and high sales turnover.

Natural factors Means of transport and communication Taxation Policy Future expectation of rise in prices Agreement amongst producers

Law of Supply

Law of Supply : Other things being equal, the quantity of any commodity that firms will produce and offer for sale is positively related to the commodity’s own price, rising when price rises and falling when prices fall.

Movement in Supply

Movement along the Supply Curve: Movement along the same supply curve represents contraction and expansion in supply and is the result of a price change.

Shift in Supply: This happens when producers are willing to offer more or less of a commodity, because of reasons other than the price of the commodity. Increase in supply occurs when firm is willing to supply more at original price or supply same quantity at a lower price.

Elasticity of Supply

Es = Proportionate change in quantity supplied ------------------------------------------------------ Proportionate change in price

Perfectly Inelastic : Quantity offered for sale does not change with a change in price.

Inelastic or Less than Unit Elastic : Supply of a commodity is said to be inelastic, if the quantity offered for sale changes in a lesser proportion to change in price.

Unit Elastic : Proportionate change in the quantity supplied is exactly equal to the proportionate change in price.

More than Unit Elastic or Elastic : Proportionate change in quantity supplied is more than the proportionate change in price.

Perfectly Elastic : Supply of a commodity may increase or decrease to any extent irrespective of a change in price.

Any straight line supply curve through the origin has an elasticity of one. If a straight line, goes through the quantity axis, it is inelastic. If a straight line supply curve goes through the price axis it is elastic.

Factor influencing Elasticity of Supply Nature of commodity : Perishable goods as they cannot be stored for long,

have inelastic supply, whilst durable goods have elastic supply.

Changes in cost of production: Elasticity of supply depends on the ease with which increases in production can be had without bringing any increase in cost of production. In the short run, when increase in production is brought about by increasing the variable factors, diminishing returns eventually result, thereby supply becomes relatively inelastic. In the long run, when all factors are variable, the supply curve tends to be more elastic.

Technique of Production : Simple techniques of production more elastic is supply, complex techniques have inelastic supply as technology would need time to be installed and thus it would be difficult to respond immediately to increase in price.

Estimate of future prices : If firms expect price to rise in future, inelastic is the supply and vice versa.