Chapter 3

Demand and Supply Analysis

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Lecture Plan

• Objectives• Demand• Types of demand• Determinants of demand

– Demand function– Law of demand– Demand schedule and individual demand curve

• Market demand• Change in demand• Exceptions to the law of demand• Supply

– Supply schedule and supply curve – Change in supply

• Market equilibrium– Determination of market equilibrium – Changes in market equilibrium

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Chapter Objectives

To introduce the basics of demand and supply and their relevance in economic decision making.

To analyze the different determinants of demand and supply and their effects on demand and supply curves.

To help develop an understanding of demand and supply functions in determining market equilibrium.

To introduce the concepts of market equilibrium and disequilibrium.

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Demand

The process to satisfy human wants/ needs/desires. Want: having a strong desire for something Need: lack of means of subsistence Desire: an aspiration to acquire something

Demand: effective desire Demand is that desire which backed by willingness and ability to buy a

particular commodity. Amount of the commodity which consumers are willing to buy per

unit of time, at that price. Things necessary for demand:

Time Price of the commodity Amount (or quantity) of the commodity consumers are willing to

purchase at the price

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Types of Demand

Direct and Derived Demand Direct demand is for the goods as they are such as Consumer goods Derived demand is for the goods which are demanded to produce

some other commodities; e.g. Capital goods Recurring and Replacement Demand

Recurring demand is for goods which are consumed at frequent intervals such as food items, clothes.

Durables are purchased to be used for a long period of time Wear and tear over time needs replacement

Complementary and Competing Demand Some goods are jointly demanded hence are complementary in

nature, e.g. software and hardware, car and petrol. Some goods compete with each other for demand because they are

substitutes to each other, e.g. soft drinks and juices.

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Types of Demand

Demand for Consumer Goods and Capital Goods Consumer goods are bought by the ultimate consumers for their

personal use Capital goods are used as inputs in the production of other goods and

services Demand for Perishable and Durable Goods

Durables: Last for a relatively long time and can be consumed multiple times

Demand can be postponed Non-durables:

Perishable: These must be consumed immediately Non-perishable: These do not get spoilt as quickly as perishables

Individual and Market Demand Individual demand: Demand for an individual consumer Market demand: Demand by all consumers

Contd…

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Determinants of Demand

Price of the product Single most important determinant Negative effect on demand

Higher the price-lower the demand Income of the consumer

Normal goods: demand increases with increase in consumer’s income Inferior goods: demand falls as income rises

Price of related goods Substitutes

If the price of a commodity increases, demand for its substitute rises.

Complements If the price of a commodity increases, quantity demanded of its

complement falls.

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Determinants of Demand

Tastes and preferences Very significant in case of consumer goods

Expectation of future price changes Gives rise to tendency of hoarding of durable goods

Population Size, composition and distribution of population will

influence demand Advertising

Very important in case of competitive markets

Contd…

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Demand Function

Interdependence between demand for a product and its determinants can be shown in a mathematical functional form

Dx = f(Px, Y, Py, T, A, N) Independent variables: Px, Y, Py, T, A, N Dependent variable: Dx Px: Price of x Y: Income of consumer Py: Price of other commodity T: Taste and preference of consumer A: Advertisement N: Macro variable like inflation, population growth, economic

growth

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Law of Demand

A special case of demand function which shows relation between price and demand of the commodityDx = f(Px)

Other things remaining constant, when the price of a commodity rises, the demand for that commodity falls or when the price of a commodity falls, the demand for that commodity rises.

Price bears a negative relationship with demand Reasons

Substitution Effect : When the price of a commodity falls (rises), its substitutes become more (less) expensive assuming their price has not changed.

Income Effect: When the price of a particular commodity falls, the consumer’s real income rises, hence the purchasing power of the individual rises.

Law of Diminishing Marginal Utility: as a person consumes successive units of a commodity, the utility derived from every next unit (marginal unit) falls.

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Demand Schedule and Individual Demand Curve

Point on

Demand Curve

Price (Rs per cup)

Demand (‘000 cups)

a 15 50

b 20 40

c 25 30

d 30 20

e 35 10

e

b

a

c

10 20 30

15

20

30

35

5040

25

Quantity of coffee

Pric

e of

Cof

fee

O

d

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Market Demand

Market: interaction between sellers and buyers of a good (or service) at a mutually agreed upon price.

Market demand Aggregate of individual demands for a commodity at a particular

price per unit of time. Sum total of the quantities of a commodity that all buyers in the

market are willing to buy at a given price and at a particular point of time (ceteris paribus)

Market demand curve: horizontal summation of individual demand curves

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Change in Demand

D1

D2

D0

Price

Quantity0

Shift in demand curve from D0 to D1

More is demanded at same price (Q1>Q)

Increase in demand caused by: A rise in the price of a

substitute A fall in the price of a

complement A rise in income A redistribution of income

towards those who favour the commodity

A change in tastes that favours the commodity

Shift in demand curve from D0 to D2

Less is demanded at each price (Q2<Q)

P

Q1QQ2

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Exceptions to the Law of Demand

Law of demand may not operate due to the following reasons: Giffen Goods Snob Appeal Demonstration Effect Future Expectation of Prices (Panic buying) Addiction Neutral goods

Life saving drugs Salt

Amount of income spent Match box

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Supply

• Indicates the quantities of a good or service that the seller is willing and able to provide at a price, at a given point of time, other things remaining the same.

• Supply of a product X (Sx) depends upon:– Price of the product (Px)– Cost of production (C)– State of technology (T)– Government policy regarding taxes and subsidies (G)– Other factors like number of firms (N)

• Hence the supply function is given as: Sx = (Px, C, T, G, N)

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Law of Supply Law of Supply states that other things remaining the same, the higher the

price of a commodity the greater is the quantity supplied. Price of the product is revenue to the supplier; therefore higher price

means greater revenue to the supplier and hence greater is the incentive to supply.

Supply bears a positive relation to the price of the commodity.

Point on Supply Curve

Price (Rs. Per cup)

Supply (‘000 cups per month)

a 15 10b 20 20c 25 30d 30 45e 35 60

Supply Schedule

c

e

d

Supply Curve

3010 20 605040

15

20

30

35

25P

rice

of C

offe

e

Quantity of Coffee

0

ba

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Change in Supply

S2

S1

S0

Price

Quantity O

Shift in the supply curve from S0 to S1 More is supplied at each price

(Q1>Q) Increase in supply caused by:

Improvements in the technology

Fall in the price of inputs Shift in the supply curve from S0

to S2

Less is supplied at each price (Q2<Q)

Decrease in supply caused by: A rise in the price of inputs Change in government policy

(VAT)

Q2

P

Q0 Q1

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Equilibrium occurs at the price where the quantity demanded and the quantity supplied are equal to each other.

Market Equilibrium

D

S

Quantity

Price

O

25 E

30

Price(Rs)

Supply (‘000 cups/

month)

Demand (‘000 cups/

month)

15 10 50

20 15 40

25 30 30

30 45 15

35 70 10

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For prices below the equilibrium– Quantity demanded exceeds quantity supplied (D>S) – Price pulled upward

For prices above the equilibrium– Quantity demanded is less than quantity supplied (D<S)– Price pulled downward.

Market Equilibrium

D

S

Quantity

Price

O

25 E

30

Price(Rs)

Supply (‘000 cups/

month)

Demand (‘000 cups/

month)

15 10 50

20 15 40

25 30 30

30 45 15

35 70 10

20

30

4515 19

Changes in Market Equilibrium(Shifts in Supply Curve)

The original point of equilibrium is at E, the point of intersection of curves D1 and S1, at price P and quantity Q

An increase in supply shifts the supply curve to S2

Price falls to P2 and quantity rises to Q2, taking the new equilibrium to E2

A decrease in supply shifts the supply curve to S0. Price rises to P0 and quantity falls to Q0 taking the new equilibrium to E0

Thus an increase in supply raises quantity but lowers price, while a decrease in supply lowers quantity but raises price; demand being unchanged

Q2

P2

E2

S2

S2

Q

PE

D1

D1

S1

S1

Price

QuantityO

E0P0

Q0

S0

S0

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• The original point of equilibrium is at E, the point of intersection of curves D1 and S1, at price P and quantity Q

• An increase in demand shifts the demand curve to D2

• Price rises to P1 and quantity rises to Q1 taking the new equilibrium to E1

• A decrease in demand shifts the demand curve to D0

• Price falls to P* and quantity falls to Q*

taking the new equilibrium to E2.

• Thus, an increase in demand raises both price and quantity, while a decrease in demand lowers both price and quantity; when supply remains same.

Q1

P1E1

D2

D2

Q*

P* E2

Changes in Market Equilibrium(Shifts in Demand Curve)

D0

D0

D1

D1S1

S1

Price

QuantityO

EP

Q

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Change in Both Demand and Supply

P2

Q2

E2

S2

S2

D1

D1

Quantity

Price

O

S1

S1D2

D2

Q1

P1 E1

Whether price will rise, or remain at the same level, or will fall, will depend on: the magnitude of shift and the shapes of the demand

and supply curves. Therefore, an increase in both

supply and demand will cause the sales to rise, but the effect on price can be: Positive (D increases more

than S) Negative (S increases more

than D) No change (increase in

D=increase in S)22

Summary

• Demand is defined as the desire to acquire a commodity to satisfy human wants, which is backed by ability to pay the price.

• Categories of demand are made on the basis of the nature of commodity demanded (consumer goods and capital goods); time unit for which it is demanded (short run and long run); relation between two goods (substitutes and complements), etc.

• The law of demand states that the consumers will buy more of the commodity when prices are high and less when prices are low, provided all the other factors of demand remains constant.

• Demand for a product X (Dx) is a function of price of the commodity X (Px), income of the consumer (Y), price of related (substitutes or complements) commodities (Po), tastes and preference of the consumer (T), advertising (A), future expectations (Ef), population and economic growth (N).

• A change in quantity demanded denotes movements along the demand curve due to a change in price, while a change in demand denotes a rightwards or leftward shift of the demand curve due to a change in the other determinants of demand other than price.

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Summary

• Supply is defined as the willingness to produce and sell the commodity by production units or firms.

• The law of supply states that firms will sell more of the commodity when prices are high and less of the commodity when prices are low provided all the other factors of supply remains constant.

• Supply of a product X (Sx) is a function of price of the product (Px), cost of production (C), state of technology (T), Government policy regarding taxes and subsidies (G), other factors like number of firms (N).

• Change in quantity supplied refers to movements along the same supply curve due to change in the price of the commodity. However when change in supply is associated with change in the factors like costs of production, technology, etc. it causes a shift of the supply curve upwards or downwards

• Market equilibrium occurs where demand and supply are equal. This equilibrium determines the price in the market through the forces of demand and supply. Comparative statics is the process of comparison between two equilibrium situations.

• An increase in both supply and demand will cause the sales to rise, but the effect on price can be positive, negative or equal to zero, depending on the extent of the shifts in the demand and supply curves.

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