Demand, Supply, Equilibrium and Elasticity

(Price Theory or Market Mechanism)

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Market

A set of arrangements by which buyers and sellers are in contact to exchange goods and services.

Various types of markets

Physical (Buyers , sellers and goods and services in physical presence or contact)

Intermediate (share market)

Super (prices are fixed)

Electronic (www.) and Tele (Video/phone/fax)

Auction (ascending, descending, sealed bid),

Differentiated (customer, product, quality…)

Homogenious (same type of goods and same price)

geographical (regional, city, rural, estate) etc.2

Various types of products:

Normal products (If the quantity demanded rises as incomes rise and falls when incomes fall)

Inferior products (If the quantity demanded fall as incomes rise and rises when incomes fall)

Giffen products (A special case of the inferior product arises when as price rises, more of the good in question is bought resulting upward slopping demand curve)

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Veblen products (A special case of giffen luxury product: prices goes down people will buy more prices goes up people will buy more – jewellery market -conspicuous consumption).

Independent/dependent products (goods which can/not consume independently)

Substitution Product (instead of one good we can use other good).

Complementary Products (without the help of other goods we can not use them). 4

Definition for a Demand

Purchasing power and will to spend based necessity. It is the quantity of a good buyers wish to purchase at each conceivable price. The willingness to pay a sum of money for a given amount of a specific good or service.

Ex-ante Demand (intended or expected) and

Ex-post Demand (actual demand/existing demand)

Consumer Demand (individual demand) and Market Demand (summation of individuals demand)

Speculative demand (due to expectations)5

Consumer demand curve (this relates to the amount the consumer is willing to buy to each conceivable price for a product)

Market demand curve is generally derived by summing the individual demand curves of consumers horizontally. Shape of the curve depends on the market structure)

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Factors Influencing the Individual Demand

Price of the product

income of the buyer

taste

habits and preferences

prices of complementary and substitutes

consumer expectations

advertisement effect, etc 7

Factors Influencing the Market Demand

price of the productdistribution of income and wealth communitys common habits and

preferences living standards and spending habits growth of population age and sex composition future expectation tax structure inventions and innovations fashionsweather customs, advertisement, etc

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Demand equation:

Qd =f( P ), Qd = a - bP, b =AQd/AP (slope)

Demand function:

Qd =f

(P: price of the good is concerned

Pj: Prices of substitution and complementary goods

Y: Income

T: taste

Ex: expectations

Ad: advertisements

G: government influence

W: weather .n). 9

Demand Schedule (behavior of buyers at every price)

Demand Curve (the relationship between price and quantity demanded, holding other factors constant).

P50

2000 100

25

Qd

05040408030

12020160102000

Demand ( units)Price($)

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Analysis of demand function: (Analyse the Qd with respect to change in all the factors which affect for demand)

Qd = f (P:price of the good is concerned, Pj: prices of substitution and complementary goods, Y:income, T: taste, Ex: expectations, Ad: advertisements, G: government influence, W: weather… n)

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(X and Y are substitutes)

1. Price of substitution good (X) goes up then quantity demanded from the good is concerned (Y) goes up. (relation +)

2. Price of substitution good (X) goes down then quantity demanded from the good is concerned (Y) goes down. (relation +)

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(A and B are complementary goods)

1. Price of complementary good (A) goes up then quantity demanded from the good is concerned (B) goes down. (relation -)

2. Price of complementary good (A) goes down then quantity demanded from the good is concerned (B) goes up. (relation -)

3. Price of independent good goes up or down then quantity demanded from the good is concerned does not have any impact. (relation 0)

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4. Income (disposable Yd = Y-T) goes up then demand for normal good goes up (relation +). Income goes down then demand for normal good goes down (relation +).

5. Income goes down then demand for inferior good goes up. Income goes up then demand for inferior good goes down.

Angel’s Law

As income rises the proportion of expenditure on all necessities (foods) declines and luxuries increase (non-necessities).

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4. Consumers taste goes up (due to advertising campaign) then demand for normal good goes up. Taste goes down then demand for normal good goes down (relation +)

5. Expectations, advertisements, weather go up (down) then demand for normal good goes up (down), G: government influence (tax negative – elasticity- and subsidy positive).

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The inverse relationship (negative) between price and quantity demanded depends on the

substitution effect of price changes. X and Y are substitutes. Price of X goes up then consumers shift from X to Y. Price of X goes down then consumers shift from Y to X.income effect of price changesIf consumers real income goes up then they will demand more and if their real income goes down they will demand less. This can be shown through • Marginal utility approach. • Indifference curve approach.

This will be discussed in your fourth lecture. 16

.

Unusual upward slopping demand curve Giffen goods (If prices fall while income is rising consumers buy less giffen goods because they go for superior goods. If prices increase while income is dropping they buy more giffen goods because they can not afford superior goods).

Articles of snob appeal or Conspicuous consumption (People buy as status symbol of prestigious/expensive or unique goods - diamonds, antiques and Rolls-Royces). The influence of conspicuous prices upon consumption is referred as veblen effect.

Speculation (If prices are going up people expect future price rises and then buy more - shares and some commodities).

Consumers psychological bias (upper market behaviour and brand loyality).

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.

Network Externalities in Market Demand

The bandwagon or demonstration effect (demand generated due to others pursuation, imitation or stimulation) - consumers are motivated to follow the crowd.

The snob or veblen effect (person’s desire to own unique high priced good)

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Movement along the demandShift in demand

P P

Qd Qd

P1

P2

Q1 Q20

P1

Q1 Q Q2

D

D1

D D2

0

Change and shift in demand: Change means movement (up - expansion or down - contraction) along the demand curve due to change in own price. Shift [left: decrease or right: increase] in demand curve due to changes in other factors except price.

Qd = f(P) Qd = f(Pj, T, Y..n)

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Definition for a supply (the amount which supplier willing sell and it is the quantity of a good supplier wish to sell at each conceivable price over a specific time period)

Supply equation:

Qs = f(P), Qs = a + b P,

b = AQs/AP (slope) and supply function:

Qd = f(P): price of the good is concerned

Pj: prices of substitution and complementary goods

T: technology

PI: price of inputs

Ex: Business expectations, Sn: Number of suppliers

G: government influence, W: weather…n.20

Supply Schedule ( behavior of suppliers at every price)

16050

12040

8030

4020

010

Supply ( units)Price($)

Market supply and individual supply

Market supply is the summation/aggregation of individual’s supply curve for a specific product.

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Supply Curve

(the relationship between price and quantity supplied, holding other factors constant).

If prices are low less supply, if prices are high more supply. Positive relationship between price and the quantity supplied.

P

Qs

S

0 22

Analysis supply function:

Qd = f (P: price of the good is concerned, Pj: prices of substitution and complementary goods, T: technology, PI: price of input, Ex: expectations, G: government influence, W: weather, etc )

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Change and shift in supply: Change means movement (up – extension or down - contraction) along the supply curve due to change in own price. Shift (left: decrease or right: increase) in supply curve due to changes in other factors except prices.

Qs Qs

P1

P2

Q1 Q20

P1

Q1 Q Q2

S

0

A

B AB C

P P

sS1

S2

Qs =f (p) Qs = f (Pj, Tec…..n)

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Equilibrium Price and Quantity

Equilibrium price equalizes quantity supplied to the quantity demanded and it clears the market. Above this price excess demand and below this price excess supply.

160050

1204040

808030

4012020

016010

QsQdPrice

(Qd > Qs) Excess demand Equilibrium (Qd = Qs)(Qs > Qd) Excess supply

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(30)p

Qd, Qs

Qd,Qs(80)0

DP S

Price Controls (government interference to market to forbid the adjustment of prices to clear the market)

Floor prices (minimum prices – above the equilibrium price)

Ceiling prices (maximum prices – below the equilibrium price).

Floor price

Ceiling price

Equilibrium price

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Comparative Static Analysis (response of price and quantity to changes in demand and supply)1. Shift in demand curve to both directions while supply curve

stable.

D2

Qd

P

P2

P3

Q1 Q2

D

A

B

Q3

P1 C

S

D1

0

D shift to right

P Qd = B

D shift to left

P Qd = C

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2. Shift in supply curve to both directions while demand curve stable.

D

Qd

P

P2

P3

Q1 Q2

A

B

Q3

P1

C

S

0

S shift to right

P Qd = B

S shift to left

P Qd = C

S2

S1

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3. Both supply and demand curves shift into both directions in same %.

P

Qd

P2

P3

Q1 Q2

D

A B

Q3

P1C

S

0

P Q

S2

S1D1

D2

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4. Supply and demand curves shift into both directions in different %.

Qd

P

P2

Q1 Q2

D

A

BP1

S

0

SD1

D 5% S 10% (right)

P Qd = B

4.1 Demand 5% up and supply 10% up

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Qd

P

P2

Q1 Q2

D

AP1

S

0

S1D1

D 10% S 5% (right)

P Qd = B

5%10%

B

4.2 Demand 10% up supply 5% up

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10

Qd

P

P2

Q1 Q2

D

AB

P1

S1

0

SD1

D 5% S 10% (left)

P Qd = B5%

%

4.3 Demand 5% down supply 10% down

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5

Qd

P

P2

Q1 Q2

D

A

BP1

S1

0

S

D1 D 10% S 5% (left)

P Qd = B10%

%

4.4 Demand 10% down and supply 5% down

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Consumer Surplus and Producer Surplus

S

D

xp

a

o q3oaxq3 -opxq3 = paxThe difference between the total amount of money an individual would be prepared to pay for a given quantity of a good and the amount actually paid. This concept is useful to public policy making, pricing, tax and welfare decisions. Producer surplus = OPX

Consumer surplus

Producer surplus

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For business firm this concept shows a possible source of additionalIncome (possibility of price discrimination).

For government to tax policies.

Using this concept, we can place a monetary value on activities that do not appear to have a market price.

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