DEMAND & SUPPLY

Aims & Objectives After studying this lesson, you will be able to understand: The concept of demand Determinants of demand Law of demand Process of demand estimation Concept of supply and supply function Determinants of supply Law 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 Qd) 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 Wealth of the consumer 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

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 Price/unit Quantity (unit) P1 Q1 P2 Q2 p3 Q3 A tabular representation of quantity purchased of a good at corresponding prices is referred to as a demand schedule. A graphical representation of the demand schedule is the demand curve P D O Q

Slope of a demand curve The demand curve, each point on which shows the quantity purchased of a good at various prices, is downward sloping as quantity demanded of a good is inversely related to its price This inverse price-quantity relationship may be explained with the help of the following two concepts: Income effect Substitution effect

Income effect Px ↓ → Real income ↑→ Qx ↑ 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 ↑

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

Px ↓→ it is relatively cheaper and hence attractive → Qx ↑ 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 ↑

Substitution effect negative or positive? Substitution effect is always positive.

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

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. Other exceptions are: Snob/Veblen effect, Share Market, Demonstration effect P D O Q

Shifts & movement along demand curve Shift of demand curve P1 A P P2 B Q1 Q2 Q1 Q2 Q3 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 quantity demanded decreases it is called contraction of demand 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 called increase of demand. If quantity demanded decreases it is called decrease of demand

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

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

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

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

Supply schedule & Supply curve Price/unit Quantity (unit) P1 Q1 P2 Q2 p3 Q3 A tabular representation of quantity supplied of a good at corresponding prices is referred to as a supply schedule. 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 own price P S O Q

Shifts & movement along supply curve Shift of supply curve P1 A P P2 B Q1 Q2 Q1 Q2 Q3 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 quantity supplied decreases it is called contraction of supply 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 it is called increase of supply. If quantity supplied decreases it is called decrease of supply

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.

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

Market equilibrium/Demand-supply equilibrium & its stability 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 there are some automatic forces which bring the system back to equilibrium P D S P2 E equilibrium P1 P3 Excess demand O Q1 Q

Effect on equilibrium when demand changes P D S 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 E’ P2 E P1 O Q1 Q2 Q

Effect on equilibrium when supply changes D S 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’ E P1 E’ P2 O Q1 Q2 Q

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

Price controls These are of two types: Price ceiling and Price floor

Price Ceiling When the Regulator (government) feels that the market price (Pm) of a good is too high and the consumer welfare is at stake then the government can fix the price at a level lower than the market equilibrium price. This is referred to as price ceiling. At the ceiling price (Pc)there is excess demand trying to push the price back to the higher level determined by market equilibrium. So to sustain the price ceiling the government increases the supply to match the increased demand and thereby eliminate the pressure of excess demand. To enable suppliers to supply more at lower price, the government provides subsidies to the suppliers. Demand Curve Original market supply curve Supply curve after subsidy Pm Pc Excess demand

Price Floor When the Regulator (government) feels that the market price (Pm) of a good is too less and the producer welfare is at stake then the government can fix the price at a level higher than the market equilibrium price. This is referred to as price floor. At the floor price (Pf)there is excess supply trying to push the price back to the lower level determined by market equilibrium. So to sustain the price floor the government increases the demand to match the excess supply and thereby eliminates the pressure of excess supply. To increase the demand to match the excess supply, the government procures these goods and takes initiatives to sell these procured products itself Excess supply Supply curve Pf Pm Demand curve when gov procures Original demand curve

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