DEMAND & SUPPLY

Aims & ObjectivesAfter 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

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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.

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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

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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

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Demand function• A demand function is given as:• Dx = f (Px, Py, Pz, I, W, E, A, T, O)

Where,Px → price of good XPy → price of substitutePz → price of complementI→ income of the consumerW → wealth of the consumerE → price/income expectation of the consumerA → advertisement expenditure on the goodT → taste & preference of the consumerO → other exogenous factors

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Market demand function• Market demand function is the summation of all the

individual demand functions

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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.

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Demand schedule & Demand curve

• 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

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Price/unit Quantity (unit)

P1 Q1

P2 Q2

p3 Q3

P

O Q

D

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

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Income effect• 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.

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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

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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.

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

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

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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

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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

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Q

P

O

D

Shifts & movement along demand curve• Movement along demand

curve• Shift of demand curve

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ABP2

P1

Q1 Q2

P

Q1Q2 Q3The 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

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Supply• Quantity supplied of any good or service is the

amount that sellers are willing and able to sell for a price

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

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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

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Supply schedule & Supply curve

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

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Price/unit Quantity (unit)

P1 Q1

P2 Q2

p3 Q3

P

O Q

S

Shifts & movement along supply curve

• Movement along supply curve

• Shift of supply curve

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ABP2

P1

Q1 Q2

P

Q1Q2 Q3The change in supply is due to change in price of the good all other factors affecting supplybeing 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.

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Market equilibrium

Aims and ObjectivesAfter 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

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Market equilibrium/Demand-supply equilibrium & its stability

Excess demand

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E

P S

O

D

Q

P1 equilibrium

Q1

P2

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

P3

Effect on equilibrium when demand changes

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E

P S

O

D

Q

P1

Q1

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

Q2

Effect on equilibrium when supply changes

P2

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E

P S

O

D

Q

P1

Q1

E’

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 priceQ2

S’

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

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

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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.

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Pm

Pc

Excess demand

Original market supply curve

Supply curve after subsidy

Demand Curve

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

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PmPf

Supply curve

Demand curve when gov procures

Original demand curve

Excess supply

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Thank You