Transcript 18375_unit-1-l1-8

Unit 1
Demand and Supply
Analysis
Learning Outcomes
 Conceptual Understanding of Demand,
Demand Curve and Law of Demand.
 To Understand effects of determinants of
demand on Demand Function.
 To Understand causes of change in Demand.
 Economic efficiency: How well the scarce
resources are allocated to meet the need and
want of customers
 A market can be said to have allocative
efficiency if the price of a product that the
market is supplying is equal to the marginal
value consumers place on it, and equals
marginal cost.
 Productive efficiency occurs when units of
goods are being supplied at the lowest
possible average total cost
Demand
 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
Definition: “A schedule of the quantities of a good that buyers are
willing and able to purchase at each possible price during a
period of time, ceteris paribus. [all other things held constant]”
 Demand can also be perceived as a schedule of the maximum
prices buyers are willing and able to pay for each unit of a
good.
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.
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.
Determinants of Demand
Contd…
 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
population will influence demand
of
 Advertising
 Very important in case of competitive markets
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
Law of Demand
 A special case of demand function which shows relation between
price and demand of the commodity
Dx = 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.
Demand Schedule and Individual
Demand Curve
Point
on
Demand
Curve
Price (Rs
per cup)
Demand
(‘000
cups)
a
15
50
b
20
40
25
c
25
30
20
d
30
20
e
35
10
e
35
d
30
c
b
a
15
O
10
20
40 50
30
Quantity of coffee
Complementary goods
Two goods may be complimentary, i.e. the two goods are “used
together. [tennis rackets and tennis balls or CD’s and CD Players]
An increase in the price of CD’s will tend to reduce the demand [shift
the demand function to the left] for CD Players
PCD’s
P2
As people buy fewer
CD’s, the demand for
CD players decreases.
Pplayers
As the price of CD’s increases
from P1 to P2, the quantity of
CD’s decreases from Y1
to Y.
At the same price,
Ppl , the demand
is reduced
from Dto D’.
Ppl
D’player
Dcd
P1
Y
Y1 CD’s/UT
Dplayer
X
X1 CD Players
per UT
Change in Demand
Price
 Shift in demand curve from D0 to
D1
D1
 More is demanded at same
D0
D2
P
0
Q2
Q
Q1
Quantity
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)
Exceptions to the Law of Demand
Law of demand may not operate due to the following
reasons:
 Giffen Goods -Staple foods are an example of Giffen
Goods. They are consumed by people living in poverty
for the sole reason that they are unable to afford
superior foodstuffs. As the price of a staple food rises,
consumers are unable to supplement their diet with the
more expensive foods, causing demand to increase as
the price of the staple food increases. For example,
bread is a cheap necessity and a diet is supplemented
with meat and cheese. As the price of bread rises, while
still being cheaper than meat and cheese, people
cannot afford the more luxurious food, yet must still eat
so they purchase more bread.
 Snob Appeal - a person who believes that their tastes
in a particular area are superior to those of other
people.
 The purpose of snob appeal is to persuade a
consumer to purchase a product or service by
convincing him or her that the purchase will elevate
their status. By appealing to individuals’ desires to be
among the elite, advertisers attempt to sell their
products.

 For example, some different ads that illustrate
snob appeal include the following:
 Cigarette ads with big and tough guys
smoking cigarettes makes it seem that the
consumer, too, could be amongst the elite
hearty men who smoke cigarettes.
 Commercials that show men drinking a
certain brand of beer attracting all of the
beautiful women in a bar gives the underlying
message that drinking that beer will make the
consumer more attractive to women.




Demonstration Effect
Future Expectation of Prices (Panic buying)
Addiction
Neutral goods
 Life saving drugs
 Salt
The Concept of Elasticity
 Elasticity is a measure of the responsiveness of
one variable to another.
 The greater the elasticity, the greater the
responsiveness.
Elasticity
 4 basic types used:

Price elasticity of demand – PED

Price elasticity of supply – PES

Income elasticity of demand – YED

Cross elasticity – Cross ED or XED
Price Elasticity
 The price elasticity of demand is the
percentage change in quantity demanded
divided by the percentage change in price.
Percentage change in quantity demanded
ED =
Percentage change in price
Sign of Price Elasticity
 According to the law of demand, whenever the
price rises, the quantity demanded falls. Thus
the price elasticity of demand is always
negative.
 Because it is always negative, economists
usually state the value without the sign.
What Information Price Elasticity
Provides
 Price elasticity of demand and supply gives
the exact quantity response to a change in
price.
Classifying Demand and Supply as
Elastic or Inelastic
 Demand is elastic if the percentage change
in quantity is greater than the percentage
change in price.
E>1
Classifying Demand and Supply as
Elastic or Inelastic
 Demand is inelastic if the percentage
change in quantity is less than the
percentage change in price.
E<1
Elastic Demand
 Elastic Demand means that quantity changes
by a greater percentage than the percentage
change in price.
Inelastic Demand
 Inelastic Demand means that quantity doesn't
change much with a change in price.
Calculating Elasticities: Price elasticity
of Demand
What is the price elasticity of
demand between A and B?
P
$26
$23
$20
B
Midpoint
C
A
10 12 14
Q2–Q1
½(Q2+Q1)
%ΔQ
ED = %ΔP =
P2–P1
½(P2+P1)
10–14
½(10+14)
-.33
= 26–20 = .26 = 1.27
½(26+20)
D
Q
7-27
Elasticity – XED
 Cross Elasticity:
 The responsiveness of demand of one good
to changes in the price of a related good –
either a substitute or a complement
% Δ Qd of good t
__________________
XED =
% Δ Price of good y
Example
 A 2% increase in the price of petrol causes a
4 % reduction in the qty demanded of cars.
Calculate XED? Are the goods
complementary or subsitute
 Sol: XED= % change in Q/ % change in P
= -4/2
= -2
Since the XED is –ive so products are
complementary
Elasticity – XED
 Goods which are complements:

Cross Elasticity will have negative sign
(inverse relationship between the two)
 Goods which are substitutes:

Cross Elasticity will have a positive sign
(positive relationship between the two)
Income Elasticity of Demand
 Income elasticity of demand (YED) measures
the responsiveness of quantity demanded to
changes in real income.
 YED = %Δ demand / %Δ in income
 Example:

A rise in consumer real income of 7% leads to
an 9.5% rise in demand for pizza deliveries.

The income elasticity of demand:
= 9.5/ 7 = +1.36
Effect
Income elasticity
coefficient
Classification of
good
A proportionately
larger change in
the quantity
demanded
>1
Luxury good
A proportionately
smaller change in
the quantity
demanded
<1
Normal
A negative
change in the
quantity
demanded
<0
Inferior good
Different Types of Goods and their
Income Elasticity
Luxury
Normal Necessity Inferior Good
Air travel
Fresh vegetables
Frozen vegetables
Fine wines
Instant coffee
Cheep Cigarettes
Luxury chocolates
Natural cheese
Processed cheese
Private education
Fruit juice
Margarine
Private health care
Spending on
utilities
Tinned meat
Antique furniture
Shampoo /
toothpaste /
detergents
Value “own-brand”
bread
Designer clothes
Rail travel
Bus travel
Degrees of Price Elasticity
Slope of demand curve is used to
display price elasticity of demand
Perfectly elastic demand
 ep=∞ (in absolute terms).
 Horizontal demand curve
 Unlimited quantities of the commodity
can be sold at the prevailing price




Perfectly inelastic demand
ep=0 (in absolute terms)
Vertical demand curve
Quantity demanded of a commodity
remains the same, irrespective of any
change in the price
 Such goods are termed neutral.
Price
P
D
O
Q1
Q2
Quantity
D
Price
P1
P2
O
Q1
Quantity
Importance of Elasticity
 Relationship between changes in price and
total revenue
 Importance in determining what goods to tax
(tax revenue)
 Importance in analyzing time lags in
production
 Influences the behavior of a firm
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)
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.
Supply Schedule
Point on
Supply
Curve
a
b
c
d
e
Price
(Rs. Per
cup)
15
20
25
30
35
Supply (‘000
cups per
month)
10
20
30
45
60
Supply Curve
35
e
30
25
c
20
b
15
0
d
a
10
20
30 40 50 60
Quantity of Coffee
Change in Supply
Price
S2
S0
S1
P
O
Q2
Q0
Q1
Quantity
 Shift in the supply curve from
S0 to S1
 More is supplied at each
price (Q1>Q0)
 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<Q0)
 Decrease in supply caused by:
 A rise in the price of inputs
 Change in government
policy (VAT)
Market Equilibrium
 Equilibrium occurs at the price where the quantity demanded and
the quantity supplied are equal to each other.Qd=Qs
 At point E demand is equal to supply hence 25 is equilibrium price
Price
S
E
25
D
O
30
Quantity
Demand
(‘000 cups/
month)
Price
(Rs)
Supply
(‘000 cups/
month)
15
10
50
20
15
40
25
30
30
30
45
15
35
70
10
Market Equilibrium
 At point E demand is equal to supply hence 25 is equilibrium price.
 Qd>Qs is excess demand or shortage
 Qd<Qs is excess supply or surplus
Price
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
S
30
E
25
20
D
O
Qs
30 Qd
Quantity
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
Price
S0
S1
D1
S2
E0
P0
E
P
P2
S0
E2
S1
S2
O
D1
Q0 Q Q2
Quantity
Changes in Market Equilibrium
(Shifts in Demand Curve)
Price
D2
S1
D1
D0
 A decrease in demand shifts the
demand curve to D0
E
P
P*
E2
D2
S1
O
 Price rises to P1 and quantity rises to
Q1 taking the new equilibrium to E1
E1
P1
D0
Q* Q
Q1
 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
D1
Quantity
 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.
Change in Both Demand and Supply
 Initial equilibrium is at E1, with price
Price
D2
D2
D1
S1
S2
P2
P1
E1
S1
O
S2
E0
E2
D1
Q1
Q2
D2
D2
Quantity
quantity combination (P1, Q1).
 An increase in both demand and
supply takes place;
 demand curve shifts to the right
from D1 D1 to D2 D2
 supply curve also shifts to the
right from S1 S1 to S2 S2.
 The new equilibrium is at E2, and
price quantity is (P2, Q2).
 An increase in both supply and
demand will cause the sales to rise
Price Floors and Ceilings
 Price Floors and Price Ceilings are Price
Controls, examples of government
intervention in the free market which changes
the market equilibrium.
Price Floors
 Price Floors are minimum prices set by the
government for certain commodities and services that
it believes are being sold in an unfair market with too
low of a price and thus their producers deserve some
assistance. Price floors are only an issue when they
are set above the equilibrium price, since they have
no effect if they are set below market clearing price.
 When they are set above the market price, then there
is a possibility that there will be an excess supply or a
surplus. If this happens, producers who can't foresee
trouble ahead will produce the larger quantity where
the new price intersects their supply curve.
Price ceiling
 Price Ceilings are maximum prices set by the government for
particular goods and services that they believe are being sold at
too high of a price and thus consumers need some help
purchasing them. Price ceilings only become a problem when
they are set below the market equilibrium price.
When the ceiling is set below the market price, there will be
excess demand or a supply shortage. Producers won't produce
as much at the lower price, while consumers will demand more
because the goods are cheaper. Demand will outstrip supply, so
there will be a lot of people who want to buy at this lower price
but can't. Still, if the demand curve is relatively elastic, then the
net effect to consumer surplus will be positive.
Cardinal Utility and Ordinal
Utility
1. Cardinal Utility Concept:
 The neo-classical economists propounded the
theory of consumption (consumer behavior
theory) on the assumption that utility is
cardinal. For measuring utility, a term ‘util’ is
coined which means units of utility.
 Following are the assumptions of the
cardinal utility concept that were followed
by economists while measuring utility:
 a. One util equals one unit of money
 b. Utility of money remains constant
 However, over a passage of time, it has been
felt by economists that the exact or absolute
measurement of utility is not possible. There
are a number of difficulties involved in the
measurement of utility. This is because of the
fact that the utility derived by a consumer
from a good depends on various factors, such
as changes in consumer’s moods, tastes, and
preferences.
2. Ordinal Utility Concept
 According to Economists, it may not be possible to
measure exact utility, but it can be expressed in
terms of less or more useful good. For instance, a
consumer consumes coconut oil and mustard oil. In
such a case, the consumer cannot say that coconut
oil gives 10 utils and mustard oil gives 20 utils.
 Instead he/she can say that mustard oil gives more
utility to him/her than coconut oil. In such a case,
mustard oil would be given rank 1 and coconut oil
would be given rank 2 by the consumer. This
assumption lays the foundation for the ordinal theory
of consumer behavior.
Indifference Curve
 Indifference curve shows different
combinations of two goods that gives equal
satisfaction to the consumer and consumer is
indifferent in the choice of matter between
them.
Pears
Constructing an indifference curve
30
28
26
24
22
20
18
16
14
12
10
8
6
4
2
0
a
Pears Oranges
30
24
20
14
10
8
6
0
2
4
6
8
10
12
Oranges
14
a
b
c
d
e
f
g
6
7
8
10
13
15
20
16
Point
18
20
22
An indifference map
Units of good Y
30
20
10
I5
I4
I1
0
0
10
Units of good X
I2
20
I3
Properties of Indifference Curves
sloping. (negatively sloped)
 Higher
indifference
curve
represents higher utility.
 Indifference curves can never
intersect.
 Indifference curves are convex to
the origin.
 Indifference curve do not touch the
horizontal or vertical axis.
Y
A
Good Y
 Indifference curves are downward
B
C
D
IC
1
O
Good X
IC
2
X
Budget Line
 It is the locus of combination of two goods
that an individual can afford to buy with his
income
A budget line
a
Units of good Y
30
b
20
Units of
good X
Units of Point on
good Y budget line
0
5
10
15
30
20
10
0
a
b
Assumptions
10
PX = £2
PY = £1
Budget = £30
0
0
5
10
Units of good X
15
20
Effect of an increase in income on the budget line
40
Assumptions
PX = £2
PY = £1
Budget = £40
Units of good Y
30
n
20
m
16
10
Budget
= £40
Budget
= £30
0
0
5
7
10
Units of good X
15
20
Effect on the budget line of a fall in the price of good X
a
30
Units of good Y
Assumptions
PX = £1
PY = £1
Budget = £30
20
10
B2
B1
c
b
0
0
5
10
15
Units of good X
20
25
30