1. Demand and Supply Analysis
Unit 1
Demand and Supply Analysis

2. 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.

3. 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

4. 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.

5. 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.

6. 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.

7. 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 of population will influence demand
Advertising
Very important in case of competitive markets

8. 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

9. 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.

10. Demand Schedule and Individual Demand Curve10 20 30 15 35 50 40 25
Quantity of coffee
Price of Coffee O
Point on Demand Curve
Price (Rs per cup)
Demand (‘000 cups) a 15 50 b 20 40 c 25 30 d e 35 10 e d c b a

11. Complementary goods PCD’s Pplayers Ppl Dcd Dplayer
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
As people buy fewer
CD’s, the demand for
CD players decreases.
CD’s/UT
PCD’s
Dcd
CD Players
per UT
Pplayers
Dplayer
D’player
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’. X1 X
Ppl P2 P1 Y Y1

12. Change in Demand 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) D0
Price
Quantity D1 D2 P Q2 Q Q1

13. 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.

15. 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. 

16. 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. 

17. Future Expectation of Prices (Panic buying) Addiction Neutral goods
Demonstration Effect
Future Expectation of Prices (Panic buying)
Addiction
Neutral goods
Life saving drugs
Salt

18. The Concept of Elasticity
Elasticity is a measure of the responsiveness of one variable to another.
The greater the elasticity, the greater the responsiveness.

19. 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

20. Price Elasticity
The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.

21. 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.

22. What Information Price Elasticity Provides
Price elasticity of demand and supply gives the exact quantity response to a change in price.

23. 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

24. 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

25. Elastic Demand
Elastic Demand means that quantity changes by a greater percentage than the percentage change in price.

26. Inelastic Demand
Inelastic Demand means that quantity doesn't change much with a change in price.

27. Calculating Elasticities: Price elasticity of Demand
What is the price elasticity of demand between A and B? P
Q2–Q1
½(Q2+Q1)
P2–P1
½(P2+P1) =
ED =
%ΔQ
%ΔP B
Midpoint
$26 C
$23 A =
10–14
½(10+14)
26–20
½(26+20)
$20
-.33
.26 =
1.27 D Q 10 12 14
7-27 27

28. 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

29. 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

30. 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)

31. 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

32. Income elasticity coefficient Classification of good
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

33. 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

34. 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
Quantity O P D Q1 Q2 D Q1
Price
Quantity O P1 P2

35. 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

36. 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)

37. Supply (‘000 cups per month)
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
Supply Curve 30 10 20 60 50 40 15 35 25
Price of Coffee
Quantity of Coffee
Point on Supply Curve
Price (Rs. Per cup)
Supply (‘000 cups per month) a 15 10 b 20 c 25 30 d 45 e 35 60 e d c b a

38. Change in Supply 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) S0
Price
Quantity O S2 S1 P Q0 Q2 Q1

39. 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
Quantity
Price O
Price
(Rs)
Supply
(‘000 cups/ month)
Demand (‘000 cups/ month) 15 10 50 20 40 25 30 45 35 70 D S 25 E 30

40. 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 D S
Quantity
Price O
Price
(Rs)
Supply
(‘000 cups/ month)
Demand (‘000 cups/ month) 15 10 50 20 40 25 30 45 35 70 30 25 E 30 20 Qs Qd

41. 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 Q P E D1 S1
Price
Quantity O E0 P0 Q0 S0 S2 Q2 P2 E2

42. Changes in Market Equilibrium
(Shifts in Demand 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 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. D1 S1
Price
Quantity O E P Q D2 D0 Q1 P1 E1 Q* P* E2

43. Change in Both Demand and Supply
Initial equilibrium is at E1, with price 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 D2
Quantity
Price O D2 D1 S1 S2 P2 Q2 E2 P1 E1 E0 Q1

44. 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. 

45. 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.

47. 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.

50. 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

51. 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.

52. 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.

53. 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.

54. Constructing an indifference curve
Pears
Oranges
Point 30 24 20 14 10 8 6 6 7 8 10 13 15 20 a b c d e f g
Pears
Oranges

55. An indifference map
Units of good Y I5 I4 I3 I2 I1
Units of good X

56. Properties of Indifference Curves
Indifference curves are downward 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. X Y O
Good X
Good Y
IC2
IC1 A B C D

57. Budget Line
It is the locus of combination of two goods that an individual can afford to buy with his income

58. A budget line a Units of good X 5 10 15 Units of good Y 30 20 105 10 15
Units of
good Y 30 20 10
Point on
budget line a b b
Units of good Y
Assumptions
PX = £2
PY = £1
Budget = £30
Units of good X

59. Effect of an increase in income on the budget line
Assumptions
PX = £2
PY = £1
Budget = £40
Units of good Y n m 16
Budget
= £40
Budget
= £30 7
Units of good X

60. Effect on the budget line of a fall in the price of good X
Assumptions
PX = £1
PY = £1
Budget = £30
Units of good Y B2 B1 b c
Units of good X