Unit 1

1. 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. e 35 30 d c Price of Coffee 25 b 20 a 15 O 40 50 10 20 30 Quantity of coffee Demand Schedule and Individual Demand Curve

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

12. Price D1 D0 D2 P 0 Q2 Q1 Q Quantity 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)

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. 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) %ΔQ %ΔP ED = = B Midpoint $26 C $23 10–14 ½(10+14) 26–20 ½(26+20) A $20 -.33 .26 = = = 1.27 D Q 10 12 14 7-27

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

33. Different Types of Goods and their Income Elasticity

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

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. 35 e 30 Price of Coffee d 25 c 20 a b 15 0 40 50 60 10 20 30 Quantity of Coffee 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

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

39. Price S E 25 D 30 O Quantity 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

40. 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 S E 25 D O 30 Quantity Market Equilibrium 30 20 Qs Qd

41. Price S0 S1 D1 S2 E0 P0 E P E2 S0 P2 S1 S2 D1 O Q0 Q Q2 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 P2and 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

42. Price D2 S1 D1 D0 E1 P1 E P E2 P* D2 D1 S1 D0 O Q1 Q Q* Quantity Changes in Market Equilibrium (Shifts in Demand Curve) • The original point of equilibrium is at E, the point of intersection ofcurves D1 and S1, at price P and quantity Q • An increase in demand shifts the demand curve to D2 • Price rises to P1and 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.

43. D2 D2 Price D1 S1 S2 P2 E2 D2 D2 S1 S2 D1 O Q2 Quantity 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 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