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THEORY OF DEMAND AND SUPPLY

Demand
Desire to buy Willingness to buy Ability to buy

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Types of Demand
Individual Demand

The individual demand for a product and services in a given period of time.

Market Demand

The sum of the demand of all individuals in a given period of time.

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Determinants of Demand

Income of the consumer Price of the substitute product Price of complementary product Change in policy Tastes and preferences of the consumer Existing wealth of the consumer Expectation regarding future price changes
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Nature of Demand Curve

Price

P1

D Q Q1 Quantity demanded
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For normal product, the demand curve slopes downwards to the right It shows inverse relationship between price and quantity demanded
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Law of Demand

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Law of Demand
Y D P

P1 D O Q Q1 Quantity demanded X

When the price of a product is high, the quantity demanded is low When the price of a product is low, the quantity demanded is high
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Price

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Change in Demand Curve

Contraction and Extension in Demand

Consumer moves at same demand curve Shift in demand curve

Increase and Decrease in Demand

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Contraction and Extension in Demand


Y D Extension in demand Price Price P P1 D O Q Q1 Quantity demanded X O Q Q1 Quantity demanded P1 P D X Y D

Contraction in demand

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Increase and Decrease in Demand


Y D P1 P D O Q1 Quantity demanded Q2 D1 X O Q Q1 Quantity demanded D1 Y Increase in demand Price P P1 D1 D Decrease in demand

Price

D1

D X

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Example of Change in Demand


Consumer As Income = Rs. 1,000 Consumer As Income = Rs. 4,000
Cake Price (Rs.) Quantity Demanded of Cake (kg. Per month) 2 4 Cake Price (Rs.) Quantity Demanded of Cake (kg. Per month) 1 2 4 6 10

70 60 50 40 30

70 60 50 40 30

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10

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Why do Demand Curves Slope Downwards?


The law of diminishing marginal utility New consumers Income effect Substitution effect

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Exception of Law of Demand

Giffen Goods Products which are used as status symbols Expectation of change in the price of the product

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Elasticity of Demand

It is defined as the percentage change in quantity demanded due to change in the determinant of demand under consideration, keeping other factors constant. E= Percentage change in X Percentage change in Y

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Types of Elasticity of Demand


Price elasticity of demand Cross elasticity of demand Income elasticity of demand Advertising or promotional elasticity of demand

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Price Elasticity of Demand

Price elasticity of demand is defined as percentage change in quantity demanded of a product due to the percentage change in its price, other things remaining constant.
Ep =
Percentage change in quantity demanded Percentage change in Price

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Degrees of Price Elasticity of Demand


Perfectly Elastic Perfectly Inelastic Unitary Elastic Elastic Inelastic

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Factor determining Price Elasticity of Demand


Availability of closeness of substitutions Proportions of income spend on the product Time period Uses of the product Habit formation

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Application of Price Elasticity of Demand

Pricing decisions of business organizations Pricing regulation by governments Use in international trade Fiscal policy

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Cross Elasticity of Demand

It is the ratio of percentage change in the quantity demanded for one product to a percentage change in the price of another related product, other factors remaining constant.
Ec =
% change in quantity demanded of Product X % change in Price of product Y

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Application of Cross Elasticity of demand

The knowledge of cross elasticity of demand is very important in decision making for developing an appropriate price strategy Firms selling multiple products use cross elasticity of demand to analyze the effect of change in the price of one product to the demand of others
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Income Elasticity of Demand

An increase in real income increases the demand for products, other factors remaining the same. Income elasticity of demand for a product is the percentage change in the demand for that product divided by the percentage change in the consumers income.
EY =
% change in the quantity demanded of product X % change in the income of consumer
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Determinants of Income Elasticity of Demand


Nature of the product Level of income in a country Time period

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Application of Income Elasticity of Demand

In developing countries like India, having scarce resources, income elasticity of demand helps firms to decide what to produce. In the time of business cycles, managers of the firms can decide what to produce with the help of income elasticity of demand.
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Advertising or promotional elasticity of demand

Advertising elasticity of demand measures the extent of change in the quantity demanded of a product to change in expenditure on advertisements and other promotional activities

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Determinants of Advertising Elasticity of Demand


Effect of time Stages of product Advertising by competitors

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Case

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SUPPLY

Determinants of Supply

Cost of production Availability of other products Climate changes Changes in government policies

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Law of Supply

Price

P1 P

S O Q Quantity supplied
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Other factors remaining constant, higher the price of, greater the quantity supplied and lower the price, lower the quantity supplied

Q1
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Nature of Supply Curve

In examining the forces determining the supply curve, we need to analyze the factors upon which the supply of a particular product depends. These can be stated in the form of a supply function: SX = f(PX, PY, PZ,PF, T)

Price of the product Prices of related product Prices of factors of production State of technology
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Shits in Supply

A shift in supply means an increase or decrease in quantity supplied at the same price. Here, supply changes due to other factors than price of the product. The supply curve revels the quantity of a product supplied at various price levels.
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Elasticity of Supply
Es = % change in the quantity supplied of a product
% change in its price

Es = Q P
P Q Q = change in quantity supplied, P = change in the price, Q = original quantity supplied, P = original price
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Types of Elasticity of Supply

Equal to infinity More than one but less than infinity Equal to one Less than one but more than zero Equal to zero

S2

S5 S4

Price

S3 P0 S1

O Quantity supplied
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Equilibrium of Supply & Demand


Y D A P1 Price P P2 S C E D B

Equilibrium at point E Excess Supply AB Excess demand CD Equilibrium price P

Demand & Supply

X
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Effect of a shift in Supply & Demand

If supply remains constant, increase in demand results in increase in price and vice versa If demand remains constant, increase in supply results in decrease in price and vice versa If increase in demand is grater than increase in supply then price will increase If increase in supply is greater than increase in demand then price will fall If the increase in demand is equal to increase in supply then price will remain same
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Rationing by Prices, Price Ceiling & Floor Price


Government control on price Price Ceiling- price which is set less than equilibrium price. Price Floor minimum price which legally charged

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Impact of Tax on Price & Quantity


If the demand curve is perfectly inelastic, then the customers bore the entire tax. If the supply is perfectly inelastic then the entire tax is borne by the suppliers. If the demand curve is perfectly elastic then tax is borne by the suppliers. If the supply curve is perfectly elastic then price increase by full amount of tax.
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