Micro Economics

[SOM 602]

Trupti Mishra
Shailesh J Mehta School Of Management
IIT Bombay
 Demand Analysis
 Demand
- Desire: Advertising
- Willingness to buy : Promotional scheme and discount
- Ability to pay: Financing options
What is demand?

 A relation showing the quantities of a good that

consumers are willing and able to buy at various
prices per period, other things constant.
Law of Demand

 Relationship between Price and quantity demanded

is an economic law.

 The quantity of a good demanded per period relates

inversely to its price, other things constant.
Exception to Law of Demand

- Giffen Goods
- Veblen Effect
- Prediction
- Demonstration effect
- Share Market
- Insignificant proportion of Income spent
- Goods with No substitute
Demand Schedule and Demand Curve

Individual point on demand curve / schedule shows quantity demanded and

entire demand curve/schedule shows demand.
Factors Influencing Demand

• Price of good or service (P)

• Incomes of consumers (M)
• Prices of related goods & services (PR)
• Taste patterns of the consumer (T)
• Expected future price of product (Pe)
• Number of consumers in market (N)
Generalized Demand Function

• Qd  f ( P, M , PR , , Pe , N )

Qd  a  bP  cM  dPR  e   fPe  gN

 b, c, d, e, f, & g are slope parameters

 Measure effect on Qd of changing one of the variables while holding
the others constant

 Sign of parameter shows how variable is related to Qd

 Positive sign indicates direct relationship
 Negative sign indicates inverse relationship
Factors Influencing Demand
Variable Relation to Qd Sign of Slope Parameter
P Inverse b = Qd/P is negative

M Direct for normal goods

Inverse for inferior goods
PR Direct for substitutes d = Qd/PR is positive
Inverse for complements d = Qd/PR is negative

T Direct e = Qd/T is positive

Pe Direct f = Qd/Pe is positive

N Direct g = Qd/N is positive

Factors Influencing Demand
Variable Relation to Qd Sign of Slope Parameter
P Inverse b = Qd/P is negative

M Direct for normal goods

Inverse for inferior goods
PR Direct for substitutes d = Qd/PR is positive
Inverse for complements d = Qd/PR is negative

T Direct e = Qd/T is positive

Pe Direct f = Qd/Pe is positive

N Direct g = Qd/N is positive

Demand Function

 Demand function shows relation between P & Qd when all other variables
are held constant
 Qd = f(P)
 Qd/P must be negative

 Qd = 500 – 5P

 At zero price, demand is equal to 500 units.

 (- ) shows inverse relationship between price and demand .
 (5) Implies that for each one rupees change is price demand changes by 5
units
Market Demand

 Market demand is the sum of all individual demands

at each possible price
 Graphically, individual demand curves are summed
horizontally to obtain the market demand curve.
Change in the Demand Curve

 Change in quantity demanded

 Occurs when price changes
 Movement along demand curve

 Change in demand
 Occurs when one of the other variables, or
determinants of demand, changes
 Demand curve shifts rightward or leftward
Change in the Demand Curve
Variables That Shift Market
Demand
Variables That Shift Market
Demand
 A Shifts in the Demand Curve
Price of
Cigarettes,
per Pack.

A policy to
discourage smoking
shifts the demand
curve to the left.

B A
RS 2.00

D1

D2
10 20 Number of Cigarettes
0 Smoked per Day

17
 A Movement Along the Demand Curve
Price of
Cigarettes,
per Pack.

C A tax that raises

the price of
Rs 4.00 cigarettes results
in a movements
along the demand
curve.

A
Rs 2.00

D1

0 12 20 Number of Cigarettes
Smoked per Day

18
Supply
Supply of a goods refers to the various quantities
of the good which a seller is willing and able to
sell at a different prices in a given market, at a
particular point of time.

 Law of Supply
 The law of supply states that, other things
equal, the quantity supplied of a good rises
when the price of the good rises.

19
Factors Influencing Supply

 Price of good or service (P)

 Input prices (PI )
 Prices of goods related in production (Pr)
 Technological advances (T)
 Expected future price of product (Pe)
 Number of firms producing product (F)

20
Generalize Supply Function

Qs  h  kP  lPI  mPr  nT  rPe  sF

 k, l, m, n, r, & s are slope parameters
 Measure effect on Qs of changing one of the variables while holding
the others constant
 Sign of parameter shows how variable is related to Qs
 Positive sign indicates direct relationship
 Negative sign indicates inverse relationship

21
Generalize Supply Function
Variable Relation to Qs Sign of Slope Parameter

P Direct k = Qs/P is positive

PI Inverse l = Qs/PI is negative

Inverse for substitutes m = Qs/Pr is negative

Pr
Direct for complements m = Qs/Pr is positive

T Direct n = Qs/T is positive

Pe Inverse r = Qs/Pe is negative

F Direct s = Qs/F is positive

22
Supply Function
- Supply function, or supply, shows relation between P & Qs
when all other variables are held constant
 Qs = g(P)

Supply Schedule
- The supply schedule is a table that shows the relationship
between the price of the good and the quantity supplied.
Supply Curve

-The supply curve is a graph of the relationship between the

price of a good and the quantity supplied.

23
Supply Schedule: Example

Price of Ice-cream Cone (Rs) Quantity of cones Supplied

0.00 0
0.50 0
1.00 1
1.50 2
2.00 3
2.50 4
3.00 5

24
 Supply Curve: Example
Price of
Ice-Cream
Cone

Rs 3.00

2.50

2.00

1.50

1.00

0.50

6 8 10 12 Quantity of
0 1 2 3 4 5 Ice-Cream
Cones
25
Market supply Schedule
Price of Ice-cream Cone
(Rs)
A B Market

0.00 0 + 0 = 0

0.50 0 0 0

1.00 1 0 1

1.50 2 2 4

2.00 3 4 7

2.50 4 6 10

3.00 5 8 13

26
The Determinants of Quantity Supplied

27
Shifts in Supply
P

S2
80
S0
70 S1
60 • •
Price (Rupees)

Supply
decrease
50

40
• •
30
Supply
20 increase

10

Qs
0 100 300 500 700 900

Quantity

28
Market Equilibrium

 Equilibrium refers to a situation in which the price has

reached the level where quantity supplied equals
quantity demanded.

 Equilibrium price & quantity are determined by the

intersection of demand & supply curves
 At the point of intersection, Qd = Qs
 Consumers can purchase all they want & producers
can sell all they want at the “market-clearing” price

29
Equilibrium
Demand Schedule Supply Schedule

At Rs 2.00, the quantity demanded is equal to the quantity

supplied!

30
 The Equilibrium of Supply and Demand
Price of Ice-
Cream Cone

Supply

Equilibrium Equilibrium
Rs 2.00 price

Demand

Equilibrium
quantity

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of Ice-
Cream Cones
31
Equilibrium
 Surplus
When price > equilibrium price, then quantity supplied >
quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby
moving toward equilibrium.
 Shortage
When price < equilibrium price, then quantity demanded >
the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers
chasing too few goods, thereby moving toward
32
equilibrium.
Excess Supply
Price of
Ice-Cream
Cone
Surplus
Supply
2.50

2.00

Demand

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream
Quantity Quantity Cones
Demanded Supplied
33
Excess Demand
Price of
Ice-Cream
Cone

Supply

2.00

1.50

Shortage
Demand

0 1 2 3 4 5 6 7 8 9 10 11 Quantity of
Ice-Cream
Quantity Quantity Cone
Supplied Demanded
34
How an Increase Demand Affects the Equilibrium
Price of
Ice-Cream
Cone 1. Hot weather increases the
demand for ice cream…

Supply
Rs2.50 New equilibrium

Rs 2.00
Initial D2
2. … resulting equilibrium
in a higher
price …

D1

0 1 2 3 4 5 6 7 10 11 Quantity of
Ice-Cream
3. … and a higher quantity Cone
sold.
35
 How a Decrease Demand Affects the
Equilibrium
Price of S2
Ice-Cream
Cone
1. A technical failure reduces the
supply of ice cream…
S1
New
Rs 2.50
equilibrium

Initial
Rs 2.00 equilibrium

2. … resulting
in a higher
price …

Demand

0 1 2 3 4 7 10 11 Quantity of
Ice-Cream
3. … and a lower quantity Cones
sold.
36
 A Shift in Both Supply and Demand
Price of
Large increase
Ice-Cream in demand
Cone
New
S2
equilibrium S1
P2
Small decrease
in supply

P1 Initial equilibrium D2

D1

0 Q1 Q2 Quantity of
Ice-Cream
Cone
37
 A Shift in Both Supply and Demand
Price of Small increase in
Ice-Cream demand
Cone New S2
equilibrium
S1
P2

Large decrease
in supply

P1 Initial
equilibrium

D2

D1

0 Q2 Q1 Quantity of
Ice-Cream
Cone
38
Simultaneous Shifts
 When demand & supply shift simultaneously

 Can predict either the direction in which price changes or

the direction in which quantity changes, but not both

 The change in equilibrium price or quantity is said to be

indeterminate when the direction of change depends on
the relative magnitudes by which demand & supply shift

39
The Linear Demand Function


2-40
Understanding the Linear Demand
Function


2-41
 Demand
The Linear Demand Function in Action

The Linear Demand Function in Action

Inverse Demand Function


2-44
Graphing the Inverse Demand Function in
Action
Price

$2,020

0 6,060 Quantity

2-45
The Linear Supply Function

 Supply
Understanding the Linear Supply Function


2-47
 The Linear Supply Function in Action

 The Linear Supply Function in Action

Inverse Supply Function

 Market Equilibrium II

Elasticity of Demand

 Price Elasticity of Demand

 Income Elasticity of Demand
 Cross Elasticity of demand
Elasticity of Demand

 Elasticity of Demand measures the degree of

responsiveness of the quantity demanded of a
commodity to a given change in any of the
determinants of demand.

 Price elasticity of demand is a measure of how much

the quantity demanded of a good responds to a
change in the price of that good.
Price elasticity of demand

 P & Q are inversely related by the law of demand so

E is always negative. %Q
E 
%P
 The larger the absolute value of E, the more
sensitive buyers are to a change in price
Degree of Price Elasticity of Demand

Inelastic Demand
Quantity demanded does not respond strongly to price changes.
Elastic Demand
Quantity demanded responds strongly to changes in price.
Perfectly Inelastic
Quantity demanded does not respond to price changes.
Perfectly Elastic
Quantity demanded changes infinitely with any change in price.
Unit Elastic
Quantity demanded changes by the same percentage as the price.
Perfectly Elastic & Inelastic Demand

Price Price

Quantity Quantity
Perfectly Elastic Perfectly Inelastic

56
 Inelastic Demand
Price
Demand E<1

5.00

4.00
1. A 25%
increase in
price…

0 90 100 Quantity
2. … Leads to a 10% decrease in quantity demanded.

57
 Unit Elastic Demand
Price E=1
Demand

5.00

4.00
1. A 25%
increase in
price…

0 75 100 Quantity

2. … Leads to a 25% decrease in quantity demanded.

58
 Elastic Demand
Price E>1
Demand

5.00

4.00
1. A 25%
increase in
price…

0 50 100 Quantity

2. … Leads to a 50% decrease in quantity demanded.

59
Measurement of Price Elasticity of Demand
Point Elasticity of Demand
Q
 100
%Q Q Q P
E    
%P P P Q
 100
P

ARC Elasticity of Demand

Q Average P
E 
P Average Q
Determinants of Price Elasticity of Demand

 Nature of Commodity
 Availability and proximity of Substitutes
 Proportion of Income Spent on the Commodity
 Time
 Durability of the Commodity
 Items of addiction
Total Revenue
Price

4.00

P x Q = 400
(revenue)
Demand

0 100 Quantity

62
How Total Revenue Changes When Prices Changes:
Inelastic Demand
Price

3.00

P x Q = 240
(revenue)
1.00
P x Q = 100
(revenue) Demand

0 80 100 Quantity

63
How Total Revenue Changes When Prices Changes:
Elastic Demand
Price
Change in Total Revenue when Price Changes

5.00

4.00

Demand

Revenue = 200

Revenue = 100

0 20 50 Quantity

64
Price Elasticity & Total Revenue

Elastic Unitary elastic Inelastic

%Q%P %Q%P %Q%P
Q-effect dominates No dominant effect P-effect dominates

Price TR falls No change in TR TR rises

rises
Price TR rises No change in TR TR falls
falls

65
Demand & Marginal Revenue

 When inverse demand is linear, P = A + BQ

 Marginal revenue is also linear, intersects the vertical

(price) axis at the same point as demand, & is twice as
steep as demand
MR = A + 2BQ

66
Linear Demand, MR, & Elasticity

67
MR, TR, & Price Elasticity

Marginal Price elasticity of

revenue Total revenue demand

MR > 0 TR increases as Q ElasticElastic(E>

increases 1) (E> 1)

MR = 0 TR is maximized UnitUnit elastic

elastic (E=
1) (E= 1)

MR < 0 TR decreases as Q Inelastic

Inelastic (E<
increases 1) (E< 1)

68
Income Elasticity of Demand

Income elasticity (EM) measures the responsiveness of quantity

demanded to changes in income, holding the price of the good &
all other demand determinants constant.

%Qd Qd M
EM   
%M M Qd

Positive for a normal good

Negative for an inferior good
Zero for a neutral goods
Income Elasticity of Demand

If Em > 1, Luxury good

If Em < 1, Necessity Goods
If Em = 1, Semi Luxury goods
Income Elasticity

 Suppose that the income elasticity of demand for

transportation is estimated to be 1.80. If income is
projected to decrease by 15 percent,
 what is the impact on the demand for
transportation?
 is transportation a normal or inferior good?
Income Elasticity

Cross-Price Elasticity

Cross-Price Elasticity

Cross-Price Elasticity

Elasticities for Linear Demand Functions

Example

Elasticities for Linear Demand Functions

Using Elasticities in Managerial Decision Making

Demand for coffee X as follows:

 QX= 1.5 –3.0PX+ 0.8I+ 2.0PY–0.6PS+ 1.2A
where:
 QX = sales of coffee X, in millions of pounds per year.
 PX = price of coffee X, in dollars per pounds.
 I= personel disposable income, in trillions of dollars per year.
 PY = price of competitive brand of coffee, in dollars per
pounds.
 PS = price of sugar, in dollars per pounds.
 A = advertising expenditures for coffee X, in hundreds of
thousands of dollars per year..
79
Using Elasticities in Managerial Decision Making

 Supposed that, PX= $2, I= $2.5, PY= $1.80, PS= $0.50

and A = $1
We get
 QX= 1.5 –3.0(2) + 0.8(2.5) + 2.0(1.8) –0.6(0.50)+ 1.2(1) = 2
 Thus, the firm would sell 2 million pounds of coffee X

80
Using Elasticities in Managerial Decision Making

 From this info, the firm can find elasticity of demand for
coffee X with respect to its price, income, price of competitive
coffee Y, price of sugar and advertising
 EP= -3(2/2)) = -3
 EI= 0.8(2.5/2) = 1
 EXY= 2(1.8/2) = 1.8
 EXS= -0.6(0.50/2) = -0.15
 EA= 1.2(1/2) = 0.6

81
Using Elasticities in Managerial Decision Making

 To estimate/forecast demand for next year.

 Suppose the firm:
•increase price by 5%.
•increase advertisement by 12%.
•expect personal disposable income rise by 4%
•PY to rise by 7%.
•PS to fall by 8%

82
Using Elasticities in Managerial Decision Making

 Using level of sales (QX) for this year of 2 million pounds, the
firm can determine its sales for next year:
 Q’X= QX+ QX(ΔPX/PX)EP+ QX(ΔI/I)EI+ QX(ΔPY/PY)EXY+
QX(ΔPS/PS)EXS+ QX(ΔA/A)EA
 = 2 + 2(5%)(-3) + 2(4%)(1) + 2(7%)(1.8) + 2(-8%)(-0.15) +
2(12%)(0.6)= 2.2 million pounds.

83
Government Policies That Alter the Private Market
Outcome

 Price controls
Price ceiling: a legal maximum on the price
of a good or service. Example: rent control.
Price floor: a legal minimum on the price of
a good or service. Example: minimum wage.
 Taxes
The govt can make buyers or sellers pay a specific
amount on each unit bought/sold.
The Market for Apartments

Rental P S
price of
apts

$800
Equilibrium
without
price
controls D
Q
300
Quantity of
apartments
How Price Ceilings Affect Market Outcomes

A price ceiling P
above the S
Price
equllibrium price $1000
ceiling
is
not binding – $800
it has no effect
on the market
outcome.
D
Q
300
How Price Ceilings Affect Market Outcomes

The equilibrium P S
price ($800) is
above the ceiling
and therefore
illegal. $800
The ceiling
Price
is a binding $500
ceiling
constraint shortage
on the price, and D
causes Q
250 400
a shortage.
How Price Ceilings Affect Market Outcomes

In the long run, P S

supply and
demand
are more
$800
price-elastic.
So, the shortage Price
$500
is larger. ceiling
shortage
D
Q
150 450
Shortages and Rationing

 With a shortage, sellers must ration the goods among buyers.

 Some rationing mechanisms: (1) long lines
(2) discrimination according to sellers’ biases
 These mechanisms are often unfair, and inefficient: the goods
don’t necessarily go to the buyers who value them most highly.
 In contrast, when prices are not controlled,
the rationing mechanism is efficient (the goods
go to the buyers that value them most highly)
and impersonal (and thus fair?).
The Market for Unskilled Labor

Wage W S
paid to
unskilled
workers
$4
Equilibrium
without
price
controls D
L
500
Quantity of
unskilled workers
How Price Floors Affect Market Outcomes

A price floor W
below the S
equilibrium price
is
not binding – $4
it has no effect
on the market Price
$3
floor
outcome.
D
L
500
How Price Floors Affect Market Outcomes
labor
The eq’m wage ($4) is W surplus S
below the floor and Price
therefore $5
floor
illegal.
The floor $4
is a binding constraint
on the wage,
and causes
a surplus
(i.e., unemployment). D
L
400 550
The Minimum Wage

W unemployment
S
Min.
$5
wage

Min wage laws $4

do not affect
highly skilled
workers.
They do affect D
L
unskilled workers. 400 550
Taxes

 The govt levies taxes on many goods & services to

raise revenue to pay for national defense, public
schools, etc.
 The govt can make buyers or sellers pay the tax.
 The tax can be a percentage of the good’s price, or a
specific amount for each unit sold.
For simplicity, we analyze per-unit taxes only.
Equilibrium without Tax

P
S1

$10.00

D1

Q
500
A Tax on Buyers
A tax on
buyers shifts
Effects of a $1.50 per unit tax
the D curve
P on buyers
down by the
amount of S1
PB = $11.00
the tax. Tax
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers D2
receive falls, Q
430 500
eq’m Q falls.
The Incidence of a Tax

How the burden of a tax is shared among

market participants P
S1
PB = $11.00
Tax
Because
of the tax, $10.00
buyers pay PS = $9.50
$1.00 more,
D1
sellers get
$0.50 less. D2
Q
430 500
A Tax on Sellers
A tax on
sellers shifts Effects of a $1.50 per unit tax on
the S curve P
sellers
S2
up by the
S1
amount of PB = $11.00
Tax
the tax.
$10.00
PS = $9.50
The price
buyers pay
D1
rises, the
price sellers
receive falls, Q
430 500
eq’m Q falls.
The Outcome Is the Same in Both Cases!
The effects on P and Q, and the tax incidence are the
same whether the tax is imposed on buyers or sellers!

What matters P
is this: S1
PB = $11.00
A tax drives Tax
a wedge $10.00
between the PS = $9.50
price buyers
pay and the D1
price sellers
receive. Q
430 500
Elasticity and Tax Incidence
CASE 1: Supply is more elastic than demand
P In this case,
buyers bear
Buyers’ share PB S most of the
of tax burden burden of
Tax
Price if no tax the tax.

Sellers’ share PS
of tax burden
D
Q
Elasticity and Tax Incidence
CASE 2: Demand is more elastic than supply
P In this case,
S
sellers bear
Buyers’ share most of the
of tax burden PB
burden of
Price if no tax the tax.
Tax
Sellers’ share
of tax burden PS
D

Q
Elasticity and Tax Incidence

 If buyers’ price elasticity > sellers’ price elasticity,

buyers can more easily leave the market when the tax
is imposed, so buyers will bear a smaller share of the
burden of the tax than sellers.
 If sellers’ price elasticity > buyers’ price elasticity, the
reverse is true.