Business Economics - Unit II

551/552MG34 Business Economics
Unit – II : Demand Supply and Market Equilibrium
Demand – Law of Demand – Determinants– Elasticity – Demand Function –

Forecasting- theories of Demand –Supply-Law of Supply – Elasticity of Supply –
Supply Functions-Market Equilibrium-Changes in Market Equilibrium.
Meaning:
o In Economics, use of the word ‘demand’ is made to show the relationship between the prices of a
commodity and the amounts of the commodity which consumers want to purchase at those price.
o Demand is one of the forces determining price.
o The theory of demand is related to the economic activity of a consumer, that is consumption, the
process through which a consumer obtains the goods and services he wants to consume is known as
demand.
Definition of Demand:
Hibdon defines, “Demand means the various quantities of goods that would be purchased per time
period at different prices in a given market.”
Bober defines, “By demand we mean the various quantities of given commodity or service which
consumers would buy in one market in a given period of time at various prices, or at various incomes,
or at various prices of related goods.”
Law of Demand:
The Law of demands states that the demand for a commodity increases when its price decreases
and falls when its price increases or raises, other things remains constant or same.
‘the other things’ includes income, price of the substitutes and complements, taste and preferences
of the consumer etc.
The law of demand can be illustrated more conveniently with the help of a demand schedule and a
demand curve.
Demand Schedule:
Demand schedule is a numeric tabulation showing the quantity that is demanded at selected prices. It
is the way of expressing the relationship between the price of a commodity and quantity demanded.
E.g. A hypothetical demand schedule for tea is given below;
Price per cup of tea (k) No. of cups of tea emanded Symbols representing price-
per consumer per day quantity combination
700 1 I
600 2 J
500 3 K
400 4 L
300 5 M
200 6 N
100 7 O
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o The table shows even alternative prices and the corresponding quantities (number of cups of tea)
demanded per day.
o Each price has a unique quantity demanded associated with it.
o As price per cup of tea decreases, daily demand for tea increases
o This relationship between quantity demanded of a product and its price is the law of demand
Demand Curve:
A demand curve is a graphical representation of the relationship quantity demanded and price. A
normal demand curve slops downwards form left to right. It is known as the negative slope of the
demand curve. Downward slope of a demand curve indicates an inverse relationship between the price
and quantity demanded. It implies that the quantity demanded rises as the price falls.
Price per cup (k)
Y D
7 i
6 j
5 k
4 l
3 m
2 n
0
1 D’
1 2 3 4 5 6 7 8
O X
Why does a demand curve slope downwards?
The negative slope of a demand curve, illustrating the inverse relationship between the price of a
commodity and the quantity demanded. There are two different alternative approaches to this
problems, they are known as;
(i) traditional approach
(ii) Modern approach
(1) Traditional approach:

It is based on the law of diminishing marginal utility. It was propagated by Alfred Marshall. It
states that as a consumer consumes more units of a commodity, it yields him lesser and lesser marginal
utility. That a consumer will continue consuming a commodity until the marginal utility of the
commodity becomes equal to its price that is
MUx = Px
i.e
Marginal Utility Price of
of commodity X = Commodity X
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Marginal utility and price

Y D
M
P
M1
P1
M2
P2
D’
O Q Q1 Q3 X
Quantity of Commodity
Price Quantity demanded
OP OQ
OP1 OQ1
OP2 OQ2
 As at the price OP, the consumer will demand OQ quantity of the commodity
 At the price OP1 ,he will demand OQ1quantity
 At the price OP2, he will demand OQ2 quantity
 Thus at lower price, the consumer demands more of the commodity. This is what the law of
demand states.
 The marginal utility curve itself becomes the demand curve of consumer.
The approach incorporates the following factors:
(i) Change in the number of consumers:

At a lower price, more consumers can afford to buy the commodity and vice-versa
(ii) Diverse use of a commodity:
At a lower price, a commodity can be put to different uses, at a higher price, use of the commodity is
restricted to a few important uses.
(e.g) The electricity can be used for lighting, cooking, heating, cooling, etc. suppose the price of
electricity rises, its consumption will be restricted only for lighting purpose, or cooking as result, the
total consumption of electricity or total demand for electricity will be decreased.
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(2) Modern Approach:

It explains the law of demand in terms of two effects viz
(i) income effect
(ii) substitution effect
(i) Income effect:

This is based on the concept of real income (purchasing power). A fall in the price of a commodity
also implies an increase in real income of the consumer. i.e ability to purchase more quantity of the
same commodity with the same income. Similarly at a higher price consumer’s ability to purchase
commodity falls.
E.g. At a price of K5000 per cassette, you may afford to buy 2 cassettes. But if the price falls to K3000
per cassette, you can buy 3 cassettes, and price of K2500 you can buy 5 cassettes so on.
(ii) Substitution effect:

It is based on the concept of relative prices. A fall in the price of X means, all the other prices and
income levels remaining unchanged, that the prices of all other commodities would have increased in
terms of X. Therefore the consumer is induced to purchase more of X and cut down on the demand for
other commodities.
Determinants of Demand:
1. Non- durable goods:

There are 3 basic factors influencing the demand for Non durable goods.
(a) Disposable income:

This is determined by disposable personal income.
Disposable Income (DI) = Personal income – direct taxes –
other deductions
Disposable income is published by the central statistical organization. It is expressed by DN = f

(Y) , Y means income, other things being equal, the demand for commodity N depends upon the
disposable income of the house hold. DI gives an idea about the purchasing power of house hold.
(b) Price:
It is expressed as DN = f (P) P is price, other things being equal. The demand for commodity N
depends upon its own prices of the related goods i.e complements and substitutes. The demand for a
commodity is inversely related to its own price and the price of its complements. It is positively
related to its substitutes. Price elasticities and cross elasticities of nondurable goods help in their
demand forecasting.
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(c) Population:
It is expressed by DN = f (S), S means size of the population, other thing being equal, the demand
for commodity N depends upon the size of the population and its composition. Population can be
classified on rural and urban ratio, sex ratio, income groups, social status, and literacy. Demand for
nondurable goods influence by all these factors.
2. Durable consumer goods:
In forecasting the demand for Durable consumer goods, we have to study the following factors
about the demand for the goods.
(i) In case of durable consumer goods the consumer can post pone its replacement. He can use the
existing commodity longer buy getting repair to purchase latest model bike it depends upon factors
like social status, prestige of the commodity, income, taste, availability of spares etc. The rate of
replacement depends upon the wear, and tear rate.
(ii) use of consumer durable goods depends upon some other special facilities like electricity
supply for household goods, good roads for cars and bikes.
(iii) The purchase is durable consumer goods is a decision influenced by the family rather than
individual consumer durables are consumed in common by the member of a family.
E.g Television, refrigerator, washing machine, etc. are used common by the household.
The demand forecast of goods commonly used should take into account the number of households
rather than size of population while estimating the number of households, the income of house holds,
and composition of family should be taken into consideration.
(iv) Demand for durable consumer goods is very much influenced by their prices and the credit
facilities available by them. Some times availability of credit facilities, installment payments etc., can
offset the effect of a price increase on the demand.
Elasticity of Demand:
Elasticity of demand is the measure of the degree of change in the amount demanded of the
commodity in response to a given change in price of the commodity, price of some related goods or
change in consumer income.
Elasticity of Demand is 3 types:
1. Price elasticity of demand

2. Income elasticity of demand
3. Cross elasticity of demand
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(1) Price elasticity of demand:
“The elasticity of demand in a market is great or small according as the amount demanded
increases much or little for a given fall in price and diminishes much or little for a given rise in price.”
– Alfred Marshal.
That the price elasticity of demand measures the responsiveness of the quantity demanded of a
commodity to a change in its price. The price elasticity of demand is commonly called the elasticity of
demand. This is because price is the most changeable factor influencing demand.
(or)
Symbolically:
Where, Q = Original quantity demanded, P= Original Price, ∆Q = Change in quantity demanded,

∆P = change in price, EP = Price elasticity coefficient.
E.g. Suppose 10 units of a commodity are demanded at a price of K4 each. If 12 units of the
commodity are demanded at a price of K3 each elasticity of demand for this commodity can be
calculated as
EP = ∆ Q = 12 – 10 = 2, ∆ P = 4-3 = 1
= = 0.8
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Value of Elasticity Co-efficient and their description:

(a) Perfectly elastic demand ( = ∞):
Where no reduction in price is needed to cause an increase in quantity demanded. In this case in
demand curve is horizontal and parallel to the quantity axis.
(b) Absolutely inelastic demand: ( = 0)
Where a change in price however large, causes no change in quantity demanded. In this case
demand curve is vertical and parallel to price axis.
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(c) Unit elasticity of demand: ( = 1)
Where a given proportionate change in price causes an equal proportionate change in quantity
demanded. Here the demand curve takes the form of, whose form is given by PQ= K, a constant.
(d) Relatively elastic demand: ( › 1)

Where a change in price causes a more than proportionate change in quantity demanded. In this
case demand curve is more flatter.
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(e) Relatively inelastic demand: ( ‹1)

Where a change in price causes a less than proportionate change in quantity demanded. In this
case demand curve is steeper.
Factors that influence the price elasticity of demand:
a) Number of close substitutes:

The more substitutes that are available, the greater the price elasticity of demand.
b) Luxury or necessity:
Necessities generally will tend to have inelastic demand while luxuries will tend to have an elastic
demand.
c) Durable or nondurable goods:

In the case of durable goods, replacements takes place before the commodity reaches the end of its
life. People exchange their cars just because of new model is preferred. So consumers can actually
decide just when they want to enter the replacement market. If price rises they can postpone purchase.
Or if price falls, they might purchase earlier than intended.
d) Number of uses which the product has:

The more uses a product has, the more elastic the demand.
e) Percentage of consumer’s budget:

The more expensive a product and the bigger part it plays in the total consumer’s budget, the more
strongly the price changes are going to be felt by the consumer and there will not necessarily be
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inelastic because the frequency of purchase is also to be considered to find the overall part played that
commodity in the total budget.
f) Habit:
Once people form a habit of using a particular commodity, they do not care of price changes over a
certain range. Therefore demand for such commodities becomes inelastic.
g) Time:
Longer the period of time, more elastic is the demand. Shorter the time, less elastic is the
demand.
(2) Income Elasticity of Demand:

Income elasticity of demand means the ratio of the percentage change in the quantity demanded to
the percentage change in income. Income elasticity measures the responsiveness of demand to change
in income. It gives us an idea of the sensitivity of demand for a commodity as consumer’s income
changes.
(or)
Symbolically:
EY =
E.g A household demands 30 liters of milk, when his monthly income is K300, 000. If the house
hold’s income increases to K500, 000 his demand for milk increases to 40 liters, the income elasticity
of demand will be,
EY =
∆Q = 40 – 30 = 10
∆Y = 500, 000 – 300, 000 = 200, 000
EY = = 0.5
Hence the house hold’s demand for milk is income elastic.
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Types of Income Elasticity of Demand:
(a) Positive income elasticity of demand:
When the amount demanded of commodity increases with increases in income and vice-versa, the
income demand curve will be shown as positively sloping from left upwards to the right. In this case
commodity in X axis and income Y axis the commodity is normal.
(b) Zero income elasticity:
When the demand for a commodity for a commodity does not respond to changes in income. It is
said to be completely income inelastic. E.g Salt, post cards etc.
In these case, the income demand curve is shown as a straight line parallel to the vertical axis Y.
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(c) Negative income elasticity:
When the amount demanded of a commodity diminishes with an increase in income of the
consumer, the commodity is said to be an inferior one. (e.g) low quality food grains, soaps, etc.
The income demand curve will be shown as sloping from left downwards to right.
(3) Cross Elasticity of Demand:
The cross elasticity of demand is a measure of the responsiveness of purchases of Y to change in the
price of X. That is a change in the price of one good cause a change in the demand for another good.
(or)
Symbolically:
EC =
For e.g. Suppose the price of coffee rises from K1000 of 250 grams to K1200 per tin. As a result,
consumers’ demand for tea, an immediate substitute, rises from 70 kilos to 100 kilos. The cross
elasticity of demand of tea for coffee is
EC =
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∆Qx = 100 – 70 =30 kilos
∆Py = 1200 – 1000 = k 200
Qx = 70 kg
Py = 1000
EC = = 2.14
Classification of commodities through Cross elasticity:
The Cross elasticity of demand can be used to classify goods into three types;
(1) Substitute goods:

The Cross elasticity of demand for tea and coffee goods is positive, because a rise in the price of
tea will raise the demand of Coffee. The raise in demand for coffee as a result of the rise in the price of
tea will give a positive co-efficient of Cross elasticity.
(2) Independent goods:

Goods as eggs and diesel engines have no price relationships with one another. If eggs price go
cheaper, the demand for diesel engine remains unaffected. The value of Cross elasticity is Zero
therefore called as ‘Independent goods’.
(3) Complementary goods:

Milk and sugar are examples of complementary goods, when price of milk rises; its demand falls
since sugar is used along with milk, so demand for sugar will also fall. The value of cross elasticity in
this case will be negative because the price of milk and the demand for sugar move in opposite
directions.
Types of Demand:
The demand types are as follows;

a) Individual demand and Market demand
b) Autonomous and Derived demand
c) Demand for durable and non durable goods demand
d) Short term and long term demand
a) Individual demand:
The quantity of a commodity which an individual is willing to buy at a particular price at specific
time, his given income, his taste and prices of the other commodities is known as ‘Individual’ demand
for a commodity.
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Market demand: The total quantity which all the consumers of a commodity are willing to buy at a
given price, income, other prices and taste is known as market demand.
b) Autonomous and Derived demand:

Autonomous demand: The demand for a commodity is one that arises independent of the demand
for any other commodity. E.g. demand for a commodity which arises from needs of human, like food,
cloths, shelter,etc.
Derived demand: It is one that is tied to the demand for some ‘parent product’. The demand for a
commodity that arises because of the demand for some other commodity is called derived demand.
E.g. Agricultural tools and implements, cotton, bricks, cement etc.
c) Demand for Durable and Non-durable goods:

Durable goods are those whose total utility is not exhausted by a single use, it can be used
repeatedly or continuously over a period. Durable goods can be consumer goods and producer goods
e.g. furniture, scooter, car, building etc.
The demand for durable goods changes over a relatively longer period. The demand will be
exponentially.
Non-durable goods: the goods which can be used or consumed only once and their total utility is
exhausted in a single use. Eg. Food items, drinks, soaps, fuel etc. The demand for nondurable goods
depends largely on their current prices, consumers income and fashion and is subject to frequent
change where as the demand for the durable is influenced also by their. The demand will be lineally.
d) Short term and long term demand:

Short term demand: It refers to the demand for such goods are demanded over a short period. The
goods like fashion consumer goods, seasonal goods, inferior substitutes during the scarcity of superior
goods, fashion wears etc.
Long term demand: It refers to the demand which exists over long period. The change is
perceptible only after a long period. E.g the change is perceptible only after a long period like
producer goods, consumer goods, durables and nondurable goods. Though their brands or varieties
demand will be short term demand.
Demand Forecasting:
A forecast is merely a prediction concerning the future. Thus a demand forecast is a prediction of
future sales. Demand forecasting is essential for a firm because it must plan its output to meet the
forecasted demand according to the quantities demanded and the time at which these are demanded.
The forecasting demand helps a firm to arrange for the supplies of the necessary inputs without any
wastage of materials and time and also helps a firm to diversify its output to stabilize its income
overtime. Demand forecasting is given great importance in countries like USA and UK because in
these countries firms produce on mass scale and overproduction may land the firms in big losses.
The purpose of demand forecasting differs according to the type of forecasting.
(1) The purpose of the Short term forecasting:

It is difficult to define short run for a firm because its duration may differ according to the nature
of the commodity. For a highly sophisticated automatic plant 3 months time may be considered as
short run, while for another plant duration may extend to 6 months or one year. Time duration may be
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set for demand forecasting depending upon how frequent the fluctuations in demand are, short- term
forecasting can be undertaken by affirm for the following purpose;
(i) Appropriate scheduling of production to avoid problems of over production and under- production.
(ii) Proper management of inventories
(iii) Evolving suitable price strategy to maintain consistent sales
(iv)Formulating a suitable sales strategy in accordance with the changing pattern of demand and extent
of competition among the firms.
(v) Forecasting financial requirements for the short period.
(2) The purpose of long- term forecasting:

The concept of demand forecasting is more relevant to the long-run that the short-run. It is
comparatively easy to forecast the immediate future than to forecast the distant future. Fluctuations of
a larger magnitude may take place in the distant future. In fast developing economy the duration may
go up to 5 or 10 years, while in stagnant economy it may go up to 20 years. More over the time
duration also depends upon the nature of the product for which demand forecasting is to be made. The
purposes are;
(i) Planning for a new project, expansion and modernization of an existing unit, diversification and
technological up gradation.
(ii) Assessing long term financial needs. It takes time to raise financial resources.
(iii) Arranging suitable manpower. It can help a firm to arrange for specialized labour force and
personnel.
(iv)Evolving a suitable strategy for changing pattern of consumption. The emerging pattern of
industrialisation, urbanisation, education, degree of contact with the rest of the world could be closely
studied by a firm for forecasting demand.
Steps involved in Demand forecasting:
Various steps involved in demand forecasting they are;

(1) Setting the objective: Clarity of objective makes the process of demand forecasting easier. The
firm should be clear as to the purpose of demand forecasting. The firm may use demand forecasting
for determining the size of output, fixation of price, inventory control, change in product- mix, up
gradation of technology.
(2) Selection of goods: Categorisation of goods facilitates the selection of approach for demand
forecasting. Two fold classifications of goods may be resorted for forecasting.
(a) Consumer goods and capital goods
(b) Existing goods and new goods.
(3) Selection of method: There are different methods are there the success of particular method
depends upon the are of investigation, time available, resources, availability of data, availability of
trained personnel.
(4) Interpreting the results: This is most important step in demand forecasting. The results of
demand forecasting should be very carefully analysed before any inferences in drawn out of them.
Forecasting is based on a number of assumptions. If these assumption change, as they may due to
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changes in political, economic, social and international factors, the revision of forecast may become
inevitable.
The requirements for demand forecasting:

Demand forecasting can be made merely by guess. It requires through understanding of the current
and future conditions. Such understanding is obtained through market research the requirements are;
(a) Elements relating to consumers:

 total number of consumers
 distribution of consumers / products
 total purchasing power and per capita income / household
 income elasticities
 consumer tastes, social customs etc
 consumer marketing details like when, where, how, how many do they buy
 effects of design, colours, etc on consumers preferences.
(b) Elements concerning the suppliers:

o Current levels of sales
o Current stocks of goods
o Trends in sales and stocks
o Market shares
o Pattern of seasonal fluctuations
o Research and development trends
o Company strength and weakness
o Product life cycle
o New product possibilities
(c) Elements concerning the market:

 The effect of price change i.e price elasticity
 Product characteristics
 Identification of competitive and complementary products.
 Number and nature of competitors
 Forms of market competitions
 General price levels
(d) Other exogenous elements:

 National income, population, education etc
 Government policies
 Taxation levels
 International economic climate etc.
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Demand forecasting methods:
Methods of Demand Forecasting
Survey Methods Statistical Methods
Experts opinion Consumers survey Trend projection Regression Barometric Simultaneous

Survey method method method method method methods
Demand Forecasting
Estimation of demand for a product in a forecast year/ period is termed as Demand forecast.
Demand forecast is a must for a firm operating its business as today's market is competitive,
dynamic and volatile.
Methods of Forecasting
Surveys Technique
• Survey of business executives, plant and equipment, expenditure plans. Basically
compilation of expenditure plans of related industries.
• Survey of plans for inventory changes and sales expectations.
• Survey of consumer expenditure plans.
Opinion Polls
• Consumer survey: In this method the consumers are contacted personally to disclose their
future purchase plans. This could be of two types-Complete enumeration and sample survey.
• Sales force opinion method: In this method people who are closest to the market( sales
peoples) are asked for their opinion on future demand. Then opinion of different people is
compiled to get overall demand forecast.
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• Expert Opinion (Delphi Technique): Opinions of different experts are taken and compiled. If
there are discrepancies between the different viewpoints, successive rounds of iterations are
undertaken taking into account the opinions of other experts, until near consensus emerges
Statistical Methods
Time Series Analysis

Forecasts on the basis of an analysis of historical time series data
Trend Projection Method
Based on the assumption that there is an identifiable trend in the variable to be forecast which
will continue in the future
Time Series data is used to fit a trend line on the variable under forecast either graphically or
by statistical techniques
Y = a + bt; t → time
Forecasting is done by extrapolating the trend line into the future.
Barometric Methods
Leading Indicator Method : correlated with the variable to be forecast. These indicators tend
normally to anticipate turning points in a business cycle.
• Coincident indicators: These are indicators which move in step or coincide with movements
in general economic activity or business cycle.
• Lagging indicator: These are indicators which lag the movements in economic activity or
business cycle.
Regression Method
• Identification of variables which influence the demand for the good whose function is under
estimation.
• Collection of historical data on all relevant variables.
• Choosing an appropriate form of the function.
• Estimation of the function
• Simultaneous Equation Method
• (Econometric Models)
• Econometric forecasting models range from single equation models of the demand that the
firm faces for its product to large multiple equation models describing hundreds of sectors
and industries of the economy. Use estimating equations based on Economic Theory
• Input – Output Forecasting
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• Input output analysis was introduced by Prof. Leontief. With this technique the firm can also
forecast using Input output tables. It shows the use of the output of each industry as input by
other industries and for final consumption. Input and output analysis allow us to trace
through all these inter industry input and outputs flow though out the economy and to
determine the total increase of all the inputs required to meet the increased demand.
Supply
The term supply refers the amount of a goods and services that the producers are willing and able to
offer to the market at various prices during a period of time. The two important points of supply are
mentioned below:
a. Supply refers to the quantity of a commodity offered for sale in the market.
b. Supply is a flow. It is always measured at particular price and at particular point of time.
LAW OF SUPPLY:
Supply has functional relationship with price.
“Other things remaining the same, as the price of a commodity raises its supply are extended, and as
the price falls, its supply contracted.”
The quantity offered for sales varies directly with prices. i.e. the higher the price the larger is the
supply and vice versa.
The supply schedule represents the relationship between prices and the quantities that people are
willing to produce and sell. E.g. the following is the (market) supply schedule of supply.
Price per dozen (K) Quantity supplied (in dozens)

700 43
600 40
500 36
400 31
300 25
200 18
100 10
It shows that price falls supply is contracted (or) amount supplied decreases and as price raises
supply is extended. This is the law of supply. It is represents by following chart,
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In this diagram, quantities supplied are measured along OX, and prices along OY, SS’ is the supply
curve, from any point P on the supply curve, PM is drawn perpendicular to OX and PO’ to OY.
Then at PM (=O’O), PO’ (=OM) quantity will be supplied. Note that supply curve slopes
downwards from right to left, as contrasted with demand curve, which slopes left to right. This
because price rises, supply is extended. If price falls too much, supply is extended. If price falls too
much, supply may dry up altogether. The price below which the seller will refuse to sell is called the
reserve price.
Increase and Decrease in Supply:

Other things are remaining same. Supply is said to increase, when at the same price more is offered
for sale, or the same quantity is offered at a lower price. The supply is said to be decrease, when at
the same price, less is offered for sale or the same quantity is offered at a higher price. This is
illustrated as below;
Suppose SS is the supply curve before the changes. S’S’ shows a decrease in supply because at the
same price PM (=P’M’) less is offered for sale. i.e. OM’ instead of OM.
The S”S” shows an increase in supply because at the same price PM (=P”M”) more is offered for
sale, OM” instead of OM. The student should carefully distinguish between the increase in quantity
supplied (extension of supply) and increase in supply.
Increase in supply means that the whole supply curve has shifted to a new position to the right. It is a
new curve.
Increase in the quantity supplied means that more is being offered at a higher price. The supply
curve is the same; the movement along the same curve simply indicates changes in quantities offered
as a result of a change in price. It does not represent any change in the supply schedule or condition
of supply.
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Supply Function or Factors affecting supply of a commodity
Supply function studies the functional relationship between supply of a commodity and its various
determinants. The supply of a commodity mainly depends on the goal of the firm, price of the
commodity, price of other goods, prices of factors of production used in the production of the
commodity and state of technology. In other words, supply of a commodity is a function of several
factors as expressed in the form of the following equation:
Sx=f(PX,Po,NF,G,PF,T,EX,GP)
Here,
Sx=Supply of Commodity
F=Functional relation
Px=Price of Commodity
Po=price of other goods
NF=Number of firms
G=Goal of the firm
PF=Price of factors of Production
T=technology
Ex=Expected future price
Gp=Government policy
Price of the commodity:

There is a direct relationship between price of a commodity and its quantity supplied. Generally,
higher the price, higher the quantity supplied, and lower the price, lower the quantity supplied.
Prices of other Goods:

The supply of a goods depends upon the prices of other goods. An increase in the prices of other
goods makes them more profitable for the firm. They will increase their supply. On the other hand,
the supply of good, the price of which has not changed, will become relatively less profitable. The
supply of such a good may decrease.
Number of Firms:
Market supply of a commodity also dpends upon number of firm in the market. Increase in the
number of firms implies increase in market supply and conversely, decrease in the number of firms
implies decrease in market supply of a commodity.
Goal of the Firm:
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If the goal of the firm is to maximize profits, more quantity of the commodity will be offered at high
price. On the other hand, if the goal of the firm is to maximize sales or maximize output or
Employment more will be supplied even at the same price.
Price of factors of Production:

Supply of commodity is also affected by the price of factors used for the production of the
commodity. If the factor price dereases, cost of production also reduces, accordingly supply
increases. Conversely, if the factor price increase cost of production also increases and supply tends
to decrease.
Change in Technology:
Change in technology also affects supply of the commodity. Improvement in the technique of
production reduces cost of production. Consequently, profits tend to increase inducing an increase in
supply.
Expected future price:

If the producer expects price of the commodity to rise in the near future, current supply of the
commodity should reduce. If, on the other hand, fall in the price is expected, current supply should
increase.
Government Policy:
‘Taxation and Subsidy’ policy of the government also affects market supply of the commodity.
Increase in taxation tends to reduce the supply, while subsidies tend to induce greater supply of
commodity.
Elasticity of supply
The elasticity of supply is defined as the responsiveness of the quantity supplied of goods to
a change in its price. Elasticity of supply is measured by dividing the percentage change in quantity
supplied of goods with the percentage change in its price.
Types of elasticity of supply:
There are five types of elasticity of supply.

1. Perfectly elastic supply:
The coefficient of elasticity of supply is infinity. (es is ∞). For a small change
or no change in price, there will be infinite amount of supply. (SS1 in diagram)
2. Relatively elastic supply:
The coefficient of elastic supply is greater than 1 (es > 1). Quantity supplied
changes by a larger percentage than price. (SS2 in diagram)
3. Unitary elastic supply:
The coefficient of elastic supply is equal to 1 (es = 1). A change in price will
cause a proportionate change in quantity supplied. (SS3 in diagram)
22
4. Relatively inelastic supply:

The coefficient of elasticity is less than 1 (es < 1). Quantity supplied changes
by a smaller percentage than price. (SS4 in diagram)
5. Perfectly inelastic supply:

The coefficient of elasticity of supply is equal to zero (es =0). A change in price
will not bring about any change in quantity supplied. (SS5 in diagram)
23
Factors affecting Elasticity of Supply
The following are the main factors which affect the elasticity of supply of a commodity:
Nature of the inputs used:

The elasticity of supply depends on the nature of inputs used for the production of commodity. If the
production of a product utilizes factors of production that are commonly used to produce other
products, it will tend to have a more elastic supply. On the other hand, if it uses specified factors of
production suited only for its production, its supply will be relatively inelastic.
Nature Constraints:
The elasticity of supply is also influenced by the natural constraints in the production of a
commodity. If we wish to produce more teak wood, it will take years of plantation before it becomes
usable. Supply of teak wood will therefore be less elastic.
Risk Taking:
The elasticity of supply depends on the willingness of entrepreneurs to take risk. If entrepreneurs are
willing to take risk, the supply will be more elastic. On the other hand if entrepreneurs hesitate to
take risk, the supply will be inelastic.
Nature of the Commodity:
Perishable goods are relatively less elastic in supply than durable goods, because it is difficult to
store the perishables.
Cost of Production:
Elasticity of supply is also influenced by cost of production. If production is subject to law of
increasing costs, then supply of such goods will be elastic.
Time Factor:
Elasticity of supply is also influenced by time factor. Longer the time period, greater will be the
elasticity of supply. On the other hand, shorter the time period, lesser will be the elasticity of supply,
because it is not possible to change the supply of the goods in short period. In analyzing the effect of
time upon the elasticity of supply, economists find it useful to distinguish between:
Very Short period:

In very short period, there is insufficient time to change output, so supply is perfectly inelastic.
24
Short period:
In short period, the plant capacity is fixed but output can be changed by changing the intensity of its
use. Supply is, therefore elastic.
Long period:
In long period, all desired changes including changes in plant capacity can be made, and supply
becomes still more elastic.
Technique of Production:
If the production technique of a commodity is quite complex and needs large stock of capital, then
the supply of that commodity will be less elastic, because production cannot be easily increase. On
the other hand, goods involving simple technique of production will have more elastic supply.
Market Equilibrium
 Market equilibrium occurs where supply = demand. When the market is in equilibrium, there
is no tendency for prices to change. We say the market clearing price has been achieved
 A market occurs where buyers and sellers meet to exchange money for goods.
 The price mechanism refers to how supply and demand interact to set the market price and
amount of goods sold
 At most prices planned demand does not equal planned supply. This is a state of
disequilibrium because there is either a shortage or surplus and firms have an incentive to
change the price.
Market equilibrium
Market equilibrium can be shown using supply and demand diagrams
In the diagram below, the equilibrium price is P1. The equilibrium quantity is Q1.
25
If price is below the equilibrium

 In the above diagram, price (P2) is below the equilibrium. At this price, demand would be
greater than the supply. Therefore there is a shortage of (Q2 – Q1)
 If there is a shortage, firms will put up prices and supply more. As price rises, there will be a
movement along the demand curve and less will be demanded.
 Therefore the price will rise to P1 until there is no shortage and supply = demand.
If price is above the equilibrium
26
 If price was at P2. This is above the equilibrium of P1. At the price of P2, then supply (Q2)
would be greater than demand (Q1) and therefore there is too much supply. There is a
surplus. (Q2-Q1)
 Therefore firms would reduce price and supply less. This would encourage more demand and
therefore the surplus will be eliminated. The new market equilibrium will be at Q3 and P1.
Movements to a new equilibrium
1. Increase in demand
If there was an increase in income the demand curve would shift to the right (D1 to D2). Initially,
there would be a shortage of the good. Therefore the price and quantity supplied will increase
leading to a new equilibrium at Q2, P2.
27
2. Increase in supply
An increase in supply would lead to a lower price and more quantity sold.
28

Business Economics - Unit II

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Business Economics - Unit II

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551/552MG34 Business Economics

Unit – II : Demand Supply and Market Equilibrium

Demand – Law of Demand – Determinants– Elasticity – Demand Function –

(1) Traditional approach:

Marginal utility and price

The approach incorporates the following factors:

(i) Change in the number of consumers:

(ii) Diverse use of a commodity:

(2) Modern Approach:

(i) Income effect:

(ii) Substitution effect:

1. Non- durable goods:

(a) Disposable income:

Disposable income is published by the central statistical organization. It is expressed by DN = f

2. Durable consumer goods:

1. Price elasticity of demand

(1) Price elasticity of demand:

Where, Q = Original quantity demanded, P= Original Price, ∆Q = Change in quantity demanded,

Value of Elasticity Co-efficient and their description:

(b) Absolutely inelastic demand: ( = 0)

(c) Unit elasticity of demand: ( = 1)

(d) Relatively elastic demand: ( › 1)

(e) Relatively inelastic demand: ( ‹1)

Factors that influence the price elasticity of demand:

a) Number of close substitutes:

c) Durable or non- durable goods:

d) Number of uses which the product has:

e) Percentage of consumer’s budget:

(2) Income Elasticity of Demand:

∆Y = 500, 000 – 300, 000 = 200, 000

Hence the house hold’s demand for milk is income elastic.

Types of Income Elasticity of Demand:

(a) Positive income elasticity of demand:

(b) Zero income elasticity:

(c) Negative income elasticity:

(3) Cross Elasticity of Demand:

∆Qx = 100 – 70 =30 kilos

∆Py = 1200 – 1000 = k 200

Classification of commodities through Cross elasticity:

(1) Substitute goods:

(2) Independent goods:

(3) Complementary goods:

The demand types are as follows;

b) Autonomous and Derived demand:

c) Demand for Durable and Non-durable goods:

d) Short term and long term demand:

(1) The purpose of the Short term forecasting:

(2) The purpose of long- term forecasting:

Steps involved in Demand forecasting:

Various steps involved in demand forecasting they are;

The requirements for demand forecasting:

(a) Elements relating to consumers:

(b) Elements concerning the suppliers:

(c) Elements concerning the market:

(d) Other exogenous elements:

Demand forecasting methods:

Methods of Demand Forecasting

Survey Methods Statistical Methods

Experts opinion Consumers survey Trend projection Regression Barometric Simultaneous

• Survey of plans for inventory changes and sales expectations.

• Survey of consumer expenditure plans.

Time Series Analysis

• Collection of historical data on all relevant variables.