Demand and Supply

1.
2.
3.

Demand Schedule and Demand

Curve
Supply Schedule and the Supply
Curve
Elasticity of demand and supply

 Demand

- Total quantity customers are willing

and able to purchase.
A demand function is a behavior function for
consumers.
A supply function is a behavior function for
producers.
We describe market behavior using these two
functions.

Direct Demand and Derived

Demand
Direct

Demand-for consumption goods

Goods and services that satisfy consumer
desires.
Derived Demand-These are sometimes
called intermediate goods.
For example, demand for steel (an
intermediate good) is derived from the
demand for final goods (e.g., automobiles).

 Quantity

Demanded amount of a good

that the consumer is willing to buy and able to
buy at a given price over a period of time.
Law of Demand :All other things remaining
unchanged, the quantity demanded of a good
increases when its price decreases and vice
versa.
This relationship can be shown by a demand
schedule, a demand curve or a demand
function.

Demand Schedule

Demand Schedule
shows the different
quantities of goods that
a consumer is willing to
buy at various prices.
Prices and quantities
normally move in
opposite directions

Prices

Quantity

28

15

12

16

20

 Demand

Curve : A curve showing the

relationship between the price of a good and

the quantity demanded.
price

quantity

 Demand

Function:

demand function is a causal relationship

between a dependent variable (i.e., quantity
demanded) and various independent
variables (i.e., factors which are believed to
influence quantity demanded)
Q = f(P)
Where Q= quantity and P = price of a good.
Example Q = 2 4P

Determinants of Demand
Own

Price
Income of the consumer
Price of other goods- 1. complements
2. substitutes
Tastes and preferences
Expectations of future prices
Advertising
Distribution of income

Types of goods
Complementary

goods are a pair of goods

consumed together. As the price of one goes
up the demand for the other falls.
Example- car and petrol
Substitute goods are alternatives to each
other. As the price of one goes up the
demand for the other also goes up.
Example pepsi and coke

 Normal

goods are those goods whose

demand goes up when the consumers
income increases.
Inferior goods are those goods whose
demand falls when the consumers income
increases.
Example : autotravel, kerosene
Giffen goods are those goods whose demand
moves in same direction as price
Snob or Veblen goods are those goods
whose demand falls when price falls

Shift of the Demand Curve

A

change in demand is reflected by shift of

the Demand curve and is caused by a
change in any of the non price determinants
of demand
price
Here, the curve shifts due to an
increase in income or an
increase in price of a substitute
good etc
qty

change in quantity demanded is however

reflected in a movement along the demand
curve and is called an extension or
contraction in demand.

The movement from A to B is due to the

change in price of the good all other factors
remaining unchanged
A

Supply
The

quantity supplied is the number of units

that sellers want to sell over a specified
period of time at a particular price.
Law of Supply states that all other factors
remaining unchanged the supply of a good
increases as its price increases. This can be
shown by a supply schedule, a supply curve
or a supply function.

Supply schedule
There exists a positive
relation between
quantity and price

price

quantity

10

15

13

25

20

35

Supply Curve:

price

qty

Supply function shows the relation between quantity

and price.
It is a positive relation. Example : q= 4+3p

Determinants Of Supply
Price
Cost

of production
Technological progress
Prices of related outputs
Govt policy
All factors other than price cause a shift of the
supply curve and is called a change in supply

EQUILIBRIUM
Equilibrium

- perfect balance in supply and

demand
Determines market output and price
p
p

s
eqm

dem
q

Market forces drive market to

equilibrium
at

prices < equilibrium level: excess demand

(amount by which quantity demanded
exceeds quantity supplied at the specified
price)
at price > equilibrium level: excess supply
equilibrium price is market clearing price: no
excess demand or excess supply

Equilibrium in a Market
Demand

Price

Supply

800

$3,000

2,900

1,150

$2,500

2,550

1,500

$2,000

2,200

1,850

$1,500

1,850

2,200

$1,000

1,500

2,550

$500

1,150

2,900

$0

Surplus and Shortage

Any price above the equilibrium causes an excess

supply and any price below the equilibrium causes a
shortage.
The market if uncontrolled will automatically arrive at
the equilibrium price at which supply equals
demand.
Any shift in demand and supply curves will result in
a new equilibrium
Comparison of equilibrium is called comparative
-statics

Price Rationing
A

decrease in supply
creates a shortage at
P0. Quantity demanded
is greater than quantity
supplied. Price will
begin to rise.
The lower total supply
is rationed to those
who are willing and
able to pay the higher
price.

Alternative Price- Control

Mechanisms
A price ceiling is a maximum price
that sellers may charge for a good,
usually set by government.
Example: rent control
A price floor is a price above
equilibrium price that the buyers have
to pay.
Example : agricultural support price,
minimum wages

Elasticity
Elasticity:

A measure of the
responsiveness of one variable to changes
in another variable; the percentage change
in one variable that arises due to a given
percentage change in another variable.
By converting each of these changes into
percentages, the elasticity measure does
not depend on the units in which we
measure the variables.

ELASTICITY
Sensitivity of the quantity
demanded to price is
called: price elasticity of
demand:

% change in quantity demanded Q / Q

EP

% change in price
P/P

Arc Elasticity
To get the average elasticity
between two points on a demand
curve we take the average of the two
end points (for both price and
quantity) and use it as the initial
value:
q2-q1/(q2+q1)/2
p2-p1/(p2+p1)/2

Own Price Elasticity of

Demand

Own price elasticity: A measure of the

responsiveness of the quantity demanded of a
good to a change in the price of that good; the
percentage change in quantity demanded
divided by the percentage change in the price
of the good.
Elastic demand: Demand is elastic if the
absolute value of the own price elasticity is
greater than 1.

Types of elasticities
elastic:

the quantity demanded changes more

than in proportion to a change in price

inelastic:

the quantity demanded changes

less than in proportion to a change in price

Elasticity and slope

Price
The demand curve can be a
range of shapes each of which
is associated with a different
relationship between price and
the quantity demanded.

Quantity Demanded

Slope of the Demand Curve

P is the
change in
price. (P<0)
Q is the
change in
quantity.

Price

P
slope
Q

Demand

P
P+ P

P
Q

slope =
P/ Q
Q

Q + Q

Quantity

Elasticity and slope

P
slope
Q
1
Q

slope P
P 1
elasticity
Q slope

 Elastic

demand : Demand is elastic if the

absolute value of own price elasticity is
greater than 1.
Inelastic demand: Demand is inelastic if the
absolute value of the own price elasticity is
less than 1.
Unitary elastic demand: Demand is unitary
elastic if the absolute value of the own price
elasticity is equal to 1.
Perfectly elastic demand : e= infinity
Perfectly inelastic demand : e = 0

Linear Demand Curve:

price
E = infinity

e=lower segment/upper segment

E=1

E=0
Qty

Determinants of Elasticity

Number and closeness of substitutes

the greater the number of substitutes,
the more elastic

The proportion of income taken up by the product the smaller

the proportion the more inelastic

Price of the product- lower the price, lower the elasticity

Luxury or Necessity - for example,

addictive drugs

Time period the longer the time under consideration the more
elastic a good is likely to be

Cross-Price Elasticity
Cross-price

elasticity: A measure of the

responsiveness of the demand for a good to
changes in the price of a related good; the
percentage change in the quantity demanded
of one good divided by the percentage change
in the price of a related good.
The cross-price elasticity is positive whenever
goods are substitutes.
The cross-price elasticity is negative whenever
goods are complements.

Cross-price elasticity of
demand
how quantity of one good
changes as price of
another good increases

%change in quantity demanded

%change in price of another good
Q / Q Q Po
EQ , P o

Po / Po Po Q

Income elasticity of demand

% change in quantity demanded
EI
% change in income
Q / Q Q I

Y / Y Y Q

Income Elasticity
Income

elasticity: A measure of the

responsiveness of the demand for a good to
changes in consumer income; the percentage
change in quantity demanded divided by the
percentage change in income.
The income elasticity is positive whenever the
good is a normal good.
The income elasticity is negative whenever the
good is an inferior good.

Factors affecting Income elasticity:

Nature

of the good:
inferior goods have negative income elasticity
Normal goods have positive income elasticity
Luxury goods have income elasticity greater
than one
Necessary goods have income elasticity less
than one

Advertising Elasticity
The

own advertising elasticity of demand for

good X defines the percentage change in the
consumption of X that results from a given
percentage change in advertising spent on X.

Elasticity and Total Revenue

If

demand is elastic, an increase (decrease)

in price will lead to a decrease (increase) in
total revenue.
If demand is inelastic, an increase (decrease)
in price will lead to an increase (decrease) in
total revenue.
Total revenue is maximized at the point
where demand is unitary elastic.

price

revenue

elasticity

Increases

increases

E< 1

increases

decreases

E>1

decreases

decreases

E<1

decreases

increases

E>1

Increases/
decreases

constant

E=1

MARGINAL REVENUE
TR

= P.Q
MR = P + Q dP/dQ
= P(1 + Q/P. dP/dQ)
= P(1- 1/e)
= AR(1-1/e)
Hence if e=1, MR =0
if e =0 , MR = INFINITY
if e = infinity, MR = AR

MR,AR
E=infinity

E=1

E=0
MR

QTY

Total
revenue

E=1

qty

Tr is
max

Elasticity of Supply

Price Elasticity of Supply:

The responsiveness of supply to changes

in price
If es is inelastic (<1)- it will be difficult for suppliers to react
swiftly to changes in price
If es is elastic(>1) supply can react quickly to changes in
price

%
Quantity Supplied
____________________
es =
% Price

Paradox of the Bumper harvest

When

prices of food crops increase, the

demand does not increase proportionally.
Hence the revenue earned by farmers fall.
The Govt announces a floor price for the
farmers- agricultural price subsidy.
This interference with prices comes at a cost
to the Govt in form of storage costs of Govt
granaries.

Application of elasticity:
Incidence

of taxation: Supply
after tax
supply

pt
p1

e1

tax

eqm

p0

demand