Demand And Supply Analysis

Demand Analysis
Demand

Desire + ability to pay + willingness to pay

Determinants of Demand

 Price
 Income
 Prices of related goods
 Taste and preferences
 Customs and traditions
 Government policy
 Advertising
 Seasons/Climate
 Population
 Location
 Service
 Quality
 Law of Demand
• A decrease in the price of a good, all other
things held constant, will cause an increase in
the quantity demanded of the good and an
increase in the price of a good will cause a
decrease in the quantity demanded of the
good.
Change in Quantity Demanded

Price
An increase in price
causes a decrease in
quantity demanded.
P1

P0

Quantity
Q1 Q0
Change in Quantity Demanded

Price
A decrease in price
causes an increase in
quantity demanded.

P0

P1

Quantity
Q0 Q1
 Increase in Demand

An increase in demand
Price
refers to a rightward shift
in the market demand
curve.

P0

Quantity
Q0 Q1
 Decrease in Demand

A decrease in demand
Price
refers to a leftward shift
in the market demand
curve.

P0

Quantity
Q1 Q0
Why demand curve slopes downwards
• Law of diminishing marginal utility
• Income effect
• Substitution effect
 Exception to the law of demand
• Network Externalities
 Bandwagon effect
 Snob effect

• Giffen Goods
• Buyers illusions
• Brand loyalty
• Monopoly
• Speculation
• Caterpillar Tractor, one of the largest producers of
farm machinery in the world, has hired you to
advise it on pricing policy. One of the things the
company would like to know is how much a 5 %
increase in price likely to reduces sales. What would
you need to know to help the company with this
problem? Why these facts are important?
• Ans. the elasticity of demand to determine the
percentage decrease in sales, and you would also
need to know the initial quantity sold to determine
the lower level of sales.
Suppose that a study has found that the price
elasticity of demand for flyover rides is 0.7 in
Bangalore Electronic city to Silk Board junction.
The company wants to cut the operating deficit
of the Elevated Highway System. Should the
manager contemplate increasing or decreasing
the price of a flyover ride?
• You run a small business and would like to
predict what will happen to the quantity
demanded for your product if you raise your
price. While you do not know the exact
demand curve for your product, you do know
that in the first year you charged $45 and
sold 1200 units and that in the second year
you charged $30 and sold 2500 units.
 Elasticity
• Elasticity is a measure of responsiveness of
one variable to another variable.
• Can involve any two variables.
• An elastic relationship is responsive.
• An inelastic relationship is unresponsive.
 Types of Elasticity of demand
• Price Elasticity of demand
• Income elasticity of demand
• Cross Elasticity of demand
• Promotional Elasticity of demand
 Price elasticity:

• p=%Q/%P
• An elastic response is one where numerator is greater
than denominator.
i.e., %Q>%P so Ep 

• An inelastic response is one where numerator is smaller

than denominator.
i.e., %Q<%P so Ep 
 Look at the Extremes
•Perfectly Elastic D •Perfectly Inelastic D
Ep infinite
P P
D
Ep 0
D

Q
Q
Relatively Elastic vs. Inelastic Demand
Curves

P
D’ is relatively more elastic
than D

P1

P2
D’
D
Q
Q1 Q2 Q 2’
 Point Elasticity Formula
• Price (Rs.)
•Point elasticity
– Point elasticity is
responsiveness at a point
along the demand function
Ep Q/Q1 P1
P/P1
D
simplifying:
Q
Ep Q/P)* P1 /Q1 Q1
 Point Elasticity Formula
• Price (Rs.)
•Point elasticity
– Point elasticity is
responsiveness at a point
along the demand
function
P1
Ep Q/Q1
P/P1 D
simplifying: Q
Q1
Ep Q/P)* P1 /Q1
 Example: Q=56-0.002*P
•Point elasticity • Price (Rs)
Ep Q/P)* P1 /Q1

•Suppose P=17000
•Q=56-0.002*17000
•Q=56-34=22 17k
•Plug into equation gives:
Ep -0.002)* 17000 /22
D
Ep =-34/22=-1.54 Q
22
Arc Elasticity
• The end-point problem – the
percentage change differs depending
on whether you view the change as a
rise or a decline in price.
 Arc Elasticity Formula

•Arc elasticity: Price ($)

Responsiveness along a range of D.
function

Ep Q/((Q1+ Q2)/2) Avg.

P2 responsiveness
P/((P1+ P2)/2)
P1
D
simplifying:
Q
EpQ/P)*((P1+P2)/(Q1+Q2)) Q2 Q1
 Example Q=56-0.002*P
•Arc elasticity Price ($)
Ep Q/P)*((P1+P2)/(Q1+Q2))
•Look at P range 16k - 17k
•Q=56-0.002*17000
•Q=56-34=22
•Plug into equation gives: 17k
Ep -0.002)*(33000/46) 16k
Ep =-66/46=-1.43 D

22 24 Q
 Factors determining the price
elasticity of demand:
• The number of close substitutes for a good:
• The more close substitutes in the market, the more elastic is demand
because consumers can easily switch their demand if the price of one
product changes relative to others.

• The strength of the brand loyalty to a product

• Products which have strong consumer brand loyalty often have relatively
inelastic demand, consumers are prepared to accept price increases
because of other attractive features of the brand which mean they will
stay loyal.

• The cost of switching between products

• There may be significant costs involved in switching between products. In
this case, demand tends to be relatively inelastic.
• The degree of necessity or whether the good is a luxury
• Goods and services deemed by consumers to be necessities tend to have
an inelastic demand whereas luxuries tend to have a more elastic demand.
• The time period allowed following a price change
• Demand tends to be more price elastic, the longer that we allow
consumers to respond to a price change.
• Whether the good is subject to habitual consumption
• When this occurs, the consumer becomes less sensitive to the price of the
good in question because their default position is to buy the same
products at regular intervals.
• Peak and Off-peak demand
• Demand tends to be price inelastic at peak times and more elastic at off-
peak times.
 Factors influence Price elasticity of
demand
• Nature of commodity
• Availability of substitute
• Multiplicity of uses
• Habit
• Proportion of income spent
• Price range
• Complementary products
 Managerial Applications of Price elasticity
of demand
• Pricing Decision
• Taxation
• Labor market
• International trade
 The Farmer’s Dilemma

For many crops, a strange situation

arises a bad crop year results in a good
year for farm incomes, and a good crop
year results in a bad year for farm
incomes.
How can this happen to farm community?
• Price elasticity gives us the answer:

– Bad crop year: supply decreases, prices for farm products rise,
but quantity demanded doesn’t fall very much. The quantity
demanded of farm products is not very responsive to changes
in prices
– Good crop year: supply increases, prices for farm products
fall, but quantity demanded doesn’t increase very much. The
quantity demanded of farm products is not very responsive to
changes in prices

• It is easy to show this with a graph. But first we need yet another
concept: Total Revenue = Price x Quantity
 Elasticity and Total Revenue
• TR = P x Q
• If P goes down Q goes up, but what happens
to TR?
• If P goes up Q goes down, but what happens
to TR?
• Elasticity can answer the question….
 The Farm Example
• During bad crop years, prices rise and quantity
falls (but not that much) so total revenue to
farmers goes up.
• During good crop years, prices fall and
quantity increases (but not that much) so total
revenue to farmers goes down.
• The graphs….
An Increase in Supply in the Market for Wheat

Price of
Wheat 1. When demand is inelastic,
2. . . . leads an increase in supply . . .
to a large fall S1
in price . . . S2

$3

Demand

0 100 110 Quantity of

Wheat
3. . . . and a proportionately smaller
increase in quantity sold. As a result,
revenue falls from $300 to $220.
Copyright©2003 Southwestern/Thomson Learning
 Income Elasticity of Demand

EI = %  Qd / %  Id

Measures the sensitivity of DEMAND to changes

in disposable income.
 Engel Curve:
An Engel curve describes how household
expenditure on a particular good or service
varies with household income. ... They are
named after the German statistician Ernst
Engel (1821–1896), who was the first to
investigate this relationship between goods
expenditure and income systematically in
1857.
 Engel Curve: Normal Good
Disposable
Income

Engel Curve for a

Normal Good
EI > 0

Qd/ut
 Luxury Goods
Luxury Goods are Normal Goods but they have
an

EI >= 1
Quantity demanded is very senstive to changes
in disposable income
 “Necessities”
“Necessities” are Normal Goods but

0 < EI < 1
Quantity demand is not very sensitive to
changes in disposable income
 Engel Curve: Inferior Good
Disposable
Income
Engel Curve for an
Inferior Good
EI < 0

Qd/ut
• Normal Goods (EI >0)
– Luxury Goods (EI >= 1)
– Necessitites (0 < EI < 1)

• Inferior Goods (EI < 0)

 Cross-Price Elasticity
Measures how sensitive DEMAND for a
commodity is to changes in the price of a
substitute or complement commodity
 Cross-Price Elasticity

Ecp of x,y =

%  Q x / %  Py
 Cross-Price Elasticity

Ecp > 0  Substitute

Ecp < 0  Complement

Ecp = 0  Independent
 Promotion or Advertising elasticity
of demand

Rate of change in demand for a commodity

due to a change in promotion expenditure
 Demand forecasting

It is an objective assessment or estimation of

future course of demand
- Micro level
- Industry level
- Macro level
 OBJECTIVES OF SHORT TERM DEMAND
FORECASTING

• Production planning
• Evolving sales policy
• Fixing sales targets
• Determining price policy
• Inventory control
• Short term financial planning
 OBJECTIVES OF LONG-TERM DEMAND
FORECASTING
• Business planning

• Manpower planning

• Long-term financial planning

 Methods of forecasting
• Consumers interview
• Sales force polling
• Experts opinion
• Delphi
• End- use
• Market Experimentation
• Trend projection
• Regression
• Supply
Supply Shifters
•Price
•Input Price
•Technology
•Government regulations
and taxes
•Number of firms
•Availability of raw-
materials
 The Supply Function
• An equation representing the supply curve:
QxS = f(Px , PR ,W, H,)

– QxS = quantity supplied of good X.

– Px = price of good X.
– PR = price of a related good
– W = price of inputs (e.g., wages)
– H = other variable affecting supply
 Law of Supply

A decrease in the price of a good, all other

things held constant, will cause a decrease in
the quantity supplied of the good and an
increase in the price of a good will cause an
increase in the quantity supplied of the good.
Change in Quantity Supplied

A decrease in price
Price causes a decrease in
quantity supplied.

P0

P1

Quantity
Q1 Q0
Change in Quantity Supplied

An increase in price
Price causes an increase in
quantity supplied.

P1

P0

Quantity
Q0 Q1
 Change in Supply
An increase in supply
refers to a rightward shift
Price in the market supply curve.

P0

Quantity
Q0 Q1
 Change in Supply
A decrease in supply refers
to a leftward shift in the
Price market supply curve.

P0

Q1 Q0 Quantity
 Market Equilibrium
•Balancing supply and demand
– QxS = Qxd
•Steady-state
Equilibrium Price and quantity

Price S

8 Quantity
Price
If price is too low...
S

7
6
5

Shortage D
12 - 6 = 6
6 12 Quantity
 If price is too high…
Surplus
Price 14 - 6 = 8
S
9
8
7

6 8 14 Quantity
 Increases in Demand and Supply

•Higher demand leads to higher •Higher supply leads to lower

equilibrium price and higher equilibrium price and higher
equilibrium quantity. equilibrium quantity.
Decreases in Demand and Supply

•Lower demand leads to lower •Lower supply leads to higher

price and lower quantity price and lower quantity
exchanged. exchanged.
Relative Magnitudes of Change

• The relative magnitudes of change in supply and demand determine the

outcome of market equilibrium.
Relative Magnitudes of Change

• When supply and demand both increase, quantity will increase, but
price may go up or down.
 2-66
Price Restrictions

Price Ceilings
–The maximum legal price that can be charged.
Floor Price (MSP)
–The minimum legal price that can be charged.
 2-67

Impact of a Price Ceiling

Price S

PF

P*

P Ceiling

Shortage D

Qs Qd Quantity
Q*
• The Municipal Corporation of a small college town decides to
regulate rents in order to reduce student living expenses.
Suppose the average annual market-clearing rent for a two
bedroom apartment had been $700 per month, and rents
were expected to increase to $900 within a year. The
Municipal Corporation limits rents to their current $700-per-
month level. Draw a supply and demand graph to illustrate
what will happen to the rental price of an apartment after the
imposition of rent controls. Do you think this policy will benefit
students? Why or why not?
 2-69

Impact of a Price Ceiling

Price S

$1000

$900

$700

Shortage D

50 100 175 Quantity

 2-70

Impact of a Price Floor

Price Surplus
S
PF

P*

Qd Q* QS Quantity
 2-71

Impact of a Price Floor

Price Surplus
S
31

27

34 42 67 Quantity
The demand and supply functions for pulses are
Qd =15– P and Qs= 4+ P respectively.
The Government announces a support price of Rs.6 per
Kg of pulses and would like to release pulses to the
market only through Food Corporation of India (FCI).
Accordingly FCI procures the pulses and off loads the
same at a price that clears the procured stock.
Assuming support price equals to procurement cost.
What is the total loss incurred by FCI?
• Demand and supply functions for a product
are:
• Qd = 10,000 – 4P
• Qs = 2,000 + 6P
• If the government imposes a Excise duty of
Rs.100 per unit, what will be the new
equilibrium price?