Demand Analysis

Demand & Supply Analysis & Market Equilibrium

 Introduction
• It is of vital importance for any firm to have an understanding of the demand for its
products.
• Demand relationships determine revenues and indirectly affect output and costs,
having a fundamental impact on profits.
• An understanding of demand is also relevant for planning purposes, involving
production, transportation, inventory, sales, marketing and finance functions.
• The identification of factors affecting demand and its precise effects is therefore a
core element in managerial economics.

2
 What Is Demand?

• The word demand has a precise meaning in economics. It refers to:

• The willingness and ability of buyers to purchase different quantities of a good.
• At different prices,
• During a specific time period (per day, week, etc.).

3
 Markets and Competition

• A market is a group of buyers and sellers of a particular product.

• A competitive market is one with many buyers and sellers, each has a negligible
effect on price.
• In a perfectly competitive market:
• All goods exactly the same
• Buyers & sellers so numerous that no one can affect market price – each is a “price taker”
• In this chapter, we assume markets are perfectly competitive.

4
 Definition and Representations

• We can understand demand in the form of

• schedules,
• demand curves,
• functions,
• equations.

5
 Definition and Representations

• “A schedule of the quantities of a good that buyers are willing and able
to purchase at each possible price during a period of time, ceteris
paribus. [all other things held constant]”

• Law of demand
• “Other things being equal, the higher the price of the commodity, less
is the quantity demanded and lower the price, more is the quantity
demanded.”

6
 Types of Demand
• Direct / Autonomous Demand
• Demand for goods meant for final consumption
• Ex. TV, Sunglasses, Pizza, Milk
• Derived Demand
• Demand is derived from the demand for final commodity
• Ex. Milk, Cement, Petrol, Paint
• Recurring and Replacement Demand
• Consumer goods and Durables
• Ex. Cigarettes, Tea, Meals, Mobile phones, clothes, light bulbs,
7
 Types of Demand
• Competitive Demand
• Demand for substitutes
• Ex. Pepsi – Coke, Ola – Uber,
• Joint or Complementary Demand
• Two or more goods consumed together
• Ex. Petrol –Two-wheelers, Bread-Butter,
• Composite Demand
• Commodities which have several uses
• Ex. Electricity, Milk, Laptop, 8
 Test Your Knowledge

1) Demand refers to the willingness of buyers to purchase different quantities of a good

at different prices during a specific time period.

What is wrong with the above statement:

A) Instead of “demand”, it should be “quantity demanded”.

B) Instead of “willingness”, it should be “ability”.

C) Demand refers to the willingness and ability of buyers, not just willingness.

D) There is nothing wrong with the statement.

Answer : C 9
 Test Your Knowledge
2) Which of the following is consistent with the law of demand?
A) A decrease in the price of milk causes a decrease in the quantity of milk demanded.
B) An increase in the price of a pizza causes a decrease in the quantity of pizza
demanded.
C) An increase in the price of apples causes an increase in the quantity of apples
demanded.
D) A decrease in the price of juice causes no change in the quantity of juice demanded.

Answer : B
10
 Tables / Schedules, Graphs and Equations
Price Quantity
• Demand schedule: of of coffee
a table that shows the relationship between the coffee demanded
price of a good and the quantity demanded $0.00 16
• Example: 1.00 14
Hiten’s demand for coffee. 2.00 12
3.00 10
 Notice that Hiten’s preferences obey
4.00 8
the Law of Demand.
5.00 6
6.00 4

1
 Tables / Schedules, Graphs and Equations
Price of Price Quantity
Coffee Hiten’s Demand Schedule & Curve of of coffee
$6.00 coffee demanded
$0.00 16
$5.00
1.00 14
$4.00
2.00 12
$3.00 3.00 10
$2.00 4.00 8
5.00 6
$1.00
6.00 4
$0.00
Quantity of
0 5 10 15 Coffee

12
 Market Demand versus Individual Demand
• The quantity demanded in the market is the sum of the quantities demanded by all buyers at
each price.
• Suppose Hiten and Ketan are the only two buyers in the Coffee market. (Qd = quantity
demanded)

Price Hiten’s Qd Ketan’s Qd Market Qd

$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
13
 The Market Demand Curve for Coffee
Qd
P P
(Market)
$6.00
$0.00 24
$5.00 1.00 21
$4.00 2.00 18
$3.00 3.00 15
4.00 12
$2.00
5.00 9
$1.00 6.00 6
$0.00 Q
0 5 10 15 20 25

14
 Why is the Demand Curve Negatively Sloped?

• Substitution Effect
• The first reason is that people substitute lower priced goods for higher priced
goods.
• Two substitutes – Orange juice and Sweet lime juice
• Price of orange juice rises – people shift to Sweet lime juice being relatively
cheaper
• A rise in the price of orange juice leads to a decrease in the quantity demanded of it.
• The second reason for the inverse relationship between price and quantity
demanded has to do with the law of diminishing marginal utility, which states that
for a given time period, the marginal utility gained by consuming successive units
of a good will decline as the amount consumed increases. 15
 Why is the Demand Curve Negatively Sloped?

• Income Effect:
• When Px falls, the consumer can purchase more of commodity x with a given
income.
• A fall in the price of x is equivalent to a rise in real income.
• With this rise in real income, the consumer feels richer and can choose to buy
more of x in which case, the good is normal and the income effect is positive.
• But it is also possible that with a rise in real income the consumer may choose
to buy less of x because one can now shift to superior quality goods.
• In this case, the good x is an 'inferior' good and the income effect is negative.

16
 Tables / Schedules, Graphs and Equations

• Equations are the most useful method of representation for analytical purposes.
• They explicitly show the effects of all the variables affecting quantity
demanded.
• The general form of the demand function in terms of price and quantity
demanded is:
Q = f (P )
• It can be expanded by including any number of variables that might affect
quantity demanded –
Qd = f (PX, I, Pr , P, A);
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 Tables / Schedules, Graphs and Equations
Quantity
In the two-variable case the demand function can be expressed in a linear Price
of coffee
of coffee
form: Qd = a + bP demanded
30 120
The coefficients a and b can be calculated for the demand schedule using 40 100
simultaneous equations and substituting any two pairs of values in the table to 50 80
solve for a and b. 60 60
It is more insightful to calculate the value of b first, using the 70 40
mathematical concept that b represents DQ / DP .
If the first pair of values is taken the
For example, if the first two pairs of values are taken, following expression is obtained: 120
substituting the value of b, to calculate the value of a : = a – 2(30)
b = – 20/ 10 = – 2
Thus a = 180 and the demand
The value of b can be interpreted as a slope coefficient and equation can now be written:
the value of a can be interpreted as an intercept. Q = 180 – 2P

18
 Inverse Demand Function

• In the graphical interpretation of the coefficients, the value of b represents

the slope of the demand curve and a represents the vertical intercept if the
graph is drawn with the Q on the vertical axis
• If we switch the equation around we obtain: P = 90 – 0.5Q
• In this case the value of –0.5 represents the slope of the demand curve and
the value of 90 represents the vertical intercept if the graph is drawn in
the customary way, with P on the vertical axis.
19
 Inverse Demand Function
• Qd = 180 – 2P
• Where Q is the negative function of price q = D(p)
• What is the inverse demand equation?
• 180 – Qd = 2P If an inverse demand function is given as P = 300 - 2Q Where
180 – Qd P is the negative function of quantity (p = d(Q) What is the
=P
2 demand equation?

• 90 – 0.5Qd = P Q = 150 - 0 .5P

• P = 90 – 0.5Qd
This can be applied to a multiple-variable equations; each coefficient of a variable representing the
marginal effect of that variable on quantity demanded. Thus in the equation: Q = a + bP + cY , the value
of c represents the marginal effect of Y (income) on Q.
20
 Test Your Knowledge
3) Each point on the demand curve reflects
• A) the highest price consumers are willing and able to pay for that particular
unit of a good.
• B) the highest price sellers will accept for all units they are producing.
• C) the lowest-cost technology available to produce a good.
• D) all the wants of a given household.

Answer : A

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 Test Your Knowledge

4) Consider the diagram on the right and answer

the following question.
If the price of the good is $1 per unit, what will be
the quantity demanded?
• A) 5
• B) 10
• C) 15
• D) 20
Answer : C
22
 Test Your Knowledge

5) At a price of $4.95, a pulp fiction novel is expected to sell 9,000 copies. If the
novel is offered for sale at a price of $3.95, then the publisher can expect to sell
A) Less than 9,000 copies
B) 9,000 copies
C) More than 9,000 copies
D) It is impossible to predict the effect of a lower price on sales.

Answer : C
23
 Practice Problem
• The demand function for mineral water in the city is
Qd = 400 – 4 P
• Qd = quantity of mineral water (in ‘000 bottles per week)

a) Construct a demand curve assuming price Rs. 10, 12, 15, 20 and 25 per bottle.

b) At what price the demand would be zero?

c) If the producer want to sell 3,80,000 bottles per week, what price should he
charge ?
 Solution

• a)
• P = 10: Qd = 400 - 4 x 10 = 360
• P = 12: Qd = 400 – 4 X 12 = 352
• P = 15: Qd = 400 – 4 X 15 = 340
• P = 20: Qd = 400 – 4 X 20 = 320
• P = 25: Q = 400 – 4 X 25 = 300
 Solution

b) Qd = 400 – 4 P, c) Qd = 400 - 4P
let us put Qd = 0
Let Qd = 380
400 – 4P = 0
4P = 400 380 = 400 – 4 P
P = 400 / 4 = 100 4P = 400 – 380 = 20
P = 20 / 4 = 5
At price Rs 100 per bottle, the To sell 3,80,000 he should
demand will be zero charge Rs 5 per bottle
 Determinants of Demand
• Price of the Product
• Income
• Consumer tastes, preferences, needs, etc.
• Availability and Price of related goods
• substitutes and compliments
• Fashion
• Advertisements
• Population- size, composition, density, and Income distribution,
• Distribution of Income
• Future expectations of consumers
• Government Policy
• Climatic Conditions
27
 Exceptions to the Law of Demand

• Giffen Goods (Inferior Goods)

• Prestige Goods/Articles of Snob Appeal
Also called the Veblen Effect

(named after the American economist Thorstein Veblen)

• Speculation/Future Expectation
• Consumer’s Psychological Bias
• Ignorance on part of consumers
• Emergencies
 Test Your Knowledge

The demand for a good increases when the price of a substitute ________ and also
increases when the price of a complement ________.
A) falls; falls
B) rises; falls
C) rises; rises
D) falls; rises

Answer : B
29
 Two Rules for Movements vs. Shifts

• Change in Quantity Demanded versus Change in Demand

• Rule One
• When an independent variable changes and it appear on the graph, a movement
along the existing curve will occur.

• Rule Two
• When an independent variable changes and that variable does not appear on the
graph, the curve on the graph will shift.
 Two Rules for Movements vs. Shifts

Change in Quantity Demanded

• Movement along the demand curve.
• Caused by a change in the price of the product.
• It is also called expansion and contraction in demand.

31
 Changes in Quantity Demanded
Price of
Cigarettes per
Pack
A tax that raises the price of
cigarettes results in a
B movement along the demand
4.00
curve.

2.00 A

D1

0 Number of Cigarettes
12 20 Smoked per Day
32
 Two Rules for Movements vs. Shifts

Change in Demand
• A shift in the demand curve, either to the left or right.
• Caused by a change in a determinant other than the price.
• It is also called increase or decrease in demand.
 Demand Curve Shifters: Income

Demand for a normal good is positively

Inferior Good Normal Good related to income.
P
$6.00 Increase in income causes increase in quantity
demanded at each price, shifts D curve to the
$5.00 right.

$4.00
Demand for an inferior good is negatively
$3.00 related to income.

$2.00 An increase in income shifts D curves for

inferior goods to the left.
$1.00
$0.00 Q
0 5 10 15 20 25 30 34
 Variable A change in this variable…
Summary: Variables That Influence Buyers
Price …causes a movement
along the D curve
# of buyers …shifts the D curve

Income …shifts the D curve

Price of related goods …shifts the D curve

Taste …shifts the D curve

Expectations …shifts the D curve

35
 Supply

• Just as the word demand has a specific meaning in economics, so does

the word supply.
• Supply refers to –
• the willingness and ability of sellers to produce and offer to sell different
quantities of a good

• at different prices
• during a specific time period (per day, week, etc.).

36
 The Law of Supply

• The law of supply states that “as the price of a good rises, the quantity
supplied of the good rises, and as the price of a good falls, the quantity
supplied of the good falls, ceteris paribus.”
• Simply put, the price of a good and the quantity supplied of the good
are directly related, ceteris paribus.
• The (upward-sloping) supply curve is the graphical representation of
the law of supply
37
 The Supply Schedule

Price Quantity
• Supply schedule: of of coffee
A table that shows the relationship between coffee supplied
the price of a good and the quantity supplied. $0.00 0
1.00 3
• Example:
2.00 6
Starbucks’ supply of coffee.
3.00 9
4.00 12
 Notice that Starbucks’ supply schedule obeys the
Law of Supply. 5.00 15
6.00 18

38
 Starbucks’ Supply Schedule & Curve

Price Quantity
P of of coffees
$6.00 coffee supplied
$0.00 0
$5.00
1.00 3
$4.00
2.00 6
$3.00 3.00 9
$2.00 4.00 12

$1.00 5.00 15
6.00 18
$0.00 Q
0 5 10 15

39
 Market Supply versus Individual Supply
• The quantity supplied in the market is the sum of the quantities supplied by all sellers at each
price.
• Suppose Starbucks and CCD the only two sellers in this market. (Qs = quantity supplied)

Price Starbucks CCD Market Qs

$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
40
 The Market Supply Curve
P QS (Market)
P
$6.00 $0.00 0
1.00 5
$5.00
2.00 10
$4.00
3.00 15
$3.00 4.00 20
$2.00 5.00 25
6.00 30
$1.00
$0.00 Q
0 5 10 15 20 25 30 35 43
 Supply Function
• The supply function can be expressed as :
Sx = f(Px, Pr, C, T, G, N)
• Px, = price of the product
• Pr = price of related goods
• C, = cost of production
• T, = state of technology
• G, = government policies
• N = number of firms
• Holding other factors constant, supply function can be expressed
Sx =as:
f(P)
• The supply function can be expressed in a linear form:
Qs = c + dP
44
 Change in Quantity Supplied

• A change in the price of the good causes a change in the “quantity

supplied.”

• It signify a “movement on the supply function,” and not a “shift of the

supply function.”
 Change in Quantity Supplied
Price of Ice-
Cream Cone S

C
$3.00 A rise in the price of
ice cream cones
results in a
movement along the
supply curve.
A
1.00

Quantity of
0 1 5 Ice-Cream
Cones
 “Change in Supply”

• A change in supply is “caused” by a change in any variable, other than

price, that influences supply.
• A change in supply can be represented by a shift of the supply function on
a graph.
 Change in Supply
S3
Price of Ice-
Cream Cone S1
S2

Decrease in
Supply

Increase in
Supply

Quantity of
0 Ice-Cream
Cones
 Determinants of Supply

• The factors that can change supply include:

• Price
• Prices of relevant resources
• Technology
• Prices of other goods
• Number of sellers
• Expectations of future price
• Taxes and subsidies and
• Government restrictions
 Test Your Knowledge

11) At a price of $299.95, the manufacturer of a portable gas-powered generator is

willing to produce 19,000 units per quarter. At a price of $349.95, it is likely that the
manufacturer will be willing to produce
A) Less than 19,000 units per quarter.
B) 19,000 units per quarter.
C) More than 19,000 units per quarter.
D) It is impossible to predict the effect of a higher price on the number of units of a
product that a firm will be willing to produce.

Answer: B

50
 Test Your Knowledge

13) Unionized workers may be able to negotiate with management for higher
wages during periods of economic prosperity. Suppose that workers at automobile
assembly plants successfully negotiate a significant increase in their wage package.
How would the new wage contract be likely to affect the market supply of new
cars?
A) Supply will shift to the right.
B) Supply will shift to the left.
C) Supply will not shift, but the quantity of cars produced per month will decrease.
D) Supply will not shift, but the quantity of cars produced per month will increase.

Answer: B
51
 Change in Quantity Supplied versus Change in Supply

Va ri a b le s t h a t
Affe c t Qu a n t i t y A Ch a n g e in Th i s Va ri a b le . . .
S u p p li e d
P r ice Repr esen t s a m ovem en t a lon g t h e
su pply cu r ve
In pu t pr ices Sh ift s t h e su pply cu r ve
Tech n ology Sh ift s t h e su pply cu r ve
E xpect a t ion s Sh ift s t h e su pply cu r ve
N u m ber of seller s Sh ift s t h e su pply cu r ve

52
 Market Equilibrium

• A state of rest or balance due to the equal action of opposing forces.

• In a market an equilibrium is said to exist when the forces of supply
[sellers] and demand [buyers] are in balance: the actions of sellers and
buyers are coordinated.

• The quantity supplied equals the quantity demanded!

53
Price of Ice-
Equilibrium of Supply and Demand
Cream Cone
Supply
$3.00

2.50 Equilibrium

2.00

1.50

1.00

0.50 Demand
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
Price of Ice-
Cream Cone
Excess Supply Supply
$3.00 Surplus

2.50

2.00

1.50

1.00

0.50 Demand
Quantity of
0 1 2 3 4 5 6 7 8 9 10 11 12 Ice-Cream
Cones
 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 12 13 Quantity of
Ice-Cream Cones
 Three Steps To Analyzing Changes in Equilibrium

• Decide whether the event shifts the supply or demand curve (or both).
• Decide whether the curve(s) shift(s) to the left or to the right.
• Examine how the shift affects equilibrium price and quantity.
 Shortage
An increase in demand causes equilibrium prices and qty to rise
Price of
Ice-Cream Supply
Cone

P2

P1
Shortage D2

D1

0 Q1 Q2 Quantity of
Ice-Cream Cones
 Surplus
A decrease in demand causes equilibrium price and quantity to fall
Price of
Ice-Cream Supply
Cone

Surplus
P1

P2
D1

D2

Q2 Q1 Quantity of
Ice-Cream Cones
 Surplus
An increase in supply causes equilibrium price to fall and quantity to rise
S1
Price of Ice-
Cream Cone S2
Surplus

P1

P2

Demand

Quantity of
Q1 Q2 Ice-Cream
Cones
 Shortage
A decrease in supply causes equilibrium price to rise and quantity to fall
S2
Price of Ice-
Cream Cone
S1

Shortage
P2

P1

Demand

Quantity of
Q2 Q1 Ice-Cream
Cones
How an Increase in Demand Affects the Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

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

D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
 How a Decrease in Supply Affects the Equilibrium

Price of
Ice-Cream 1. An earthquake reduces
Cone S2 the supply of ice cream...

S1

New
$2.50 equilibrium
2.00 Initial equilibrium
2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
3. ...and a lower Ice-Cream Cones
quantity sold.
 Illustration

• Demand for wrist watches by Beyond Time Ltd. for the year 2012 was given by
• Qd = 1000 – P and
• supply is given by : Qs = 100 +4P
• What is the equilibrium price?
• What is the excess demand or supply if the price is:
• a) Rs 500
• b) Rs100
64
 Solution
• At equilibrium quantity Qd = quantity supplied Qs
• Therefore, 1000 – P = 100 + 4P
• 5P = 1000 – 100
• P = 180
• A) when price is Rs 500
• Qd = 1000 – 500 = 500,
• Qs = 100 + 4(500) = 2100
• Therefore, excess supply = 2100 – 500 = 1600
• B) when price is Rs 100
• Qd = 1000 – 100 = 900
• Qs = 100 + 4(100) = 500 65

• Excess demand is 900 – 500 = 400

 Illustration

• Demand for X is given as

• Dx = 1500 – 10Px + 4Y – 15Py
• Where Y = consumers income, and
• Py is the price of related goods
• Find demand equation for X in terms of price of X (Px) when Y is Rs
500 and Py is Rs 60.

• Supply function is given by the equation –

• Sx = 800 + 2Px
• Find equilibrium price and quantity.
66
 Solution
• Demand function by substituting the values of Y and Py
• Dx = 1500 – 10Px + 4Y – 15Py
• 1500 – 10Px + 4 (500) – 15 (60) = 2600 – 10Px
• Given the supply function:
• Sx = 800 + 2Px equilibrium will occur when Dx = Sx
• 2600 – 10Px = 800 + 2Px
• 12Px = 2600 – 800
• Px = 150
• Equilibrium quantity is Dx = 2600 – 10Px
• 2600 – 10 (150)
• Dx = 1100
67
 Test Your Knowledge

• 15) If a rise in supply exceeds a rise in demand, then we should expect

• a. the equilibrium price and quantity levels will rise.
• b. the equilibrium price will rise while the equilibrium quantity will decline.
• c. The equilibrium price will fall while the equilibrium quantity will rise.
• d. the equilibrium price and quantity levels will decline.

Answer : C
68
 Test Your Knowledge

• 16) In which instance will both the equilibrium price and quantity rise?
• a. When demand and supply increase, but the rise in demand exceeds the rise in
supply.
• b. When demand and supply increase, but the rise in supply exceeds the rise in
demand.
• c. When demand and supply decline, but decline in the demand exceeds the
decline in supply.
• d. When demand and supply decline, but the decline in supply exceeds decline in
the demand.

Answer : A 69