Chapter 3

Demand and Supply

Analysis
 Lecture Plan
 Objectives
 Demand
 Types of demand
 Determinants of demand
 Demand function
 Law of demand
 Demand schedule and individual demand curve
 Change in demand
 Exceptions to the law of demand
 Market demand
 Supply
 Supply schedule and supply curve
 Change in supply
 Market equilibrium
 Determination of market equilibrium
 Changes in market equilibrium
 Chapter Objectives

 To introduce the basics of demand and supply and

their relevance in economic decision making.
 To analyze the different determinants of demand and
supply and their effects on demand and supply curves.
 To help develop an understanding of demand and
supply functions in determining market equilibrium.
 To introduce the concepts of market equilibrium and
disequilibrium.
 Demand
 The process to satisfy human wants/ needs/desires.
 Want: having a strong desire for something
 Need: lack of means of subsistence
 Desire: an aspiration to acquire something

 Demand: effective desire

 Demand is that desire which backed by willingness and ability to
buy a particular commodity.
 Amount of the commodity which consumers are willing to buy
per unit of time, at that price.
 Things necessary for demand:
 Time
 Price of the commodity
 Amount (or quantity) of the commodity consumers are willing
to purchase at the price
 Types of Demand

 Direct and Derived Demand

 Direct demand is for the goods as they are such as Consumer
goods
 Derived demand is for the goods which are demanded to
produce some other commodities; e.g. Capital goods
 Recurring and Replacement Demand
 Recurring demand is for goods which are consumed at frequent
intervals such as food items, clothes.
 Durables are purchased to be used for a long period of time
 Wear and tear over time needs replacement
 Complementary and Competing Demand
 Some goods are jointly demanded hence are complementary in
nature, e.g. software and hardware, car and petrol.
 Some goods compete with each other for demand because
they are substitutes to each other, e.g. soft drinks and juices.
 Determinants of Demand
 Price of the product
 Single most important determinant
 Negative effect on demand
 Higher the price-lower the demand

 Income of the consumer

 Normal goods: demand increases with increase in consumer’s
income
 Inferior goods: demand falls as income rises
 Price of related goods
 Substitutes
 If the price of a commodity increases, demand for its

substitute rises.
 Complements
 If the price of a commodity increases, quantity demanded of

its complement falls.

 Determinants of Demand
Contd…

 Tastes and preferences

 Very significant in case of consumer goods
 Expectation of future price changes
 Gives rise to tendency of hoarding of durable
goods
 Population
 Size, composition and distribution of
population will influence demand
 Advertising
 Very important in case of competitive markets
 Demand Function

 Interdependence between demand for a product and its

determinants can be shown in a mathematical functional
form
 Dx = f(Px, Y, Py, T, A, N)
 Independent variables: Px, Y, Py, T, A, N
 Dependent variable: Dx
 Px: Price of x
 Y: Income of consumer
 Py: Price of other commodity
 T: Taste and preference of consumer
 A: Advertisement
 N: Macro variable like inflation, population growth, economic
growth
 Law of Demand
 A special case of demand function which shows relation between
price and demand of the commodity
Dx = f(Px)
 Other things remaining constant, when the price of a commodity
rises, the demand for that commodity falls or when the price of a
commodity falls, the demand for that commodity rises.
 Price bears a negative relationship with demand
 Reasons
 Substitution Effect : When the price of a commodity falls (rises), its
substitutes become more (less) expensive assuming their price has
not changed.
 Income Effect: When the price of a particular commodity falls, the
consumer’s real income rises, hence the purchasing power of the
individual rises.
 Law of Diminishing Marginal Utility: as a person consumes
successive units of a commodity, the utility derived from every next
unit (marginal unit) falls.
 Demand Schedule and Individual
Demand Curve

Point on e
Demand Demand 35
Curve Price (Rs (‘000 d

Price of Coffee
per cup) cups)
30
a 15 50 c
b 20 40 25
b
c 25 30 20
d 30 20 a
15
e 35 10
O
10 20 30 40 50
Quantity of coffee
 Change in Demand

 Shift in demand curve from D0 to D1

Price
D1  More is demanded at same
D0 price (Q1>Q)
D2  Increase in demand caused by:
 A rise in the price of a
substitute
 A fall in the price of a
complement
P  A rise in income
 A redistribution of income
towards those who favour the
commodity
 A change in tastes that favours
0 the commodity
Q2 Q Q1 Quantity  Shift in demand curve from D0 to D2
 Less is demanded at each price
(Q2<Q)
 Exceptions to the Law of Demand
Law of demand may not operate due to the following
reasons:
 Giffen Goods
 Snob Appeal
 Demonstration Effect
 Bandwagon effect
 Future Expectation of Prices (Panic buying)
 Addiction
 Neutral goods
 Life saving drugs
 Salt
 Amount of income spent
 Match box
 Market Demand

 Market: interaction between sellers and buyers of a

good (or service) at a mutually agreed upon price.
 Market demand
 Aggregate of individual demands for a commodity at a
particular price per unit of time.
 Sum total of the quantities of a commodity that all
buyers in the market are willing to buy at a given price
and at a particular point of time (ceteris paribus)
 Market demand curve: horizontal summation of
individual demand curves
 Supply

 Indicates the quantities of a good or service that the

seller is willing and able to provide at a price, at a given
point of time, other things remaining the same.
 Supply of a product X (Sx) depends upon:
 Price of the product (Px)
 Cost of production (C)
 State of technology (T)
 Government policy regarding taxes and subsidies (G)
 Other factors like number of firms (N)

 Hence the supply function is given as:

Sx = (Px, C, T, G, N)
 Law of Supply
 Law of Supply states that other things remaining the same, the
higher the price of a commodity the greater is the quantity supplied.
 Price of the product is revenue to the supplier; therefore higher price
means greater revenue to the supplier and hence greater is the
incentive to supply.
 Supply bears a positive relation to the price of the commodity.

Supply Schedule Supply Curve

Point on Price Supply (‘000 35

Price of Coffee
Supply (Rs. Per cups per e
Curve cup) month) 30
a 15 10 25 d
c
b 20 20 20
b
c 25 30 15 a
d 30 45
e 35 60 0
10 20 30 40 50 60
Quantity of Coffee
 Change in Supply

 Shift in the supply curve from

S0 to S1
Price S2  More is supplied at each
S0 price (Q1>Q0)
S1
 Increase in supply caused by:
 Improvements in the
technology
 Fall in the price of inputs
P  Shift in the supply curve from
S0 to S2
 Less is supplied at each
price (Q2<Q0)
 Decrease in supply caused by:
O  A rise in the price of inputs
Q2 Q0 Q1 Quantity
 Change in government
policy (VAT)
 Market Equilibrium
 Equilibrium occurs at the price where the quantity demanded and
the quantity supplied are equal to each other.
 At point E demand is equal to supply hence 25 is equilibrium price

Price Demand
Supply (‘000 cups/
Price (‘000 cups/ month)
S (Rs) month)

15 10 50

E 20 15 40
25
25 30 30
30 45 15

D 35 70 10
O 30 Quantity
 Market Equilibrium
 For prices below the equilibrium, Quantity demanded exceeds
quantity supplied (D>S)
 Price pulled upward
 For prices above the equilibrium, Quantity demanded is less than
quantity supplied (D<S)
 Price pulled downward.
 At point E demand is equal to supply hence 25 is equilibrium price.

Price
S Supply Demand
Price (‘000 cups/ (‘000 cups/
30 (Rs) month) month)
E 15 10 50
25
20 15 40
20
25 30 30
30 45 15
D
35 70 10
O
30 Quantity
 Changes in Market Equilibrium
(Shifts in Supply Curve)
 The original point of equilibrium is
at E, the point of intersection of
curves D1 and S1, at price P and
quantity Q Price
S0
 An increase in supply shifts the
D1 S1
supply curve to S2
 Price falls to P2 and quantity rises E0 S2
P0
to Q2, taking the new equilibrium to E
E2 P
S0
E2
P2
 A decrease in supply shifts the
S1
supply curve to S0. Price rises to S2 D1
P0 and quantity falls to Q0 taking
O
the new equilibrium to E0 Q0 Q Q2 Quantity
 Thus an increase in supply raises
quantity but lowers price, while a
decrease in supply lowers quantity
but raises price; demand being
unchanged
 Changes in Market Equilibrium
(Shifts in Demand Curve)

 The original point of equilibrium is at

E, the point of intersection of curves
Price D1 and S1, at price P and quantity Q
 An increase in demand shifts the
D2
demand curve to D2
S1
D1  Price rises to P1 and quantity rises to
D0 Q1 taking the new equilibrium to E1
E1  A decrease in demand shifts the
P1
E demand curve to D0
P
E2  Price falls to P* and quantity falls to
P*
D2 Q* taking the new equilibrium to E2.
 Thus, an increase in demand
S1 D0 D1
raises both price and quantity, while
O a decrease in demand lowers both
Q* Q Q1
Quantity price and quantity; when supply
remains same.
 Change in Both Demand and Supply
 Initial equilibrium is at E 1, with price
quantity combination (P1, Q1).
D2  An increase in both demand and
Price D2
supply takes place;
D1
S1  demand curve shifts to the right

S2 from D1 D1 to D2 D2
 supply curve also shifts to the right
from S1 S1 to S2 S2.
P2 E2
P1  The new equilibrium is at E , and
E1 E0 2
price quantity is (P2, Q2).
 An increase in both supply and
S1 D demand will cause the sales to rise,
S2 D2 2
D1 but
O  the price will increase if increase
Q1 Q2 Quantity in D>S (as at E2 )
 No change in price if increase in
D=increase in S (as at E0 )
 Summary
 Demand is defined as the desire to acquire a commodity to satisfy
human wants, which is backed by ability to pay the price.
 Categories of demand are made on the basis of the nature of
commodity demanded (consumer goods and capital goods); time unit
for which it is demanded (short run and long run); relation between two
goods (substitutes and complements), etc.
 The law of demand states that the consumers will buy more of the
commodity when prices are high and less when prices are low,
provided all the other factors of demand remains constant.
 Demand for a product X (Dx) is a function of price of the commodity X
(Px), income of the consumer (Y), price of related (substitutes or
complements) commodities (Po), tastes and preference of the
consumer (T), advertising (A), future expectations (E f), population and
economic growth (N).
 A change in quantity demanded denotes movements along the
demand curve due to a change in price, while a change in demand
denotes a rightwards or leftward shift of the demand curve due to a
change in the other determinants of demand other than price.
 Summary
 Supply is defined as the willingness to produce and sell the commodity by
production units or firms.
 The law of supply states that firms will sell more of the commodity when
prices are high and less of the commodity when prices are low provided all
the other factors of supply remains constant.
 Supply of a product X (Sx) is a function of price of the product (Px), cost of
production (C), state of technology (T), Government policy regarding taxes
and subsidies (G), other factors like number of firms (N).
 Change in quantity supplied refers to movements along the same supply
curve due to change in the price of the commodity. However when change in
supply is associated with change in the factors like costs of production,
technology, etc. it causes a shift of the supply curve upwards or downwards
 Market equilibrium occurs where demand and supply are equal. This
equilibrium determines the price in the market through the forces of demand
and supply. Comparative statics is the process of comparison between two
equilibrium situations.
 An increase in both supply and demand will cause the sales to rise, but the
effect on price can be positive, negative or equal to zero, depending on the
extent of the shifts in the demand and supply curves.