Demand and Supply Notes

Theory of Demand and Supply

Introduction

• Economics analysis is incomplete without understanding demand and supply.
• Demand analysis is crucial for business decision-making.
• Demand determines the size and pattern of the market.
• Firm's profit is influenced by demand and supply conditions of its output and input.
• Demand is the foundation of all economic activities, impacting production planning, sales, profit targeting, pricing policies, inventory management, and marketing strategies.

Concept of Demand

• Demand is a technical economic concept broader than desire or want.
• It includes five elements:
  • Desire to acquire a product.
  • Ability to pay for it (purchasing power).
  • Willingness to spend on it.
  • Given/particular price.
  • Given/particular time period.

Characteristics of Demand

• Effective desire/want.
• Related to a specific price.
• Related to a specific time period.

What is Demand

• Definition: willingness and ability of consumers to purchase a quantity of a good or service at a given price and time.
• Expresses the relationship between the price of a good and the quantity demanded.
• Quantity demanded: the quantity people will actually buy.
• Demand can be for an individual, household, group, or the total market demand.

Relationship between Demand and Price

• Generally, the relationship is negative (inverse).
  • Quantity demanded decreases when the price increases.
  • Quantity demanded increases when the price decreases.
• This is known as the Law of Demand.

What is Law of Demand

• The law of demand states an inverse relationship between price and quantity demanded; as price increases, quantity demanded decreases, and vice versa.
• Assumptions:
  • Money income of consumer remains the same.
  • No change in consumer preferences (taste, habit, & fashion).
  • No change in the price of substitute goods.
  • No expectation of price changes in the near future.

Exception to the Law of Demand

• Situations where consumers buy more at a higher price and less at a lower price.
• Giffen goods (Inferior goods): non-luxury items with higher demand when prices rise (e.g., rice, wheat).
• Veblen goods (Luxury goods): consumption increases as price increases (e.g., diamonds).
• Consumer psychological bias: Perception that high-priced goods are better quality and low-priced goods are inferior.
• The law does not apply to life-saving essentials or during extraordinary circumstances like inflation, deflation, war, and natural calamities.

Demand schedule and Demand curve

Demand Schedule

• A tabular statement showing the quantities of a commodity bought at different prices during a specified time.
• Individual Demand Schedule (IDS): for an individual.
• Market Demand Schedule (MDS): for the whole market.
• Example (Tea):

Demand Curve

• A graphical representation of the relationship between the price of a good or service and the quantity demanded over a period of time.
• Price on the vertical axis, quantity demanded on the horizontal axis.
• Can be linear or non-linear, depending on the demand function.
• Most demand curves slope downward to the right.

Why there is a downward sloping demand curve?

• Due to the inverse relationship between the price of a commodity and its quantity demanded.

Reasons for downward Sloping

• Substitution effect: As the price falls, that commodity becomes relatively cheaper than its substitutes, increasing demand.
• Income effect: Lower prices increase real income, leading to increased demand.
• Falling prices attract new consumers, making the commodity affordable.
• Consumers start using the commodity in less important uses as the price falls, increasing demand due to varied uses.

Determinant of market demand

• Price of good or service: demand tend to fall and vice-versa
• Consumer preferences: these preferences can change rapidly in response to advertising, fashions and customs
• Income: Demand is also affected by the amount of income that consumer have available to spend
• Price of other goods: the demand for a good is often influenced by changes in the price of other goods. The nature of the impact depends on whether the goods are substitutes or complements.
• Taste, preference and habits of consumers may also have decisive influence on the pattern of demand
• Advertisement has great influence on demand. It is in observed fact that sales turnover of firms increases up to a point due to advertisement – this is promotional effect on demand
• Climate also influences the demand for different goods. For instance, the demand for coolers and A.C. increases in summers, while their demand declines in winters
• The number and composition (age, sex etc.) of population also influence the demand for goods.
• Government policy on taxes and subsidies also influences the demand of different goods differently.
• For instance, increase in tax rates / imposition of new taxes reduce the demand, while increase in subsidies increase the demand

Types of Demand

Price Demand

• Indicates the ‘price effect’ – the impact of price changes on quantity demanded, assuming other factors are constant.
• Functional relationship: Dx=f(Px)

Income Demand

• Shows the ‘income effect’ – the impact of changes in consumer income on demand, other things being constant.
• Functional relationship: Dx=f(y)

From an income demand perspective, goods can be classified into two categories:

• Superior good: In case of such goods income effect is positive as demand for them increases with increase in income of the consumer and vice-versa. Luxury cars, sailing Yacht , bespoke tailoring, designer brand shoes ,clothes e.t.c
• Inferior good : The demand for such goods declines with increase in the income of the consumer and vice- versa. The income effect is negative in case of such goods. low-quality clothing, boxed and canned food and no-name brands of staple products.

Cross Demand

• The demand is influenced by the price of related goods (cross effect).
• Depends on the nature of related goods:
  • Cross demand for substitute E.g. Tea & coffee, pepsi and coca- cola Substitute effect is always positive

Cross demand for complementary goods

• Those goods which are used together for satisfying a particular want are known as complementary goods. For instance, tea, sugar and milk or pen and ink etc.
• The complementary effect is negative as the price of one good increases, the demand for other good decreases and vice-versa.

Change in quantity demanded vs Change in demand

Change in Quantity demanded

• Relates to the law of demand, referring to ‘extension’ or ‘contraction’ of demand.
• Graphically depicted by movement along the same demand curve.
• Downward movement = extension of demand (more quantity demanded at a lower price).
• Upward movement = contraction of demand (less quantity demanded at a higher price).

Change in Demand

• Related to ‘increase’ or ‘decrease’ in demand.
• Caused by changes in non-price factors (income, taste & preference, price of related goods, etc.).
• Income demand and cross demand represent changes in demand.
• Graphically depicted by shifting of the demand curve.
• Rightward shift = increase in demand.
• Leftward shift = decrease in demand.

Elasticity of Demand

• Law of demand describes the qualitative aspect regarding the inverse relationship between price and demand and elasticity of demand describe the quantitative aspect regarding the inverse relationship

• relationship between price and quantity demanded for a product

• A manager needs an exact measure of this relationship for appropriate business decisions

• Elasticity of demand is a measure, which comes to the rescue of a manager here. It measures the responsiveness of demand to changes in prices as well as changes in income.

• Elasticity of demand, refers to the degree in the change in demand when there is a change in another economic factor, such as price or income.

• Elasticity of Demand = %change in demand/%change in the price of a commodity

Classification of Demand

• Demand can be elastic, inelastic, or unitary.
  • Elastic demand: large change in quantity demanded due to a change in price.
  • Inelastic demand: small change in quantity demanded due to a change in price.
• The formula used here for computing elasticity of demand is: \frac{Q2-Q1}{P2-P1} * \frac{P1}{Q1}
• If the |formula| > 1, the demand is elastic (quantity changes faster than price).
• If the |formula| < 1, demand is inelastic (quantity changes slower than price).
• If the |formula| = 1, elasticity of demand is unitary (quantity changes at the same rate as price).
• Elastic goods: luxury items, certain foods, and beverages.
• Inelastic goods: tobacco, prescription drugs.

Price elasticity

• A price change can either increase or decrease total revenue depending in the nature of the demand function

• Pricing involves so many uncertainty

• The uncertainty involved in pricing decision could be reduced if manager had a method of measuring the probable effect of price changes on total revenue

• One such measure is Price elasticity which is defined as the percentage change in quantity demand, divided by the percentage change in price

• EP=\frac{\%\Delta Q}{\% \Delta P}

• EP indicate the % change in quantity demanded for a 1 % change in price

• ILLUSTRATION:

• Find elasticity of demand given that when the price of a commodity is Tsh 4, and the quantity demanded is 10 units, and when the price increases to Tshs 8, quantity demanded decreases to 8 units.
  Also try if quantity changed from 2 units to 8 units, and price changed Tshs 4 to 2 shs.

• Perfectly elastic demand, Price elasticity is said to be perfectly elastic if demand changes while price remains constant.

• Perfectly inelastic demand Price elasticity of demand is said to be perfectly inelastic when quantity demanded remains the same when price changes.

Determinants of Price Elasticity

• Availability of substitutes: More substitutes lead to higher price elasticity.
• Proportion of income spent: Smaller proportion leads to inelastic demand (e.g., salt).
• Time period: Demand is more elastic in the long run.

Price elasticity and Decision making

• Information about price elasticities can be extremely useful to managers as they contemplate pricing decision
• If the demand is inelastic at the current price, a price decrease will result in a decrease in total revenue
• On other hand reducing the price of the product with elastic demand would cause revenues to increase
• If demand is unitary elastic price change will not change total revenue

Income elasticities

• Income elasticities are used to measure the responsiveness of demand to change in income
• Income elasticity of a goods or services is the % change in quantity demanded associated with a 1% change in income
• EI= \frac{\%\Delta Q}{\% \Delta I}
• Income elasticity can be expressed in either arc or point terms. Arc income elasticity is used when relatively large changes in income are being considered and is defined as:
• Ei= \frac{Q2-Q1}{I2-I1} × \frac{I2+I1}{Q2+Q1}

Normal goods and services have positive income elasticities, luxury goods are goods and services for which
EI> 1 ❑This means that the change in demand is proportionately greater than the change in income. As individual become wealthier, they have more disposable income. Thus purchase of necklaces, rings, and fine watches tend to represent a large share of their income

Income elasticity and decision making

• During periods of expansion, income are rising and firms selling luxury goods, the demand for their product will increase at a rate that is faster than the rate of income growth
• During recession, demand may decrease rapidly, conversely seller of necessities such fuel and basic good items will not benefit much during periods of economic prosperity
• Knowledge of income elasticities can be useful in targeting market efforts

Cross elasticity

• Cross elasticity measure the responsiveness of quantity demanded to changes in price of other goods
• Cross elasticity is defined as the percentage change in quantity demanded of one good caused by a 1% change in the price of some other goods
• Ec= \frac{\%\Delta QX}{\% \Delta PY}
• The arc elasticity is computed as:
  • Ec = \frac{Qx2-Qx1}{Py2-Py1} × \frac{Py2+Py1}{Qx2+Qx1}

Uses

Classify the relationship between goods:

• If Ec> 0, 𝑎𝑛 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒 in the price of Y causes an increase in the quantity demanded of X and the two products are said to be substitute, e,g cola and pepsi
• When Ec< 0, the goods or services involved are classified as complement( goods that are used together).
  Increase in the price of Y reduce the quantity demanded of that product X. Example bread and butter, cars and tires, computers and computer software

Formula for Income elasticity

The formula used here for computing elasticity of demand is:
(Q2-Q1)/(Y2-Y1) *(Y1/Q1)
ILLUSTRATION:
If an increase in the income from Tshs 200 to Tsh 400 made a customer to buy two bottles of soda instead of one that he used to buy before, the income elasticity of demand will be?

Formula for cross elasticity illustration

Calculate cross elasticity of demand given the following information, when the Price of Tea is Tshs 4 the demand of coffee is 10 units,when the price of tea increases to Tshs 8 the demand for coffee increases to 200.
SOLN:

SUPPLY

• Supply refers to the quantity of a commodity which producers or sellers are willing to produce and offer for sale at a particular price’, in a given market, at a particular period of time

• The three important aspects of supply are…

  • Supply is a desired quantity
  • Supply is always explained with reference to price
  • Time during which it is offered for sale

Supply Schedule and Supply Curve

• Supply schedule shows a tabular representation of law of supply. It presents the different quantities of a product that a seller is willing to sell at different price levels of that product.
• The graphical representation of supply schedule is called supply curve.
• Supply Schedule and Supply Curve are of two types
• Individual Supply Schedule & Individual Supply Curve
• Market Supply Schedule & Market Supply Curve

Supply Function or Determinants of Supply

• Supply function studies the functional relationship between supply of a commodity and its various determinants

• Sx = f ( PX, PR, NF, G, PF, T, EX, GP)

  • Where,
    • Sx = Supply of a Commodity
    • PX = Price of the Commodity
    • PR = Price of the Related 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. When price increases, supply also increases because it motivate the firm to supply more in order to get more profit. When price decreases, smaller quantity will be supplied as profit decreases

• Price of Related Goods

  • Producers always have the tendency of shifting from the production of one commodity to another commodity. If the prices of another commodity increases, especially substitute goods, producers will find it more profitable to produce that commodity by reducing the production of the existing commodity.

• Number of Firms

  • Increase in the number of firms implies increase in the market supply, and decrease in the number of firms implies decrease in the market supply of a commodity.

• Goal of the Firm

  • If goal of the firm is to maximise profits, more quantity of the commodity will be offered at a higher price. On the other hand, if goal of the firm is to maximise sale more will be supplied even at the same price.

• Price of the Factor of Production

  • If the factor price decreases, cost of production also reduces. Accordingly, more of the commodity is supplied at its existing price. Conversely, if the factor price increases cost of production also increases. In such a situation less of the commodity is supplied at its existing price.

• Change in Technology

  • Improvement in the technique of production reduce cost of production. Consequently, more of the commodity is supplied at its existing price.

• Expected Future Price

  • If the producer expects price of the commodity to rise in the near future, current supply of the commodity will reduce. If, on the other hand, fall in the price is expected, current supply will increase.

• Government Policy

  • Increase in taxation tends to reduce supply. On the other hand, subsidies tend to increase supply of the commodity

Law of Supply

• ‘Law of supply states that other things remaining the castant, the quantity of any commodity that firms will produce and offer for sale rises with rise in price and falls with fall in price.’
• i.e. Higher the price, higher will be quantity supplied and lower the price smaller will be quantity supplied.
• ‘Other things remaining the same’ means determinants other than own price such as technology, goals of the firm, government policy, price of related goods etc. should not change.

Relationship between Supply and Price

• It shows positive relationship between price of the commodity and its quantity supplied.
• As price rises quantity supplied also rises.

Assumptions of the Law of Supply

• There is no change in the prices of the factors of production.
• There is no change in the technique of production.
• There is no change in the goal of firm.
• There is no change in the prices of related goods.
• Producers do not expect change in the price of the commodity in the near future.

Exceptions to the Law of Supply

• The law of supply does not apply strictly to agricultural products whose supply is governed by natural factors.
• If due to natural calamities, there is fall in the production of wheat, then its supply will not increase, however high the price may be.
• Supply of goods having social distinction will remain limited even if their price tends to rise.
• Seller may be willing to sell more units of a perishable commodity at a lower price.

Why Does Supply Curve Slope Upwards?

Supply Curve Slopes upward from left to right.

• The level of price determines profit. i.e. higher the price, higher the profit and vice versa. So higher the price, the greater is the incentive for the producer to produce and supply more in the market, other things remain the same.
• Positive slope of supply curve is also caused by the rise in the cost of production. Usually cost of production increases with increase in production. In this situation a producer will produce and sell more units only at a higher price.
• The rise in price also motivates other producers to produce this commodity so as to earn higher profit.

Change in Quantity Supplied

• Change in quantity Supplied( Movement along Supply curve)
• Increase in quantity supplied of a commodity due to rise in its price is called Extension of Supply and decrease in quantity supplied due to fall in its price is called Contraction of Supply

Change in Supply

• Change in Supply( Shift in Supply curve)
• Increase in Supply occurs when more is supplied at the existing price, while decrease in supply occurs when less is supplied at the existing price. While increase in supply cause a forward shift in supply curve, decrease in supply cause a backward shift in supply curve.

Elasticity of Supply

• The law of supply indicates the direction of change—if price goes up, supply will increase. But how much supply will rise in response to an increase in price cannot be known from the law of supply.

• To quantify such change we require the concept of elasticity of supply that measures the extent of quantities supplied in response to a change in price.

• Elasticity of supply measures the degree of responsiveness of quantity supplied to a change in own price of the commodity. It is also defined as the percentage change in quantity supplied divided by percentage change in price.

• It can be calculated by using the following formula: \frac{\% change in quantity supplied}{\% change in price}

• Symbolically, ES = \frac{\Delta Q}{\Delta P} × \frac{P}{Q}

• Elastic supply happens when a percentage change in price brings a larger proportion change in quantity supplied.(pe is greater than 1)

• Inelastic supply happens when a percentage change in price brings a smaller percentage change in quantity supplied.e.g agricultural products.

• Its greater than zero and less than one.
  Unitary Elastic supply happens when a proportional change in price brings an equal proportionate change in quantity supplied.(pe is equal to 1)

Factors Affecting Elasticity of Supply

• Nature of the Inputs Used: If factors of production are commonly used, commodity supply will be elastic. If specialized factors are used, supply will be less elastic.
• Natural Constraints: Supply elasticity is influenced by natural constraints. (e.g., Teak wood).
• Risk Taking: Supply elasticity depends on the willingness of entrepreneurs to take risks. If they are willing, the supply will be more elastic.
• Nature of the commodity: Perishable goods are relatively less elastic in supply than durable goods.
• Time Factor: Longer the time period, greater will be the elasticity of supply.

How demand and supply determine market price

• Price is dependent on the interaction between demand and supply components of a market.
• Demand and supply represent the willingness of consumers and producers to engage in buying and selling.
• An exchange of a product takes place when buyers and sellers can agree upon a price.

Equilibrium price

• When a product exchange occurs, the agreed upon price is called an equilibrium price, or a market clearing price. Graphically, this price occurs at the intersection of demand and supply

• A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller

• If the price is above the equilibrium price,

  • quantity supplied > quantity demanded
  • excess supply.
  • Sellers cannot sell as much as they want,

• so they will tend to offer buyers a lower price.Therefore, the price will tend to move downwards towards the equilibrium price

• If the price is below the equilibrium price,

  • quantity demanded > quantity supplied
  • excess demand,
  • buyers will not be able to buy all they want to buy,

• Problem example: Qd = 20 - 2P and Qs = 5 + 3P, then what is equilibrium price? what is equilibrium quantity?

QUESTION

• With the help of illustrations describe the concept of price ceiling and Price floor.