Demand and Supply Analysis

Objectives

After studying this unit, you will be able to:

  • Distinguish between want and demand.
  • Explain the law of demand with the help of a demand schedule and a demand curve.
  • Identify the movement along a demand curve and a shift of the demand curve.
  • State the concept of supply and its determinants.
  • Discuss the concept of elasticity of demand and supply and various methods of their measurement.
  • Explain the importance and determinants of elasticity of demand and supply.

Introduction

Satisfaction of human needs is the basic end and goal of all production activities in an economy. Human wants are unlimited and recurring, while the means to satisfy them are limited. A rational consumer must make optimal use of available resources. Demand and supply analysis provides a framework for these decisions. This unit discusses various issues related to the theory of demand and supply analysis.

The Nature of Demand

  • Desire: A wish to possess a commodity.
  • Want: Desire backed by purchasing power and willingness to buy.
  • Demand: Wish to get a definite quantity of a commodity at a given price, backed by sufficient purchasing power.

Key points about quantity demanded:

  1. It is the quantity desired to be purchased (desired purchase), not necessarily the actual purchase.
  2. It is a flow measured over a period of time (e.g., 10 oranges per day).
  3. It has economic meaning only at a given price (e.g., demand for 10 oranges per week at Rs. 100 per dozen).

Determinants of Demand

The demand for a product is determined by numerous factors:

Determinants of Demand by a Consumer

  1. Price of the commodity in question
  2. Prices of other related commodities
  3. Income of the consumers
  4. Taste of the consumers

Demand function: Dx = f(Px, Py, Pz, M, T)

  • Dx: quantity demanded of X commodity
  • Px: price of X commodity
  • Py: price of substitute commodity
  • Pz: price of a complement good
  • M: income
  • T: taste of the consumer

Usually, only one factor is allowed to change at a time, assuming all other factors remain constant (ceteris paribus).

Demand Relationship:

  1. Price of the commodity: Higher price, lower demand (Law of Demand).
  2. Size of the consumer’s income:
    • Normal good: Increase in income leads to an increase in quantity demanded.
    • Inferior good: Increase in income leads to a fall in quantity demanded.
  3. Prices of other commodities:
    • Complementary goods: Consumed along with the commodity in question (inverse relationship).
    • Substitutes: Used in place of the commodity in question (direct relationship).
    • Example: Tea and coffee are substitutes; a car and petrol are complementary goods.
  4. Tastes of consumer: Preference for a commodity leads to higher demand; changes in taste affect demand. Seasons also play a role (e.g., cold drinks in summer, warm drinks in winter).

Determinants of Market Demand

In addition to the factors determining individual consumer demand, two additional factors influence market demand:

  1. Size of the population: Larger population, more demand.
  2. Income distribution:
    • Larger income share to the rich increases demand for luxury goods.
    • Larger income share to the poor increases demand for wage goods.

A correct specification of the demand equation is essential for accurate predictions.

The Law of Demand

The inverse relationship between the quantity of a commodity and its price, given all other factors, is the Law of Demand. This results in a demand curve that slopes downwards to the right.

The Demand Schedule

A table that records quantities demanded at different prices.

Example Demand Schedule:

Price of Apple per Kg (in Rs.)Quantity Demanded of Apples (in Kg. per week)
10015
20012
3008
4003

As the price of apples rises, the quantity demanded falls.

The Demand Curve

Graphically shows the relationship between the quantity of a good consumers are willing to buy and the price of the good.

The demand curve slopes downward from left to right. It can be a straight line or a curve. The shape depends on how much quantity demanded changes with price changes.

Market demand curve is a horizontal summation of individual demand curves.

Why does a Demand Curve Slope Downwards?

  1. Substitution Effect: Change in the relative price of a commodity. If Coke's price rises relative to Pepsi, demand for Coke decreases.
  2. Income Effect: Change in the purchasing power of money income. If the price of mangoes falls, purchasing power rises, and more mangoes can be bought.
    • Normal good: Positive income effect (direct relationship between income and quantity demanded).
    • Inferior good: Negative income effect (inverse relationship between income and quantity demanded).
  3. Price Effect: Sum total of the substitution effect and income effect: PE = SE + IE
    • PE = Price Effect
    • SE = Substitution Effect
    • IE = Income Effect

Substitution effect always increases quantity demanded as price falls. The law of demand will apply if:

  1. The commodity is normal (positive income effect).
  2. The commodity is inferior, but the substitution effect outweighs the negative income effect.
  3. If the income effect is negative and outweighs the substitution effect, the law of demand does not hold.
Giffen Good

A case where the negative income effect outweighs the substitution effect. Named after Robert Giffen. A fall in price may lead to a fall in demand.

Change in Quantity Demanded vs. Change in Demand

  • Change in quantity demanded: Change in demand due to a change in the price of the commodity (movement along the demand curve).
  • Change in demand: Change in demand due to factors other than the price of the commodity (shift of the demand curve).

Expansion and Contraction in Demand

  • Expansion in demand: Fall in price causes quantity demanded to rise.
  • Contraction in demand: Rise in price causes quantity demand to fall.

Change in Demand

Occurs due to a change in any determinant of demand other than the price of the commodity.

  • Increase in demand:
    • At a given price, higher quantity is demanded.
    • At a higher price, the same quantity is demanded.
    • Graphically, a rightward shift of the demand curve.
  • Decrease in demand:
    • At a given price, lower quantity is demanded.
    • At a lower price, the same quantity is demanded.
    • Graphically, a leftward shift of the demand curve.

Factors that shift a demand curve:

  1. Rise in income: Enables consumers to demand more at a given price (rightward shift).
  2. Change in price of a substitute: Increase in substitute price shifts demand curve to the right.
  3. Change in consumer taste: Development of taste shifts demand curve to the right.

The Concept of Supply

Supply refers to the quantity of a commodity producers are willing to sell at different prices per unit of time.

Key Features:

  1. Indicates offered quantities (current supply can differ from current production due to changes in inventories).
  2. Referenced to the price at which the quantity is supplied (price must be mentioned).
  3. It is a flow with a time unit (per day/week/month).

Determinants of Supply

  1. Price of the commodity supplied: Most immediate determinant. Higher price encourages larger quantity supplied.
  2. Prices of factors of production or cost of production: Affects cost of production and profits. A rise in factor prices discourages production and supply.
  3. Prices of other goods: As other commodity prices rise, they become more attractive to produce, reducing the supply of the original commodity.
  4. The state of technology: Improvement in technology lowers production costs and increases output.
  5. Goals of the producer: Influences production and supply decisions.

The Law of Supply

A producer aims to maximize profits: Profit = TR – TC,
TR = Total Revenue (q.p)
, TC = Total Cost (q.AC)
where AC is average cost.

A higher price means more profits, encouraging producers to supply more. Conversely, a lower price results in a smaller quantity supplied. This direct relationship is the Law of Supply.

Supply function: S = f(P)
The supply of a commodity is a function of its price and other factors:

Qs = f(P1, P2, P3… Pn, F1… Fa, T, G, ….)

  • Qs: quantity of the commodity supplied
  • P1: price of that commodity
  • P2, P3…Pa: prices of other commodities
  • F1 …… Fn: prices of all factors of production
  • T: the state of technology
  • G: the goal of the producer

The Supply Schedule

Shows quantities of a commodity that a seller is willing to supply at each price, assuming other factors remain constant.

Example Supply Schedule:

Price (in Rs) per PenQuantity Supplied (in thousand) per Month
225
340
450
560
670

The Supply Curve

A graphical representation of the supply schedule, with price on the Y-axis and quantity supplied on the X-axis.

The upward slope indicates that higher the price, the greater the quantity supplied.

Exceptions to the Law of Supply

  1. Non-maximisation of profits: Enterprise may pursue goals other than profit maximisation, such as sales maximisation.
  2. Factors other than price not remaining constant: Changes in the prices of other commodities or technology.

Changes in Supply Versus Changes in Quantity Supplied

Changes in Quantity Supplied

Changes in the quantity offered for sale due to changes in the price of the commodity only, all other factors remaining constant.

  • Contraction of supply: Price falls, quantity supplied falls.
  • Extension of supply: Price rises, quantity supplied rises.

Change in Supply

Change in supply due to changes in factors other than the price of the commodity, shown by a shift in the supply curve.

  • Decrease in supply: Quantity supplied declines at the same price (leftward shift).
  • Increase in supply: Quantity supplied increases at the same price (rightward shift).

Why the Supply Curve Shifts?

  1. Change in the prices of other commodities: Decrease in other commodity prices increases the supply of the commodity in question.
  2. Change in the prices of factors of production: Increase in factor prices reduces supply.
  3. Change in technology: Improvement in technology leads to a fall in the cost of production and increases supply.
  4. Change or expectation of change in other factors: Government policies, taxes, rate of interest, fear of war, all influence supply decisions.

The Idea of Elasticity

Elasticity measures the responsiveness or sensitivity of one variable to changes in another.

Formula: E = (% Change in X) / (% Change in Y)

Elasticity of demand for (or supply of) oranges with respect to their price: E_{Q,P} = (\Delta Q / Q) / (\Delta P / P)

Cross elasticity of demand for X with respect to the price of commodity Y: E{Qx,Py} = (\Delta Qx / Qx) / (\Delta Py / P_y)

Income elasticity of demand: E{Qx,M} = (\Delta Qx / Qx) / (\Delta M / M)

Elasticity of Demand

  • Zero elasticity: Change in price has no impact on quantity demanded.
  • Infinite elasticity: A very small fall in price leads to an extremely large increase in quantity demanded.
  • For a straight line demand curve, elasticity at any point is given by the ratio of the lower segment to the upper segment: E = (-) BE/EA

Elasticity of Supply

  • Zero elasticity: Vertical straight line.
  • Unitary elasticity: Straight line supply curve passing through the origin.
  • Infinite elasticity: Straight line supply curve running parallel to the quantity axis.
  • For a straight line supply function, Es = KM/OM

Measurement of Price Elasticity of Demand

  1. Point Method: Percentage method used when changes in price and quantity demanded are very small.
  2. Total Expenditure Method: Used when changes are not small. E = (P1Q1 ) / ( P0Q0 )
  3. Geometrical Method: Elasticity of demand is different at different points. E_d = (Lower segment) / (Upper segment)

Determinants of Price Elasticity of Demand

  1. Nature of the Commodity:
    • Necessities: Low price elasticity.
    • Comforts.
    • Luxuries: Demand also does not change much with change in price.
  2. Number of Substitutes: More substitutes, higher price elasticity.
  3. Number of uses of a commodity: Greater number of uses, greater price elasticity.
  4. Price level of a commodity: High priced commodity will have higher elasticity of demand and a low priced commodity will have lower elasticity.

Importance of Elasticity of Demand

  1. Price fixation by a monopolist: Monopolists charge higher prices if price elasticity is low.
  2. Price support programme of the government: Protect farmer’s interests with price support if elasticity is low.

Determinants of Elasticity of Supply

  1. Behaviour of costs as output varies: Costs rising rapidly limits supply response.
  2. Nature of the commodity: Perishable products have less elastic supply.
  3. Time: Supply is less elastic in the short-run.
  4. Price expectations: Expectations of future prices influence current supply.