Demand and Supply Summary

Theory of Demand and Supply

Key Demand Concepts

• Determinants of Demand: Consumer preferences, income levels, and substitute goods.

• Market Size and Buyers: Understanding buyers and their behavior.

• Demand Relationship: Cross demand (substitute effect).

Meaning of Demand

• Demand = Want + Ability to Pay + Willingness to Buy

• Demand is always at a price.

• Demand is continuous over time.

Determinants of Demand

1. Price of the Commodity:

   • Inverse relationship between price and demand.

2. Price of Related Commodities:

   • Complementary Goods: Used together (e.g., Petrol & Cars).

     • If the price of one falls, demand for both increases.

   • Substitute Goods: Used in place of each other (e.g., Tea vs. Coffee).

     • If the price of one rises, people switch to the other.

3. Disposable Income of the Consumer:

   • Normal Goods: Income ↑ → Demand ↑; Income ↓ → Demand ↓

   • Inferior Goods: Income ↑ → Demand ↓; Income ↓ → Demand ↑

4. Tastes and Preferences:

   • Influenced by trends and fashion.

   • External Utility Effects:

     • Demonstration Effect: Imitating others.

     • Bandwagon Effect: Following the crowd.

     • Snob Effect: Wanting to be different.

     • Veblen Effect: Showing status with expensive items.

5. Consumers’ Expectations:

   • Expect price rise → buy more now.

   • Expect price drop → delay buying.

6. Other Factors:

   • Size of Population: Larger population → more demand.

   • Age Distribution: Influences type of goods in demand.

   • National Income & Distribution: High & equal income = strong demand.

   • Credit & Interest Rates: Easy loans = more buying.

   • Government Policies: Taxes, subsidies affect demand.

Demand Function

• $Qx = f (Px, Y, Pr)$

  • $Qx$ = Quantity demanded of product X

  • $Px$ = Price of the product

  • $Y$ = Income of the buyer

  • $Pr$ = Price of related goods

Law of Demand

• Price ↑ → Demand ↓

• Price ↓ → Demand ↑

• Condition: Ceteris Paribus (all other things remain constant).

Demand Schedule

• Table showing quantity bought at different prices.

Demand Curve

• Graphical representation of demand schedule.

• Downward sloping.

Market Demand Schedule

• Total demand from all consumers at each price.

Market Demand Curve

• Market demand = sum of all individual demands at each price.

• Also slopes downward.

• Linear Demand Equation: $Q = a − bP$

Rationale of the Law of Demand

1. Price Effect:

   • Substitution Effect: Switch to cheaper goods.

   • Income Effect: Lower price increases purchasing power.

2. Utility-Maximizing Behavior:

   • Marginal Utility falls with each extra unit.

   • Willing to pay less for each additional unit.

3. Arrival of New Consumers:

   • Lower prices attract new buyers.

4. Multiple Uses of a Good:

   • Demand increases for existing and new uses when price falls.

Exceptions to the Law of Demand

1. Veblen Goods: Price ↑ → Demand ↑ (luxury items).

2. Giffen Goods: Price ↑ → Demand ↑ (necessity staples for poor).

3. Conspicuous Necessities: Must-have status symbols.

4. Future Price Expectations: Expecting further price increases.

5. Incomplete Information & Irrational Behavior: Paying more due to misinformation or impulse buys.

6. Demand for True Necessities: Quantity demanded changes very little regardless of price.

7. Speculative Goods: Rising prices attract more buyers.

Expansion and Contraction of Demand

• Expansion: Price falls → quantity rises.

• Contraction: Price rises → quantity falls.

• Movement along the same demand curve.

Increase and Decrease in Demand

• Increase: Demand curve shifts right.

• Decrease: Demand curve shifts left.

• Due to non-price factors.

Movements Along vs. Shift of Demand Curve

• Movements along the demand curve are due to price changes only.

• Shifts of the demand curve are due to other factors.

Elasticity of Demand

• Responsiveness of quantity demanded to changes in price or other factors.

• Price Elasticity of Demand = ${\% Change in Quantity Demanded} / {\% Change in Price}$

Types of Price Elasticity of Demand

• Elastic (Ep > 1): Responsive to price change.

• Unitary Elastic (Ep = 1).

• Inelastic (Ep < 1): Not very responsive to price change.

Illustrations for practice (examples in transcript)

Point Elasticity

• Measures responsiveness at a specific point on the demand curve.

• Point elasticity = $(Price ÷ Quantity) × (Reciprocal of slope of the demand curve)$

Measurement of Elasticity on a Linear Demand Curve: Geometric Method

• Varies along the curve; highest at the top, lowest at the bottom.

Arc Elasticity

• Measures elasticity between two price-quantity points.

• Midpoint Formula: $\frac{Q2 - Q1}{(Q2 + Q1)/2} / \frac{P2 - P1}{(P2 + P1)/2}$

Interpretation of Numerical Values of Elasticity of Demand

• Perfectly Inelastic (Ep = 0): Vertical line.

• Inelastic (0 < Ep < 1): Steep downward slope.

• Unitary Elastic (Ep = 1): Rectangular hyperbola.

• Elastic (Ep > 1): Gentle slope.

• Perfectly Elastic (Ep = ∞): Horizontal line.

Total Outlay Method

• Total Outlay = Price × Quantity

• Elastic Demand (Ep > 1): TO moves opposite to price.

• Inelastic Demand (Ep < 1): TO moves with price.

• Unitary Elastic (Ep = 1): TO stays the same when price changes.

Determinants of Price Elasticity of Demand

1. Availability of Substitutes: More substitutes → more elastic.

2. Position in Consumer’s Budget: Larger budget share → more elastic.

3. Nature of the Need: Luxuries → elastic, Necessities → inelastic.

4. Nature of Uses: Multiple uses → elastic.

5. Time Horizon: Long-run → more elastic.

6. Consumer Habits: Strong habits → inelastic.

7. Tied Demand

8. Price Range

9. Minor Complementary Items

Income Elasticity of Demand

• $Ei = {\% Change in Quantity Demanded} / {\% Change in Income}$

  • Ei > 1: Luxury.

  • 0 < Ei < 1: Necessity.

  • Ei < 0: Inferior good.

Cross-Price Elasticity of Demand

• $Ec = {\% Change in Quantity Demanded of X} / {\% Change in Price of Y}$

  • Positive Ec → Substitutes.

  • Negative Ec → Complements.

Advertisement Elasticity

• $Ea = {\% Change in Quantity Demanded} / {\% Change in Advertising}$

Theory of Consumer Behaviour

Nature of Human Wants

1. Unlimited & Unending

2. Vary in Intensity

3. Competing & Scarce

4. Complementary & Alternative

5. Subjective & Changing

6. Habit-Forming

Utility: Satisfaction from Wants

• Total Utility (TU): $\sum MU_i$

• Marginal Utility (MU): $ΔTU / ΔN$

• Diminishing MU.

Classification of Wants

1. Necessaries

2. Comforts

3. Luxuries

Relationship between TU & MU

• TU = $∑ MU$

• MU = $TUn - TUn-1$

• Diminishing MU.

• TU Peaks when MU = 0.

• Negative MU.

Law of Diminishing Marginal Utility

• Extra satisfaction from additional units falls as more is consumed.

• Assumptions include:

  • Identical Units

  • Standard Measurement

  • Continuous Consumption

  • Exemption

  • Substitutes.

Consumer Surplus

• Consumer Surplus = Maximum Willingness to Pay − Market Price

Applications of Consumer Surplus

1. Gauge Customer Happiness & Loyalty

2. Smart Pricing & Segmentation

3. Investment & Project Planning

4. Assessing Price Hikes

5. Guiding Tax Policy

Limitations of Consumer Surplus

1. Hard to Measure Exactly

2. Necessities Break the Model

3. Depends on Substitutes

4. Prestige Goods Don’t Fit

5. Money’s Utility Changes

6. Relies on Measuring Utils

Indifference Curve Analysis

• Ordinal approach to consumer choice.

Assumptions

1. Complete Information

2. Rational Choice

3. Ordinal Utility

4. Transitive Preferences

5. More Is Better

Indifference Curve Map

• Collection of Indifference Curves

Marginal Rate of Substitution (MRS)

• Rate at which you’re willing to give up some of good Y to gain one more unit of good X.

• $MRS = {MUx}/{MUy}$

Properties of Indifference Curves

1. Downward sloping to the right.

2. Convex to the origin

3. Never intersect each other

4. Higher represents a higher satisfaction

5. Will not touch either axes

The Budget Line

• Shows possible combinations of two goods with limited money.

• Equation: $PxQx + PyQy = B$

Consumer Equilibrium

• When consumer picks the bundle that maximizes happiness given the budget.

Supply

Introduction

• Supply is the amount producers offer for sale.

Determinants of Supply

1. Price of the Good: Higher price → more supply.

2. Prices of Related Outputs: Substitute and Complement goods

3. Prices of Inputs: Higher input costs → lower supply.

4. Technology & Productivity: Better technology → higher supply.

5. Government Policies: Taxes/Subsidies.

6. Market Structure & Competition: More competition → greater supply.

7. Future Price Expectations: Expect higher prices → hold back supply.

8. Number of Sellers: More firms → higher supply.

9. Other Factors

Law of Supply

• Price ↑ → Supply ↑

• Price ↓ → Supply ↓

Movements on the Supply Curve

• Price Rise → Expansion of Supply.

• Price Fall → Contraction of Supply.

• Movement along the supply curve.

Shifts in Supply Curve

• Increase in Supply: Curve shifts right.

• Decrease in Supply: Curve shifts left.

Elasticity of Supply

• $Es = {\% Change in Quantity Supplied} / {\% Change in Price}$

Types of Elasticity of Supply

1. Perfectly Inelastic (Es = 0): Vertical line.

2. Relatively Inelastic (0 < Es < 1): Steeper slope.

3. Relatively Elastic (Es > 1):

4. Unit Elastic (Es = 1)

5. Perfectly Elastic (Es → ∞): Horizontal line.

Measurement of Supply Elasticity

• Point elasticity

• Arc Elasticity

Determinants of supply Elasticity

1. Cost of Expanding Production

2. Time Horizon

3. Number of Producers

4. Spare Capacity

5. Input Availability

6. Inventory Levels

7. Ease of Factor Substitution

8. Mobile Capital & Labor

9. Future Price Expectations

Equilibrium Price

• Where supply and demand curves cross.

• Surplus above this price, Shortage below this Price

Market Equilibrium & Social Efficiency