THE THEORY OF DEMAND SUPPLY 1

THE THEORY OF DEMAND & SUPPLY 1

DEMAND Ø Demands for a commodity refers to the quantity of the commodity which an individual consumer is willing to and able to purchase per unit of time at a particular price. 2

DETERMINANTS OF DEMAND Ø Price of the commodity Ø Price of Related Goods and Services Ø Consumer’s Income Ø Consumer’s Taste & Preferences Ø Distribution of Income Ø Expectations Ø Sociological Variables Ø Demonstration Effect & Band –Wagon Effect 3

DEMAND SCHEDULE Demand Schedule is the tabular presentation of a series of quantities which consumer would like to buy per unit of time at different prices. Demand schedule for fruits is given in Table below: Demand Schedule for Fruit by an Individual Price (Rs per Kg) Quantity demanded (dozen) 100 1 90 3 80 7 70 11 60 13 4

DEMAND FUNCTION • Demand function is referred to as a mathematical expression of the relationship between quantity demanded of a commodity to the factors that determine the quantity demanded. 5

Mathematically, Demand Function is expressed as – where: Qdx refers to the quantity demanded of product X, Px refers to the price of product X Y refers to the level of household income P 1……P n-1 refers to price of related goods. T refers to taste and references of consumer Ey refers to the consumer’s expected further income. Ep refers to consumer’s expectation about the future prices. S refers to sociological factors. refers to those determinants which are not covered in the list of determinants given above. 6

THE LAW OF DEMAND • The law of demand holds that other things equal, as the price of a good or service rises, its quantity demanded falls. – The reverse is also true: as the price of a good or service falls, its quantity demanded increases. 7

DEMAND CURVE The demand curve has a negative slope, consistent with the law of demand. 8

WHY DEMAND CURVE SLOPES DOWNWARDS TO RIGHT? Ø Substitution Effect Ø Income effect Ø Diminishing Marginal utility (MU = P) Ø Number of Uses and Buyers 9

EXCEPTIONS TO LAW OF DEMAND Ø Giffen Goods Ø Status Goods Ø Expectation of future price Ø Emergencies Ø Ignorance 10

MOVEMENT ALONG THE DEMAND CURVE The movement along the demand curve is due to change in the own price of the commodity. • Extension of demand is when quantity demanded of a commodity increases as a result of fall in its price, other determinants remaining constant. • Contraction of demand is when quantity demanded of a commodity decreases as a result of increase in it price, other determinants remaining constant. 11

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SHIFT IN THE DEMAND CURVE • A change in any variable other than price that influences quantity demanded produces a shift in the demand curve or a change in demand. • Factors that shift the demand curve include: – – Change in consumer incomes Population change Consumer preferences Prices of related goods: • Substitutes: goods consumed in place of one another • Complements: goods consumed jointly 13

SHIFT IN THE DEMAND CURVE This demand curve has shifted to the right. Quantity demanded is now higher at any given price. 14

TYPES OF DEMAND • Direct/Autonomous Demand Derived Demand • Non Durables Goods Demand Durable Goods Demand • Industry Demand Individual Firm Demand • Short Run Demand Long-Run Demand 15

SUPPLY Ø Supply of a commodity refers to the various quantities of the commodity which a seller is willing and able to sell at different prices, in a given market, at a point of time, other things remaining the same. 16

DETERMINANTS OF SUPPLY Ø Price of related goods Ø Cost of Production/Factors of Production Ø State of Technology Ø Goal of Producer Ø Natural factors Ø Other Factors 17

SUPPLY SCHEDULE Supply Schedule is the tabular presentation of a series of quantities which producer would like to at different prices. Supply schedule for Garments is shown in Table below: Price of Garment (Rs. 60 per garment) Quantity Supplied 10 9 8 7 6 15 12 10 8 6 18

MARKET SUPPLY SCHEDULE Ø A market supply schedule for a commodity is the sum of individual supply schedules for all the producer producing a commodity in a given time. It reflects the sum total of various quantities offered for sale by all producers at different prices. Table shows the market supply schedule which illustrates a market comprising of producer A and B. Price (Rs. ) 5 4 3 2 1 Individual Supply Schedule QA 25 20 18 15 10 QB 20 16 15 12 10 Market Supply Schedule QA + QB 45 36 33 27 20 19

SUPPLY FUNCTION Supply function refers to the mathematical expression of the quantity supplied and the factors that determine the supply. Sx = f (P x P 1…. Pn C, T, G, O) Where Sx refers to the quantity supplied of good X Px refers to the price of good X P 1…. Pn refers to the price of related goods C refers to the cost of production T refers to the state of technology. G refers to the goal of the firm O refers to other factors. 20

THE LAW OF SUPPLY • The law of supply holds that other things equal, as the price of a good rises, its quantity supplied will rise, and vice versa. 21

WHY IS SUPPLY CURVE AN UPWARD SLOPING CURVE? • Profit Maximization • The Law of Diminishing Marginal Productivity 22

Supply Curve The supply curve has a positive slope, consistent with the law of supply. 23 23

MOVEMENT OF SUPPLY CURVE The change in the quantity supplied due to change in the price level is known as movement of supply curve. Ø Expansion of Supply: when the quantity supplied rises due to rise in the price of commodity Ø Contraction of Supply: When the quantity supplied falls due to the fall in the price of the commodity. 24

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Shift in the Supply Curve Ø A change in any variable other than price that influences quantity supplied produces a shift in the supply curve or a change in supply. Ø Factors that shift the supply curve include: § Price of related goods § Cost of Production/Factors of Production § State of Technology § Goal of Producer § Natural factors § Other Factors 26

Shift in the Supply Curve For an given rental price, quantity supplied is now lower than before. 27

DETERMINATION OF EQUILIBRIUM Ø Equilibrium is established at the point where the quantity that suppliers are willing and able to offer for sale is the same as the quantity that buyers are willing and able to purchase. 28

EQUILIBRIUM Equilibrium occurs at a price of $3 and a quantity of 30 units. 29

SHORTAGES AND SURPLUSES • A shortage occurs when quantity demanded exceeds quantity supplied. – A shortage implies the market price is too low. • A surplus occurs when quantity supplied exceeds quantity demanded. – A surplus implies the market price is too high. 30

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EQUILIBRIUM AFTER A DEMAND SHIFT The shift in the demand curve moves the market equilibrium from point A to point B, resulting in a higher price and higher quantity. 32

EQUILIBRIUM AFTER A SUPPLY SHIFT The shift in the supply curve moves the market equilibrium from point A to point B, resulting in a higher price and lower quantity. 33

ELASTICITY Ø Elasticity may be defined as “The percentage change in the dependent variable that is caused by a one percent change in one independent variables, others are held constant”. 34

ELASTICITY OF DEMAND Ø Elasticity of demand measures degree of responsiveness of the quantity demanded to change in any one of the factors that influence it. Ed = Percentage change in quantity demanded of good X Percentage change in determinant Y 35

KINDS OF DEMAND ELASTICITIES Ø Price elasticity of demand Ø Income elasticity of demand Ø Cross elasticity of demand Ø Advertising elasticity of demand Ø Price Expectation Elasticity 36

PRICE ELASTICITY OF DEMAND Ø Price elasticity of demand is referred to as degree of responsiveness of quantity demanded for a commodity to change in its price 37

Price (a) Perfectly Inelastic ep= 0 D P 1 P 0 D 0 X Quantity Demanded 38

ep <1 Price b. Relatively Inelastic D P 0 P 1 D 0 X 1 Quantity Demanded 39

ep=1 Price c) Unitary Elastic D P 0 P 1 D 0 X 1 Quantity Demanded 40

Price d) Relatively Elastic ep > 1 D P 0 P 1 D 0 X 1 Quantity Demanded 41

ep =∞ Price e) Perfectly elastic P 0 D 0 X 1 X 0 Quantity Demanded 42

MEASUREMENT OF PRICE ELASTICITY Elasticity of demand can be measured with the help of any one of the four techniques. Ø Percentage Method Ø Point Method Ø Arc Method Ø Total Outlay Method 43

PERCENTAGE METHOD According to this method, elasticity of demand is the ratio of percentage (or proportionate) change in quantity demanded to a percentage (or proportionate) change in its price. 44

ILLUSTRATION Ø Find the elasticity of demand at price Rs 4, when price and quantity demanded behave in the following manner Price (Rs per Litre) Quantity demanded (Litres) 10 6 8 10 6 15 4 22 2 35 45

Solution: The elasticity of demand when price changes from Rs 4 to Rs 2. 46

Graphical Method / Point Method • This method is used to measure elasticity at a point on the demand curve. 47

Price e= D e>1 B e=1 A e<1 C 0 E=0 D 1 Quantity 48

ØArc Elasticity Arc elasticity is a measure of average elasticity i. e. it is the elasticity at the mid point of the chord that connects the two point A and B on the demand curve, defined by the initial and new price level. 49

Price D A P 1 B P 2 D 0 Q 1 Q 2 Quantity 50

Illustration • 15 Units of commodity was demanded at the price of Rs 20 each. If the price of commodity falls to Rs 10, the demand for commodity increases to 25 units. Find the elasticity of demand using arc elasticity method. 51

• Solution: 52

TOTAL OUTLAY METHOD/EXPRENDITURE METHOD In this method, we study the elasticity of demand in relation to change in total outlay (expenditure) as a result of change in price and the consequent change in demand for a product. Limitation: It does not give the precise value of the elasticity of demand, rather it only tells whether the elasticity is equal to one, greater than one or less than one. 53

Price Quantity Demanded Total outlay Nature of Elasticity Case I a. ses b. ses ses ses Elasticity is more than one Case II ses ses ses Elasticity is less than one Case III ses ses No change Unit elastic 54

FACTORS AFFECTING ELASTICITY OF DEMAND • • Nature of Commodity Number of close substitutes available The Proportion of Buyer’s Budget Number of uses of Commodity Consumer’s Behaviour Price Level of the Commodity Time Period 55

INCOME ELASTICITY OF DEMAND The income elasticity of demand measures the degree of responsiveness to income changes. The income elasticity of demand is defined as the percentage change in quantity demanded for a product divided by percentage change in income, everything else held constant. Ø Normal Good – Positive Income Elasticity Ø Inferior Good – Negative Income Elasticity 56

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ILLUSTRATION A study conducted by researcher revealed that a rise in average household income from Rs. 30, 000 to 40, 000 led to increase in consumer’s demand for a commodity from 100 units per month to 200 units. 58

Solution: The income elasticity of demand is 3 59

TYPES OF INCOME ELASTICITY Ø Zero Income Elasticity Ø Unitary Income Elasticity Ø High Income Elasticity Ø Low Income Elasticity 60

DETERMINANTS OF INCOME ELASTICITY Ø Nature of the need of commodity Ø Initial level of income of country Ø Time period 61

CROSS ELASTICITY OF DEMAND It is defined as percentage change in quantity demanded for one good divided by percentage change in the price of related good, everything is held constant. 62

Ø The sign of cross elasticity is negative if x and y are complimentary goods and positive if x and y are substitute goods. Ø Determinant of cross elasticity – nature of the commodity relative to their use. 63

• Illustration: Suppose that there is an increase in the price of tea from Rs 100 per Kg to Rs 125 per Kg and consequently the quantity demanded of coffee would increase from Rs 10 Kg to Rs 15 Kg. Find the cross elasticity of demand between coffee and tea. 64

Solution: The higher the value the cross elasticity, the stronger will be the degree of substitutability or complementarily of two goods. 65

Advertising Elasticity of Demand • It measures degree of responsiveness of demand to changes in the advertising and other promotional expenses 66

Determinants of advertisement elasticity Ø Kind of product Ø Stage of product’s development Ø Target customers Ø Quantity and quality of advertisement Ø Reaction of rival firm 67

• Illustration: Suppose the original level of advertising by Firm A is Rs 10 lakh and sales for the year end recorded was 500 units. With increase in advertisement expenditure to Rs 12 lakhs, the sale volume increased by 200 units. Find the advertisement elasticity. 68

Solution Original level of advertising Original quantity New level of addressing New Quantity = Rs. 10 Lakh = 500 units = Rs. 12 lakh = 700 units Therefore, the advertising elasticity of demand is 2, which is termed as relatively elastic. In other words, a 1% increase in the level of advertising will cause a 2 % increase in quantity demanded. 69

Elasticity of Price Expectation: It is defined as the ratio of the relative change in expected future prices to the relative change in current price. Symbolically: 70

Elasticity of Value of Price Coefficient Expectations Purchasers Expectations Relatively Elastic Epe> 1 Purchases expect that future price will increase by a larger percentage than current price. Relatively Inelastic Epe<1 Purchaser expect that future price will increase by smaller percentage than current price Unitary Elastic Epe=1 Future price will increase by same percentage as current price Perfectly Inelastic Epe=0 An increase in current price will have no effect on future price Perfectly Elastic Epe=∞ Increase in current price will be followed by decrease in future price 71

Significance of elasticity of demand Ø Factor Pricing Ø Business Decisions Ø Government Policies Ø Taxation Policies Ø Foreign Trade Ø Demand Forecasting 72

Elasticity of Supply • Elasticity of supply of the commodity is defined as the responsiveness of quantity supplied to a unit change in price of that commodity. 73

Price Perfectly Elastic P 0 S 0 X 1 X 0 Quantity Supplied 74

Price Perfectly Inelastic S P 1 P 0 S 0 X Quantity Supplied 75

Price Relatively Inelastic S P 0 P 1 D 0 X 1 X 0 Quantity Supplied 76

Price Relatively Elastic S P 1 P 0 0 Q 1 Quantity Supplied 77

Price Unitary Elastic S 0 Quantity Supplied 78

Determinants of Elasticity of Supply Ø Time Ø Nature of commodity Ø Future price expectation Ø Limited Supply of inputs Ø The cost of attracting factors of production 79