Demand and Supply

Dr. Sanja Samirana Pattnayak

Introduction Demand supply model fundamentally describes how consumers

and sellers interact to determine the quantity of a good or service sold in a market place and the price at which it is sold.

It can be applied to varieties of important and interesting problems such as:

How changing market conditions affect market price and production

Evaluating the impact of various incentive structure Prediction of future demand

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Demand The relationship between demand and price: (Law of Demand)

When the price of a good rises, the quantity demanded will fall and vice-versa.

There are two reasons behind it:

People will feel poorer. They will not be able to afford to buy so much of the good with their money. The purchasing power of their income (the real income) has fallen. This is called in income effect of a price rise.

The good is now dearer relative to other goods. People will thus switch to alternative or substitution goods. This is known as substitution effect of a price rise.

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Demand Curve Demand for a good or a service is determined by the willingness

and ability to pay for that good or service at a given point of time

Demand Curve shows the amount of a good that consumers are willing to buy at different prices, holding other factors constant.

Demand curve is downward-sloping.

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Determinants of Demand Tastes: The more desirable people find the good, the more they

will demand.

Tastes are affected by advertising, by fashion, by observing other consumers and by the experience from consuming the good on previous occasions.

Advertising may be informative as well as persuasive. Informative advertising communicates information to potential

buyers. Persuasive advertising aim to influence consumer choice.

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Determinants of Demand Manufacturer of cigarettes and cosmetics, for instance, use

commercials to retain the loyalty of the existing consumers and attract others to switch brand.

Markets may also use persuasive advertising to promote new products.

Generally, an increase in advertising expenditure, whether informative or persuasive, will increase demand.

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Determinants of Demand

The price of substitute goods: Two products are substitutes, if an increase in the price of one causes the demand for the other to increase. (example tea and coffee)

The price of complementary goods: Two products are complements if an increase in the price of one causes the demand for other to fall. (coffee and milk).

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Determinants of Demand Income: As peoples income rise, their demand for most goods

will rise. Such goods are called normal goods.

By contrast, the demand for an inferior good is inversely related to changes in buyers income.

Generally, broad categories of products tend to be normal, while particular product within the categories may be inferior.

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Determinants of Demand

Example: Transportation services. The entire category is probably a normal product: the higher a persons income, the more s/he tends to spend on transportation.

Public transportation, however, may be an inferior product: with a higher income, the typical consumer switches from public transport to a private car.

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Determinants of Demand Expectations of future price changes: If people think that prices

are going to rise in the future, they are likely to buy more now before the price does go up and so demand will increase.

EXAMPLE: Think about the housing market. If people expect the price of houses to increase, they try to buy now before that happens.

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The Demand Function A general equation representing the demand curve

Qxd = f(Px , PY , M, H,)

Qxd = quantity demand of good X. Px = price of good X. PY = price of a related good Y.

Substitute good. Complement good.

M = income. Normal good. Inferior good.

H = any other variable affecting demand.

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Inverse Demand Function

Price as a function of quantity demanded. Example:

Demand FunctionQxd = 10 2Px

Inverse Demand Function:2Px = 10 Qxd Px = 5 0.5Qxd

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Movements along and shifts in the Demand curve Movement along the demand curve: Change in quantity demand

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Movements along and shifts in the Demand curve Shifts in the demand curve: Change in Demand.

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Market Demand Market demand: it tells us how the quantity of a good demanded

by the sum of all consumers in the market depends on the price and various other factors.

My demand for mangoes is five kilograms is wrong statement!!

Five kilograms is the quantity demanded at a certain price instead of demand only.

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Market Demand Horizontal summation of individual demands

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Market Demand

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Market Demand The aggregation of individual to market demand is not just

theoretical exercise.

It becomes an important practice when market demands are built up from the demands of different demographic groups or from consumers located in different areas. Example: we might obtain information about the demand for home

computers by adding independently obtained information about the demands of the following groups

Households with children Households without children Single individual

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Supply and Price The general relationship between supply and price: when the

price of a good rises, the quantity supplied will also rise.

Supply curve: The supply curve shows the amount of a good that will be produced at alternative prices.

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Other determinants of supply The cost of production: The higher the cost of production, the less

profit will be made at any price.

As costs rise, firms will cut back on production, probably switching to alternative products ( a substitute in supply) becomes more profitable to supply than before, producers are likely to switch from the first good to this alternative.

The profitability of goods in joint supply: sometimes when one good is produced, another good is also produced at the same time. These are said to be goods in joint supply.

Example: An example is the refining of crude oil to produce petrol.

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Other determinants of supply Example (cont): Other grade fuels will be produced as well,

such as diesel and paraffin. If more petrol is produced, due to a rise in demand, then the supply of these other fuels will rise too.

Nature, random shocks and other unpredictable events: In this category we would include the weather and diseases affecting farm output, wars affecting the supply of imported raw materials, the breakdown of machinery, industrial disputes, earthquakes, floods, fire and so on.

Expectations of a future price changes: if price is expected to rise, producers may temporarily reduce the amount they sell.

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Other determinants of supply Expectations of a future price changes (cont): instead they are

likely to build up their stocks and only release them onto the market when the price does rise.

At the same time they may plan to produce, by installing new machines, or taking on more labor, so they can be ready to supply more when the price has risen.

Example: consider the housing market again. If you are thinking of selling your house, but expect that house prices will soon be higher , it would be rational to wait and put your house on the market only when price has risen.

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Movements along and shifts in the supply curve Change in Quantity Supplied

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Movements along and shifts in the supply curve Change in Supply

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Market Equilibrium We can combine our demand and supply analysis and will show

how the actual price of a product and actual quantity bought and sold in a free and competitive market.

The Price (P) that Balances supply and demandQxS = QxdNo shortage or surplus

Steady-state

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Market Equilibrium If price is too low

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Market Equilibrium If price is too high

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Price Restrictions Price Ceilings

The maximum legal price that can be charged. Examples:

Rental Housing

Price Floors The minimum legal price that can be charged. Examples:

Minimum wage.

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Comparative Static Analysis How do the equilibrium price and quantity change when a

determinant of supply and/or demand change?

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The Determination of Equilibrium Price At price P*, the quantity demanded is equal to the quantity

supplied.

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Demand Shift A recent scientific study revealed that the consumption of apple

reduces the hazard of heart attack.

What would happen to the apple market? Demand increases

What happens to the equilibrium price and quantity?

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Increase in Demand Equilibrium is at a higher price and higher quantity.

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Demand Shift

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Supply Shift The benign weather brought a bumper crop.

What would happen to agricultural market? Supply increases

What happens to the equilibrium price and quantity?

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Increase in Supply Equilibrium is at a lower price and higher quantity.

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Supply Shift

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Effects of Changes in Demand and Supply

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Effects of Increase on Demand and Supply

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Effects of Simultaneous Changes in Demand and Supply

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Applications of Demand and Supply Analysis Event: The WSJ reports that the prices of PC components are

expected to fall by 5-8 percent over the next six months.

Scenario 1: You manage a small firm that manufactures PCs.

Scenario 2: You manage a small software company.

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Use Comparative Static Analysis to see the Big Picture! Comparative static analysis shows how the equilibrium price

and quantity will change when a determinant of supply or demand changes.

Scenario 1: Implications for a Small PC Maker

Step 1: Look for the Big Picture.

Step 2: Organize an action plan (worry about details).

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Big Picture: Impact of decline in component prices on PC market Big Picture.

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Big Picture Analysis: PC Market

Equilibrium price of PCs will fall, and equilibrium quantity of computers sold will increase.

Use this to organize an action plancontracts/suppliers?inventories?human resources?marketing?do I need quantitative estimates?

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Scenario 2: Software Maker

More complicated chain of reasoning to arrive at the Big Picture.

Step 1: Use analysis like that in Scenario 1 to deduce that lower component prices will lead toa lower equilibrium price for computers.

a greater number of computers sold.

Step 2: How will these changes affect the Big Picture in the software market?

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Big Picture: Impact of lower PC prices on the software market Big Picture:

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Big Picture Analysis: Software Market Software prices are likely to rise, and more software will be sold.

Use this to organize an action plan.

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Conclusion Use supply and demand analysis to

clarify the big picture (the general impact of a current event on equilibrium prices and quantities).

organize an action plan (needed changes in production, inventories, raw materials, human resources, marketing plans, etc.).

Reference: Wheat soars after Russian crop failure, The Financial Times, November 8, 2012. (Application of demand-supply model)

http://www.ft.com/cms/s/0/7cbc024c-2998-11e2-a5ca-00144feabdc0.html#axzz36Cwc929i

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Learning activity The law of demand states that, holding all else constant

a. As price falls, demand will fall alsob. As price rises, demand will also risec. Price has no effect on quantity demandedd. As price falls, quantity demanded rises

Which of the following would not shift the demand for good A?a. Drop in price of good Ab. Drop in price of good Bc. Consumer incomed. Change in the level of advertising of good A

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Learning activity A change in income will not lead to

a. A movement along the demand curveb. A leftward shift of the demand curvec. A rightward shift of the demand curved. All of the statements associated with the question are correct

Good A is an inferior good, an increase in income leads to:a. A decrease in the demand for good Bb. A decrease in the demand for good Ac. An increase in the demand for good Ad. No change in the quantity demanded of good A

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Learning activity The inverse demand curve for Q=2a-bP a. P/Q b. 1/Q c. P=2a/b-Q/b d. Cannot be determined

If A and B are complements, an increase in the price of good A would:a. Have no effect on the quantity demanded of Bb. Lead to an increase in demand for Bc. Lead to a decrease in demand for Bd. None of the statements associated with this question are correct

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Learning activity How does a decrease in the price of good X affect the market rate

of substitution between goods X and Y?a. It increasesb. It decreasesc. Remains unchangedd. Indeterminable without more information

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