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Chapter- 2

Demand and Supply Analysis

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Demand Analysis

How important in decision-making?

1. Provides the basis for analyzing market influences on the firm’s products.

2. Provides guidance in the manipulationof demand.

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Characteristics of Demand

1. Desire for a commodity2. Willingness to pay3. Ability to pay

Demand is always with reference to:1. Price2. Period of time3. Place

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Determinants of Demand(Factors Influencing Demand)

Price of the own commodity (P)Income of the consumer (Y)Taste & Preference of the Consumer (T)Price of Related Commodities (Pr)Price of Substitutes (Ps)Price of Complementary (Pc)Expectation of the Consumer (E)

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Expectation of the Future Price (Ep)Expectation of the Future Income (Ey)Number of Consumers (N)Distribution of Consumers (D)Advertisement (A)

Demand Function(An algebraic expression of the relationbetween demand for a commodity & its determinants)

D = f (P, Y, T, Ps, Pc, Ep, Ey, N, D, A…..n )

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Law of Demand

“Other things remaining the same, there is an inverse relationship between the price of a commodity & its quantity demanded”.

Demand ScheduleVarious quantities of a commodity demanded at different price levels.IDS: Individual Demand ScheduleMDS: Market Demand Schedule

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90858075

10152025

Q (Units)P ($)

D

D

Graphical Presentation of Demand Schedule is known as Demand Curve which slopes downwards from Left to Right.

Demand Schedule

o X

Y

Price

Quantity Demanded

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A demand curve demonstrates the effect of a price change on the quantity demanded of a commodity (Price Effect).Price Effect = Income Effect + Substitution Effect.Income Effect: Measures the effect of a price change on the real income of the consumer.Substitution Effect: Is the adjustment of demand to the relative price change alone.

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Household is better off

Substitution Effect

HouseholdsBuy more

IncomeEffect

Household isworse off

Opportunity Cost of

good rises

Substitution Effect

Opportunitycost of

good falls

Income Effect

Households Buy less

HouseholdsBuy less

HouseholdsBuy more

Rises

Falls

Income & Substitution Effects of a Price Change

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Exceptions to the Law(Actual Behavior does not conform to the Law)

Giffen Goods (special type of inferior goods).Luxury ItemsFuture changes in PricesGoods attached with prestige valueHaunted by Phobia (high-priced good is better in quality than a low-priced one).Out-dated fashion items.

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Elasticity of DemandThe degree of responsiveness of QD due to a change in its determinants.The extent to which the QD will rise or falldue to a change in the determinants (Price, Income, Price of related goods, Advertisement Budget, etc.)An analysis of demand sensitivity with respect to determinants.Facilitates the business to forecast markettrends for the future.

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Own Price as a determinant: Price Elasticity of Demand.Income of the Consumer: Income Elasticity of Demand.Price of related Goods (Substitutes and Complementary): Cross Elasticity of Demand.Advertising Expenses: Promotional Elasticity or Advertisement Elasticity of DemandElasticity of Demand can be measured for any variable provided it can be Quantified.

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Price Elasticity of DemandThe degree of responsiveness of quantitydemanded to changes in Price.

Proportionate Change in QEp =

Proportionate change in PAny Value of Elasticity is arrived at by dividing the Percentage change in the QD by the Percentage change in the own price.

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Category ValuePerfectly Elastic ………………Ep = ∞Perfectly Inelastic ……………Ep = 0Relatively Elastic ……………..1<Ep< ∞Relatively Inelastic …………..0<Ep< 1Unitary Elastic ………………….Ep=1

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CharacteristicsE = ∞ Any amount will be bought at a certain price, but nothing at a higher price.E = 0 QD remains constant as price changes.1 < Ep < ∞ Proportionate change in QD is greater than the Proportionate change in price.0 < Ep < 1 Proportionate change in QD is less than the Proportionate change in price.Ep = 1 Proportionate change in QD is the same as the Proportionate change in price.

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Elasticity of Demand&

Total OutlayDemand is Elastic when a certain % cut in price brings about more than proportionate expansion in demand so as to increase total outlay.Demand is Inelastic when a certain % cut in price leads to a smaller percentage increase in the QD, in which case total outlay falls.

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Demand has unitary price elastic when a certain % fall in price brings about an exactly equal % increase of QD so as to leave total outlay unchanged.

Nature of Demand Effect on TR of a PriceIncrease Decrease

Elastic TR decreases TR increasesUnit Elastic TR unchanged TR unchangedInelastic TR increases TR decreases

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Problem(10 minutes)

A consumer demands 150 units of a product at a price of $ 3. If the demand is unit elastic, what will be his demand for that product at a price of $ 5.

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Elasticity & Firm’s Decision Making

Pricing with an Inelastic DemandIf a firm faces an inelastic demand, then increasing price will raise revenue. Raising price will reduce output. So costs will also be falling. With revenue rises and cost falls, profit will increase. A firm should not lowerthe price if demand for its product is inelastic, because revenue will fall and costs will rise with output. Profit must decline.

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Pricing with an Elastic DemandFirm has a more difficult decision to make if demand for its product is elastic. The firm can increase its revenue by lowering price, but this will also increase output and therefore cost. The decision is based upon-which has gone up more – revenue or costs?

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Determinants of Elasticity of Demand

Substitutability:If a product has many close substitutes, switching over to alternatives is possible in the event of a rise in the price of the product. Demand will be highly elastic.QD falls by a large amount due to a given rise in price.

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Nature of the Product:Demand for the Necessities tends to be Price Inelastic.Demand for Luxuries tends to be Elastic, i.e., Substantial reduction in the QD is expected if Price rises.Proportion of Income:Demand tends to be Elastic when the proportion of income spent on the product is large.

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Demand for the same product is Inelastic for a rich man as the proportion of Income spent on it is very small. The Possibility of New Purchases:A fall in the price leads to the rise in demand as it induces people in a numerous income group to buy resulting in considerable Elasticity of Demand.

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Addiction:Once a product is Habit-forming, this will tend to reduce its Elasticity of Demand. Expected Price:If the Ep will rise in future, a small reduction in its price will lead to a Substantial increase in its Demand. Time-Horizon:The longer the period of time, the more Elastic is the demand.

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Income Elasticity of Demand

The Degree of Responsiveness of Demand to changes in Income of the consumer.

It may be Positive, Negative or Zero depending upon whether QD goes up, down or remains constant as income increases.

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Category ValueNegative Income Elasticity… Ey < 0Zero Income Elasticity……….. Ey = 0Income Inelastic Demand………0 < Ey < 1Unit Income Elasticity……………Ey = 1Income Elastic Demand…………1< Ey< ∞

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Category Characteristics-ve IE Demand decreases as Y rises0 IE Demand does not change to YIIED Demand rises by a smaller

proportion than YUIE Demand rises by exactly the same

proportion as YIED Demand rises by a greater

proportion than Y

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Cross Elasticity of Demand

The Degree of Responsiveness of QD of one good to changes in the price of another.Either be Positive or negative depending upon whether the two goods considered are Substitutes or Complements.

Proportionate Change in QDx

Ec = ---------------------------------------Proportionate change in Py

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Determinants of Supply

Price of the own Commodity (P)Prices of the Factors of Production (Pf)Factor Productivities (Fp)Prices of other Products related in Production (Pr)Goals of the Firm (G)Expected level of Profit, costs, sales (Eπ,C, S )Expected price in the Future (Ep)Level and Nature of Competition (C)

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Elasticity of Supply

Measures the extent to which the QS of a good responds to a change in its own Price.

Percentage Change in QSEs =

Percentage Change in PriceEs is Positive since the Supply curve slopes

upwards from left to right.

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Es may be Elastic, Inelastic or Unitary.A rise in Price: the QS rises by a greater, smaller or equal percentage.Supply function of a firm relates the quantity of a commodity that the seller is willing and able to supply to the factors that determine that supply.

Sx = f (P, Pf ,Fp ,Pr , G, Eπ,C, S, Ep ,C….n)

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Class Tasks(10 minutes)

What happens to demand when the following changes occur:

1. Income decreases and the commodity is inferior.2. The price of a substitute good decreases.3. The price of a complementary good decreases.4. The price of a commodity is expected to

decrease. 5. If the price of computers goes up, the demand

for internet connections will ………. why?