MANAGERIAL

ECONOMICS, 3E

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Chapter 4
Demand and Supply
Analysis
 Lecture Plan
 Objectives
 Demand
 Types of demand
 Determinants of demand
 Demand function
 Law of demand
 Change in demand
 Market demand
 Supply
 Supply schedule and supply curve
 Change in supply
 Market equilibrium
 Determination of market equilibrium
 Changes in market equilibrium

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 Chapter Objectives

 To introduce the basics of demand and supply

and their relevance in economic decision
making.
 To analyze the different determinants of demand
and supply and their effects on demand and
supply curves.
 To help develop an understanding of demand
and supply functions in determining market
equilibrium.
 To introduce the concepts of market equilibrium
and disequilibrium.

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 Demand
 The process to satisfy human wants/ needs/desires.
 Want: having a strong desire for something
 Need: lack of means of subsistence
 Desire: an aspiration to acquire something
 Demand: effective desire
 Demand is that desire which backed by willingness and
ability to buy a particular commodity.
 Amount of the commodity which consumers are willing
to buy per unit of time, at that price.
 Things necessary for demand:
 Time
 Price of the commodity
 Amount (or quantity) of the commodity consumers are
willing to purchase at the price

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 Types of Demand

 Direct and Derived Demand

 Direct demand is for the goods which are demanded for
final consumption; such as clothes or food
 Derived demand is for the goods which are demanded to
produce some other commodities; such as diesel or cement
 Recurring and Replacement Demand
 Recurring demand is for goods which are consumed at
short intervals such as food.
 Durable goods are purchased to be used for a long period
of time, hence they need replacement, such as cars.
 Complementary and Competing Demand
 Some goods are jointly demanded hence are
complementary in nature, e.g. software and hardware, car
and petrol.
 Some goods compete with each other for demand because
they are substitutes to each other, e.g. soft drinks and
juices.
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 Types of Demand
Contd…

 Demand for Consumer Goods and Capital Goods

 Consumer goods are demanded for final consumer for
personal consumption, in some cases their demand will be
direct demand
 Capital goods are demanded to produce some other
commodities; hence their demand is similar to derived
demand
 Demand for Perishable Goods and Durable Goods
 Perishable goods have recurring demand.
 Durable goods have replacement demand.
 Individual and Market Demand
 Demand by a single consumer for a product is Individual
demand. The micro economics is primarily based on
individual demand.
 Demand by all the consumers for the product is market
demand.
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 Determinants of Demand

Primary determinants:
 Price of the product
 Single most important determinant
 Negative effect on demand
 Higher the price-lower the demand
 Income of the consumer
 Normal goods: demand increases with increase in
consumer’s income
 Inferior goods: demand falls as income rises
 Price of related goods
 Substitutes
 If the price of a commodity increases, demand for its
substitute rises.
 Complements
 If the price of a commodity increases, quantity
demanded of its complement falls.
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 Determinants of Demand
Contd…
Other determinants
 Tastes and preferences
 Very significant in case of consumer goods as it might nullify the effect
of price and income
 Advertising
 Very important in case of competitive markets, especially where
product differentiation is low or insignificant
 Expectation of future price changes
 Results in panic buying and gives rise to tendency of hoarding of
durable goods
 Population
 Size, composition and distribution of population will influence structure
of demand
 Growth of economy
 Determines general standard of living of people
 Consumer Credit
 Availability of credit to buy consumer goods affects demand Copyright © 2018
 Demand Function

Interdependence between demand for a product

and its determinants can be shown in a
mathematical functional form
Dx = f(Px, Y, Py, T, A, N)
 Dependent variable: Dx
 Independent variables: Px, Y, Py, T, A, N
 Px: Price of x
 Y: Income of consumer
 Py: Price of other commodity
 T: Taste and preference of consumer
 A: Advertisement
 N: Macro variable like inflation, population growth,
economic growth

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 Law of Demand
 A special case of demand function which shows relation
between price and demand of the commodity
Dx = f(Px)
 Other things remaining constant, when the price of a
commodity rises, the demand for that commodity falls or
when the price of a commodity falls, the demand for that
commodity rises.
 Price bears a negative relationship with demand
 Reasons
 Substitution Effect : When the price of a commodity falls
(rises), its substitutes become more (less) expensive
assuming their price has not changed.
 Income Effect: When the price of a particular commodity
falls, the consumer’s real income rises, hence the
purchasing power of the individual rises.
 Law of Diminishing Marginal Utility: as a person
consumes successive units of a commodity, the utility
derived from every next unit (marginal unit) falls. Copyright © 2018
 Demand Schedule and Individual
Demand Curve

Point e
on Demand
Demand 35
Price (Rs (‘000 d

Price of Coffee
Curve per cup) cups)
30
a 15 50 c
b 20 40 25
b
c 25 30 20
d 30 20 a
15
e 35 10
O
10 20 30 40 50
Quantity of coffee

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 Shift in Demand

 Shift in demand curve from D to D

0 1
Price  More is demanded at same
D1
price (Q1>Q)
D0  Increase in demand might be due
D2 to:
 A rise in the price of a substitute
 A fall in the price of a
complement
 A rise in income
P  A redistribution of income
towards those who favour the
commodity
 A change in tastes that favours
the commodity
0  Shift in demand curve from D to D
Q2 0 2
Q Q1 Quantity  Less is demanded at the price
(Q2<Q)

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 Exceptions to the Law of Demand
Due to any of the following reasons it is possible that law of demand
does not operate:
 Giffen Goods: when the price of a necessity good increases its
demand also increases as the consumer does not have enough
money to buy other luxury goods (especially applies to staple food)
 Snob Appeal: goods are not demanded for intrinsic utility but for
show off. Also called as Veblen goods. They are opposite to Giffen
goods
 Demonstration Effect: Social or peer pressure
 Future Expectation of Prices: Panic buying; consumers fear that
prices may rise further.
 Addiction: no consideration for price
 Neutral goods
 Life saving drugs
 Salt
 Amount of income spent is very small or insignificant
 Match box
 Salt Copyright © 2018
 Market Demand

 Market: interaction between sellers and buyers of a

good (or service) at a mutually agreed upon price.
 Market demand
 Aggregate of individual demands for a commodity at a
particular price per unit of time.
 Sum total of the quantities of a commodity that all
buyers in the market are willing to buy at a given price
and at a particular point of time (ceteris paribus)
 Market demand curve: horizontal summation of
individual demand curves

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 Supply

 Indicates the quantities of a good or service that

the seller is willing and able to provide at a price,
at a given point of time, other things remaining the
same.
 Supply of a product X (S x) depends upon:
 Price of the product (Px): positive relation
 Cost of production (C): negative relation
 State of technology (T)
 Government policy regarding taxes and
subsidies (G)
 Other factors like number of firms (N)
 Hence the supply function is given as:
Sx = (Px, C, T, G, N)
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 Law of Supply
 Supply bears a positive relation to the price of the commodity.
 Law of Supply states that other things remaining the same, the
higher the price of a commodity the greater is the quantity
supplied.
 Price of the product is revenue to the supplier; therefore higher
price means greater revenue to the supplier and hence greater
is the incentive to supply.

Supply Schedule Supply Curve

Point on Price Supply 35

Price of Coffee
Supply (Rs. Per (‘000 cups e
Curve cup) per month) 30
a 15 10 25 d
c
b 20 20 20
b
c 25 30 15 a
d 30 45
e 35 60 0
10 20 30 40 50 60
QuantityCopyright
of Coffee© 2018
 Shift in Supply
 Shift in the supply curve from
S0 to S1
Price S2  More is supplied at each
S0 price (Q1>Q0)
 Increase in supply might be
S1 due to:
 Improvements in the
technology
 Fall in the price of inputs
P  Shift in the supply curve from
S0 to S2
 Less is supplied at each
price (Q2<Q0)
 Decrease in supply caused by:
O  A rise in the price of inputs
Q2 Q0 Q1 Quantity
 Change in government
policy regarding subsidies
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 Market Equilibrium
 Equilibrium occurs at the price where the quantity demanded and the
quantity supplied are equal to each other.
 At point E demand is equal to supply hence 25 is equilibrium price

Price Demand of
Supply of coffee
coffee (‘000 cups/
Price (‘000 cups/ month)
S (Rs) month)

15 10 50

E 20 15 40
25
25 30 30
30 45 15

D 35 70 10
O 30 Quantity
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 Market Equilibrium
 For prices below the equilibrium, Quantity demanded exceeds
quantity supplied (D>S)
 Price pulled upward
 For prices above the equilibrium, Quantity demanded is less
than quantity supplied (D<S)
 Price pulled downward.
 At point E demand is equal to supply hence 25 is equilibrium
price.
Price
Demand
S Supply (‘000 cups/
Price (‘000 cups/ month)
30 (Rs) month)
E 15 10 50
25
20 15 40
20
25 30 30
30 45 15
D
35 70 10
O
30 Quantity
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 Changes in Market Equilibrium
(Shifts in Supply Curve)
 The original point of equilibrium is
at E, the point of intersection of
curves D1 and S1, at price P and
quantity Q Price
S0
 An increase in supply shifts the
D1 S1
supply curve to S2
 Price falls to P2 and quantity rises S2
P0 E0
to Q2, taking the new equilibrium to E
E2 P E2
S0
 A decrease in supply shifts the P2
S1
supply curve to S0. Price rises to
S2 D1
P0 and quantity falls to Q0 taking
the new equilibrium to E0 O
Q0 Q Q2 Quantity
 Thus an increase in supply raises
quantity but lowers price, while a
decrease in supply lowers quantity
but raises price; demand being
unchanged Copyright © 2018
 Changes in Market Equilibrium
(Shifts in Demand Curve)
 The original point of equilibrium is
at E, the point of intersection of
Price curves D1 and S1, at price P and
quantity Q
D2  An increase in demand shifts the
S1 demand curve to D2
D1  Price rises to P1 and quantity rises
D0 to Q1 taking the new equilibrium to
E1 E1
P1
E  A decrease in demand shifts the
P
E2 demand curve to D0
P*
D2  Price falls to P* and quantity falls
to Q* taking the new equilibrium to
S1 D0 D1 E2.
 Thus, an increase in demand
O
Q* Q Q1 raises both price and quantity,
Quantity
while a decrease in demand
lowers both price and quantity;
when supply remains same.
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 Change in Both Demand and
Supply
 Initial equilibrium is at E1, with price
quantity combination (P1, Q1).
D2  An increase in both demand and
Price D2 supply takes place;
D1
S1  demand curve shifts to the right
S2 from D1 D1 to D2 D2
 supply curve also shifts to the
right from S1 S1 to S2 S2.
P2 E2
P1 E1 E0
 The new equilibrium is at E2, and
price quantity is (P2, Q2).
 An increase in both supply and
S1 D2 demand will cause the sales to rise,
S2 D2
D1 but
O  the price will increase if increase
Q1 Q2 Quantity in D>S (as at E2 )
 No change in price if increase in
D=increase in S (as atCopyright
E0 ) © 2018
 Summary
 Demand is defined as the desire to acquire a commodity to satisfy human wants, which
is backed by ability and willingness to pay the price.
 Categories of demand are made on the basis of the nature of commodity demanded
(consumer goods and capital goods); time unit for which it is demanded (short run and
long run); relation between two goods (substitutes and complements), etc.
 Demand for a product X (Dx) is a function of price of the commodity X (P x), income of the
consumer (Y), price of related (substitutes or complements) commodities (P o), tastes
and preference of the consumer (T), advertising (A), future expectations (E f), population
and economic growth (N).
 The law of demand states that the consumers will buy more of the commodity when
prices are high and less when prices are low, provided all the other factors of demand
remains constant.
 The law of supply states that firms will sell more of the commodity when prices are high
and less of the commodity when prices are low provided all the other factors of supply
remains constant.
 Supply of a product X (Sx) is a function of price of the product (Px), cost of production (C),
state of technology (T), Government policy regarding taxes and subsidies (G), other
factors like number of firms (N).
 Market equilibrium occurs where demand and supply are equal. This equilibrium
determines the price in the market through the forces of demand and supply.
Comparative statics is the process of comparison between two equilibrium situations.
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