Demand, Supply and Price

Market
Buyers- households/demanders
Suppliers- producers/firms
Demand-The ability and willingness to buy specific
quantities of good at alternate prices in a given time
period
Or the desire to buy a product, which is backed up by
willingness and ability to pay for the it.
Quantity demanded- the amount of a product that the
consumers wish to purchase.
Demand schedule- a table which shows the quantities of
a good, a consumer is willing and able to buy at alternate
prices, in a given time period.
Individual demand schedule-
Price Quantity (consumer A)
0.5 6
1 5
1.5 4
2 3
2.5 2
3 1
Price Quantity
(consumer A)
Quantity
(consumer B)
Market
0.5 6 10 16
1 5 8 13
1.5 4 6 10
2 3 4 7
2.5 2 2 4
3 1 0 1
Market demand schedule- a table that shows the
quantity of commodities that would be demanded
by all consumers at given prices.
Demand curve- graphical representation of demand
schedule. Each point on the demand curve represents a
specific quantity that will be demanded at a given
price.
Market demand curve- is the horizontal sum of the
demand curves of all consumers in the market.
u C A u C 8 M u
Law of demand- in a given time period, the quantity
demanded of a good increases as its price falls, other
things remaining the same(ceteris paribus).
Q
d
=f(price)
Negative relationship
When price of product rises?
When price of product falls?
Change in quantity demanded- is a movement along the
demand curve due to price changes, if other factors are
held constant.
Upward movement along the demand curve due to a price
risea in quantity demanded.
Downward movement along the demand curve due to a
price fallan in quantity demanded.

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Downward movement along the demand curve
due to a price fall leads to an in quantity
demanded.
Upward movement along the demand curve
due to a price rise leads to a in quantity demanded.
Change in quantity demanded
Determinants of demand
(Non-price determinants of demand)
Q
d
=f(tastes and preferences, income of the
consumer, prices of related goods, expectations,
number of buyers)
1. tastes and preferences-likes and dislikes of
consumers. It is also influenced by advertisement.
2. income-as income increases demand also increases
3. prices of related goods- a good is related to another
by being a substitute or complement.
substitute goods-goods that can be substituted for
each other. When the price of good X increases, the
demand for good Y increases.
complementary goods- goods that are consumed together
or in combination. When price of good X rises, the
demand for good Y falls.
4. expectations- expectation of a price rise in the future may
cause current demand to increase.
Eg. Financial instruments, agricultural commodities
5. number of buyers- if it increases demand also increases
and vice versa.
A demand curve is valid only so long as the underlying
determinants of demand remain constant. But these
determinants of demand can and do change. Thus, if
ceteris paribus is violated, demand curve will shift to
new position.
Change in demand- shift in demand curve due to changes in other
factors, and price is held constant.
increase in demand-represented by a rightward shift of the demand curve
decrease in demand-represented by a leftward shift of the demand curve
Shifts in the demand curve - Any change that raises the quantity that
buyers wish to purchase at a given price shifts the demand curve to
the right. Any change that lowers the quantity that buyers wish to
purchase at a given price shifts the demand curve to the left.
In short, the change in the determinants of quantity demanded is
represented as follows:
Identify whether the following causes a movement or
shift in the demand curve?
An increase in income of the consumer
A policy to discourage smoking
A tax that raises the price of cigarettes
Supply
Suppliers/firms profit maximization
Quantity supplied-amount of product the firms are able and willing
to offer for sale.
Q
s
=f (price)
Supply schedule- a table that shows the relationship between the
price of a good and the quantity supplied.
Individual supply schedule-
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Market supply schedule- the quantity supplied in a
market is the sum of the quantities supplied by all the
sellers.
Supply curve- a graph of the relationship between the
price of a good and the quantity supplied.
Law of supply-holding other things constant, the quantity
supplied increases with increase in its own price in a given
time period.
positive relationship between price and quantity supplied.
Change in quantity supplied- movements along the supply
curve. An upward movement along the supply curve due to a
price rise increases the quantity supplied. A downward
movement along the supply curve due to a price fall decreases
the quantity supplied.
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^
^
Determinants of supply
Q
s
=f (price of inputs, technology, expectations,
number of sellers)
1. Input prices-supply of a good is negatively related to
prices of inputs.
2. Technology- advances in technology increases the
supply
3. Expectations-expectation of a price rise in the future
leads to less supply today.
4. Number of sellers- if it increases, supply increases
and vice versa
Shifts in the supply curve- Any change that raises the
quantity that sellers wish to produce at a given price shifts
the supply curve to the right(increase in supply). Any
change that lowers the quantity that sellers wish to
produce at a given price shifts the supply curve to the
left(decrease in supply).
^
^
^
^
^
^
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Market Equilibrium
Market Equilibrium- point where demand and supply
intersect with each other.
Equilibrium price- the price that balances supply and
demand.
Equilibrium quantity- the quantity supplied and the
quantity demanded when the price has adjusted to
balance supply and demand.
At equilibrium price, the quantity of the good that
buyers are willing and able to buy exactly balances
the quantity that sellers are willing and able to sell.
This equilibrium price is sometimes called the
market-clearing price.
Market Equilibrium
Price Demand Supply
0.5 6 0
1 5 1
1.5 4 2
2 3 3
2.5 2 4
3 1 5
^
^

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Surplus (excess supply)- a situation in which quantity supplied

is greater than quantity demanded.
Shortage (excess demand)-a situation in which quantity
demanded is greater than quantity supplied.
How does the market restore the equilibrium price (P0)and
quantity(q0), if there is excess supply or excess demand?
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What is the effect on price and quantity if,
1. No change in supply and
a) if demand rises dd curve shifts to right P? Q?
b) if demand falls dd curve shifts to left P? Q?
2. No change in demand and
a) if supply rises ss curve shifts to right P? Q?
b) if supply falls ss curve shifts to left P? Q?
3. If both demand and supply shifts to the right by the same
amount, what is its effect on new equilibrium price and
quantity?
1. a. If there is no change in supply and if demand
rises, at new equilibrium E1 price increases and
quantity increases.
1. b. If there is no change in supply and if demand
falls, at new equilibrium E1, price decreases and
quantity decreases.
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3. At the new equilibrium E1, price remains unchanged
whereas quantity increases from q to q1.
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Scarcity : The core problem
Scarcity- Lack of enough resources to satisfy all
desired uses of those resources.
Factors of Production: resources used to produce
goods and services.
1. Land- all natural resources
2. Labor- skills and abilities to produce goods
3. Capital-final goods produced for use in further
production
4. Entrepreneurship-assembling of resources to
produce new or improved products and technologies
Core Issues
What to produce
how much of each commodity should be produced.
should the emphasis be on agriculture,
manufacturing or services. Should it be on health,
education, defence, infrastructure or housing?
How to produce
different ways to produce goods but which
production method to use. labour intensive, land
intensive, capital intensive? ; Efficiency.
For whom to produce
who is going to get the output produced? Should
everyone get an equal share?
Opportunity Cost
- Cost of the next best alternative forgone.
- Helps us to understand the true cost of decision
making and in valuing different choices.
Suppose a machine can produce either X or Y .The
opportunity cost for producing a given quantity of X
is the quantity of Y, which the resource would have
produced.
If the machine can produce 10units of X and 20
units of Y, then the opportunity cost of 1x is 2Y.
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Production Possibility Curve
- Alternative combinations of final goods and services
that could be produced in a given time period, with
all available resources and technology.
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Production possibility curve illustrates two essential
principles: scarce resources and opportunity cost.
All points on production possibility curve are
efficient points of production.
Points inside the production possibility curve shows
inefficient utilisation of resources.
Points outside the production possibility curve are not
attainable with the current level of resources.
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Growth: Increasing Production Possibilities
-if more resources or better technology becomes available. The
economic growth is shown by the outward shift of production
possibility curve.
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Circular Flow of Income: Two Sector Model
- Flow of goods and services between households
(consumers) and firms (producers).
Assumptions
Only two sectors - households and firms
Households supply factor services to firms
Firms hire factor services from households
Firms sell all the goods and services to households
Households spend all their income on goods an services
No government intervention and no foreign trade
Households are the owners of productive resource - land,
labour, capital and enterprise
Product market and Factor market.
Real flow-involves flow of goods and services.
Monetary flow-flow of money payments and expenditure.
It can be derived from the two sector model that:
Total production of goods and services by firms = Total
consumption of goods and services by household sector.
Factor payments by firms = Factor incomes of household
sector.
Consumption expenditure of household sector = Income
of firm sector.
Hence, real flows of production and consumption of firms
and households = Monetary flows of income and
expenditure of firms and households.
Circular Flow of Income with Financial System
Brings about the role of saving and investment.
Financial institutions are primarily intermediaries
between savers and investors, or lenders and
borrowers.
Financial institutions pay interest to the savers as
their funds are placed with them for a period of time
under a contract.
Firms pay dividend and interest for the sums they
have borrowed from the financial markets in the form
of shares, bonds and public deposits.
Circular Flow of Income In a Three Sector Economy
Government purchases goods and services from firms
and labour services from households. Government
collects taxes from households and firms in order to
finance its expenditure.
The government makes transfer payments to the
households in the form of social security,
scholarships, etc. It also gives subsidies to the firms
for various purposes.
Circular Flow of Income In a Four Sector Economy
The domestic economy and the rest of the
world(foreign sector) are connected through inter
import and export of goods and services ultimately
decide what the domestic economy gains or loses in
the international trade.
trade surplus- when there is excess of exports over
imports.
trade deficit- when there is excess of imports over
exports.
The four-sector model of the economy demonstrates
the overall macro economic condition of income and
output in the following identity:
Y C + I + G + (X M)
wherein,
Y = Income or output
C = Private consumption expenditure on consumer
goods
I= Investment expenditure by producing sectors
G = Government purchases
X M = Net exports (X = Exports, M = Imports)
Definitions
Marginalism
Incrementalism
Opportunity principle
Discounting
Time perspective
Marginalism
Marginal analysis is related to a unit change in
independent variable, say increase in costs as a result
of a unit change in output.
Marginal output of labour: output produced by the
last unit of labour
Marginal cost of production: cost incurred for
producing an additional unit of output
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Units
of
output
(1)
Total
Revenue
(Rs)
(2)
Marginal
revenue (Rs)
(3)
Total
costs
(Rs)
(4)
Marginal
cost (Rs)
(5)
Total
profits
(Rs)
(6)=(2)-
(4)
Average
profit (Rs)
(7)=(6) / (1)
Marginal
profits
(Rs)
(8)
1 20 - 15 5 5.0 -
2 40 20 29 14 11 5.5 6
3 60 20 42 13 18 6.0 7
4 80 20 52 10 28 7.0 10
5 100 20 65 13 35 7.0 7
6 120 20 81 16 39 6.5 4
7 140 20 101 20 39 5.6 0
8 160 20 125 24 35 4.4 -4
Incrementalism
Incremental reasoning involves estimating the impact of
decision alternatives.
Usually, changes occur in chunk rather than unit
changes.
Incrementalism is more general whereas marginalism is
more specific.
Incremental costs :change in total costs as a result of
change in the level of output, investment etc.
Incremental revenue is a change in total revenue resulting
from a change in the level of output, price etc.
While taking a decision, always incremental revenue
should always be greater than incremental costs
Opportunity Principle
Cost of next best alternative foregone or the cost
expressed in terms of the next best alternative
sacrificed.
Helps us view the true cost of decision making
Implies valuing different choices
Highest valued benefit that must be sacrificed as a
result of choosing an alternative.
Discounting
The concept of discounting is based on the fact that a
rupee now is worth more than a rupee earned a year
after.
Even if one is sure about future income, yet it has to
be discounted because to wait for future implies a
sacrifice for the present
Suppose a sum of Rs 100 is due after one year. Let
the rate of interest be 10 percent. Then we can
determine the sum to be invested now so as to
produce the return (R) of Rs 100 at the end of the
year. The present value or the discounted values of
Rs100 will then be V
1
= R
(1+i)
n
V
1
= 100
1+0.10
= Rs.90.90
A present value of Rs100 due two years later would
be V
1
= 100
(1+.10)
2
= Rs.82.64
Time perspective
Short run versus long run
Short run- at least one factor of production will be
kept constant
Long run- all factors are varied
Elasticity of Demand
Concept of elasticity
Elasticity is a measure of the responsiveness of one variable to
another.
The greater the elasticity, the greater the responsiveness.
Elasticity to measure how much consumers respond to
changes in variables(price, income, prices of relative
goods).
When price rises the demand falls. But by how much the
demand falls?
If price rises by 10%, quantity demanded falls. But is the
reduction in quantity demanded is by more than 10% or by
less than 10%. This is understood from the concept of
elasticity.
Elasticity of demand measures the direction as well as
magnitude.
measures the extent to which the demand will change.
Types of Elasticity of Demand
1. Price elasticity of demand (own price elasticity of demand/elasticity
of demand)
2. Income elasticity of demand
3. Cross elasticity of demand
Price elasticity of demand- percentage change in quantity
demanded divided by the percentage change in price.
Or it measures how much the quantity demanded responds to a
change in price.
E
d
= percentage change in quantity demanded
percentage change in price
E
d
= q/q i.e. E
d
= q X p i.e. E
d
= q2-q1 X p1
p/p p q p2-p1 q1
where q=q2-q1, p=p2-p1. q and p stands for the initial
quantity(q1) and price(p1).
The price elasticity of demand is always negative as there is an
inverse relationship between price and quantity demanded,
according to the law of demand.
Note:
The own price elasticity of demand is always negative.
Economists usually refer to the own price elasticity of
demand by its absolute value (ignore the negative sign).
Price elasticity of demand is elastic if the percentage change in quantity
is greater than the percentage change in price.
Or if quantity demanded responds substantially to change in price.
E
d
>1
Elastic demand means that the quantity demanded is sensitive to the
price.
Price elasticity of demand is inelastic if the percentage change in
quantity is less than the percentage change in price.
Or if quantity demanded responds only slightly to change in price.
E
d
<1
Inelastic demand means that the quantity demanded is not very
sensitive to the price.
Types of price elasticity of demand
1. Relatively elastic demand
2. Relatively inelastic demand
3. Unit elastic demand
4. Perfect elastic demand
5. Perfect inelastic demand
Relatively elastic demand (E
d
>1)- quantity demanded changes
more than proportionately to changes in price.
- demand curve is flatter.
E
d
= 50-100 5-4 = -2 i.e. E
d
= |-2| = 2
100 4
- a 25% (5-4/4) increase in price leads to more than 25% i.e. 50%
(50-100/100) decrease in quantity demanded.

Relatively inelastic demand (E

d
<1)- quantity demanded
changes less than proportionately to changes in price.
- demand curve is steeper.
E
d
= 90-100 5-4 = -0.4 i.e. E
d
= |-0.4| = 0.4
100 4
- a 25% (5-4/4) increase in price leads to less than 25% i.e.10%
(90-100/100) decrease in quantity demanded.

Unit elastic demand (E

d
=1)- quantity demanded changes
proportionately to changes in price.
E
d
= 75-100 5-4 = -1 i.e. E
d
= |-1| = 1
100 4
- a 25% (5-4/4) increase in price leads to a 25% (75-100/100)
decrease in quantity demanded.

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Perfectly elastic demand (E
d
=)- very small changes in
price leads to huge changes in quantity demanded.
i.e. when a 1% change in the price would result in an infinite
change in quantity demanded.
Perfectly inelastic demand (E
d
=0)- an increase or decrease
in the price leaves the quantity demanded unchanged.
i.e. when a 1% change in the price would result in no change
in quantity demanded.
E
d
=100-100 5-4 i.e. E
d
=0
100 4
Determinants of elasticity of demand
1. Availability of close substitutes- commodities with close
substitutes tends to have more elastic demand. For goods
with no close substitutes, demand is less elastic.
2. Necessity v/s luxury- Necessities tend to have inelastic
demands, whereas luxuries have elastic demands.
3. Proportion of income spent- if small amount is spent for
consumption demand is inelastic.
4. Time horizon-Goods tend to have more elastic demand over
longer time horizons.
Total revenue(TR) and Price elasticity of demand(E
d
)
TR= p x q
TR= 4 x 100=400.
How does TR changes when price changes: Inelastic demand
an increase in the price causes an increase in total revenue
At p1=1 and q1=100 , TR=100. At p2=3 and q2=80, TR= 240.
p/p=2 and q/q= -0.2. E
d
= -0.1
Percentage rise in price is > Percentage fall in quantity.
If demand is inelastic- when P,TR and when P,TR.
How does TR changes when price changes: Elastic demand
an increase in the price causes a decrease in total revenue
At p1=4 and q1=50 , TR=200. At p2=5 and q2=20, TR= 100.
p/p=0.25 and q/q= -0.6. E
d
= -2.4
Percentage rise in price is < Percentage fall in quantity.
If demand is elastic- when P,TR and when P,TR.
If demand is unit elastic, what is the effect on total revenue
if price changes?
Income elasticity of demand- measures how quantity
demanded changes as consumers income changes.
Y
ed
= percentage change in quantity demanded i.e. Y
ed
= q/q
percentage change in income Y/Y
i.e. Y
ed
= q x Y where Y-income, q-quantity demanded
Y q
Normal good (Y
ed
>0)- as income increases, quantity demanded
also increases and vice versa. positive Y
ed
.
a) Luxuries(Y
ed
1)
b) Necessities(0< Y
ed
<1)
Inferior good (Y
ed
<0)- as income increases, quantity demanded
decreases and vice versa. negative Y
ed
.
Unit income elasticity of demand(Y
ed
=1)
Zero income elasticity of demand(Y
ed
=0)
Cross price elasticity of demand- measures how much the
quantity demanded of one good responds to changes in the
price of another good.
E
cp(X,Y)
= percentage change in quantity demanded of good X
percentage change in price of good Y
E
cp(X,Y)
= q
x x P
p
y q
For substitutes cross elasticity is positive. i.e. E
cp(X,Y)
>0
For compliments cross elasticity is negative. i.e. E
cp(X,Y)
<0
For eg. E
cp(COKE,PEPSI)
=0.90
This implies that for every 1% increase in the price of pepsi,
the quantity demanded of coke would increase by 90%.
Problems
1. When price of X decreases from INR20 to INR10, its quantity
demanded increases from 20 to 50 units. Find the own price
elasticity of demand. Identify the nature of elasticity of
demand.
2. If quantity demanded of good A increases from 2 to 6 units,
due to an increase in the income of the consumer from
INR500 to INR750. Find the respective elasticity of demand.
Is it income elastic or income inelastic.
3. Suppose the quantity demanded of a commodity X increased
from 10 to 80 units due to a rise in the price of its related
commodity Y from INR15 to INR75. Calculate the respective
elasticity of demand and identify the nature of commodities.
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Costs in the Short run
Total cost-the market value of all resources used to produce a
good or service.
Total cost = fixed cost + variable cost
TC=FC+VC
Fixed cost(FC or TFC)- costs of production that does not change
when the rate of output is altered.
Eg. Cost of basic plant and equipment, rent
Variable cost(VC or TVC)- costs of production that change when the
rate of output is altered.
Eg. Labor and material cost
Total cost rises as output increases and as output is zero variable
costs are zero and TC is equal to total fixed cost.
How fast the total costs rise depends on variable costs only.
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Break Even Analysis
Break even is the point of production where a
firms revenue is equal to the total costs of
production
When total revenue is equal to total cost the
process is at the break-even point.
TR = TC
Margin of safety - the difference between the
firms current level of output and break even
output
Break-Even Analysis
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