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DEMAND & SUPPLY

Aims & Objectives


After studying this lesson, you will be able to understand:
The concept of demand
Determinants of demand
Law of demand
Process of demand estimation
Concept of supply and supply function
Determinants of supply
Law of supply

Demand defined
Demand is the desire, want or need to purchase a good or service at
a given price backed up by the willingness and ability to pay for it
Quantity demanded (normally denoted as Qd) is the amount of a
particular good or service that consumers are willing or able to
purchase at a given price, during a given period of time.

Types of Demand

Individual vs Market demand


Company vs Industry demand
Market segment vs Total market demand
Domestic vs National demand
Direct vs Indirect demand
Autonomous vs induced demand
New vs replacement demand
Household vs Corporate vs Government demand

Determinants of Demand
Price of the commodity
Income of the consumer
Price of related goods - Price of substitutes & Price of
complements
Wealth of the consumer
Price/Income Expectation
Advertisement expenditure
Taste & preferences
Other factors

Demand function
A demand function is given as:
Dx = f (Px, Py, Pz, I, W, E, A, T, O)
Where,
Px price of good X
Py price of substitute
Pz price of complement
I income of the consumer
W wealth of the consumer
E price/income expectation of the consumer
A advertisement expenditure on the good
T taste & preference of the consumer
O other exogenous factors

Market demand function


Market demand function is the summation of all the individual
demand functions

Law of Demand
All other factor affecting demand for a commodity remaining
constant, if price of the good rises then quantity demanded of the
good falls and vice versa.

Demand schedule & Demand curve


A tabular representation of
quantity purchased of a good at
corresponding prices is
referred to as a demand schedule.
A graphical representation of the
demand schedule is the demand
curve

Price/unit

Quantity
(unit)

P1

Q1

P2

Q2

p3

Q3

D
O

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Slope of a demand curve


The demand curve, each point on which shows the quantity
purchased of a good at various prices, is downward sloping as
quantity demanded of a good is inversely related to its price
This inverse price-quantity relationship may be explained with the
help of the following two concepts:
Income effect
Substitution effect

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Income effect
When the price of a commodity falls, less has to be spent on the
purchase of the same quantity of the commodity. This leads to an
increase in purchasing power of the money with the buyer. This is
referred to an increase in real income of the consumer.
The increase in real income leads to an increase in purchase of the
commodity whose price has fallen. This is referred to as income
effect of a price change.

Px Real income Qx

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Income effect negative or positive?


Px Real income Qx income effect is positive X is a
normal good
Px Real income Qx income effect is negative X is an
inferior good

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Substitution Effect
When price of a commodity falls, its becomes cheaper relative to
other commodities. This leads to substitution of other commodities
(which are now relatively more expensive) by this commodity. Thus
the demand for the cheaper good rises. This is called the
substitution effect.

Px it is relatively cheaper and hence attractive


Qx

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Substitution effect negative or positive?


Substitution effect is always positive.

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Inferior good vs Giffen good


A good with negative income effect is referred to as inferior good
A good whose negative income effect dominates the positive
substitution effect is a Giffen good.
Thus, all Giffen goods are inferior goods but all inferior goods are
not Giffen goods

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Exception to Law of Demand


Giffen paradox: when negative income effect of an inferior good
dominates its positive substitution effect, the total effect of a price
change of the good on its quantity demanded tends to be positive. That
is, as price falls, demand for its falls too & if price rises then demand
for its rises too. This results in an upward sloping demand curve.
P

Other exceptions are: Snob/Veblen effect, Share Market, Demonstration effect

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Shifts & movement along demand curve


Movement along demand curve
P1
P2

A
B

Q1 Q2
The change in demand is
due to
change in price of the
good all
other factors affecting
demand
being constant. This is
referred
to as change in quantity

Shift of demand curve

Q1Q2 Q3
The change in demand is due
to
change in any one of the
other
factors
affecting
demand (say, income), price
of the good remaining the
same. This is referred to as
change
in
quantity
demanded.
If
quantity

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Estimation of demand

Involves estimating demand relationship and forecasting demand.


Steps involved are:
Collecting information: consumer surveys, Market information
Data Analysis by statistical estimation of demand relationships

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Supply
Quantity supplied of any good or service is the amount that
sellers are willing and able to sell for a price

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Determinants of supply

Input prices
Technology
Expectation of future prices
Number of sellers in the market
Price of substitute or complementary goods

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Supply function

Sx = S (Px, Pw, Pv, C, T, E, N, In, Dr)


Where
Px denotes price of X
Pw denotes price of substitute
Pv denotes price of complement
C denotes input prices or cost
T denotes technology
E denotes price expectation
N denotes number of sellers
In denotes inventory demand
Dr denotes reservation demand

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Supply schedule & Supply curve


A tabular representation of
quantity supplied of a good at
corresponding prices is
referred to as a supply schedule.
A graphical representation of the

Price/unit

Quantity
(unit)

P1

Q1

P2

Q2

p3

Q3
S

supply schedule is the supply


curve. The supply curve is
upward rising as quantity supplied
of a good is directly related to its
own price

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Shifts & movement along supply curve


Movement along supply curve

P1
P2

A
B

Q1 Q2
The change in supply is
due to
change in price of the
good all
other factors affecting
supply
being constant. This is
referred
to as change in quantity

Shift of supply curve

Q1Q2 Q3
The change in supply is due
to
change in any one of the
other factors affecting
supply(say, technology), price
of the good remaining the
same. This is referred to as
change in supply. If quantity
supplied increases it is

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Law of Supply
All other factor affecting supply of a commodity remaining constant,
if price of the good rises then quantity supplied of the good also
rises.

Market equilibrium

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Aims and Objectives


After studying this lesson, you will be able to understand
Concept of market equilibrium
Effect of changes in demand on equilibrium
Effect of changes in supply on equilibrium

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Market equilibrium/Demand-supply equilibrium & its


stability
P

Excess supply

P2
P1

P3

Excess
demand
Q1

Market equilibrium occurs when


demand for a good matches its
supply and the market gets cleared.
An equilibrium is said to be stable
when following any deviation from
equilibrium the equilibrium there are some
automatic forces which bring the
system back to equilibrium
S

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Effect on equilibrium when demand changes


P

Let demand increase for some


reason. New demand curve is D
now. With same supply there is
excess demand at each price.
This pushes up the price and
the new equilibrium occurs at E
at a higher price and higher
quantity

E
P2

P1

Q1 Q2

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Effect on equilibrium when supply changes


P

S
S

Let supply increase for some


reason. New supply curve is S
now. With same demand there
is excess supply at each price.
This pushes down the price and
the new equilibrium occurs at E
at a higher quantity and lower
price

E
P1
P

E
2

Q1
Q2

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Exercise
Work out effect on equilibrium in the following situations:
When there is a technological up gradation
When income of consumer increases
When input prices rise
When price of substitute rises

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Price controls
These are of two types: Price ceiling and Price floor

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Price Ceiling
When the Regulator (government) feels that the market price (Pm) of a
good is too high and the consumer welfare is at stake then the
government can fix the price at a level lower than the market
equilibrium price. This is referred to as price ceiling.
At the ceiling price (Pc)there is excess demand trying to push the price
back to the higher level determined by market equilibrium. So to
sustain the price ceiling the government increases the supply to match
the increased demand and thereby eliminate the pressure of excess
demand.
To enable suppliers to supply more at lower price, the government
provides subsidies to the suppliers.
Demand Curve

Original market supply curve


Supply curve after subsidy

Pm
Pc
Excess demand

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Price Floor
When the Regulator (government) feels that the market price (Pm) of a
good is too less and the producer welfare is at stake then the
government can fix the price at a level higher than the market
equilibrium price. This is referred to as price floor.
At the floor price (Pf)there is excess supply trying to push the price
back to the lower level determined by market equilibrium. So to sustain
the price floor the government increases the demand to match the
excess supply and thereby eliminates the pressure of excess supply.
To increase the demand to match the excess supply, the government
procures these goods and takes initiatives to sell these procured
products itself
Excess supply

Pf
Pm

Supply curve
Demand curve when gov procures
Original demand curve

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Thank You