Demand and Supply

Learning outcomes
► How is the price of a commodity
determined?
► What brings a change in price?
► Why the change in price of food is more
sensitive and reaction of consumers
different from that of change in price of
cars?
► Why is the pricing strategy of computers
different from that of textiles.
► How to analyse what factors influence the
sales of your product?
► What is a demand function?
► What is a supply function
n?
► Why study elasticities? Its usefulness.
► How to forecast the demand for a product?
► What happens to price when the
government intervenes in the market?
 Supply and Demand
Two pillars of Microeconomics

Crucial for Determining Price of the Product

Price is determined by the interaction of

supply and demand
 Demand
Estimating Demand is central to any business
operation

A firm before starting its operations has to

forecast the demand.

A change in price is analysed through demand

and supply.
 Demand
► The amount of a good that a consumer is
willing to buy and able to purchase at a
period of time at a certain price.

Law of Demand
Other things remaining same, when the price
of a commodity falls, its QD increases and
vice versa.
Inverse relationship between price and
quantity demanded.

Price is the most important factor that

determines demand.

Assumption of ceteris paribus.

 Factors influencing Demand
Dx = f( Px, Ps, Pc, I, T, F exp, Gp, Ec)

Demand for the product can vary with any of

the above factors varying.
 Why are the food prices soaring
high

Needs to be analysed through the demand

and supply function for food commodities.
 Nature of Relationships
Factor Nature of Relationship

Price Inverse

Prices of Substitutes Directly related

Price of complements Inversely

Income of the consumer Directly

Tastes and preferences ----------

Expectation of Future prices Directly

 The Demand curve
► The Demand curve is also the average
revenue curve of the firm.
► Relation between price and quantity
demanded.
► Typically a downward sloping demand curve
MIC AR MR TR example.xls
 Demand Curve

Plotting Price and Quantity

Points in a Graph

12 of 28
 Demand function
Demand Function
D = a – bP
b = change in D/Change in P
b= -5
Taking any values of P and D
50 = a – 5 (15)
a = 125
D = 125 – 5 P
 Elasticity
► Elasicity is measured at a point of the
demand curve.
► Elasticity would vary from point to point
ep = % change in quantity demanded /%
change in price
say at point B when P = 15 and Q = 55
ep= -5 * (14/55) = 1.27
At point C when P = 13 and Q = 60, ep =1
► Change in Quantity demanded and change
in demand
► Movement along the demand curve and
shift in the curve
 Change in quantity demanded and change in demand

Taking Into Account More Than Two Variables on a Graph

Showing Three Variables on a

Graph

16 of 28
► Shoulddemand curve always be downward
sloping?
 Exceptions to the Law

Giffen Goods: Consumers purchase less of the

good when the price falls and vice versa.
Explained in terms of change in the real
income.
Change in the price of bread, coarse cereals.
This requires differentiating real income from
the nominal income.
Inferior goods:

This exception is explained when the change

occurs due to change in the nominal income
Veblen effect: Attach quality to the price of
the product
Conspicous consumption.
 Elasticity of a Demand Curve
► Elasticity could be measured for any two
variables
► Price elasticity of demand
► Income Elasticity of Demand
► Cross price elasticity of demand
 Elasticity
► Elasticity A measure of how much one
economic variable responds to changes in
another economic variable.
 Price Elasticity of Demand
► Price elasticity of demand The responsiveness of the
quantity demanded to a change in price, measured by dividing
the percentage change in the quantity demanded of a product by
the percentage change in the product’s price.

► Measuring the Price Elasticity of Demand

 Appendix 1A:
Using Graphs and Formulas

Graphs of Two Variables

Slopes of Lines Slope 
Change in value on the vertical axis

Δy Rise

1A - 4 Change in value on the horizon tal axis Δx Run
Calculating the Slope of a Line

Δ Price of pizza ($12  $14)  2

Slope     0.2
23 of 28 Δ Quantity of pizza (65  55) 10
► Elastic Demand and Inelastic Demand

► Elastic demand Demand is elastic when the percentage change

in quantity demanded is greater than the percentage change in price,
so the price elasticity is greater than 1 in absolute value.

► Inelastic demand Demand is inelastic when the percentage

change in quantity demanded is less than the percentage change in
price, so the price elasticity is less than 1 in absolute value.

► Unit-elastic demand Demand is unit-elastic when the

percentage change in quantity demanded is equal to the percentage
change in price, so the price elasticity is equal to –1.
Demand Schedule, Curve and the Function
Price Demand ep Arc ep
0 50 --
1 45 0
2 40 1.1 2-4= ep=
0.42
3 35 0.25
(.01..from 3
to 1)

4 30 0.42
5 25 0.66
6 20 1
7 15 1.5
8 10 2.3
9 5 4
10 0 9
Price, TR, MR and elasticity
P QD TR MR ep
0 50 0
1 45 45 -9 0
2 40 80 -7 0.11
3 35 105 -5 0.25
4 30 120 -3 0.42
5 25 125 -1 0.66
6 20 120 1 1
7 15 105 3 1.5
8 10 80 5 2.3
9 5 45 7 4
10 0 0 9 9
Relation between elasticity and
total revenue
 Demand function

D = a – bP
D= demand for a product
a= intercept of the function
b=slope of the function
P=price of the product
D= 50-5P
The Price Elasticity of Demand
and Its Measurement

Elastic and Inelastic Demand

Curves

29 of 29
The Price Elasticity of Demand
and Its Measurement
► The Price Elasticity of Demand
 Elasticities and revenue of the
firm
First case of last slide
at P = 30 and Q = 16, ep > 1 (1.37)
Total revenue
30*16 = 480
20*28 = 560
In second case ep= 0.55
30*16 = 480
20*20 = 400
In the third case ep = 1
30*16 = 480
20*24 = 480
 The Arch Price Elasticity

The Midpoint Formula

Price elasticity of demand =

32 of 29
 Cross price elasticity
for example for tea and coffee
epij = %cha in the QD of Y / % cha in the price of X
PT QC Ch Qc/Ch Pt *Pt/Qc
150 100 20/10 * 150/100
160 120
epij = 3

Cross price elasticity is positive for substitutes

Negative for complements

Similarly you can have income or advertising elasticity of

demand
 Elasticities of Different commodities
 Cigarettes (US)[41]
 −0.3 to −0.6 (General)
 −0.6 to −0.7 (Youth)
 Alcoholic beverages (US)[42]
 −0.3 or −0.7 to −0.9 as of 1972 (Beer)
 −1.0 (Wine)
 −1.5 (Spirits)
 Airline travel (US)[43]
 −0.3 (First Class)
 −0.9 (Discount)
 −1.5 (for Pleasure Travelers)
 Livestock
 −0.5 to −0.6 (Broiler Chickens)[44]
 Oil (World)
 −0.4
 Car fuel[45]
 −0.09 (Short run)
 −0.31 (Long run)
 Medicine (US)
 −0.31 (Medical insurance)[46]
 −.03 to −.06 (Pediatric Visits)[47]
 Patents
 Rice[49]
 −0.47 (Austria)
 −0.8 (Bangladesh)
 −0.8 (China)
 −0.25 (Japan)
 −0.55 (US)
 Cinema visits (US)
 −0.87 (General)[46]
 Live Performing Arts (Theater, etc.)
 −0.4 to −0.9[50]
 Transport
 −0.20 (Bus travel US)[46]
 −2.8 (Ford compact automobile)[51]
 Soft drinks
 −0.8 to −1.0 (general)[52]
 −3.8 (Coca-Cola)[53]
 −4.4 (Mountain Dew)[53]
 Steel
 −0.2 to −0.3[54]
 Eggs
 −0.1 (US: Household only),[55] −0.35 (Canada),[56] −
Generally Luxurious items are more elastic in
nature.
Necessities are more inelastic in nature.

Elasticity is determined by
Nature of the commodity
Closeness of the substitutes
Time period
 Elasticity
Elasticity change Ch in rev for Ch in rev for dec
increase in P in price

Unit elastic %Δ Q = %ΔP No change No change

Relatively elastic %Δ Q > %ΔP Decrease in rev Increase in rev

Perfectly elastic %Δ Q = ∞ Revenue will fall to Cant reduce the

zero price

Relatively inelastic %Δ Q < %ΔP Increase in rev Decrease in rev

Perfectly inelastic %Δ Q = 0 Increase in rev Decrease in

revenue
Relation between Average Revenue, Marginal
Revenue and Total Revenue of the firm
► MIC AR MR TR example.xls

► AR curve of the firm= Demand curve of the

firm.
► AR = TR/Q = P
► TR = AR(Q)
► MR = dTR/dQ
 Forecasting Beer demand
► Build an MRA model
► Analyse the scenario and identify the factors
► Convert raw data into meaningful variables- which ones
can be converted here?
► Select variables important for the model
► Analyse the relative importance of variables
► What other variables can be included (which are not
mentioned in the case and may be accessible now for
analysis)
► Forecast the future demand for beer.
 Case analysis 2- The difference
between nominal and real price
► Petroleum elasticity.xlsx

► Look at the difference between the impact

of real and nominal price in estimations.
► Convert the nominal into real.
 Analysis of Supply
Supply

Various quantities of a good which a seller is

willing and able to sell at different prices in
a particular period of time, other things
remaining the same.

Sx = f ( Px, Pi, Gp, Season, Tech)

Law of supply

Other things remaining same more of a good

is supplied at a higher price than at a lower
price.
Supply schedule and the curve
Qs P

0 10

10 20

20 30

30 40

40 50
 Change in Supply and change in
quantity supplied
► Supply curve
► Change in supply and change in quantity
supplied.

► Elasticity
of supply
► Determinants of elasticity
► Nature of the commodity, Technology,
Economies of scale and time lag.
 Equilibrium
Demand = Supply

D = 50-5P
S = -10+2P
Qd = Qs (Market Clearing)
P= 8.5
Q= 7.5
Equilibrium to Disequilibrium and
Disequilibrium to equilibrium
► In a true sense markets move from
equilibrium to disequilibrium and from
disequilibrium to equilibrium.
► So what causes the disequilibrium and how
is the equilibrium restored is the purpose of
analysis.
► The disequilibrium is caused either by the
shift in the supply or the demand curves.
Say increase in the price of inputs for cars
would cause the supply curve for cars to
shift to the left leading to a new equilibrium.
Similarly recession leading to fall in demand
for houses would shift the demand curve for
houses to shift to the left.
The arrival of summer season shifts the
demand curve for soft drinks to the right.
 Administered Prices
► Ceilingor floor fixed by the govt.
► Minimum support price: Excess supply may
be absorbed by the PDS
► Rent ceiling: Shortage of houses
 ►The Romance of Rent Control

Figure 1: In (a), the elimination of rent control causes an increase from Q1 to

Q2 in the quantity of apartments being rented. In (b) this causes the
demand for currently non-rent-controlled apartments to shift to the left from
D1 to D2. The equilibrium rent declines from $2,000 to $1,500.
48 of 27
 Impact of taxes
Shifts the supply curve to left
► Imposition of tax : Unit tax
S = -a+bP
= -10+2P
=-10+2(P-10) P

= -30+2P

s
 Tax as a percentage of the value of the
commodity.
S = -a+bP P

= -10+2P
= -10+2P{1-(10/100)}
= -10+2P-.2P
= -10+1.8P
S
 Tax Burden on the Buyer and Seller

Nature of Elasticity Effect of Taxes

Demand more elastic Less burden on the buyer and more on

the seller.

Demand is less elastic More burden on the buyer and less on

the seller
 Tax burden on the buyer and the seller

Tax Burden on the Buyer

= (Es /(Es+Ed))*tax rate

Tax Burden on the Seller

= (Ed/(Es+Ed))*tax rate
► Withthe introduction of GST Appollo taxes
on many medical products (which is at the
range of 4-5 percent) only 2% can be
absorbed by the company. The rest will be
passed to the consumers.
If the elasticity of demand and supply are 3
and 2 respectively. The government
imposes a specific sales tax of Rs 25 per
unit, what is the tax burden on the buyer?
 Problems
1. Use supply and demand curves to illustrate
how each of the following events would
affect the price of butter and quantity of
butter bought and sold: a) an increase in
the price of margarine; b) an increase in the
price of milk; c) a decrease in average
income levels.
► 2.Demand function for ballpoint pens is
QD = 100-0.5P. Compute the price elasticity
at the price of 10.
3. The supply function for a product is
Qs = 500P – 1000. What is the point price
elasticity of supply at the price of 10.
4. Time Watches Co. assembles wrist watches and sells in
western India. Demand function faced by company is
estimated to be –Q = 40,000- 2Pt – 2I + 4Pc
Where Q = number of watches demanded from Time watch
company
Pt = Price of watches sold by Time watch Co.
I = per capita income in western India
Pc = Price charged by competitors.
Currently Pt, I and Pc are Rs 350, Rs 10,000 and Rs
400 respectively.
► Estimate the price elasticity of demand
► Estimate the income elasticity of demand
► Estimate cross price elasticity of demand
► Given this price if Time watch wants to maximise its
revenue what do you recommend?
5. The sales response function of a consumer durable for
brand x is estimated to be Qx = 50000-2Px+3Py+50Ax-
20Ay

Where Qx=Sales in units of brand X

Px = Price of brand X = Rs 3000
Py = Price of brand Y = Rs 3500
Ax = No of advertising messages for brand X
Ay = No of advertising messages brand Y
 Contd..
► The manufacturer of brand X decides to increase the
advertising messages from the current level of 250 to 375.
With the increase in number of messages for brand X it is
expected that the number of messages for brand Y will
also increase by the same number. Current advertising for
Y is 500 messages. If the cost of production of brand X is
Rs 1500 and the cost of an advertising message is Rs 250,
how will the increase in advertising messages with regard
to brand X affect the profits?
6. A farm product has the following demand and supply
functions.
Demand: Q = 13500 – 500P
Supply: Q = 3000 + 200P

a. Determine the equilibrium price and output

b. Government imposes a specific sales tax at the rate of

Rs 10 per unit what is the eql price and output.