Demand –Supply Analysis & Government

Intervention in the Market

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 Demand Analysis

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What is Demand?
• It is a buyer’s desire or want backed up by ability and willingness to pay for its price

Demand = Desire + Ability to Pay(Purchasing

power)+Willingness to Pay

• Demand for a product is the quantity of a commodity bought at a particular price

and time.

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Determinants of Demand
Price of the product

Prices of related goods – substitutes & complements

Income of the consumer – Inferior, neutral and normal goods

Tastes and preferences

Expectations

Advertisements

Demonstration effect

Availability of credit facilities

Population of the country

Distribution of National Income

Climate & weather conditions

Customs & Habits

Innovations

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Price of the Product

• Inverse relationship between price and quantity demanded.

• Increase in price leads to decline in demand and vice versa.

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Prices of Related Goods
Substitutes –
Two goods for which an increase in price of one leads to an increase in demand for the
other.
Example: If Commodity Coke & Pepsi are substitues, increase in price of Coke will lead to
decline in demand for Coke and increase in demand for Pepsi.

Complements –
When the price of a complementary goods goes up, demand for its parent goods goes
down.
Example:If the price of a complementary item (diesel) goes up, the demand for the parent
good (car) goes down.

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Income of the Consumers
• Normal Goods – A good for which other things equal, an increase in income leads
to an increase in demand.
Example: Clothes, eating out

• Inferior goods : A good for which other things equal, an increase in income leads to
an decrease in demand.
Example: Travelling in bus, shopping at large discounted chains.

• Neutral Goods: Demand does not depend on income.

Insulin for diabetics, salt.

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Tastes & Preferences

• Favourable tastes & preferences towards a good or service – Increase in demand

• Unfavourable tastes & preferences towards a good or service – Decrease in
demand

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Expectations

• If a consumer is expecting a fall in price of product in the near future, his current
demand will be less.

• If a consumer is expecting a hike in price of product in the near future, his current
demand will be more.

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Advertisements

• Advertisements normally create a positive effect on the demand.

• Informative and manipulative advertising

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Demonstration Effect

• Demonstration effect or people’s tendency to imitate the consumption patterns of

others also create a positive effect on demand.
• Tendency to get influenced by pace setters or trend setters(film
stars,models,friends)
• Demand is conditioned by the consumption of others than by the price.
• Demand for a commodity is increased due to the fact that others are also using it.
E.g Demand for iphone,ipad etc

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Credit Facility & Population

Credit Facility
• Availability of liberal credit facilities leads to increase the demand for a product.
• E.g: Lower rate of interest on loans,EMI schemes, Lower down payment amount
etc
Population
• Increase in population creates more demand for products.
• Change in composition of population affects the demand for various products.

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Distribution of National Income & Climatic Conditions

Distribution of National Income

• Equitable distribution of income – Increase in demand as more people have
purchasing power.
• Inequitable distribution of income – Decline demand as less people have
purchasing power.

Climatic Conditions
• Change in weather leads to change in demand for certain products
• E.g:Demand for woolen clothes is more during winter & less during summer.
• Demand for fruit juices is more during summer and less during winter

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Customs & Habits

• Religious festivals and ceremonies create more demand for sweets, gold
clothes etc.
Example
• Increase in demand for gold on Akshaya Tritiya

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Innovation & Creative Destruction

• Innovation leads to creation of demand for new products and decline in

demand for older ones.
• Creative destruction refers to the incessant product and process innovation
mechanism by which new products/services replace existing ones. This term
was coined by Joseph Shumpeter(1942)
Example
CDs have replaced floppy discs and later Pen drives were replaced CDs.

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Government Policies

Ban of a product by the government leads to decline in demand

Examples
• Alcohol Ban in some states
• Ban on the sale of pan masala

Taxation Policies
• Increase in Tax—Increase in price—Decline in demand
• Reduction in Tax—Reduction in price—Increase in Demand.

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Sin Taxes
• A state-sponsored tax that is added to products or services that are seen as vices,
such as alcohol and tobacco. These type of taxes are levied by governments to
discourage individuals from partaking in such activities without making the use of
the products illegal. These taxes also provide a source of government revenue.

• Two purposes are usually used to argue for such taxes. First, to directly pay for the
damage to society caused by these goods, and second, to increase the price and
reduce their use. Increasing a sin tax is often more popular than increasing other
taxes.

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Demand Function

• Mathematical of expression of functional relationship between determinants (such as price,

income, etc., determining variables) and the amount of demand of a given product.
• Composite Demand Function
• Dx = f (Px, Ps, Pc, Yd, T, A, N, u)
• The ‘own price’ of the product itself (P)
• The price of the substitute and complementary goods (Ps or Pc)
• The level of disposable income (Yd)
• Change in the buyers’ taste and preferences (T)
• The advertisement effect (A)
• Changes in population number or the number of the buyers (N).
• Any other unknown determinant (u)
• Simple Demand Function Dx = f(Px)

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Demand Schedule
• A tabular statement of price/quantity relationship is called the demand schedule.

Individual Demand Schedule

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Market Demand Schedule

• It is a tubular statement narrating the quantities of a commodity demanded in

aggregate by all the buyers in the market at different prices, over a given period of
time

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Market Demand Curve

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Assumptions of the Law of Demand
• No change in consumer’s income
• No change in consumer’s tastes & preferences
• No change in the price of related goods
• No expectation of future price changes
• No change in size, age composition and sex ratio of the population
• No change in the range of goods available to the consumers
• No change in the distribution of income
• No change in government policy
• No change in weather conditions

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Statement of the Law

Ceteris Paribus,the higher the price of a commodity, the smaller is

the quantity demanded and lower the price larger is the quantity.

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Demand Curve

Downward sloping demand curve indicates an

inverse relationship between price and demand.

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Exceptions to the Law of Demand

• Meaning : Increase in price leads to increase in demand and decline in price leads
to decline in demand.
• Upward sloping demand curve

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Exceptions to the Law of Demand
• Giffen Paradox
• Veblen Effect or conspicuous consumption – articles of snob appeal.
• Demonstration or bandwagon effect
• Fear of shortage.
• Buyers’ illusion
• Ignorance of the consumer
• Depression(Price and demand less)

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Giffen Paradox

• Introduced by Sir Robert Giffen based on a study conducted in Ireland in the 19th
century.
• Based on 3 pre conditions
1. It should be an inferior good
2. There must be lack of close substitute goods
3. Substantial percentage of consumers’ income should be spent on this.
• The paradox: The poor people in Ireland(19th century) spent a substantial part of
their income on bread & the remaining on meat. When the price of bread rose,
they stopped the consumption of meat & increased the consumption of bread.
When price increased demand also increased.

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The paradox

• “There are however some exceptions. For instance, as Mr Giffen has pointed out, a
rise in the price of bread makes so large a drain on the resources of the poorer
labouring families and raises so much the marginal utility of money to them, that
they are forced to curtail their consumption of meat and the more expensive
farinaceous foods: and, bread being still the cheapest food which they can get and
will take, they consume more, and not less of it. But such cases are rare; when they
are met with they must be treated separately “(p. 208).
• Principles of Economics(3rd Ed.1895) by Alfred Marshall
Source:http://mikael.cozic.free.fr/stigler47-History%20of%20giffen%20goods.pdf

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Veblen Effect

• Introduced by Thorestein Veblen

• Demand for Expensive goods with snob appeal by affluent people.
• Aristocratic desire to preserve exclusiveness for unique goods.
• E.g.Rolls Royce cars, rare paintings, antique pieces.
• Rich people demand these items only if the price is high.
• A person’s tendency to demand a good is decreased when it is consumed by many
people.
• Urge to use unique products will induce the consumer to pay a higher price.
• Limited Edition Products

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Demonstration or Bandwagon Effect

• Demand for certain good are not decided by usefulness, but on account of
demonstration effect.
• Tendency to get influenced by pace setters or trend setters(film
stars,models,friends)
• Demand is conditioned by the consumption of others than by the price.
• Demand for a commodity is increased due to the fact that others are also using it.
• E.g Demand for iphone,ipad etc

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Fear of shortage, Buyers Illusion, Ignorance

Fear of shortage
• Fear of shortage induces people to buy even at a high price.
• Shortage during war, natural calamities, supply shocks.
Buyers Illusion
• High priced goods are of high quality.
Ignorance about the Prices
• Due to ignorance consumers may end up paying higher prices.

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Depression & Boom

Depression
• Consumers may buy less even at lower price, because of the lack of purchasing
power.
Boom
• Consumers may buy more even at higher price, because of the increase in
purchasing power

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Changes in Demand
1. Expansion and contraction of demand.
2. Increase and decrease in demand

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Changes in Demand
• Expansion & Contraction of DD Increase & Decrease in DD

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 Supply Analysis

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What is Supply?

Distinction between supply and stock.

• Stock represents the total production of a commodity.
• Supply is the amount of stock offered for sale at particular prices.

• Example :A farmer produces 1000 kg of rice. At a price of Rs.30/kg he offers only

600 kg of rice in the market.

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Determinants of Supply

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Cost of Production

• Increase in cost of production leads to decline in supply and decline in cost of

production leads to increase in supply.
• Inverse relationship between cost of production and supply.

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State of Technology
• Better technology leads to increase in supply

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Factor Prices
• Increase in factor prices leads to increase in cost of production and thereby leading
to a decline in supply.

Labour shortage, rise in cost hits rice production

The Times of India,August 17,2012
Hassan: Sakleshpur is known for its coffee and rice production but the scenario has
changed due to acute labour shortage and an increase in the production cost. If the situation
prevails it would result in price rise, affecting common man.
In the taluk, rice is grown on 12,550 hectares, out of which 3,200 hectares is submerged in
Hemavathi backwater. Currently 9,550 hectares is available for rice cultivation. Four
thousand acres is used for multi crops. However, the farmers were not able to cultivate on
1,350 hectares this year.
Year after year fertile land is turning barren as the farmers are not able to use the land for
cultivation due to uncertain rainfall but mainly due to labour shortage and rise in production
cost.
https://timesofindia.indiatimes.com/city/mysuru/labour-shortage-rise-in-cost-hits-rice-production/articleshow/155
26198.cms

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Prices of other Goods
• Profitability in some sectors may induce producers to make more investment in
those sectors.
Examples
• Shift from production of food crops to cash crops.
• Production of more electric cars by manufactures

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Number of Firms in the Market

• Higher the number of sellers in a market higher will be the supply and vice versa.

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Government policies
• Ban/Restrictions – lead to reduction in supply
Example: Ban on plastic bags, ban on alcohol
• Provision of subsidies – leads to increase in supply

https://swachhindia.ndtv.com/world-environment-day-plastic-ban-india-20774

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Weather Conditions

• Adverse weather conditions reduce supply, especially of agricultural products

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Speculation, Hoarding & Black Marketing
• Increase in Speculation, Hoarding & Black Marketing reduces the supply.

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Discovery of New Sources

“Shale oil supply shock shifts global power balance”

The sharp rise in US oil production is largely thanks to shale oil, a product many
have hailed as the saviour of the US energy market.

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Supply Function

Other things being equal(which means we are assuming all determinants of supply
except price to be constant)

Sx = Supply of commodity x
Px = Price of commodity x
f = function

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Supply Curve

A graphic representation of relationship between price and the quantity supplied

,other things being equal

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Supply Schedule and Supply Curve

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Market Supply as the Sum of Individual Supplies

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Market Supply as the Sum of Individual Supplies

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Reserve Price
The price below which the seller will refuse to sell any quantity of
a commodity is known as reserve price.

• It mainly depends on Cost of production

• Reserve price also depends on the perishability of goods. Greater the
perishability lower the price.
• For non perishable items :Future price expectations
• Competitor’s prices
• Liquidity preference of the seller.

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Law of Supply

Other things being equal, supply of a commodity varies directly with its
price. Larger quantity will be supplied at higher price and smaller quantity
will be supplied at lower prices

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Assumptions of the Law
• Constant cost of production
• Constant technology
• Constant production function
• Constant government policies
• Constant transportation cost
• No speculation
• Prices of other goods produced by the firm remain constant.

All the determinants of supply, except price are assumed to be constant

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Why supply curve slopes upward?
• Incentive for the firms to produce more as the price increases, other things being
equal.
• Increase production leads to increase in dd for factors of production and increase
in factor cost. To cover higher cost higher price should be charged.

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Changes in Supply
Changes in supply are of 2 types
1. Expansion and contraction of Supply.
2. Increase and decrease in Supply

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Changes in Supply

• Movement along the same supply curve • Shift in the supply curve
• Happens due to change in price • Happens due to changes in factors
other than price

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 Combining Demand and Supply

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The Equilibrium of Supply and Demand

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Markets Not in Equilibrium

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The Three-Step Program for Analyzing Changes in Equilibrium

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How an Increase in Demand Affects the Equilibrium?

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How a Decrease in Supply Affects the Equilibrium

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A Shift in Both Supply and Demand

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 Government Intervention in the Market

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Can the Law of Supply & Demand be Repealed?

Objective of Government Intervention: Social Welfare

• Price Ceiling :Legally established maximum price a seller can charge. To

protect the interests of the buyers.
• Price Floor: A legally established minimum price a seller can be paid. To
protect the interests of the sellers.

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A Market with a Price Ceiling that is not Binding

• A price ceiling($4) above the eq

price ($3) creates a surplus in
the market.
• When there is surplus in the
market, ideally the price should
go down and reach the
equilibrium price.
• The price ceiling in the diagram
is unable to prevent the price
from falling back to $3.
• A price ceiling can only prevent
prices from going above the
ceiling and not prevent prices
from falling below the ceiling.
• Therefore the ceiling is not
binding or not effective in this
case.

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A Market with a Price Ceiling that is Binding

• When the price ceiling($2) is below the

market price ($3),there will be a
shortage in the market.
• When there is shortage in the market
ideally prices should go up and reach
the equilibrium price($3).
• However the price ceiling in this case
prevents the prices from going back to
$3.The market price will not go $3 due
to the ceiling of $2.
• Therefore the price ceiling is binding or
effective in this case.

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A Market with a Price Floor that is Not Binding

• When the price floor ($2)is fixed below

the market price($3),there will be
shortage in the market.
• When there is a shortage in the market,
ideally the prices should increase up to
the equilibrium price.
• In this case, the price floor unable to
prevent the prices from going up. A price
floor can only prevent prices from going
below the floor.
• Therefore the price floor is non binding
or not effective in this case.

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A Market with a Price Floor that is Binding

• When the price floor($4) is fixed above

the equilibrium price($3) there will be
surplus in the market.
• Due to the surplus, ideally prices should
come down to the equilibrium price.
• However the price floor which is fixed at
$4 is not letting the market prices to
come down to the equilibrium level.
• Therefore the price floor is
binding/effective in this case

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 Producer Surplus

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What is Producer Surplus?

• It measures the benefit sellers receive from participating in a market.

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The Costs of Four Possible Sellers

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The Supply Schedule and the Supply Curve

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Measuring Producer Surplus with the Supply Curve

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Measuring Producer Surplus with the Supply Curve

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How the Price Affects Producer Surplus?

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How the Price Affects Producer Surplus?

• There is a direct relationship

between Price & Producer
surplus.
• Higher the Price ,higher the
Producer surplus and vice versa

Initial Producer Surplus(When Price is P1) : ABC

New Producer Surplus (When Price is P2) -: ADF

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Consumer and Producer Surplus in the Market Equilibrium

•Consumer Surplus is the benefit that buyers receive from

participating in a market.
• Producer surplus is the benefit that sellers receive.

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 Measuring Economic Welfare using
Consumer and Producer Surplus

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Measuring Economic Welfare using Consumer and Producer
Surplus
• Consumer and Producer Surplus are the basic tools that economists use to study
the welfare of the buyers and the sellers.
• These tools can help us address a fundamental economic question. Is the
allocation of resources determined by free market desirable?

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Measuring Economic Welfare using Consumer and Producer
Surplus
• Consumer Surplus = Value to Buyers – Amount Paid by the Buyers
• Producer Surplus = Amount Received by Sellers – Cost to sellers

• Total Surplus = (Value to Buyers – Amount Paid by the Buyers) + (Amount

Received by Sellers – Cost sellers)
• The amount paid by buyers equals the amount received by sellers, so the middle
two terms in the expression cancel each other. As a result, we can write total
surplus as

• Total Surplus = Value to Buyers – Cost to Sellers

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Total Surplus

• Total surplus is the sum of consumer and producer surplus – is the area between
the supply and demand curves up to the equilibrium point.
• Total surplus in the image below is AEC.

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Efficiency of Free Markets - Demand side

• When the market is in equilibrium the price determines which buyers and sellers
participate in the market. Those buyers who value the good equal to or more than
price(Segment AE) on the demand curve choose to buy the good, buyers who
value it less than the price(segment EB) do not.
• Free markets allocate the supply of goods to the buyers who value them most
highly, as measured by their willingness to pay.
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Efficiency of Free Markets –Supply-side

• Those sellers whose costs are less than or equal to the price(segment CE)choose
to produce and sell the goods; sellers whose costs are greater than the
price(segment ED)do not.
• Free markets allocate the demand for goods to the sellers who can produce
them at the lowest cost.
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Deadweight Loss
Definition: It is the loss of economic efficiency in terms of utility for
consumers/producers such that the optimal or allocative efficiency is not
achieved. This arises due to reasons like taxes or subsidies, price ceilings or
floors, externalities and monopoly pricing. It is the excess burden created due
to loss of benefit to the participants in trade which are individuals as
consumers or producers.

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Deadweight Loss due to price Floor

• When a price floor is imposed, there is a

loss in the economic surplus (Area A and
B) known as deadweight loss.
• Since consumer surplus is the area
below the demand curve and above the
price, with the price floor the area of
consumer surplus is reduced from areas
B, C, and E to only area E.
• Producer surplus which is below the
price and above the supply curve
changes from area A and D to D and C.

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Deadweight Loss due to Price Ceiling

• A price ceiling also creates a

deadweight loss of area A and B.
• The consumer surplus area
changes from areas E and B to E
and C.
• Producer surplus area is reduced
from A, C, and D to only D.

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