The Basics of Demand, Supply and Equilibrium
Dr. Prerna Jain
If
you cant pay for a thing, dont buy it. If you cant get paid for it, dont sell it. Benjamin Franklin
Demand
Demand is defined as the want which is backed by willingness and ability to buy a particular commodity in a given period of time. Quantity demanded (Qd) Amount of a good or service consumers are willing and able to purchase during a given period of time
Types of Demand
Direct Demand
When a commodity is demanded for its own sake by the final consumer, it is known as consumer good and its demand is derived demand. Ex: TV, refrigerator, computer and eatables. A final consumer is one who derives satisfaction from a good without any further value addition.
Derived Demand
When a commodity is demanded for using it either as a raw material or as an intermediary for value addition in any other good or in the same good, it is known as a capital good and its demand is derived demand.
Recurring Demand
Consumable goods have recurring demand, i.e., they are consumed at frequent intervals, like you eat food twice a day
Replacement Demand
Goods like TV, cars, furniture and houses are all examples of durable consumer goods. They are purchased to be used for a long period of time. But they wear and tear over time due to use or obsolescence of technology; thus they need replacement.
Complementary Demand
Competing Demand
Goods which create joint demand are complementary goods; therefore demand for one commodity is dependent upon demand for the other one
Goods that compete with each other to satisfy any particular want are called substitutes.
Individual Demand
Market Demand
Demand for an individual consumer is normally expressed as individual demand and the theory of demand is based on individual demand.
Demand by all the consumers for its product is known as market demand.
Determinants of Demand
Price of the product Normally, price has a negative effect on demand. Income of the consumer Normally, income bears a positive relationship with demand. Normal goods have a positive relation whereas inferior goods have negative relation.
Price of related goods If price of a commodity increases, its demand falls, but when demand for another product also falls as a consequence to rise in price of this commodity such goods are complementary to each other (car and petrol). On the other hand when demand for another commodity rises as a consequence of increase in price of this commodity, they are substitutes (tea and coffee). Thus an increase in the price of a commodity increases the demand for its substitute and reduces the demand for its complement.
Tastes and Preferences Tastes and preferences have such effect that in spite of a fall in price, demand may not increase if the good has gone out of fashion and in spite of increase in price, demand may not decrease because of the product being in fashion.
Advertising Advertising has gained remarkable ground as a determinant of demand, especially in the modern age of cut throat competition among brands. Consumers expectation of future income and price. Population Growth of economy
Demand Function
Demand function DX = f (Px, Y, Po, T, A, Ef, N)
Milestones on the Road to Theory of Demand and Supply
Antoine- Augustin Cournot was the first scholar to bring out the Law of Demand in 1838, but his theory could not gain popularity as it was in pure mathematical terms with which the then students of economics was unfamiliar. In 1844 Dupuit drew the first demand curve and called it the curve of consumption. The law of demand was discovered a few years later and given its first application by lardner in 1850 to explain transportation services.
Fleeming Jenkin was the first scholar to draw the demand and supply curves together to explain the determination of price in 1870. Jenkin also was the first to use theories of demand and supply to make predictions about the effects of taxes. Alfred Marshall is recognised as the first person to present complete and modern explanation of demand and supply theory through his monumental treatise to economics Principles of Economics.
Generalized Demand Function
Qd = a bP + cY + dPo + eT + fA+ gN b, c, d, e, f, & g are slope parameters Measure effect on Qd of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is related to Qd
Positive sign indicates direct relationship Negative sign indicates inverse relationship
Law of Demand
A decrease in the price of a good, all other things held constant, will cause an increase in the quantity demanded of the good. An increase in the price of a good, all other things held constant, will cause a decrease in the quantity demanded of the good.
Reasons Behind Law of Demand
Price Effect: This explains why a fall in price results in rise in demand and vice versa. Some commodities may have multiple uses, like electricity, milk, coal, steel, etc. A fall in the price of such a commodity would induce a consumer to put it to alternative uses, like electricity can be used for lighting, cooling, cooking, running machines, etc.
Substitution Effect: When the price of a commodity falls, it becomes more easily affordable and thus more attractive to the consumer; as also its substitute become more expensive, assuming that its price has not changed. The consumer tries to substitute this particular commodity for other commodities. As a result, demand for the commodity rises.
Income effect demand depends upon the income of the consumer and law of demand assumes that income is given. When price of a particular commodity falls, the consumers real income rises, though money income remains the same. Thus, with fall in the price of the commodity, income remaining the same, purchasing power of the individual rises, inducing the consumer to buy more of that commodity.
Exceptions to the Law of Demand
Giffen Goods: In Ireland it was observed that the poor population consumed two goods: meat (which was costly) and bread (which was cheap). A very strange phenomenon was observed when the price of bread was increased, it made a large drain on the resources of the poor people that they were forced to curtail their consumption of meat and buy more of bread which was still the cheapest food. This implied that quantity demanded of bread (an inferior good) increased with increase in its price. Sir Robert Giffen was the first to give an explanation to this situation
Hence, such goods which display direct price demand relationship are called giffen goods. These goods are considered inferior by the consumer, but they occupy a significant place in the individuals consumption basket. It so happens that people in this case, with the rise of price of that good (bread) are forced to reduce their purchase of other expensive goods (say, meat) and increase the purchase of that good (bread) in larger quantity to supplement the reduction in luxury food items. Hence these goods are those on which major portion of income is spent, hence they are termed as giffen.
Snob Appeal There are certain goods which have snob value, for which the consumers measures the satisfaction derived not by their utility value, but by social status. The consumers of this particular commodity want to show it off to others, and as a result they buy less of it at a lower prices and more at higher prices. Demonstration Effect: When a persons behaviour is influenced by observing the behaviour of others, this is known as demonstration effect. Fashion is one such incidence. In such a case price is not a governing parameter and goods are bought even though prices are rising.
Future expectation of prices Goods with no substitutes Those goods which have no substitute, such as life saving drugs, petrol and diesel, people have no option but to buy them, whatever be the price
Graphing Demand Curves
A
point on a demand curve shows either:
Maximum amount of a good that will be purchased for a given price Maximum price consumers will pay for a specific amount of the good
Graphing Demand Curves
Change
in quantity demanded
Occurs when price changes Movement along demand curve
Change
in demand
Occurs when one of the other variables, or determinants of demand, changes Demand curve shifts rightward or leftward
Change in Quantity Demanded
Price An increase in price causes a decrease in quantity demanded.
P1
P0
Q1
Q0
Quantity
Change in Quantity Demanded
Price A decrease in price causes an increase in quantity demanded.
P0
P1
Q0 Q1 Quantity
Changes in Demand
Change
in Buyers Tastes Change in Buyers Incomes
Normal Goods Inferior Goods
Change
in the Number of Buyers Change in the Price of Related Goods
Substitute Goods Complementary Goods
Change in Demand
Price
An increase in demand refers to a rightward shift in the market demand curve.
P0
Q0
Q1
Quantity
Change in Demand
Price
A decrease in demand refers to a leftward shift in the market demand curve.
P0
Q1
Q0
Quantity
Supply
Supply refers to 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 and vice versa.
Supply
Six
Price of good or service (P) Input prices (PI ) Prices of goods related in production (Pr) Technological advances (T) Expected future price of product (Pe) Number of firms producing product (F)
Generalized
variables that influence Qs
supply function
Qs f ( P, PI , Pr , T , Pe , F )
Generalized Supply Function
Qs h kP lPI mPr nT rPe sF
k, l, m, n, r, & s are slope parameters Measure effect on Qs of changing one of the
variables while holding the others constant
Sign of parameter shows how variable is related to Qs
Positive sign indicates direct relationship Negative sign indicates inverse relationship
Generalized Supply Function
Variable Relation to Qs
Direct Inverse Inverse for substitutes Direct for complements Direct Inverse Direct
Sign of Slope Parameter
P PI Pr
k = Qs/P is positive l = Qs/PI is negative m = Qs/Pr is positive m = Qs/Pr is negative
T
Pe F
n = Qs/T is positive
r = Qs/Pe is negative s = Qs/F is positive
Graphing Supply Curves
A point on a supply curve shows either: Maximum amount of a good that will be offered for sale at a given price Minimum price necessary to induce producers to voluntarily offer a particular quantity for sale
Graphing Supply Curves
Change in quantity supplied Occurs when price changes Movement along supply curve Change in supply Occurs when one of the other variables, or determinants of supply, changes Supply curve shifts rightward or leftward
Law of Supply
A decrease in the price of a good, all other things held constant, will cause a decrease in the quantity supplied of the good. An increase in the price of a good, all other things held constant, will cause an increase in the quantity supplied of the good.
Change in Quantity Supplied
Price
A decrease in price causes a decrease in quantity supplied.
P0
P1
Q1
Q0
Quantity
Change in Quantity Supplied
Price
An increase in price causes an increase in quantity supplied.
P1
P0
Q0
Q1
Quantity
Changes in Supply
Change
in Production Technology Change in Input Prices Change in the Number of Sellers
Change in Supply
Price An increase in supply refers to a rightward shift in the market supply curve.
P0
Q0
Q1
Quantity
Change in Supply
Price A decrease in supply refers to a leftward shift in the market supply curve.
P0
Q1
Q0
Quantity
Market Equilibrium
Market
equilibrium is determined at the intersection of the market demand curve and the market supply curve. The equilibrium price causes quantity demanded to be equal to quantity supplied.
Market Equilibrium
Price
D S
Quantity
Market Equilibrium
Price
D0 P1 P0 D1 S0 An increase in demand will cause the market equilibrium price and quantity to increase.
Q0 Q1
Quantity
Market Equilibrium
Price
D1 P0 P1 D0 S0 A decrease in demand will cause the market equilibrium price and quantity to decrease.
Q1 Q0
Quantity
Market Equilibrium
Price
D0 S0 S1
P0 P1
An increase in supply will cause the market equilibrium price to decrease and quantity to increase.
Q0 Q1
Quantity
Market Equilibrium
Price
D0 S1 S0
P1 P0
A decrease in supply will cause the market equilibrium price to increase and quantity to decrease.
Q1 Q0
Quantity
