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Demand And Supply Analysis
Demand Analysis Demand
Desire + ability to pay + willingness to pay
Determinants of Demand
Price Income Prices of related goods Taste and preferences Customs and traditions Government policy Advertising Seasons/Climate Population Location Service Quality 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 and an increase in the price of a good will cause a decrease in the quantity demanded of the good. Change in Quantity Demanded
Price An increase in price causes a decrease in quantity demanded. P1
P0
Quantity Q1 Q0 Change in Quantity Demanded
Price A decrease in price causes an increase in quantity demanded.
P0
P1
Quantity Q0 Q1 Increase in Demand
An increase in demand Price refers to a rightward shift in the market demand curve.
P0
Quantity Q0 Q1 Decrease in Demand
A decrease in demand Price refers to a leftward shift in the market demand curve.
P0
Quantity Q1 Q0 Why demand curve slopes downwards • Law of diminishing marginal utility • Income effect • Substitution effect Exception to the law of demand • Network Externalities Bandwagon effect Snob effect
• Giffen Goods • Buyers illusions • Brand loyalty • Monopoly • Speculation • Caterpillar Tractor, one of the largest producers of farm machinery in the world, has hired you to advise it on pricing policy. One of the things the company would like to know is how much a 5 % increase in price likely to reduces sales. What would you need to know to help the company with this problem? Why these facts are important? Suppose that a study has found that the price elasticity of demand for flyover rides is 0.7 in Bangalore Electronic city to Silk Board junction. The company wants to cut the operating deficit of the Elevated Highway System. Should the manager contemplate increasing or decreasing the price of a flyover ride? • You run a small business and would like to predict what will happen to the quantity demanded for your product if you raise your price. While you do not know the exact demand curve for your product, you do know that in the first year you charged $45 and sold 1200 units and that in the second year you charged $30 and sold 2500 units. Elasticity • Elasticity is a measure of responsiveness of one variable to another variable. • Can involve any two variables. • An elastic relationship is responsive. • An inelastic relationship is unresponsive. Types of Elasticity of demand • Price Elasticity of demand • Income elasticity of demand • Cross Elasticity of demand • Promotional Elasticity of demand Price elasticity:
• p=%Q/%P • An elastic response is one where numerator is greater than denominator. i.e., %Q>%P so Ep
• An inelastic response is one where numerator is smaller
than denominator. i.e., %Q<%P so Ep Look at the Extremes •Perfectly Elastic D •Perfectly Inelastic D Ep infinite P P D Ep 0 D
Q Q Relatively Elastic vs. Inelastic Demand Curves
P D’ is relatively more elastic than D
P1
P2 D’ D Q Q1 Q2 Q 2’ Point Elasticity Formula • Price (Rs.) •Point elasticity – Point elasticity is responsiveness at a point along the demand function P1 Ep Q/Q1 P/P1 D simplifying: Q Q1 Ep Q/P)* P1 /Q1 Point Elasticity Formula • Price (Rs.) •Point elasticity – Point elasticity is responsiveness at a point along the demand function P1 Ep Q/Q1 P/P1 D simplifying: Q Q1 Ep Q/P)* P1 /Q1 Example: Q=56-0.002*P •Point elasticity • Price (Rs) Ep Q/P)* P1 /Q1
•Suppose P=17000 •Q=56-0.002*17000 •Q=56-34=22 17k •Plug into equation gives: Ep -0.002)* 17000 /22 D Ep =-34/22=-1.54 Q 22 Arc Elasticity • The end-point problem – the percentage change differs depending on whether you view the change as a rise or a decline in price. Arc Elasticity Formula
•Arc elasticity: Price ($)
Responsiveness along a range of D. function
Ep Q/((Q1+ Q2)/2) Avg.
P/((P1+ P2)/2) P2 responsiveness
P1 D simplifying: EpQ/P)*((P1+P2)/(Q1+Q2)) Q Q2 Q1 Example Q=56-0.002*P •Arc elasticity Price ($) Ep Q/P)*((P1+P2)/(Q1+Q2)) •Look at P range 16k - 17k •Q=56-0.002*17000 •Q=56-34=22 •Plug into equation gives: 17k Ep -0.002)*(33000/46) 16k Ep =-66/46=-1.43 D
22 24 Q Factors determining the price elasticity of demand: • The number of close substitutes for a good: • The more close substitutes in the market, the more elastic is demand because consumers can easily switch their demand if the price of one product changes relative to others.
• The strength of the brand loyalty to a product
• Products which have strong consumer brand loyalty often have relatively inelastic demand, consumers are prepared to accept price increases because of other attractive features of the brand which mean they will stay loyal.
• The cost of switching between products
• There may be significant costs involved in switching between products. In this case, demand tends to be relatively inelastic. • The degree of necessity or whether the good is a luxury • Goods and services deemed by consumers to be necessities tend to have an inelastic demand whereas luxuries tend to have a more elastic demand. • The time period allowed following a price change • Demand tends to be more price elastic, the longer that we allow consumers to respond to a price change. • Whether the good is subject to habitual consumption • When this occurs, the consumer becomes less sensitive to the price of the good in question because their default position is to buy the same products at regular intervals. • Peak and Off-peak demand • Demand tends to be price inelastic at peak times and more elastic at off- peak times. Factors influence Price elasticity of demand • Nature of commodity • Availability of substitute • Multiplicity of uses • Habit • Proportion of income spent • Price range • Complementary products Managerial Applications of Price elasticity of demand • Pricing Decision • Taxation • Labor market • International trade The Farmer’s Dilemma
For many crops, a strange situation
arises a bad crop year results in a good year for farm incomes, and a good crop year results in a bad year for farm incomes. How can this happen to farm community? • Price elasticity gives us the answer:
– Bad crop year: supply decreases, prices for farm products rise, but quantity demanded doesn’t fall very much. The quantity demanded of farm products is not very responsive to changes in prices – Good crop year: supply increases, prices for farm products fall, but quantity demanded doesn’t increase very much. The quantity demanded of farm products is not very responsive to changes in prices
• It is easy to show this with a graph. But first we need yet another concept: Total Revenue = Price x Quantity Elasticity and Total Revenue • TR = P x Q • If P goes down Q goes up, but what happens to TR? • If P goes up Q goes down, but what happens to TR? • Elasticity can answer the question…. The Farm Example • During bad crop years, prices rise and quantity falls (but not that much) so total revenue to farmers goes up. • During good crop years, prices fall and quantity increases (but not that much) so total revenue to farmers goes down. • The graphs…. An Increase in Supply in the Market for Wheat
Price of Wheat 1. When demand is inelastic, 2. . . . leads an increase in supply . . . to a large fall S1 in price . . . S2
in disposable income. Engel Curve: An Engel curve describes how household expenditure on a particular good or service varies with household income. ... They are named after the German statistician Ernst Engel (1821–1896), who was the first to investigate this relationship between goods expenditure and income systematically in 1857. Engel Curve: Normal Good Disposable Income
Engel Curve for a
Normal Good EI > 0
Qd/ut Luxury Goods Luxury Goods are Normal Goods but they have an
EI >= 1 Quantity demanded is very senstive to changes in disposable income “Necessities” “Necessities” are Normal Goods but
0 < EI < 1 Quantity demand is not very sensitive to changes in disposable income Engel Curve: Inferior Good Disposable Income Engel Curve for an Inferior Good EI < 0
Qd/ut • Normal Goods (EI >0) – Luxury Goods (EI >= 1) – Necessitites (0 < EI < 1)
• Inferior Goods (EI < 0)
Cross-Price Elasticity Measures how sensitive DEMAND for a commodity is to changes in the price of a substitute or complement commodity Cross-Price Elasticity
Ecp of x,y =
% Q x / % Py Cross-Price Elasticity
Ecp > 0 Substitute
Ecp < 0 Complement
Ecp = 0 Independent Promotion or Advertising elasticity of demand
Rate of change in demand for a commodity
due to a change in promotion expenditure Demand forecasting
It is an objective assessment or estimation of
future course of demand - Micro level - Industry level - Macro level OBJECTIVES OF SHORT TERM DEMAND FORECASTING
• Production planning • Evolving sales policy • Fixing sales targets • Determining price policy • Inventory control • Short term financial planning OBJECTIVES OF LONG-TERM DEMAND FORECASTING • Business planning
• Manpower planning
• Long-term financial planning
Methods of forecasting • Consumers interview • Sales force polling • Experts opinion • Delphi • End- use • Market Experimentation • Trend projection • Regression • Supply Supply Shifters •Price •Input Price •Technology •Government regulations and taxes •Number of firms •Availability of raw- materials The Supply Function • An equation representing the supply curve: QxS = f(Px , PR ,W, H,)
– QxS = quantity supplied of good X.
– Px = price of good X. – PR = price of a related good – W = price of inputs (e.g., wages) – H = other variable affecting supply 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 and an increase in the price of a good will cause an increase in the quantity supplied of the good. Change in Quantity Supplied
A decrease in price Price causes a decrease in quantity supplied.
P0
P1
Quantity Q1 Q0 Change in Quantity Supplied
An increase in price Price causes an increase in quantity supplied.
P1
P0
Quantity Q0 Q1 Change in Supply An increase in supply refers to a rightward shift Price in the market supply curve.
P0
Quantity Q0 Q1 Change in Supply A decrease in supply refers to a leftward shift in the Price market supply curve.
P0
Q1 Q0 Quantity Market Equilibrium •Balancing supply and demand – QxS = Qxd •Steady-state Equilibrium Price and quantity
Price S
8 Quantity Price If price is too low... S
7 6 5
Shortage D 12 - 6 = 6 6 12 Quantity If price is too high… Surplus Price 14 - 6 = 8 S 9 8 7
6 8 14 Quantity Increases in Demand and Supply
•Higher demand leads to higher •Higher supply leads to lower
equilibrium price and higher equilibrium price and higher equilibrium quantity. equilibrium quantity. Decreases in Demand and Supply
•Lower demand leads to lower •Lower supply leads to higher
price and lower quantity price and lower quantity exchanged. exchanged. Relative Magnitudes of Change
• The relative magnitudes of change in supply and demand determine the
outcome of market equilibrium. Relative Magnitudes of Change
• When supply and demand both increase, quantity will increase, but price may go up or down. 2-66 Price Restrictions
Price Ceilings –The maximum legal price that can be charged. Floor Price (MSP) –The minimum legal price that can be charged. 2-67
Impact of a Price Ceiling
Price S
PF
P*
P Ceiling
Shortage D
Qs Qd Quantity Q* • The Municipal Corporation of a small college town decides to regulate rents in order to reduce student living expenses. Suppose the average annual market-clearing rent for a two bedroom apartment had been $700 per month, and rents were expected to increase to $900 within a year. The Municipal Corporation limits rents to their current $700-per- month level. Draw a supply and demand graph to illustrate what will happen to the rental price of an apartment after the imposition of rent controls. Do you think this policy will benefit students? Why or why not? 2-69
Impact of a Price Ceiling
Price S
$1000
$900
$700
Shortage D
50 100 175 Quantity
2-70
Impact of a Price Floor
Price Surplus S PF
P*
Qd Q* QS Quantity 2-71
Impact of a Price Floor
Price Surplus S 31
27
34 42 67 Quantity The demand and supply functions for pulses are Qd =15– P and Qs= 4+ P respectively. The Government announces a support price of Rs.6 per Kg of pulses and would like to release pulses to the market only through Food Corporation of India (FCI). Accordingly FCI procures the pulses and off loads the same at a price that clears the procured stock. Assuming support price equals to procurement cost. What is the total loss incurred by FCI? • Demand and supply functions for a product are: • Qd = 10,000 – 4P • Qs = 2,000 + 6P • If the government imposes a Excise duty of Rs.100 per unit, what will be the new equilibrium price?
