Demand and supply concept

Demand

Desire + ability to pay + willingness to pay

Price Income Prices of related goods Taste and preferences Customs and traditions Government policy Advertising Population Location Service Quality

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.

Quantity

Price

P0

Q0

P1

Q1

An increase in price causes a decrease in quantity demanded.

Quantity

Price

P0

Q0

P1

Q1

A decrease in price causes an increase in quantity demanded.

Quantity

Price

P0

Q0 Q1

An increase in demand refers to a rightward shift in the market demand curve.

Quantity

Price

P0

Q1 Q0

A decrease in demand refers to a leftward shift in the market demand curve.

Law of diminishing marginal utility Income effect Substitution effect Multiplicity of uses

Giffen Goods Prestigious goods Buyers illusions Necessary goods Brand loyalty Monopoly Speculation

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.

Price Elasticity of demand Income elasticity of demand Cross Elasticity of demand Promotional Elasticity of demand

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

Perfectly Elastic D Ep

infinite Perfectly Inelastic

DP

Q

P

Q

Ep 0

D

D

Q1 Q2 Q2’

P1

P2

D’D

D’ is relatively more elasticthan D

P

Q

Point elasticity Point elasticity is

responsiveness at a point along the demand function

Ep Q/Q1

P/P1simplifying:Ep

Q/P)* P1 /Q1

Price (Rs.)

QQ1

P1

D

Point elasticity Point elasticity is

responsiveness at a point along the demand function

Ep Q/Q1

P/P1simplifying:Ep

Q/P)* P1 /Q1

Price (Rs.)

QQ1

P1

D

Point elasticityEp

Q/P)* P1 /Q1

Suppose P=17000 Q=56-0.002*17000 Q=56-34=22 Plug into equation gives:

Ep -0.002)* 17000 /22

Ep =-34/22=-1.54

Price (Rs)

Q22

17k

D

Arc elasticity is simply an average elasticity along a range of the demand curve.

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: Responsiveness along a

range of D. function

Ep Q/((Q1+ Q2)/2)

P/((P1+ P2)/2)

simplifying:EpQ/P)*((P1+P2)/(Q1+Q2))

Price ($)

QQ2

P2

P1

Q1

Avg. responsiveness

D

Arc elasticityEp

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:Ep

-0.002)*(33000/46)Ep

=-66/46=-1.43

Price ($)

Q22

17k

D

24

16k

Nature of commodityAvailability of substituteMultiplicity of usesHabitProportion of income spentPrice range

Pricing DecisionTaxationLabor market International trade

EI = % Qd / % Id

Measures the sensitivity of DEMAND to changes in disposable income.

Shows the relationship between quantity demanded and disposable income given a constant price.

DisposableIncome

Qd/ut

Engel Curve for a Normal GoodEI > 0

Luxury Goods are Normal Goods but they have an

EI >= 1Quantity demanded is very

senstive to changes in disposable income

“Necessities” are Normal Goods but

0 < EI < 1Quantity demand is not very

sensitive to changes in disposable income

DisposableIncome

Qd/ut

Engel Curve for an Inferior GoodEI < 0

Normal Goods (EI >0) Luxury Goods (EI >= 1) Necessitites (0 < EI < 1)

Inferior Goods (EI < 0)

Measures how sensitive DEMAND for a commodity is to changes in the price of a substitute or compliment commodity

Ecp of x,y =

% Qx / % Py

Ecp > 0 Substitute

Ecp < 0 Compliment

Ecp = 0 Independent

Rate of change in demand for a commodity due to a change in promotion expenditure

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

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….

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

Copyright©2003 Southwestern/Thomson Learning

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

It is an objective assessment or estimation of future course of demand

- Micro level- Industry level- Macro level

Production planning Evolving sales policy Fixing sales targetsDetermining price policy Inventory controlDetermining short-term financial

planning

Business planning

Manpower planning

Long-term financial planning

Consumers interview Sales force pollingExperts opinionDelphiEnd- useMarket ExperimentationTrend projectionCausal regression

Price Input Price Technology Government

regulations and taxes Number of firms Substitutes in

production Producer expectations

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

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.

Quantity

Price

P1

Q1

P0

Q0

A decrease in price causes a decrease in quantity supplied.

Quantity

Price

P0

Q0

P1

Q1

An increase in price causes an increase in quantity supplied.

Quantity

Price

P0

Q1Q0

An increase in supply refers to a rightward shift in the market supply curve.

Quantity

Price

P0

Q1 Q0

A decrease in supply refers to a leftward shift in the market supply curve.

Balancing supply and demand Qx

S = Qxd

Steady-state

Price

Quantity

S

D

8

7

Price

Quantity

S

D

5

6 12

Shortage12 - 6 = 6

6

7

Price

Quantity

S

D

9

14

Surplus14 - 6 = 8

6

8

8

7

Higher demand leads to higher equilibrium price and higher equilibrium quantity.

Higher supply leads to lower equilibrium price and higher equilibrium quantity.

Lower demand leads to lower price and lower quantity exchanged.

Lower supply leads to higher price and lower quantity exchanged.

• The relative magnitudes of change in supply and demand determine the The relative magnitudes of change in supply and demand determine the outcome of market equilibrium.outcome of market equilibrium.

• When supply and demand both increase, quantity will increase, but When supply and demand both increase, quantity will increase, but price may go up or down.price may go up or down.

Price Ceilings The maximum legal price that can be

charged. Examples:

▪ Rent control Act.▪ Proposed restrictions on ATM fees.

Price Floors The minimum legal price that can be

charged. Examples:

▪ Minimum wage.▪ Agricultural price supports.

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Price

Quantity

S

D

P*

Q*

P Ceiling

Q s

PF

Shortage

Q d

2-61

The dollar amount paid to a firm under a price ceiling, plus the nonpecuniary price.

PF = Pc + (PF - PC) PF = full economic price PC = price ceiling PF - PC = nonpecuniary price

2-62

Ceiling price of gasoline: $1. 3 hours in line to buy 15 gallons of gasoline

Opportunity cost: $5/hr. Total value of time spent in line: 3 $5 =

$15. Non-pecuniary price per gallon:

$15/15=$1. Full economic price of a gallon of gasoline:

$1+$1=2.

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For example, ceiling price of apartments: PFor example, ceiling price of apartments: PCeilingCeiling = = Rs.4,800 per month.Rs.4,800 per month.

Apartment seekers in Bangalore often require the Apartment seekers in Bangalore often require the services of a real estate agent or apartment services of a real estate agent or apartment broker to assist them in securing an apartment broker to assist them in securing an apartment lease. Typical broker fees are one month's rent.lease. Typical broker fees are one month's rent.

For example, suppose you stay for 4 years, or 48 For example, suppose you stay for 4 years, or 48 months.months.

• Non-pecuniary price per month: Rs.4,800/48 = Non-pecuniary price per month: Rs.4,800/48 = Rs.100 per month.Rs.100 per month.

Full economic price of apartments: PFull economic price of apartments: Pfullfull = = Rs(4,800+100) = Rs.4,900.Rs(4,800+100) = Rs.4,900.

Price

Quantity

S

D

P*

Q*

Surplus

PF

Qd QS

2-65

Full Economic Price The dollar amount paid to a supplier under a price floor,

minus the non-pecuniary (non-money) price suppliers loose through their competition to sell the goods.

The Full Price falls unless the government supports the price floor. Minimum wages.

PFloor = price ceilingPFull = PFloor + (PFull - PFloor)

PFull = full economic price PFull - PFloor = non-pecuniary price

For example, floor price of labor in California: PFor example, floor price of labor in California: PFloorFloor = $8 per = $8 per hour.hour.

For example, $5 per hour is wasted to get the $8 per hour job.For example, $5 per hour is wasted to get the $8 per hour job. Dressing for success to work at McDonalds.Dressing for success to work at McDonalds. Being agreeable or attractive to your boss.Being agreeable or attractive to your boss. Showing up early and staying late, off the clock.Showing up early and staying late, off the clock.

Full economic price of an hour of labor: PFull economic price of an hour of labor: PFullFull = $(8–5) = $3 = $(8–5) = $3 per hour.per hour.

Demand and supply functions for a product are:

Qd = 10,000 – 4P Qs = 2,000 + 6P If the government imposes a sales

tax of Rs.100 per unit, what will be the new equilibrium price?

The supply and demand function for a product is as follows:

Qd = 6,000 – 3PQs = 3,000 + 4.5PThe Government imposes a excise

duty of Rs.20 per unit. What is the proportion of tax that is borne by the producer ?