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Chapter 3

Demand and Supply


Analysis

Lecture Plan

Objectives
Demand
Types of demand
Determinants of demand
Demand function
Law of demand
Demand schedule and individual demand curve
Market demand
Change in demand
Exceptions to the law of demand
Supply
Supply schedule and supply curve
Change in supply
Market equilibrium
Determination of market equilibrium
Changes in market equilibrium

Chapter Objectives
To introduce the basics of demand and supply
and their relevance in economic decision
making.
To analyze the different determinants of demand
and supply and their effects on demand and
supply curves.
To help develop an understanding of demand
and supply functions in determining market
equilibrium.
To introduce the concepts of market equilibrium
and disequilibrium.
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Demand
The process to satisfy human wants/ needs/desires.
Want: having a strong desire for something
Need: lack of means of subsistence
Desire: an aspiration to acquire something
Demand: effective desire
Demand is that desire which backed by willingness and
ability to buy a particular commodity.
Amount of the commodity which consumers are willing
to buy per unit of time, at that price.
Things necessary for demand:
Time
Price of the commodity
Amount (or quantity) of the commodity consumers are
willing to purchase at the price
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Types of Demand
Direct and Derived Demand
Direct demand is for the goods as they are such as
Consumer goods
Derived demand is for the goods which are demanded to
produce some other commodities; e.g. Capital goods

Recurring and Replacement Demand


Recurring demand is for goods which are consumed at
frequent intervals such as food items, clothes.
Durables are purchased to be used for a long period of time
Wear and tear over time needs replacement

Complementary and Competing Demand


Some goods are jointly demanded hence are complementary
in nature, e.g. software and hardware, car and petrol.
Some goods compete with each other for demand because
they are substitutes to each other, e.g. soft drinks and juices.
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Types of Demand
Contd

Demand for Consumer Goods and Capital Goods


Consumer goods are bought by the ultimate consumers
for their personal use
Capital goods are used as inputs in the production of
other goods and services

Demand for Perishable and Durable Goods


Durables: Last for a relatively long time and can be
consumed multiple times
Demand can be postponed

Non-durables:
Perishable: These must be consumed immediately
Non-perishable: These do not get spoilt as quickly as perishables

Individual and Market Demand


Individual demand: Demand for an individual consumer
Market demand: Demand by all consumers
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Determinants of Demand
Price of the product
Single most important determinant
Negative effect on demand
Higher the price-lower the demand

Income of the consumer


Normal goods: demand increases with increase in
consumers income
Inferior goods: demand falls as income rises

Price of related goods


Substitutes
If the price of a commodity increases, demand for its
substitute rises.
Complements
If the price of a commodity increases, quantity
demanded of its complement falls.
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Determinants of Demand
Contd

Tastes and preferences


Very significant in case of consumer goods

Expectation of future price changes


Gives rise to tendency of hoarding of durable
goods

Population
Size, composition and distribution of population
will influence demand

Advertising
Very important in case of competitive markets
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Demand Function
Interdependence between demand for a product
and its determinants can be shown in a
mathematical functional form
Dx = f(Px, Y, Py, T, A, N)

Independent variables: Px, Y, Py, T, A, N


Dependent variable: Dx
Px: Price of x
Y: Income of consumer
Py: Price of other commodity
T: Taste and preference of consumer
A: Advertisement
N: Macro variable like inflation, population growth,
economic growth
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Law of Demand
A special case of demand function which shows relation
between price and demand of the commodity
Dx = f(Px)
Other things remaining constant, when the price of a
commodity rises, the demand for that commodity falls or
when the price of a commodity falls, the demand for that
commodity rises.
Price bears a negative relationship with demand
Reasons
Substitution Effect : When the price of a commodity falls
(rises), its substitutes become more (less) expensive
assuming their price has not changed.
Income Effect: When the price of a particular commodity
falls, the consumers real income rises, hence the purchasing
power of the individual rises.
Law of Diminishing Marginal Utility: as a person
consumes successive units of a commodity, the utility
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derived from every next unit (marginal unit) falls.

Demand Schedule and Individual


Demand Curve

Price (Rs
per cup)

Demand
(000
cups)

15

50

20

40

25

30

30

20

35

10

e
35
Price of Coffee

Point on
Demand
Curve

30

25

20

15
O

10

20

40 50
30
Quantity of coffee

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Market Demand
Market: interaction between sellers and buyers of
a good (or service) at a mutually agreed upon
price.
Market demand
Aggregate of individual demands for a commodity at
a particular price per unit of time.
Sum total of the quantities of a commodity that all
buyers in the market are willing to buy at a given
price and at a particular point of time (ceteris
paribus)

Market demand curve: horizontal summation of


individual demand curves
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Change in Demand
Shift in demand curve from
Price

D1
D2

D0

Q2

Q1

Quantity

D0 to D1
More is demanded at same
price (Q1>Q)
Increase
in
demand
caused by:
A rise in the price of a
substitute
A fall in the price of a
complement
A rise in income
A
redistribution
of
income towards those
who
favour
the
commodity
A change in tastes that
favours the commodity
Shift in demand curve from
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D0 to D2

Exceptions to the Law of Demand


Law of demand may not operate due to the
following reasons:
Giffen Goods
Snob Appeal
Demonstration Effect
Future Expectation of Prices (Panic buying)
Addiction
Neutral goods
Life saving drugs
Salt

Amount of income spent


Match box
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Supply
Indicates 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, other things remaining the same.
Supply of a product X (Sx) depends upon:
Price of the product (Px)
Cost of production (C)
State of technology (T)
Government policy regarding taxes and subsidies
(G)
Other factors like number of firms (N)
Hence the supply function is given as:
Sx = (Px, C, T, G, N)
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Law of Supply
Law of Supply states that other things remaining the same, the
higher the price of a commodity the greater is the quantity
supplied.
Price of the product is revenue to the supplier; therefore higher
price means greater revenue to the supplier and hence greater is
the incentive to supply.
Supply bears a positive relation to the price of the commodity.

Supply Schedule
Point on
Supply
Curve

Price
(Rs. Per
cup)

Supply
(000 cups
per month)

15

10

20

20

25

30

30

45

35

60

Price of Coffee

Supply Curve
35

30
25

20

15
0

a
10

20

30 40 50 60
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Quantity of Coffee

Change in Supply

Price

S2
S0
S1

Q2

Q0

Q1

Quantity

Shift in the supply curve


from S0 to S1
More is supplied at each
price (Q1>Q)
Increase in supply caused
by:
Improvements in the
technology
Fall in the price of inputs
Shift in the supply curve
from S0 to S2
Less is supplied at each
price (Q2<Q)
Decrease in supply caused
by:
A rise in the price of
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inputs

Market Equilibrium
Equilibrium occurs at the price where the quantity
demanded and the quantity supplied are equal to
each other.
Price
S

25

D
O

30

Quantity

Demand
(000 cups/
month)

Price
(Rs)

Supply
(000 cups/
month)

15

10

50

20

15

40

25

30

30

30

45

15

35

70

10
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Market Equilibrium
For prices below the equilibrium
Quantity demanded exceeds quantity supplied (D>S)
Price pulled upward

For prices above the equilibrium


Quantity demanded is less than quantity supplied (D<S)
Price pulled downward.
Price
S
30
25

20
D
O

15 30

45

Quantity

Price
(Rs)

Supply
(000 cups/
month)

Demand
(000 cups/
month)

15

10

50

20

15

40

25

30

30

30

45

15

35

70

10
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Changes in Market Equilibrium


(Shifts in Supply Curve)
The

original
point
of
equilibrium is at E, the point
of intersection of curves D1
and S1, at price P and
quantity Q
An increase in supply shifts
the supply curve to S2
Price falls to P2 and quantity

rises to Q2, taking the new


equilibrium to E2

Price

S1

D1

P
P2

S2

E0

P0

A decrease in supply shifts

the supply curve to S0. Price


rises to P0 and quantity falls
to
Q0
taking
the
new
equilibrium to E0

S0

E
S0

E2

S1
S2

D1
Q0 Q Q2

Quantity

Thus an increase in supply

raises

quantity

but

lowers

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Changes in Market Equilibrium


(Shifts in Demand Curve)
The
original
point
of
equilibrium is at E, the point of
intersection of curves D1 and
S1, at price P and quantity Q
An increase in demand shifts
the demand curve to D2

Price
D2

D0

E1

P1
E2

D2
S1

D0
Q* Q

Q1

D1
Quantity

Price rises to P1 and quantity rises to


Q1 taking the new equilibrium to E1

A decrease in demand shifts


the demand curve to D0

P
P*

S1

D1

Price falls to P* and quantity falls to


Q* taking the new equilibrium to E2.

Thus, an increase in demand


raises both price and quantity,
while a decrease in demand
lowers
both
price
and
quantity; when supply remains
same.
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Change in Both Demand and Supply

D2

Price

D1

S1
S2

E1
P1
P2

E2

S1
O

D2

S2

D1
Q1 Q2

Quantity

Whether price will rise, or


remain at the same level,
or will fall, will depend on:
the magnitude of shift
and
the shapes of the
demand and supply
curves.
Therefore, an increase in
both supply and demand
will cause the sales to
rise, but the effect on
price can be:
Positive (D increases
more than S)
Negative (S increases
more than D)
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Summary

Demand is defined as the desire to acquire a commodity to satisfy


human wants, which is backed by ability to pay the price.
Categories of demand are made on the basis of the nature of
commodity demanded (consumer goods and capital goods); time
unit for which it is demanded (short run and long run); relation
between two goods (substitutes and complements), etc.
The law of demand states that the consumers will buy more of the
commodity when prices are high and less when prices are low,
provided all the other factors of demand remains constant.
Demand for a product X (Dx) is a function of price of the
commodity X (Px), income of the consumer (Y), price of related
(substitutes or complements) commodities (Po), tastes and
preference of the consumer (T), advertising (A), future
expectations (Ef), population and economic growth (N).
A change in quantity demanded denotes movements along the
demand curve due to a change in price, while a change in demand
denotes a rightwards or leftward shift of the demand curve due to
a change in the other determinants of demand other than price.
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Summary

Supply is defined as the willingness to produce and sell the commodity


by production units or firms.
The law of supply states that firms will sell more of the commodity
when prices are high and less of the commodity when prices are low
provided all the other factors of supply remains constant.
Supply of a product X (Sx) is a function of price of the product (Px), cost
of production (C), state of technology (T), Government policy regarding
taxes and subsidies (G), other factors like number of firms (N).
Change in quantity supplied refers to movements along the same
supply curve due to change in the price of the commodity. However
when change in supply is associated with change in the factors like
costs of production, technology, etc. it causes a shift of the supply
curve upwards or downwards
Market equilibrium occurs where demand and supply are equal. This
equilibrium determines the price in the market through the forces of
demand and supply. Comparative statics is the process of comparison
between two equilibrium situations.
An increase in both supply and demand will cause the sales to rise, but
the effect on price can be positive, negative or equal to zero,
depending on the extent of the shifts in the demand and supply
curves.
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