Demand and supply

Dr. Ravindra K

Meaning

Demand is the quantity of a good or service that customers are willing and able to purchase during a specified period under a given set of economic conditions. For managerial decision making, a prime focus is on market demand. Market demand is the aggregate of individual, or personal, demand.

Direct Demand : This model is appropriate for analyzing individual demand for goods and services that directly satisfy consumer desires - Demand for consumption products Derived Demand: Demand is derived from the demand for the products they are used to provide. Demand for inputs used in production

Importance

Understanding and predicting how changing world economic conditions affect market price and production Evaluating the impact of government price controls, minimum wages, price supports, and production incentives Determining how taxes, subsidies, tariffs, and import quotas affect consumers and producers

Consumption & Price of Copper 1880-1998

Demand Curve
Shows amount purchased as a function of price D = f(P) Depends on: - income - tastes - prices of competitive products - prices of complementary products

Change in Demand

Change in the quantity demanded: Movement along a given demand curve reflecting a change in price and quantity shift in demand: Switch from one demand curve to another following a change in a non-price determinant of demand

Demand Curve Determination

Quantity of Product X Demanded = Qx = f (Price of X, Prices of Related goods,, Expectations of Price Changes, Consumer Incomes, Tastes and Preferences, Advertising, Expenditures, and so on) Assume that the demand function for the automobile industry is Q = a1P + a2PI + a3 I + a4Pop + a5i + a6A

This equation states that the number of new domestic automobiles demanded during a given year (in millions), Q, is a linear function of the average price of new domestic cars (in $), P; the average price for new import cars (in $), PI; disposable income per household (in $), I; population (in millions), Pop; average interest rate on car loans (in percent), i; and industry advertising expenditures (in $ millions), A. The terms a1, a2, . . ., a6 are called the parameters of the demand function.

Assume that the parameters of this demand function are known with certainty, as shown in the following equation: Q = 500P + 210PX + 200I + 20,000Pop 1,000,000i + 600A

To illustrate, Assuming that import car prices, income, population, interest rates, and advertising expenditures are all held constant, the relation between the quantity demanded of new domestic cars and price is expressed as

Q = 500P + 210($50,000) + 200($45,000) + 20,000(300) 1,000,000(8) + 600($5,000) = 20,500,000 500P

Alternatively, when price is expressed as a function of output, the industry demand curve can be written: P = $41,000 $0.002Q

The equation states that automobile demand falls by 500 for each $1 increase in the average price charged by domestic manufacturers; it rises by 210 with every $1 increase in the average price of new luxury cars (PX), a prime substitute; it increases by 200 for each $1 increase in disposable income per household (I); it increases by 20,000 with each additional million persons in the population (Pop); it decreases by 1 million for every 1 percent rise in interest rates (i); and it increases by 600 with each unit ($1 million) spent on advertising (A).

Supply Curve
Amount offered for sale as a function of price Qs = f (P) Depends on costs of production, which in turn depend on - costs of inputs - technology

The Market Mechanism

Price ($ per unit)

S
The curves intersect at equilibrium, or marketclearing, price. At P0 the quantity supplied is equal to the quantity demanded at Q0 .

P0

Q0

Quantity

The Market Mechanism

Characteristics of the equilibrium or market clearing price:

QD = QS No shortage No excess supply No pressure on the price to change

Demand Curve -Income Rises

Demand Shifts

Supply shifts

D & S shift

The Market Mechanism

Price ($ per unit)

Surplus
P1 P2
Assume the price is P1 , then: 1) Qs : Q1 > Qd : Q2 2) Excess supply is Q1:Q2. 3) Producers lower price. 4) Quantity supplied decreases and quantity demanded increases. 5) Equilibrium at P2Q3

D Q1 Q3 Q2 Quantity

The Market Mechanism

A Surplus

The market price is above equilibrium

There is excess supply Producers lower prices Quantity demanded increases and quantity supplied decreases The market continues to adjust until the equilibrium price is reached.

The Market Mechanism

Price ($ per unit)

P3

P2

Assume the price is P2 , then: 1) Qd : Q2 > Qs : Q1 2) Shortage is Q1:Q2. 3) Producers raise price. 4) Quantity supplied increases and quantity demanded decreases. 5) Equilibrium at P3, Q3

Shortage
Q1 Q3

D
Q2 Quantity

The Market Mechanism

Shortage

The market price is below equilibrium:

There is a shortage Producers raise prices Quantity demanded decreases and quantity supplied increases The market continues to adjust until the new equilibrium price is reached.

The Market Mechanism

Market Mechanism - Summary:

1) Supply and demand interact to determine the market-clearing price.

2) When not in equilibrium, the market will adjust to alleviate a shortage or surplus and return the market to equilibrium.
3) Markets must be competitive for the mechanism to be efficient.

Consumption & Price of Copper 1880-1998

The Long-Run Behavior of Natural Resource Prices

Observations
Consumption of copper has increased about a hundred fold from 1880 through 1998 indicating a large increase in demand. The real price for copper has remained relatively constant.

Changes In Market Equilibrium

S1998
Price

S1900

S1950

D1998

D1950
D1900
Quantity

Changes In Market Equilibrium

Conclusion

Decreases in the costs of production have increased the supply by more than enough to offset the increase in demand.

Price elasticity of demand:

Measures responsiveness of demand to price.
Defined as E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q)

Why is it defined in proportional terms?

- Unit free.

- Scale sensitive.
A negative number.

Q = 8 - 2P or P = 4 - 0.5Q

Elasticity = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) = -2*(P/Q)

Elasticity and Pricing

If elasticity is between 0 and -1 then raising price will raise profits - it will raise revenues and lower costs. If elasticity is lower than -1 then raising price will lower revenues and also costs, so the effect on profits is not clear. Moral - never operate where the elasticity is between 0 and -1.

Relationship between demand, quantity and revenue:

Q = 8 - 2P or

P = 4 - 0.5Q
so as revenue R is price times quantity

R = 4Q - 0.5Q2

Revenue rises as price rises Revenue falls as price rises

PED = -1

PED = 0

This is a quadratic pointing up. The slope is:

DR =4-Q DQ
which is zero at Q = 4. Slope is positive for Q<4 and vice versa. Maximum revenue comes when Q = 4, therefore P = 2, and max revenue is 8

PED when revenue is maximum

Revenue is max when Q = 4, P = 2. E = (DQ/Q)/(DP/P) = (DQ/DP)*(P/Q) So E = (DQ/DP)*(1/2) and DQ/DP = -2 so E = -2 * 1/2 = -1 when R is at a maximum.

Cross price elasticity of demand:

The responsiveness of demand for good A to change in price of good B: DQA/QA = DQA * PB DPB/PB DPB PA Example:

responsiveness of demand for Dell computers to prices of HP computers

Supply Elasticity

The responsiveness of supply to price changes. (DS/S)/(DP/P), proportional change in supply divided by proportional change in price. Usually positive.

Elasticities of Supply and Demand

The Market for Wheat

1981 Supply Curve for Wheat

QS = 1,800 + 240P QD = 3,550 - 266P

1981 Demand Curve for Wheat

Elasticities of Supply and Demand

The Market for Wheat

Equilibrium: Q S = Q D

1,800 240P 3,550 266P 506P 1,750

P 3.46 / kg

Q 1,800 (240)(3.46) 2,630 million kgs

Elasticities of Supply and Demand

The Market for Wheat

ED=(P/Q) (DQD/DP) = (3.46/2630)(-266)= 0.35 ES=(P/Q) (DQS/DP) = (3.46/2630)(+240)= 0.32

Changes in the Market: 1981-1998

The Market for Wheat

Supply (Qs) Demand (QD)

1981 1800 + 240P 3550 - 266P

Equilibrium Price (Qs = QD)

1800+240P = 3550-266P 506P = 1750 P1981 = Rs. 3.46/kg 1,944+207P = 3,244-283P P1998 = Rs.2.65/kg

1998

1,944 + 207P

3,244 - 283P

Marginal Revenue

Increase in revenue from one extra sale Rate of change of revenue with respect to sales Typically less than price as demand curve slopes down Depends on PED

Marginal Revenue & PED

MR

= P{1 + 1/PED} Remember PED < 0 so MR < P. The larger PED as a number the nearer MR is to P If PED = - 1, then MR = 0. (Top of revenue curve) Derivation - dR/dQ = d{P(Q).Q}/dQ = P + Q*dP/dQ = P{1 + (Q/P)*dP/dQ}

Income Elasticity of Demand:

Responsiveness of demand to changes in income IED = (DQ/Q)/DI/I) = (DQ/DI)*(I/Q) Use to define necessities and luxuries

Necessities - IED < 1

Luxuries - IED > 1 Cyclical vs. defensive sectors

Cyclical - high IED - foreign travel, consumer durables Defensive - low IED - food, utilities

Short-run vs. long-run elasticities

Critical in understanding oil market, energy markets, metal markets Responding to a price movement takes time possibly many years Long-run elasticity measures total response Short-run elasticity measures immediate response

Short-run demand

P1

Po

Long-run demand

Long-run drop in demand

Short-run drop in demand

Short-Run Versus Long-Run Elasticities

The Demand for Gasoline

Years Following Price or Income Change Elasticity Price Income 1 2 3 4 5 6

-0.11 -0.22 -0.32 -0.49 -0.82 -1.17 0.07 0.13 0.20 0.32 0.54 0.78

Short-Run Versus Long-Run Elasticities

The Demand for Automobiles

Years Following Price or Income Change

Elasticity 1 2 3 4 5 6

Price
Income

-1.20 -0.93 -0.75 -0.55 -0.42 -0.40

3.00 2.33 1.88 1.38 1.02 1.00

Short-Run Versus Long-Run Elasticities

The Demand for Gasoline and Automobiles

Data Explains: 1) Why the price of oil did not continue to rise above $30/barrel even though it rose very rapidly in the early 1970s. 2) Why automobile sales are so sensitive to the business cycle.

The World Oil Market

In 1995:
P* = $18/barrel World demand and total supply = 23 bb/yr (= 63 mbd) OPEC supply = 10 bb/yr (= 27 mbd) Non-OPEC supply = 13 bb/yr (= 35 mbd) US consumption about 17 mbd = 5.5 bb/yr

Price of Crude Oil

Impact of Saudi Production Cut

SC Price 45
($ per barrel) 40 35 30 25 20 18 15 10 5 0 5 10 15 20 23 25 30
Quantity 35 (billions barrels/yr)

D ST ST

Short-Run Effect

Impact of Saudi Production Cut

Price 45
($ per barrel) 40 35 30 25 20 18 15 10 5 0 5 10 15 20 23 25 30 35
Quantity (billions barrels/yr)

SC
D

ST ST

Long-run Effect
Due to the elasticity of the long-run supply and demand curves, the long-run effect of a cut in production is much less.