Demand and Supply Analysis

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Resource Person: Furqan-ul-haq Siddiqui

Chapter # 2

Demand Demand indicates how much of a

product consumers are both willing and able to buy at each possible price during a given period, Ceteris paribus*

Demand= Will to purchase + Power to Purchase

* Latin phrase, literally translated as "with other things the same”. In order to formulate laws, it is usually necessary to rule out factors which interfere with examining a specific causal relationship.

If the price of a telephone call is Rs.3.50, Imran will make 7 calls. Which of the following is correct regarding Imran’s demand for telephone calls if

the price rises to Rs. 7.00? A. The quantity demanded will

increase to 3 calls

B. Her demand for telephone calls will increase

C. The quantity demanded will decrease to 3 calls

D. Her demand for telephone calls will decrease

Law of Demand The law of demand says that quantity demanded varies

inversely with price, other things constant. Thus, the higher the price, the smaller the quantity demanded and vise versa, Ceteris paribus.

Chief Characteristics:1. Inverse relationship.2. Price independent and demand dependent variable.3. Income effect & substitution effect.

Few Assumptions: No change in tastes and preference of the consumers. Consumer’s income must remain the same. The price of the related commodities should not change. The commodity should be a normal commodity

The Individual Demand Schedule andthe Law of Demand

The demand schedule is a table of numbers that shows the relationship between price and quantity demanded by a consumer, ceteris paribus (everything else held fixed).

Demand Schedule for Pizza

Price ($)

Quantity of pizzas per month

2 13

4 10

6 7

8 4

10 1

Market Demand

• Market demand is the sum of all individual demands at each possible price.

Graphically, individual demand curves are summed horizontally to obtain the market demand curve.

• Assume the ice cream market has two buyers as follows…

03.00

100.50

AliPrice of Ice-cream

Cone ($)

Market demand as the Sum of Individual Demands

+

1

6

Ahmed

1

22.50

42.00

61.50

81.00

2

3

4

5

4

7

10

13

16

Market

=

Demand Curve & Characteristics

Demand curve is the graph showing the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.

The demand curve is drawn with price on the vertical axis and quantity on the horizontal axis

The demand curve usually slopes downwards from left to right; that is, it has a negative association.

The negative slope is often referred to as the "law of demand", which means people will buy more of a service, product, or resource as its price falls.

Assumptions (Ceteris paribus) and Determinants of Demand

1. Tastes, Preferences & Fashion of the consumer remain the same

2. No change in the income of the consumer

3. No climatic changes (weather)-Demand for woolen clothes goes up in winter whereas their demand is extremely less in summer .

4. The cost of all factors of production remain constant.

5. The technology level remains same.

6. Price of related goods: The principal related goods are complements and substitutes. A complement is a good that is used with the primary good. Eg. automobiles and fuel. If the price of the complement goes up the quantity demanded of the other good goes down. The other main category of related goods are substitutes. Substitutes are goods that can be used in place of the primary good.. a fall in the price of one good reduces the demand for another good, the two goods.

7. Consumer expectations about future prices and income or any other anticipation: If a consumer believes that the price of the good will be higher in the future he is more likely to purchase the good now and same situation will prevail if income rises.

8. Changes in interest rates- Many goods are bought on credit using borrowed money and therefore the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the SBP decides to raise interest rates - the demand for many goods and services may fall. Examples of "interest sensitive" goods include household appliances, electronic goods, new furniture and motor vehicles. The demand for new homes is affected by changes in mortgage interest rates.

9. Discovery of Substitute:

10. State of business: The level of demand for different commodities also depends upon the business conditions in the country. If the country is passing through boom conditions, there will be a marked increase in demand and vise versa.

11. Size and composition of Population : larger the population larger will be the number of consumers. Also the composition of population has an effect on the demand. eg : A higher number of females will have an increased demand for cloths. These are the demographic effects on demand for the commodities.

12. Distribution of income: If the distribution of income in the country is unequal the the demand for luxurious goods will increase. On the other hand if the distribution of income is equal the demand for basic goods of necessities will increase whereas demand for luxurious goods will decrease.

13. Government policy : If government imposes taxes on commodities their price will increase and demand will decrease while in case if granting subsidies the price will decrease and hence the demand will increase.

Exceptions to the law of demand Giffen Goods: These are low price goods that people on low

incomes spend a high proportion of their income on. When price falls, they are able to discard the consumption of these goods and move onto better goods. Demand may fall when the price falls. These tend to be very basic foods such as rice and potatoes. For example, when the price of potatoes (which is the staple food of some poor families) decreases significantly, then a particular household may like to buy superior goods out of the savings which they can have now due to superior goods like cereals, fruits etc., not only from these savings but also by reducing the consumption of potatoes.

A staple food is a food that can be stored for use for the longtime and forms the basis of a traditional diet.

Veblen good: Some goods are luxurious items where satisfaction comes from knowing the price of the good. A higher price may be a reflection of quality and people on high incomes are prepared to pay this for the "snob value effect". Examples would include perfumes, designer clothes, fast cars.

Expectation of change in the price of commodity Emergency: Conspicuous consumption: a term used to

describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Change in Demand There are TWO types of change in demand;1. A movement ALONG the demand curve- A

movement along the demand curve is caused by a change in PRICE of the good or service. For instance, a fall in the price of the good results in an EXTENSION of demand (quantity demanded will increase), whilst an increase in price causes a CONTRACTION of demand (quantity demanded will decrease).

2. A SHIFT in the demand curve- A shift in the demand curve is caused by a change in any non-price determinant of demand. The curve can shift to the right or left.

Price of Cigarettes,

per Pack.

Number of Cigarettes Smoked per Day

0 20

$2.00

D1

A

A tax that raises the price of cigarettes results in a movements along the demand curve.

C

12

$4.00

A Movement Along the Demand Curve

Price of Cigarettes,

per Pack.

Number of Cigarettes Smoked per Day

D2

A policy to discourage smoking shifts the demand curve to the left.

0 20

$2.00

D1

A

10

B

A Shifts in the Demand Curve

A rightward shift represents an increase in the quantity demanded (at all prices), D1 to D2, where as a leftward shift represents a decrease in the quantity demanded (at all prices). D1 to D3.

How will the demand curve for a normal good shift if the price of a complementary good falls? (Select one answer)(a) Shift left(b) Shift right(c) No Shift

The fall in the price of the complementary good will cause an extension in the quantity demanded. This will cause an increase in the demand for all complementary goods. Therefore, the demand curve will shift to the right. (b)

How will the demand curve for a normal good shift if the price of the good becomes more expensive? (Select one answer)(a) Shift left(b) Shift right(c) No Shift

If the good becomes more expensive then the price will change. A change in the price causes a movement along the curve (c)

The Determinants of Quantity Demanded

SUPPLY Quantity Supplied refers to the amount (quantity) of

a good that sellers are willing to make available for sale at alternative prices for a given period.

Law of supply: The law of supply states that the quantity supplied will go up as the price goes up and vice versa.. Higher prices means more profit so firms will produce more of that product whose price has increased. New producers will also emerge in the market. And total supply will also increase. Direct relationship between Supply & Price

The Supply Schedule and the Supply Curve

The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied.

The supply curve is a graph of the relationship between the price of a good and the quantity supplied. The supply curve is upward sloping.

Ceteris Paribus: “Other thing being equal”

Individual Supply and the Law of Supply A firm’s supply schedule is a table of numbers that shows

the relationship between price and quantity supplied, ceteris paribus (everything else held fixed).

Mc Donald's Schedule for Pizza

Price ($)

Quantity of pizzas per month

4 100

6 200

8 300

10 400

12 500

Individual Supply to Market Supply

If there are 100 identical pizzerias, market supply equals 100 times the quantity supplied by a single firm at each price level.

Forces Behind the supply Curve Cost of Production- Low the cost of the commodity as compare to its

market price, high the supply and vise versa. When cost are high as compare to price, firms produce less, shift to other products or leave the business.

Price of related goods- Suppose a farmer grows rice and wheat on his one farm. If the price of rice rises, he will grow more of it, and less of wheat, so his supply of wheat falls.

Technology- A technological advance would cause the average cost of production to fall which would be reflected in an outward shift of the supply curve

Expectations: Sellers expectations concerning future market condition can directly affect supply. If the seller believes that the demand for his product will sharply increase in the foreseeable future the firm owner may immediately increase production in anticipation of future price increases.

Government policies and regulations- Government intervention can have a significant effect on supply. Government intervention can take many forms including environmental and health regulations, hour and wage laws, taxes, electrical and natural gas rates and zoning and land use regulations.

The Number of Producers in the Market- As more or fewer producers enter the market this has a direct effect on the amount of a product that producers (in general) are willing and able to sell. More competition usually means a reduction in supply, while less competition gives the producer a opportunity to have a bigger market share with a larger supply.

Price of inputs: Price of inputs: If the price of inputs increases the supply curve will shift in as sellers are less willing or able to sell goods at existing prices. For example, if the price of electricity increased a seller may reduce his supply because of the increased costs of production. The seller is likely to raise the price the seller charges for each unit of output.

Change in Supply1. A movement ALONG the supply curve- A movement

along the supply curve is caused by a change in PRICE of the good or service. For instance, an increase in the price of the good results in an EXTENSION of supply (quantity supplied will increase), whilst a decrease in price causes a CONTRACTION of supply (quantity supplied will decrease).

2. A SHIFT in the supply curve- A shift in the supply curve is caused by a change in any non-price determinant of supply. The curve can shift to the right or left.

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

S3

S2S1

Decrease in supply

Increase in supply

Shifts in the Supply Curve

A rightward shift represents an increase in the quantity supplied (at all prices) S1 to S2, whilst a leftward shift represents a decrease in the quantity supplied (at all prices). S1 to S3.

The Determinants of Quantity Supplied

How will the supply curve for a normal good shift when the price of labor increases? (Select one answer)

(a) supply curve shifts to the left(b) supply curve shifts to the right(b) supply curve does not shift

The increase in the costs of labor will increase the costs of production. Therefore, the higher cost of production will cause firms to leave the market. The outcome is that the price increases because the supply curve shifts to the left. (a)

How will the supply curve for a normal good shift when the price of the good increases? (Select one answer)

(a) supply curve shifts to the left(b) supply curve shifts to the right(b) supply curve does not shift

If the good becomes more expensive then the price will change. A change in the price causes a movement along the curve. (C)

Equilibrium The supply curve shows the quantity supplied at a

given price by the seller. The demand curve shows the quantity demanded at

a given price by consumers.

An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.

Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded.

At $2.00, the quantity demanded is equal to the quantity supplied!

Demand Schedule

Supply Schedule

Equilibrium

Equilibrium price

Demand

Supply

$2.00

6 8 100

Equilibrium

Equilibrium quantity

Quantity of Ice-Cream Cones

Price of Ice-Cream

Cone

421 3 5 7 9 11

The Equilibrium of Supply and Demand

Market Equilibrium Only in equilibrium

is quantity supplied equal to quantity demanded.

• At any price level At any price level other than other than PP00, the , the

wishes of buyers wishes of buyers and sellers do not and sellers do not coincide.coincide.

7

SP

Qo

$5

4

3

2

1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

$54321

12,00010,000

7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORN

MARKET

CORN

MARKETSurplusAt a $4 price

more is being

supplied than

demanded

Market Disequilibria Excess supply, or

surplus, is the condition that exists when quantity supplied exceeds quantity demanded at the current price.

• When quantity supplied exceeds quantity demanded, price When quantity supplied exceeds quantity demanded, price tends to fall until equilibrium is restored.tends to fall until equilibrium is restored.

when Qs > Qd at current market price. Amount of surplus = Qs - Qd

117

SP

Qo

$5

4

3

2

1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

$54321

12,00010,000

7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORN

MARKET

CORN

MARKET

At a $2 price

more is being

demanded than

supplied

Shortage

Market Disequilibria Excess demand, or

shortage, is the condition that exists when quantity demanded exceeds quantity supplied at the current price.

When quantity demanded exceeds quantity supplied, When quantity demanded exceeds quantity supplied, Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium.

when Qd > Qs at current market price. Amount of Shortage = Qd - Qs

117

SP

Qo

$5

4

3

2

1

2 4 6 8 10 12 14 16

P QD

$54321

2,0004,0007,000

11,00016,000

$54321

12,00010,000

7,0004,0001,000

D

P QS

Price of Corn

Quantity of Corn

CORN

MARKET

CORN

MARKET

Shortage

Surplus

P - price Q - quantity of good S - supply D - demand P0 - price of market balance A - surplus of demand - when

P<P0 B - surplus of supply - when

P>P0

When the price is above the equilibrium point there is a surplus of supply; where the price is below the equilibrium point there is a shortage in supply.

Three Steps To Analyzing Changes in Equilibrium

1. Decide whether the event shifts the supply or demand curve (or both).

2. Decide whether the curve(s) shift(s) to the left or to the right.

3. Use the supply-and-demand diagram to see how the shift affects equilibrium price and quantity.

Example: A Heat Wave

D1

Supply

$2.00

6 100 Quantity of Ice-Cream Cone

Price of Ice-Cream

Cone

421 3 5 7 11

D2

$2.50

1. Hot weather increases the demand for ice cream…

2. … resulting in a higher price …

3. … and a higher quantity sold.

New equilibrium

Initial equilibrium

How an Increase Demand Affects the Equilibrium

Demand

S1

$2.00

100 Quantity of Ice-Cream Cones

Price of Ice-Cream

Cone

421 3 7 11

S2

$2.50

1. An earthquake reduces the supply of ice cream…

2. … resulting in a higher price …

3. … and a lower quantity sold.

New equilibrium

Initial equilibrium

How a Decrease Demand Affects the Equilibrium

D1

S1

0 Quantity of Ice-Cream Cone

Price of Ice-Cream

Cone

Q1

D2

Large increase in demand

P2

S2

Q2

New equilibrium

Small decrease in supply

Initial equilibriumP1

A Shift in Both Supply and Demand

D1

S1

0 Quantity of Ice-Cream Cone

Price of Ice-Cream

Cone

Q1

D2

Large decrease in supply

P2

S2

Q2

New equilibrium

Small increase in demand

Initial equilibriumP1

A Shift in Both Supply and Demand

What Happens to Price and Quantity when Supply or Demand Shifts

Elasticity (economics)

In economics, elasticity is the ratio of the percent change in one variable to the percent change in another variable. “responsiveness of one variable to changes in another.”

In proper words, it is the relative response of one variable to changes in another variable. The phrase "relative response" is best interpreted as the percentage change.

TYPES OF ELASTICITY

There are four major types of elasticity:

1. Price Elasticity of Demand

2. Price Elasticity of Supply

3. Income Elasticity of Demand

4. Cross-Price Elasticity of Demand

HOW MUCH MORE OR LESS?

Think About It...

THE LAW OF DEMAND SAYS...

Consumers will buy more when prices go down and less when prices go up

Price Elasticity Provides an Answer Price Elasticity Provides an Answer

1. Price Elasticity of Demand Percentage change in quantity demanded with

respect to the percentage change in price, ceteris paribus.

if we raise a price, the Qd will decline, but how much? Elasticity answers the “how much” question.

In Business, we want to know the relationship between Qd and Price

PЄd = % Change in Quantity Demanded

% Change in Price

Where Є = Epsilon; universal notation for elasticity.

Market Demand Curve and Price Elasticity of Demand

A 10% rise in the price of milk (from $2 to $2.20) decreases the quantity demanded by 15% (from 100 to 85), so the price elasticity of demand is 1.50 = 15%/10%.

Price (£)

Quantity Demanded

10

D

5

Total Revenue

5

6

% Δ Price = -50%

% Δ Quantity Demanded = +20%

Ped = -0.4

Total Revenue would fall

Producer decides to lower price to attract sales

Not a good move!

Total

Revenue

Total Revenue is the amount of money that is brought into a company by its business activities

Price (£)

Quantity Demanded

D

10

5

Total Revenue

20

Producer decides to reduce price to increase sales

7

% Δ in Price = - 30%

% Δ in Demand = + 300%

Ped = - 10Total Revenue rises

Good Move!Total Revenue

Types of The Price Elasticity of Demand

Elastic Demand: The price elasticity is greater than one.

Inelastic Demand:Inelastic Demand: The price elasticity of demand is The price elasticity of demand is less than one.less than one.

Unitary Elasticity:Unitary Elasticity: The price elasticity of demand The price elasticity of demand equals one.equals one.

Perfectly inelastic

Perfectly elastic

When the price elasticity of demand for a good is perfectly inelastic (Ed = 0), changes in the price do not affect the quantity demanded for the good; raising prices will cause total revenue to increase.

When the price elasticity of demand for a good is relatively inelastic (- 1 < Ed < 0), the percentage change in quantity demanded is smaller than that in price. Hence, when the price is raised, the total revenue rises, and vice versa.

When the price elasticity of demand for a good is unit (or unitary) elastic (Ed = -1), the percentage change in quantity is equal to that in price, so a change in price will not affect total revenue.

When the price elasticity of demand for a good is relatively elastic (- ∞ < Ed < - 1), the percentage change in quantity demanded is greater than that in price. Hence, when the price is raised, the total revenue falls, and vice versa.

When the price elasticity of demand for a good is perfectly elastic (Ed is - infinite), any increase in the price, no matter how small, will cause demand for the good to drop to zero. Hence, when the price is raised, the total revenue falls to zero.

Elasticity

If demand is price elastic:

Increasing price would reduce TR (%Δ Qd > % Δ P)

Reducing price would increase TR

(%Δ Qd > % Δ P)

If demand is price inelastic:

Increasing price would increase TR (%Δ Qd < % Δ P)

Reducing price would reduce TR (%Δ Qd < % Δ P)

Price of Black Coffee

Suppose a retail coffee outlet is selling its premium “Black Coffee” for $3/cup. The store generally is selling 15 cups of “BC” per hour, and the store manager is thinking seriously of raising the price to $5/cup. He knows he will lose some sales but thinks that most of his customers are willing to pay more. Help him quantify his decision by determining how many fewer cups he can sell and still generate more revenue per hour.

2. Price Elasticity of Supply Price elasticity of supply is the percentage change in

quantity supplied with respect to the percentage change in price.

Price elasticity of supply can be illustrated by the following formula:

PЄs = Percentage change in Quantity SuppliedPercentage change in Price

If a 15% rise in the price of a product causes a 15% rise in the quantity supplied, the price elasticity of supply will be:

PЄs = 15 % = 1 15 %

3. Income Elasticity of Demand: Income elasticity of demand is the percentage change in

quantity demanded with respect to the percentage change in income of the consumer.

Income elasticity of demand can be illustrated by the following formula:

YЄd = Percentage change in Quantity DemandedPercentage change in Income

If a 2% rise in the consumer’s incomes causes an 8% rise in product’s demand, then the income elasticity of demand for the product will be:

YЄd = 8% =4 2%

Interpretation A negative income elasticity of demand is associated with

inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes.

A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.

A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

4. Cross-Price Elasticity of Demand: Cross price elasticity of demand is the percentage change in

quantity demanded of a specific good, with respect to the percentage change in the price of another related good.

PbЄda = Percentage change in Demand for good aPercentage change in Price of good b

If, for example, the demand for butter rose by 2% when the price of margarine rose by 8%, then the cross price elasticity of demand of butter with respect to the price of margarine will be. PbЄda = 2% = 0.25

8% If, on the other hand, the price of bread (a compliment) rose, the

demand for butter would fall. If a 4% rise in the price of bread led to a 3% fall in the demand for butter, the cross-price elasticity of demand for butter with respect to bread would be:

PbЄda = - 3% = - 0.75 4%

Two goods that complement each other show a negative cross elasticity of demand: as the price of good Y rises, the demand for good X falls

Two goods that are substitutes have a positive cross elasticity of demand: as the price of good Y rises, the demand for good X rises

Two goods that are independent have a zero cross elasticity of demand: as the price of good Y rises, the demand for good X stays constant

Substitute Goods Consider Coke and Pepsi. If the price of

Coke goes up, what would you expect to happen to the quantity demanded of Pepsi?It will rise, since people will buy less

Coke and more Pepsi. Thus the Demand for Pepsi will rise.

So the bottom of the elasticity fraction is positive and top of the elasticity fraction is positive.

Complement goods Consider Washing Machines and Dryers. If the

price of Washing Machines goes up, what would you expect to happen to the quantity demanded of Dryers?It will fall, since people will buy less washers

at the new price, they will need less dryers. So the bottom of the elasticity fraction is positive

and top of the elasticity fraction is negative.