Demand and supply

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Demand and supply

  1. 1. Demand and Supply <ul><li>Demand Schedule and Demand Curve </li></ul><ul><li>Supply Schedule and the Supply Curve </li></ul><ul><li>Elasticity of demand and supply </li></ul>
  2. 2. <ul><li>Demand - Total quantity customers are willing and able to purchase. </li></ul><ul><li>A demand function is a behavior function for consumers. </li></ul><ul><li>A supply function is a behavior function for producers. </li></ul><ul><li>We describe market behavior using these two functions. </li></ul>
  3. 3. Direct Demand and Derived Demand <ul><li>Direct Demand-for consumption goods </li></ul><ul><li>Goods and services that satisfy consumer desires. </li></ul><ul><li>Derived Demand-These are sometimes called intermediate goods. </li></ul><ul><li>For example, demand for steel (an intermediate good) is derived from the demand for final goods (e.g., automobiles). </li></ul>
  4. 4. <ul><li>Quantity Demanded – amount of a good that the consumer is willing to buy and able to buy at a given price over a period of time. </li></ul><ul><li>Law of Demand : All other things remaining unchanged, the quantity demanded of a good increases when its price decreases and vice versa. </li></ul><ul><li>This relationship can be shown by a demand schedule, a demand curve or a demand function. </li></ul>
  5. 5. Demand Schedule <ul><li>Demand Schedule shows the different quantities of goods that a consumer is willing to buy at various prices. </li></ul><ul><li>Prices and quantities normally move in opposite directions </li></ul>Prices Quantity 4 28 8 15 12 5 16 1 20 0
  6. 6. <ul><li>Demand Curve : A curve showing the relationship between the price of a good and the quantity demanded. </li></ul>price quantity
  7. 7. <ul><li>Demand Function: </li></ul><ul><li>A demand function is a causal relationship between a dependent variable (i.e., quantity demanded) and various independent variables (i.e., factors which are believed to influence quantity demanded) </li></ul><ul><li>Q = f(P) </li></ul><ul><li>Where Q= quantity and P = price of a good. </li></ul><ul><li>Example Q = 2 – 4P </li></ul>
  8. 8. Determinants of Demand <ul><li>Own Price </li></ul><ul><li>Income of the consumer </li></ul><ul><li>Price of other goods- 1 . complements </li></ul><ul><li>2 . substitutes </li></ul><ul><li>Tastes and preferences </li></ul><ul><li>Expectations of future prices </li></ul><ul><li>Advertising </li></ul><ul><li>Distribution of income </li></ul>
  9. 9. Types of goods <ul><li>Complementary goods are a pair of goods consumed together. As the price of one goes up the demand for the other falls. </li></ul><ul><li>Example- car and petrol </li></ul><ul><li>Substitute goods are alternatives to each other. As the price of one goes up the demand for the other also goes up. </li></ul><ul><li>Example – pepsi and coke </li></ul>
  10. 10. <ul><li>Normal goods are those goods whose demand goes up when the consumer’s income increases. </li></ul><ul><li>Inferior goods are those goods whose demand falls when the consumer’s income increases. </li></ul><ul><li>Example : autotravel, kerosene </li></ul><ul><li>Giffen goods are those goods whose demand moves in same direction as price </li></ul><ul><li>Snob or Veblen goods are those goods whose demand falls when price falls </li></ul>
  11. 11. Shift of the Demand Curve <ul><li>A change in demand is reflected by shift of the Demand curve and is caused by a change in any of the non price determinants of demand </li></ul>price qty Here, the curve shifts due to an increase in income or an increase in price of a substitute good etc
  12. 12. <ul><li>A change in quantity demanded is however reflected in a movement along the demand curve and is called an extension or contraction in demand. </li></ul><ul><li>The movement from A to B is due to the change in price of the good all other factors remaining unchanged </li></ul>A B
  13. 13. Supply <ul><li>The quantity supplied is the number of units that sellers want to sell over a specified period of time at a particular price. </li></ul><ul><li>Law of Supply states that all other factors remaining unchanged the supply of a good increases as its price increases. This can be shown by a supply schedule, a supply curve or a supply function. </li></ul>
  14. 14. <ul><li>Supply schedule </li></ul><ul><li>There exists a positive relation between quantity and price </li></ul>price quantity 1 2 5 10 8 15 13 25 20 35
  15. 15. <ul><li>Supply Curve: </li></ul>qty price <ul><li>Supply function shows the relation between quantity </li></ul><ul><li>and price. </li></ul><ul><li>It is a positive relation. Example : q= 4+3p </li></ul>
  16. 16. Determinants Of Supply <ul><li>Price </li></ul><ul><li>Cost of production </li></ul><ul><li>Technological progress </li></ul><ul><li>Prices of related outputs </li></ul><ul><li>Govt policy </li></ul><ul><li>All factors other than price cause a shift of the supply curve and is called a change in supply </li></ul>
  17. 17. EQUILIBRIUM <ul><li>Equilibrium - perfect balance in supply and demand </li></ul><ul><li>Determines market output and price </li></ul>eqm p q s dem p
  18. 18. Market forces drive market to equilibrium <ul><li>at prices < equilibrium level: excess demand (amount by which quantity demanded exceeds quantity supplied at the specified price) </li></ul><ul><li>at price > equilibrium level: excess supply </li></ul><ul><li>equilibrium price is market clearing price: no excess demand or excess supply </li></ul>
  19. 19. Equilibrium in a Market Demand Price Supply 800 $3,000 2,900 1,150 $2,500 2,550 1,500 $2,000 2,200 1,850 $1,500 1,850 2,200 $1,000 1,500 2,550 $500 1,150 2,900 $0 0
  20. 20. Surplus and Shortage <ul><li>Any price above the equilibrium causes an excess supply and any price below the equilibrium causes a shortage. </li></ul><ul><li>The market if uncontrolled will automatically arrive at the equilibrium price at which supply equals demand. </li></ul><ul><li>Any shift in demand and supply curves will result in a new equilibrium </li></ul><ul><li>Comparison of equilibrium is called comparative -statics </li></ul>
  21. 21. Price Rationing <ul><li>A decrease in supply creates a shortage at P 0 . Quantity demanded is greater than quantity supplied. Price will begin to rise. </li></ul><ul><li>The lower total supply is rationed to those who are willing and able to pay the higher price. </li></ul>
  22. 22. Alternative Price- Control Mechanisms <ul><li>A price ceiling is a maximum price that sellers may charge for a good, usually set by government . </li></ul><ul><li>Example: rent control </li></ul><ul><li>A price floor is a price above equilibrium price that the buyers have to pay. </li></ul><ul><li>Example : agricultural support price, minimum wages </li></ul>
  23. 23. Elasticity <ul><li>Elasticity: A measure of the responsiveness of one variable to changes in another variable; the percentage change in one variable that arises due to a given percentage change in another variable. </li></ul><ul><li>By converting each of these changes into percentages, the elasticity measure does not depend on the units in which we measure the variables. </li></ul>
  24. 24. ELASTICITY <ul><li>Sensitivity of the quantity demanded to price is called: price elasticity of demand : </li></ul>
  25. 25. Arc Elasticity <ul><li>To get the average elasticity between two points on a demand curve we take the average of the two end points (for both price and quantity) and use it as the initial value: </li></ul><ul><li>q2-q1/(q2+q1)/2 </li></ul><ul><li>p2-p1/(p2+p1)/2 </li></ul>
  26. 26. Own Price Elasticity of Demand <ul><li>Own price elasticity: A measure of the responsiveness of the quantity demanded of a good to a change in the price of that good; the percentage change in quantity demanded divided by the percentage change in the price of the good. </li></ul><ul><li>Elastic demand: Demand is elastic if the absolute value of the own price elasticity is greater than 1. </li></ul>
  27. 27. Types of elasticities <ul><li>elastic : the quantity demanded changes more than in proportion to a change in price </li></ul><ul><li>inelastic : the quantity demanded changes less than in proportion to a change in price </li></ul>
  28. 28. Elasticity and slope Price Quantity Demanded The demand curve can be a range of shapes each of which is associated with a different relationship between price and the quantity demanded.
  29. 29. Slope of the Demand Curve <ul><li> P is the change in price. (  P<0) </li></ul><ul><li> Q is the change in quantity. </li></ul><ul><li>slope =  P/  Q </li></ul>Price Quantity Demand Q Q +  Q  Q P P+  P  P
  30. 30. Elasticity and slope
  31. 31. <ul><li>Elastic demand : Demand is elastic if the absolute value of own price elasticity is greater than 1. </li></ul><ul><li>Inelastic demand: Demand is inelastic if the absolute value of the own price elasticity is less than 1. </li></ul><ul><li>Unitary elastic demand: Demand is unitary elastic if the absolute value of the own price elasticity is equal to 1. </li></ul><ul><li>Perfectly elastic demand : e= infinity </li></ul><ul><li>Perfectly inelastic demand : e = 0 </li></ul>
  32. 32. Linear Demand Curve: <ul><ul><li>price </li></ul></ul>Qty E = infinity e=lower segment/upper segment E=0 E=1
  33. 33. Determinants of Elasticity <ul><li>Number and closeness of substitutes – the greater the number of substitutes, the more elastic </li></ul><ul><li>The proportion of income taken up by the product – the smaller the proportion the more inelastic </li></ul><ul><li>Price of the product- lower the price, lower the elasticity </li></ul><ul><li>Luxury or Necessity - for example, addictive drugs </li></ul><ul><li>Time period – the longer the time under consideration the more elastic a good is likely to be </li></ul>
  34. 34. Cross-Price Elasticity <ul><li>Cross-price elasticity: A measure of the responsiveness of the demand for a good to changes in the price of a related good; the percentage change in the quantity demanded of one good divided by the percentage change in the price of a related good. </li></ul><ul><li>The cross-price elasticity is positive whenever goods are substitutes. </li></ul><ul><li>The cross-price elasticity is negative whenever goods are complements. </li></ul>
  35. 35. Cross-price elasticity of demand <ul><li>how quantity of one good changes as price of another good increases </li></ul>
  36. 36. Income elasticity of demand
  37. 37. Income Elasticity <ul><li>Income elasticity: A measure of the responsiveness of the demand for a good to changes in consumer income; the percentage change in quantity demanded divided by the percentage change in income. </li></ul><ul><li>The income elasticity is positive whenever the good is a normal good. </li></ul><ul><li>The income elasticity is negative whenever the good is an inferior good. </li></ul>
  38. 38. <ul><li>Factors affecting Income elasticity : </li></ul><ul><li>Nature of the good: </li></ul><ul><li>inferior goods have negative income elasticity </li></ul><ul><li>Normal goods have positive income elasticity </li></ul><ul><li>Luxury goods have income elasticity greater than one </li></ul><ul><li>Necessary goods have income elasticity less than one </li></ul>
  39. 39. Advertising Elasticity <ul><li>The own advertising elasticity of demand for good X defines the percentage change in the consumption of X that results from a given percentage change in advertising spent on X. </li></ul>
  40. 40. Elasticity and Total Revenue <ul><li>If demand is elastic, an increase (decrease) in price will lead to a decrease (increase) in total revenue. </li></ul><ul><li>If demand is inelastic, an increase (decrease) in price will lead to an increase (decrease) in total revenue. </li></ul><ul><li>Total revenue is maximized at the point where demand is unitary elastic. </li></ul>
  41. 41. price revenue elasticity Increases increases E< 1 increases decreases E>1 decreases decreases E<1 decreases increases E>1 Increases/ decreases constant E=1
  42. 42. MARGINAL REVENUE <ul><li>TR = P.Q </li></ul><ul><li>MR = P + Q dP/dQ </li></ul><ul><li>= P(1 + Q/P. dP/dQ) </li></ul><ul><li>= P(1- 1/e) </li></ul><ul><li>= AR(1-1/e) </li></ul><ul><li>Hence if e=1, MR =0 </li></ul><ul><li>if e =0 , MR = INFINITY </li></ul><ul><li>if e = infinity, MR = AR </li></ul>
  43. 43. <ul><li>MR,AR </li></ul>QTY E=1 E=infinity MR E=0
  44. 44. Total revenue qty E = 1 Tr is max
  45. 45. Elasticity of Supply <ul><li>Price Elasticity of Supply: </li></ul><ul><ul><li>The responsiveness of supply to changes in price </li></ul></ul><ul><ul><li>If e s is inelastic (<1)- it will be difficult for suppliers to react swiftly to changes in price </li></ul></ul><ul><ul><li>If e s is elastic(>1) – supply can react quickly to changes in price </li></ul></ul>e s = % Δ Quantity Supplied ____________________ % Δ Price
  46. 46. Paradox of the Bumper harvest <ul><li>When prices of food crops increase, the demand does not increase proportionally. </li></ul><ul><li>Hence the revenue earned by farmers fall. </li></ul><ul><li>The Govt announces a floor price for the farmers- agricultural price subsidy. </li></ul><ul><li>This interference with prices comes at a cost to the Govt in form of storage costs of Govt granaries. </li></ul>
  47. 47. Application of elasticity: <ul><li>Incidence of taxation: </li></ul>Supply after tax supply demand tax e1 eqm pt p1 p0

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