Demand and Supply

Dr. Sanja Samirana Pattnayak

Introduction
 Demand supply model fundamentally describes how consumers
and sellers interact to determine the quantity of a good or service
sold in a market place and the price at which it is sold.

 It can be applied to varieties of important and interesting problems

such as:

 How changing market conditions affect market price and

production
 Evaluating the impact of various incentive structure
 Prediction of future demand

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Demand
 The relationship between demand and price: (Law of Demand)
When the price of a good rises, the quantity demanded will fall
and vice-versa.

 There are two reasons behind it:

 People will feel poorer. They will not be able to afford to buy so
much of the good with their money. The purchasing power of their
income (the real income) has fallen. This is called in income effect of
a price rise.

 The good is now dearer relative to other goods. People will thus
switch to alternative or substitution goods. This is known as
substitution effect of a price rise.
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Demand Curve
 Demand for a good or a service is determined by the willingness
and ability to pay for that good or service at a given point of time

 Demand Curve shows the amount of a good that consumers are

willing to buy at different prices, holding other factors constant.
 Demand curve is downward-sloping.

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Determinants of Demand
 Tastes: The more desirable people find the good, the more they
will demand.

 Tastes are affected by advertising, by fashion, by observing other

consumers and by the experience from consuming the good on
previous occasions.

 Manufacturer of cigarettes and cosmetics, for instance, use

commercials to retain the loyalty of the existing consumers and
attract others to switch brand.

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Determinants of Demand

 The price of substitute goods: Two products are

substitutes, if an increase in the price of one causes the
demand for the other to increase. (example tea and
coffee)

 The price of complementary goods: Two products are

complements if an increase in the price of one causes
the demand for other to fall. (coffee/tea and milk).

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Determinants of Demand
 Income: As people’s income rise, their demand for most goods
will rise. Such goods are called normal goods.

 By contrast, the demand for an inferior good is inversely related to

changes in buyer’s income.

 Generally, broad categories of products tend to be normal, while

particular product within the categories may be inferior.

 Example: Transportation services. The entire category is a normal

product: the higher a person’s income, the more s/he tends to
spend on transportation.

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Determinants of Demand
 Public transportation, however, may be an inferior product: with a
higher income, the typical consumer switches from public
transport to a private car.

 The distinction between normal and inferior is important for

business strategy.

 When the economy is growing and incomes rising, the demand for
normal products will rise, while demand for inferior product will
fall.

 Converse happens when economy is in recession.

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Determinants of Demand
 Expectations of future price changes: If people think that prices
are going to rise in the future, they are likely to buy now before
the price does go up and so demand will increase.

 EXAMPLE: Think about the housing market. If people expect

the price of houses to increase, they try to buy now before that
happens.

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The Demand Function
 A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)

 Qxd = quantity demand of good X.

 Px = price of good X.
 PY = price of a related good Y.
 Substitute good.
 Complement good.
 M = income.
 Normal good.
 Inferior good.
 H = any other variable affecting demand.

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Inverse Demand Function
 Price as a function of quantity demanded.
 Example:
Demand Function
 Qxd = 10 – 2Px
Inverse Demand Function:
 2Px = 10 – Qxd
 Px = 5 – 0.5Qxd

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Movements along and shifts in the
Demand curve
 Movement along the demand curve: Change in quantity demand

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Movements along and shifts in the
Demand curve
 Shifts in the demand curve: Change in Demand.

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Market Demand
 Market demand: it tells us how the quantity of a good demanded
by the sum of all consumers in the market depends on the price
and various other factors.

 My demand for mangoes is five kilograms is wrong statement!!

 Five kilograms is the quantity demanded at a certain price instead

of demand only.

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Market Demand
 Horizontal summation of individual demands

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Market Demand

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Market Demand
 The aggregation of individual to market demand is not just
theoretical exercise.

 It becomes an important practice when market demands are built

up from the demands of different demographic groups or from
consumers located in different areas.
 Example: we might obtain information about the demand for home
computers by adding independently obtained information about the demands
of the following groups
 Households with children
 Households without children
 Single individual

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Understanding the Linear Demand Function

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Understanding the Linear Demand Function

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Understanding the Linear Demand Function

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Supply and Price
 The general relationship between supply and price: when the price
of a good rises, the quantity supplied will also rise.

 Supply curve: The supply curve shows the amount of a good that
will be produced at alternative prices.

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Other determinants of supply
 The cost of production: The higher the cost of production, the
less profit will be made at any given price.

 The profitability of goods in joint supply: sometimes when one

good is produced, another good is also produced at the same time.
These are said to be goods in joint supply.

 Example: An example is the refining of crude oil to produce

petrol.

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Other determinants of supply
 Example (cont…): Other grade fuels will be produced as well,
such as diesel and paraffin. If more petrol is produced, due to a
rise in demand, then the supply of these other fuels will rise too.

 Nature, random shocks and other unpredictable events: In this

category we would include the weather and diseases affecting
farm output, wars affecting the supply of imported raw materials,
the breakdown of machinery, industrial disputes, earthquakes,
floods, fire and so on.

 Expectations of a future price changes: if price is expected to

rise, producers may temporarily reduce the amount they sell.

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Other determinants of supply
 Expectations of a future price changes (cont…): instead they
are likely to build up their stocks and only release them onto the
market when the price does rise.

 At the same time they may plan to produce, by installing new

machines, or taking on more labor, so they can be ready to supply
more when the price has risen.

 Example: consider the housing market again. If you are thinking

of selling your house, but expect that house prices will soon be
higher , it would be rational to wait and put your house on the
market only when price has risen.

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Movements along and shifts in the
supply curve
 Change in Quantity Supplied

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Movements along and shifts in the
supply curve
 Change in Supply

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The Linear Supply Function

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Understanding the Linear Supply Function

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Understanding the Linear Supply Function

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Market Equilibrium
 We can combine our demand and supply analysis and will show
how the actual price of a product and actual quantity bought and
sold in a free and competitive market.

 The Price (P) that Balances supply and demand

QxS = Qxd
No shortage or surplus
 Steady-state

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Example: Market Equilibrium

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Market Equilibrium
 If price is too low…

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Market Equilibrium
 If price is too high…

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Price Restrictions
 Price Ceilings
 The maximum legal price that can be charged.
 Examples:
 Govt. preventing Kerosene prices from rising along with
the oil prices

 Price Floors
 The minimum legal price that can be charged.
 Examples:
 Minimum wage.

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Effects of price controls
 Some gain and some lose.
 Our figure (slide 28) suggests that producers lose:
 They receive lower prices and some leave the industry.
 Some not all consumers gain
 Those who can purchase the goods at lower price are
better off
 Those who have been rationed out are worse off
 To understand the amount of gain and loss we need a
method to measure them ( subject matter to discuss
later..)

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Comparative Static Analysis
 How do the equilibrium price and quantity change when a
determinants of supply and/or demand change?

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The Determination of Equilibrium
Price
 At price P*, the quantity demanded is equal to the quantity
supplied.

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Demand Shift
 A recent scientific study revealed that the consumption of apple
reduces the hazard of heart attack.

 What would happen to the apple market?

 What happens to the equilibrium price and quantity?

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Increase in Demand
 Equilibrium is at a higher price and higher quantity.

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Supply Shift
 The benign weather brought a bumper crop.

 What would happen to agricultural market?


 What happens to the equilibrium price and quantity?

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Increase in Supply
 Equilibrium is at a lower price and higher quantity.

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Simultaneous Shifts in Demand and Supply

 Managers may encounter events that lead to

simultaneous shifts in both demand and supply.

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Applications of Demand and Supply
Analysis
 Event: The WSJ reports that the prices of PC components are
expected to fall by 5-8 percent over the next six months.

 Scenario 1: You manage a small firm that manufactures PCs.

 Scenario 2: You manage a small software company.

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Use Comparative Static Analysis to
see the Big Picture!
 Comparative static analysis shows how the equilibrium price and
quantity will change when a determinant of supply or demand
changes.

 Scenario 1: Implications for a Small PC Maker

 Step 1: Look for the “Big Picture.”

 Step 2: Organize an action plan (worry about details).

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Big Picture: Impact of decline in
component prices on PC market
 Big Picture….

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Big Picture Analysis: PC Market

 Equilibrium price of PCs will fall, and

equilibrium quantity of computers sold will
increase.
 Use this to organize an action plan
inventories?
human resources?
marketing?
do I need quantitative estimates?

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Scenario 2: Software Maker
 More complicated chain of reasoning to arrive at the
“Big Picture.”
 Step 1: Use analysis like that in Scenario 1 to deduce
that lower component prices will lead to
a lower equilibrium price for computers.

a greater number of computers sold.

 Step 2: How will these changes affect the “Big Picture”

in the software market?

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Big Picture: Impact of lower PC
prices on the software market
 Big Picture:

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Big Picture Analysis: Software
Market
 Software prices are likely to rise, and more software will be sold.

 Use this to organize an action plan.

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Conclusion
 Use supply and demand analysis to
 clarify the “big picture” (the general impact of a current event
on equilibrium prices and quantities).
 organize an action plan (needed changes in production,
inventories, raw materials, human resources, marketing plans,
etc.).

Reference:
Wheat soars after Russian crop failure”, The Financial Times,
November 8, 2012. (Application of demand-supply model)

http://www.ft.com/cms/s/0/7cbc024c-2998-11e2-a5ca-
00144feabdc0.html#axzz36Cwc929i
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Learning activity
 The law of demand states that, holding all else constant
a. As price falls, demand will fall also
b. As price rises, demand will also rise
c. Price has no effect on quantity demanded
d. As price falls, quantity demanded rises

 Which of the following would not shift the demand for good A?
a. Drop in price of good A
b. Drop in price of good B
c. Consumer income
d. Change in the level of advertising of good A

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Learning activity
 A change in income will not lead to
a. A movement along the demand curve
b. A leftward shift of the demand curve
c. A rightward shift of the demand curve
d. None of the above is true

 Good A is an inferior good, an increase in income leads to:

a. A decrease in the demand for good B
b. A decrease in the demand for good A
c. An increase in the demand for good A
d. No change in the quantity demanded of good A

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