Microeconomics

Supply and Demand

Wants: Human wants are unlimited. This is the fundamental fact of economic life of the people. If the
wants are limited then no economic problem would have arisen. But in real life, when one want is
satisfied, another one grows up. The important thing is that all wants are not of equal intensity.
Because of the different intensities of the wants, people are able to allocate the resources to satisfy
some of their wants.

Utility: Since the intensity of want differs, the people are able to allocate the scarce resources to satisfy
their wants. The power of the commodity which satisfies wants is called utility. “The utility means
levels of satisfaction which people get form consuming a commodity”. Different persons derive
different amounts of utility from a given good. If a person derives more for that commodity, he expects
greater utility from it. People know utility of goods by their psychological feelings. Finally question of
ethics or morality is not unsolved in the use of word “utility” in economics.
For example using alcohol may be considered as an activity by society, but no such meaning is
conveyed in economics. So, alcohol possesses utility for some persons who use it.

Demand: As we have discussed earlier, the greater utility in a commodity attracts the consumer whose
wants they satisfy. The consumers desire for the commodity and they will go for purchase. To purchase
a good, he must have ability to pay. The demand for a commodity is consumer’s attitude and reaction
towards commodity. It is that mere desire for a commodity does not constitute demand for it, if it is not
backed by the utility to pay. The word demand has precise meaning in economics. It refers to
o The willingness and utility to purchase different qualities of a good.
o At different prices.
o During a specific time period ( per day, week and so on )

Demand for a good or service is determined by many different factors other than price. Some of them
are as follows:
a) The taste and desire of the consumer for a commodity.
b) Income of the consumer.
c) Price of substitute goods.
d) Price of complementary goods.

When there is a change in any of these factors demand of the consumer for a good change. Individual
demand for a commodity can be expressed in the following general function form:

Qd = f (Px, I, Pr, I, T, A)
Where:
PX = Price of the commodity x.
I = income of individual.
Pr = Price of released commodity.
T = Total preference.
A = Advertising expenses made by producer.
Qd = Quantity demanded.

We write the demand function of an individual in the following way, if all determining factors remain
constant expected quantity demanded of a good and its own price

Qd = f ( Px ).
This is only general functional form. For the purpose of estimating demand of a commodity we need a
specific form of demand function
Qd = a – b Px
The demand function considered to be of a linear form.

Demand curve
A demand schedule is presented in Table 1. In this schedule we see that a consumer purchase 10 units if
the prices at $15, when the price falls @ $ 10 then demand falls to 15 units. If the price falls at $2 then
the demand for unit will be 75 units.
DEMAND SCHEDULE

PRICE QUALITY DEMANDED

12 10
10 20
08 30
06 40
04 50

12

10

8
PRICE

2
D
O 10 20 30 40 50 60 70 X

QUANTITY

Shifts in demand curve

There will be a shift in the demand curve, when demand changes due to the factors other than Price.
The other factors are income of the consumer, prices of related goods and his taste and performance.
Illustrations
1. Income increases There will be increases in demand - shift in the demand curve to the right.
2. Decreases in income There will be decrease in income - demand curve shift to left.
3. Prices of related commodities There is an increase in price of the product, then consumer would
like to change for another substitute. Therefore the demand for the substitute rises and the
demand curve of substitute shift to right.
4. Preference of the people Two wheeler will be of great demand, when the cost of car or petrol
increases. The demand curve for two wheeler will shift to right.
5. The price related commodities substitute and complements can also change the demand for a
commodity.
6. Expectation about future prices if people expect that the price of the good is likely to go up in
future, which will increases the current demand and causes a shift in the demand curve to the
right.
Market demand curve
Individual consumer’s demand and market demand for a good may be distinguished. Market demand
for a good is the total sum of the demands of individual consumers, who purchase the good in the
market.. We sum up various quantities of a commodity demanded in the market by the consumers. By
adding this, we can obtain the demand curve for a commodity. Like the individual consumers demand
curve will slope down ward to the right.
Law of diminishing marginal utility
“The utility means levels of satisfaction which people get from consuming a commodity” but the
marginal utility is an additional satisfaction a consumer gets from consuming are more unit of a
commodity or service.
For example, A is hungry and wants food. He ate the first plate of food and he gets a certain amount of
satisfaction. He took second plate and he will get lesser satisfaction with the second plate. The
additional amount of satisfaction desired by the consumers while consuming each additional plate is
known as marginal utility. Marshall-- Who was famous exponent of the marginal utility analysis has
started the law of diminishing marginal utility as: “the additional benefit which a person derives from a
given increases of his stock of a thing diminished with every increase in the stock that he already has”
The law is based on the following factor
1. Total wants of man is unlimited and each single want is satisfiable. The individual consumes
more and more units of goods, the intensity of wants falls. At a particular point, he has reached
saturation point. The individual wants no more units to consume. At this point the marginal
utility is zero.
2. The fact, on which the law of diminishing utility is based, is that the different goods are not
perfect substitute for each other in the satisfaction of various particular wants. The marginal
utility of the good would not have diminished.
Elasticity of demand
The law of demand expresses the relationship between the price and the commodity demanded. That is,
if the price of the commodity falls, the quality demanded will rise and if the price of the commodity
rises, the quantity demanded will fall. Thus there is an inverse relationship between prices and quantity
demanded as per law of demand. All other things which are assumed to be constant are taste and
preference of consumer, the income of the consumer and the prices of related goods.
The law of demand indicates the only the direction of change in quantity demanded in response to a
change in price but not the exact quantity or to what extreme the quantity demanded of a good will
change. Elasticity is the percentage change in one variable divided by the percentage change in another.
Thus it is a measure of relative changes. It is useful to know how the quantity demanded will change
when price change. This is known as price elasticity of demand.
Price elasticity of demand
Price elasticity of demand is defined as the ratio of percentage in quantity to a percentage in price.

i.e. ep = Percentage in quantity demand

Percentage change in price
When percentage of change in quantity demanded a commodity is greater than the percentage change in
price, the price elasticity of demand (ep) will be greater than one and in this case the demand said to be
elastic.
When a percentage in quantity demanded of a commodity is less than the percentage change in price
that the price elasticity of demand is less than one and it is known as inelastic. The percentage change
in quantity demanded of a commodity is equal to percentage change in price. The price elasticity is
equal to one.

Y D Y D

P
P
P1

P1
D D

O M M1 X O M1 N
Fig 1 Fig 2

The above two figures (1, 2) represents two demand curves (elastic and inelastic) for a given fall from
op to op1, increase in quantity demanded is much greater in fig1 than fig2.
Figure1 is generally said to be elastic and the demand forPERFECTLY
PERFECTLY the good in figure 2 to be inelastic.
As Yper Marshall’s theory “the elasticity or responsiveness
INELASTIC Y ofELASTIC
demand in a market is great or small
according to the amount demanded increases much or little for a given fall in price and diminishes
much or little for a given rise in price. Elastic is a matter of degree and used in the relative sense. When
we say that demandDfor good is elastic we mean only that the demand for it is relatively more elastic.
Alternatively, when we say that demand for a goodepis =inelastic,
∞ we do not mean that its demand is
absolutely epinelastic
=0 but only that it is relatively less elastic.
Then, P
Elastic demand = ep > 1
Inelastic demand = ep < 1
Unitary elastic demand = ep = 1.
There are extreme cases in price elasticity of demand. One is perfectly inelastic demand ( i.e. ep
= 0 ). And the other is perfectly in elastic demand. ( ep = ∞ )
O Q X O X
 PRICE
PRICE

QUANTITY QUANTITY
Fig 3
Fig 4

See fig no 3 in the Q to D is straight vertical line represent demand curve. It is vertical because it is
perfectly inelastic. That means, what ever the price, quantity demand of a commodity remain
unchanged @ 0 Q – example – medicine required for a patient. What- ever the price he will buy the
quantity demanded.
See fig no 4. This is perfectly elastic demand i.e. ( ep = ∞ ). In this case the demand curve is in a
horizontal line. A small change in price of a good will charge the buyer to change completely away
from the good, so that, the quantity demanded falls zero. This means “that if any perfectly competitive
firms raise the price of its good, it will loose all its customers to buy good from it”.
Determinants of price elasticity: The following are some of the main factors which determine the
elasticity of demand for a good.
1. The proportion of consumer’s income spent on a commodity
This is the most important factor; the elasticity of demand of a commodity can be influenced by the
proportion of income spent on a particular commodity. That means, the proportion of consumer’s
income spent on a specific commodity will have the effect on the elasticity of demand. The greater
proportion of income spent on the product, and greater will be the elasticity of demand and vice
versa. For example: A common salt: The demand for a common salt will be highly inelastic because
household spent only a fraction of their income on it.
2. The uses of a commodity
If the commodity have greater number of uses, the elasticity of demand of the commodity will be
greater. The price of a commodity will be very high; if the same has several uses and it will be put to
the most important use.
3. Time period considered
The time factor is very important inelasticity of demand which influences the elasticity of demand for a
product. If time involved is long, the demand tends to be more elastic. The consumer may shift to
substitute goods in the long run. In the short run, it is too difficult to switch over to substitute product.
4. The availability of substitute
This substitute’s availability is one of the most important factors, which determine the price elasticity
of demand. If substitute available, its demands tends to be elastic. If the price of such commodity goes
up, there will be a shift to close substitute by the consumers and the demand for the commodity will
greatly decline. If the substitute is not available, the consumers will have to buy it even at the higher
prices and therefore its demand would tend to be inelastic.
 5. Joint demand for goods
This will also affect the elasticity of demand.
6. Degree of luxury or necessity
Luxury products tend to have greater elasticity than necessities. The products that initially
have a law of degree of necessity which forms habits. The same can be a “necessity to some consumers,
due to formation habits.
7. Permanent or temporary price change
The response in a one day sale will be different from the response for a permanent price
decrease of the same magnitude.

Cross elasticity of demand:( substitute and complements)

There are two goods which are related to each other and their price remains the same. If there is any
change in price of one product, the demand of the product will change and demand of other good, also
changes when its own price remains the same.
“The percentage of changes in the demand for one good in response to a percentage change in price of
another good represents the cross elasticity of demand of one good for the other.”
The cross price elasticity of demand measures the responsiveness of the demand of a good to a change
in the price of another good.
The formula used to calculate the coefficient cross elasticity of demand is

EA, B = Percentage change with quantity demanded of ‘A’

Percentage change in the price of good ‘B’

E A,B = (ΔqA * 100 ) / qA = ΔqA / qA

(ΔpB * 100) /pB ΔpB / pB

Where:
E, stands for cross elasticity of demand of A for B.
qA, stands for the original quantity demanded of A.
ΔqA, stands for change in quantity demanded of good A.
pB, stands for original price of good B.
ΔpB, stands for a small change in the price of good B.
Y In theD`case
x
of substitute,
Dx the cross elasticity of demand
Y is positive.
Dy If the price of one goes up,
the price of another also increases. In case of perfect substitute, the cross elasticity of demand is
equal to infinity,
 In the case of two complementary goods the cross elasticity of demand is negative. This means
the prices of one good goes up, and the price of another
P1 will decrease.
 Where two goods are independent the cross elasticity of demand will be zero.
PP P2

Dx Dy

D`x
O O
M2 M1 Q1 Q2
PRICE

PRICE
Income elasticity of demand
QUANTITY QUANTITY

The income elasticity of demand may be defined “as the ratio of the percentage change in purchase of a
good to the change in income.” The income elasticity of demand measures the responsiveness of
demand of a good to the change in income of the people demanding the good.
This can be calculated as follows:

Income elasticity = % change in purchase of a good

% change in income

Δq = I
ΔI Q
Where:
∆Q, change in quantity purchased.
∆I, change in income
I, initial income
Q, stands for initial quantity.
o A zero income demand occurs when an income is not associated with a change in demand of a
good.
o A positive income elasticity of demand is associated with normal goods. An income in demand
will lead to rise in demand. If the elasticity of demand is less than 1, then it is a necessity good.
If it is more than one then it is luxury good or superior good.
o A negative income elasticity of demand is associated with inferior goods. An increase in
income may lead to fall in demand.
Consumer’s Behavior
Marginal utility theory: Cardinal or marginal utility analysis is an important theory of Consumer
behaviors, which provides an explanation for consumer’s demand for a product. This establishes an
inverse relationship between price and quantity demanded of a product.
The utility means the satisfaction derived by the consumer from the consumption of a commodity. If he
expects greater utility from a commodity, he must have greater desire for that commodity. Total utility
of a commodity to person is the sum of utilities which he obtains from consuming a certain number of
units of a commodity per period.
Marginal utility of a commodity is the additional utility which he gets when he consumes one more unit
of a commodity.
Consider the following table. Which explain diminishing marginal utility?
Cups of coffee Total utility Marginal utility
Consumer per day ( utils ) ( utils )
1 15 15
2 27 12
3 37 10
4 45 8
5 50 5
6 51 1
7 48 -2
8 43 -5

The number of units of a commodity consumed at which consumer is fully satisfied is known as
“satiation quantity.” Total utility declines when the consumer consumes more than 6cups of coffee for
per day. Marginal utility can be expressed in the following.

M Un = TUn - TUn – 1
• Where ‘n’ is any given number
In graphical analysis marginal utility of a commodity can be known by measuring the slope of the
utility curve.
Law of diminishing marginal utility and law of equal marginal utility, explain consumer behavior and
have general uses.
1. Law of diminishing marginal utility
According to the law, the marginal utility of a good diminishes when a consumer consumes
more units of good.
Marshal has stated the law as follows.
“The additional benefit which a person derives from a given increase of his stock of a thing diminishes
with every increase in the stock that he already has.”
This law describes the fundamental tendency of human nature. The law can be arrived at by observing
how people behave.

Application of law of diminishing marginal utility

a) This law helps in deriving law of demand. The concept of consumer supply is based on
principal of diminishing marginal utility.
b) Redistribution of income will increase social welfare. For example. Improving
progressive income tax on such section of the society and spending the tax on social
services of the poor people is based on the diminishing marginal utility.
c) This law of diminishing marginal utility has helped to explain the paradox or
contradiction of value this is knows as diamond – water paradox. Water is essential to
live and has value for human being. But they are less priced or no price at all. But
diamond has high price, but no value for consumer.
The water is available in large quantities so that its marginal utility is very low or even zero.
That is why, its price is low or zero.

2. Law of equal – marginal utility

Law of equal – marginal utility is “that the consumer will distribute his money income between the
goods in such a way that the utility derived from the last dollar spent on each good is equal.” This is
that the consumer is in equilibrium position when marginal utility of money expenditure on each good
is the same. Therefore, the marginal utility of money expenditure on a good is equal to the marginal
utility of a good divided by the price of a good.

i.e = MUm = MUa

Pa
Where: MUa = marginal utility of a good a.
Pa = price of good a.
MUm = marginal utility of money expenditure.
Consumer surplus
“Consumer surplus = what a purchaser is willing to pay – what he actually pays.”
Consumer’s surplus can be defined as “the difference between price that ‘one is willing to pay and the
price one actually pays ‘for a particular product. The net effect is the consumer derives extra
satisfaction from the purchase he daily makes over the price of goods than the price they actually pay
for them. The extra satisfaction the consumer gets from buying a good has been called consumer
surplus. If the consumer derives greater utility from a good, he is willing to pay greater amount of
money. That means the marginal utility of a unit determine the price, a consumer will be prepared to
pay for the unit.
Therefore consumer surplus = ∑ marginal utility – ( price * number of unit purchased ).
Where ∑ Mu is is the sum of marginal utilities of units of a good purchased.

o We can also derive the concept of consumer surplus from the law of diminishing utility. The
marginal utility goes on diminishing when a consumer purchase more units of good and the
consumer’s willingness to pay for additional units, declines as he has more units.
o When the marginal utility from a product becomes equal to its given price, that means that at
the margin what a consumer will be willing to pay is greater than the price he actually pays for
them.
Y

Consumer Surplus
MARGINAL UTILITY

P S
PRICE AND

D`
MU

O M X
QUANTITY

The uses of the concept of consumer surplus

 o The consumer surplus is useful in showing benefit which a consumer obtains from a fall in
price of a good.
o Consumer surplus is used to evaluate gain from a subsidy.
o Consumer surplus is used to measure loss of benefit from imposition of a tax.
o The concept of consumer surplus is used to resolve water – diamond paradox.
o In modern welfare economics the concept of a consumer surplus is used to cost – benefit
analysis of public investment projects.
Indifference curves
We have explained Marshal’s cardinal utility analysis of demand. Two English economists J.R
hicks and R.G.D.Allen severely criticized Marshal’s consumer demand analysis, based up on cardinal
measurement of utility and presented the indifference curve approach based up on the notion of ordinal
utility. The ordinal utility is that the utility of a particular good and service cannot be measured using
an objective scale, since the utility is a psychological feeling which cannot be quantifiable. The
assumption of ordinal utility is quite reasonable and realistic, according to them. A consumer is capable
of ranking different alternatives available that is ‘ comparing different levels of satisfaction’.
According to ordinal utility, the consumer may not be able to give the exact amount of utilities that he
derives from commodities, but he is capable of judging whether the satisfaction is equal to, lower than
or higher than another.
If the consumer is presented with a number of various combinations of goods, he can rank them.. He
can indicate his preference or indifference between any other pair of combination. “This concept of
ordinal utility implies the consumer cannot go beyond stating his preference or indifference and he can
not tell by how much he prefers.
The indifference curve represents all those combinations of two goods which give same satisfaction to
consumers. This is the basic tool of Hicks Allen cardinal analysis of demand.
An indifference curve map consists of a set up indifference curves. This represents complete
description consumers (individual) preference

SUPPLY

Supply curve and law of supply

Supply can be defined as “the quantity that produces are willing and able to offer for sale at a given
price over a given period of time”
Supply can also be defined as the total amount of good or service available for purchase; along with
demand.
There is a vast difference between stock and supply. Stock is “ the total volume of commodity which is
available at a particular moment of time and can therefore be brought into market for sale at a short
notice” and supply means the quantity which is actually brought in the market at a price during a
period.
The supply schedule is the relationship between the quantity of goods by the producer of a good and the
current market price.
It is graphically represented by the supply curve. “The supply schedule or supply curve of a commodity
means how quantity of a commodity which the seller (or produces) are willing and able to make
available in the market, varies with changes in the price.”
The supply schedule giving various prices of rice and quantities of Rice supplied at those prices
is shown in the table
 Supply schedule
QUANTITY
PRICE $ SUPPLIED
225 100
275 200
325 300
375 400
425 500

This schedule shows that the whole schedule or curve depicting the relationship between price and
quantity which the sellers produce as offer for scale in the market during a period of time.

Law of supply
The law of supply can be defined as “when the price of commodity rises, the quantity supplied
of it in the market increases and when the price of a commodity falls , its quantity supplied decreases ,
other factors determining supply remaining the same.”

When the price of Rice raises $225 to $425 per quintal the quantity supplied of rice in the
market increases from 100 quintals to 500 quintals per period.

Y
S

425

375

325

275

225 S

O 100 200 300 400 500

According to law of supply the quantity supplied of a commodity is directly or positively

related to price.
The law of supply curve implies that only at a higher price of good, more quantity if it will be
produced and made available in the market during a given period. We have to understand why more
quantity of a good is supplied, when the price is high. The producer expects generally maximum gain
from producing and supplying it in the market. While the sellers sell at a higher price, they make
greater potential gain. Here there are two assumptions, one producer aims at maximum profit from
production and sale of a commodity and two is, output of a commodity expanded, the addition cost of
producing extra units goes up due to diminishing returns to the variable factors.
The supply curve of the commodity slopes upward to the right is due to the direct relationship between
price of the goods and its quantity supplied.
Supply price is the term used for the price at which a given quantity of the commodity is supplied by
the sellers is called supply price.
The term supply is used as the whole schedule or curve depicting the relationship between price and
quantity supplied in a period.
The term quantity supplied refers to the quantity of a commodity which produces would make it
available at a particular point.

Extension of supply
The term extension of supply is used” when the rise in price of a commodity brings about increase in
quantity supplied of the commodity, other factors determining supply remaining constant.
This is entirely different from increase in supply. “While extension in supply of a commodity occurs as
a result of rise in price of the commodity, increases in supply mean that due to the reduction of price of
resources, improvement in technology, etc.
This is contraction in supply of a commodity when the price falls, then a smaller quantity of it is
supplied at a lower price.
The decrease in supply implies that because of rise in prices of resources, example: imposition of excise
duty.

Factors determining supply

a. Prices of factors
Here the factors refer to resources. Change in prices of resources will cause a change in
cost of production and because of the cost increases; there will be decreases in supply. This
implies that supply curve would shift to the left.
b. Prices of other products
We assume that the prices of all other produces remain unchanged, when we draw a
supply curve. Any change in prices of other products would influence the supply product by
creating substitution of one product for another.
c. Production technology
While making a supply curve, we assume that other factors remain the same when other
factor changes, they cause a shift in the entire supply curve. A change in technology affects the
supply function by altering cost of production. If the cost of production declines, the firm
would supply more than before at the given price. Supply curve would shift to the right if the
supply increases.
d. Number of producers
If the number of producers of a product increases, the supply will increase causing a right ward
shift in the supply curve.
e. Taxes and subsidies
The supply of a product will also be influenced by the taxes and subsidies.
The imposition of a sales tax or excise duty will increase the price of the product. The firms
will supply the same quantity of it at a higher price or less quantity of it at the same price. This
facto causes a left ward shift in supply curve.
f. Future price
The seller’s expectations of future price also influence the supply of a product in the
market. During the period of inflation, Seller’s expects the prices to rise in future, they will
reduce the supply of production. The hoarding huge quantities also an important factor is
reducing supplies and causing further rise in their prices.

g. Objective of the firm

 The objective of the firm is also another important factor which determines the supply of
good produced by it. A firm aims at maximum sales or revenue and profit is not the aim of the
firm at present. Large quantity of products made available by the company in the market.
Therefore at this point, supply will be more in the market.
Elasticity of supply
We have already discussed about the elasticity. The elasticity is the percentage change in one variable
divided by the percentage in another variable. It is a measure of relative changes. When a small fall in
price of a commodity leads to contraction of supply, the supply is elastic and when a big fall in price
leads to a very small contraction in supply is said to be inelastic. On the other hand, a small rise in price
leading to big extension in supply, the supply is said to be elastic and when a big rise in price leads to
small extension to supply indicates inelastic supply.
In Precise terms, the elasticity of demand can be defined as a percentage in the quantity supplied
of a product divided by the percentage change in price that caused the change in quantity supplied.

Elasticity of supply = % change in quantity supplied

% change in price

= ∆Q x P
∆P Q
For example, the price of a motor cycle rises from 5000$ per unit to 5500$. Due to change in price, the
supply of motor cycle increases 3000 units from 2000units. The elasticity of supply will be
= 1000 * 5000 = 2 * 5 = 3.33.
500 3000 3
Two supply curves have been drawing in two graphs below. At price P(1) the quantity supplied in figure
A is OQ1 with a rise in price of the product the quantity supplied increases to OQ2 from OQ1 in figure
‘A’ and from ON1 to ON2 in figure ‘B’. Now compare, both the figure (A and B) regarding the quantity
supplied. Quantity supplied in ‘A’ is larger than the quantity supplied figure ‘B’ (i.e N 1 and N2 ).
Therefore supply in ‘A’ is said to be elastic and in figure ‘B’ the supply is said to inelastic.

Y Y

S S

P2
PRICE

PRICE

P2

P1 P1

S S

O Q1 Q2 X O N1 N2 X
QUANTITY
QUANTITY

FIGURE A FIGURE B
Elasticity of supply depends upon various key factors. These factors play important role in determining
prices of products.
1. Availability of the production facilities
If the producers want to expand their production, they must have infrastructural facilities for
expanding output. For example, in industrial field if there is shortage of power and fuel, the
expansion in supply would not be possible in responsible to the rise in price of individual
products.
2. The length of time
The elasticity of supply of a product depends upon the time duration in which the products
get to make adjustments for changing the level of output in response to the change in price.

The time period may be divided into three following types:

a. Very short time
If the market period is very short it is not possible to make any production. The supply curve is
vertical and therefore perfectly inelastic.
b. Short run
In the short period of time the firm can change the output in response to change in price. Short
– run supply curve is elastic.
c. Long run
In the long run also the firm can change the output after adjusting all factors of production.
There is a possibility of entry for new firms or leave the industry. The long run supply curve is
more elastic.
3. Substitution of one product for another
The change in quantity supplied depends on the possibilities of substitution, the greater the extent
of possibilities of shifting resources from the ‘B’ product’s production to product ‘A’, the greater
the elasticity of supply of the ‘A’ product. For example the market price of ‘wheat’ rises. The
farmers shift their resources to develop wheat production, due to rise in price, the greater the
extent of shifting resource from other products to wheat, the greater the elasticity of supply of
wheat.