Chapter 3

Demand and Supply

Analysis

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 Lecture Plan
• Objectives
• Demand
• Types of demand
• Determinants of demand
– Demand function
– Law of demand
– Demand schedule and individual demand curve
• Market demand
• Change in demand
• Exceptions to the law of demand
• Supply
– Supply schedule and supply curve
– Change in supply
• Market equilibrium
– Determination of market equilibrium
– Changes in market equilibrium
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 Chapter Objectives

 To introduce the basics of demand and supply and their

relevance in economic decision making.
 To analyze the different determinants of demand and supply
and their effects on demand and supply curves.
 To help develop an understanding of demand and supply
functions in determining market equilibrium.
 To introduce the concepts of market equilibrium and
disequilibrium.

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 Demand
 The process to satisfy human wants/ needs/desires.
 Want: having a strong desire for something
 Need: lack of means of subsistence
 Desire: an aspiration to acquire something
 Demand: effective desire
 Demand is that desire which backed by willingness and ability to buy a
particular commodity.
 Amount of the commodity which consumers are willing to buy per
unit of time, at that price.
 Things necessary for demand:
 Time
 Price of the commodity
 Amount (or quantity) of the commodity consumers are willing to
purchase at the price

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 Types of Demand

 Direct and Derived Demand

 Direct demand is for the goods as they are such as Consumer goods
 Derived demand is for the goods which are demanded to produce
some other commodities; e.g. Capital goods
 Recurring and Replacement Demand
 Recurring demand is for goods which are consumed at frequent
intervals such as food items, clothes.
 Durables are purchased to be used for a long period of time
 Wear and tear over time needs replacement
 Complementary and Competing Demand
 Some goods are jointly demanded hence are complementary in
nature, e.g. software and hardware, car and petrol.
 Some goods compete with each other for demand because they are
substitutes to each other, e.g. soft drinks and juices.
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 Types of Demand
Contd…
 Demand for Consumer Goods and Capital Goods
 Consumer goods are bought by the ultimate consumers for their
personal use
 Capital goods are used as inputs in the production of other goods and
services
 Demand for Perishable and Durable Goods
 Durables: Last for a relatively long time and can be consumed multiple
times
 Demand can be postponed
 Non-durables:
 Perishable: These must be consumed immediately
 Non-perishable: These do not get spoilt as quickly as perishables
 Individual and Market Demand
 Individual demand: Demand for an individual consumer
 Market demand: Demand by all consumers

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 Determinants of Demand
 Price of the product
 Single most important determinant
 Negative effect on demand
 Higher the price-lower the demand
 Income of the consumer
 Normal goods: demand increases with increase in consumer’s income
 Inferior goods: demand falls as income rises
 Price of related goods
 Substitutes
 If the price of a commodity increases, demand for its substitute
rises.
 Complements
 If the price of a commodity increases, quantity demanded of its
complement falls.

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 Determinants of Demand
Contd…

 Tastes and preferences

 Very significant in case of consumer goods
 Expectation of future price changes
 Gives rise to tendency of hoarding of durable goods
 Population
 Size, composition and distribution of population will
influence demand
 Advertising
 Very important in case of competitive markets

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 Demand Function

 Interdependence between demand for a product and its

determinants can be shown in a mathematical functional
form
 Dx = f(Px, Y, Py, T, A, N)
 Independent variables: Px, Y, Py, T, A, N
 Dependent variable: Dx
 Px: Price of x
 Y: Income of consumer
 Py: Price of other commodity
 T: Taste and preference of consumer
 A: Advertisement
 N: Macro variable like inflation, population growth, economic
growth
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 Law of Demand
 A special case of demand function which shows relation between price and
demand of the commodity
Dx = f(Px)
 Other things remaining constant, when the price of a commodity rises, the
demand for that commodity falls or when the price of a commodity falls,
the demand for that commodity rises.
 Price bears a negative relationship with demand
 Reasons
 Substitution Effect : When the price of a commodity falls (rises), its
substitutes become more (less) expensive assuming their price has not
changed.
 Income Effect: When the price of a particular commodity falls, the
consumer’s real income rises, hence the purchasing power of the individual
rises.
 Law of Diminishing Marginal Utility: as a person consumes successive
units of a commodity, the utility derived from every next unit (marginal
unit) falls.
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 Demand Schedule and Individual
Demand Curve

Point e
on Demand 35
Demand Price (Rs (‘000 d
Curve per cup) cups)
30
a 15 50 c
b 20 40 25
b
c 25 30 20
d 30 20 a
15
e 35 10
O
10 20 30 40 50
Quantity of coffee

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 Market Demand

 Market: interaction between sellers and buyers of a good (or

service) at a mutually agreed upon price.
 Market demand
 Aggregate of individual demands for a commodity at a particular
price per unit of time.
 Sum total of the quantities of a commodity that all buyers in the
market are willing to buy at a given price and at a particular
point of time (ceteris paribus)
 Market demand curve: horizontal summation of individual
demand curves

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 Change in Demand
 Shift in demand curve from D0 to
D1
Price
 More is demanded at same price
D1 (Q1>Q)
D0  Increase in demand caused by:
D2  A rise in the price of a
substitute
 A fall in the price of a
complement
 A rise in income
P
 A redistribution of income
towards those who favour the
commodity
 A change in tastes that
0
favours the commodity
Q2 Q1
Q Quantity  Shift in demand curve from D0 to
D2
 Less is demanded at each price
(Q2<Q) 13
 Exceptions to the Law of Demand
Law of demand may not operate due to the following reasons:
 Giffen Goods
 Snob Appeal
 Demonstration Effect
 Future Expectation of Prices (Panic buying)
 Addiction
 Neutral goods
 Life saving drugs
 Salt
 Amount of income spent
 Match box

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 Supply

• Indicates the quantities of a good or service that the seller is

willing and able to provide at a price, at a given point of time,
other things remaining the same.
• Supply of a product X (Sx) depends upon:
– Price of the product (Px)
– Cost of production (C)
– State of technology (T)
– Government policy regarding taxes and subsidies (G)
– Other factors like number of firms (N)
• Hence the supply function is given as:
Sx = (Px, C, T, G, N)
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 Law of Supply
 Law of Supply states that other things remaining the same, the higher the
price of a commodity the greater is the quantity supplied.
 Price of the product is revenue to the supplier; therefore higher price
means greater revenue to the supplier and hence greater is the incentive
to supply.
 Supply bears a positive relation to the price of the commodity.

Supply Schedule Supply Curve

Point on Supply (‘000 35
Supply Price (Rs. cups per e
Curve Per cup) month) 30
a 15 10 25 d
c
b 20 20 20
b
c 25 30 15 a
d 30 45
e 35 60 0
10 20 30 40 50 60
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Quantity of Coffee
 Change in Supply

 Shift in the supply curve from S0

to S1
Price  More is supplied at each price
S2
S0 (Q1>Q)
 Increase in supply caused by:
S1
 Improvements in the
technology
 Fall in the price of inputs
P
 Shift in the supply curve from S0
to S2
 Less is supplied at each price
(Q2<Q)
 Decrease in supply caused by:
O  A rise in the price of inputs
Q2 Q0 Q1 Quantity  Change in government policy
(VAT)
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 Market Equilibrium
 Equilibrium occurs at the price where the quantity demanded and
the quantity supplied are equal to each other.

Price Demand
Supply (‘000 cups/
S Price (‘000 cups/ month)
(Rs) month)

15 10 50

E 20 15 40
25
25 30 30
30 45 15

D 35 70 10
O 30 Quantity 18
 Market Equilibrium
 For prices below the equilibrium
– Quantity demanded exceeds quantity supplied (D>S)
– Price pulled upward
 For prices above the equilibrium
– Quantity demanded is less than quantity supplied (D<S)
– Price pulled downward.

Price
S Supply Demand
Price (‘000 cups/ (‘000 cups/
(Rs) month) month)
30
E 15 10 50
25
20 15 40
20
25 30 30
30 45 15
D
35 70 10
O
15 30 45 Quantity 19
 Changes in Market Equilibrium
(Shifts in Supply Curve)
 The original point of equilibrium is at
E, the point of intersection of curves
D1 and S1, at price P and quantity Q
Price
 An increase in supply shifts the S0
supply curve to S2
D1 S1
 Price falls to P2 and quantity rises to
Q2, taking the new equilibrium to E2 S2
P0 E0
 A decrease in supply shifts the
E
supply curve to S0. Price rises to P0 P E2
and quantity falls to Q0 taking the S0
P2
new equilibrium to E0 S1
 Thus an increase in supply raises S2 D1
quantity but lowers price, while a O
decrease in supply lowers quantity Q0 Q Q2 Quantity
but raises price; demand being
unchanged

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 Changes in Market Equilibrium
(Shifts in Demand Curve)
• The original point of equilibrium is
at E, the point of intersection of
curves D1 and S1, at price P and
Price quantity Q
• An increase in demand shifts the
D2 demand curve to D2
S1 • Price rises to P1 and quantity rises to Q1
D1 taking the new equilibrium to E1
D0 • A decrease in demand shifts the
E1
P1 demand curve to D0
E • Price falls to P* and quantity falls to Q*
P taking the new equilibrium to E2.
P* E2
D2 • Thus, an increase in demand raises
both price and quantity, while a
S1 D1
D0 decrease in demand lowers both
O price and quantity; when supply
Q* Q Q1
Quantity remains same.

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 Change in Both Demand and Supply
 Whether price will rise, or
remain at the same level, or will
fall, will depend on:
Price D2  the magnitude of shift and
D1  the shapes of the demand
S1 and supply curves.
E1 S2  Therefore, an increase in both
P1 supply and demand will cause
P2 E2 the sales to rise, but the effect
on price can be:
 Positive (D increases more
than S)
S1 D2
S2  Negative (S increases more
D1 than D)
O Quantity
Q1 Q2  No change (increase in
D=increase in S)
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 Summary

• Demand is defined as the desire to acquire a commodity to satisfy human wants,

which is backed by ability to pay the price.
• Categories of demand are made on the basis of the nature of commodity
demanded (consumer goods and capital goods); time unit for which it is demanded
(short run and long run); relation between two goods (substitutes and
complements), etc.
• The law of demand states that the consumers will buy more of the commodity
when prices are high and less when prices are low, provided all the other factors of
demand remains constant.
• Demand for a product X (Dx) is a function of price of the commodity X (Px), income
of the consumer (Y), price of related (substitutes or complements) commodities
(Po), tastes and preference of the consumer (T), advertising (A), future expectations
(Ef), population and economic growth (N).
• A change in quantity demanded denotes movements along the demand curve due
to a change in price, while a change in demand denotes a rightwards or leftward
shift of the demand curve due to a change in the other determinants of demand
other than price.

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 Summary
• Supply is defined as the willingness to produce and sell the commodity by
production units or firms.
• The law of supply states that firms will sell more of the commodity when prices
are high and less of the commodity when prices are low provided all the other
factors of supply remains constant.
• Supply of a product X (Sx) is a function of price of the product (Px), cost of
production (C), state of technology (T), Government policy regarding taxes and
subsidies (G), other factors like number of firms (N).
• Change in quantity supplied refers to movements along the same supply curve
due to change in the price of the commodity. However when change in supply is
associated with change in the factors like costs of production, technology, etc. it
causes a shift of the supply curve upwards or downwards
• Market equilibrium occurs where demand and supply are equal. This equilibrium
determines the price in the market through the forces of demand and supply.
Comparative statics is the process of comparison between two equilibrium
situations.
• An increase in both supply and demand will cause the sales to rise, but the effect
on price can be positive, negative or equal to zero, depending on the extent of the
shifts in the demand and supply curves.

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