Fundamental Concepts & Basic Framework of Demand and Supply:

Materials intended to be covered in this session

Objectives of EA fundamentals of microeconomic analysis Concerns of micro & macro-economics Race between human wants & scarcity of economic resources giving rise to the fundamental economic choice problem Functions of an economic system role of prices, government & institutions Notion of market The demand side Law of demand Factors affecting demand Features of a market demand curve Movement along & off (i.e., shift of) the demand curve The supply side Law of supply Factors affecting supply Features of a supply curve Movement along & off the supply curve Price determination through interaction between demand & supply Existence & stability of equilibrium Shifts in demand & supply Concepts of point & arc elasticity; Price, income & cross elasticity of demand; Certain properties of elasticity Some applications & food for thought

Objectives of EA etc.
Why EA dealing with micro-economics?
Perhaps the most important component of any business analysis, providing clues towards answering a whole lot of questions; Provides insights thro analysis of decision-making process by economic agents and their interaction with the market Provides basis for a number of applied fields in management Macro dealing with behavior of aggregative variables like price, income, employment, money supply, exchange rate etc.

Distinctive feature of micro-economics vis-vis macro-economics:

Fundamental issue & methodology used

Race between human wants & scarce economic resources land, labor, capital and entrepreneurial skill
Example, asking a poor man about his demand for credit: why does he specify his demand as a very large number, a small number & even a zero, depending upon how we pose the question? What are his wants and demand? Marginal analysis; Positive rather than normative analysis; Trade off involved in most choices

Broad methodology used:

Functioning of an economic system

Role of prices in resolving issues like what to produce & for whom to produce (i.e., issues on marketing), how to produce (i.e., issues on technology & institutions) Role of prices (interest, wages, rent, profit etc.) in fostering economic growth Can prices ensure rationing over time & achieve sustainability? Is there any role for government and other institutions?

The Market
A market is an institutional arrangement under which buyers and sellers can voluntarily exchange some quantity of a good or service at a mutually agreeable price. It can, but need not be a specific place or location where buyers and sellers actually come face to face for the purpose of transacting their business e.g. market for professors has no physical location

The Concept of Demand

Human wants are all the goods, services, and conditions of life that individuals desire (i.e., has use value) Demand in economics is want backed by purchasing power A consumers claim on a good/service is recognized by the producer only if it is backed by sufficient purchasing power

Law of Demand & the Market Demand Curve

Other things remaining the same, the quantity demanded of a commodity is inversely related to its price. A lower price may encourage existing consumers to consume larger quantities Also, other consumers who were previously unable to afford the commodity may now begin consuming it The market demand curve refers to the behavior of an aggregate of economic agents over a given period of time while holding constant all other relevant economic variables on which demand depends (ceteris paribus assumption) On the presumption that different units of the commodity are homogeneous (else weights of product composition to be taken into consideration)

Example: Demand For Ice Cream

Price of Ice Cream

Demand
Interpret points above & below the demand curve

Quantity of Ice Cream

Ceteris Paribus . . .
...implies that all the relevant

variables (e.g. determinants of demand) are held constant, except the one(s) being studied at the time. Among other variables held constant are consumers incomes, tastes and preferences, prices of related commodities (substitutes and complements), number of consumers in the market, weather, future expectations, etc.

Determinants of Demand
Market Price: Price Demand Consumer Income: Income Prices of Related Goods
- Substitutes: Price of Tea
Positive Relationship - Complements: Price of Butter Negative Relationship Demand

Demand of Coffee
Demand of bread

Determinants of Demand
Tastes: Jeans, skirts, sarree Expectations: Future Price
Current demand Number of Consumers: Consumers Demand

Special influences: Helmets, woolen clothes Wealth of Consumer: Wealth Demand

Determinants of Demand: Market Price

Law of Demand:
There exists an P

inverse relationship between Price and Quantity Demanded.

Q

Determinants of Demand: Income

As income increases, the demand for a normal good will increase.

Determinant of Demand: Income

As income increases, the demand for an

inferior good

decreases (e.g., in case of coarse cereals).

Q

Determinants of Demand: Prices of Related Goods

When the fall in price of one good reduces the demand for another good, the two goods are substitutes.

Determinants of Demand: Prices of Related Goods

When the fall in price of one good increases the demand for another good, the two goods are

complements.

Tastes & preferences, consumer expectations of future income & price

Determinants of Demand:

Advertisement, for example, may shift up demand. Expectations of future income rise or price rise may shift up current demand.

Demand function general form

Qx = function of
Px (own price) (-) Pz (price of related goods) (+/-) Y (consumer income) (+/-) N (size of population) (+) (tastes/preferences) (+/-) Pe/P or Ye/Y (expectations about future price or income) (+/-)

Demand Schedule and Demand Curve

Demand Schedule: A table that shows the relationship between the price of the good and the quantity demanded
Qx 100 50 20 Px 1 2 3

Demand Curve: The downward-sloping line relating price and quantity demanded

Numericals
1. Page 17, Illus 2.1 2. Page 17, Illus 2.2

Movements vs. Shifts in the Demand Curve

Change in Quantity Demanded Movement along the demand curve caused by a change in the market price of the product. Change in Demand A shift in the demand curve, either to the left or right i.e. a change in the quantity demanded at each commodity price
The demand curve shifts when there is a change in (a) consumers incomes, (b) tastes and preferences, (c) prices of related commodities, and (d) number of consumers in the market, etc.

Price
$2.00
$1.00

Changes in Quantity Demanded

Quantity
7 13

Change in Demand
Price
$2.00

Quantity
7 10

The Concept of Supply.

Quantity Supplied refers P to the amount (quantity) of a good that sellers are willing and able to make
available for sale at alternative prices in a given point in time.

Interpret points above & below the supply curve

Determinants of Supply
Market price (+) Input prices (-) Cheaper technology (+) Price of alternative goods (-) Government tax (-) or subsidy (+) Expectations of future price rise (-) Number of Producers (+)

Determinant of Supply: Market Price

Law of Supply
There exists an direct (positive) relationship between Price and Quantity Supplied.
Q

 Change in Quantity Supplied Movement along the supply curve, caused by a change in the market price of the product. Change in Supply A shift in the supply curve, either to the left or right.

Change in quantity supplied verses change in supply

Supply: Schedule and Curve

Supply Schedule A table that shows the relationship between the price of the good and the quantity supplied. Supply Curve The upward-sloping line relating price and quantity supplied.

Price
$2.00
$1.00

Changes in Quantity Supplied

Quantity
1 7

Change in Supply
Price
$2.00

Quantity
7 11

 Equilibrium Price is one at which the supply and demand curve intersect (i.e., D=S)

Supply and Demand Together

Generally, there is one stable equilibrium, as shown in next slide. However, adjustments may not always lead to a stable equilibrium (i.e., convergence). Moreover, there may be multiple equilibrium, some of which may not be fully stable, as we shall see shortly.

(assimilating interests of two conflicting groups thro negotiation & adjustment in terms of price)

Forces of Demand and Supply At Rest

Price

Market Equilibrium

$2.00

Quantity
7

Actions of buyers and sellers that move toward equilibrium.

Excess Supply
Price is above equilibrium price, therefore producers are unable to sell all they want at the going price.
Price is below equilibrium price, therefore consumers are unable to buy all they want at the going price.

Excess Demand

Actions of buyers and sellers that move toward equilibrium.

Price Excess Supply

Quantity

Actions of buyers and sellers that move toward equilibrium.

Price

Excess Demand
Quantity

Comparative Statics: Analyzing Changes in Equilibrium

Determine if event shifts supply curve, the demand curve, or both. Determine if curve(s) shift to left or right. Determine how shift affects equilibrium price and quantity. Example: Demand for ice cream given hot weather.

Change in demand for ice cream due to hot weather

Price
Pe
Pe

New Equilibrium

Quantity
Qe

Qe

Price Elasticity of Demand

Price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in price.

Determinants of price elasticity of demand

Closeness of substitute Closer the substitute more elastic is the demand Necessaries- inelastic, Luxuries- elastic Proportion of income spent on product Higher the proportion of income spent, the more elastic is the demand - Ex: Textbooks and Banana chips

Determinants of price elasticity of demand

Time elapsed since a price change - The greater the time lapse since a price change, the more elastic is demand - Ex: Oil prices Nature of the good - Ex: Luxury items: Price elastic, Necessity items: Price inelastic

 Ep=% Change in quantity demanded % Change in Price Numerical - Page 19 Ep= Q2-Q1 * P1 P2-P1 Q1 Numerical - Page 19

 Price elasticity over a segment of demand curve or considering average price Ep= Q1-Q0 * (P0+P1)/2 P1-P0 (Q0+Q1)/2 Numerical: Page 21

 Elasticity at a point on demand curve Slope of AB= Change in price Change in quantity -OA OB Elasticity at point R: Ep= -RB AR

P
A

Different Types of elasticities

Page 23

Difference between slope and elasticity

Two demand curves may have the same slope but different elasticities as well as different slopes and the same elasticities, at the same price levels

Same slope, Different elasticity

Two demand curves are parallel Select price level P Slope at AB= OA and at CD = OC OB OD Elasticity at R= RB and at S= SD RA SC RB = OP and SD= OP RA PA SC PC OP > OP PA PC Elasticity of AB is more than CD, inspite of their slopes being same P

C
A P R S

Same elasticity, Different slope

Two demand curves originate from same point: A Select price level P Slope at AB= OA and at AC = OA OB OC Slopes are not same Elasticity at R= RB and at S= SC RA SA RB = OP and SC= OP RA PA SA PA Elasticities are same
P A R S

TR, AR, MR
TR= P * Q AR= TR = P*Q = P Q Q MR= Change in Revenue Change in Quantity MR= TR 2Q

 When Ep=1, then MR=0 When Ep>1, then MR>0 When Ep<1, then MR<0 Example: Price=6,5,4,3,2,1 and Q= 1,2,3,4,5,6. Find TR, AR, MR

AR,MR,TR B

TR

AR

D MR

Numericals
Page 31

Cross Price elasticity of demand

Ec= % change in QD of product 1 % change in P of product 2 = Change in Qx * P0 of Product Y Change in PY Q0 of Product X For substitutes, Ec is positive For complementary goods, Ec is negative

Numericals
Page 34, 35, 36

Income elasticity of demand

Ey= % change in QD % change in Y = Change in QX * Y Change in Y QX

Determinants of income elasticity of demand

Nature of the need the good covers - Ey between 0 to 1= Necessity goods - Ey above 1= Luxury goods - Ey negative= Inferior goods The initial level of income of a country Time period - Consumers adjust to rising income at faster rate than to falling incomes

Numericals
Page 37, 38

Promotional or advertising elasticity of demand

Ea= % change in QD % change in advertisement expense

Applying supply and demand

Impact of tax on price and quantity Prices fixed by law Maximum ceilings Minimum floors Ex: Rent Control Ex: Minimum Wages