Download Demand and Supply: Basic Framework

Fundamental Concepts &
Basic Framework of
Demand and Supply:
Prof. Samar K. Datta
Session 1
28th June, 2007
Materials intended to be
covered in this session
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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
• Distinctive feature of micro-economics vis-àvis macro-economics:
– Macro dealing with behavior of aggregative variables
like price, income, employment, money supply,
exchange rate etc.
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?
• Broad methodology used:
– Marginal analysis;
– Positive rather than normative analysis;
– Trade off involved in most choices
• Question: Why heath care expenses increasing steadily
in the US?
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 (note difference
between effective demand and notional
demand)
• A consumer’s 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)
Price of Ice Cream
Example: Demand For
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
Consumer Income
Prices of Related Goods
Tastes
Expectations
Number of Consumers
Determinants of Demand:
Market Price
Law of Demand:
There exists an
inverse
relationship
between Price
and Quantity
Demanded.
P
Q
Determinants of Demand:
Income
• As income
increases, the
demand for a
normal good will
increase.
P
Q
Determinant of Demand:
Income
• As income
increases, the
demand for an
inferior good
decreases (e.g., in
case of coarse
cereals).
P
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.
Determinants of Demand:
Tastes & preferences, consumer
expectations of future income & price
• 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) (+)
α (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
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.
Changes in Quantity
Demanded
Price
$2.00
$1.00
Quantity
7
13
Change in Demand
Price
$2.00
Quantity
7
10
GEOMETRIC FEATURES
OF A DEMAND CURVE
• Its level, depending on role of non-price factors
(interpret intercepts on both axes)
• Its shape – i.e., inverse relationship, decided by
law of demand
• Its slope, is decided by units of P & Q (the curve
becoming flatter with rise in unit of Q or P), the
reference period (usually flatter in long run), &
role of non-price factors (e.g., flatter for luxury
goods)
• Its curvature – can be concave, convex, straight
line or a combination (theory proving no further
clue)
The Concept of Supply.
Quantity Supplied refers
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
P
Q
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.
P
Q
Interpreting features
of a supply curve
•
•
•
•
Level/intercept
Direction
Slope
Curvature
Change in quantity
supplied verses change
in supply
• 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.
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.
Changes in Quantity
Supplied
Price
$2.00
$1.00
Quantity
1
7
Change in Supply
Price
$2.00
Quantity
7
11
Supply and Demand Together
• Equilibrium Price is one at which the supply
and demand curve intersect (i.e., D=S)
(assimilating interests of two conflicting
groups thro’ negotiation & adjustment in
terms of price)
• 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.
Forces of Demand and Supply At
Rest
Market Equilibrium
Price
$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.
• Excess Demand
Price is below equilibrium price,
therefore consumers are unable to buy
all they want at the going price.
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
Stability of Market
Equilibrium
The backward
bending supply
curve of labor may
cause multiple
equilibrium - some
unstable (e.g. at A),
some stable (e.g.,
at B).
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
New
Equilibrium
Pe
Pe
Quantity
Qe
Qe
A point to note
• For analytical convenience, an artificial
dichotomy is created between producers and
consumers; and demand and supply
• Very often in the real world, producers and
consumers are either
• the same person e.g. a farmer who eats his own crop, or
• play both roles simultaneously – a person who produces
one product, consumes others
• Also, demand and supply may be dependent on
each other – e.g. generation of income during
production may expand the customer base for
the product e.g. workers in Ford buying the
Ford motor car.
Price Elasticity of
Demand
• Price elasticity of demand measures the
percentage change in the quantity
demanded resulting from a 1-percent
change in price.
Q/Q Q / P
EP 

P/P
Q/P
Price Elasticity and
Consumer Expenditure
Demand
If Price Increases,
Expenditures:
If Price Decreases,
Expenditures:
Inelastic (Ep <1)
Increase
Decrease
Unit Elastic (Ep = 1)
Unchanged
Unchanged
Elastic (Ep >1)
Decrease
Increase
Point Elasticity of
Demand
–
–
Point elasticity measures elasticity at a
point on the demand curve.
Its formula is:
EP  (P/Q)(1/sl ope)
Variation in Point Elasticity
over a Linear Demand Curve
Elastic vs. Inelastic
Demand Curves
Problems Using Point
Elasticity
–
–
We may need to calculate price
elasticity over portion of the demand
curve rather than at a single point.
The price and quantity used as the base
will alter the price elasticity of demand
(point elasticity of demand is not
symmetric).
Arc Elasticity of
Demand
–
–
Arc elasticity calculates elasticity over
a range of prices
Its formula is:
EP  ( Q/P)( P / Q)
P  the average price
Q  the average quantity
Income Elasticity of
Demand
• Income elasticity of demand measures
the percentage change in the quantity
demanded resulting from a 1-percent
change in income.
– Its formula is:
EI
Q
I


I
Q
Income Elasticity of
Demand and type of Good
• Income Elasticity
– Positive
•0<e<1
•e>1
– Negative
• Type of Good
– Normal Good
• Necessity
• Luxury
– Inferior Good
Cross-price Elasticity
of Demand
• Cross-price elasticity of demand
measures the percentage change in the
quantity demanded of good Y resulting
from a 1-percent change in price of good
X.
– Its formula is:
EC
QY

PX
PX

QY
Cross-Price Elasticity of
Demand and type of Good
• Cross-price
Elasticity
• Type of good
– Positive
– Substitutes
– Negative
– Complements
Some applications & food for
thought
• How to cut down cigarette smoking ?
• Does minimum wages really help the workers ?
• Why is rent control often found to create more
shortage of urban housing ?
• Why do we often observe greater wage inequality
between unskilled and skilled workers ?
• Why is coffee price found declining, whereas
Nestle and coffee shops are found to be making
huge profits ?
• Why is long run price of natural resources like
copper declining in spite of the fact that it is
exhaustible ?
• Why did average rental price fall in NY Mahattan
following 9/11, 2001?
Some applications & food for
thought
• Why and how does imposition of price ceiling (rationing) on
an essential item often lead to emergence of a black market
in that good?
• Although in general longer run supply curves are flatter as
compared to their shorter run counterparts, why do we then
often observe a reversal in case of supply of secondary
copper (i.e., new supply based on scrap copper), for
example?
• Why is demand curve for gasoline flatter in the long-run,
but steeper in the short-run, while the opposite is true for
automobiles?
• For what type of products the long-run supply curve is
steeper as compared to its short-run counterpart?
(answer in terms of the basic supply-demand framework and
shifts in one or both curves)