Basic Economics Principles

Demand, Supply, and

Market Equilibrium

By Neelam Tandon
Demand and Supply
Demand
• The amount of a good or service consumers are
willing to purchase during a given period of time is
called quantity demanded.
• The six principle variables that influence the quantity
demanded of a good or service are:
• The price of the good or service, the income of the
consumers, the price of related goods and services,
the taste and preference patterns of consumers, the
expected price of the product in future periods and
the number of consumers in the market ( for market
demand).
Generalized demand
function
• Qd = f (P, M, Pr, T, Pe, N)

• To know the individual effect that any

one of these six variables has on Qd,
we must explain how changing that
one variable by itself influences Qd. It
requires all other variables be held
constant.
Demand function
• A table, a graph, or an equation that shows
how quantity demanded is related to
product price, holding constant the five
other variables that influences demand.
• Linear demand function:
Qd = a+ bP + cM + dPr + eT+ fPe
The intercept a shows the value of Qd when
the variables P, M, Pr , T , Pe are all
simultaneously equal to zero.
 Linear Demand Function

• Qd = a+ bP + cM +dPr +eT+fPe

• The other parameters, b,c,d,e and f are slope

parameters.
• Slope Parameters- Parameters in a linear
function that measure the effect on the
dependent variable (Qd) of changing one of
the independent variables (P,M,Pr, T, Pe )
while holding rest of these variables constant.
Summary Of the Linear
Demand Function
• When the slope parameter of a specific variable is
positive( negative ) in sign, quantity demanded is
directly (inversely) related to that variable.
• b is negative because the relationship between price
and quantity demanded is inverse.
• c will be +ve if it is normal good and –ve if the good is
inferior. d will +ve for substitute good and –ve for
complement good, e will be +ve for favourable change
and –ve for unfavourable change, f will be + always.
Example Linear Demand
Equation
• Qd = 1,800- 20P + 0.6 M – 50 Pr
• Suppose consumer’s income is Rs. 20,000
and the price of related good is Rs 250.
Find the demand function and calculate
quantity demanded when price for the
good is Rs.50, Rs. 40 and Rs.30.
Supply
• The amount of a good or service offered for sale during
a given period of time.
• It depends on :
• The price of the good itself.
• The price of factor inputs used to produce the good
• The level of technology.
• The price of goods related in production
• Expectations of producer concerning the future price of
the good
• Number of firms.
 Supply
Supply Price-The minimum price necessary to
induce producers voluntarily to offer a given
quantity for sale.

Change in quantity supplied- A movement along a

given supply curve that occurs when the price of
the good changes , all else constant.

Change in supply- A shift in supply curve because

of change in other determinants of supply except
the price of the commodity.
Supply Elasticity

• The responsiveness of supply to price

changes.
• (∆ S/S)/(∆ P/P), proportional change
in supply divided by proportional
change in price.
• Usually positive.
Pricing
• How much product should you produce and
what price should you charge for it?
• How can you best segment your market if
there are different types of buyers with
different demand characteristics (e.g.,
business travelers vs. vacation travelers,
home PC buyers vs. corporate buyers)?
• What are the types of pricing schemes
available (e.g., bundling, promotional
offers, loyalty bonuses, volume discounts)?
Analyzing the Structure of a Market
• Aim: to understand key aspects of
markets:
– nature of demands for the products

– closeness or otherwise of competitors

– structure of costs

– dependence of profits on the level of

output
The Market Mechanism

• Characteristics of the equilibrium or

market clearing price:
– QD = QS
– No shortage
– No excess supply
– No pressure on the price to change
The Market Mechanism
Price
(Rs. per unit) S

The curves intersect at

equilibrium, or market-
clearing, price. At P0 the
P0 quantity supplied is equal
to the quantity demanded
at Q0 .

Q0 Quantity
Demand Curve -Income
Rises

Price

Quantity
demanded
In case of normal goods demand will increase with
increase in income
Demand Shifts
Supply

New demand
Price Initial
demand

Quantity demanded
Equilibrium price increases from P1 to P2 with
increase in demand while supply remains
same.
Supply shifts
S
D
S1

With increase in supply the equilibrium price decreases and equilibrium

quantity increases while demand for the good remains same.
 D & S shift

Price

Quantity demanded
 The Market Mechanism

Surplus
Price S
(Rs. per unit)
Excess Supply
P1
Assume the price is P1 , then:
1) Qs : Q1 > Qd : Q2
2) Excess supply is Q1:Q2.
P2 3) Producers lower price.
4) Quantity supplied decreases
and quantity demanded
increases.
5) Equilibrium at P2Q3

Q1 Q3 Q2 Quantity
The Market Mechanism
Excess
Excess Supply
Supply

• The market price is above equilibrium

– There is excess supply
– Producers lower prices
– Quantity demanded increases and
quantity supplied decreases
– The market continues to adjust until the
equilibrium price is reached.
 The Market Mechanism

Shortage
Price
(Rs. per unit) S

Assume the price is P2 , then:

1) Qd : Q2 > Qs : Q1
2) Excess Demand is Q1:Q2.
P3 3) Producers raise price.
4) Quantity supplied increases
and quantity demanded
decreases.
P2 5) Equilibrium at P3, Q3
Excess Demand
D

Q1 Q3 Q2 Quantity
 The Market Mechanism
Excess
Excess Demand
Demand

• The market price is below equilibrium:

– There is a shortage
– Producers raise prices
– Quantity demanded decreases and quantity
supplied increases
– The market continues to adjust until the new
equilibrium price is reached.
The Market Mechanism
• Market Mechanism - Summary:
1) Supply and demand interact to
determine the market-clearing price.
2) When not in equilibrium, the market
will adjust to alleviate a shortage or surplus
and return the market to equilibrium.
3) Markets must be competitive for the
mechanism to be efficient.
Demand Analysis
– Analysis of demand

•demand curves,
•price, income & cross
elasticities of demand
• use of demand
parameters in forecasting
Price elasticity of demand:
Measures responsiveness of demand to
price.

Defined as E = (∆ Q/Q)/(∆ P/P) =

(∆ Q/∆ P)*(P/Q)

Why is it defined in proportional terms?

- Unit free.

- Scale sensitive.
 Price

Ed = 0

Price

Quantity
Demanded Quantity Demanded
 Geometric Method of Calculating Price
Elasticity of Demand

Q = 8 - 2P or P = 4 - 0.5Q

Elasticity = (∆ Q/Q)/(∆ P/P) = (∆ Q/∆ P)*(P/Q) =

-2*(P/Q)
Income Elasticity of
Demand:

Responsiveness of demand to
changes in income

IED = (∆ Q/Q)/∆ I/I) = (∆ Q/∆ I)*(I/Q)

Use to define necessities and luxuries

Necessities - IED < 1

Luxuries - IED > 1

Cyclical vs. defensive sectors

Cyclical - high IED - foreign travel,

consumer durables

Defensive - low IED - food, utilities

 Cross price elasticity of
demand:
The responsiveness of demand for good
A to change in price of good B:
∆ QA/QA = ∆ QA * PB
∆ PB/PB ∆ PB PA

Example:
responsiveness of demand for Nokia cell
phone to Motorola cell phone in the
market.
Cross Price Elasticity

• Cross price elasticity represents whether

two goods are substitute or compliment.
• If Ep value is greater than 0, two goods are
substitute goods.
• If Ep value is less than 0 , two goods are
complimentary goods.
• If Ep value is 0, two goods are independent
goods.
Advertising or Promotional
Elasticity Of Demand
• Qd = f (A)
• A is advertisement expenditure of the firm
• The degree of responsiveness of demand to
changes in advertising or promotional elasticity
of demand is measured;
• eA = Percentage change in quantity demanded
/ percentage change in advertisement
expenditure
Arc advertising Elasticity

• It is used when price- quantity

changes are very small
• eA arc= change in quantity
demanded/ change in advertising
expenditure * Average of advertising
expenditure / Average of quantity
demanded
Short-run vs. long-run
elasticities
Critical in understanding oil market,
energy markets, metal markets

Responding to a price movement takes

time - possibly many years

Long-run elasticity measures total

response
Short-run elasticity measures
immediate response
 Short-run
demand

P1
Po Long-run
demand

Long-run drop Short-run drop

in demand in demand
Revenue , Elasticity and
Pricing
• If the demand for the commodity is
elastic. Total revenue will increase with
decrease in price.
• Total revenue will be maximum when
demand is unit elastic that will be the
optimum price for the producer.
• Total revenue will decrease if the demand
for the commodity is inelastic even with
decrease in price for the good.
Marginal Revenue

• Increase in revenue from one extra

sale
• Rate of change of revenue with
respect to sales
• Typically less than price as demand
curve slopes down
• Depends on PED
Relationship between
demand, quantity and
revenue:
Q = 8 - 2P
or
P = 4 - 0.5Q
so as revenue R is price times quantity
R = 4Q - 0.5Q2
 Revenue rises as price rises
Revenue falls
as price rises

PED=>1 PED = <1

Price PED = -1
PED = 0
2
Q = 8 - 2P
This is a quadratic pointing up.
The slope of revenue curve is:
∆ R =4-Q
∆Q
As R= 4Q – 0.5 Q2
MR =4 – 0.5 * 2Q
MR= 4-Q which is zero at Q = 4.
Slope is positive for Q<4 and vice versa.
Maximum revenue comes when Q = 4, therefore
P = 2, and max revenue is 8
PED when revenue is
maximum
• Revenue is max when Q = 4, P = 2.
• E = (∆ Q/Q)/(∆ P/P) = (∆ Q/∆ P)*(P/Q)
• So E = (∆ Q/∆ P)*(1/2) and
• ∆ Q/∆ P = -2 so E = -2 * 1/2 = -1
when TR is at a maximum.
• PED is price elasticity of demand.
Marginal Revenue & PED
• MR = dR/dQ
• R= P*Q
• Differentiating both sides of equation with
respect to Q we get –
• dR/dQ = P* dQ/dQ + Q*dP/dQ
• MR = P + Q*dP/dQ
• MR= P{1 + (Q/P)*dP/dQ}
PED = dQ/dP*P/Q
MR = P{1 - 1/PED} ( IF PED is taken in
absolute terms)
• Remember PED < 1 so MR <0.
• If PED = 1, then MR = 0. (Top of revenue curve)
• If PED <1 , then MR >0.
Pricing Theater Tickets During
Off- Peak Hours
• Suppose you manage a movie theater
and want to maximize profits for
midweek screenings. Demand is slack
during midweek, and it’s likely to take a
very low price to fill the theater. As the
cost is independent of the number of
admissions you sell. Hence you can
maximize your profit from the sale of
tickets when you maximize revenue from
admissions.
Demand and Total Revenue per
Midweek
Price No: of Total PED
• If the demand for (Rs.) admissions revenue
admissions to your demanded

midweek screenings is
linear. Along the linear 3.00 200 600 Elastic
demand curve , each 1 2.50 300 750 Elastic
paisa reduction in 2.00 400 800 Unit Elastic
ticket prices results in
1.50 500 750 Inelastic
the sale of two more
1.00 600 600 Inelastic
tickets. The theater’s
capacity is 600
persons.
 Elasticity and Revenue

• The demand schedule indicates that if you

choose a ticket price of Rs. 3, the no: of
admissions demanded would be 200. Total
revenue would be Rs. 600 for the evening.
Because Rs.3 is relatively high price , demand
for theater admissions is elastic at that price.
It means if you were to lower price ,total
revenue would increase.
• Each paisa reduction in price results in two
more admissions.
• Total Revenue will continue to increase as
long as demand remains elastic and will
begin to decline just at the point at which
price is reduced to make demand inelastic.
• At a price of Rs 2 , demand is unit elastic,
because if price were reduced an additional
paisa, to Rs 1.99, admissions would
increase to 402 and total revenue would
decline to Rs. 750, because demand would
be inelastic.
• The theater could be fill by you if you charge
Rs.1 for admission but your total revenue
would be only Rs. 600!
• To maximize revenue you would choose to
price your tickets at Rs. 2 and be content
filling only two thirds of your seating capacity
but enjoying Rs. 800 revenue for the evening.
• Hence if a business wants to maximize
revenue, it must choose the price at which
demand just becomes inelastic. This is the
price for which demand is unit elastic.
Marginal Analysis For Optimal
Decisions
• Making optimal decisions about the
levels of various business activities is
an essential skill for all managers.
• It requires managers to analyze
benefits and costs to make the best
possible decision under a given set of
circumstances.
The Analytical Technique

• Marginal Analysis forms the foundation of

the theories of Profit Maximization,
Production, Input- Choice and even
Consumer Behaviour.
• It helps to estimate how changing the
business activity will affect both the
benefits the firm receives from the activity
and costs the firm incurs from engaging in
the activity.
Concepts
• Objective Function- The function the decision maker seeks
to maximize or minimize.
• Maximization Problem- An optimization problem that
involves maximizing the Objective Function.
• Minimization Problem – An optimization problem that
involves minimizing the Objective Function.
• Activities or choice variables- Variables that determine the
value of the Objective Function.
Concepts

• Unconstrained Optimization- An optimization

problem in which the decision maker can
choose the level of activity from an
unrestricted set of values.
• Constrained Optimization – An optimization
problem in which the decision maker selects
values for the choice variables from a
restricted set of values.
Optimal Advertising
Expenditures
(An example of Constrained Maximization )
• Objective – A manager of small retail firm wants to
maximize the effectiveness (in total sales) of the firm’s
weekly advertising budget of Rs 2000.
• Choice Variables- He has an option of advertising on
the local television station or local FM radio station.
• Maximization objective – To maximize the number of
units sold, thus the total benefits is measured by the
total number of units sold.
 Estimates of Increase in Weekly
Sales (MBs) from Increasing
Advertising Expenditure
Number Marginal benefits Marginal benefits from
of ads from TV Radio

1 400 360
2 300 270
3 280 240
4 260 225
5 240 150
6 200 120
Constraint Advertising
Budget
• Advertising budget is Rs 2000.
• If price of ad on TV is Rs 400/ad and on
radio is Rs. 300/ad.
• The marginal benefit /Rs spent on
advertising is the most important thing to
know. It is clear from the schedule TV ads
are more powerful than radio ads.
• MB(TV) = 400/400 = 1
• MB(Radio) = 360/300 = 1.2
• MB(Radio) > MB (TV)
Allocation of budget
• This indicates that sales rise by I unit per
rupee spent on the 1st ad and 1.2 units
on the 1st radio ad. Therefore when the
manager is allocating the budget , the
first ad she selects will be a radio ad- the
activity with the larger MB per rupee
spent. Following the same rule, the Rs.
2000 advertising budget would be
allocated as follows:
Budget Schedule
Decision MB/ Price Ranking of Cumulative
MB/Price Expenditure
Buy 1st radio ad 360/300=1.20 1 300

Buy 1st TV ad 400/400=1 2 700 =300 +400

Buy 2nd radio ad 270/300=0.90 3 1000=700+300

Buy 3rd radio ad 240/300=0.80 4 1300=1000+300

Buy 2nd TV ad 300/400=0.75 5 1700=1300 +

400
Buy 4th radio ad 225/300=0.75 5 2000=1700+300
Optimum Allocation Of
Budget
• By selecting 2 TV ads and 4 Radio ads, the
manager of firm has maximized sales
subject to the constraint that only Rs 2000
can be spent on advertising activity.

• MB TV/P TV = MB radio/P radio= 0.75

Constrained Minimization

• Objective Function- to minimize total cost

subject to a constraint that the level of
activities be chosen such that a given level of
total benefit is achieved.
• A manager has to minimize the total cost of
two activities, A and B, subject to the
constraint that 3,000 units of benefits to be
generated by those activities.
Assumptions

• Price of A/ unit= Rs.5

• Price of B / unit = Rs 20
• If a manager uses 100 units of A and
60 units of B his total benefit is 3,000
units.
• If MB of last unit of A = 30 and MB of
last unit of B = 60.
 Minimize Total Cost

• To choose the level of each activity so that

marginal benefit per rupee spent is equal for
all activities.
• MBA/PA = MBB/PB= MBC/PC = ----
• MBA/Rupee spent on activity A =30/5= 6
• MBB/Rupee spent on activity B = 60/20=3
• MBA/PA > MBB/PB
• Hence manager will substitute B for A. One less
unit of B means total benefit (TB) to decrease by
units reducing cost by Rs 20.
• To keep TB constant, 60 units of lost benefit can
be made by increasing activity A by 2 units with a
MB of 30 each. Two additional units of A will
increase the cost by Rs 10 (Rs5* 2units).
• Total cost reduces by Rs 10 (Rs20(B)-Rs10(A))
• As long as MBA/PA > MBB/PB, the manager will
continue to increase activity A and decrease
activity B at the rate that holds TB constant until
MBA/ PA = MBB/PB