Demand and Supply

Dr. Sanja Samirana Pattnayak

Introduction
Demand supply model fundamentally describes how consumers
and sellers interact to determine the quantity of a good or service
sold in a market place and the price at which it is sold.
It can be applied to varieties of important and interesting
problems such as:

How changing market conditions affect market price and

production
Evaluating the impact of various incentive structure
Prediction of future demand

Demand
The relationship between demand and price: (Law of Demand)
When the price of a good rises, the quantity demanded will fall
and vice-versa.
There are two reasons behind it:
People will feel poorer. They will not be able to afford to buy so
much of the good with their money. The purchasing power of their
income (the real income) has fallen. This is called in income effect
of a price rise.
The good is now dearer relative to other goods. People will thus
switch to alternative or substitution goods. This is known as
substitution effect of a price rise.
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Demand Curve
Demand for a good or a service is determined by the willingness
and ability to pay for that good or service at a given point of time

Demand Curve shows the amount of a good that consumers are

willing to buy at different prices, holding other factors constant.
Demand curve is downward-sloping.

Determinants of Demand
Tastes: The more desirable people find the good, the more they
will demand.

Tastes are affected by advertising, by fashion, by observing other

consumers and by the experience from consuming the good on
previous occasions.
Advertising may be informative as well as persuasive.
Informative advertising communicates information to potential
buyers.
Persuasive advertising aim to influence consumer choice.

Determinants of Demand
Manufacturer of cigarettes and cosmetics, for instance, use
commercials to retain the loyalty of the existing consumers and
attract others to switch brand.
Markets may also use persuasive advertising to promote new
products.

Generally, an increase in advertising expenditure, whether

informative or persuasive, will increase demand.

Determinants of Demand
The price of substitute goods: Two products are substitutes, if an
increase in the price of one causes the demand for the other to
increase. (example tea and coffee)

The price of complementary goods: Two products are

complements if an increase in the price of one causes the
demand for other to fall. (coffee and milk).

Determinants of Demand
Income: As peoples income rise, their demand for most goods
will rise. Such goods are called normal goods.

By contrast, the demand for an inferior good is inversely related

to changes in buyers income.
Generally, broad categories of products tend to be normal, while
particular product within the categories may be inferior.

Determinants of Demand
Example: Transportation services. The entire category is probably
a normal product: the higher a persons income, the more s/he
tends to spend on transportation.

Public transportation, however, may be an inferior product: with

a higher income, the typical consumer switches from public
transport to a private car.

Determinants of Demand
Expectations of future price changes: If people think that prices
are going to rise in the future, they are likely to buy more now
before the price does go up and so demand will increase.
EXAMPLE: Think about the housing market. If people expect
the price of houses to increase, they try to buy now before
that happens.

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The Demand Function

A general equation representing the demand curve
Qxd = f(Px , PY , M, H,)
Qxd = quantity demand of good X.
Px = price of good X.
PY = price of a related good Y.
Substitute good.
Complement good.
M = income.
Normal good.
Inferior good.
H = any other variable affecting demand.
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Inverse Demand Function

Price as a function of quantity demanded.
Example:
Demand Function
Qxd = 10 2Px
Inverse Demand Function:
2Px = 10 Qxd
Px = 5 0.5Qxd

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Movements along and shifts in the

Demand curve
Movement along the demand curve: Change in quantity demand

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Movements along and shifts in the

Demand curve
Shifts in the demand curve: Change in Demand.

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Market Demand
Market demand: it tells us how the quantity of a good demanded
by the sum of all consumers in the market depends on the price
and various other factors.
My demand for mangoes is five kilograms is wrong statement!!
Five kilograms is the quantity demanded at a certain price
instead of demand only.

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Market Demand
Horizontal summation of individual demands

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Market Demand

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Market Demand
The aggregation of individual to market demand is not just
theoretical exercise.

It becomes an important practice when market demands are built

up from the demands of different demographic groups or from
consumers located in different areas.
Example: we might obtain information about the demand for home
computers by adding independently obtained information about the
demands of the following groups
Households with children
Households without children
Single individual

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Supply and Price

The general relationship between supply and price: when the
price of a good rises, the quantity supplied will also rise.

Supply curve: The supply curve shows the amount of a good that
will be produced at alternative prices.

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Other determinants of supply

The cost of production: The higher the cost of production, the less
profit will be made at any price.

As costs rise, firms will cut back on production, probably

switching to alternative products ( a substitute in supply)
becomes more profitable to supply than before, producers are
likely to switch from the first good to this alternative.
The profitability of goods in joint supply: sometimes when one
good is produced, another good is also produced at the same
time. These are said to be goods in joint supply.
Example: An example is the refining of crude oil to produce
petrol.

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Other determinants of supply

Example (cont): Other grade fuels will be produced as well,
such as diesel and paraffin. If more petrol is produced, due to a
rise in demand, then the supply of these other fuels will rise too.
Nature, random shocks and other unpredictable events: In this
category we would include the weather and diseases affecting
farm output, wars affecting the supply of imported raw
materials, the breakdown of machinery, industrial disputes,
earthquakes, floods, fire and so on.
Expectations of a future price changes: if price is expected to rise,
producers may temporarily reduce the amount they sell.

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Other determinants of supply

Expectations of a future price changes (cont): instead they are
likely to build up their stocks and only release them onto the
market when the price does rise.
At the same time they may plan to produce, by installing new
machines, or taking on more labor, so they can be ready to
supply more when the price has risen.
Example: consider the housing market again. If you are thinking
of selling your house, but expect that house prices will soon be
higher , it would be rational to wait and put your house on the
market only when price has risen.

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Movements along and shifts in the

supply curve
Change in Quantity Supplied

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Movements along and shifts in the

supply curve
Change in Supply

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Market Equilibrium
We can combine our demand and supply analysis and will show
how the actual price of a product and actual quantity bought and
sold in a free and competitive market.

The Price (P) that Balances supply and demand

QxS = Qxd
No shortage or surplus
Steady-state

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Market Equilibrium
If price is too low

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Market Equilibrium
If price is too high

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Price Restrictions
Price Ceilings
The maximum legal price that can be charged.
Examples:
Rental Housing
Price Floors
The minimum legal price that can be charged.
Examples:
Minimum wage.

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Comparative Static Analysis

How do the equilibrium price and quantity change when a
determinant of supply and/or demand change?

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The Determination of Equilibrium Price

At price P*, the quantity demanded is equal to the quantity
supplied.

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Demand Shift
A recent scientific study revealed that the consumption of apple
reduces the hazard of heart attack.

What would happen to the apple market? Demand increases

What happens to the equilibrium price and quantity?

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Increase in Demand
Equilibrium is at a higher price and higher quantity.

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Demand Shift

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Supply Shift
The benign weather brought a bumper crop.
What would happen to agricultural market?
Supply increases
What happens to the equilibrium price and quantity?

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Increase in Supply
Equilibrium is at a lower price and higher quantity.

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Supply Shift

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Effects of Changes in Demand and Supply

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Effects of Increase on Demand and Supply

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Effects of Simultaneous Changes in

Demand and Supply

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Applications of Demand and Supply

Analysis
Event: The WSJ reports that the prices of PC components are
expected to fall by 5-8 percent over the next six months.

Scenario 1: You manage a small firm that manufactures PCs.

Scenario 2: You manage a small software company.

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Use Comparative Static Analysis to see

the Big Picture!
Comparative static analysis shows how the equilibrium price
and quantity will change when a determinant of supply or
demand changes.
Scenario 1: Implications for a Small PC Maker
Step 1: Look for the Big Picture.
Step 2: Organize an action plan (worry about details).

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Big Picture: Impact of decline in

component prices on PC market
Big Picture.

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Big Picture Analysis: PC Market

Equilibrium price of PCs will fall, and
equilibrium quantity of computers sold will
increase.
Use this to organize an action plan
contracts/suppliers?
inventories?
human resources?
marketing?
do I need quantitative estimates?
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Scenario 2: Software Maker

More complicated chain of reasoning to arrive at the
Big Picture.
Step 1: Use analysis like that in Scenario 1 to deduce
that lower component prices will lead to
a lower equilibrium price for computers.
a greater number of computers sold.
Step 2: How will these changes affect the Big Picture
in the software market?
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Big Picture: Impact of lower PC prices

on the software market
Big Picture:

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Big Picture Analysis: Software Market

Software prices are likely to rise, and more software will be sold.
Use this to organize an action plan.

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Conclusion
Use supply and demand analysis to
clarify the big picture (the general impact of a current
event on equilibrium prices and quantities).
organize an action plan (needed changes in production,
inventories, raw materials, human resources, marketing
plans, etc.).

Reference:
Wheat soars after Russian crop failure, The Financial Times,
November 8, 2012. (Application of demand-supply model)
http://www.ft.com/cms/s/0/7cbc024c-2998-11e2-a5ca00144feabdc0.html#axzz36Cwc929i
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Learning activity
The law of demand states that, holding all else constant
a. As price falls, demand will fall also
b. As price rises, demand will also rise
c. Price has no effect on quantity demanded
d. As price falls, quantity demanded rises
Which of the following would not shift the demand for good A?
a. Drop in price of good A
b. Drop in price of good B
c. Consumer income
d. Change in the level of advertising of good A

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Learning activity
A change in income will not lead to
a. A movement along the demand curve
b. A leftward shift of the demand curve
c. A rightward shift of the demand curve
d. All of the statements associated with the question are correct
Good A is an inferior good, an increase in income leads to:
a. A decrease in the demand for good B
b. A decrease in the demand for good A
c. An increase in the demand for good A
d. No change in the quantity demanded of good A

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Learning activity

The inverse demand curve for Q=2a-bP

a. P/Q
b. 1/Q
c. P=2a/b-Q/b
d. Cannot be determined

If A and B are complements, an increase in the price of good A would:

a. Have no effect on the quantity demanded of B
b. Lead to an increase in demand for B
c. Lead to a decrease in demand for B
d. None of the statements associated with this question are correct

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Learning activity
How does a decrease in the price of good X affect the market rate
of substitution between goods X and Y?
a. It increases
b. It decreases
c. Remains unchanged
d. Indeterminable without more information

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