Theory of Demand and Supply pdf

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THEORY OF DMAND AND SUPPLY

Demand: Demand is an economic principle referring to a consumer’s desire to purchase goods and services and willingness to pay a price for a specific good or service.

Example: If ‘x’ is a person wants to purchase a Bike and also the person have money for purchasing the bike that’s called demand.

Law of Demand:

According to the law of demand, other things being equal, if price of a commodity falls, the quantity demanded of it will rise, and if price of the commodity rises, its quantity demanded will decline. It implies that there is an inverse relationship between the price and quantity demanded of a commodity,. In other words, other things being equal, quantity demanded will be more at a lower price than at higher price.

The law of demand describes the functional relationship between price and quantity demanded. Among various factors affecting demand, price of a commodity is the most critical factor. Thus, demand of a commodity is mainly determined by the price of commodity.

The law of demand may be understood from the following example:

Assumptions of the law of demand:

‘other things being equal following ceteris paribus assumptions:

1.No Change in Consumer’s Income

2. No Change in Consumer’s Preferences

3. No Change in the Fashion

4. No Change in the Price of Related Goods

5. No Expectation of Future Price Changes or Shortages

6. No Change in Size, Age Composition and Sex Ratio of the Population

7. No Change in the Range of Goods Available to the Consumers

8. No Change in the Distribution of Income and Wealth of the Community

9. No Change in Government Policy

10. No Change in Weather Conditions

EXCEPTIONS TO THE LAW OF DEMAND

There are few exceptional cases where the law of demand is not applicable, which may be categorised as follows:

Giffen Goods : In the case of certain inferior goods called Giffen goods (named after Sir Robert Giffen), when the prices fall, quite often less quantity will be purchased than before because of the negative income effect and people’s increasing preference for a superior commodity with the rise in their real income. Examples of Giffen goods can include bread, rice, and wheat.

Articles of Snob Appeal : Sometimes, certain commodities are demanded just because they happen to be expensive or prestige goods, and have a ‘snob appeal’. They satisfy the aristocratic desire to preserve exclusiveness for unique goods.

Speculation : When people speculate about changes in the price of a commodity in the future, they may not act according to the law of demand at the present price, say, when people are convinced that the price of a particular commodity will rise still further, they will not contract their demand with the given price rise: on the contrary, they may purchase more for the purpose of hoarding.

Consumer’s Psychological Bias or Illusion : When the consumer is wrongly biased against the quality of the commodity with the price change, he may contract this demand with a fall in price.

Law of Supply:

Supply represents how much the market can offer. The quantity supplied refers to the amount of a good producers are willing to supply when receiving a certain price. The supply of a good or service refers to the quantities of that good or service that producers are prepared to offer for sale at a set of prices over a period of time. Supply means a schedule of possible prices and amounts that would be sold at each price. The supply is not the same concept as the stock of something in existence, for example, the stock of commodity X in Delhi means the total quantity of Commodity X in existence at a point of time; whereas, the supply of commodity X in Delhi means the quantity actually being offered for sale, in the market, over a specified period of time.

The law of supply states that a firm will produce and offer to sell greater quantities of a product or service as the price of that product or service rises, other things being equal. There is direct relationship between price and quantity supplied. In this statement, change in price is the cause and change in supply is the effect. Thus, the price rise leads to increase in supply and not otherwise. It may be noted that at higher prices, there is greater incentive to the producers or firms to produce and sell more. Other things include cost of production, change of technology, prices of inputs, level of competition, size of industry, government policy and non-economic factors.

The law of supply is the microeconomic law that states that, all other factors being equal, as the price of a good or service increases, the quantity of goods or services that suppliers offer will increase, and vice versa. The law of supply says that as the price of an item goes up, suppliers will attempt to maximize their profits by increasing the quantity offered for sale.

Assumptions of Law of Supply

The term “other things remaining the same” refers to the following assumptions in the law of supply:

  1. No change in the state of technology.
  2. No change in the price of factors of production.
  3. No change in the number of firms in the market.
  4. No change in the goals of the firm.
  5. No change in the seller’s expectations regarding future prices.
  6. No change in the tax and subsidy policy of the products.
  7. No change in the price of other goods.

The equilibrium price is the market price where the quantity of goods supplied is equal to the quantity of goods demanded. This is the point at which the demand and supply curves in the market intersect.

At equilibrium, there is no shortage or surplus unless a determinant of demand or a determinant of supply changes. If a change in the price of a good or a service creates a shortage, it means that consumers want to buy a higher quantity than the one offered by producers. In this case, demand exceeds supply and consumers are not satisfied. In contrast, if a change in the price of a product or a service creates a surplus, it means that consumers want to buy less quantity than the one offered by producers. In this case, supply exceeds demand and producers need to lower the price of the product or the service to avoid excessive inventory.

Let us take an example to understand the concept.

In the table above, the quantity demanded is equal to the quantity supplied at the price level of $60. Therefore, the price of $60 is the equilibrium price. At any other price level, there is either surplus or shortage. Specifically, for any price that is lower than $60, the quantity supplied is greater than the quantity demanded, thereby creating a surplus. For any price that is higher than $60, the quantity demanded is greater than the quantity supplied, thereby creating a shortage.

ELASTICITY OF DEMAND

In economics, the demand elasticity (elasticity of demand) refers to how sensitive the demand for a good is to changes in other economic variables, such as prices and consumer income.


Demand elasticity is calculated as the percent change in the quantity demanded divided by a percent change in another economic variable. A higher demand elasticity for an economic variable means that consumers are more responsive to changes in this variable.


“Elasticity of demand is the responsiveness of the quantity demanded of a commodity to changes in one of the variables on which demand depends. In other words, it is the percentage change in quantity demanded divided by the percentage in one of the variables on which demand depends.” The variables on which demand can depend on are:

There are major three types of elasticity of demand, i.e. Price elasticity; Income elasticity and Cross elasticity.

Price Elasticity of Demand:

The price elasticity of demand is the response of the quantity demanded to change in the price of a commodity. It is assumed that the consumer’s income, tastes, and prices of all other goods are steady. It is measured as a percentage change in the quantity demanded divided by the percentage change in price. Therefore, price elasticity of demand is:

Types of Price Elasticity of Demand:

The extent of responsiveness of demand with change in the price is not always the same. The demand for a product can be elastic or inelastic, depending on the rate of change in the demand with respect to change in price of a product.


Elastic demand is the one when the response of demand is greater with a small proportionate change in the price. On the other hand, inelastic demand is the one when there is relatively a less change in the demand with a greater change in the price.

The various forms of price elasticity of demand are as under:

1- Perfectly Elastic Demand : When a small change in price of a product causes a major change in its demand, it is said to be perfectly elastic demand. In perfectly elastic demand, a small rise in price results in fall in demand to zero, while a small fall in price causes increase in demand to infinity. In such a case, the demand is perfectly elastic or ep = . (Infinity)

2- Perfectly Inelastic Demand : A perfectly inelastic demand is one when there is no change produced in the demand of a product with change in its price. The numerical value for perfectly inelastic demand is zero (ep
=0).

3-Relatively Elastic Demand : Relatively elastic demand refers to the demand when the proportionate change produced in demand is greater than the proportionate change in price of a product. The numerical value of relatively elastic demand ranges between one to infinity (ep>1).

4- Relatively Inelastic Demand: Relatively inelastic demand is one when the percentage change produced in demand is less than the percentage change in the price of a product. For example, if the price of a product increases by 30% and the demand for the product decreases only by 10%, then the demand would be called relatively inelastic. The numerical value of relatively elastic demand ranges between zero to one (ep
<1).

5-Unitary Elastic Demand : When the proportionate change in demand produces the same change in the price of the product, the demand is referred as unitary elastic demand. The numerical value for unitary elastic demand is equal to one (ep=1).

Factors affecting Price Elasticity of Demand:

1-Price Level : The demand is generally elastic for moderately priced goods but, the demand for very costly and very cheap goods is inelastic. The rich do not bother about the prices of the goods that they buy. Very costly goods are demanded by the rich people and hence their demand is not affected much by change in prices. For example, increase in the price of Toyota car from Rs. 5,00,000 to Rs. 5,20,000 will not make any noticeable difference in its demand. Similarly, the change in the price of very cheap goods (such as salt) will not have any effect on their demand, for their consumption which is very small and fixed.

2-Availability of Substitutes : If a good has close substitutes, the price elasticity of demand for a commodity will be very elastic as some other commodities can be used for it. A small rise in the price of such a commodity will induce consumers to switch their consumption to its substitutes. For example gas, kerosene oil, coal etc. will be used more as fuel if the price of wood increases. On the other hand, the demand of such commodities which have no close substitutes is inelastic, such as salt.

3-Necessities : If a good is a necessity, then the demand tends to be inelastic. For example, if the price for drinking water rises, then there is unlikely to be a huge drop in the quantity demanded since drinking water is a necessity.

4-Time Period : Over time, a good tends to become more elastic because consumers and businesses have more time to find alternatives or substitutes. For example, if the price of gasoline goes up, over time people will adjust for the change, i.e., they may drive less or use public transportation or form carpools.

5-Habits : The demand for addictive or habitual products is usually inelastic. This is because the consumer has no choice but no pay whatever the producer is demanding. For example, if the price for a pack of cigarettes goes up, it will likely not have any effect on demand.

6-Nature of the Commodities : The demand for necessities is inelastic and that for comforts and luxuries is elastic. This is so because certain goods which are essential will be demanded at any price, whereas goods meant for luxuries and comforts can be dispensed with easily if they appear to become costlier.

7-Various Uses : A commodity which has several uses will have an elastic demand such as milk, wood etc. On the other hand, a commodity having only one or fewer uses will have inelastic demand. The consumer finds it easier to adjust the quantity demanded of a good when it is to be used for satisfying several wants than if it is confined to a single or few uses. For this reason, a multiple-use good tends to have more elastic demand.

8-Postponing Consumption : Usually the demand for commodities, the consumption of which can be postponed, is elastic as the prices rise and are expected to fall again. For example, the demand for mp3 is elastic because its use can be postponed for some time if its price goes up, but the demand for rice and wheat is inelastic because their use cannot be postponed when their prices increase.

Income Elasticity of Demand

Income elasticity of demand is the degree of responsiveness of demand to the change in income. Prof. Watson defines it as : “Income elasticity of demand is the rate of change of quantity with respect to changes in the income, other determinants remaining constant.” The income elasticity of demand can be measured by the following formula :

Ey = Percentage change in quantity demanded/Percentage change in income

Percentage change in quantity demanded = New quantity demanded (Delta Q)/Original quantity demanded (Q)

Percentage change in income = New income (Delta Y)/original income (Y)

Income elasticity of demand, thus explains the responsiveness of demand to a change in income. Ordinarily, demand for most goods increases with increase in household’s level of income. Demand for inferior goods, however, shows a negative relation to change in income.

Types of Income Elasticity of Demand

Income elasticity of demand can be of five different types : These are tabulated with description below:

Cross Elasticity of Demand
The responsiveness of demand to changes in prices of related commodities is called cross elasticity of demand. Prof. Watson defines it as, “Cross elasticity of demand is the rate of change in quantity associated with a change in the price of related goods.” Thus cross elasticity of demand is the responsiveness of demand for commodity X to change in price of commodity Y.

The relationship between X and Y commodities may be substitutive as in case of tea and coffee or complementary as in the case of ball pens and refills. Main measures of cross elasticity with description are as follows :

1- Cross elasticity = Infinity (Commodity X is nearly a perfect substitute for commodity Y)

2Cross elasticity = Zero (Commodity X and Y are not related)

3- Cross elasticity = Negative (Commodities X and Y are complementary)

Thus, if Ec approaches infinity, it means that commodity X is nearly a perfect substitute for commodity Y. On the other hand, if Ec approahes Zero it would mean that the two commodities in question are not related at all. Ec shall be negative when commodity Y is complementary to commodity X.

INCREASE AND DECREASE IN DEMAND AND EXPANSION AND CONTRACTION OF DEMAND

Increase in Demand and Decrease in Demand

Changes in demand include an increase or decrease in demand. Due to the change in the price of related goods, the income of consumers, and the preferences of consumers, etc. the demand for a product or service changes.

a) Increase in Demand : When demand changes not because of price but because of changes in other determinants of demand, it is a case of either increase or decrease in demand. “Increase in demand means more demand at same price”.
Increases in demand are shown by a shift to the right in the demand curve. This could be caused by a number of factors, including a rise in income, a rise in the price of a substitute or a fall in the price of a complement.

b) Decrease in Demand: Decrease in demand means, “Less demand at same price”. Demand can decrease and cause a shift to the left of the demand curve for a number of reasons, including a fall in income, assuming a good is a normal good, a fall in the price of a substitute and a rise in the price of a complement.

Expansion and Contraction of Demand


When quantity demanded of a commodity increases as a result of the fall in the price, it is called extension (or expansion) in demand and when the quantity demanded decreases as a result of an increase in the price of the commodity, it is called contraction in demand. The following is the diagrammatical presentation of expansion and contraction of demand:

FORMS OF MARKET COMPETITION


A variety of market structures will characterize an economy. Such market structures essentially refer to the degree of competition in a market.


There are other determinants of market structures such as the nature of the goods and products, the number of sellers, number of consumers, the nature of the product or service, economies of scale etc. We will discuss the five basic types of market structures in any economy.

1- Perfect Competition


In a perfect competition market structure, there are a large number of buyers and sellers. All the sellers of the market are small sellers in competition with each other. There is no one big seller with any significant influence on the market. So, all the firms in such a market are price takers.


There are certain assumptions when discussing the perfect competition. This is the reason a perfect competition market is pretty much a theoretical concept. These assumptions are as follows,

• The products on the market are homogeneous, i.e. they are completely identical

• All firms only have the motive of profit maximization

• There is free entry and exit from the market, i.e. there are no barriers

• And there is no concept of consumer preference

2- Monopolistic Competition


This is a more realistic scenario that actually occurs in the real world. In monopolistic competition, there are still a large number of buyers as well as sellers. But they all do not sell homogeneous products. The products are similar but all sellers sell slightly differentiated products.

Now the consumers have the preference of choosing one product over another. The sellers can also charge a marginally higher price since they may enjoy some market power. So, the sellers become the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are all similar but slightly differentiated in terms of taste and flavours. Another such example is toothpaste

3- Oligopoly

In an oligopoly, there are only a few firms in the market. While there is no clarity about the number of firms, 3-5 dominant firms are considered the norm. So, in the case of an oligopoly, the buyers are far greater than the sellers.


The firms in this case either compete with another to collaborate together, They use their market influence to set the prices and in turn maximize their profits. So, the consumers become the price takers. In an oligopoly, there are various barriers to entry in the market, and new firms find it difficult to establish themselves.

4-Monopoly


In a monopoly type of market structure, there is only one seller, so a single firm will control the entire market. It can set any price it wishes since it has all the market power. Consumers do not have any alternative and must pay the price set by the seller. Monopolies are extremely undesirable. Here the consumers loose all their power and market forces become irrelevant. However, a pure monopoly is very rare in reality.


(5) Duopoly

A duopoly is a kind of oligopoly: a market dominated by a small number of firms. In the case of a duopoly, a particular market or industry is dominated by just two firms (this is in contrast to the more widely-known case of the monopoly when just one company dominates).


In very rare cases, this means they are the only two firms in the entire market (this almost never occurs); in practice, it usually means the two duopolistic firms have a great deal of influence, and their actions, as well as their relationship to each other, powerfully shape their industry. Duopolistic markets are imperfectly competitive, so entry barriers are typically significant for those attempting to enter the market, but there are usually still other, smaller businesses persisting alongside the two dominant firms.

ELASTICITY OF SUPPLY


The elasticity of supply establishes a quantitative relationship between the supply of a commodity and it’s price. Hence, we can express the numeral change in supply with the change in the price of a commodity using the concept of elasticity. Note that elasticity can also be calculated with respect to the other determinants of supply.


However, the major factor controlling the supply of a commodity is its price. Therefore, we generally talk about the price elasticity of supply. The price elasticity of supply is the ratio of the percentage change in the price to the percentage change in quantity supplied of a commodity.

Types of Price Elasticity of Supply

1- Perfectly Inelastic Supply : A service or commodity has a perfectly inelastic supply if a given quantity of it can be supplied whatever might be the price. The elasticity of supply for such a service or commodity is zero. A perfectly inelastic supply curve is a straight line parallel to the Y-axis. This is representative of the fact that the supply remains the same irrespective of the price.

The supply of exclusive items, like the painting of Mona Lisa, falls into this category. Whatever might be the price on offer, there is no way we can increase its supply.

2- Relatively Less- Elastic Supply : When the change in supply is relatively less when compared to the change in price, we say that the commodity has a relatively-less elastic supply. In such a case, the price elasticity of supply assumes a value less than 1.

Quantity Supplied changes by a lower percentage than a percentage change in price.

3-Relatively Greater- Elastic Supply : When the change in supply is relatively more when compared to the change in price, we say that the commodity has a relatively greater-elastic supply. In such a case, the price elasticity of supply assumes a value greater than 1.

4-Unitary Elastic Supply : For a commodity with a unit elasticity of supply, the change in quantity supplied of a commodity is exactly equal to the change in its price. In other words, the change in both price and supply of the commodity are proportionately equal to each other. To point out, the elasticity of supply in such a case is equal to one. Further, a unitary elastic supply curve passes through the origin.

5- Perfectly Elastic supply : A commodity with a perfectly elastic supply has an infinite elasticity. In such a case the supply becomes zero with even a slight fall in the price and becomes infinite with a slight rise in price. This is indicative of the fact that the suppliers of such a commodity are willing to supply any quantity of the commodity at a higher price. A perfectly elastic supply curve is a straight line parallel to the X-axis.

Factors influencing the elasticity of supply

1- Price of the Good : The supply and elasticity of supply of a good depend upon the price of the good. If the price of a good increases or decreases, the quantity supplied of it will also increase or decrease, respectively. This is the law of supply. Also the coefficient of price-elasticity of supply (ES) will depend on the price of the good. ES may be greater than, less than, or equal to one, depending on the price.

2- Probability that the Price would Change in Future : If the sellers think that the price of the good will increase (or decrease) in near future, then, at any particular price at present, they would want to decrease (or increase) their supply. In this case, the supply curve for the good would shift to the left (or to the right).

3-Conditions regarding Cost of Production : If the cost of production of a good increases (or decreases), i.e., if its cost curve shifts upwards (or downwards), then the quantity supplied of the good would decrease (or increase) at any particular price, i.e., the supply curve would shift to the left (or to the right).

4-Nature of the Good : The supply of a good depends upon the nature of the good, e.g., on the perishability and lumpiness of the good. The more the perishability or lumpiness of the good, the more would be its market localised, and, in a localised market, the supply of a good at any particular price would be relatively small.

5-Length of Time : If the price of a good rises, then by how much would supply rise, or, how large will be the price-elasticity of supply, would depend on the length of time available for the necessary adjustments (e.g., in the quantities of the factor inputs used) to complete. That is why; the elasticity of supply in the long-period market would be larger than that in the short period market.


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