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Concept of Demand, Supply

and Total Surplus

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Demand Theory

Demand refers to the quantity of the commodity which the consumer is willing to buy at a particular price during a particular period of time.

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Want,

• Desire to have a BMW Car, but do not have enough money –simply a wish

• In spite of having the money you do not want to spend on BMW Car, this condition is prevailed by unwillingness- Want

• Your desire to have a BMW Car, and you are able and have willingness to pay for it. - demand

DESIRE, DEMAND

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Dx= f (Px, Y,PR,A, T, C, D,E,P)

Where, Dx= demand for X commodities

F= depends uponPx= price of x commodities

Y= income of consumerPR= price of related goods

A= advertisementT= taste nature and fashion of consumerC= climate and seasonD= distribution of incomeE= expectation of further change in priceP= population, size and composition

FACTORS DETERMINING DEMAND & DEMAND FUNCTION

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There is an inverse relationship between the price of a commodity and the quantity demanded of that commodity. In the words of Samuelsson, “Law of demand states that people buy more at low price and buy less at higher price other things remaining the same” Dx= f (Px), ceteris peribus

where, Dx = quantity demanded of good X

Px = price of the good X

Law of Demand

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1.PRICE OF RELATED GOODS IS CONSTANT

2.THE INCOME OF THE CONSUMERS REMAIN UNCHANGED.

3.CONSUMERS TASTES AND PREFERENCES REMAINS SAME.

4.EXPECTATIONS OF THE CUSTOMERS IS CONSTANT

5.NUMBER OF POPULATION REMAINS SAME.

6.ALL THE UNITS OF THE GOODS ARE HOMOGENOUS.

7.COMMODITY SHOULD BE NORMAL GOOD.

ASSUMPTIONS OF THE LAW OF DEMAND

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Low Price

High Price

Meagre

Demand

Mor

e

dem

and

Diagrammatic Representation

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Demand Schedule

Demand Schedule is a tabular representation showing the different quantities of a good that the consumers are willing to pay at different levels of prices during a given period of time.

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Demand Curve : It’s a graphical representation of the demand schedule showing the different quantities of a good that the consumers are willing to pay at different levels of prices during a given period of time.

Demand Curve

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Quantity demanded

Pri

ce

X

Y

DEMAND CURVE

11Quantity demanded

Pri

ce

X

Y

????

Why does demand curve slopes downward?

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Why does demand curve slopes downward?

NEW CONSUMERS CREATING DEMAND AS PRICE OF A COMMODITY FALLS, A NEW CONSUMER CLASS APPEARS WHO CAN NOW AFFORD THE GOOD. THUS, THE DEMAND INCREASES.

Quantity demanded

Pri

ce

X

Y

????

13

Income Effect With the fall in the price of a good, the real income or the purchasing power of the consumer rises and he demands more of the good. This shows inverse relationship between price and quantity demanded.

Why does demand curve slopes downward?

Quantity demanded

Pri

ce

X

Y

????

14

Emergency In case of emergency like war, curfew, drought or famine, the law of demand does not hold.

Why does demand curve slopes downward?

Quantity demanded

Pri

ce

X

Y

????

15

Expectation of price rise in future If the price of a commodity rises and the consumer expects further rise in price, it leads to an increase in the demand for that commodity and vice versa. Eg. Shares.

Why does demand curve slopes downward?

Quantity demanded

Pri

ce

X

Y

????

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Giffen Goods and Inferior Goods Demand for inferior good decreases with the rise in income and fall in its price. Eg. Rara Instant Noodles - Giffen good is the one which has negative income effect that is greater than the positive substitution effect as close substitutes are not available. Eg.Fine Quality wine - A Giffen good is always an inferior good, but an inferior good is not always a Giffen good.

Why does demand curve slopes downward?

Quantity demanded

Pri

ce

X

Y

????

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Different Uses With the fall in the price of a good, it is put to various uses and demand for that commodity increases and vice versa. Eg. Milk can be used for making butter, cheese, curd and drinking purposes etc.

Why does demand curve slopes downward?

Quantity demanded

Pri

ce

X

Y

????

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Change in Quantity Demanded / Movement along the demand curve It is caused by the change in the price of good other things remaining constant. 1. Expansion of Demand : It refers to rise in demand due to the fall in price of the good.2. Contraction of Demand : It refers to fall in demand due to the rise in price of the good.

19Quantity demanded

Pri

ce

X

Y

Contraction in demand

Quantity demanded

Expansion in demand

GRAPHICAL REPRESENTATION

20

Shift / Increase or Decrease in Demand It is caused by changes in factors other than price of the good like consumer’s income, price of related goods, consumer’s taste and preferences consumer’s expectations etc.

21Quantity demanded

Pri

ce

X

Y

------------------------------

-------------------

Increase in demand

Decrease in demand

GRAPHICAL REPRESENTATION

22

ELASTICITY OF DEMAND

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Elasticity of Demand Elasticity of Demand measures the responsiveness of the quantity demanded of a good, to change in its price, price of other goods and changes in consumer’s income.

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Types of Elasticity of Demand 1. Price Elasticity of Demand 2. Cross Elasticity of Demand3. Income Elasticity of Demand

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Price elasticity of demand is one of the major concepts in Economics as it is basis of other law . It refers to the change in quantity demanded of a commodity due to change in price of that commodity. A measure of the responsiveness of quantity demanded to changes in price.

Price Elasticity of Demand

Qd

P

ΔP

ΔQdEp

Qd

P

P

Qd

100PP

100QdQd

pricein change Percentage

demandedQuantity in change PercentageEp

ally,Mathematic

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Factors Determining Price Elasticity of Demand 1. Availability of close substitute 2. Consumer’s loyalty 3. Necessities versus luxuries 4. Proportion of income spent on the product 5. Postponement of the Use6. Time

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Availability of Close Substitutes The demand for a good is price elastic which have substitutes like tea and coffee, orange juice and lime juice. It is because when the price of a commodity falls in relation to its substitutes, the consumers will go on for it and demand increases. Goods having no substitutes like Cigarettes, liquor etc. have inelastic demand.

Consumer’s Loyalty The demand for a good is price inelastic if consumers are habituated in buying that good and are unwilling to use substitutes – example. Cigarettes, tobacco, coffee, liquor etc. - and vice versa if the good is price elastic

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Necessities versus luxuries Generally, the more that a good is considered a luxury (a good that we can do without) rather than a necessity (a good that we can’t do without), the higher the price elasticity of demand.

Proportion of Income spent on the product The demand for a good is price inelastic if the good takes only small proportion of income and the consumers will not react significantly – example: Boot-polish, needles, newspapers etc. - and vice versa if the good is price elastic.

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Postponement of the Use The demand for a good is price inelastic if the goods whose demand

cannot be postponed – example: Education, health services - and vice versa (constructing a house).

Time The longer the time period the more elastic is the demand and vice versa. It is because in the long run a consumer can change his habits more

conveniently than in short period.

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Pri

ce

Quantity demanded

X

Y

Five Coefficient/Degrees of Price Elasticity of Demand

1. Perfectly Elastic Demand (Ed = ∞) The quantity demanded of a commodity remains constant or tiny changes is observed in Demand while the price varies in huge quantity then, this situation is called Perfectly elastic Demand.

DD

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2. Elastic / More than Unit Elastic Demand (Ed > 1) If the percentage change in quantity demanded is

greater than percentage change in price then, it is called More than Unit Elastic Demand

Contd…

Pri

ce

Quantity demanded

X

Y

D

D

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3. Unitary Elastic Demand (Ed = 1)The percentage change in quantity demanded is equal to the

percentage change in price. Quantity demanded changes proportionately to price changes.

Pri

ce

Quantity demanded

X

Y

D

D

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4. Inelastic / Less than Unit Elastic Demand (Ed < 1)The percentage change in quantity demanded is less than the

percentage change in price. Quantity demanded changes proportionately less than price changes. Applicable in necessary goods like salt, kerosene.

Pri

ce

Quantity demanded

X

Y

D

D

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5. Perfectly Inelastic Demand (Ed = 0) Quantity demanded does not change as price changes.

Pri

ce

Quantity demanded

X

Y

D

D

35Quantity demanded

Pri

ce

X

Y

D

D5

D3

D4

D2

D1

Ep > 1

Ep < 1

Ep = 1E

p = 0

Ed = ∞

GRAPHICAL REPRESENTATION

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Total Expenditure / Revenue Method This is also known as Total Outlay Method propounded by Alfred Marshall. This method compares the total expenditure before and after change in price of a commodity. How much and in what direction total expenditure/ revenue changes determines the Price Elasticity of Demand of a commodity.

Cross Elasticity of DemandCross Elasticity of Demand refers to the change in quantity demanded of Y commodity due to change in price of X commodity.In other words, it is the measure of the responsiveness of quantity demanded of Y-commodity due to changes in price of X commodity. Moreover it can be defined as proportionate change in quantity demanded of Y commodity divided by proportionate change in price of X commodity.

Qx

Py

ΔPx

ΔQyExy

Qy

Px

Px

Qy

100PxPx

100QyQy

Commodity X of pricein change Percentage

commodity Y of

demandedQuantity in change Percentage

Eyx

ally,Mathematic

,,,

1. Positive Cross elasticity of Demand (Cross elastic )The percentage change in quantity demanded of a good is greater than the percentage change in price of other good. Here, quantity demanded of a good and price of other good move towards same direction and is generally observed in substitute goods. Higher the value of Exy, symbolizes the availability of close substitute.

Degrees of Cross Elasticity of Demand

Px%Qdy%1Eyx

Px%Qdy%

100Px

ΔPx100

Qdy

ΔQdy

Px

ΔPx

Qdy

ΔQdy

1ΔPx

Px

Qdy

ΔQdyor,

Qdy

Px

ΔPx

ΔQdyEyx

ally,Mathematic

2. Negative Cross elasticity of demand (Cross Inelastic )The percentage change in quantity demanded of a good is less than the percentage change in price of other good. Here, quantity demanded of a good and price of other good move towards opposite direction and is generally observed in complementary goods.

Contd…

Px%Qdy%1Eyx

Px%Qdy%

100Px

ΔPx100

Qdy

ΔQdy

Px

ΔPx

Qdy

ΔQdy

1ΔPx

Px

Qdy

ΔQdyor,

Qdy

Px

ΔPx

ΔQdyEyx

ally,Mathematic

3. Zero Cross elasticity of Demand (Cross Unit Elastic)The percentage change in quantity demanded of a good does not effect the percentage change in price of other good. This cases occurs in the independent goods.

0Qdy 0Eyx

0Qdy

0Qdy

ΔQdy

0ΔPx

Px

Qdy

ΔQdyor,

Qdy

Px

ΔPx

ΔQdyEyx

ally,Mathematic

42Quantity demanded

Pri

ce

X

Y

D

D2

D3

D1

E xy > 1

Exy < 1

Exy =

0

GRAPHICAL REPRESENTATION OF CROSS ELASTICITY

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SUBSTITUTE GOODS

COMPLIMENTRY GOODS

INDEPENDENT GOODS

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INCOME ELASTICITY OF DEMAND

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Income Elasticity of DemandIncome Elasticity of Demand refers to the change in quantity demanded of a commodity due to change in income of consumer. A measure of the responsiveness of quantity demanded to changes in income.

Qd

Y

ΔY

ΔQdEy

Qd

Y

Y

Qd

100YY

100QdQd

incomein change Percentage

demandedQuantity in change PercentageEy

ally,Mathematic

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1. Positive Income elasticity of Demand If the quantity demanded of a good increases with the rise in income of consumer or vice versa then it is said to be positive income elasticity of demand. Here, quantity demanded of a good and price of other good move towards same direction and is generally observed in superior or quality goods.

2. Negative Income elasticity of demand If the quantity demanded of a good increases with the fall in income of consumer or vice versa then it is said to be positive income elasticity of demand. Here, quantity demanded of a good and price of other good move towards opposite direction and is generally observed in inferior or low quality goods.

3. Zero Income elasticity of Demand If the quantity demanded of a good does not changes with the income of consumer. This cases occurs in the neutral goods.

Income Elasticity of Demand

47Quantity demanded

Pri

ce

X

Y

D

D2

D3

D1

E y > 1

Ey < 1

Ey =

0

GRAPHICAL REPRESENTATION OF INCOME ELASTICITY

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Market Equilibrium and

Effects of Shift in Demand

and Supply Curves

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What is a market? It is defined as a mechanism by which buyers and sellers interact to determine the price and quantity of a good or service.

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Features of market

1. There must be a commodity which is being demanded and sold.

2. There must be buyers and sellers of the commodity. 3. There must be communication between buyers and sellers. 4. There must be a place or area where buyers and sellers could

interact with each other.

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Market Equilibrium/ Market Clearing Price Forces of demand and supply determine the equilibrium price and equilibrium quantity in a perfectly competitive market. Equilibrium is struck in the market where Quantity demanded = Quantity supplied

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Market Equilibrium is a situation of zero excess demand and zero excess supply

Quantity demanded

Pri

ce

X

Y

--------------------------Shortage

----------------------------

--------------------------Surplus -----------------------------

D

DS

S

Market Equilibrium

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Surplus and Shortage

Surplus (Excess Supply) A condition in which quantity supplied is greater than quantity demanded. Surpluses occur only at prices above equilibrium price.

Shortage (Excess Demand) A condition in which quantity demanded is greater than quantity supplied. Shortages occur only at prices below equilibrium price.

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Effects of Changes in Demand and Supply on Equilibrium Price Changes in Demand It takes place due to :- - changes in price of related goods - changes in income of the consumers - change in taste and preference - change in market size - change in expectations of the consumers

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When there is an increase in demand, supply remaining constant, equilibrium price and equilibrium quantity both increases.

Quantity demanded

Pri

ce

X

Y

---------------------------------------------------------

D D1 S

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When there is a decrease in demand, supply remaining constant, equilibrium price and equilibrium quantity both decreases.

Quantity demanded

Pri

ce

X

Y

---------------------------------

DD1

S

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Changes in Supply It takes place due to :- - changes in the cost of production - changes in production technology - change in excise tax - change in subsidy - change in price of substitute goods - change in number of firms

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When there is an increase in supply, demand remaining constant, equilibrium price decreases and equilibrium quantity increases.

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60

61

62

63

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Consumer, Producer and Total Surplus Consumers’ Surplus (CS) CS= Maximum buying price - Price paid The difference between the maximum price a buyer is willing and able to pay for a good or service and the price actually paid.

Producers’ (Sellers’) Surplus (PS) PS = Price received - Minimum Selling price The difference between the price sellers receive for a good and the minimum or lowest price for which they would have sold the good.

Total Surplus (TS) TS =CS +PS The sum of consumers’ surplus and producers’ surplus.

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Consumer Surplus According to Prof. Dr. Alfred Marshall, “ The excess of price which he would be willing to pay rather than go without a thing over that which he actually does pay is the economic measure of surplus satisfaction, which is called as Consumer surplus.”It is the difference between the maximum a consumer would pay for a good and the price actually paid.

Quantity demanded

Pri

ce

X

Y

D

D

S

66

Producer Surplus It is the difference between the minimum price a producer would accept to supply a given quantity of good and the price actually received.

Quantity demanded

Pri

ce

X

Y

D

D

S

Producer Surplus

67Quantity demanded

Pri

ce

X

Y

D

D

S

Total Surplus= CS+PS

68Quantity demanded

Pri

ce

X

Y

--------------------------Shortage

----------------------------

D

DS

S

Price Ceiling A government-mandated maximum price above which legal trades cannot be made. Price Ceiling

Creates Shortage.

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Price Floor A government-mandated minimum price below which legal trades cannot be made.

Quantity demanded

Pri

ce

X

Y

--------------------------Surplus -----------------------------

D

DS

S

Price Floor creates Surplus.