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DEMAND AND SUPPLY ANALYSIS:

▪ Demand Analysis: Definition of demand; law of demand and the exceptions of the law,
Determinants of demand, Individual and market demand curve. Supply Analysis: Definition of
supply, law of supply, exceptions, Determinants of supply, Market supply.

▪ Concept of equilibrium: Determination of market equilibrium price and quantity; Effects of

Changes in supply and demand and the effect they have on equilibrium price and quantity. Price
controls: Minimum and maximum price controls

DEMAND AND SUPPLY ANALYSIS

A market is nothing more or less than the locus of exchange; it is not necessarily a place, but simply
buyers and sellers coming together for transactions. A set up where two or more parties engage in
exchange of goods, services and information is called a market. Ideally a market is a place where two
or more parties are involved in buying and selling.

Types of Markets

1. Physical Markets - Physical market is a set up where buyers can physically meet the sellers
and purchase the desired merchandise from them in exchange of money. Shopping malls,
department stores, retail stores are examples of physical markets.
2. Non-Physical Markets/Virtual markets - In such markets, buyers purchase goods and
services through internet. In such a market the buyers and sellers do not meet or interact
physically, instead the transaction is done through internet. Examples - Rediff shopping, eBay
etc.
3. Auction Market - In an auction market the seller sells his goods to one who is the highest
bidder.
4. Market for Intermediate Goods - Such markets sell raw materials (goods) required for the
final production of other goods.
5. Black Market - A black market is a setup where illegal goods like drugs and weapons are
sold.
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6. Knowledge Market - Knowledge market is a setup which deals in the exchange of

information and knowledge-based products.
7. Financial Market - Market dealing with the exchange of liquid assets (money) is called a
financial market.

DEMAND ANALYSIS

• Demand refers to the willingness of the consumers to want something at a particular price at a
given time
• The demand schedule (demand curve) reflects the law of demand it is a downward sloping
function and is a schedule of the quantity demanded at each and every price.
• Demand Schedule: Shows relationship of price and quantity demanded of good X

Price of good X 200 180 160 140 120 100

Quantity of good X 2 4 6 8 10 14

• A demand curve is a graph depicting the relationship between the price of a certain
commodity (the y-axis) and the quantity of that commodity that is demanded at that price (the
x-axis).
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• The diagram shows that the demand curve is downward sloping from left to right. Also, both
the demand schedule and demand curve reflect the law of demand. The lower the price, the
higher the quantity demanded, as the price decreases from p0 to p1, the quantity increases from
q0 to q1.

• The Law of Demand: states that the quantity demanded will decrease as the price rises, or the
quantity demanded will increase as the price of the good falls, when all other things being
equal. i.e., this relationship between quantity and price will follow the demand curve as long as
the determinants of demand don't change.

Mathematically, a demand function – which is an algebraic formulation – can also be used to show
the relationship between demand and price. The standard function is a linear one where Qd = a –
bP. example the demand function is Qd = 1600 – 20p.

• Demand curves generally has a negative gradient indicating the inverse relationship between
quantity demanded and price.

Explanations of Why Demand Curves Slope Downwards:

a) Diminishing marginal utility: One of the earliest explanations of the inverse relationship between
price and quantity demanded is the law of diminishing marginal utility. This law suggests that as
more of a product is consumed the marginal (additional) benefit to the consumer falls, hence
consumers are prepared to pay less. This can be explained as follows: Most benefit is generated by
the first unit of a good consumed because it satisfies most of the immediate need or desire. A second
unit consumed would generate less utility – perhaps even zero, given that the consumer has less
need or less desire. With less benefit derived, the rational consumer is prepared to pay rather less
for the second, and subsequent, units, given that the marginal utility falls.
b) The income effect: The income can also be used to explain why the demand curve slopes
downwards. If we assume that money income is fixed, the income effect suggests that, as the price
of a good falls, real income – that is, what consumers can buy with their money income – rises and
consumers increase their demand. Therefore, at a lower price, consumers can buy more from the
same money income, and, ceteris paribus (all other things being constant), demand will rise.
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Conversely, a rise in price will reduce real income and force consumers to cut back on their
demand.
c) The substitution effect: In addition, as the price of one good falls, it becomes relatively less
expensive. Therefore, assuming other alternative products stay at the same price, at lower prices the
good appears cheaper, and consumers will switch from the expensive alternative to the relatively
cheaper one.

EXCEPTIONS OF THE LAW OF DEMAND

• It is possible to identify some exceptions to the normal rules regarding the relationship between
price and current demand.

Giffen Goods: Giffen goods are those which are consumed in greater quantities when their price
rises. In essence, a Giffen good is a staple food, such as bread or rice, unga, which forms are large
percentage of the diet of the poorest sections of a society, and for which there are no close substitutes.
From time to time the poor may supplement their diet with higher quality foods, and they may even
consume the odd luxury, although their income will be such that they will not be able to save.

b. Veblen goods are a second possible exception to the general law of demand. These goods are
named after the American sociologist, Thorsten Veblen, who, in the early 20th century, identified a
‘new’ high-spending leisure class. According to Veblen, a rise in the price of high-status luxury goods
might lead members of this leisure class to increase in their consumption, rather than reduce it. The
purchase of such higher priced goods would confer status on the purchaser – a process which Veblen
called conspicuous consumption.

A MARKET DEMAND SCHEDULE is a table that lists the quantity of a good all consumers in a
market will buy at every different price. A market demand schedule for a product indicates that there
is an inverse relationship between price and quantity demanded.

The individual consumer, however, is only one of many participants in the market for good X. The
market demand curve for good X includes the quantities of good X demanded by all participants in
the market for good X.
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suppose that there were just two consumers in the market for good X, Consumer 1 and Consumer 2.
These two consumers have different individual demand curves corresponding to their different
preferences for good X. The two individual demand curves are depicted in Figure, along with the
market demand curve for good X.

The market demand curve for good X is found by summing together the quantities that both consumers
demand at each price. For example, at a price of $1, Consumer 1 demands 2 units while Consumer 2
demands 1 unit; so, the market demand is 2 + 1 = 3 units of good X. In more general settings, where
there are more than two consumers in the market for some good, the same principle continues to
apply; the market demand curve would be the horizontal summation of all the market participants'
individual demand curves.

FACTORS AFFECTING DEMAND OF A PRODUCT OR DETERMINANTS OF DEMAND

1. Price of the Given Commodity: It is the most important factor affecting demand for the given
commodity. Generally, there exists an inverse relationship between price and quantity demanded. It
means, as price increases, quantity demanded falls due to decrease in the satisfaction level of
consumers.

2. Price of Related Goods: Demand for the given commodity is also affected by change in prices of
the related goods. Related goods are of two types:
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(i) Substitute Goods: Substitute goods are those goods which can be used in place of one another for
satisfaction of a particular want, like tea and coffee. An increase in the price of substitute leads to an
increase in the demand for given commodity and vice-versa. For example, if price of a substitute good
(say, coffee) increases, then demand for given commodity (say, tea) will rise as tea will become
relatively cheaper in comparison to coffee. So, demand for a given commodity is directly affected by
change in price of substitute goods.

(ii) Complementary Goods: Complementary goods are those goods which are used together to satisfy
a particular want, pen and ink. Petrol and use car. An increase in the price of complementary good
leads to a decrease in the demand for given commodity and vice-versa. For example, if price of a
complementary good (say, sugar) increases, then demand for given commodity (say, tea) will fall as it
will be relatively costlier to use both the goods together. So, demand for a given commodity is
inversely affected by change in price of complementary goods.

3. Income of the Consumer: Demand for a commodity is also affected by income of the consumer.
However, the effect of change in income on demand depends on the nature of the commodity under
consideration.

(i) If the given commodity is a normal good, then an increase in income leads to rise in its demand,
while a decrease in income reduces the demand.

(ii). If the given commodity is an inferior good, then an increase in income reduces the demand, while
a decrease in income leads to rise in demand.

4. Tastes and Preferences: Tastes and preferences of the consumer directly influence the demand for
a commodity. They include changes in fashion, customs, habits, etc. If a commodity is in fashion or is
preferred by the consumers, then demand for such a commodity rises. On the other hand, demand for a
commodity falls, if the consumers have no taste for that commodity.

5. Expectation of Change in the Price in Future: If the price of a certain commodity is expected to
increase in near future, then people will buy more of that commodity than what they normally buy.
There exists a direct relationship between expectation of change in the prices in future and change in
demand in the current period. For example, if the price of petrol is expected to rise in future, its
present demand will increase.
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6. Advertisement Expenditure: Advertisement expenditure made by a firm to promote the sales of its
product is an important factor determining demand for a product, especially of the product of the firm
which gives advertisements. The purpose of advertisement is to influence the consumers in favour of a
product. Advertisements are given in various media such as newspapers, radio, and television.
Advertisements for goods are repeated several times so that consumers are convinced about their
superior quality. When advertisements prove successful they cause an increase in the demand for the
product.

7. The Number of Consumers in the Market: The market demand for a good is obtained by adding
up the individual demands of the present as well as prospective consumers of a good at various
possible prices. The greater the number of consumers of a good, the greater the market demand for it
Besides, when the seller of a good succeeds in finding out new markets for his good and as a result the
market for his good expands the number of consumers for that good will increase.

Another important cause for the increase in the number of consumers is the growth in population. For
instance, in India the demand for many essential goods, especially food grains, has increased because
of the increase in the population of the country and the resultant increase in the number of consumers
for them.

CHANGES IN DEMAND VERSUS CHANGES IN QUANTITY DEMANDED

A) Changes in demand. This is indicated by a shift in demand curve either to the right or to the left
due to all other factors affecting demand other than price of the commodity. If demand increases,
the entire curve will move to the right. That means larger quantities will be demanded at every
price. If the entire curve shifts to the left, it means total demand has dropped for all price levels.
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Diagram

An increase in demand is shown by the shift of the demand curve to the right from D to D2, notice that
at each price there is a greater quantity demanded along D2 (the dotted line) than was demanded with
D (the solid line). Note this is due to the factors determine demand being favorable, eg, an increase in
price of the commodity

A decrease in demand, means a shift of the demand curve to the left. Suppose original demand curve
was D2, then a change in demand shifts the demand curve to D. at the same price quantity demanded
decreases from D2 to D. Note this is due to the factors determine demand being unfavorable, eg, a
decrease in price of the commodity

B) Changes in Quantity Demanded: This is indicated by a movement along the demand curve either to
the right or to the left. Due to changes to changes in the price of the commodity only.
Diagram

When price increases from 10 to 12, then there is a movement along the demand curve to the left,
quantity demanded decreases from 55 to 40, and this is referred to as a contraction of demand
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When price decreases from 10 to 7, then there is a movement along the demand curve to the right,
and quantity demanded increases from 55 60 75, and this is referred to as an extension of demand

A) SUPPLY ANALYSIS

Definition: Supply refers to the quantity that producers are willing to supply at any moment at a given
price

Supply schedule- is a table showing the relationship between price of a commodity and the quantity
supplied

Price of good X 300 280 250 200 180 130

Quantity of good X 15 12 10 8 6 2

Supply curve is nothing more than a schedule of the quantities at each and every price.

Draw the supply curve

There is a positive relation between price and quantity on a supply curve. The supply curve slopes
upwards from left to right, ie, as the price increases then more is supplied or as the price decreases
then less is supplied.
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Why is supply curve generally upward sloping?

Generally, a higher price encourages firms to produce more. This is for two reasons.

• A higher price makes the good more profitable to produce.

• In the short term, the cost of production (marginal cost) is affected by the law of diminishing marginal
returns. Increasing output with capital fixed leads to a point where marginal costs rise rapidly, so the
firm needs a higher price to compensate for the higher cost of production

The law of supply: States that when price of a commodity increases the supply of the commodity
also increase or when the price of the commodity decreases the supply of the commodity decreases
when all other things are held constant. Thus, there is a direct relationship between price of the
commodity and its supply

Supply curve equation is of the form Qs = a + bP or Qs=200 + 500P

Factors Affecting or Determining the Supply of a good

1. Price: Refers to the main factor that influences the supply of a product to a greater extent. Unlike
demand, there is a direct relationship between the price of a product and its supply. If the price of a
product increases, then the supply of the product also increases and vice versa. Change in supply with
respect to the change in price is termed as the variation in supply of a product. Speculation about
future price can also affect the supply of a product. If the price of a product is about to rise in future,
the supply of the product would decrease in the present market because of the profit expected by a
seller in future. However, the fall in the price of a product in future would increase the supply of
product in the present market.

2. Cost of Production: Implies that the supply of a product would decrease with increase in the cost
of production and vice versa. The supply of a product and cost of production are inversely related to
each other. For example, a seller would supply less quantity of a product in the market, when the cost
of production exceeds the market price of the product. In such a case the seller would wait for the rise
in price in future. The cost of production rises due to several factors, such as loss of fertility of land,
high wage rates of labor, and increase in the prices of raw material, transport cost, and tax rate.
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3. Natural Conditions: Implies that climatic conditions directly affect the supply of certain products.
For example, the supply of agricultural products increases when the climate is favorable. However,
the supply of these products decreases at the time of drought. Some of the crops are climate specific
and their growth purely depends on climatic conditions.

4. Technology: Refers to one of the important determinant of supply. A better and advanced
technology increases the production of a product, which results in the increase in the supply of the
product. For example, the production of fertilizers and good quality seeds increases the production of
crops. This further increase the supply of food grains in the market.

5. Transport and communication conditions: Refer to the fact that better transport facilities increase
the supply of products. Transport is always a constraint to the supply of products, as the products are
not available on time due to poor transport facilities. Therefore, even if the price of a product
increases, the supply would not increase.

6. Factor Prices and their Availability: Act as one of the major determinant of supply. The inputs,
such as raw material, labour, equipment, and machines, required at the time of production are termed
as factors. If the factors are available in sufficient quantity and at lower price, then there would be
increase in production. This would increase the supply of a product in the market. For example,
availability of cheap labor and raw material nearby the manufacturing plant of an organization would
help in reducing the labor and transportation costs. Consequently, the production and supply of the
product would increase

7. Government’s Policies: Implies that the different policies of government, such as fiscal policy and
industrial policy, has a greater impact on the supply of a product. For example, increase in tax on
excise duties would decrease the supply of a product. On the other hand, if the tax rate is low, then the
supply of a product would increase.
smsf
Changes in Supply Versus changes in Quantity Supply
a) Changes in supply: Indicated by a shift of the supply curves either to the right or to the left.
Changes in one or more of the non-price determinants of supply cause the supply curve to shift. A
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shift to the left of the supply curve is called a decrease in supply; a shift to the right is called an
increase in supply

Diagram

A shift to the right from s1 to s2 is caused by the factors affection supply being favorable, eg, a
reduction in government taxes, better technology, better communication means etc

While a shift to the left is caused by the factors affection supply being unfavorable, eg, an increase in
government taxes. Poor technology and poor communication means, etc

b) Changes in quantity supplied: occurs due to changes in the price of the commodity only,

Diagram

Changes in price cause changes in quantity supplied, starting with the original price 16, quantity
supplied is 55.

When price increases from 16 to 22, then there is an upward movement and supply increases from 55
to 75. This is referred to as an extension in supply
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When price decreases from 16 to 12, then there is a downward movement and supply decreases from
55 to 40. This is referred to as a contraction in supply
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MARKET EQUILIBRIUM:
• Definition of market equilibrium – A situation where for a particular good supply = demand.
When the market is in equilibrium, there is no tendency for prices to change. We say the
market-clearing price has been achieved. Equilibrium price is also called market clearing price
because at this price the exact quantity that producers take to market will be bought by
consumers, and there will be nothing ‘left over’.
• As indicated in the diagram this occurs where supply equals demand (supply curve intersects
demand curve). An equilibrium implies that there is no force that will cause further changes in
price, hence quantity exchanged in the market.
Diagram

• Where the supply and demand curves intersect, equilibrium price is determined (Pe) and
equilibrium quantity is determined (Qe)
• The graph of a market in equilibrium can also be expressed using a series of equations. Both
the demand and supply curve can be expressed as equations.
Mathematically
Example 1: Let us suppose we have two simple supply and demand equations

• Qd = 20 – 2P and Qs = -10 + 2P

At equilibrium QS = Qd we put the two equations together

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• 20-2P = -10 + 2P
• 20+10= 4P
• 30/4=P
• P = 7.5

To find Q, we just put this value of P into one of the equations

• Q = 20 – (2×7.5)
• Q= 5

Example 2

Suppose that the demand for soda is given by the following equation: Qd=16–2P

where Qd is the amount of soda that consumers want to buy (i.e., quantity demanded), and P is the
price of soda. Suppose the supply of soda is Qs=2+5P

Given the equilibrium condition as Qd = Qs , The determine the equilibrium price and quantity

EFFECTS OF CHANGES IN SUPPLY AND DEMAND CONDITIONS ON THE

EQUILIBRIUM PRICE AND QUANTITY

• Changes in the underlying factors that affect demand and supply will cause shifts in the
position of the demand or supply curve at every price. Whenever this happens, the original
equilibrium price will no longer equate demand with supply, and price will adjust to bring
about a return to equilibrium.

The changes are better understood using graphs to demonstrate what happens in a market when
there are changes in non-price determinants of supply and demand.
a) Changes in demand conditions while supply conditions are held constant. These changes are either a
rise or a fall in demand
(i)A rise in demand is indicated by a shift of the demand curve to the right form D to D1
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Effect are, a new equilibrium point where D1 = S, Price increases from P to P1, and quantity
increases from Q to Q1

(ii) A fall in Demand is indicated by a shift of the demand curve to the left form D to D1

Effect, a new equilibrium point where D1 = S, Price decreases from P to P1, and quantity
decreases from Q to Q1

b). Changes in supply conditions while demand conditions are held constant. These are either a rise or
a fall in supply

(i) Supply rises is indicated by a shifts the supply curve to the right, which reduces price and increases
output.
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Effects are: Read the diagram

(ii)Supply falls is indicated by a shift in supply curve to the left, which increases price

Effects are: READ the Diagram

the same time.

c) Changes in both demand and supply conditions in the market.
Suppose, there is a large rise in the demand for mangoes because of a rise in per capita income of
the people.

GOVERNMENT AND PRICE CONTROLS.

National and local governments sometimes implement price controls, legal minimum or legal
maximum prices for specific goods or services, to attempt managing the economy by direct
intervention. Price controls can be price ceilings or price floors.
• A price ceiling is the legal maximum price for a good or service,
• while a price floor is the legal minimum price.

Although both a price ceiling and a price floor can be imposed, the government usually only selects
either a ceiling or a floor for particular goods or services.
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When prices are established by a free market, then there is a balance between supply and demand.
The quantity supplied at the market price equals the quantity demanded at that price. So, the
government imposition of price controls causes either excess supply or excess demand, since the
legal price often differs greatly from the market price. Indeed, the government imposes price
controls to solve a problem perceived to be created by the market price. For instance, rent control is
imposed to make rent more affordable for tenants.
(i) Price ceiling: Always set below the equilibrium price set by the market forces
Some countries set price ceilings on basic necessities like cooking oil, sugar or flour. Consider the
market for corn flour information below.

Note that the demand(Qd) is greater than supply (Qs) which means that there is an excess demand for
this commodity that is not being satisfied by suppliers at this artificially low price. The distance
between Qs and Qd is called a shortage.
Price ceiling in a long run can cause adverse effect on market and create huge market inefficiencies.
Some effects of price ceiling are

i) Shortage: if price ceiling is set below the existing market price, the market undergoes problem of
shortage. When price ceiling is set below the market price, producers will begin to slow or stop their
production process causing less supply of commodity in the market. On the other hand, demand of
the consumers for such commodity increases with the fall in price. And with this imbalance between
supply and demand of the commodity, shortage is created in the market
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ii) Government rationing and queuing: When there is extreme shortage in the market, government
begins rationing distribution to restrict the demand of the consumers. As a result, consumers won’t be
able to utilize as much goods as they need. Government rationing also results in consumers needing to
stay in queue for great deal of times, and this can be troublesome to elderly, disabled and other people
who cannot afford to stay in line for a long time.

iii). Black market: Shortage of commodities encourages black market. Sellers begin trading
commodities to relatives and friends, and they start charging other people prices multiple times higher
than that of price ceiling.

iv) Degradation of quality: Producers won’t be able to generate desirable profit when government set
price ceiling. During such condition, many producers may use raw materials of comparatively lesser
quality in order to maintain same or almost same revenue as before.

a) Price floor (i.e., the minimum you can charge for a product). For a price floor to be effective, it
must be set above the competitive equilibrium price

Notice that at the floor price, Supply (Qs) is greater than demand (Qd), the distance between Qd and
Qs is the amount of the surplus. Minimum wages are the best-known examples of price floors.
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Effect of price floor

ii) In case of producer surplus, producers would have reduced the price to increase consumers’
demands and clear off the stock. But since it is illegal to do so, producers cannot do anything. So,
government has to intervene and buy the surplus inventories. Government may sell these inventories
in situation when there is scarcity of those commodities, or it can also distribute to the poor people
and public entities.
iii) Minimum wage and unemployment: if minimum wage is set above market price, employers
may distribute more work among few workers and terminate rest of the workers in order to not to pay
more wage to more workers. Setting price floor will obviously help few workers in getting higher
wage. But at the same time, other workers will also have to lose their jobs, creating unemployment.