Fundamental Fundamental Concepts & Basic Concepts & Basic

Framework of Framework of Demand and Supply:Demand and Supply:

Fundamental Fundamental Concepts & Basic Concepts & Basic

Framework of Framework of Demand and Supply:Demand and Supply:

Prof. Samar K. DattaProf. Samar K. Datta

Session 1Session 1

28th June, 200728th June, 2007

Materials intended to be covered in this

session• Objectives of EA – fundamentals of microeconomic analysis• Concerns of micro & macro-economics• Race between human wants & scarcity of economic resources giving rise to

the fundamental economic choice problem• Functions of an economic system – role of prices, government & institutions• Notion of market• The demand side

– Law of demand– Factors affecting demand– Features of a market demand curve– Movement along & off (i.e., shift of) the demand curve

• The supply side– Law of supply– Factors affecting supply– Features of a supply curve– Movement along & off the supply curve

• Price determination through interaction between demand & supply– Existence & stability of equilibrium– Shifts in demand & supply

• Concepts of point & arc elasticity; Price, income & cross elasticity of demand; Certain properties of elasticity

• Some applications & food for thought

Objectives of EA etc.• Why EA dealing with micro-economics?

– Perhaps the most important component of any business analysis, providing clues towards answering a whole lot of questions;

– Provides insights thro’ analysis of decision-making process by economic agents and their interaction with the market

– Provides basis for a number of applied fields in management

• Distinctive feature of micro-economics vis-à-vis macro-economics:– Macro dealing with behavior of aggregative

variables like price, income, employment, money supply, exchange rate etc.

Fundamental issue & methodology used

• Race between human wants & scarce economic resources – land, labor, capital and entrepreneurial skill– Example, asking a poor man about his demand for

credit: why does he specify his demand as a very large number, a small number & even a zero, depending upon how we pose the question? What are his wants and demand?

• Broad methodology used:– Marginal analysis;– Positive rather than normative analysis;– Trade off involved in most choices

• Question: Why heath care expenses increasing steadily in the US?

Functioning of an economic system

• Role of prices in resolving issues like what to produce & for whom to produce (i.e., issues on marketing), how to produce (i.e., issues on technology & institutions)

• Role of prices (interest, wages, rent, profit etc.) in fostering economic growth

• Can prices ensure rationing over time & achieve sustainability?

• Is there any role for government and other institutions?

The Market• A market is an institutional

arrangement under which buyers and sellers can voluntarily exchange some quantity of a good or service at a mutually agreeable price.

• It can, but need not be a specific place or location where buyers and sellers actually come face to face for the purpose of transacting their business – e.g. market for professors has no physical location

The Concept of Demand

• Human wants are all the goods, services, and conditions of life that individuals desire (i.e., has use value)

• Demand in economics is want backed by purchasing power (note difference between effective demand and notional demand)

• A consumer’s claim on a good/service is recognized by the producer only if it is backed by sufficient purchasing power

Law of Demand & the Market Demand Curve

• Other things remaining the same, the quantity demanded of a commodity is inversely related to its price.– A lower price may encourage existing consumers to

consume larger quantities– Also, other consumers who were previously unable

to afford the commodity may now begin consuming it

• The market demand curve – refers to the behavior of an aggregate of economic

agents – over a given period of time – while holding constant all other relevant economic

variables on which demand depends (ceteris paribus assumption)

– On the presumption that different units of the commodity are homogeneous (else weights of product composition to be taken into consideration)

Example: Demand For Ice Cream

Pri

ce o

f Ic

e C

ream

Quantity of Ice Cream

Demand

Interpret points above & below the demand curve

Ceteris Paribus . . . ...implies that all the relevant

variables (e.g. determinants of demand) are held constant, except the one(s) being studied at the time. Among other variables held constant are consumers’ incomes, tastes and preferences, prices of related commodities (substitutes and complements), number of consumers in the market, weather, future expectations, etc.

Determinants of Demand

Market PriceConsumer IncomePrices of Related GoodsTastesExpectationsNumber of Consumers

Determinants of Demand: Market Price

Law of Demand: There exists an

inverse relationship

between Price and Quantity Demanded.

P

Q

Determinants of Demand: Income

• As income increases, the demand for a normal good will increase.

P

Q

Determinant of Demand: Income

• As income increases, the demand for an inferior good decreases (e.g., in case of coarse cereals).

P

Q

Determinants of Demand: Prices of Related Goods

When the fall in price of one

good reduces the demand for another good, the two goods

are substitutes.

Determinants of Demand: Prices of Related Goods

When the fall in price of one

good increases the demand for another good, the two goods

are complements.

Determinants of Demand: Tastes & preferences, consumer expectations of future income &

price

• Advertisement, for example, may shift up demand.

• Expectations of future income rise or price rise may shift up current demand.

Demand function general form

• Qx = function of– Px (own price) (-)– Pz (price of related goods) (+/-)– Y (consumer income) (+/-)– N (size of population) (+)– α (tastes/preferences) (+/-)– Pe/P or Ye/Y (expectations about

future price or income) (+/-)

Demand Schedule and

Demand Curve• Demand Schedule:

A table that shows the relationship between the price of the good and the quantity demanded

Qx Px100 150 220 3

• Demand Curve:The downward-sloping line relating price and

quantity demanded

Movements vs. Shifts in the Demand

Curve• Change in Quantity Demanded

Movement along the demand curve caused by a change in the market price of the product.

• Change in DemandA shift in the demand curve, either to the left

or right i.e. a change in the quantity demanded at each commodity price• The demand curve shifts when there is a change in

(a) consumers’ incomes, (b) tastes and preferences, (c) prices of related commodities, and (d) number of consumers in the market, etc.

Changes in Quantity Demanded

Price

Quantity

$2.00

7

$1.00

13

Change in DemandPrice

$2.00

7

Quantity

10

GEOMETRIC FEATURES OF A DEMAND CURVE

• Its level, depending on role of non-price factors (interpret intercepts on both axes)

• Its shape – i.e., inverse relationship, decided by law of demand

• Its slope, is decided by units of P & Q (the curve becoming flatter with rise in unit of Q or P), the reference period (usually flatter in long run), & role of non-price factors (e.g., flatter for luxury goods)

• Its curvature – can be concave, convex, straight line or a combination (theory proving no further clue)

The Concept of Supply.

Quantity Supplied refers to the amount (quantity) of a good that sellers are willing and able to make available for sale at alternative prices in a given point in time. Interpret points above & below the supply curve

P

Q

Determinants of Supply

Market price (+)Input prices (-)Cheaper technology (+)Price of alternative goods (-)Government tax (-) or subsidy (+)Expectations of future price rise (-)Number of Producers (+)

Determinant of Supply: Market Price

Law of Supply There exists an direct (positive)

relationship between Price and Quantity

Supplied.

P

Q

Interpreting features of a supply

curve

• Level/intercept• Direction• Slope• Curvature

Change in quantity supplied verses

change in supply• Change in Quantity Supplied

Movement along the supply curve, caused by a change in the market price of the product.

• Change in Supply A shift in the supply curve, either to

the left or right.

Supply: Schedule and Curve

• Supply ScheduleA table that shows the relationship

between the price of the good and the quantity supplied.

• Supply CurveThe upward-sloping line relating

price and quantity supplied.

Changes in Quantity Supplied

Price

Quantity

$2.00

7

$1.00

1

Change in SupplyPrice

Quantity

$2.00

7 11

Supply and Demand Together

• Equilibrium Price is one at which the supply and demand curve intersect (i.e., D=S) (assimilating interests of two conflicting groups thro’ negotiation & adjustment in terms of price)

• Generally, there is one stable equilibrium, as shown in next slide.

• However, adjustments may not always lead to a stable equilibrium (i.e., convergence).

• Moreover, there may be multiple equilibrium, some of which may not be fully stable, as we shall see shortly.

Forces of Demand and Supply At Rest

Market EquilibriumPrice

Quantity

$2.00

7

Actions of buyers and sellers that move toward equilibrium.

• Excess SupplyPrice is above equilibrium price,

therefore producers are unable to sell all they want at the going price.

• Excess DemandPrice is below equilibrium price,

therefore consumers are unable to buy all they want at the going price.

Actions of buyers and sellers that move

toward equilibrium.Price

Quantity

Excess Supply

Actions of buyers and sellers that move

toward equilibrium.Price

Quantity

ExcessDemand

Stability of Market Equilibrium

The backward bending supply curve of labor may cause multiple equilibrium - some unstable (e.g. at A), some stable (e.g., at B).

Comparative Statics: Analyzing Changes in

Equilibrium• Determine if event shifts supply

curve, the demand curve, or both.• Determine if curve(s) shift to left or

right.• Determine how shift affects

equilibrium price and quantity.• Example: Demand for ice cream

given hot weather.

Change in demand for ice cream due to hot

weather

Price

Quantity

New Equilibrium

Pe

Qe

Pe

Qe

A point to note• For analytical convenience, an artificial

dichotomy is created between producers and consumers; and demand and supply

• Very often in the real world, producers and consumers are either

• the same person e.g. a farmer who eats his own crop, or

• play both roles simultaneously – a person who produces one product, consumes others

• Also, demand and supply may be dependent on each other – e.g. generation of income during production may expand the customer base for the product e.g. workers in Ford buying the Ford motor car.

Price Elasticity of Demand

• Price elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in price.

PQ

PQ

P/P

Q/Q EP

/

/

Price Elasticity andConsumer Expenditure

Demand If Price Increases, If Price Decreases,

Expenditures:Expenditures:Inelastic (Ep <1) Increase Decrease

Unit Elastic (Ep = 1) Unchanged Unchanged

Elastic (Ep >1) Decrease Increase

Point Elasticity of Demand

– Point elasticity measures elasticity at a point on the demand curve.

– Its formula is:

ope)(P/Q)(1/sl E P

Variation in Point Elasticity over a Linear

Demand Curve

Elastic vs. Inelastic Demand Curves

Problems Using Point Elasticity

– We may need to calculate price elasticity over portion of the demand curve rather than at a single point.

– The price and quantity used as the base will alter the price elasticity of demand (point elasticity of demand is not symmetric).

Arc Elasticity of Demand

– Arc elasticity calculates elasticity over a range of prices

– Its formula is:

e quantitythe averagQ

e pricethe averagP

QPP)(Q/( E P

)/

Income Elasticity of Demand

• Income elasticity of demand measures the percentage change in the quantity demanded resulting from a 1-percent change in income.– Its formula is:

Q

I

I

Q E I

Income Elasticity of Demand and type of

Good• Income Elasticity

– Positive

•0 < e < 1

•e > 1

– Negative

• Type of Good – Normal Good

• Necessity

• Luxury

– Inferior Good

Cross-price Elasticity of Demand

• Cross-price elasticity of demand measures the percentage change in the quantity demanded of good Y resulting from a 1-percent change in price of good X.– Its formula is:

Y

X

X

Y C Q

P

P

Q E

Cross-Price Elasticity of Demand and type of

Good• Cross-price

Elasticity

– Positive

– Negative

• Type of good

– Substitutes

– Complements

Some applications & food for thought

• How to cut down cigarette smoking ?• Does minimum wages really help the workers ?• Why is rent control often found to create more

shortage of urban housing ?• Why do we often observe greater wage inequality

between unskilled and skilled workers ?• Why is coffee price found declining, whereas Nestle

and coffee shops are found to be making huge profits ?

• Why is long run price of natural resources like copper declining in spite of the fact that it is exhaustible ?

• Why did average rental price fall in NY Mahattan following 9/11, 2001?

Some applications & food for thought

• Why and how does imposition of price ceiling (rationing) on an essential item often lead to emergence of a black market in that good?

• Although in general longer run supply curves are flatter as compared to their shorter run counterparts, why do we then often observe a reversal in case of supply of secondary copper (i.e., new supply based on scrap copper), for example?

• Why is demand curve for gasoline flatter in the long-run, but steeper in the short-run, while the opposite is true for automobiles?

• For what type of products the long-run supply curve is steeper as compared to its short-run counterpart?

(answer in terms of the basic supply-demand framework and shifts in one or both curves)