Unit 1: Demand and Supply Analysis

I. Foundations of Economics — Orientation to Economic Choice

Economics studies how individuals and societies use scarce resources to satisfy competing wants; modern systematic analysis developed from classical political economy, notably Adam Smith’s The Wealth of Nations (1776).

A. Nature and scope of economics

Economics is a social science concerned with choice, scarcity, resource allocation, and the production, distribution, and consumption of goods and services.

• Scarcity: Resources such as land, labour, capital, time, and enterprise are limited relative to human wants.
• Choice: Scarcity forces households, firms, and governments to select among alternatives.
• Opportunity cost: The real cost of a choice is the value of the next-best alternative forgone; using land for a hospital, for example, may mean giving up housing on that site.
• Central economic questions:
  • What to produce? The combination of goods and services to create.
  • How to produce? The techniques and resources to employ.
  • For whom to produce? The way output and income are distributed.
• Economic agents:
  • Households: Consume goods and supply factors of production.
  • Firms: Hire factors and produce goods and services.
  • Government: Taxes, spends, regulates, and provides public goods.
• Scope: Economics examines consumption, production, exchange, income, employment, inflation, growth, public finance, international trade, and environmental resource use.
• Efficiency and equity: Efficiency concerns obtaining maximum output from resources, whereas equity concerns the fairness of economic outcomes.
• Ceteris paribus convention: Economists isolate relationships by assuming “other things remain equal,” such as examining price and quantity demanded while holding income and tastes constant.

B. Branches of economics

Economics is principally divided into microeconomics and macroeconomics according to the level at which economic behaviour is examined.

1. Microeconomics: Studies individual consumers, firms, industries, and specific markets.
   • Core questions: How households allocate income, how firms determine output, and how market prices are formed.
   • Concrete example: Analysis of the price and quantity of coffee belongs to microeconomics.
2. Macroeconomics: Studies the economy as a whole through aggregate variables.
   • Core questions: National income, unemployment, inflation, economic growth, and the balance of payments.
   • Concrete example: Analysis of a country’s 6% unemployment rate belongs to macroeconomics.
   • Interdependence: Macroeconomic outcomes result partly from millions of microeconomic decisions, while inflation, taxation, and interest rates influence individual decisions.
   • Other specialised branches: Public economics studies government activity; international economics studies cross-border transactions; development economics studies structural change and living standards.

C. Positive and normative economics

Positive economics explains observable economic relationships, whereas normative economics makes value judgments about what economic policy ought to achieve.

1. Positive economics:
   • Nature: Descriptive, explanatory, and in principle testable using evidence.
   • Example: “A higher tax on petrol increases its consumer price” can be checked against market data.
   • Language: Commonly uses terms such as “is,” “causes,” and “will result.”
2. Normative economics:
   • Nature: Prescriptive and based partly on ethical or political values.
   • Example: “The government should reduce petrol taxes” depends on judgments about fairness, revenue, and environmental costs.
   • Language: Commonly uses “should,” “ought,” “fair,” and “desirable.”
   • Policy connection: Evidence may predict the effects of a minimum wage positively, but deciding whether those effects are socially desirable is normative.

II. Demand — Consumer Willingness and Ability to Buy

Demand represents the quantities consumers are both willing and able to purchase under specified conditions during a given period.

A. Meaning of demand

Demand is not mere desire; it requires willingness to purchase, purchasing power, and reference to a particular price and time period.

• Quantity demanded: The amount consumers buy at one specific price; for example, 500 loaves per day at ₹40 each.
• Demand schedule: A table showing quantities demanded at alternative prices.
• Demand curve: A graphical representation with price usually on the vertical axis and quantity on the horizontal axis.
• Individual and market demand:
  • Individual demand: Demand of one consumer.
  • Market demand: Horizontal sum of all consumers’ quantities demanded at every price.
• Demand function: Quantity demanded depends on several variables.

Qd = f(P, Y, Pr, T, E, N)

• Symbols: Qd = quantity demanded; P = own price; Y = income; Pr = prices of related goods; T = tastes; E = expectations; N = number of buyers.

B. Law of demand

The law of demand states that, ceteris paribus, quantity demanded varies inversely with the good’s own price.

P ↑ → Qd ↓
P ↓ → Qd ↑

• Conditions: Income, tastes, related-goods prices, expectations, and buyer numbers must remain unchanged.
• Downward slope: A demand curve generally slopes from upper left to lower right.
• Explanations:
  • Substitution effect: When tea becomes cheaper relative to coffee, consumers substitute tea for coffee.
  • Income effect: A lower price raises consumers’ real purchasing power, allowing more units to be bought.
  • Diminishing marginal utility: Additional units generally provide less extra satisfaction, so consumers buy more only at lower prices.
• Linear form:

Qd = a − bP

• Symbols: a = quantity demanded when price is zero; b = positive responsiveness coefficient; the minus sign expresses the inverse relationship.
• Limitations: Status goods, expectations of further price increases, emergencies, and some strongly inferior Giffen goods may produce unusual behaviour.

C. Determinants of demand

Demand shifts when a factor other than the good’s own price changes.

• Consumer income:
  • Normal good: Higher income increases demand, as with restaurant meals.
  • Inferior good: Higher income decreases demand, as consumers replace basic alternatives.
• Prices of related goods:
  • Substitutes: A rise in coffee’s price may increase demand for tea.
  • Complements: A rise in car prices may reduce demand for petrol.
• Tastes and preferences: Advertising, fashion, health information, and social trends can alter demand.
• Expectations: Anticipated price increases or income growth may raise current demand.
• Number and composition of buyers: Population growth usually raises market demand; an ageing population changes its composition.
• Season and climate: Umbrella demand may rise during the rainy season.
• Credit conditions: Lower borrowing costs can raise demand for houses, vehicles, and durable goods.

III. Supply — Producer Willingness and Ability to Sell

Supply refers to quantities producers are willing and able to offer for sale at different prices during a specified period.

A. Law of supply

The law of supply states that, ceteris paribus, quantity supplied varies directly with the good’s own price.

P ↑ → Qs ↑
P ↓ → Qs ↓

• Profit incentive: A higher market price generally makes additional production more profitable.
• Rising marginal cost: Expanding output may require overtime, less efficient machinery, or costlier inputs, so higher prices are needed.
• Upward slope: The normal supply curve rises from lower left to upper right.
• Supply function:

Qs = c + dP

• Symbols: Qs = quantity supplied; P = price; c = intercept; d = positive supply-response coefficient.
• Conditions: Technology, input prices, taxes, expectations, weather, and seller numbers remain constant.
• Possible exceptions: Fixed-capacity goods, unique artworks, and labour supplied beyond certain wage levels may not follow the usual pattern.

B. Determinants of supply

Supply shifts when production conditions change independently of the product’s current price.

• Input prices: Higher wages, energy prices, or raw-material costs reduce supply by raising production cost.
• Technology: Automation that lowers unit cost increases supply.
• Taxes and subsidies: A per-unit tax reduces supply, while a production subsidy increases it.
• Prices of alternative products: Farmers may supply less wheat when producing maize becomes more profitable.
• Joint production: Increased beef production may also increase the supply of leather.
• Expectations: Producers expecting a higher future price may withhold stock, reducing present supply.
• Number of sellers: Entry of firms increases market supply; exit decreases it.
• Natural conditions: Favourable rainfall may increase crop supply, while floods or droughts reduce it.
• Regulation and infrastructure: Compliance costs may restrict supply, whereas improved transport can expand it.

IV. Market Coordination — Interaction of Buyers and Sellers

A competitive market coordinates buyers’ demand and sellers’ supply through adjustments in price and quantity.

A. Market equilibrium and price determination

Market equilibrium occurs where quantity demanded equals quantity supplied, creating no inherent pressure for price to change.

Qd = Qs

• Equilibrium price: The price Pe at which planned purchases equal planned sales.
• Equilibrium quantity: The quantity Qe exchanged at Pe.
• Shortage: At a price below equilibrium, Qd > Qs; competition among buyers tends to push price upward.
• Surplus: At a price above equilibrium, Qs > Qd; unsold stock encourages sellers to reduce price.
• Worked example:

Qd = 100 − 2P
Qs = 20 + 2P

100 − 2P = 20 + 2P
80 = 4P
Pe = 20
Qe = 60

• Interpretation: At a price of 20 currency units, both buyers and sellers plan to trade 60 units.
• Price mechanism: Changing prices transmit information and create incentives, rationing scarce goods among buyers and directing resources toward profitable production.

V. Curve Changes — Distinguishing Price Effects from Other Effects

Correct analysis requires separating movement along an existing curve from a shift of the entire curve.

A. Movements and shifts in demand and supply curves

Movements result from changes in a good’s own price, while shifts result from changes in non-price determinants.

1. Demand-curve changes:
   • Movement along demand: A price fall causes an extension, or increase in quantity demanded; a price rise causes a contraction.
   • Rightward shift: An increase in demand occurs at every price, perhaps because income rises for a normal good.
   • Leftward shift: A decrease in demand occurs at every price, perhaps because the number of buyers falls.
2. Supply-curve changes:
   • Movement along supply: A price rise causes an extension, or increase in quantity supplied; a price fall causes a contraction.
   • Rightward shift: An increase in supply occurs at every price, perhaps because technology lowers costs.
   • Leftward shift: A decrease in supply occurs at every price, perhaps because input prices rise.
   • Equilibrium effects:
   • Higher demand raises both equilibrium price and quantity, other things equal.
   • Higher supply lowers equilibrium price but raises equilibrium quantity.
   • Lower demand reduces both equilibrium price and quantity.
   • Lower supply raises equilibrium price but reduces equilibrium quantity.
   • Simultaneous shifts: If demand and supply both change, one equilibrium outcome may be indeterminate without knowing their relative sizes; for example, increases in both definitely raise quantity, but their effects on price oppose each other.