Unit 1: Demand and Supply Analysis - Subjective Questions

Economics is the social science that studies how individuals, firms, governments, and societies use scarce resources to satisfy unlimited wants. Since resources are limited and have alternative uses, every economic decision involves choice and opportunity cost.

Nature of economics:

• It is a social science because it studies human behavior and relationships.
• It is concerned with the problem of scarcity and choice.
• It has both positive and normative aspects.
• It is both theoretical and practical in nature.
• It studies production, consumption, exchange, and distribution.

Scope of economics:

• Microeconomics: Study of individual consumers, firms, prices, and markets.
• Macroeconomics: Study of national income, employment, inflation, economic growth, and the balance of payments.
• It also includes public finance, international economics, development economics, and monetary economics.

Thus, economics helps explain how resources are allocated and how economic welfare can be improved.

Microeconomics and macroeconomics are the two major branches of economics.

Microeconomics uses concepts such as individual demand and supply, while macroeconomics examines aggregate demand and aggregate supply. Both branches are interdependent because the performance of individual units influences the economy as a whole.

Positive economics deals with objective, factual, and testable statements about economic behavior. It explains what is, what was, or what may be. For example, "An increase in the price of a commodity generally reduces its quantity demanded" is a positive statement because it can be tested using evidence.

Normative economics deals with value judgments, opinions, and recommendations about what ought to be. For example, "The government should reduce taxes on essential goods" is a normative statement because it expresses a view about desirable policy.

Major differences:

• Positive economics is descriptive; normative economics is prescriptive.
• Positive statements can be verified or disproved; normative statements depend on values and opinions.
• Positive economics assists in explaining economic relationships; normative economics assists in policy formulation.

Both are important because facts provide the basis for analysis, while value judgments guide economic decisions and public policy.

Demand refers to the quantity of a good or service that a consumer is willing and able to purchase at different prices during a given period, assuming other relevant factors remain constant.

The essential elements of demand are:

• Desire for the commodity: The consumer must want the good or service.
• Ability to pay: The consumer must possess sufficient purchasing power.
• Willingness to pay: The consumer must be prepared to spend money on the commodity.
• Specific price: Demand is always related to a particular price.
• Specific period: Demand must be measured over a stated time period.

A mere desire is not demand. For example, a person may desire an expensive car but cannot be said to demand it unless they have both the ability and willingness to purchase it. Demand can be expressed through a demand schedule or a demand curve.

The law of demand states that, other things remaining constant, the quantity demanded of a commodity varies inversely with its price. Thus, when price rises, quantity demanded falls, and when price falls, quantity demanded rises.

The relationship can be represented as:

Reasons for the law of demand:

• Diminishing marginal utility: Additional units provide progressively less satisfaction.
• Substitution effect: Consumers substitute relatively cheaper goods for expensive goods.
• Income effect: A fall in price increases the real purchasing power of consumers.
• New consumers: A lower price may enable more consumers to buy the commodity.

Assumptions:

• Consumer income remains constant.
• Prices of related goods remain unchanged.
• Tastes, preferences, and fashion do not change.
• The size and composition of the population remain constant.
• Consumers do not expect major future price changes.

The law is generally represented by a downward-sloping demand curve.

Demand is influenced by several factors in addition to the commodity's own price. The major determinants are:

• Price of the commodity: Generally, a rise in price reduces quantity demanded, while a fall increases it.
• Income of consumers: Demand for normal goods usually increases with income, whereas demand for inferior goods may decrease.
• Prices of related goods: Demand for substitutes rises when the price of the related substitute increases. Demand for complementary goods may fall when the price of the complement increases.
• Tastes and preferences: Favorable changes in fashion, habits, or preferences increase demand.
• Population and demographic structure: A larger population or a change in age composition can increase demand for particular goods.
• Expectations about future prices: Expected future price increases may raise current demand.
• Distribution of income: More equal income distribution can increase demand for mass-consumption goods.
• Advertising and sales promotion: Effective advertising can influence consumer preferences and increase demand.
• Season and weather: Demand for some goods varies according to climatic and seasonal conditions.

Therefore, demand depends on both price and non-price determinants.

A demand schedule is a tabular statement showing the quantities of a commodity demanded at different prices during a given period. A demand curve is a graphical representation of the relationship between price and quantity demanded.

For example:

To construct a demand curve:

• Measure price on the vertical axis.
• Measure quantity demanded on the horizontal axis.
• Plot each price-quantity combination from the schedule.
• Join the plotted points smoothly.

The resulting curve generally slopes downward from left to right because price and quantity demanded have an inverse relationship. A movement along the same curve occurs when the commodity's own price changes, while a shift of the entire curve occurs when a non-price determinant of demand changes.

The law of supply states that, other things remaining constant, the quantity supplied of a commodity varies directly with its price. Thus, producers generally supply more at a higher price and less at a lower price.

The relationship can be expressed as:

Reasons for the law of supply:

• A higher price generally increases the profitability of production.
• Producers are encouraged to use more resources in the industry.
• Existing firms may expand their output.
• New firms may enter the market.

Assumptions:

• Input prices remain constant.
• Technology does not change.
• Prices of related goods remain unchanged.
• Government taxes and subsidies remain constant.
• Producers do not expect major future price changes.
• The number of firms remains unchanged in the short run.

Graphically, the supply curve generally slopes upward from left to right, showing a positive relationship between price and quantity supplied.

The quantity supplied of a commodity is affected by the following factors:

• Price of the commodity: A higher price generally encourages producers to supply more.
• Prices of inputs: An increase in wages, raw materials, rent, or energy costs raises production costs and reduces supply.
• Technology: Improved technology lowers costs and increases productive capacity, causing supply to rise.
• Prices of related goods: Producers may shift resources toward goods offering higher returns.
• Government policy: Taxes increase production costs and reduce supply, while subsidies lower costs and increase supply.
• Number of sellers: An increase in the number of firms generally increases market supply.
• Expectations about future prices: Producers may withhold current supply if they expect higher future prices.
• Natural conditions: Weather and other natural factors strongly affect agricultural supply.
• Objectives of firms: A firm focused on sales growth may supply more than a firm focused only on maximum profit.
• Availability of inputs: Scarcity of labor, capital, or raw materials can restrict supply.

A change in the commodity's own price causes movement along the supply curve, whereas changes in other determinants shift the entire curve.

Market equilibrium is a situation in which quantity demanded equals quantity supplied at a particular price. The corresponding price is called the equilibrium price, and the corresponding quantity is called the equilibrium quantity.

Equilibrium conditions are:

Suppose the demand and supply functions are:

At equilibrium:

Therefore:

The equilibrium quantity is obtained by substituting into either the demand or supply function.

Adjustment process:

• If price is above equilibrium, supply exceeds demand, creating a surplus. Sellers reduce prices.
• If price is below equilibrium, demand exceeds supply, creating a shortage. Buyers compete for the good and price tends to rise.
• Price changes continue until quantity demanded equals quantity supplied.

Thus, market forces determine equilibrium through the interaction of demand and supply.

Consider the following hypothetical market schedule:

At a price of $6, quantity demanded and quantity supplied are both 40 units. Therefore:

• Equilibrium price = $6
• Equilibrium quantity = 40 units

At a price below $6, such as $4, quantity demanded exceeds quantity supplied. This creates a shortage of 20 units, causing upward pressure on price. At a price above $6, such as $8, quantity supplied exceeds quantity demanded. This creates a surplus of 40 units, causing downward pressure on price.

The equilibrium point is found graphically where the demand curve intersects the supply curve. At that point, there is no tendency for the market price or quantity to change, provided other conditions remain constant.

A movement along the demand curve occurs when the quantity demanded changes because of a change in the commodity's own price, while all other factors remain constant. It is also called a change in quantity demanded.

• Expansion of demand: A fall in price causes movement downward along the same demand curve and increases quantity demanded.
• Contraction of demand: A rise in price causes movement upward along the same demand curve and decreases quantity demanded.

A shift in the demand curve occurs when demand changes because of factors other than the commodity's own price.

• Increase in demand: The entire demand curve shifts rightward because of higher income, favorable tastes, a rise in the price of a substitute, or a fall in the price of a complement.
• Decrease in demand: The entire demand curve shifts leftward because of lower income for a normal good, unfavorable preferences, a fall in the price of a substitute, or a rise in the price of a complement.

Thus, movement is shown on the same curve, whereas a shift involves a new demand curve.

A movement along the supply curve occurs when quantity supplied changes because of a change in the commodity's own price, with other factors remaining constant.

• Expansion of supply: A rise in price causes movement upward along the same supply curve and increases quantity supplied.
• Contraction of supply: A fall in price causes movement downward along the same supply curve and decreases quantity supplied.

A shift in the supply curve occurs when supply changes because of non-price factors.

• Increase in supply: The entire supply curve shifts rightward when input costs fall, technology improves, subsidies increase, or more firms enter the market.
• Decrease in supply: The entire supply curve shifts leftward when input costs rise, taxes increase, technology deteriorates, natural conditions worsen, or firms leave the market.

A movement represents a change in quantity supplied, while a shift represents a change in supply itself. Confusing these two concepts can lead to incorrect analysis of market outcomes.

When demand changes, the demand curve shifts while the supply curve remains unchanged in the short run.

Increase in demand:

• The demand curve shifts rightward from to .
• At the original equilibrium price, a shortage is created.
• Buyers compete for the available quantity.
• Both equilibrium price and equilibrium quantity generally increase.

Decrease in demand:

• The demand curve shifts leftward from to .
• At the original equilibrium price, a surplus is created.
• Sellers reduce prices to sell the excess stock.
• Both equilibrium price and equilibrium quantity generally decrease.

The exact size of the changes depends on the slopes or elasticities of the demand and supply curves. For example, if supply is highly responsive, quantity may change considerably while price changes only slightly. If supply is relatively inelastic, the price effect may be larger.

A change in supply shifts the supply curve while the demand curve remains unchanged.

Increase in supply:

• The supply curve shifts rightward from to .
• At the original equilibrium price, a surplus is temporarily created.
• Sellers reduce the price to clear the market.
• Equilibrium price falls and equilibrium quantity rises.

Decrease in supply:

• The supply curve shifts leftward from to .
• At the original equilibrium price, a shortage is created.
• Buyers compete for the reduced supply.
• Equilibrium price rises and equilibrium quantity falls.

Examples include improved technology causing an increase in supply and an increase in input prices causing a decrease in supply. The final effect depends on the relative responsiveness of demand and supply.

At market equilibrium, quantity demanded equals quantity supplied:

Substitute the given functions:

Rearranging:

Therefore, the equilibrium price is .

Substitute into the demand function:

Substitute into the supply function:

Therefore, the equilibrium quantity is 50 units.

Conclusion:

• Equilibrium price:
• Equilibrium quantity: units

At this price, the quantity consumers wish to buy exactly equals the quantity producers wish to sell.

A competitive market tends toward equilibrium through changes in price.

Shortage: A shortage occurs when quantity demanded is greater than quantity supplied at the prevailing price:

A shortage usually occurs when price is below equilibrium. Buyers compete for the limited quantity, which puts upward pressure on price. As price rises, quantity demanded falls and quantity supplied rises.

Surplus: A surplus occurs when quantity supplied is greater than quantity demanded:

A surplus usually occurs when price is above equilibrium. Sellers compete to dispose of unsold goods, which puts downward pressure on price. As price falls, quantity demanded rises and quantity supplied falls.

Equilibrium: The market reaches equilibrium when:

At equilibrium, there is neither a shortage nor a surplus, so there is no immediate pressure for the price to change. This process is often called the price-adjustment or market-clearing mechanism.

Substitute goods are goods that can be used in place of one another, such as tea and coffee. If the price of coffee rises, consumers may purchase more tea, causing the demand curve for tea to shift rightward. If the price of coffee falls, demand for tea may decrease.

Complementary goods are goods that are used together, such as cars and petrol or printers and ink. If the price of petrol rises significantly, demand for cars may decrease, causing the demand curve for cars to shift leftward. If the price of petrol falls, demand for cars may increase.

The effects can be summarized as follows:

• Rise in the price of a substitute increase in demand for the commodity.
• Fall in the price of a substitute decrease in demand for the commodity.
• Rise in the price of a complement decrease in demand for the commodity.
• Fall in the price of a complement increase in demand for the commodity.

These are shifts in demand, not movements along the demand curve.

A change in the commodity's own price causes a movement along the existing demand curve, assuming other factors remain constant. A fall in price results in expansion of quantity demanded, while a rise in price results in contraction of quantity demanded.

A change in consumer income is a non-price determinant and causes the entire demand curve to shift.

• For a normal good, an increase in income shifts demand rightward, while a decrease in income shifts demand leftward.
• For an inferior good, an increase in income may shift demand leftward because consumers replace it with superior alternatives, while a decrease in income may increase its demand.

Main distinction:

• Own-price change: movement along the same demand curve.
• Income change: shift of the entire demand curve.

For example, a reduction in the price of rice increases quantity demanded along the same curve. An increase in household income may shift the demand curve for rice to the right if rice is a normal good.

Although the law of demand generally applies, certain situations may produce an opposite or unusual relationship between price and quantity demanded.

• Giffen goods: In the case of a strongly inferior staple good, a price rise may reduce real income so much that consumers buy more of the staple and less of superior alternatives.
• Veblen or prestige goods: Some luxury goods may be demanded more at higher prices because the high price creates status or exclusivity.
• Expectation of further price increases: If consumers expect prices to rise further, they may purchase more even when the current price is rising.
• Speculative demand: In financial or property markets, rising prices may attract buyers who expect further gains.
• Ignorance: Consumers may assume that a high-priced product is of higher quality and increase their purchases.
• Necessities and emergencies: Demand for essential goods such as life-saving medicines may not fall significantly when prices rise.

These are exceptions or limitations rather than complete refutations of the law. In ordinary circumstances, the inverse relationship between price and quantity demanded remains valid.