Unit 2: Demand and Supply Analysis

I. Orientation: The Price Mechanism

Managerial economics treats price as the signal that reconciles what buyers want with what sellers offer. Demand and supply analysis is the partial-equilibrium framework (attributed to Alfred Marshall, 1890) for a single market, holding conditions in all other markets constant (ceteris paribus).

• Demand: the quantity of a good buyers are willing and able to purchase at each price in a given period. Willingness plus purchasing power, not mere desire.
• Supply: the quantity sellers are willing and able to offer for sale at each price in a given period.
• Ceteris paribus: "other things equal." Only price varies along a curve; a change in any other determinant shifts the whole curve.
• Flow concept: both are measured per unit of time (units per week), not as a stock.
• Effective vs. notional: managerial forecasting uses effective demand (backed by ability to pay), not wishful demand.
• Market convention: price on the vertical axis, quantity on the horizontal axis, following Marshall's diagrams.

II. Determinants of Demand and Supply

A. The two laws (orientation)

• Law of demand: price and quantity demanded move inversely, so the demand curve slopes downward: ∂Qd/∂P < 0.
• Law of supply: price and quantity supplied move directly, so the supply curve slopes upward: ∂Qs/∂P > 0.
• Movement vs. shift: a price change causes movement along a curve; a non-price determinant causes a shift of the curve.

B. Determinants of demand

The demand function collects every variable that moves the quantity demanded of good X.

Qdx = f(Px, Y, Pr, T, E, N, ...)

• Px — own price: the sole variable behind movement along the curve; a rise in Px cuts Qdx.
• Y — consumer income: shifts the curve. For a normal good ∂Qd/∂Y > 0; for an inferior good (e.g. coarse grain) ∂Qd/∂Y < 0.
• Pr — prices of related goods:
  • Substitutes: tea and coffee — a rise in the coffee price raises tea demand (∂Qd tea/∂P coffee > 0).
  • Complements: cars and petrol — a rise in the petrol price lowers car demand (∂Qd cars/∂P petrol < 0).
• T — tastes and preferences: fashion, advertising and habit shift the curve outward or inward with no price change.
• E — expectations: if buyers expect prices to rise next month, current demand rises.
• N — number of buyers: population growth or a widening market shifts demand right.

C. Determinants of supply

The supply function lists what sellers respond to.

Qsx = f(Px, C, Tec, Pr, E, F, ...)

• Px — own price: drives movement along the supply curve; a higher price makes extra output profitable.
• C — input (factor) prices: a rise in wages or raw-material cost shifts supply left (higher cost per unit, less offered at each price).
• Tec — technology: an improvement lowers unit cost and shifts supply right.
• Pr — prices of related goods in production: if wheat prices rise, farmers switch land from barley, so barley supply falls.
• E — producer expectations: expected future price rises may cut present supply as sellers withhold stock.
• F — number of firms: entry shifts market supply right; exit shifts it left.
• Taxes and subsidies: an excise tax shifts supply left (adds to cost); a subsidy shifts it right.

III. Individual and Market Demand and Supply

A. From the single agent to the market (orientation)

• Aggregation rule: market curves are the horizontal summation of individual curves — quantities are added at each common price.
• Common price assumption: all agents face the same market price, so summing across quantity is valid.

B. Individual demand and supply

• Individual demand: one consumer's quantity at each price, from a demand schedule.

  Price (₹)	Consumer A (units)	Consumer B (units)
  10	2	1
  8	4	3
  6	6	5

• Basis of the individual curve: derived from utility maximisation — the consumer buys until marginal utility per rupee is equal across goods, giving the downward slope.

• Individual supply: one firm's quantity at each price, given by the portion of its marginal-cost curve above average variable cost; the firm supplies where P = MC.

C. Market demand and supply

• Market demand: sum of all individual demands at each price. Using the table above, Qd(market) = QA + QB, so at ₹8 the market wants 4 + 3 = 7 units.
• Market supply: sum of all individual firms' supplies at each price.
• Worked aggregation: if a market has 100 identical consumers each demanding q = 20 − 2P, market demand is Q = 100(20 − 2P) = 2000 − 200P. At P = 5, Q = 1000.
• Why the market curve is flatter: adding buyers or sellers widens the quantity response to any price change, so market curves are more price-elastic than individual ones.
• Managerial use: the firm plans capacity and pricing against the market curve, not one buyer's schedule.

IV. Market Equilibrium

A. Definition and condition (orientation)

Equilibrium is the price–quantity pair at which the plans of buyers and sellers coincide, so there is no tendency to change.

• Condition: Qd = Qs, at the equilibrium price P* and equilibrium quantity Q*.
• Graphically: the intersection of the demand and supply curves.
• Market-clearing: at P* there is neither unsold stock nor unmet demand.

B. Determination of equilibrium

• Solving the system: set demand equal to supply.

Demand:  Qd = 100 − 5P
Supply:  Qs = 40 + 5P
Set Qd = Qs:
100 − 5P = 40 + 5P
60 = 10P  →  P* = 6
Q* = 100 − 5(6) = 70

• Interpretation: at P* = ₹6, buyers want 70 units and sellers offer 70 units — the market clears.

C. Disequilibrium and adjustment

Away from P*, price pressures push the market back to equilibrium.

1. Surplus (excess supply): when price is above P*, Qs > Qd. At P = ₹8 in the example, Qs = 80, Qd = 60, a surplus of 20 units. Unsold stock forces price down.
2. Shortage (excess demand): when price is below P*, Qd > Qs. At P = ₹4, Qd = 80, Qs = 60, a shortage of 20 units. Competing buyers bid price up.

• Walrasian adjustment: price moves in response to the excess-demand gap until the gap is zero.

D. Shifts in equilibrium (comparative statics)

Comparative statics compares equilibria before and after a determinant changes.

• Demand increase (income rises, normal good): curve shifts right, raising both P* and Q*.
• Demand decrease: curve shifts left, lowering both P* and Q*.
• Supply increase (better technology): curve shifts right, lowering P* but raising Q*.
• Supply decrease (input-cost rise): curve shifts left, raising P* but lowering Q*.
• Simultaneous shifts: when both curves move, the direction of Q* is determinate but the direction of P* is ambiguous (or vice versa) — the outcome depends on the relative size of the two shifts.

E. Significance and limitations

• Significance: the model underpins pricing decisions, forecasting, and the analysis of taxes, price ceilings and floors.
• Price floor (e.g. minimum support price): set above P* it creates a persistent surplus.
• Price ceiling (e.g. rent control): set below P* it creates a persistent shortage.
• Limitations:
  • Ceteris paribus is unrealistic: many determinants move at once in real markets.
  • Partial view: it ignores feedback from linked markets that general equilibrium captures.
  • Static: the basic model shows the end state, not the time path or lags of adjustment.
  • Data problems: estimating actual demand and supply functions is difficult, so managers work with approximations.