Unit 2: Demand and Supply Analysis - Subjective Questions

Demand refers to the quantity of a good or service that a consumer is willing and able to purchase at a given price during a specific period of time.

Essential conditions for demand:

• Desire for the commodity: The consumer must have a want or desire for the good.
• Willingness to pay: Mere desire is not enough; the consumer must be willing to spend money on it.
• Ability to pay: The consumer must possess the purchasing power (income) to buy the good.
• Reference to price: Demand is always expressed with reference to a particular price.
• Reference to time: Demand relates to a specific period (per day, week, month, etc.).

Thus, demand = Desire + Willingness to pay + Ability to pay. A poor person desiring a car but unable to pay does not constitute demand, whereas a person willing and able to buy at a given price does.

Law of Demand states that, other things remaining constant (ceteris paribus), there exists an inverse relationship between the price of a commodity and the quantity demanded. As price rises, quantity demanded falls, and as price falls, quantity demanded rises.

Mathematically:

Assumptions of the Law:

• No change in consumer income.
• No change in tastes and preferences of consumers.
• Prices of related goods (substitutes and complements) remain constant.
• No expectation of future price changes.
• No change in the size and composition of population.

Reasons for the inverse relationship:

• Law of Diminishing Marginal Utility: Consumers buy more only at lower prices as extra units give less satisfaction.
• Income Effect: A fall in price increases real income, enabling more purchases.
• Substitution Effect: When a good becomes cheaper, consumers substitute it for costlier alternatives.
• New consumers enter the market at lower prices.

Apart from the price of the good itself, several factors determine demand:

• Income of the consumer: For normal goods, demand rises with income; for inferior goods, demand falls as income rises.
• Prices of related goods:
  • Substitutes: A rise in the price of tea increases the demand for coffee.
  • Complements: A rise in the price of cars reduces the demand for petrol.
• Tastes and preferences: Changes in fashion, habits, and advertising alter demand.
• Consumer expectations: If prices are expected to rise in future, current demand increases.
• Population and demographics: A larger population and changing age structure raise demand.
• Distribution of income: A more equal distribution generally raises demand for essential goods.
• Government policy: Taxes and subsidies affect purchasing power and demand.
• Climate and season: Demand for woollens rises in winter, coolers in summer.

The general demand function is:

where = own price, = price of related goods, = income, = tastes, = expectations, = population.

These two concepts are often confused but are fundamentally different.

Change in Quantity Demanded (Movement along the curve):

• Caused only by a change in the price of the good itself.
• Represented by a movement along the same demand curve.
• Expansion (downward movement) when price falls; Contraction (upward movement) when price rises.

Change in Demand (Shift of the curve):

• Caused by changes in factors other than price (income, tastes, prices of related goods, etc.).
• Represented by a shift of the entire demand curve.
• Increase in demand: rightward shift ().
• Decrease in demand: leftward shift ().

Diagrammatically, movement along a fixed curve shows expansion/contraction, while a parallel shift of the whole curve shows increase/decrease in demand.

Individual Demand: The quantity of a commodity that a single consumer is willing and able to buy at various prices during a given period.

Market Demand: The total quantity of a commodity demanded by all consumers in the market at various prices during a given period.

Derivation of Market Demand:

Market demand is obtained by the horizontal summation of all individual demand curves. At each price, we add the quantities demanded by every consumer.

Example: At price , if consumer A demands 5 units and consumer B demands 7 units, market demand = 12 units.

Key differences:

• Individual demand relates to one buyer; market demand to all buyers.
• The market demand curve is flatter (more elastic) and lies to the right of individual curves.
• Market demand is affected additionally by the number of consumers in the market.

Normally demand and price move inversely, but there are certain exceptions where demand rises with price (upward sloping demand curve):

• Giffen Goods: Named after Sir Robert Giffen, these are highly inferior goods (e.g., coarse grains). A rise in price forces poor consumers to cut consumption of superior goods and buy more of the inferior good, so demand rises with price.
• Veblen/Prestige Goods (Conspicuous consumption): Luxury items like diamonds, expensive cars, and designer goods are bought for status. Higher prices increase their prestige value and demand.
• Speculation: When people expect prices to rise further (e.g., shares, real estate), they buy more even at higher prices.
• Ignorance / Price-Quality relationship: Consumers often judge quality by price and buy more of a higher-priced good believing it superior.
• Necessities of life: Essential goods like salt or medicines may be purchased regardless of price changes.
• Fear of shortage: During emergencies or wars, rising prices induce panic buying.

In these cases the demand curve slopes upward from left to right, violating the normal law.

Supply refers to the quantity of a commodity that producers are willing and able to offer for sale at a given price during a specific period of time.

Law of Supply: Other things remaining constant, there is a direct (positive) relationship between the price of a commodity and its quantity supplied. As price rises, quantity supplied increases, and as price falls, quantity supplied decreases.

Mathematically:

Assumptions:

• No change in the technique of production.
• Prices of factors of production remain constant.
• Prices of related goods remain unchanged.
• No change in the goals of the firm.
• No expectation of future price changes.
• Number of firms in the market remains constant.

Reasons for the positive relationship:

• Higher prices mean higher profits, motivating producers to supply more.
• At higher prices, new firms enter the industry.
• Rising prices cover the higher marginal cost of producing additional units.

The supply curve therefore slopes upward from left to right.

Besides the own price of the good, supply is influenced by several factors:

• Prices of factors of production (input costs): A rise in wages, rent, or raw material costs reduces supply; a fall increases it.
• State of technology: Improved technology lowers cost of production and increases supply.
• Prices of related goods: If the price of an alternative good a producer can make rises, supply of the current good may fall.
• Government policy (taxes and subsidies): Higher taxes reduce supply; subsidies increase it.
• Goals/objectives of the firm: A profit-maximizing firm behaves differently from a sales-maximizing one.
• Expectations about future prices: If prices are expected to rise, producers may withhold current supply.
• Number of firms/sellers: More sellers in the market increase total supply.
• Natural factors: Weather, floods, and droughts affect agricultural supply.

The supply function can be written as:

where = own price, = factor prices, = technology, = related goods' prices, = government policy, = expectations, = number of sellers.

Change in Quantity Supplied (Movement along the supply curve):

• Occurs only due to a change in the own price of the good.
• Represented by a movement along the same supply curve.
• Extension of supply: rise in quantity supplied when price rises.
• Contraction of supply: fall in quantity supplied when price falls.

Change in Supply (Shift of the supply curve):

• Occurs due to changes in factors other than price (input costs, technology, taxes, etc.).
• Represented by a shift of the entire supply curve.
• Increase in supply: rightward shift () — more supplied at the same price.
• Decrease in supply: leftward shift () — less supplied at the same price.

Understanding this distinction is crucial for analyzing how markets respond to different economic changes.

Market Equilibrium is a situation in which the quantity demanded equals the quantity supplied at a particular price, so there is no tendency for price or quantity to change.

Condition for equilibrium:

Determination:

• The equilibrium is found where the demand curve intersects the supply curve.
• The price at this point is called the equilibrium price ().
• The quantity is called the equilibrium quantity ().

Adjustment mechanism:

• If price > equilibrium price: Quantity supplied exceeds quantity demanded → surplus (excess supply) → price falls.
• If price < equilibrium price: Quantity demanded exceeds quantity supplied → shortage (excess demand) → price rises.
• These forces push the market back to equilibrium.

Numerical example: Suppose and .

Setting :

Thus equilibrium price is and equilibrium quantity is 80 units.

Step 1: Find equilibrium. At equilibrium :

Step 2: Equilibrium quantity.

(Check with supply: ✓)

Step 3: At (below equilibrium):

• Shortage (excess demand) = units → price tends to rise.

Step 4: At (above equilibrium):

• Surplus (excess supply) = units → price tends to fall.

Thus the market clears at and units, with disequilibrium prices creating pressures that restore equilibrium.

Changes in the non-price determinants shift the demand and/or supply curves, altering equilibrium.

Case 1: Increase in Demand (supply constant)

• Demand curve shifts rightward.
• Equilibrium price rises, equilibrium quantity rises.

Case 2: Decrease in Demand (supply constant)

• Demand curve shifts leftward.
• Equilibrium price falls, equilibrium quantity falls.

Case 3: Increase in Supply (demand constant)

• Supply curve shifts rightward.
• Equilibrium price falls, equilibrium quantity rises.

Case 4: Decrease in Supply (demand constant)

• Supply curve shifts leftward.
• Equilibrium price rises, equilibrium quantity falls.

Simultaneous shifts: When both curves shift, the effect on one variable is determinate and on the other indeterminate:

The net outcome depends on the relative magnitude of the two shifts.

Substitute Goods: Goods that can be used in place of one another to satisfy the same want. There is a direct/positive relationship between the price of one and the demand for the other.

• Examples: Tea and coffee, Coke and Pepsi, butter and margarine.
• If the price of tea rises, consumers switch to coffee → demand for coffee rises.
• Cross elasticity of demand is positive.

Complementary Goods: Goods that are used jointly to satisfy a want. There is an inverse/negative relationship between the price of one and the demand for the other.

• Examples: Car and petrol, pen and ink, bread and butter.
• If the price of cars rises, fewer cars are bought → demand for petrol falls.
• Cross elasticity of demand is negative.

Understanding these relationships helps firms in pricing and product-line decisions.

These classifications describe how demand responds to changes in income and price.

Normal Goods:

• Demand increases as income increases (positive income elasticity).
• Examples: branded clothing, restaurant meals, cars.
• Follow the normal law of demand (inverse price–demand relationship).

Inferior Goods:

• Demand decreases as income increases (negative income elasticity), because consumers switch to superior alternatives.
• Examples: coarse grains, second-hand goods, public transport (in some cases).
• Still follow the law of demand with respect to price.

Giffen Goods:

• A special class of highly inferior goods where the negative income effect outweighs the substitution effect.
• Demand rises when price rises and falls when price falls — an exception to the law of demand.
• Example: staple foods like coarse bread or cheap grains for very poor households.

Key point on effects:

• For normal goods, income and substitution effects reinforce each other.
• For inferior goods, they work in opposite directions but substitution dominates.
• For Giffen goods, the income effect dominates, producing an upward-sloping demand curve.

Individual Supply: The quantity a single firm is willing to offer for sale at various prices.

Market Supply: The total quantity offered by all firms in the market at various prices.

Derivation: The market supply curve is obtained by the horizontal summation of all individual firms' supply curves. At each price, we add up the quantities supplied by every firm.

Hypothetical schedule (two firms A and B):

Key features:

• The market supply curve slopes upward like individual curves.
• It is flatter (more elastic) than individual curves because it aggregates output of many firms.
• The number of firms affects the position of the market supply curve — more firms shift it rightward.

Excess Demand (Shortage):

• Occurs when the market price is below the equilibrium price.
• At this price, quantity demanded > quantity supplied ().
• Buyers compete for the limited goods, bidding up the price.
• As price rises: quantity demanded contracts and quantity supplied extends, until .

Excess Supply (Surplus):

• Occurs when the market price is above the equilibrium price.
• At this price, quantity supplied > quantity demanded ().
• Sellers are unable to sell all their stock and lower prices to attract buyers.
• As price falls: quantity demanded extends and quantity supplied contracts, until .

Restoration of equilibrium:

• The price mechanism acts as an automatic self-correcting device.
• Shortage → upward pressure on price.
• Surplus → downward pressure on price.
• Both forces converge to the equilibrium price where and there is no tendency to change.

This self-adjusting property of competitive markets is often called the working of the "invisible hand."

When the price of a good changes, the change in quantity demanded can be split into two effects:

Substitution Effect:

• When the price of a good falls, it becomes relatively cheaper compared to substitutes.
• Consumers substitute this good for now costlier alternatives, so quantity demanded rises.
• The substitution effect is always negative (price and quantity move in opposite directions).

Income Effect:

• A fall in price increases the consumer's real income (purchasing power).
• With higher real income, the consumer can buy more.
• For normal goods, the income effect is positive (reinforces the substitution effect).
• For inferior goods, the income effect is negative (works against it).

Explaining the downward-sloping demand curve:

• For normal goods, both effects work in the same direction → demand curve slopes downward strongly.
• For inferior goods, the substitution effect dominates → demand curve still slopes downward.
• Only for Giffen goods does the negative income effect outweigh the substitution effect, producing an upward-sloping demand curve.

Total price effect = Substitution effect + Income effect. For most goods this results in the familiar inverse price–quantity relationship.

Step 1: Initial equilibrium. Set :

So initial equilibrium: , .

Step 2: New equilibrium after demand increases. New demand , supply unchanged:

New equilibrium: , .

Step 3: Comment.

• The demand curve shifted rightward (increase in demand).
• Equilibrium price rose from 20 to 30 (+10).
• Equilibrium quantity rose from 300 to 350 (+50).

This confirms the theoretical result: with supply constant, an increase in demand raises both equilibrium price and quantity. The higher price induced producers to extend supply along the fixed supply curve.

Demand relates to buyers/consumers, while Supply relates to sellers/producers. Both are core forces determining market price.

Similarities:

• Both are expressed with reference to a specific price and time period.
• Both depend on the own price of the good plus a set of other determinants.
• Both can be shown by a schedule and a curve.
• Both distinguish between movement along the curve and shift of the curve.

Differences:

Interaction: The opposing slopes of demand and supply curves ensure they intersect at a unique point, which determines the equilibrium price and quantity in a competitive market.

Alfred Marshall emphasized that supply responses to price changes depend heavily on the time period available to producers to adjust output.

1. Market Period (Very Short Run):

• Time is too short to change the quantity produced; supply is fixed (existing stock).
• The supply curve is a vertical line (perfectly inelastic), .
• Price is determined mainly by demand. Example: fresh fish, perishable vegetables in a day's market.

2. Short Run:

• Firms can vary variable factors (labour, raw materials) but not fixed factors (plant, machinery).
• Supply can be increased to a limited extent; supply is relatively inelastic (, moderately elastic).
• Supply curve slopes upward but is fairly steep.

3. Long Run:

• All factors of production are variable; firms can expand capacity and new firms can enter.
• Supply is highly elastic ( or more responsive).
• Supply curve is flatter, and quantity adjusts fully to price changes.

Conclusion: The longer the time period, the more elastic the supply, because producers have greater freedom to adjust all inputs and respond fully to changes in price.