Demand and Supply Theory

Theory of Demand and Supply

• Theory of Demand and Supply includes: Meaning of demand, determinants of demand, law of demand, movement along the demand curve, elasticity of demand, price elasticity, cross elasticity, and income elasticities.

Meaning of Demand

• Demand is the quantity of a good or service buyers are willing and able to purchase at various prices during a given period.
• Effective demand requires desire, means to purchase, and willingness to use those means.

Determinants of Demand

• The important factors that determine demand:
• Price of the commodity
  • The demand for a commodity is inversely related to its price
  • A rise in price causes a fall in quantity purchased
  • Income and substitution effects cause this inverse relationship
• Price of related commodities
  • Complementary goods
    • Goods bought or consumed together
    • Examples: tea and sugar, automobile and petrol, pen and ink
  • Substitute goods
    • Goods that satisfy the same want and can be used in place of one another
    • A rise in the price of a product increases the demand for its substitutes
• Disposable income of the consumer
  • Rise in disposable income usually increases the demand for goods and services at any given price
  • Decrease in disposable income lowers quantity demanded at all prices
  • There are goods for which the quantity demanded rises only up to a certain level of income
  • Beyond this level, the quantity demanded decreases with an increase in money income
  • These goods are called inferior goods
• Tastes and preferences of buyers:
  • Modern or fashionable goods are in higher demand
• External effects on utility
  • Demonstration effect
    • Desire to emulate the consumption behaviour of others
  • Bandwagon effect
    • Extent to which demand increases due to others consuming the same commodity
    • Represents the desire to be fashionable or stylish, or to conform to desired social groups
  • Snob effect
    • Extent to which demand decreases because others are consuming the same commodity
    • Represents the desire to be exclusive and different from the "common herd."
  • Veblen effect
    • Highly priced goods are consumed by status-seeking rich people to satisfy their need for conspicuous consumption
    • Thorstein Veblen gave the name
    • It is a function of price
• Consumers’ Expectations:
  • Expectations regarding future prices, income, and supply conditions influence current demand
• Other factors may be:
  • Size of population
  • Age distribution of the population
  • Credit facilities and interest rates,
  • Government policies and regulations
  • Weather conditions
  • Business conditions

The Demand Function

• Qx = f (Px, Y, Pr)
  • Qx is the quantity demanded of product X
  • Px is the price of the commodity
  • Y is the money income of the consumer
  • Pr is the price of related goods

The Law of Demand

• The law of demand:
  • There is an inverse relationship between price and quantity demanded
  • "The amount demanded increases with a fall in price and diminishes with a rise in price."
• It works with these assumed influences, or the law may be invalid:
  • Prices of related commodities
  • Income of consumers
  • Tastes and preferences of consumers
  • Other factors influencing demand

Demand Schedule

• A table showing the quantities of a good that buyers would choose to purchase at different prices
• per unit of time
• variables held constant

Demand Curve

• A graphical presentation of the demand schedule
• The vertical axis measures the price per unit of the good
• The horizontal axis measures the quantity of the good

Market Demand

• Summation of individual demands
• Market Demand Schedule - Quantities of a item at various prices, buyable by the buyers
  • Other things stay the same
• This depends on these demands:
  • Every individual consumer
  • The amount of possible consumers

Rationale of the Law of Demand

• Price Effect includes:
  • Effects on income
  • With falling prices, it still provides the same service
  • Effects on substitutability
    • A product gets better compared to others
• Utility Maximising Behaviour maximizes benefit in the face of equal or less cost - Only less price justifies buying it more
• Arrival of new consumers - As costs go down, consumers are more likely to purchase the goods
• Different uses and therefore increased demand

Exceptions to the Law of Demand

• Conspicuous goods:
  • Articles of prestige and status or display of wealth
  • A.k.a, "Veblen effect"
  • They increase attractivity only if their prices hold good
• Giffen goods:
  • Inferior goods with available, not-close substitutes
• Conspicuous necessities:
  • Become required due to their demand, and will be inelastic
• Expectations about prices:
  • As prices rise, people will still buy in the expectation of future gains because of increased price
• Incomplete information and irrational behaviour:
  • Irrational buys are out of character, and unknowledgeable too
• Necessaries of life for consumers are not affected through elasticity
• Speculative goods:
  • Higher demands follow higher pricing in speculative markets

Expansion and Contraction of Demand

• Expansion of demand
  • Increase in quantity demanded due to a decrease in price
• Contraction of demand
  • Decrease in quantity demanded due to an increase in price

Increase and Decrease in Demand

• Increase in demand
  • Shift of the demand curve to the right
  • Indicates an greater quantity
• Decrease in demand
  • Shift of the demand curve to the left
  • Indicates a decreased quantity

Factors Leading to an increase in demand

• Rise in income (for normal goods)
• Fall in the price of a complement
• An increase in the number of buyers
• A change in tastes in favor of the commodity

Factors Leading to a decrease in demand

• A fall in income (for normal goods)
• Rise in the price of a substitute food
• A decrease in the number of buyers
• A change in tastes against the commoditys

Movements along the Demand Curve vs. Shift of Demand Curve

• Movement along the demand curve
  • Indicates changes in quantity demanded due to price changes
  • Other factors remain constant
• Shift of the demand curve
  • Indicates a change in demand at each possible price
  • One or more other factors change

Elasticity of Demand

• Elasticity of demand measures the responsiveness of quantity demanded to changes in its determinants
• Types
  • Price elasticity
  • Income elasticity
  • Advertisement elasticity
  • Cross elasticity

Price Elasticity of Demand

• Elasticity = (% change in quantity demanded) / (% change in price)