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UNIT -1 Demand and Supply Analysis 1.1 Scope & Importance of Micro Economics, Demand function: Meaning, determinants ,,Variation and change in demand, Supply function: Meaning,determinants 1.2 Shifts in the Demand and Supply Curves and Equilibrium 1.3 Elasticity :Meaning, Significance, Types of Elasticity of demand(Price, Income, Cross and Promotional) MEANING, SCOPE AND IMPORTANCE OF MICRO ECONOMICS MEANING.R Microeconomics (from Greek prefix micro- meaning "small" + "economics") is a branch of economics that studies the behavior of individual households and firms in making decisions on the allocation of limited resources. M Typically, it applies to markets where goods or services are bought and sold. Microeconomics examines how these decisions and behaviors affect the supply and demand for goods and services, which determines prices, and how prices, in r. turn, determine the quantity supplied and quantity demanded of goods and services. D SCOPE OF MICRO ECONOMICS Microeconomics seeks to analyze the market form or other types of mechanisms that establish relative prices amongst goods and services and/or allocates society’s resources amongst their many alternative uses. In microeconomics, we study the following: 1. Theory of product pricing, which includes(a) Theory of consumer behaviour. (b) Theory of production and costs. 2. Theory of factor pricing, which constitutes(a) Theory of wages. (b) Theory of rent. (c) Theory of interest.(d) Theory of profits. 3. Theory of economic welfare. Microeconomics has occupied a very important place in the study of economic theory. In fact, it is the stepping–stone to economic theory. It has both theoretical and practical implications. IMPORTANCE OF MICROECONOMICS 1. Determination of demand pattern: The study of microeconomics has several uses. It determines the pattern of demand in the economy, i.e., the amounts of the demand for the different goods and services in the economy, because the total demand for a good or service is the sum total of the demands of all the individuals. Thus, by determining the demand patterns of every individual or family, microeconomics determines the demand pattern in the country as a whole. 2. Determination of the pattern of supply: In a similar way, the pattern of supply in the country as a whole, can be obtained from the amounts of goods and services produced by the firms in the economy. Microeconomics, therefore, determines the pattern of supply as well..R 3. Pricing: Probably the most important economic question is the one of price determination. The prices of the various goods and services determine the pattern of resource allocation in the economy. The prices, in turn, are determined M by the interaction of the forces of demand and supply of the goods and services. By determining demand and supply, microeconomics helps us in understanding the process of price determination and, hence, the process of determination of r. resource allocation in a society. D 4. Policies for improvement of resource allocation: As is wellknown, economic development stresses the need for improving the pattern of resource allocation in the country. Development polices, therefore, can be formulated only if we understand how the pattern of resource allocation is determined. For instance, if we want to analyse how a tax or a subsidy will affect the use of the scarce resources in the economy, we have to know how these will affect their prices. By explaining prices and, hence, the pattern of resource allocation, microeconomics helps us to formulate appropriate development policies for an underdeveloped economy. 5. Solution to the problems of micro-units: Finally, it goes without saying that, since the study of microeconomics starts with the individual consumers and producers, policies for the correction of any wrong decisions at the micro-level are also facilitated by microeconomics. For example, if a firm has to know exactly what it should do in order to run efficiently, it has to know the optimal quantities of outputs produced and of inputs purchased. Only then can any deviation from these optimal levels be corrected. In this sense, microeconomics helps the formulation of policies at the micro-level. MARKET DEMAND, MARKET SUPPLY In economics both demand and supply are the important forces through which market economy functions. Individual’s demand is a desire backed by his / her ability and willingness to pay. There is an indirect or negative relationship between price and quantity demanded. Individual Supply is the amount of a product that a producer is willing to sell at given prices. There is a direct or positive relationship between price and quantity supplied. Market Demand Individual demand for a product is based on an individual’s choice / Preference among different products, price of the product, income etc. Individual demand is nothing but desire backed by an individual's ability and willingness to pay. By summing up the demand of all the consumers or individuals for the product we get market demand for that particular product. Table 2.1Market Demand Schedule Price Demand of Demand.R Market Demand Individual of (Demand of Individual A A Individua + Demand of Individual M l B) B 10 5 7 12 r. 20 4 6 10 D 30 3 5 8 40 2 4 6 50 1 3 4 The above table 2.1 represents the demand schedule of individual A, individual B and Market Demand. Same schedule can be represented with the help of a graph. Diagram 2.1 Market Demand Curve.R Diagram 2.1 represents the demand curve of individual A, individual B and Market Demand. DA is a demand curve of individual A. DB is the demand curve of individual B. DM is the market demand curve. All curves are downward sloping indicating a negative relationship between M price and quantity demanded. Market Supply r. Individual Supply is the amount of a product that a producer is willing to sell at given prices. By summing up the supply of all the producers for D the product we get market supply for that particular product. Table 2.2 Market Supply Schedule Price Supply of Supply of Market Supply Producer Producer (Supply of Producer A A B + Supply of Producer B) 10 1 3 4 20 2 4 6 30 3 5 8 40 4 6 10 50 5 7 12 The above table 2.2 represents supply schedules of producer A, producer B and Market supply. Same schedule can be represented with the help of a graph Diagram 2.2 Ma122rket Supply Curve.R M r. 11 D Diagram 2.2 represents supply curve of producer A, producer B and Market supply. SA is a supply curve of producer A. SB is the supply curve of producer B. SM is the market supply curve. All curves are upward sloping indicating positive relationship between price and quantity demanded. SHIFTS IN DEMAND AND SUPPLY CURVES SHIFTS / CHANGES IN DEMAND : Shifts in demand take place due to changes in non-price factors such as income, population, government policies, tastes, preferences, habits, fashion etc. Whenever there are favourable changes in these factors then the demand curve shifts outward. It is also known as Increase in Demand. Whenever there are unfavourable changes in these factors then the demand curve shifts inward. It is also known as Decrease in demand. Diagram 2.4 Changes in Demand 13 In the above diagram D is the original demand curve. At price P, OQ quantity is demanded. If there are favourable changes in the non-price factors affecting demand then the demand curve shifts outward and becomes D1. Here we can see that at same price P, now more.R quantity i.e. OQ1 quantity is demanded. If there are unfavourable changes in the non-price factors affecting demand then the demand curve shifts inward and becomes D2. Here we can see that at same price P, now less quantity i.e. OQ2 quantity is demanded. Shift from D to D1 M is known as Increase in Demand and shift from D to D2 is known as Decrease in Demand. r. D QUESTIONS 1) List out the factors that lead to changes in demand. 2) List out the factors that lead to changes in supply. 3) Write a short note on Market Demand. 4) Write a short note on Market Supply. 5) Complete the following table and draw the graph. Price Demand of Demand of Market Individual A Individual B Demand 10 15 10 ? 20 14 9 ? 30 13 8 ? 40 12 7 ? 50 11 6 ? 6) Complete the following table and draw the graph. Price Supply of Producer A Supply of Producer B Market Supply 10 8 6 ? 20 9 7 ? 30 10 8 ? 40 11 9 ? 50 12 10 ?.R DEMAND FUNCTION M Demand function is an arithmetic expression that shows the functional relationship between the demand for a commodity and the various r. factors affecting it. This includes the income of a consumer and the price of a commodity along with other various determining factors affecting D demand. The demand for a commodity is the dependent variable, while its determinants factors are the independent variables. The demand for a commodity depends on various factors which determine the quantity of a commodity demanded by various individuals or a group of individuals. The following equation shows the demand function which expresses the relationship between the quantity demanded of a commodity X and its determinants. Qdx = f (Px,Y, Py,T, A) Where, Qdx = Quantity demanded of commodity X. Px = Price of commodity X. Y = income of a consumer. Py = Price of related commodities. T = Taste and Preference of an individual consumer. A = Advertising expenditure made by the producer. DETERMINANTS OF DEMAND The important determinants of demand for a commodity are explained below: 1. Price of commodity (Px): The price of a commodity is a very important determinant of demand for any commodity. Other things remain the same, the rise in price of the commodity, the demand for the commodity contracts, and with the fall in price, its demand expands. So, the quantity demanded and price shows an inverse relationship in the case of normal goods. In other words, changes in price bring changes in the consumer’s demand for that commodity. 2. Income (Y): Another important determinant of demand for a commodity is consumer’s income. Change in consumer’s income also influences the change in consumer’s demand for commodities. The demand for normal goods increases with the increasing level of income and vice versa. it shows a direct relationship between income and quantity demanded. 3. Price of related commodities (Py):The demand for a commodity is.R also affected by the price of other commodities, especially of substitute or complementary goods. A good may have some related goods either substitute or complementary. The relation between two M may be different. Substitute Goods: Substitute Goods are those goods which can be substituted from each other. For Instance Tea & Coffee. When the rise in r. the price of Tea causes a rise in demand for Coffee because there is no change in price of coffee such goods are called substitute goods. In other D words the relation between two substitute goods is positive. An incase the price of one commodity increases the demand for another. Complementary Goods: Complementary goods are those goods which one purchased together. For Instance Car & Petrol. When their a rise in price of Petrol leads to fall in demand for Car such goods are called complementary good. In other words, the relation between two complementary goods is negative. An increase in price of one commodity leads to decrease in demand for another. 4. Taste and Preference (T): The demand for a commodity also depends on the consumer’s taste and preferences such as change in fashion, culture, tradition etc. As the consumer's taste and preference for a particular commodity changes the demand for that particular commodity also changes. Therefore, Taste and Preference of a consumer plays an important role. 5. Advertising expenditure (A): Advertising expenditure by a firm influences the demand for a commodity. The advertisements by the manufacturer and sellers attract more customers towards the commodity. There exists a positive relationship between advertising expenditure and demand for the commodity. MEANING OF DEMAND The demand in economics means the desire to purchase the commodity backed by willingness and the ability to pay for it. Demand= Desire + Willingness to buy + Ability to pay LAW OF DEMAND The law of demand was propounded by the famous economist Alfred Marshall in early 1892. Due to the general observation of law, economists have come to accept the validity of the law under most situations. The law of demand states that other things being equal the relationship between the price and the quantity demanded of a commodity are inversely related to each other. In other words, when the price of a commodity rises the quantity demanded for the commodity falls. The law of demand helps to.R explain the consumer’s choice behaviour due to change in the price of a commodity. M Assumptions: The law of demand is based on the following assumption given below: r. 1. No change in consumers income: There should not be any change in the consumer income while operating under the law of demand. If D the income of a consumer increases the consumer may buy more goods at the same price or buy the same quantity even if price increases. The income is assumed to be constant, as it may lead to enticement to the consumer to buy more goods and raise the demand for a commodity despite an increase in the price of the commodity. 2. No change in the price of other goods: The price of substitute goods and complementary goods should remain the same. If any of the price changes may lead to change in the demand for the other commodity and it will change the consumer preference will affect the law of demand. 3. No change in taste and preference: The law assumes that the consumer’s taste and preference for a commodity remains the same. If there is a change in consumer’s taste and preferences there will be a change in the demand for the commodity. 4. No expectation of change in the future price: The law of demand remains valid if there is no change in future expectation about the price of commodities. If a consumer is expecting a rise in price in future, he will buy more quantities even at a higher price in present time and vice-versa. 5. No change in the size and composition of population: The law also assumes that the size and composition of the total population of a country should not change. That means, the population must neither increase nor decrease. Because a rise in the populations would increase the demand for commodities. Along with the size of population, composition of population also matters. If the number of senior citizens is more then the demand for medical care will be more. If the female population is more then the demand for cosmetics will be more. 6. No change in government policies: The law assumes that there is no change in the government policy which will either increase or decrease the demand for the commodity. Demand Schedule and Demand Curve: The law of demand can be simply explained through a demand schedule and demand curve. The demand schedule is a tabular representation of the law of demand which is shown below: Demand Schedule: Table 3.1 Price (`).R Quantity demanded of a commodity ‘X’ (Units) M 50 10 40 20 r. 30 30 D 20 40 10 50 Representation of table: It can be seen from the above table, that when the price of a commodity ‘X’ is `50 per unit, the consumer purchases 10 units of the commodity. Further when the price of the commodity falls to `40, he purchases 20 units of the commodity. Similarly, when the price falls further the quantity demanded by the consumer goes on increasing by 30 units as so on. This demand schedule shows the inverse relationship between the price and quantity demanded of a commodity. Demand curve: Quantity Demand Diagram 3.1 The demand curve is a graphical representation of the quantities of goods demanded by the consumer at various possible prices in a period of time. The Diagram shows quantity demanded on X-axis and the price of a commodity on the Y-axis. If the demand schedule is.R plotted on the demand curve, we get the various price-quantity combination points and if we join these points, we get the downward sloping demand curve. Thus, the downward sloping demand curve M according to the law of demand shows the inverse relationship between price and quantity demanded. Exceptions to the Law of Demand: The law of demand is generally r. valid in most of the cases but there are few cases where the law is not applicable. Such cases are explained below: D 1. Goods having prestige value (Veblen effect): This exception to the law of demand was propounded by an economist Thorstein Veblen in his work ‘conspicuous consumption’. According to him, some consumers measure the utility of a commodity by its price i.e., the higher the price of a commodity, the higher its utility. For example, People sometimes buy certain expensive or prestigious goods like diamonds at high prices not due to their intrinsic value but only because it has snob value. On the other hand, as price falls, they demand less due to the loss of its snob value. This effect is called the Veblen effect or Snob value. 2. Giffen goods: Another exception to the law of demand was put forward by the economist Sir Robert Giffen. There is a direct price – demand relationship in case of giffen goods. When with the rise in the price of a giffen goods, its quantity demand increases and with the fall in its price its quantity demand decreases, the demand curve will slope upward to the right hand side and not downward. 3. Price Expectations: When the consumer expects there is a rise in price of a commodity in future, he/she may purchase more of the commodity at present. Where the law of demand is not applicable. 4. Emergencies: During the time of emergencies such as natural and man-made calamities, the law of demand becomes ineffective. In such circumstances, people often fear the shortage of the necessity goods and hence demand more goods and services even at higher prices. 5. Change in fashion and taste & preferences: The change in taste and preferences of the consumers denies the effect of the law of demand. The consumer tends to buy those commodities which are in trends in the market even at higher prices. On the other hand, when a product goes out of fashion, a reduction in the price of the product may not increase the demand for it. Change in Demand – Increase / Decrease versus Expansion/Contraction in Demand Movement along the Demand Curve: A demand curve is drawn on the assumption.R that all factors determining the demand behavior of a consumer, other than the price of the good itself, remain the same. When the price of the good changes, the consumer moves along the given demand curve and changes the quantity M demanded of the good. The law of demand tells us that ceteris paribus, an increase in a good’s price causes a decrease in quantity demanded and a decrease in price causes an increase in r. quantity demanded. This change in price causes movement along the demand curve. It is important to note a change in price does not change demand. It only D changes the quantity demanded. SHIFTS IN DEMAND :.R Shifts in demand take place due to changes in non-price factors such as income, population, government policies, tastes, preferences, habits, M fashion etc. Whenever there are favourable changes in these factors then the demand curve shifts outward. It is also known as Increase in Demand. r. Whenever there are unfavourable changes in these factors then the demand curve shifts inward. It is also known as Decrease in D demand.Rightward shifts are always an increase, and leftward shifts are always a decrease. There are non-price determinants of demand; or demand shifters. Rightward shifts are always an increase, and leftward shifts are always a decrease. 1. Consumer tastes and preferences: when goods go in then out of style the demand for those goods increase then decrease. Anything that would cause consumers to like a product more will shift demand to the right and anything that would cause consumers to like a product less will shift demand to the left. 2. Market size (number of consumers): when the number of consumers available to purchase a product changes, the demand curve also shifts. More potential customers shifts demand right and fewer potential customers shifts demand to the left. 3. Prices of related goods: Changes in the prices of substitutes have a direct relationship with changes in demand (when the price of a substitute increases, demand for the good in question also increases) and price changes for complements have an inverse relationship with demand changes (an increase in the price of a complement causes a decrease in the demand for the good in question).If ice cream and frozen yogurt are substitutes then an increase in the price of ice cream will shift the demand for frozen yogurt to the right. If ice cream and hot fudge are complements, an increase in the price of ice cream will shift the demand for hot fudge to the left. 4. Changes in income: When consumers’ incomes rise, they demand more normal goods and fewer inferior goods.If Nike shoes are normal goods, an increase in consumers’ incomes will cause the demand of Nikes to increase. But if store brand cereal (the kind that comes in a bag) is an inferior good, that same increase will cause a decrease in the demand for store brand cereal. 5. Expectations of the future: Predictions about the future impact the demand for a product today (an expected price increase a month from now will cause an increase in demand today)..R M r. D.R M r. D ELASTICITY OF DEMAND Elasticity of demand helps us to estimate the level of change in demand with respect to a change in any of the determinants of demand. The concept of elasticity of demand helps the firm or manager in decision making with respect to pricing, promotion and production policies. It has a very great importance in economic theory as well for formulation of suitable economic policy. Meaning of elasticity: Elasticity is the measure of the degree of responsiveness of change in one variable to the degree of responsiveness change in another variable. Thus, Elasticity = % change in A % change in B The concept of elasticity of demand therefore refers to the degree of responsiveness of quantity demanded of a good to the change in its price, consumers income and price of related goods. 1)Price Elasticity of Demand Price elasticity of demand refers to the responsiveness of demand to a Change in price of a commodity. It may be noted that the price elasticity of demand has a negative sign because of the negative relationship between price and demand. The formula for calculating price elasticity is: ep = Percentage change in quantity demanded Percentage change in price There are five types of Price Elasticity of Demand depending upon the magnitude of response of demand to a change in price.: – 1) Perfectly elastic demand 2) Perfectly inelastic demand.R 3) Relatively elastic demand 4) Relatively inelastic demand M 5) Unitary elastic demand r. D FACTORS AFFECTING PRICE ELASTICITY OF DEMAND The price elasticity of demand depends upon a number of factors which affects its elasticity. They are as follows: a. Nature of goods or commodity: The elasticity of demand for a commodity depends upon the nature of the commodity, i.e., whether the commodity is a necessary, comfort or luxury good. The elasticity of demand for a necessary commodity is relatively small. For example, if the price of such a good rises, its buyers generally are not able to reduce its demand as its necessity commodity. The elasticity of demand for luxury goods is usually high. This is because the consumption of such goods, unlike that of a necessary commodity, can be delayed. That is why if the price of such a commodity increases, the demand for the good can be significantly reduced. b. Availability of Substitute Goods: The price elasticity of demand also depends upon the substitution of goods. If there is a close substitute for a particular commodity in the market, then the demand for such commodity would be relatively more elastic. For example, since tea and coffee are close substitutes for each other in the commodity market, a rise in the price of coffee will result in a considerable fall in its demand and a consequent rise in the demand for tea. Therefore, a demand for coffee will be relatively more elastic because of the availability of tea in the market. c. Alternative and Variety of Uses of the Product: as we know that the resources have an alternative use. The demand for such goods has many uses. The more the alternative and variety of uses of a good, the more would be its elasticity of demand. For example, Electricity is used for many purposes such as lighting, heating, cooking, ironing and also used as a source of power in many industries & households. That is why when the price of electricity increases, its demand will decrease and vice versa. d. Role of Habits and custom: if the consumer has a habit of something, he will not reduce his consumption even if the price of such commodity increases the demand for them does not decrease considerably and so their elasticity of demand will be inelastic. Ex;.R Alcohol, Cigarettes which are injurious for health but people still consume it because of their habit. M e. Income Level of the consumer: The elasticity of demand differs due to the change in the income level of the households. Elasticity of demand for a commodity is low for higher income level groups then r. the people with low incomes. This is because rich people are not influenced much by changes in the price of goods. Poor people are D highly affected by the increase or decrease in the price of goods. As a result, demand for the lower income group is highly elastic in demand. f. Postponement of Consumption: if the consumer postponed the consumption of commodity in future the demand is relatively elastic. For example, commodities whose demand is not urgent, have highly elastic demand as their consumption can be postponed if there is an increase in their prices. However, commodities with urgent demand like medicines have inelastic demand because it is an essential commodity whose consumption cannot be postponed. g. Time Period: Price elasticity of demand is related to a period of time. The elasticity of demand varies directly with the time period. In the short run the demand is generally inelastic and in the long-run it becomes relatively elastic. This is because consumers find it difficult to change their habits, in the short run, in order to respond to the change in the price of the commodity. However, demand is more elastic in the long run as there are other substitutes available in the market, if the price of the given commodity rises. For eg Since the elasticity during the evening is inelastic ,customers are less sensitive to an increase in price. The percentage decrease in number of customers will be less compared with the percentage increase in price thus, increasing revenues. During the afternoon hours, demand is price elastic. Customers are more sensitive to price increase, therefore, charging lower prices will increase number of customers attending the movie theatres, increasing revenues. h.Proportion of income spent: The higher the proportion of income spent on a good and service, the more responsive or sensitive the quantity demanded will be to a change in the price. The price elasticity of quantity demanded is therefore higher and more elastic. The lower the proportion of income spent on a good or service, the less responsive or sensitive the quantity demanded will be to a change in price. The price elasticity of the quantity demanded is therefore lower and more inelastic.For eg Peter's spending on petrol : the high proportion of his income that he spends on petrol makes it more elastic..R DEGREES OF ELASTICITY OF DEMAND Different commodities have different elasticities of demand. Some M commodities have more elastic demand then others, while other commodities have relatively elastic demand. The elasticity of demand ranges from zero to infinity (0-∞). It can be equal to zero, one, less than one, greater than one and equal to unity. r. “The degree of responsiveness to the change in demand in a D market for a commodity is great or small, as the amount demanded increases much or little for a given fall in price and diminishes much or little for a given rise in price of the commodity”. The various level or the degree of elasticity of demand is explained in brief below: There are five types of Price Elasticity of Demand depending upon the magnitude of response of demand to a change in price.: – 6) Perfectly elastic demand 7) Perfectly inelastic demand 8) Relatively elastic demand 9) Relatively inelastic demand 10) Unitary elastic demand 1. Perfectly elastic demand (Ep = ∞): The demand is said to be perfectly elastic, if slight change in price leads to infinite change in the quantity demanded of the commodity. The demand curve under this situation is horizontal straight line parallel to X axis This type of demand curve is relevant in perfect competition. But in the real world, this case is exceptionally rare and is not of any practical interest..R M 2. Perfectly inelastic demand (Ep = 0): The demand is said to be perfectly inelastic, if the demand for a commodity does not change r. with a change in price of the commodity. Under the perfectly D inelastic demand, a rise or fall in price of a commodity the quantity demanded for a commodity remains the same. The elasticity of demand will be equal to zero. The demand curve is a vertical straight line parallel to Y-axis 3. Unitary elastic demand (Ep = 1): Demand is said to be unitary elastic when the percentage change in the quantity demanded for a commodity is equal to the percentage change in its price. The numerical value of unitary elastic of demand is exactly equal to one i.e. Marshall calls it as unit elastic. The demand curve is rectangular hyperbola 4. Relatively Elastic demand (Ep> 1): Demand is said to be relatively elastic, when the percentage change in quantity demanded of a commodity is greater than the percentage change in its price. In other words, it refers to a situation in which a small change in price leads to a great change in quantity demanded. The demand curve under this situation is flatter.Such a demand curve is seen under monopolistic competition..R M r. D Diagram 3.12 5. Relatively Inelastic demand (Ep< 1): Demand is relatively inelastic when the percentage change in the quantity demanded of a commodity is less than the percentage change in the price of the commodity. The demand curve under this situation is steeper shown in Diagram 3.13. Such a demand curve is observed under monopoly market..R Price elasticity of demand can be measured through three popular methods. M These methods are: – Percentage Method – Total Expenditure Method – Graphic Method or Point Method r. 1. Percentage Method According to this method, price elasticity is estimated by dividing the percentage change in quantity demanded by the percentage change in price D of the commodity. Thus, given the percentage change of both quantity demanded and price; the elasticity of demand can be derived. If the percentage change in quantity demanded is greater that the percentage change in price, the elasticity will be greater than one. If percentage change in quantity demanded is less than percentage change in price, the elasticity is said to be less than one. But if percentage change of both quantity demanded and price is same, elasticity of demand is said to be unit. 2. Total Expenditure Method: Total expenditure method was formulated by Alfred Marshall. The elasticity of demand can be measured on the basis of change in total expenditure in response to a change in price.. Total Outlay/ Expenditure = Price x Quantity Demanded If, with a fall in price, it is found that the expenditure remains the same, elasticity of demand is said to be one (Ed = 1),.R if the total expenditure increases the elasticity of demand is said to be greater than one (Ed> 1), if the total expenditure diminishes with the fall in price, elasticity of demand is less M than one (Ed< 1), and vice-versa. r. TYPES OF ELASTICITY OF DEMAND D 1.INCOME ELASTICITY OF DEMAND The consumer’s income is one of the important determinants of demand for a commodity. The demand for a commodity and consumer’s income is directly related to each other, unlike price-demand relationships. Income elasticity of demand shows the degree of responsiveness of quantity demanded of a commodity to a small change in the income of a consumer. Percentage change in Quantity Income Elasticity = demanded of a commodity/ Percentage change in income Classification of goods based on income elasticity of demand: We can broadly classify the various goods on the basis of value of income elasticity of demand. 1. Normal Goods: Normal goods are those goods which are usually purchased by a consumer as his income increases. In other words, normal goods means an increase in income causes an increase in the demand for a commodity. It has a positive income elasticity of demand. Normal goods are further classified as: 2. Inferior goods: Inferior goods are those goods where a consumer buys less of goods as his income increases. Goods having negative income elasticity are known as inferior goods. Demand falls as income rises. For example as income increases, the demand for higher quality cereals goes up against the low-quality cheap cereals. Normal goods have a positive income elasticity coefficient since increases in incomes cause increases in the demand for normal goods. Inferior goods have a negative income elasticity coefficient. This is because.R increases in incomes cause decreases in the demand for inferior goods. 2. CROSS ELASTICITY OF DEMAND M Cross elasticity of demand measures the degree of responsiveness of demand for one good in response to the change in the price of another good. r. Cross-price elasticity is about substitutes and complements. Substitutes are goods that can be used in place of each other; like butter and margarine, or jam and jelly. When the D price of one increases, the demand for the other also increases. Complements are goods that are used together; like bread and butter or tooth brushes and toothpaste. When the price of one increases, demand fbor the other decreases. When there is a change in the price of substitute or complement, the demand for the good in question will change. The formula for cross-price elasticity is %∆Q of X / %∆P of Y (P is the price of the other good). Substitute goods will have a positive coefficient because an increase in the price of a substitute will cause an increase in the demand for the good in question. Complementary goods will have a negative coefficient because an increase in the price of a complement will cause a decrease in the demand for the good in question. 3.PROMOTIONAL ELASTICITY OF DEMAND It is also known as ‘Advertisement elasticity’. In modern times an increase in expenditure on advertisement or promotion leads to an increase in the demand for a commodity Promotional elasticity of demand is the proportional change in quantity demand due to proportionate change in promotional expenditure. The greater the elasticity of demand, its better for a firm to spend more on promotional activities. The promotional elasticity of demand is usually positive. CONCEPT OF SUPPLY Supply represents how much the market can offer. The quantity supplied refers to the amount a good producer are willing to supply when receiving a certain price. The supply of a good or service refers to the quantities of that good or service that producers are prepared to offer for sale at a set of prices over a period of time..R Determinants of Supply M (a) Costs of the Factors of Production: The cost of factor inputs such as land, labour, capital etc. is one of the determinant factors which influence the market supply of a product. For instance, if the price of labour goes up, then the supply of the product will decline due to higher labor cost. r. (b) Change in Technology: The change in technology as a result of constant D research and development activities in terms of improved machinery, improved methods of organization and management helps the business units or firms to reduce the cost of production. All this contributes significantly to the increase in market supply at given prices. (c) Price of Related Goods (Substitutes): Prices of related commodities also affect the supply of a commodity (say X). If the price of a substitute good, Y increases, the supply for that good increases and the producer would shift the allocation of resources to Y from X. (d) Change in the Number of Firms in the Industry (Market): A change in the number of firms in the industry as a result of profitability also influences the market supply of a good. For example, an increase in number of firms in the industry attracted by higher profit would increase the quantity supplied of good at given prices. (e) Taxes and Subsidies: A change in government fiscal policy in terms of change in tax rate or amount of subsidy may influence the supply of a good in the market. A decrease/increase in the amount of tax/ subsidy on the good would allow firms to offer larger amount of a good at a given prices. (f) Goal of a Business Firm: The goal of a business firm such as profit maximization, sales maximization or both is also responsible to influence the market supply of a good or service. In case the firm is interested to maximize profit, the same may be attained by decreasing the market supply of a good under certain conditions whereas goal of sales maximization will be attained by increasing the supply. (g) Natural Factors: Natural Factors such as climatic changes, particularly in the case of agricultural products influence the supply. Law of Supply The law of supply states that a firm will produce and offer to sell greater quantities of a product or service as the price of that product or service rises, other things being equal. There is direct relationship between price and quantity supplied. It may be noted that at higher prices, there is greater incentive to the producers or firms to produce and sell more. Other things include cost of.R production, change of technology, prices of inputs, level of competition, size of industry, government policy and non-economic factors. Thus ‘Ceteris Paribus’; M (a) With an increase in the price of a good, the producer is willing to offer more quantity in the market for sale. (b) The quantity supplied is related to the specified time interval over which it is offered. r. Supply Schedule: A supply schedule is a tabular statement that shows different D quantities or services that are offered by the firm or producer in the market for sale at different prices at a given time. It describes the relationship between quantities supplied of a good in response to its price per unit, while all non-price variables remain unchanged.. There are two types of supply schedule, namely – individual supply schedule – market supply schedule Individual Supply Schedule: It relates the supply of a good or service by one firm at different prices, other things remain constant or equal. Table 2.3 shows that as the price of good X increases from Rs. 10 to 60 the corresponding supply of the commodity increases from 1000 units to 6000 units. Market Supply Schedule: The market supply schedule, on the other hand, like market demand schedule is the sum of the amounts of good supplied for sale by all the firms or producers in the market at different prices during a given time. Let us assume, there are two producers for a good (Table, 2.4). At price Rs. 10 per unit, producer A sells 1000 units and producer B offers 2000 units. Hence the total market supply at Rs. 10 per unit is 3000. As price increases from Rs 10 to Rs. 50, the market supply increases from 3000 units to 11000 units..R M r. D Supply Curve: The supply curve is a graphical representation of the information given in the supply schedule. The higher the price of the commodity or product, the greater will be the quantity of supply offered by the producer for sale and vice versa, other things remain constant.shows supply curve of producer A, where X-axis is quantity supplied and Y-axis shows prices. As the price increases from 10 to 60 the quantity supplied rises from 1000 to 6000, establishing a positive relation among the two.This implies that the supply curve is upward sloping. Change in Supply – Increase / Decrease versus Expansion/Contraction in Supply Movement along the Supply Curve: An increase in price will increase the quantity supplied, but a decrease in price will reduce the quantity supplied. The.R supply curve is positively sloped- upward and to the right, as against the demand curve which is negatively sloped. A reduction in quantity of supply on account of a decrease in price is termed as ‘contraction’ in supply. In this case, the supplier moves downwards along the supply curve. In contrast, if the price M of the good rises, the supplier moves upwards along the supply curve and offers to sell more of the good. This is termed as ‘expansion’ in supply. r. D SHIFTS / CHANGES IN SUPPLY Shifts in supply take place due to changes in non-price factors such as cost of production, government policies, state of technology etc. Whenever there are favourable changes in these factors then the supply curve shifts outward. It is also known as Increase in supply. Whenever there are unfavourable changes in these factors then the supply curve shifts inward. It is also known as Decrease in supply..R M r. D Equilibrium, Excess Demand and Excess Supply The Market: A market is a mechanism through which buyers and sellers interact. It is common to think of markets as a cluster of shops selling various goods. But a market does not have to be a physical space. If buyers and sellers interact ‘virtually’ (e.g., online shopping), that is still a market. All buyers and sellers of a particular commodity together constitute the market for that commodity. The number of buyers and sellers in the market determines the ‘structure’ of the market. How markets work. Consider the market for sugar. The table on your screen depicts the quantities of sugar demanded and supplied in a market every day. Market Demand and Supply Schedule of Sugar A B C D E Price Market Demand Market Supply Demand – Supply Excess (Rs.) (Kg/day) (Kg/day) (Kg/day) demand/supp ly 20 1000 200 800 Excess Demand 40 800 400 400 Excess Demand 60 600 600 0 Equilibrium 80 400 800 -400 Excess Supply 100 200 1000 -800 Excess Supply The first row of the table shows that when the price of the sugar is Rs. 20, market demand for sugar is 1000 Kg/day and the supply is 200 kg/day. Demand is more than supply at this price, and this is called ‘excess demand’. In such a situation, consumers.R are likely to offer to pay a higher price for the available quantity of sugar. Sellers will also want to sell to whoever is willing to pay the most. As a result, the price of sugar begins to increase. M Suppose the market price rises to Rs.100. The last row of the table shows how at this price, the quantity demanded is 200 kg/day, but the quantity supplied is now 1000 r. kg/day. Supply now exceeds demand, and we have a situation of excess supply. Sellers will find that they have unsold stocks. They begin to reduce prices in a bid to clear D these excess stocks. Eventually the price will settle at Rs.60. At this price, consumers want to purchase 600 kg/day of sugar, which is exactly the quantity that the sellers want to sell. The plans of sellers and buyers match! Demand equals supply. This is called equilibrium. Market Equilibrium: A market is said to be in equilibrium if there is no tendency for the price prevailing in the market, and the quantity bought and sold at that price, to change. This happens when market demand equals market supply. Equilibrium Price: Equilibrium price is the price at which the quantity demanded exactly equals the quantity supplied. This price remains unchanged as long as there is no change in any of the variables affecting demand and supply. Equilibrium quantity: The quantity of the commodity which is bought and sold at the equilibrium price is called equilibrium quantity. The table can be represented diagrammatically as in Figure 1: Figure 1: Excess Demand And Excess Supply In this diagram, DD represents the demand curve and SS represents the supply curve. Market equilibrium occurs where the demand curve intersects the supply curve (at point E). E is described by the price-quantity combination (Rs.60, 600 kg/day). At any price above Rs. 60, we have a situation of excess supply. At any price below.R Rs.60, we have a situation of excess demand. M It is important to understand the ROLE OF MARKET PRICES in achieving equilibrium in the market. If there is excess demand in the market, some consumers are not getting what they want to buy. The increase in price acts like a signal to sellers to raise the quantity supplied. It also acts as a signal to consumers to lower the r. quantity demanded. Conversely, if there is excess supply in the market, a decrease in prices signals to the producers to lower the quantity supplied. It signals the consumer D to raise the quantity demanded. So sellers and buyers don’t need to know each others’ plans regarding how much to sell and buy. They only need to respond to price signals. i.Effects of Change in demand (Shift in demand curve) ii. Effects of Change in Supply (Shift in supply curve) Recall that an individual’s demand curve is drawn assuming that “other things remain the same '' i.e., the income of the consumer, prices of other commodities, and the consumer’s preferences remain unchanged. If any of these factors change, the consumer’s demand curve shifts. A shift in the individual consumer’s demand curve will cause the market demand curve to shift correspondingly. Similarly, the supply curve is also drawn up assuming that “other things remain the same '' i.e., technology, prices of factors of production etc. remain unchanged. If any of these factors change, the firm’s supply curve shifts. A shift in the individual firm’s supply curve will cause the market supply curve to shift correspondingly. In this section we explore the impact of shifts in the demand and supply curves on the market equilibrium. 1. Effect of shift of demand curve (increase in demand) Fig-2: Effect of shift of demand curve (increase in demand) We start with the demand curve DD and supply curve SS. DD and SS intersect at point E. The equilibrium price is OP and equilibrium quantity is OQ. Suppose incomes of consumers increase. This ‘increases’ the demand, and the demand curve shifts from DD to D1D1. At the price OP, the demand is now OQ2. The supply has not changed, so supply remains OQ. This leads to an excess demand equal to QQ2 at the given price OP. Because of this excess.R demand, price of the commodity rises. As price rises, law of demand comes in to effect and quantity demanded starts falling along D1D1. As price rises, law of supply also comes in to effect and quantity supplied starts rising (along SS) M These changes continue till quantity demanded and quantity supplied are equal at points E1. Notice that E1 is the intersection of the supply curve SS, with the new demand curve D1D1. Equilibrium price rises from OP to OP1 and equilibrium quantity rises from OQ to OQ1. r. Thus, when the demand curve shifts rightward (i.e. when demand for a commodity increases while supply remains constant), equilibrium price and D quantity both increase. 2. Effect of leftward shift of demand curve (decrease in demand) Fig 3: Effect of leftward shift of demand curve (decrease in demand).R Let us now see what happens if the demand curve shifts leftwards. Like in our previous diagram, suppose the equilibrium price is OP and equilibrium quantity is OQ, and suppose now that the income of consumers decreases. This will cause the demand to decrease. The decrease in demand shifts the demand M curve from DD to D2D2 to the left. At the price OP, the demand now falls to OQ1, leading to an excess supply equal to Q1Q2. Since sellers will not be able to sell all what they want to sell, there will be competition among sellers which r. results in the fall in price. As the price falls, law of demand comes in operation and quantity demanded starts rising along D2D2. As price falls, law of supply D comes in to operation and quantity supplied starts falling (along SS). This change continues till quantity demand and quantity supplied are equal. This happens at the new equilibrium point E2, which is the intersection of the supply curve SS with the new demand curve D2D2 Equilibrium price falls from OP to OP2 and equilibrium quantity falls from OQ to OQ2 Thus, when demand curve shifts leftward (i.e. when demand for a commodity decreases while supply remains constant.), equilibrium price and quantity will decrease. 3. Effect of Rightward Shift in Supply Curve (Increase in Supply) Fig-4. Effect of Rightward Shift in Supply Curve (Increase in Supply).R Suppose the supply curve shifts to the right to S1S1 say because of a drop in labour wages. As the cost of production drops, firms can supply more and M hence the supply increases at every price. Given the price OP, firms are now willing to supply OQ2. This leads to an excess supply equal to QQ2 at the given price OP. Since the seller will not be able to sell that quantity at the initial price, there will be competition among sellers, which result in fall in price. As r. price falls, law of demand comes in to effect and quantity demanded starts rising. Eventually, the new equilibrium point E1 is attained at the intersection of D the demand curve DD with the new supply curve S1S1. Equilibrium price falls from OP to OP1 and equilibrium quantity rises from OQ to OQ1 So, when the supply curve shifts rightward (i.e., when supply for a commodity increases while demand remains constant), equilibrium price falls but equilibrium quantity rises. 4. Effects of Leftward Shift in Supply Curve (Decrease in Supply) Fig-5 Effects of Leftward Shift in Supply Curve (Decrease in Supply) Similarly, if labour wages increase, the cost of production rises. This will cause the supply to decrease from SS to S2S2. With a constant demand curve, we now have a situation of excess demand. The new equilibrium point E2 is attained at the intersection.R of the new supply curve, S2S2 with the demand curve DD. Equilibrium price rises from OP to OP2 and equilibrium quantity falls from OQ to OQ2. When supply curve shifts towards leftward (i.e., when supply for a commodity increases M while demand remains constant.), equilibrium price increases, while the equilibrium quantity falls. Simultaneous Change in demand and Supply and Market Equilibrium and its effect on equilibrium price and quantity: r. (a) Effect of simultaneous rightward shift (i.e. increase) in demand and supply. D An increase in supply leads to increase in equilibrium quantity and decrease in equilibrium price. An increase in demand leads to increase in both equilibrium quantity and equilibrium price. What happens when both demand and supply increase simultaneously? Clearly, equilibrium quantity will rise. What about the price? That will depend on which is the larger effect on price: the effect of the change in demand or the effect of the change in supply. Accordingly, three possibilities may occur. Price may increase, decrease or remain unchanged. 1. When effect of the increase in demand on equilibrium price is equal to effect on increase in supply: Fig-6: Effect of the increase in demand on price equals effect of increase in supply Consider the figure where the original demand and supply curves DD and SS intersect each other at the initial equilibrium point E, with equilibrium price =.R OP and equilibrium quantity = OQ. An increase in demand and supply result in rightward shifts to D1D1 and S1S1. Increase in demand (AB) is equal to increase in supply (CD). The new demand and supply curve intersect at point E1. The M equilibrium price remains the same at OP but equilibrium quantity rises from OQ to OQ1. r. 2. When the effect of increase in demand on equilibrium price is less than the effect of the increase in supply D

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