Demand and Supply:

Key to Economics
 Demand refers to Cont…

(a) the desire to have possession and

(b) the willingness and abilityto pay for
that possession.
Thus demand in the economists' does not
mean the wants, desire or need for
people since these may not be backed up
by the ability to pay. But it is the amount
the consumers are willing to pay at a
given price over a given period of time.
Demand for any commodity is the Cont…

desire for that commodity backed by

willingness as well as ability to pay for
it and is always defined with reference
to a particular time and given values of
variables on which it depends.
The market demand curve (just
demand curve) shows the relationship
between the price of a good and the
quantity demanded by individuals
Cont…
 Cont…
Each point on the curve shows the total
quantity that buyers would choose to
buy at a specific price.
A fundamental characteristic of
demand is that all other things
constant, as price fall/rise the quantity
demanded will rises/falls respectively-
law of demand.
In short there is a negative relationship
between price and quantity demand.
If the price of wine rises from $2.00 toCont…
$4.00 per bottle, the number of bottles
demanded falls from 6,000 to 4,000. This
is a movement along the demand curve,
from point B to point A, and we call it a
decrease in quantity demanded.
More generally, a change in a good’s
price causes us to move along the
demand curve.
We call this a change in quantity
demanded.
Change in Demand
The new demand curve lies to the rightCont…
of
the old curve. For example, at a price of
$2.00, the old demand curve told us that
the quantity demanded was 6,000 bottles
(point B).
But after the increase in income, buyers
would want to buy 8,000 bottles at that
price (point C).
Rise in household income has shifted the
demand curve to the right. We call this an
increase in demand.
Determinants
 of Demand
Price of the product( own price )
Consumer's income
Consumer's preferences
Prices of related goods
Population and distribution
Consumer's expectations of future price
 A Change in Demand
A change in demand is a change in the amount of
a good demanded resulting from a change in
something other than the price of the good, which
causes a shift of the entire demand curve.

An increase in
demand
(rightward shift)
results in higher
quantity
demanded at each
price level.
Shifting the Demand Curve
Changes in determinants
of demand other than price
cause the demand curve to
shift.

 A rightward
shift shows an
increase in
demand and a
leftward shift a
decrease in
demand.
Causes of a Decrease in
 A decrease in
Demand Less preference for the

income (normal good in question
goods) or an
increase in income  An expectation of lower
(inferior goods) future prices
 A decrease in the
price of a
 A decrease in the
substitute good number of consumers
 An increase in the
price of a
complementary
good
 Elasticity of demand
We are quite aware from our previous
discussion that whenever the price of the good
goes up, the quantity demand generally goes
down (the law of demand)
But what is missing from the law of demand is
that the extent to which this quantity demanded
will fall.
It is not enough for the businessmen to only
know the negative relationship that exists
between price and quantity demand.
Businesses also need to forecast the Cont…
effect of the price changes on their
revenue and buyers sensitivity to price
changes.
The coefficient of elasticity of demand
is the percentage change in quantity
demanded divided by the percentage
change in price.
Price Elasticity of Demand (Ed)
It measures the
responsiveness
of buyers’
quantity
demanded to
changes in
price of the
good.
The price elasticity of demand ranges from zero to
infinity, but can be categorized as
Elastic demand: it is when Ed >1 e.g.
if a 1% change in the price results in a
3% change in quantity demand.
Inelastic demand: it is when If Ed<1,
if a 3% change in the price results in a
1% change in quantity demand.
Unitary elastic: it is when Ed=1 if a
2% change in the price results in a 2%
change in quantity demand.
Practical uses of Price elasticity of demand
Businessmen trying to enhance his total
sales revenue would like to know
whether rising or reducing the price of
the product will increase the revenue.
Along the demand curve price and
quantity always move in opposite
direction. How a change in price affect
total revenue (price x quantity)
depends up on elasticity of demand.
Total Revenue and Elastic Demand Relationship
Cont….
Cont…
 Cont….
If the seller reduces price and demand for
the product is found to be elastic, total
revenue will increase.
The price cut reduces total revenue the
rise in quantity demand, caused by price
cuts, increases the total revenue.
Demand is elastic means that when price
is reduced by a given percent ,quantity
demanded increases by more than that
percent and as a consequence total
revenue increases.
Total Revenue and Inelastic Demand Relationship
Cont…
Cont…
 Cont….
If demand is inelastic, then the total
revenue will fall when its price fall.
Hence, when demand is inelastic, it is
better for a profit maximizing firm to
increase price.
If demand is unitary elastic, a fall in
price doesn’t change total revenue.
Revenue doesn’t change when price
changes is unitary elastic.
Total Revenue and Unitary Elastic Relationship
An increase or decrease in the price leaves total
revenue unchanged. The loss in revenue from a
lower price is exactly offset by the gain in
revenue from accompanying increase in sales.
For example:
Price of movie tickets is $6 per ticket and 1,000
tickets are sold
Price of movie tickets goes to $5 per ticket and
1,200 tickets are sold
TR = $6 X 1,000 = $6,000
TR = $5 X 1,200 = $6,000 No change in total
revenue
Cont…
Cross price elasticity of demand

(E ab
)
This is a measure of
responsiveness of
quantity demanded
of one good to
changes in the price
of another good.
The numerical vale,
Eab which measures
the strength of the
relation between two
goods
 Cont…

Substitute goods: if cross elasticity of

demand of demand is positive. The larger
the positive coefficient, the greater the
substitutability between the he two
products.
Complementary goods: it is when the
cross elasticity is negative. The larger the
negative coefficient, the greater the
complementarily between two goods.
Independent goods: a zero cross
elasticity suggests that the two products
are unrelated or independent goods.
 Cont…
Income Elasticity
It is percentage change in quantity demanded
divided by percentage change in income.
em=percentage change in quantity demanded
Percentage change in income
Based on em Commodities can be classified
into
1.Luxury
2.Basic necessities
3.Inferior goods
Utility
Utility is the level of satisfaction that is
obtained by consuming a commodity or
undertaking an activity.
 In defining strict preference, given any two
consumption bundles(X1,Y1) and (X2,Y2),the
consumer definitely wants the X bundle than
the Y bundle if (X1,Y1) > (X2,Y2).
This means, the consumer preferred bundle
(X1,Y1) to bundle (X2,Y2) if and only if the
utility (X1,Y1) is larger than the utility of
(X2,Y2).
 Cont..
A Consumer considers the following points to
get maximum utility or level of satisfaction:
How much satisfaction he gets from buying
and then consuming an extra unit of a good
or service.
The price he pays to get the good.
The satisfaction he gets from consuming
alternative products.
The prices of alternative goods and services.
Approaches to measure Utility
1. The Cardinal Utility theory
Utility maximization theories are
important to deal with consumer behavior.
Neo classical economists argued that
utility is measurable like weight, height,
temperature and they suggested a unit of
measurement of satisfaction called utils.
A util is a cardinal number like 1, 2, 3 etc
simply attached to utility.
Assumptions of Cardinal Utility theory
Rationality of Consumers
Utility is cardinally Measurable
Constant Marginal Utility of Money
Limited Money Income.
Diminishing Marginal Utility (DMU).
Total Utility (TU): It refers to the total Cont…

amount of satisfaction a consumer gets from

consuming or possessing some specific
quantities of a commodity at a particular
time.
Marginal Utility (MU): It refers to the
additional utility obtained from consuming
an additional unit of a commodity
Law of Diminishing Marginal Utility (LDMU)
The utility that a consumer gets by
consuming a commodity for the first
time is not the same as the consumption
of the good for the second, third, fourth,
etc.
The Law of Diminishing Marginal
Utility States that as the quantity
consumed of a commodity increases per
unit of time, the utility derived from
each successive unit decreases.
Equilibrium of a consumer
A consumer that maximizes utility reaches
his/her equilibrium position when allocation
of his/her expenditure is such that the last
birr spent on each commodity yields the
same utility.
For example, if the consumer consumes a
bundle of n commodities i.e x1, x2,…, xn,
he/she would be equilibrium or utility is
maximized if and only if:
Limitation of the Cardinalist approach
The assumption of cardinal utility is
doubtful because utility may not be
quantified.
Utility cannot be measured absolutely
(objectively). The satisfaction obtained from
different commodities cannot be measured
objectively.
The assumption of constant MU of money is
unrealistic because as income increases,
the marginal utility of money changes.
The Ordinal Utility Theory
In this approach, utility cannot be measured
absolutely but different consumption bundles
are ranked according to preferences.
The concept is based on the fact that it may
not be possible for consumers to express the
utility of various commodities they consume
in absolute terms, like, 1 util, 2 util, or 3 util,
but it is always possible for the consumers to
express the utility in relative terms.
It is practically possible for the consumers to
rank commodities in the order of their
preference as and so on.
Assumptions of Ordinal Utility theory
The Consumers are rational-they aim at
maximizing their satisfaction or utility
The total utility of the consumer depends on
the quantities of the commodities consumed
 Diminishing Marginal Rate of Substitution
(MRS): The marginal rate of substitution is
the rate at which a consumer is willing to
substitute one commodity (x) for another
commodity (y) so that his total satisfaction
remains the same.
Utility is ordinal, i.e. utility is not absolutely
(cardinally) measurable.
Indifference Set/ Schedule: It shows the various
combinations of goods from which the consumer
derives the same level of utility.
Special Indifference
Convexity Curves
or down ward sloping is among
the characteristics of indifference curve
and this shape of indifference curve is for
most goods.
In this situation, we assume that two
commodities such as x and y can
substitute one another to a certain extent
but are not perfect substitutes.
However, the shape of the indifference
curve will be different if commodities have
some other unique relationship such as
perfect substitution or complementary.
Perfect substitutes: If two commodities are
perfect substitutes (if they are essentially the
same), the indifference curve becomes a
straight line with a negative slope. MRS for
perfect substitutes is constant.
Perfect complements: If two commodities
are perfect complements the indifference
curve takes the shape of a right angle. MRS
for perfect complements is zero
A useless good: Increasing purchases of
out-dated books does not increase utility.
This person enjoys a higher level of utility
only by getting additional food consumption.
The Budget Line or the Price line
Indifference curves only tell us about the
consumer’s preferences for any two goods but
they cannot tell us which combinations of the
two goods will be chosen or bought.
In reality, the consumer is constrained by
his/her money income and prices of the two
commodities.
The budget line indicating different
combinations of two goods that a consumer
can buy with a given income at a given prices.
Optimum of the Consumer
A rational consumer seeks to maximize
his utility or satisfaction by spending
his or her income.
It maximizes the utility by trying to
attain the highest possible indifference
curve, given the budget line.
This occurs where an indifference curve
is tangent to the budget line so that the
slope of the indifference curve ( MRSxy)
is equal to the slope of the budget line
Px/Py
Optimum of a consumer
Mathematical derivation of equilibrium
Cont….
Cont…
 Supply
When we discussed demand, we noted that
each buyer comes to a market with a goal
to make himself as well off as possible. But
the buyer also faces a constraint. He must
pay for purchases out of a limited income.
A seller, too, comes to a market with a
goal to make as much profit as possible.
And if the seller is a business firm it faces
an important constraint: (1) its production
technology, (2) the prices it must pay for
its inputs, and (3) the market price of its
output.
Together, the firm’s goal of earning the Cont…
highest possible profit, and the constraints
that it faces, determine the quantity that it
will supply in the market. More
specifically, a firm’s quantity supplied of
any good is the amount it would choose to
produce and sell at a particular price.
The law of supply states that when the
price of a good rises, and everything else
remains the same, the quantity of the good
supplied will rise.
Variables that can shift the supply curve
Prices of Inputs
Profitability of Alternate Goods
Technology
Productive Capacity
Expectations of Future Prices
 Market Equilibrium
The usual justification for the competitive-market
assumption is that each consumer or producer is
a small part of the market as a whole and thus
has a negligible effect on the market price; it is
the actions of all the agents together determine
the market price.
The equilibrium price of a good is that price
where the supply of the good equals the demand
If we let D(p) to be the market demand curve and
S(p) the market supply curve, the equilibrium
price is the price p* that solves the equation.
D(p*)=S(p*)
Market Equilibrium
Market equilibrium
is a situation in which, at
the current market price,
quantity supplied equals
quantity demanded.

 When the market is in

equilibrium, there is
no tendency for the
price to increase or
decrease.
What happens in a market when a tax is imposed
Suppose that the supplier is required to
pay tax. Then the amount supplied will
depend on the supply price- the amount
the supplier actually gets after paying
the tax- and the amount demanded will
depend on the demand price- the
amount that the demander pays.
The amount that the supplier gets will
be the amount the demander pays minus
the amount of the tax.
Passing along a Tax
Often tax on producers does not hurt profits since
firms can simply pass along a tax to consumers. How
much of a tax gets passed along will therefore
depend on the characteristics of demand and supply.
If an industry has a horizontal supply curve, it means
that the industry will supply any amount desired of
the good at some given price.
In this case the price is entirely determined by the
supply curve and the quantity sold is determined by
demand.
If an industry has a vertical supply curve, it means
that the quantity of the good is fixed. The equilibrium
price of the good is determined entirely by demand.
In the case of perfectly elastic supply curve it is Cont…
easy to see that the price to the consumers goes up
by exactly the amount of the tax. The supply price is
exactly the same as it was before the tax, and the
demanders end up paying the entire tax.
The horizontal supply curve means that the industry
is willing to supply any amount of the good at some
particular price, p*, and zero amount at any lower
price.
If any amount of the good is going to be sold at all
any equilibrium, the suppliers must receive p* for
selling It.
This effectively determines the equilibrium supply
price, and the demand price is p* + t.
If the supply curve is vertical and we shift theCont….
supply curve up we don’t change anything in the
diagram.
The supply curve just slides along itself, and we
still have the same amount of the good supplied,
with or without the tax.
 In this case, the demanders determine the
equilibrium price of the good, and they are
willing to pay a certain amount, P*, for the
supply of the good, that is available, tax or no
tax. Thus they end up paying p*-t. the entire
amount of the tax is paid by the suppliers.