Demand Supply and The Market Equilibrium

The product market is where the two sides interact:

The Consumers’ Side The Producers’ side

• Consumers create DEMAND for the product.

• Producers SUPPLY the product

The Consumers’ Choice

• Who are the consumers?

- Those who demand the product.

For final products (processed food, ready-made clothing etc.) the end user demand the product.

For Intermediate goods (Chemicals used in textile industry, transport / logistic services used for exports) the downstream firm creates the demand.

Demand for Final Products

Demand for the final Product (PIZZA, say.)

QD or Quantity Demanded by consumers of pizza depends on

• Price of pizzas – P

• Aggregate Income of the consumers - I

• Taste of the Consumer – T

QD = D ( P, I, T)

Where D (P, I, T) represents the demand function .

Relation between

price and quantity demanded

• Given a fixed income level and unchanging tastes, larger quantity of pizzas are demanded at lower prices.

• When pizzas become expensive some consumers switch to other foods and buy less pizzas.

• As price of pizzas increase from $5 to $10, quantity demanded falls from 5 to 2.

Quantity demanded of pizzas QD

Price of pizzas

P

P = $10

P = $5

QD = 2

QD = 5

Demand for

pizzas D(P,I,T)

Demand for Pizzas

Relation between

income and quantity demanded

• If income level (I) increases form I1 to I2, consumers demand higher quantity of pizzas even if price is unchanged at $10.

• D1 = D ( P, I1, T)D2 = D ( P, I2, T)

• As Income increases from I1 to I2 while price remains $10, quantity demanded rises from 2 to 4.

QD

P

P = $10

QD = 2

QD = 4

D1

D2

Relation between tastes and quantity demanded

• If consumers’ tastes move in favour of pizzas, higher quantity is demanded even if price is unchanged at $10

• D = D ( P, I, T)D’ = D ( P, I, T’)

T’ – a more favourable taste for pizzas than T

QD

Price of pizzas

P

P = $10

QD = 2

QD = 4

D

D’

Endogenous and exogenous variables

Note that

• when price changed, quantity demanded changed following the demand curve.

• When income and taste changed, the demand curve shifted.

In a price – quantity plane,

• Price and quantity are Endogenous Variables

• All other variables (income / tastes etc.) are Exogenous Variables

Endogenous and exogenous variables…Cont.

Endogenous Variables – Variables which are explained within the model. • Here changes in price and quantity demanded of pizzas can be

explained within the model.

Exogenous Variables – Variables that are not explained within the model.• Here changes in income or taste is not explained within the

model. • Nevertheless exogenous variables (income / tastes) case changes

in the endogenous variables (Price , quantity).

A Distinction: ‘quantity demanded’ & ‘demand’

Quantity demanded:

• At any given price level the quantity of the product that the consumers demand is called ‘quantity demanded’.

• To specify quantity demanded one must specify the price.

Demand:

• By ‘Demand’ we imply the demand curve.

• By ‘change in demand’ we mean change in quantity demanded at each price level.

• A change in demand is depicted by a shift in the demand curve either to the left or to the right.

Exercise 1

Bread and butter are consumed together.

Suppose for some reason price of bread has increased. How should it affect the demand for butter?

an increase in the price of watches (b)

a decrease in the price of watches

• When price of bread rises, quantity demanded of bread should fall.

• If bread is consumed less, then there is reduced demand for butter as well.

Quantity demanded of bread QxD

Price of bread

Px

Px2

Px1

Qx2 Qx1

Demand for

bread D(P,I,T)

Demand for bread

• And demand for butter would be reduced no matter what the price of butter is.

• given price of butter at Py1, reduced consumption of bread has caused the quality demanded of butter to fall from Qy1 to Qy’1

• similarly, if the price of butter is at Py2, reduced consumption of bread has caused the quality demanded of butter to fall from Qy2 to Qy’2

•This implies a leftward shift of the demand curve for butter.

Quantity demanded of butter QyD

Price of butter

Py

Py2

Py1

Qy’2 Qy’1

Demand for butter

Dy’

Dy

Qy2 Qy1

• If price of bread increases demand for butter falls.

• If price of a good increases, demand for the ‘complementary’ good falls.

• Price of a good and the demand for its complements are inversely related

Conclusion

Exercise 2

Jam and butter are substitutes.

How would a rise in price of butter affect the demand for Jam?

• When price of butter rises, quantity demanded of butter should fall.

• If butter is consumed less, then its substitute – Jam should be consumed more.

• This should increase the quantity demanded for Jam at all price levels.

Quantity demanded of butter QyD

Price of butter

Py

Py2

Py1

Qy2 Qy1

Demand for

butter D(P,I,T)

Demand for butter

• given price of jam at Pz1, reduced consumption of butter has caused the quality demanded of jam to rise from Qz1 to Qz’1

• similarly, if the price of jam is at Pz2, reduced consumption of butter has caused the quality demanded of jam to rise from Qz2 to Qz’2

• This implies a rightward shift of the demand curve for Jam. Quantity

demanded of Jam QzD

Price of Jam

Pz

Pz2

Pz1

Qz2 Qz1

Demand for Jam

Dz

Dz’

Qz’2 Qz’1

• If price of butter increases demand for jam rises.

• If price of a good increases, demand for the ‘substitute’ good increases.

• Price of a good and demand for its substitutes are directly related

Conclusion

Exercise 3

Which of the following shifts the demand for watches to the right?

(a) an increase in the price of watches (b) a decrease in the price of watch batteries if watch batteries

and watches are complements (c) a decrease in income levels of consumers (d) a decrease in the price of watches

a) If price of watches increases quantity demanded of watches falls following the demand curve.

Quantity demanded of watches QwD

Price of watches

Pw

Pw2

Pw1

Qw2 Qw1

Demand for

watches D(P,I,T)

Demand for watches

b) If price of watch batteries decreases, using watch becomes cheaper. This raises the demand for watches. Given any price for buying watches more quantity of watches would be demanded.

The demand curve for watches shifts to the right.

Quantity demanded of watches QwD

Price of watches

Pw

Pw1

Qw1 Qw’1

New Demand for

watches

Demand for watches

Demand for

watches

c) a decrease in income levels of consumers will cause consumers to demand less quantity of watches at every price level.

This will shift the demand curve to the left.

Quantity demanded of watches QwD

Price of watches

Pw

Pw1

Qw1 Qw’1

New Demand for

watches

Demand for watches

Demand for

watches

d) If price of watches decreases quantity demanded of watches rise following the demand curve.

Quantity demanded of watches QwD

Price of watches

Pw

Pw1

Pw2

Qw1 Qw2

Demand for

watches D(P,I,T)

Demand for watches

Demand for Intermediate Products

Relation between

price and quantity demanded

• Similar to the case of final products, demand for intermediate goods and its price is inversely related.

• If price of an intermediate good (flour here) falls from $7 to $3, pizza making will be cheaper. This will lead to a fall in pizza prices, and hence a rise in quantity demanded of pizzas.

• To make larger quantities of pizzas, demand for flour would rise from 20Kg to 50 Kg.

Quantity demanded of flour QD

Price of flour

P

P = $7

P = $3

QD = 20Kg

QD = 50 Kg

Demand for flour

D(P,I,T)

Demand for flour (used in pizzas)

Exercise 4

Suppose India gains a new export market in Korea for textiles produced with India cotton.

How will this affect the demand for domestic cotton producers?

Simple!

• Domestic textile producers will demand more cotton, irrespective of its price.

• This will raise the quantity demanded for domestic cotton at each level of price of cotton.

• As a result the demand curve for cotton will shift to the right. Quantity demanded of

watches QcD

Price of cotton

Pc

Pc1

Qc1 Qc’1

Demand for

cotton

Demand for cotton

New Demand for

cotton

Price Elasticity of Demand

The price elasticity of demand =

Percentage change quantity demanded Percentage change price

∆Q / Q [Q(new) – Q(old)] / Q(old)

∆P / P [P(new) – P(old)] / P(old) ∆Q P∆P Q

Ep =

=

= .

=

Price Elasticity of Demand is negative.

Compare price elasticity for the two demand curves given below considering that price increases from Rs 2 to Rs. 3

P

QD

P3=3

P1=1

4 12

A

BP2=2

C

8

P

QD

P3=3

P1=1

4 12

D

EP2=2

F

20

Exercise 5

P

QD

P3=3

P1=1

4 12

A

BP2=2

C

8

P

QD

P3=3

P1=1

4 12

D

EP2=2

F

20

• Price rises from 2 to 3. Following D1 quantity demanded falls from 8 to 4.

∆Q = 4-8 = -4 Q = 8 ∆P = 3-2 = 1 P = 2So ∆Q / Q = -4/8 = -1/2And ∆P / P = 1/2

Therefore Ep = (-1/2) / 1/2 = -1

D1 D2

• Price rises from 2 to 3. Following D2 quantity demanded falls from 12 to 4.

∆Q = 4-12 = -8 Q = 12 ∆P = 3-2 = 1 P = 2So ∆Q / Q = -8/12 = -2/3And ∆P / P = 1/2

Therefore Ep = (-2/3) / (1/2) = -4/3

Ep = -1 Ep = -4/3

Thus,

a demand curve that looks steeper is less price elastic.

&

a demand curve that looks flatter is more price elastic.

Perfectly inelastic

demand curve

P

QD

P3=3

P1=1

A

BP2=2

C

8

P

QD4 12

D EP2=2

F

20

Perfectly elastic demand

curve

Important Factors Affecting Price Elasticity of Demand:

• Availability of SubstitutesIf number of substitutes available are large then price elasticity is large. Example: Sugar has substitutes like honey, saccharine etc. but Salt does not. So demand for sugar is more elastic than demand for salt.

• Whether a good is a necessary good or a luxury product.demand for necessary good is less elastic than luxury goods. Example: even if price of necessary food items increase / decrease, quantity demanded for such products does not change much.

Significance of Price Elasticity of Demand for the firm:

• The firm can decide which price to charge if price elasticity of demand is known.

• Firm’s objective is to earn as much revenue as possible.

• The firm chooses a price such that revenue is increased.