Demand Supply and The Market Equilibrium

1. Demand Supply and The Market Equilibrium

2. The product market is where the two sides interact: The Consumers’ SideThe Producers’ side • Producers SUPPLY the product • Consumers create DEMAND for the product.

3. 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.

4. Demand for Final Products

5. 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 .

6. Demand for Pizzas Price of pizzas P 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. P = $10 Demand for pizzas D(P,I,T) P = $5 QD = 5 Quantity demanded of pizzas QD QD = 2

7. P 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. P = $10 D2 D1 QD = 4 QD = 2 QD

8. Price of pizzas P 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 P = $10 D’ D QD = 4 QD QD = 2

9. 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.)areExogenous Variables

10. 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).

11. 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.

12. Exercise1 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

13. Price of bread Px • 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. Px2 Px1 Demand for bread D(P,I,T) Qx1 Quantity demanded of bread QxD Qx2 Demand for bread

14. Price of butter Py • 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. Py2 Py1 Dy Dy’ Qy’1 Qy1 Quantity demanded of butter QyD Qy’2 Qy2 Demand for butter

15. Conclusion • 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

16. Exercise 2 Jam and butter are substitutes. How would a rise in price of butter affect the demand for Jam?

17. Price of butter Py • 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. Py2 Py1 Demand for butter D(P,I,T) Qy1 Quantity demanded of butter QyD Qy2 Demand for butter

18. Price of Jam Pz • 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. Pz2 Pz1 Dz’ Dz Qz1 Qz’1 Quantity demanded of Jam QzD Qz2 Qz’2 Demand for Jam

19. Conclusion • 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

20. 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 • a decrease in income levels of consumers • (d) a decrease in the price of watches

21. Price of watches Pw a) If price of watches increases quantity demanded of watches falls following the demand curve. Pw2 Pw1 Demand for watches D(P,I,T) Qw1 Quantity demanded of watches QwD Qw2 Demand for watches

22. Price of watches Pw 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. Pw1 New Demand for watches Demand for watches Qw’1 Quantity demanded of watches QwD Qw1 Demand for watches

23. Price of watches Pw • 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. Pw1 Demand for watches New Demand for watches Qw’1 Quantity demanded of watches QwD Qw1 Demand for watches

24. Price of watches Pw d) If price of watches decreases quantity demanded of watches rise following the demand curve. Pw1 Pw2 Demand for watches D(P,I,T) Qw2 Quantity demanded of watches QwD Qw1 Demand for watches

25. Demand for Intermediate Products

26. Demand for flour (used in pizzas) Price of flour P 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. P = $7 Demand for flour D(P,I,T) P = $3 QD = 50 Kg Quantity demanded of flour QD QD = 20Kg

27. 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?

28. Price of cotton Pc 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. Pc1 New Demand for cotton Demand for cotton Qc’1 Quantity demanded of watches QcD Qc1 Demand for cotton

29. 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.

30. Exercise 5 Compare price elasticity for the two demand curves given below considering that price increases from Rs 2 to Rs. 3 P P A D P3=3 P3=3 E B P2=2 P2=2 F C P1=1 P1=1 8 4 12 4 12 20 QD QD

31. P D1 P D2 Ep = -1 Ep = -4/3 A D P3=3 P3=3 E B P2=2 P2=2 F C P1=1 P1=1 8 4 12 4 12 20 QD QD • 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 = 2 • So ∆Q / Q = -4/8 = -1/2 • And ∆P / P = 1/2 • Therefore Ep = (-1/2) / 1/2 = -1 • 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 = 2 • So ∆Q / Q = -8/12 = -2/3 • And ∆P / P = 1/2 • Therefore Ep = (-2/3) / (1/2) = -4/3

32. Thus, a demand curve that looks steeper is less price elastic.& a demand curve that looks flatter is more price elastic.

33. Perfectly inelastic demand curve P A P3=3 B P2=2 C Perfectly elastic demand curve P1=1 P 8 QD D E F P2=2 4 12 20 QD

34. Important Factors Affecting Price Elasticity of Demand: • Availability of Substitutes If 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.

35. 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.