Chapter- 2

Demand and Supply Analysis

Demand Analysis

À How important in decision-making?

1. Provides the basis for analyzing

market influences on the firm’s
products.
2. Provides guidance in the manipulation
of demand.

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 Characteristics of Demand

1. Desire for a commodity

2. Willingness to pay
3. Ability to pay
À Demand is always with reference to:
1. Price
2. Period of time
3. Place

Determinants of Demand
(Factors Influencing Demand)

À Price of the own commodity (P)

À Income of the consumer (Y)
À Taste & Preference of the Consumer (T)
À Price of Related Commodities (Pr)
À Price of Substitutes (Ps)
À Price of Complementary (Pc)
À Expectation of the Consumer (E)

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 À Expectation of the Future Price (Ep)
À Expectation of the Future Income (Ey)
À Number of Consumers (N)
À Distribution of Consumers (D)
À Advertisement (A)
Demand Function
(An algebraic expression of the relation
between demand for a commodity & its
determinants)
D = f (P, Y, T, Ps, Pc, Ep, Ey, N, D, A…..n )
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Law of Demand
À “Other things remaining the same,
there is an inverse relationship between
the price of a commodity & its quantity
demanded”.
Demand Schedule
À Various quantities of a commodity
demanded at different price levels.
À IDS: Individual Demand Schedule
À MDS: Market Demand Schedule
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 Demand Schedule
P ($) Q (Units)
10 90
15 85
20 80
25 75
Graphical Presentation of Demand Schedule is known as
Demand Curve which slopes downwards from Left to
Right. Y
D

Price
D

o X
Quantity Demanded 7

À A demand curve demonstrates the effect of

a price change on the quantity demanded
of a commodity (Price Effect).
À Price Effect = Income Effect + Substitution
Effect.
À Income Effect: Measures the effect of a
price change on the real income of the
consumer.
À Substitution Effect: Is the adjustment of
demand to the relative price change alone.

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 Income & Substitution Effects of a Price Change

Household is Income Households

better off Effect Buy more

Falls
Opportunity
cost of Substitution Households
good falls Effect Buy more

Household is Income Households

worse off Effect Buy less

Rises
Opportunity
Substitution Households
Cost of
Effect Buy less
good rises

Exceptions to the Law

(Actual Behavior does not conform to
the Law)

À Giffen Goods (special type of inferior goods).

À Luxury Items
À Future changes in Prices
À Goods attached with prestige value
À Haunted by Phobia (high-priced good is
better in quality than a low-priced one).
À Out-dated fashion items.
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 Elasticity of Demand
À The degree of responsiveness of QD due to
a change in its determinants.
À The extent to which the QD will rise or fall
due to a change in the determinants (Price,
Income, Price of related goods,
Advertisement Budget, etc.)
À An analysis of demand sensitivity with
respect to determinants.
À Facilitates the business to forecast market
trends for the future.
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À Own Price as a determinant: Price Elasticity

of Demand.
À Income of the Consumer: Income Elasticity
of Demand.
À Price of related Goods (Substitutes and
Complementary): Cross Elasticity of Demand.
À Advertising Expenses: Promotional Elasticity
or Advertisement Elasticity of Demand
Elasticity of Demand can be measured for
any variable provided it can be Quantified.
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 Price Elasticity of Demand
The degree of responsiveness of quantity
demanded to changes in Price.

Proportionate Change in Q
Ep =
Proportionate change in P
Any Value of Elasticity is arrived at by
dividing the Percentage change in the QD by
the Percentage change in the own price.
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Category Value
À Perfectly Elastic ………………Ep = ∞
À Perfectly Inelastic ……………Ep = 0
À Relatively Elastic ……………..1<Ep< ∞
À Relatively Inelastic …………..0<Ep< 1
À Unitary Elastic ………………….Ep=1

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 Characteristics
À E = ∞ Any amount will be bought at a
certain price, but nothing at a higher price.
À E = 0 QD remains constant as price
changes.
À 1 < Ep < ∞ Proportionate change in QD is
greater than the Proportionate change in
price.
À 0 < Ep < 1 Proportionate change in QD is
less than the Proportionate change in price.
À Ep = 1 Proportionate change in QD is the
same as the Proportionate change in price.
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Elasticity of Demand
&
Total Outlay
À Demand is Elastic when a certain % cut in
price brings about more than proportionate
expansion in demand so as to increase total
outlay.
À Demand is Inelastic when a certain % cut in
price leads to a smaller percentage increase
in the QD, in which case total outlay falls.
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À Demand has unitary price elastic when a
certain % fall in price brings about an
exactly equal % increase of QD so as to
leave total outlay unchanged.

Nature of Demand Effect on TR of a Price

Increase Decrease
Elastic TR decreases TR increases
Unit Elastic TR unchanged TR unchanged
Inelastic TR increases TR decreases

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Problem
(10 minutes)

A consumer demands 150 units of a product

at a price of $ 3. If the demand is unit elastic,
what will be his demand for that product at a
price of $ 5.

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 Elasticity & Firm’s
Decision Making
Pricing with an Inelastic Demand
If a firm faces an inelastic demand, then
increasing price will raise revenue. Raising
price will reduce output. So costs will also be
falling. With revenue rises and cost falls,
profit will increase. A firm should not lower
the price if demand for its product is
inelastic, because revenue will fall and costs
will rise with output. Profit must decline.
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Pricing with an Elastic Demand

Firm has a more difficult decision to make if
demand for its product is elastic. The firm
can increase its revenue by lowering price,
but this will also increase output and
therefore cost. The decision is based upon-
which has gone up more – revenue or costs?

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 Determinants of
Elasticity of Demand
À Substitutability:
If a product has many close substitutes,
switching over to alternatives is possible in
the event of a rise in the price of the
product.
Demand will be highly elastic.
QD falls by a large amount due to a given
rise in price.

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À Nature of the Product:

Demand for the Necessities tends to be
Price Inelastic.
Demand for Luxuries tends to be Elastic,
i.e., Substantial reduction in the QD is
expected if Price rises.
À Proportion of Income:
Demand tends to be Elastic when the
proportion of income spent on the product
is large.
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 Demand for the same product is Inelastic
for a rich man as the proportion of Income
spent on it is very small.
The Possibility of New Purchases:
A fall in the price leads to the rise in
demand as it induces people in a
numerous income group to buy resulting
in considerable Elasticity of Demand.

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À Addiction:
Once a product is Habit-forming, this will
tend to reduce its Elasticity of Demand.
À Expected Price:
If the Ep will rise in future, a small
reduction in its price will lead to a
Substantial increase in its Demand.
À Time-Horizon:
The longer the period of time, the more
Elastic is the demand.

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 Income Elasticity of
Demand
The Degree of Responsiveness of Demand
to changes in Income of the consumer.

It may be Positive, Negative or Zero

depending upon whether QD goes up,
down or remains constant as income
increases.

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Category Value
Negative Income Elasticity… Ey < 0
Zero Income Elasticity……….. Ey = 0
Income Inelastic Demand………0 < Ey < 1
Unit Income Elasticity……………Ey = 1
Income Elastic Demand…………1< Ey< ∞

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Category Characteristics
-ve IE Demand decreases as Y rises
0 IE Demand does not change to Y
IIED Demand rises by a smaller
proportion than Y
UIE Demand rises by exactly the same
proportion as Y
IED Demand rises by a greater
proportion than Y

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Cross Elasticity of Demand

The Degree of Responsiveness of QD of
one good to changes in the price of
another.
Either be Positive or negative depending
upon whether the two goods considered
are Substitutes or Complements.
Proportionate Change in QDx
Ec = ---------------------------------------
Proportionate change in Py
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 Determinants of Supply
À Price of the own Commodity (P)
À Prices of the Factors of Production (Pf)
À Factor Productivities (Fp)
À Prices of other Products related in
Production (Pr)
À Goals of the Firm (G)
À Expected level of Profit, costs, sales (Eπ,C,
S)
À Expected price in the Future (Ep)
À Level and Nature of Competition (C) 29

Elasticity of Supply
À Measures the extent to which the QS of a
good responds to a change in its own
Price.
Percentage Change in QS
Es =
Percentage Change in Price
Es is Positive since the Supply curve slopes
upwards from left to right.

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 À Es may be Elastic, Inelastic or Unitary.
À A rise in Price: the QS rises by a greater,
smaller or equal percentage.
À Supply function of a firm relates the
quantity of a commodity that the seller is
willing and able to supply to the factors
that determine that supply.

À Sx = f (P, Pf ,Fp ,Pr , G, Eπ,C, S, Ep ,C….n)

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Class Tasks
(10 minutes)

À What happens to demand when the following

changes occur:
1. Income decreases and the commodity is inferior.
2. The price of a substitute good decreases.
3. The price of a complementary good decreases.
4. The price of a commodity is expected to
decrease.
5. If the price of computers goes up, the demand
for internet connections will ………. why?

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