ECONOMICS NOTES

$$ UNIT 2: Basic Elements of Supply and Demand

Demand for any Commodity
 Desire to buy
 Willingness to buy
 Ability to pay

Determinants of Demand
 Price of the Commodity
 Income of a Person
 Prices of Related Goods :- Substitutes and Complimentary
 Taste of Consumer
 Price Expectations

Dx f( Px, I, Py, Pz, E, A, T, U)

Where Dx= Demand of Commodity; Px= Price of X; I= Income; Py= Price of
Substitute; Pz= Price of Complimentary; E= Price Expectations;
A= Advertisement; T= Taste of Consumer; U= All other factors.

1. Price Effect: Dx ∝ 1/ Px
2. Substitution: Dx ∝ Py
3. Complimentary Effect: Dx ∝ 1/ Pz
4. Income Effect: Dx ∝ I (Normal Goods) & Dx ∝ 1/I (Inferior Goods)

Law of Demand
 Law of Demand explains the functional relationship between price of
a commodity and the quantity demanded of that commodity.
 The price and demand are inversely related, which means hat the
two moves in the opposite direction.

Price ∝ 1/Demand
 The increase in price leads to fall in quantity demanded and vice-
versa.
 A demand curve considers only the price demand relation, other
factors remaining the same.
The Demand Schedule
The inverse relationship between the price and the quantity remanded
for the commodity per time period is the ‘Demand Schedule’ for that
commodity and plot of the data gives the demand curve of the individual

There exists a definite relationship between the market price of a good

and the quantity demanded of that good, other things held constant. This
relationship between price and quantity bought is called the demand
schedule, or the demand curve.
 Demand Curve

Fig. 1
 The demand curve in Fig.1 which graphs the quantity of cornflakes
demanded on the horizontal axis and the price of cornflakes on the
vertical axis.
To be noted, the quantity demanded and price are inversely related
means if Q goes up when prices fall, the curve slopes downwards,
going from north-west to south-east. This important property is called
the ‘Law of Downward-Sloping Demand’. (This shows a negative
relationship)
 Law of Downward-Sloping Demand- “When the price of a commodity
is raised (and other things held constant), buyers tend to buy less of
the commodity. Similarly, when the price is lowered, other things
being constant, quantity demanded increases.”
 Market Demand- The market demand represents the total sum of all
individual’s demand. The market demand curve is found by adding
together the quantities demanded by all individual at each price.

Concept of Supply
 Specific quantity of output, a producer is willing to supply.
 Able to make available to consumers at a particular price over a
given period of time.

Determinants of Supply
 Price of the product
 Inputs
 Price of related goods
 Government Policies
 As of quantity demanded, price is the major determinant of quantity
supplied. There are other factors like price of inputs used in
production, technology, producers’ expectations and number of
producers in the market.

Law of Supply
 A/c to Law of Supply (other things remaining constant), higher the
price of the commodity, higher will be the quantity supplied and vice-
versa.
 There is a positive relationship between supply and price of a
commodity. As of quantity supplied and other things are held
constant like price of inputs used in production, technology,
producers’ expectations and number of producers in the market
might change causing a shift in supply.
Market Supply- It is the total quantity of goods and services that
producers are willing to supply at a particular price point or range
for a certain period of time. Market Supply is the submission of
supply amounts for all individual producers.

The Demand Schedule

 The supply side of a market typically involves the terms on which
businesses produce and sell their products.
 The supply schedule relates the quantity supplied of a good to its
market price, other things remain constant.

“The Supply Schedule (or Supply Curve) for a commodity shows the
relationship between its market price and the amount of that
commodity that producers are willing to produce and sell, other things
held constant.”

The table shows, for each price, the quantity of cornflakes that the
producers want to produce and sell. There is a positive relation
between the price and quantity supplied.
Supply Curve

Fig. 2
 The Supply Curve plots the price and quantity pairs from the above
table. A smooth curve is passed through these points to give the
upward-sloping to supply curve.
 Fig. 2 shows the typical case of an upward-sloping supply curve
for an individual commodity.

Forces behind the Supply Curve

 Producers supply commodities for profit and not for charity.
 One major element underlying the supply curve is the cost of
production.
 When production costs for a good are low relative to the market
price, it is profitable for producers to supply a great deal.

Equilibrium of Supply and Demand

 Till this point, we were seeing the demand and supply in isolation. We
have seen that consumers demand different amount of goods based
on their prices and producers willingly supply these goods
depending on their prices.

Q.} But how can we put both sides of the market together??
 The answer is that supply and demand interact to produce an
equilibrium price and quantity, or a market equilibrium. The market
equilibrium comes at that price and quantity where the forces of
supply and demand are in balance.
It is called equilibrium when the
forces of supply and demand are in balance, there is no reason for
price to rise or fall, as long as other things remain constant.
“ A market equilibrium comes at the price at which quantity
demanded equals quantity supplied. At that equilibrium, there is no
tendency for the price to rise or fall.”
Note: The equilibrium price is also called the market-clearing price.
 Fig. 3

We show the market equilibrium through the demand and supply curve
like combining the graphs, one made in Fig. 1 and Fig. 2. Combining the
graphs is possible because they are drawn with exactly the same
variables and units on each axis.
We find the market equilibrium by looking
for the price at which quantity demanded equals quantity supplied. The
equilibrium price comes at the intersection of the supply and demand
curves, at point C.
“ The equilibrium price and quantity come where the amount willingly
supplied equals the amount willingly demanded. In a competitive
market, this equilibrium is found at the intersection of the supply and
demand curves. There are no shortages or surpluses at the equilibrium
price.”

Elasticity of Demand and Supply

 Elasticity- Elasticity is a major of responsiveness. It is the ratio of
the percent change in one variable to percent change in another
variable, we use elasticity when we want to see how one thing
changes when we change something else.
 When the price elasticity of a good is high, then the good has “elastic”
demand.
 When the price elasticity of a good is low, then it has “inelastic”
demand.

Q.} How does demand for a good change when we change its price??
Q.} How does the demand for a good change when the price of the
substitute goods changes??

 A good or service is considered to be elastic if a slight change in

price leads to a sharp change in the quantity demanded or supplied.
Eg:- A.C., Television, Branded Clothes, etc.
 On the other hand, an inelastic good or service is one in which
changes in price witness only modest changes in the quantity
demanded or supplied, if any at all.
These goods tend to be things that
are more of a necessity to the consumers in his or her daily life.
Eg:- Rice, Vegetables, Salt, Medicines, etc.
 Price Elasticity of Demand
 The price elasticity of demand (simply called price elasticity)
measures how much the quantity demanded of a good changes when
its price changes.
Price elasticity of demand (Ed)= Percentage change in quantity demanded
Percentage change in price
 Price Elasticity of Demand is of three types-

1. Price-Elastic Demand- When a one percent change in price calls

forth more than a 1 percent change in quantity demanded, the good
has a price-elastic demand.
Eg:- 1 percent increase in price yields a 5 percent decrease in
quantity demanded, commodity has a highly price-elastic demand.
Such as luxury goods like jewellery, designer bags, cars, etc.

2. Price-Inelastic Demand- When a 1 percent change in price produces

less than a 1 percent change in quantity demanded, the good has a
price-inelastic demand.
Eg:- 1 percent increase in price yields only 0.2 percent decrease in
quantity demanded such as price of petrol, salt, rail fares, etc.
3. Unit-Elastic Demand- It occurs when the percentage change in
quantity is exactly the same as the percentage change in price.
Eg:- 1 percent increase in price yields 1 percent decrease in demand.

 Price Elasticity of Supply

 Consumption is not only thing that changes when prices go up or
down. Businesses also respond to price in their decisions about how
much to produce. The price elasticity of supply as the responsive-
ness of the quantity supplied of a good to its market price.
“ The price elasticity of supply is the percentage change in quantity
supplied divided by the percentage change in price.”
Price elasticity of supply (Es)= Percentage change in quantity supplied
Percentage change in price

 Elastic Supply- Supply is relatively elastic where the quantity

supplied changes by a larger percentage than the price change.
 Inelastic Supply- The percentage change in quantity supplied
changes by a global percentage than the percentage of price change.
Eg:- Nuclear Power

 Unitary Elastic Supply- The supply where the quantity supplied

changes by the same percentage as the price change.

Application of elasticity of demand and supply to major economic issues

 Government taxes are wide varieties of communities such as
cigarettes, alcohol, imported goods, telephone services, etc.
Who actually bears the burden of
the tax? Where the supply and demand are essential here?
 Division of Petrol:-
Crude Oil Refinery Cost Price to dealer margin
$36.50/Barrel (Rs. 14.55/Lt.) (Rs. 31.63)
(Rs.16.81/Lt.)

Petrol Price Govt. VAT Dealer Margin Excise Duty

(Rs. 70.14) (Rs. 15.25) (Rs. 3.55) (Rs. 19.98)
{It is going to producer}

Q.} Why petrol or diesel prices are not falling despite crude oil prices
crashing?

 By putting higher taxes, government wants to curve consumption,

reduce global warming and lower dependence on foreign sources of
oil. Taxes are used to discourage consumption and subsidies are used to
encourage consumption.

Q.} The ultimate economic effect of a tax on whose income- producer

or consumer??

The supply curve will shift, the consumer demand will remain the same because
gasoline is relatively inelastic.
At each quantity supplied, the market price must
rise by exactly the amount of tax. The oil industry pays a small fraction whereas
consumer bears most of the burden with the retail price rising because supply
is relatively price elastic whereas demand is relatively price inelastic.