2. Demand, Supply, & Market
Equilibrium
1
What is a Market?
Market is a mechanism through which
buyers and sellers (individuals, firms,
agents or dealers) of a good (or service)
interact to determine price and quantity of
a product.
• Physical or virtual
• DD and SS are the 2 major forces that
determine market conditions
2
Demand
What is demand?
Effective desire
Essential for the creation, survival and
profitability of a firm
Knowing the strength & stability of demand
is crucial for expansion of production
facilities and entering new market
3
Demand
Attributes of demand:
Price
 Point of Time
Market
 Quantity
4
Types of Demand
Durable and non durable goods
Demand for Non durable Goods
- Can be used only once
- Utility is exhausted in a single use.
- Have a recurring demand
- Producers’ Non durables : Raw materials,
packing items, fuel, power
- Consumers’ Non durables :Food, soap,
cooking fuel, cosmetics
5
Durable goods
Durable Goods
• Total utility is not exhausted in a single or short
•
•
•
•
term use
Can be used over a long time period
Wear & tear over a period of time; so needs
replacement
Generally used by more than 1 person (fridge)
Purchased at irregular intervals
6
Types of Demand
Durable goods
• More volatile demand as they can be
stored
• Strongly dependent on macro economic
conditions
• Need to consider both new and
replacement demand
• Style, convenience, technological
innovations are important
• Producers’ Durables (plants, building,
machinery) Consumer Durables (car,
fridge)
7
Individual & Market Demand
Market demand is derived by adding up all
individual demands at a given price
Individual demand refers to a single
consumer- Theory of demand is based on
Individual demand- Helps in understanding
various dimensions of demand analysis
But seller is interested in market demand
and analysis
8
Table 3: Market demand curve
Price
A
B
C
Market
Demand(=A
+B+C)
100
45
18
10
63
200
35
12
7
54
300
28
7
3
38
400
22
3
1
26
500
18
1
0
19
600
13
0
0
13
9
Types of Demand
Direct and Derived Demand
• Direct Demand: Goods demanded as they
are. When a commodity is demanded for
its own sake by the final consumer ;
Satisfaction is derived by the final
consumer without any further value
addition: Food, clothes, house, medicines.
10
Types of Demand
• Derived Demand: A commodity that is
demanded for use either as raw material or as
an intermediary for value addition in any other
good
-Demand for a commodity arising because of
demand for some other “parent” commodity:
Demand for land, fertilizer, agricultural tools,
steel, cement, capital goods. e.g., demand for
cement is derived from the demand for new
buildings
11
Types of Demand
Complementary & Competing Demand
• Complementary Demand: Goods that
create joint demand; so demand for one
good depends on demand for the other
• Competing Demand : Substitutes- Goods
that compete with one another to satisfy
any particular want.
12
Demand Curve
• Demand curve shows the relationship
between the price of a good and quantity
demanded, Ceteris paribus
• Has negative slope because of the inverse
relationship between P and Q
13
Law of Demand
Law of Demand (Marshall)
Other things remaining constant, (Ceteris
paribus ), when the price of a commodity
rises, the demand for the commodity falls
and when the price of a commodity falls,
the demand for the commodity rises
Quantity demanded and price are inversely
related.
14
Demand Schedule and Derivation
of DD curve
Price (Rs)
100
Quantity
Demanded
45
200
35
300
28
400
22
500
18
600
13
15
Demand Curve
16
Explaining the Negative Relationship
Why does demand rise when there is a fall
in price ?
- New/ more uses of the good
- New consumers who could not afford it
earlier buy it
17
Explaining the Law of Demand
Substitution Effect:
• When price of a commodity falls, the
consumer tries to substitute it in the place
of other commodities whose price has
remained unchanged (as the substitute
becomes relatively more expensive)
18
Explaining the Law of Demand
Income Effect:
When price of a commodity falls, the
consumer’s real income (and purchasing
power) increases
19
Explaining the Law of Demand
Law of Diminishing marginal Utility:
The utility derived from every additional unit
(marginal unit) of a commodity goes on
falling as the consumer consumes
additional units of a commodity, So,
consumer will equate MU with P and stop
buying additional units of the commodity
when MU=P.
Why?
20
Exceptions to the Law
•
•
•
•
•
Giffen goods (Inferior goods)
Veblen goods (snob value)
Demonstration effect
Future expectations regarding prices
Insignificant portion of income spent(Low
value and limited use products)
• Goods with no substitutes
21
Sum
A fruit seller wants to sell 20 kg of apples. There
are 3 customers whose individual demand
functions are given below:
• D1= 25 - 1.0P
• D2= 20 - 0.5P
• D3= 15 - 0.5P
• Determine the market demand equation for the
fruit seller. Find out the price at which he can sell
all the apples
22
Solution
• Dm= D1+ D2+D3
= (25-1.0P)+ (20-0.5P)+ (15-0.5P)
Dm= 60-2.0P (Market DD Function)
As he wants to sell 20 kg, price will be:
20= 60- 2.0P
Solving the equation, we get P=20
Respective DD for each consumer will be
D1= 5kg; D2= 10 kg; D3= 5kg
23
Determinants of Demand
Price of good X
 Price of related good Y
 Consumer Income
 Tastes and Preferences
 Advertising *
 Consumer expectations of future price & income
 Size and distribution of population
 Growth of Economy
24
Advertising & Buying Behavior
• According to a 2006 survey of rural India, 73% of
consumers felt promotion had no or moderate
effect on their buying behavior.
• For edible oils and soft drinks, 54% and 75%
said they were influenced by ads.
• Purchase of watches and bicycles did not show
any impact of ads; but friends, family members
and village retailers were the influencers of
these purchases.
25
Demand Function
Dx= f (Px, Y, Py, T, A, Ef, N)
• Multivariate
• Linear- non linear
• Coefficients can be positive or negative
• In order to assess the effect of one of the
variables, we have to assume that all other
variables are constant (partial regression
coefficient)
26
Movement and Shift
Change along a curve (Movement)
Contraction or Expansion refers to a
change along the demand curve.
• A movement occurs when a change in the
quantity demanded is caused only by a
change in price,
• Due to a change in price, demand moves
along the same demand curve- contraction
or expansion in quantity demanded
27
28
Shift in Demand Curve
• A shift in a demand curve occurs when a
good's quantity demanded changes even
though price remains the same. E.g., if the
price for a bottle of beer was $2 and the
quantity of beer demanded increased from
Q1 to Q2, then there would be a shift in
the demand for beer.
• Shifts in the demand curve means that
quantity demanded is affected by factors
29
other than price.
Shift in Demand Curve
• When factors other than price change,
demand curve shifts to its right or left.
Indicates that consumers will buy more or
less at the same price
30
Shift in Demand Curve
31
SUPPLY
Supply and Law of Supply
• SS is the quantity of a good or service that
a producer or seller is willing and able to
provide at a price, at a given point of time,
ceteris paribus.
• DD side is represented by buyers; SS side
is represented by sellers
• Market supply is the aggregate of
individual supplies
32
Supply and Law of Supply
• Supply Function represents the quantity of
a commodity that will be provided at a
price, levels of technology, input price and
all other factors
• Sx= f( Px, C, T, G, N)
33
Determinants of Supply
• Price of commodity: Positively related
• Cost of production: SS is reduced if Cost of
production increases
• State of technology: Improved technology
reduces cot of production per unit , enhances
productivity and increases SS
• Number of Firms: If entry is unrestricted, more
SS
• Government policies: Taxes & subsidies
34
Supply and Law of Supply
Law of Supply: Other things remaining
constant, supply of a product increases
with increase in price and decreases with
decrease in price.
• Supply Schedule represents quantity of a
product supplied at different prices.
• Graphic representation of supply schedule
indicates an upward moving curve:
35
36
Market Equilibrium
• Equilibrium is a state of balance from
which there is no tendency to change
• Market is at equilibrium when quantity
demanded equals quantity supplied.
The equilibrium price or clearing price is
established here
37
Market Equilibrium
Price
DD
SS
Market
Condition
Effect on
P
100
63
6
shortage
Rise
200
54
10
shortage
Rise
300
38
18
shortage
Rise
400
26
26
Equilibrium
stable
500
19
39
Surplus
Fall
38
Equilibrium
• When supply and demand are equal (i.e. when
the supply curve and demand curve intersect)
the economy is said to be at equilibrium.
• At this point, the allocation of goods is at its most
efficient because the amount of goods being
supplied is exactly the same as the amount of
goods being demanded.
• Everyone (individuals, firms, or countries) is
satisfied with the current economic condition..
39
Market Equilibrium
40
Market Equilibrium
Imbalance between DD and SS causes
either shortage or surplus.
1. Excess Supply
If the price is set too high, excess supply
will be created within the economy and
there will be allocative inefficiency.
41
Disequilibrium: S>D
42
Excess Supply
• At price P1, Q2 is the quantity of goods
that the producers wish to supply. But
consumers want to consume only Q1,
(less than Q2). Because Q2 is greater
than Q1, too much is being produced and
too little is being consumed. Suppliers are
producing more goods, in order to sell and
increase profits, but consumers purchase
less because the price is too high.
43
Disequilibrium: D >S
• Excess Demand
Excess demand is created when price is
set below the equilibrium price. Because
the price is so low, too many consumers
want the good while producers are not
making enough of it.
44
Disequilibrium: D >S
45
Disequilibrium: D >S
• At price P1, the quantity of goods
demanded by consumers is Q2 while
quantity of goods that producers are
willing to produce at this price is Q1. Thus,
there are too few goods being produced to
satisfy the wants (demand) of the
consumers.
46
Market Equilibrium
• However, as consumers have to compete
with one other to buy the good at this
price, the demand will push the price up,
making suppliers want to supply more and
bringing the price closer to its equilibrium.
• In a free market economy disequilibrium
itself generates conditions of equilibrium
47
Market Equilibrium
Law of One price• Identical goods sell at virtually identical
price in different markets.
• Market forces drive price towards equality
• Higher prices in one market attract sellers;
lower prices attract buyers
• The law also holds because of arbitrage:
buying where price is low and selling
where price is high
48
Defining the Market
• Procter & Gamble: New Product Launch Debate on common European detergent
• Defining the market
• Should Europe be defined as one market
or should each country be distinctly
designated as a separate market? –
49
P&G executives discussed the following:
• Having a single detergent would be less
costly but…
• Washing temperature preferences
• Hand wash
• European washing machines are front
loading –American, top loading
• High penetration of TVs in UK, but only
45% in Portugal and Spain
50
• European machines have smaller water
capacity and much longer wash cycles
• Business Laws differ among countries
• In Finland and Holland, phosphate levels
in detergent are limited
• In Germany, coupons and refunds are not
allowed
• In some countries, package weight and
labeling are regulated
51
• Eurobrand failed
• P&G failed to define the market
appropriately
52
• In each case there is a trade-off- Choosing
Eurobrand with a single formula, single
manufacturing structure as well as single
marketing campaign would be less costly but
has the potential problem of defining market too
broadly
• Choosing the individual market approach means
higher marketing and production costs but
products are in tune with individual markets
53
• Need for Cost benefit analysis for each
action- unified approach vs distinct
markets
• P&G did not include options such as
“Anglo” or ‘Franco” (Only “Euro” was
discussed).
• Need to have included both out-of–pocket
expenses and what is foregone
•
54
• So P&G changed its approach to
globalisation by redefining marketssubsidiaries in each country and designing
products and marketing campaigns for
each subsidiary
(Source: Boyce, The New Managerial
Economics, pp34-35)
55
Estimating Demand
1. Suppose the relationship between Qd and P is
represented by
Q= -500P +200 I -400 C+0.01 A, where
P= Price
I=Income
C=Price of complementary good
A= Expenditure on advertising,
Find the Qd when P= 600, I=Rs.15000, C=
Rs.300, A= Rs.40,000
56
REDO sums
Equilibrium P, D and S
Market equilibrium will be achieved when
Dx=Sx
Dx=A-aP
Sx=B+ bP
Where A and B are constants
a and b are coefficients
P is price
57
Equilibrium P, D and S
• Dx= 61.5 - 2Px
• Sx= 1.5+2Px
• Qd and Qs can be found by substituting the
value of P in the respective equations:
Dx = 61.5 - 2Px OR
= 61.5 – (2* 15)
=31.5 mn packets
Sx= 1.5+2Px
Sx= 1.5+ (2 *15)
=31.5 mn packets
58
Equilibrium P, D and S
2. Suppose market demand is represented
by
Qd=3,000,000-700P
and market supply is represented by
Qs=1,000,000-400P,
a) How do you determine the market price?
b) Also find Qd and Qs
59
Supply, Demand & Market
equilibrium
• Car Market- Factors Affecting
Demand
Average income: An increase leads to increase in
demand
Population: Size
Income distribution; More middle and higher
income classes, more the purchases
Price of related goods: Lower the price of
petrol/diesel, more the car demand
Substitutes: Availability and price
60
Supply, Demand & Market
equilibrium
Taste: SUV, red Ferrari
Special Influences: Availability of alternative
transport (buses, trains), safety of cars,
better roads (Express Highway),
Expectation of future price increases
61
Supply, Demand & Market
equilibrium
• Car Market- Factors Affecting Supply
• Input prices: lower wages or machinery prices
will reduce cost of production and increase
supply
• Prices of related goods being produced in the
factory: If truck demand and its price increases,
its SS will go up, entire assembly line will
produce trucks resulting in lower SS of cars
62
Supply, Demand & Market
equilibrium
• Technology: Lowers production costs and
increases supply
• Government Policy: Pollution norms,
minimum wages laws, government policy
on electricity charges for industry may
increase costs and reduce supply
• Special Influences: Internet shopping will
drive out high cost sellers out of the
market
63
CONSUMER BEHAVIOUR
Marshall’s utility Analysis:
• Law of Diminishing Marginal Utility: Other
things remaining the same, utility derived
by the consumer from the consumption of
additional units goes on decreasing
• Utility is quantifiable and additive
• consumption units are homogeneous
• Income is limited
64
CONSUMER BEHAVIOUR
A consumer is in equilibrium when he has
1. Maximised his satisfaction
2. Spent his entire income
3. Attained optimal allocation of expenditure
4. Consumed optimum quantity of each
commodity
65
CONSUMERS’ BEHAVIOUR
• Law of Equi- marginal Utility: Consumer
distributes his income in such a way that
marginal utility of each commodity per unit
of expenditure is the same.
MUx
MUy
MUz
_______=
_____
= _____ =MUm
Px
Py
Pz
66
CONSUMERS’ BEHAVIOUR
Hicks- Allen’s Indifference Curve Analysis:
Ordinal instead of cardinal measurement
Utility being subjective is rankable, not
measurable
Consumer is rational
Tastes, preferences and income remain
constant
67
CONSUMERS’ BEHAVIOUR
Indifference Curve represents combination of
goods X and Y that give the same level of
satisfaction.
Convex to the origin- consumer will sacrifice lesser
quantity of Y for each additional unit of X
It has a negative slope –For utility to remain
constant, if demand for one commodity
increases, the other one should decrease.
2 ICs can not intersect each other.
Higher the indifference curve, higher the level of
satisfaction.
68
Good Y
CONSUMERS’ BEHAVIOUR
IC3
IC2
IC1
Good X
69
CONSUMERS’ BEHAVIOUR
Budget Line:
• Represents all the combinations of the two
goods that can be purchased with the
given amount of money
• The consumer has a constraint, namely
limited income.
• Position and slope of budget line is
determined by the prices of the 2 goods.
70
CONSUMERS’ BEHAVIOUR
Quantity of Y
Budget Line
x
o
Quantity of X
71
CONSUMERS’ BEHAVIOUR
Quantity of Y
• Consumer’s Equilibrium:
Y
A
Qy
E
IC3
IC2
IC1
O
Qx
Quantity of X
B
X
72
Consumer’s Equilibrium
• The consumer has a fixed income, all of
which he spends. Given the market prices
of 2 goods, he is constrained to move on
the Budget Line.
• The consumer will move along the Budget
Line until reaching the highest attainable
indifference curve. Hence equilibrium is at
the point of tangency between IC and
budget line.
73
Research on Consumer
Behavior
Market Researcher on Consumer Behaviour:
• Law of demand is not the last word on consumer
behaviour
• A person who purchases high priced products
-Perceives high quality difference
-Is also cautious
-Feels it is risky and uncertain to go for low quality
products
74
Research on Consumer
Behavior
• A person who perceives himself as experienced
in purchasing a product will generally choose a
low priced item but an inexperienced person
would choose the costlier option
• Marketing executives think that a higher price is
essential if the product’s real advantages have
to get noticed.
• Purchasing behaviour of consumer is mostly
repetitive- as against the theory which says that
consumer tries to optimise in every transaction
and every time
75