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NME-ICT ECONOMICS Microeconomics

Lesson: DEMAND, SUPPLY AND MARKET EQUILIBRIUM Lesson Author: Ajay Gupta

S K Sharma College/Dept: Department of Economics in Shyamlal

College (Evening), University of Delhi.

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Table of Contents

1. Learning Outcomes

2. Introduction

2.1 Concept of Demand

2.1.1 Quantity Demanded

2.1.2 Demand Schedule

2.1.3 Demand Curve

2.1.4 Demand Function

2.2 Law of Demand

2.3 Determinants of Demand

2.4 Change in Demand and Change in Quantity Demanded

3. Concept of Supply

3.1 Supply Schedule

3.1.1 Supply Curve

3.1.2 Supply Function

3.2 Law of Supply

3.3 Determinants of Supply

4. Market Equilibrium

4.1 Necessary condition for equilibrium

4.2 Change in equilibrium

5. Summery

6. Check your knowledge

7. Glossary

8. MCQs

9. References

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1. Learning outcomes

After you have read this chapter, you would be able to understand the concept of

price mechanism and its components – Demand, Supply and equilibrium price and

equilibrium quantity.

Explain the determinants of demand for and supply of goods and services.

Compare the change in quantity demanded (supplied) and change in demand

(supply).

Describe the interaction between consumers (buyers) and producers (sellers to

determine the equilibrium price and equilibrium quantity.

2. Introduction

Demand and supply explain the concept of price mechanism. On the demand side, buyers

(i.e. individuals, firms and government) earn income and spend on goods and services while

on the supply side, sellers (i.e. firms) produce and supply goods and services.

2.1 Concept of Demand:

The demand for a commodity is essentially consumers attitude and reaction towards

rise to actions in purchasing units of a commodity at various given prices. Precisely stated,

the demand is a quantity of a product that a consumer or buyer would be willing & able to

buy at a given price in a given period of time.

An individual’s desire for a good to satisfy a particular want backed by her

willingness and ability to pay gives rise to demand for that good. If and only if

individuals have means to pay that demand becomes effective in the market for a

good.

For instance: A Beggar desires milk, but has no purchasing power. Hence a

beggar’s desire for milk does not constitute an effective demand for milk. As a

result, a Beggar cannot participate in market activities.

Now, we can say that there are four conditions must be fulfilled.

These are:

1 Willingness and desire

2 Their desire must be supported by income i.e

Ability to Pay

3 Given prices of Commodity and

4 Given period of time

Demand for good in a market depends on many factors, some of important

factors are:

1 Prices of related goods,

2 Consumer’s taste or preference scale,

3 Consumer’s expectations and

4 Range of goods and services availability to consumers etc.

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When there is a change in any of these factors, demand for a consumer for a

good changes.

2.1.1 Quantity Demanded

The amount/ quantity of a product that consumer wishes to purchase called

quantity demanded. It is a flow concept. For example:- 2 Ice-cream per day,

flow concept becomes time dimensional. i.e a period of time.

2.1.2 Demand Schedule

A demand schedule is one way of showing the relationship between quantity

demanded and its affecting factors (Like-Price). It can be divided into two parts

i.e

(i) Individual demand schedule (for one consumer)

(ii) Market demand schedule (for all the consumers)

We can explain these demand schedules with the help of tables

Table 1

Individual Demand Schedule

Price of X-Commodity ( Px) Quantity Demanded (Qx)

1

2

3

4

4

3

2

1

Market Demand Schedule

Px A Consumer B Consumer Market demand

1

2

3

4

4

3

2

1

5

4

3

2

9

7

5

3

2.1.3 Demand Curve

The demand curve is graphical presentation of a demand schedule (ceteris

paribus). It captures relationship between the quantities of a good which

consumers would be willing to purchase at alternative prices, other things

remaining the same demand curve can be divided into two parts such as:-

(1) Individual demand curve

(2) Market demand curve

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Individual Demand Curve : It is the graphical representation of individual demand

schedule (Figure 1)

Figure 1

Marked Demand Curve

It is the horizontal summation of individual demand curves.

Fig 2 : Market Demand Curve

2.1.4 Demand Function:

A Functional relationship between quantity demanded and all the variables that

influences it. There are two type of demand functions, ie.

(A) Individual demand function

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(B) Market demand function.

(A) Individual Demand function

Individual demand form can be explained following functional form:-

Qx = f ( Px, Py, I, T………. )

Where:-

Px = Own Price

Py = Related, commodity Price

I = Consumer’s income

T = Tastes and preference

(B) Market demand function:-

Functional form of Market demand function is:

Qx = f (Px, Py, I*, T, W, Z ……….)

Where:

I* Size of income and its distribution

Z Size of Population and Composition

Qx = f (Px, Py, I, ………………..)

- Dependent variable Independent variable

- Endogenous variable Exogenous variable

- Explained variable Explanatory variable

- Regressed variable Regressor variable

- Cause variable Effective variable

2.2 Law of Demand:

An important generalization about demand is described by the law of demand

The law of demand or functional relationship between price and quantity

demanded is one of the best known and most important laws of economic theory.

Definition: According to the law of demand, other things remaining the same

(ceteris paribus) if price of a commodity falls, the quantity demanded of it will

rise, and if price of the commodity rises, its quantity demanded will decline.

Thus there is inverse relationship between price and quantity demanded, other

things remaining the same.

These other things which are assumed to be constant in a given period of time.

Thus, the constancy of these other things (celeries paribus) is an important

qualification or assumption of law of demand. Literally translated from latin:

other things being equal. This means that other things which could change are

for the moment being assumed to remain constant. Ceteris paribus assumption is

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made in economic reasoning to focus attention on the effect of changes in a

limited set of variables of interest.

The Graphical presentation of law of demands (Figure 3):

Figure 3

The functional form af the law of demand: can be expressed

as:

Qx = f ( Px, Py, I, T , …….. )

Or

Ceteris Paribus

2.3 Determinants of demand:

The factors that influence demand for a good/ product can thus be enumerated as:-

i) Price of product

ii) Consumer’s income

iii) Price of related commodities

iv) Tastes and preferences

v) Consumer expectation

Collectively they are known as determinants of demand. i.e

Qx = f ( Px, Py, I, T, …………. )

These are determinants of demand, which affect the

quantity demande d.

Qx= F (Px)

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(i) Price of the product

Ceteris Paribus, More of a product is demanded at a lower price and less at a higher

price.

This relationship (price and quantity demanded) reflects the law of demand.

The functional form of this relationship is expressed as:-

Ceteris paribus

Above relationship can be expressed through the graphically (Figure 4):-

Figure 4

The curve is a locus of points each presenting the maximum rate of purchase at associated

price, ceteris paribus.

(ii) Related Commodity Price

Related goods include substitutes and complements.

The demand for a commodity depends also on the prices of its substitutes and

complementary commodities.

The functional relationship between quantity demanded of x and related commodity

price can be expressed as:-

(Ceteris Paribus)

Where; Py = Ps (Price of substitutes goods) and

Pc (Price of Commodity goods)

There is positive relationship between price of substitute goods (Ps) and quantity

demand Qx.

For instance, commodities X and Y are, in economic sense, substitutes for one

another demand for Y , and, vice versa . (Like- Tea and Coffee, Alcohol and drugs,

wheat and rice are some common examples of substitutes). See Figure 5

Qx = f (Px)

Qx = f (Py)

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Figure 5

There is negative relationship between Qx and Pc (Price of complementary

commodity). For examples:- Petrol is a complement to car(Vehicles). Conceptually,

two goods for which an increase is the price of one leads to a decrease in the

demand for other. (Figure 6).

(Pc= Price of Complementary goods)

Figure 6

(iii) Consumer’s Income

Other things remaining the same, generally there is positive relationship between

quantity demand of X- commodity and consumers income.

This relationship depends on nature of goods (Like- Normal/ Superior, Inferior,

Luxury goods). See Figure 7.

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Figure 7

In Short:

(iv) Tastes and Preferences

The most obvious determinant of your demand is your taste. If your demand is

your taste. If you like ice-cream, you buy more of it.

Economists normally do not try to explain people’s tastes because tastes are

based on historical and psychological forces that are beyond the realm of

economics. Economists do, however, examine. What happens when tastes

change.

Ceteris Paribus

(v) Expectations (E):-

Expectations (about income as well as price of commodity) about the future may

affect demand for a good or services.

For Example:- If you expect to earn a higher income in next month, you may be

more willing to spend some of your current savings buying ice-cream.

Qx = f (T)

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Ceteris Paribus

2.4 CHANGE IN DEMAND AND CHANGE IN QUANTITY DEMANDED

When any of the ceteris paribus conditions change, the entire demand curve

shifts. This is referred to as a change in demand as opposed to a change in

the quantity demanded, which is movement along the same demand curve.

The shift of the demand curve , upward or downward, may be due to changes

in prices of related commodities (Py), or a change is consumers income or in

the tastes and expectations.

It is called change in quantity It is called change in demand

Demanded demand

This change reflects the movement This change reflects shifting

along the same demand curve (upward or downward) from

one demand curve to another

demand curve

Assumption- Ceteris paribus i.e shifting

Factors are constant Assumption- Own price is

constant

Expansion Contraction in

in Demand Demand

Qx = f (E)

CHANGE

Due to change in Price Due to change in other factors

Rightward/upward

shifting in demand curve

or

Increase in demand

Downward shifting

or

Decrease in demand

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Figure 8 Figure 9

3. Concept of Supply

Supply is the quantity of a commodity which a seller is prepared to sell at a given price in a

given period of time.

or

The amount of goods and services offered for sale.

The supply of a commodity may be defined as the amount of that commodity which

producer’s are willing and able to offer for sale.

The stress on ability indicates that it is effective supply that is important.

Just like demand, supply also has four essential elements which are as under:

1 Willingness

2 Able to sale

3 Given prices and

4 Given period of the

Quantity Supplied: - The amount of a product that firms are able and willing to offer for

sale is called the quantity supplied.

3.1 Supply Schedule:- Supply Schedule is a table that shows the relationship between

quantity supplied and price.

Quantity Supplied changes when the price changes.

Supply Schedule

A Individual Supply Schedule Market Supply Schedule

Px Supply by A Supply by

B

Qx

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Px Qx

5

10

15

20

0

10

20

30

3.1.1 Supply Curve: Supply curve is a graphical presentation of a supply

Schedule or A curve showing the amount that firm in a industry are

willing to supply at each

Supply Curve

Individual Market supply curve

Supply curve Def: Market Supply curve is a

Horizontal summation of

individual supply curves.

Figure 10 Figure 11

5

10

15

20

0

10

20

30

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3.1.2 Supply Function: A mathematical relation between the quantity supplied and all the

variables that influence it.

It can be represented in functional form as:-

Where:-

Px = Price of the product

Pf = Price of the inputs to production

T = State of Technology

N = Natural resources

G = Goal of production

3.2 Law of Supply

The law of supply or functional relationship between price and quantity supplied,

other things remaining the same (cetris Paribus). If price of commodity rise the

quantity supplied also rise and vice versa.

Thus the is direct/ positive relationship between price and quantity supplied when

other things remains constant (ceteris paribus), in a given period of time.

The graphical presentation of law of supply

Figure 12

The functional form is expressed as under

(Ceteris paribus)

Where Qxs = Quantity Supplied

Change

Change in Supply Change in quantity supply

(Shifting) (Ceteris Paribus)

(Movement along the curve)

Increase in Decrease in Expansion contraction

Qxs = f (Px, Pf, T, N, G, ……..)

Qxs = f (Px)

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Supply Supply of supply of supply

Figure 13

3.3 Determinants of Supply

Three Major determinants of the quantity supplied in particular market are:-

(i) Price of the product

(ii) Price of inputs to production

(iii) The state of technology

(iv) Natural resources

Therefore the supply function will be

(i) The Price of the product:- Other things remaining the same, there is

positive relationship between quantity supplied and its own price. This

relationship reflects the law of supply.The functional form of the relationship

can be expressed as

Qxs = f (Px, Pf, T, N, G, ……..)

Qxs = f (Px)

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Figure 14

As price of goods X rises the quantity supplied tends to increase and vice versa is also true.

(ii) The price of Inputs

Or

Cost of Production

- When the production cost rises given the market price of the product, its supply falls.

- Other thing remaining the same, In general, there is negative relationship between

quantity supplied and cost of production. This relationship can be express as.

(iii) Technology:- Under the advanced technology, supply of the product is often

cheaper and better in quantity. In case of advanced technology, producers

can afford to supply more even. When market price remains constant. In

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(iv) Natural Resources:- Abundant natural resources helps production of the basic

inputs.

Therefore, change in technology brought about by an invention may lower costs and

enable supply to be increased.

4. Market Equilibrium

A state of balance between opposing forces so that there is no tendency to change.

In economics, equilibrium occurs where quantity demanded equals quantity supplied.

Geometrically, this occurs at the intersection (E) of the commodity’s demand and

supply curves.

The price and quantity of which equilibrium exist are known : respectively, as the

equilibrium price (Pe) and the equilibrium quantity.

(Qe)

Figure 15

Mathematically:-

Advanced Technology Cost of production Profit Supply

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Qd = a- bp

Qs = - C+dp

According to definition

Qd= Qs

a-bp = - c+ dp

P (b+d) = a+c

Qd = Qs

Qd = a-bp

Qd = a-b (a+c)

(b+d)

Qd = a (b+d)- b (a+c)

b+d

Qd= ab + ad- ba-bc

b+d

Qd = (ad-bc) Qd = Qs

(b+d)

Qd = (ad-bc) Qd = Qs

(b+d)

Or

4.1 Necessary condition for equilibrium:-

Three necessary conditions must be fulfilled for equilibrium:

(i) Existence

(ii) Unique and multiple equilibrium

(iii) Stability

(i) Existence:- Equibrium will exist if the demand and supply curves have at least

one point in common in the nonnegative quadrant.

Pe = (a+c) (b+d)

Qd= Qs= Qe = (ad-bc) (b+d)

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Figure 16

(ii) Unique and multiple Equilibrium:-

Demand & supply are equal at more than one nonnegative price quantity

combination.

Equilibrium may be unique or non-unique depending on whether the demand and

supply curves intersect each other at one point at more than one point.

Figure 17

Metastable Equilibrium:

In the unlikely Cast that the market demand curve and supply curve coincide, we

have a situation neutral or metastable equilibrium.

Or

Price may remain constant if the demand and supply curves coinside.

No unique equilibrium is defined in this case.

Unique and Multiple Equilibrium:-

Demand & supply are equal at.

(III) Stability:- An equilibrium is stable if a disturbance results in a return to equilibrium

and unstable if it does not.

The equilibrium will be stable If two conditions must be fulfilled.

(1) Excess demand (ED) decreases as prices rises.

- P ED Stable equilibrium

(2) Slope of demand function < Slope of supply-

Figure 18

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4.2 Change in Equilibrium

The elements of the change in the equilibrium position under the following three

heads:-

(i) Shift in demand

(ii) Shift in Supply

(iii) Simultaneous change in demand & supply.

(i) Shift in demand:- Changes in demand are cause by shift factors, namely

change in income, prices of related goods, tastes, expectation……….. etc.

Figure 19

(ii) Shift in Supply:- The effect of change in supply on equilibrium can be explained

on similar lines.

Figure 20

(iii) Simultaneous change in demand & supply:

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Effect of simultaneous change in Demand supply on equilibrium.

Three possibilities- Many be exist

(i) Increase in supply > Increase in demand = P

(ii) Increase in supply < Increase in demand = P

(iii) Increase in supply = Increase in demand = P- Constant

Figure 21

5. Summary

1. The consumers demand function for the commodity will depend on several

factors like prices of all goods, consumer income, tastes, expectation etc.

2. Just like demand supply of a product also depends upon its affecting factors price

of product, price of inputs, Technology……… etc.

3. Interaction between consumers and producers help in determining the make

equilibrium that is equilibrium price and quantity.

6. Check your knowledge

Q.1 When both the price of a substitute and price of a complement of a

Commodity X rise, demand for X ?

(i) Rises (ii) Falls

(iii) Remains unchanged (iv) All the above are possible

Ans. (iv) Reason:- Demand for X depends on relative strength of the

two opposing forces.

Q.2 When the price of a substitute of the commodity X falls, the

demand for X.

(i) Rises (ii) Falls

(iii) Remains unchanged (iv) All the above are possible

Ans. (B)

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Q.3 When the individual income falls (ceteris paribus), that person’s

demand for an interior good.

(a) Increases

(b) Decreases

( c) Remains unchanged or

(d) We cannot say without additional information

Ans. (A)

7. Glossary

Change in demand: A shift in the entire demand curve of a

commodity resulting from a change in the individual’s money income or tastes, or prices of

other commodities.

Change in the quantity demanded A movement along a given demand curve for a

commodity as a result of a change in its price.

Change in the quantity supplied A movement along a given supply curve for a

commodity as a result of a change in its price.

Change in Supply A shift in the entire supply curve of a commodity resulting from a

change in technology, the prices of the inputs necessary to produce the commodity and (for

agricultural commodities) climate and weather conditions.

Equilibrium The market condition which, once achieved tends to persist. This occurs when

the quantity of a commodity demanded equals the quantity supplied to the market.

Law of demand The inverse relationship between price and quantity reflected in the

negative slope of a demand curve.

Stable Equilibrium The type of equilibrium where any deviation from equilibrium brings

into operation market forces which push us back toward equilibrium

Unstable Equilibrium The type of equilibrium where any deviation from the equilibrium

position brings into operation forces which push us further away from equilibrium

8. MCQs

Q.1 The willingness to give up money to obtain something is known as

(i) Price (ii) Market value

(iii) Demand (iv) Supply

Q.2 An increase in the demand for books would

(i) Shift the demand curve to the left

(ii) Move a point on the demand curve

(iii) Shift the demand curve to the right

(iv) not cause any change.

Q.3 When the market supply curve for a commodity is negatively sloped, we have a case

of

(a) stable equilibrium

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(b) unstable equilibrium

(c) Any of the above is possible and we can not say without additional

information.

Q.4 A producer’s positively sloped supply curve for a commodity represents

(a) A maximum boundary of the producer’s intentions

(b) A minimum boundary of the producers intention

(c) In one sence a maximum and in another sence a minimum boundary of the

producer’s intentions

(d) None of above.

Q.5 In drawing an individual’s demand curve for a commodity, all but which one of the

following are kept constant ?

(i) Individual’s money income.

(ii) the prices of other commodities

(iii) the price of the commodity under consideration

(iv) the tastes of the individual

Q.6 A fall in the price of a commodity, holding everything else constant, results in and is

referred to as

(a) An increase in demand (b) a decrease in demand

(c) an increase in quantity demanded (d) decrease in quantity demanded

Q.7 When an individual’s income rises (while everything else constant), that person’s

demand for e normal good

(i) rises

(ii) falls

(iii) remains the same

(iv) Any of the above

Q.8 When an individual’s income falls (ceteris Paribus), that person’s demand for a

interior good

(i) Increases (ii) Decreases

(iii) remains unchanged (iv) Nothing can’t be said.

Q.9 Equilibrium condition in the market will exist when

(i) D = S (ii) D > S

(iii) D < S (iv) Any of the above.

Q10. Chose the move appropriate graph for stable equilibrium

(i) (ii)

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(iii) (iv)

9. Reference:

1 Bernard J.Luskin, Introduction to economics

2 Walterl-Nichol, Microeconomic Theory

3 R.G. Lipsey and K.A. Chrystal – Principle of Economics 4 Joshi, J.M. & Joshi, Rajendra, Microeconomic Theory