2.1 Supply and Demand

Supply and demand is an economic model

  • Designed to explain how prices are determined in certain types of markets
Supply and demand model is designed to explain how prices are determined in perfectly competitive markets
  • Perfect competition is rare but many markets come reasonably close
  • Perfect competition is a matter of degree rather than an all or nothing characteristic
Supply and demand is one of the most versatile and widely used models in the economist’s tool kit

2.2 Demand

  • A household’s quantity demanded of a good

     1. Specific amount household would choose to buy over some time period, given

            a. A particular price that must be paid for the good
            b. All other constraints on the household
  • Market quantity demanded (or quantity demanded) is the specific amount of a good that all buyers in the market would choose to buy over some time period, given

        1. A particular price they must pay for the good
2. All other constraints on households

2.3 The Law of Demand

  • States that when the price of a good rises and everything else remains the same, the quantity of the good demanded will fall
        1. The words, “everything else remains the same” are important
            a. In the real world many variables change simultaneously
            b. However, in order to understand the economy we must first understand each variable separately
            c. Thus we assume that, “everything else remains the same,” in order to understand how demand reacts to price

2.4 The Demand Schedule and The Demand Curve

Demand schedule
  • A list (price- quantity combination) showing the quantity of a good that consumers would choose to purchase at different prices, with all other variables held constant
The market demand curve (or just demand curve) shows the relationship between the price of a good and the quantity demanded , holding constant all other variables that influence demand
  • Each point on the curve shows the total buyers would choose to buy at a specific price
Law of demand tells us that demand curves virtually always slope downward

Figure 1

2.5 Shifts of demand vs. Movements Along The Demand Curve

  • A change in the price of a good causes a movement along the demand curve
  • In Figure 1

        1. A fall (rise) in price would cause a movement to the right (left) along the demand curve

  • A change in income causes a shift in the demand curve itself
  • In Figure 2

        1. Demand curve has shifted to the right of the old curve (from Figure 1) as income has risen
2. A change in any variable that affects demand—except for the good’s price—causes the demand curve to shift

Figure 2

2.6 Factors That Shift The Demand Curve

Income
  • An increase in income has effect of shifting demand for normal goods to the right
  • However, a rise in income shifts demand for inferior goods to the left
  • A rise in income will increase the demand for a normal good, and decrease the demand for an inferior good
Wealth
  • Your wealth—at any point in time—is the total value of everything you own minus the total dollar amount you owe
  • An increase in wealth will
        1. Increase demand (shift the curve rightward) for a normal good
        2. Decrease demand (shift the curve leftward) for an inferior good
Prices of Related Goods
  • Substitute—good that can be used in place of some other good and that fulfills more or less the same purpose
        1. A rise in the price of a substitute increases the demand for a good, shifting the demand curve to the right
  • Complement—used together with the good we are interested in
        2. A rise in the price of a complement decreases the demand for a good, shifting the demand curve to the left
Other Factors 
Population
  • As the population increases in an area
  • Number of buyers will ordinarily increase
  • Demand for a good will increase
Expected Price
  • An expectation that price will rise (fall) in the future shifts the current demand curve rightward (leftward)
Tastes
  • Combination of all the personal factors that go into determining how a buyer feels about a good
  • When tastes change toward a good, demand increases, and the demand curve shifts to the right
  • When tastes change away from a good, demand decreases, and the demand curve shifts to the left

2.7 Supply

  • A firm’s quantity supplied of a good is the specific amount its managers would choose to sell over some time period, given
        1. A particular price for the good
        2. All other constraints on the firm
  • Market quantity supplied (or quantity supplied) is the specific amount of a good that all sellers in the market would choose to sell over some time period, given
        1. A particular price for the good
        2. All other constraints on firms

2.8 The Law of Supply

States that when the price of a good rises and everything else remains the same, the quantity of the good supplied will rise
  • The words, “everything else remains the same” are important
        1. In the real world many variables change simultaneously
        2. However, in order to understand the economy we must first understand each variable separately
        3. We assume “everything else remains the same” in order to understand how supply reacts to price

2.9 The Supply Schedule and The Supply Curve

  • Supply schedule—shows quantities of a good or service firms would choose to produce and sell at different prices, (so again P-Q combination but??)with all other variables held constant
  • Supply curve—graphical depiction of a supply schedule
        1. Shows quantity of a good or service supplied at various prices, with all other variables held constant

Figure 3

2.10 Shifts of supply vs. Movements Along the Supply Curve

  • A change in the price of a good causes a movement along the supply curve
  • In Figure 3

            A rise (fall) in price would cause a rightward (leftward) movement along the supply curve
A drop in transportation costs will cause a shift in the supply curve itself

  • In Figure 4

            Supply curve has shifted to the right of the old curve (from Figure 4) as transportation costs have dropped
A change in any variable that affects supply—except for the good’s price—causes the supply curve to shift

Figure 4

2.11 Factors That Shift the Supply Curve

Input prices

  • A fall (rise) in the price of an input causes an increase (decrease) in supply, shifting the supply curve to the right (left)

Price of Related Goods

  • When the price of an alternate good rises (falls), the supply curve for the good in question shifts leftward (rightward)

Technology

  • Cost-saving technological advances increase the supply of a good, shifting the supply curve to the right

Number of Firms 

  • An increase (decrease) in the number of sellers—with no other changes—shifts the supply curve to the right (left)

Expected Price

  • An expectation of a future price increase (decrease) shifts the current supply curve to the left (right)

Changes in weather 

  • Favorable weather

        Increases crop yields
Causes a rightward shift of the supply curve for that crop

  • Unfavorable weather

        Destroys crops
Shrinks yields
Shifts the supply curve leftward
Other unfavorable natural events may effect all firms in an area

  • Causing a leftward shift in the supply curve

2.12 Market Equilibrium

  • The operation of the market depends on the interaction between buyers and sellers.
  • An equilibrium is the condition that exists when quantity supplied and quantity demanded are equal.
  • At equilibrium, there is no tendency for the market price to change.
  • When a market is in equilibrium
        1. Both price of good and quantity bought and sold have settled into a state of rest
       2. The equilibrium price and equilibrium quantity are values for price and quantity in the market but, once achieved, will remain constant
            a.Unless and until supply curve or demand curve shifts
  • The equilibrium price and equilibrium quantity can be found on the vertical and horizontal axes, respectively
        1. At point where supply and demand curves cross

Figure 5

2.13 Cob-web model

The cob-web model or Theorem analyzes the movements of prices and outputs when supply is wholly determined by prices in the previous period. As prices move up and down in cycles, quantities produced and demanded also seem to move up and down in a counter-cyclical manner (e.g. prices of perishable commodities like vegetables). This is a theory under dynamic equilibrium otherwise called micro dynamics. In order to find out the conditions for the cycles: one has to look at the slope of the demand curve and then of the supply curve.

Assumption of Cobweb theorem
The cob-web Model is based on the following assumption: The current year’s (t) supply depends on the last year’s (t-1) decisions regarding output level. Hence current output is influenced by last year’s price. i.e. P (t-1) The current period or year is divided into sub-periods of a week or fortnight. The parameters determining the supply function have constant values over a series of periods. Current demand (Dt) for the commodity is a function of current price (Pt). The price expected to rule I the current period is the actual price in the last year. The commodity under consideration is perishable and can be stored only for one year. Both supply and demand functions are linear .i.e. both are straight line curves which increases or decreases at a constant proportion.

Example of a Cob-web Model

Under the cobweb model below, the assumption holds that supply is a function of previous year i.e. S=” f” (t-1) (‘t’ is the current period and‘t-1’ is a previous period) and the demand is the function of price i.e. Dt =f (P). The equality between the quantity supplied and quantity demand is the Market equilibrium i.e. St=”Dt . Equilibrium is established through adjustment in price changes during the last year which will take place over a several consecutive periods. Supposing the price of onion last year was P1. The onion growers supply Q1 this year basing on last year price giving the market demand and supply curves for onions by DD and SS curves respectively in diagram.
Suppose there is drought which decreases output and hence supply to OQ2 > OQ1. Price goes up to OP2 in the current period., The onion growers will produce OQ3 in response to the higher price OP2 which exceeds the equilibrium quantity OQ1, the actual need of the market. The excess supply then lowers the price to OP3 which invariably discourage production and reduce supply to OQ4 in the third period. But this quantity is less than the equilibrium quantity OQ1. This will lead to again rise in price to OP4, which in turn will encourage the producers to produce OQ1 quantity. The equilibrium will be established at point g where DD and SS curves intersect. This series of adjustments from point a,b,c,d, and e to f is traced out as a cobweb pattern which converge towards the point of market equilibrium g. This is also termed as the dynamic
equilibrium with lagged adjustment. As the supply will be more due to high price in the market. On the other hand the demand will be less as compared to the supply OQ2 and the demand will reduced to OQ2. The fall in demand will force the producer to decrease price to OP2 in next period. But at this price OP2 the demand will be OQ2 which is more than the supply OQ1 which reduced. This way the prices and quantities will circulate constantly around the equilibrium.

2.14 Elasticity of Demand

  • “Elasticity” is a standard measure of the degree of responsiveness (or sensitivity) of one variable to changes in another variable.
  • Elasticity of Demand measures the degree of responsiveness of demand for a commodity to a given change in any of the independent variables that influence demand for that commodity, such as price of the commodity, price of the other commodities, income, taste, preferences of the consumer and other factors.
  • Responsiveness implies the proportion by which the quantity demanded of a commodity changes, in response to a given change in any of its determinants .
  • Mathematically, it is the percentage change in quantity demanded of a commodity to a percentage change in any of the (independent) variables that determine demand for the commodity.
  • Four major types of elasticity:
        Price elasticity,
        Income elasticity,
        Cross elasticity
        Advertising (or promotional) elasticity.
  • In order to assess the impact of one variable on demand, we assume other variables as constant (ceteris paribus)

2.14.1 Price Elasticity of Demand

  • Price is most important among all the independent variables that affect the demand for any commodity.
  •  Hence Price elasticity of demand ( “ep” or “e”) is considered to be the most important of all types of elasticity of demand.
  •  Price elasticity of demand means the sensitivity of quantity demanded of a commodity to a given change in its own price.
2.14.1.a Degrees of Price Elasticity

2.14.1.b Methods of Measuring Elasticity

2.14.2 Income Elasticity of Demand (ey)

2.14.3 Cross Elasticity of Demand

2.14.4 Promotional Elasticity of Demand

2.15 ELASTICITY OF SUPPLY

  • IT IS DEFINED AS THE RESPONSIVENESS OF THE QUANTITY SUPPLIED OF A GOOD TO A CHANGE IN ITS PRICE.
  • ELASTICITY OF SUPPLY =
                                            (% CHANGE IN QUANTITY SUPPY D) / (% CHANGE IN PRICE)

2.15.1 TYPES OF SUPPLY ELASTICITY

PERFECT INELASTIC SUPPLY :- If  as a result of a change in price, the quantity supplied of a good remains unchanged, we say that the elasticity of supply is zero.

RELATIVELY LESS-ELASTIC SUPPLY :- If as a result of a change in the price of a good its supply changes less than proportionately, we say that elasticity of supply is less than one.
RELATIVELY GREATER ELASTIC SUPPLY :- If elasticity of supply is graeter than one – when the quantity supplied of a good is changes substaintially in response to small change in price of the good.
UNIT ELASTIC SUPPLY :- If the relative change in the quantity supplied is exactly equal to the relative change in price, the supply is said to be unitary elastic.
PERFECT ELASTIC SUPPLY :- the supply elasticity is infinite when nothing is supplied at a lower price but a small increase in price causes supply to rise from zero to an indefinitely large amount indicating that producers will supply any quantity demanded at that price.

 2.16 Importance of Elasticity

Determination of price

  • Elasticity is the basis of determining the price of a product keeping its possible effects on the demand of the product in perspective

Basis of price discrimination

  • Products having elastic demand may be sold at lower price, while those having inelastic demand may be sold at high prices

Determination of rewards of factors of production

  • Factors having inelastic demand are rewarded more than factors that have relatively elastic demand.

Government policies of taxation

  • Goods having relatively elastic demand are taxed less than those having relatively inelastic demand.

2.17 Demand forecasting

According to Cundiff and Still
                  “ Demand forecasting is an estimate of demand during a specified future period based on a proposed marketing plan and a particular uncontrollable and competitive forces”
  • Forecast of demand is an estimation of the future level of demand
  • It take steps for the acquisition of the various factors of production like raw materials , labour, capital, land, building etc. at the right time.
  • Demand forecasting cannot always give best result because future is uncertain.
  • Mainly demand fore casting done at macro level , industry level or firm level.
  • Demand forecast necessitates analysis of past trends and present economic conditions.
  • Forecast may be done for a Short period or for a Long period
  • Period is depend on nature of the business.
  • Long run forecasting is connected with major strategic decisions.

2.18 OBJECTIVES OF DEMAND FORECASTING

Short – term Forecasting (Demand estimation)

  • To evolve a suitable production policy
  • To reduce the cost of purchase
  • To determine appropriate price policy
  • To set sales targets and establish control
  • To forecast short term financial requirements
Long –term Forecasting
  • Planning of a new unit or expansion of an existing unit.
  • Planning of long term financial requirements.
  • Planning of man power requirements.

2.19 METHODS OF DEMAND FORECASTING

Survey method

  • The survey method is the most extensively used method in India.
  • The survey method is generally used for short-term forecasting.

Survey method include,

  • Direct Interview Method
  • Collective opinion

Delphi method

  • This technique of forecasting is based on the opinions of experts.
  • This method is used for demand forecasting and manpower planning.
  • It is widely used in the areas of technological and environmental forecasting, defence strategies, futurology, foreign affairs etc.

Controlled experiments
Barometric techniques

  • Personal income can be used to forecast the demand of consumer goods.
  • Agricultural income can be used to forecast the demand of agricultural inputs , implements, fertilizers, etc.
  • Automobile registration can be used to forecast the demand of automobile accessories, petrol etc.

Statistical method

  • Trend projection method
  • Regression method
  • Simultaneous equation method

2.20 Concepts of revenue

  • The term revenue refers to the income obtained by a firm through the sale of goods at different prices. In the words of Dooley, ‘the revenue of a firm is its sales, receipts or income’.
  • The revenue concepts are concerned with Total Revenue, Average Revenue and Marginal Revenue.

1. Total Revenue:

  • The income earned by a seller or producer after selling the output is called the total revenue. In fact, total revenue is the multiple of price and output. The behavior of total revenue depends on the market where the firm produces or sells.
  • “Total revenue is the sum of all sales, receipts or income of a firm.” Dooley
  • Total revenue may be defined as the “product of planned sales (output) and expected selling price.” Clower and Due
  • “Total revenue at any output is equal to price per unit multiplied by quantity sold.” Stonier and Hague

2. Average Revenue:

  • Average revenue refers to the revenue obtained by the seller by selling the per unit commodity. It is obtained by dividing the total revenue by total output.
  • “The average revenue curve shows that the price of the firm’s product is the same at each level of output.” Stonier and Hague

3. Marginal Revenue:

  • Marginal revenue is the net revenue obtained by selling an additional unit of the commodity. “Marginal revenue is the change in total revenue which results from the sale of one more or one less unit of output.” Ferguson. Thus, marginal revenue is the addition made to the total revenue by selling one more unit of the good. In algebraic terms, marginal revenue is the net addition to the total revenue by selling n units of a commodity instead of n – 1.

A. Koutsoyiannis, “The marginal revenue is the change in total revenue resulting from selling an additional unit of the commodity.”
If total revenue from (n) units is 110 and from (n – 1) units is 100.
in that case
MRnth = TRn – TRn _ 1 = 100 – 100
MRnth = 10
MR in mathematical terms is the ratio of change in total revenue to change in output
MR = ∆TR/∆q or dR/dq = MR
Total Revenue, Average Revenue and Marginal Revenue:
The relation of total revenue, average revenue and marginal revenue can be explained with the help of table and fig.

2.21 Breakeven Analysis

Breakeven analysis is used to determine when your business will be able to cover all its expenses and begin to make a profit. It is important to identify your startup costs, which will help you determine your sales revenue needed to pay ongoing business expenses.
For instance, if you have $5,000 of product sales, this will not cover $5,000 in monthly overhead expenses. The cost of selling $5,000 in retail goods could easily be $3,000 at the wholesale price, so the $5,000 in sales revenue only provides $2,000 in gross profit. The breakeven point is reached when revenue equals all business costs.
To calculate your breakeven point, you will need to identify your fixed and variable costs. Fixed costs are expenses that do not vary with sales volume, such as rent and administrative salaries. These expenses must be paid regardless of sales, and are often referred to as overhead costs. Variable costs fluctuate directly with sales volume, such as purchasing inventory, shipping, and manufacturing a product. To determine your breakeven point, use the equation below:
                        Breakeven point = fixed costs/ (unit selling price – variable costs)