Module No.
and Title MODULE 2 Demand and Supply Theory
Lesson No. and Title LESSON 4 The Law of Demand and Supply
1. Discuss and analyze demand.
Learning Outcomes 2. Present Demand Forecasting.
3. Discuss and analyze supply.
Time Frame The lesson will take you about an hour and a half to complete.
Introduction
Demand in the market determines the amount or volume of products the firm has to provide.
Since firms are aiming for large sales, it is important that it must identify if how much it would
produce in the market. Demand in this sense is vital for firm’s production, costing, and revenue.
This lesson will discuss the nature of demand, demand estimation and forecasting, and supply.
Activity
Suppose that hot weather causes the demand for ice cream to increase. As a head of a
manufacturing business of ice cream, what would be your planning strategy/ies to meet the
demand in the market?
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Analysis
Based on the activity above:
✔ What are the factors to be considered in analyzing the demand of ice cream in the market?
✔ What would be the tool/s or method/s to be used in determining the demand to match your
supply in the market?
Abstraction
Demand and the Law of Demand
Demand refers to the ability and willingness of consumer, having the desire to buy the product at
a given price and period of time. It should be noted that demand is not synonymous to
consumption. Demand can be analyze with the aid of table, graph, or function reflecting the
relationship of quantity demanded and price or quantity demanded and other factors affecting it.
Ceteris paribus, the relationship of price and quantity demanded is explained by the Law of
Demand. The said law states that: “Holding other factors as constant, as the price of a particular
product increases the level of quantity demanded of the said product decrease. Likewise, as its
price decrease, the level of its quantity demanded will increase”. The said law implicates the
negative relationship between price and quantity demanded. This condition can be explained by:
a. Substitution Effect – as the price of a particular product increases the consumer will tend
to switch other substitute products which will lead to a reduction on demand of a
particular product.
b. Income Effect – as the price of a particular product increases the purchasing power of the
income reduce which leads also to the reduction on quantity demanded of the product.
In reality, majority of the products follows the mechanism of the law. However, there are also
cases where the said law does not apply. That is, the relationship between price and quantity
demanded is positive. The said cases or goods are as follows:
a. Veblem Goods – goods which satisfies aristocratic desire like diamonds, antique items,
rare paintings, etc. where prices of these items increases the quantity demanded of
wealthy individual will also increase.
b. Giffen Goods – goods due to its essentiality that even if its price increase still consumers
demand increases.
c. Consumers psychological bias or illusion about the quality of commodity with price
change.
d. Case of life saving essential goods and also in times of extraordinary circumstances like
inflation, deflation, war and other natural calamities.
e. Case of speculative demand like stock markets.
Demand Curve and Function
Both demand curve and function are tools which present the relationship of price and/or non-
price factors and quantity demanded. Demand curve illustrates the said relationship through
graphical approach. Below is an example of demand curve derived from a linear function where
price only as its factor;
Price Price
D D
QD/Unit/ QD/Unit/
Linear Demand Curve Time Non-Linear Demand CurveTime
Points will move along the curve when price only affects quantity demanded. This is also termed
as movement along the demand curve. Demand curve will shift either to the left or right if non-
price factors affects quantity demanded (depending on the impact of the non-price factor).
On the other hand, demand function illustrates the relationship of price and quantity demanded
through mathematical approach. Below is an example of a linear demand function indicating
price and non-rice factors:
QD = a – bP + cPS – dPC + eFEP fI + gTP + …..
where: QD is the amount of goods demanded
P is the products own price
PS is the price of its substitute good
PC is the price of its complement good
FEP is the Future Expectation of Price of the product
I is Income which could be positively or negatively related to QD
TP is the Taste and Preference of consumer towards the product
a is the value of quantity when price is zero; this also represents the sales of the
firm at price zero.
b,c,d,e,f,g are marginal effects of the above mentioned factor
Other demand functions example:
Q = aPb where b is the price elasticity coefficient and P is Price
Q = aPbYc where b is the price elasticity coefficient, c is income elasticity
coefficients, P is Price, and Y is Income
Factors Affecting Demand
Apart from the product’s own price, demand is also affected by other factors which are also
termed as non-price factors. Multiple factors may affect the demand level but to name a few, the
following are considered in this lesson:
a. Price of Related Goods. This refers to the prices of its substitute or complement products.
Price of substitute goods affects quantity demanded of a particular product while the price of
its complement goods affects quantity demanded negatively.
b. Income. This factor affects quantity demanded in two different ways, whether the good is
normal or inferior. If the good is normal, income affects quantity demanded positively. And
when the good is inferior it affects quantity demanded negatively.
c. Taste and Preference. This refers to the likes and dislikes of the consumer towards the
product. Hence, this factor affects quantity demanded positively.
d. Future Expectation of Prices. This refers to the anticipation of consumers with regards to
price changes of the product in the future, whether it would increase or decrease. This factor
affects quantity demanded negatively.
e. Population Size. This factor also determines the level of demand in the market of a particular
product. A larger size means more demand. Thus, this factor affects quantity demanded
positively/
As discussed earlier, the above factors will trigger the demand curve shifts whether to the left or
right. Say, an increase in population size will lead to an increase in demand and so the demand
curve will shift to the right. On the other hand, a reduction in income will lead also to a reduction
on demand of a normal good and hence will shift the demand curve to the left. Always remember
that when a factor will lead to an increase of demand then the curve will shift to the right. And
when a factor will lead to a reduction in demand then the curve will shift to the left.
Demand Forecasting
Firm’s pricing mechanism as well as promotion policies will base on the current demand in the
market. Unfortunately, those will not be realized if firm will not undergo into demand
estimation. Demand estimation is a process of identifying current values of demand under the
influence of various prices and other determined variables. The main goal of demand estimation
is to come up a mathematical model that would reflect the relationship between its dependent
variable (demand) and independent variables (prices, income, taste and preferences, etc.) to
forecast demand.
Demand forecasting estimates the future demand of the product. It helps the firm to determine
the estimated demand for its products so that it can plan its production activity accordingly. It is
undertaken either in a macro, industry, or firm level. There are different methods on demand
forecasting, namely:
For Existing Products
A. Qualitative Method
a. Survey Method – under this method few consumers are selected and their response on the
probable demand is collected. The demand of the sample so ascertained is then magnified
to generate the total demand of all the consumers for that commodity in the forecast
period.
b. Expert Opinion – under this method the researcher identifies the experts on the
commodity whose demand forecast is being attempted and probes with them on the likely
demand for the product in the forecast period.
c. Delphi Method – under this method, a panel is chosen to give suggestions in solving the
problems in hand. Panel members are separated from each other and give their views in
an anonymous manner.
d. Consumer Interview – under this method a list of potential buyers would be drawn and
each buyer will be approached and asked about their buying plans. This may be
conducted in a: complete enumeration, sample survey, or end-use method.
B. Quantitative Method
a. Trend Projection – under this method, demand is estimated on the basis of analysis of
past data. This method makes use of time series (data over a period of time). Trend in the
time series can be estimated by using least square method or free hand method or moving
average method or semi-average method.
b. Regression and Correlation – these methods combine economic theory and statistical
techniques of estimation. in this method, the relationship between dependant
variables(sales) and independent variables(price of related goods, income, advertisement
etc..) is ascertained.
c. Extrapolation – in this method the future demand can be extrapolated by applying
binomial expansion method. This is based on the assumption that the rate of change in
demand in the past has been uniform.
d. Simultaneous Equation – also called the complete system approach to forecasting. This is
the most sophisticated econometric method of forecasting. It explains the behavior of all
variables which the firm can control.
For New Products
A. Evolutionary Approach. In this method, the demand for new product is estimated on the
basis of existing product. E.g. Demand forecasting of colored TV on the basis of demand for
black & white TV.
B. Substitute Approach. The demand for the new product is analyzed as substitute for the
existing product.
C. Growth curve Approach. On the basis of the growth of an established product, the demand
for the new product is estimated.
D. Opinion Polling Approach. In this approach, the demand for the new product is estimated
by inquiring directly from the consumers by using sample survey.
E. Sales Experience Approach. The demand is estimated by supplying the new product in a
sample market and analyzing the immediate response on that product in the market..
F. Vicarious Approach. Consumer’s reactions on the new products are found out indirectly
with the help of specialized dealers.
Supply and the Law of Supply
Supply refers to the ability and willingness of the producer to sell at a given price on a particular
period of time. It reflects the seller’s decision in dealing the market with respect on its selling
activities. Supply is not synonymous to stock as the latter refers to the amount or volume of
goods stored and is not yet intended for sale. Similar to demand, supply can also be analyze with
the aid of table, graph, or functions.
The relationship of price and quantity supplied can be explained with the use of the Law of
Supply. The law simply states that: “Holding other factors as constant, as the price of the product
increase the level of its quantity supplied also increases. Likewise, as the price of the product
decrease the level of its quantity supplied will also decrease”. The said condition tells us that
there is a positive relationship between price and quantity supplied and this is due to the profit
motive of the seller. Note that the summation of the entire supply of each seller would reflect the
supply of the market.
Supply Curve and Function
Supply curve is a tool in supply analysis that shows the relationship of price and quantity
supplied in a graphical form. Since there is a positive relationship established between the two
factors (base on the Law of Supply) the structure of its curve is upward sloping. Below is the
graph showing the supply curve.
Price Price
S
S
QS/Unit/ QS/Unit/
Linear Supply Curve Time Non-Linear Supply Curve Time
Under the supply analysis, points will just move along its curve if only price affects quantity
supplied. This is also termed as movement along the supply curve. However, if non-price factors
affects quantity supplied then the entire curve will shift either upward or downward depending
on the impact of the said factors to quantity supplied.
Supply function, on the other hand, is another tool which reflects the relationship between price
and quantity supplied in a mathematical form.
Application
The Creative Publishing Company (CPC) is a coupon book publisher with markets in several
southeastern states. CPC coupon books are sold directly to the public, sold through religious and
other charitable organizations, or given away as promotional items. Operating experience during
the past year suggests the following demand function for CPC's coupon books:
Q = 5000 - 4000P + 0.02Pop + 0.25I + 1.5A
where Q is quantity, P is price ($), Pop is population, I is disposable income per household ($),
and A is advertising expenditures ($).
Source: Managerial economics by Bentzen, E. & Hirschey, M. (2016)
A. Determine the demand faced by CPC in a typical market in which P = $10, Pop - 1 000000
persons, I - $60000, and A - $10000.
B. Calculate the level of demand if CPC increases annual advertising expenditures from $10000
to $15000.
C. Calculate the demand curves faced by CPC in parts A and B.
Good job! You just finished Lesson 4.
If you are ready, you may proceed to Lesson 5.