The Market Forces of

Demand and Supply

Dr. Kanupriya
IIFT Delhi
 Learning Objectives
• Demand
• Supply
• Determinants of Demand
• Determinants of Supply
• Shift in the Demand Curves
• Shift in the Supply Curves
• Market Equilibrium and Comparative Statics
• Elasticity of Demand
• Applications of Elasticity of Demand
• Review Questions
 Demand
• Demand is an economic concept that relates to a consumer’s desire to:

 Purchase goods and services

 Willingness to pay a specific price for them
• Both ability and willingness to pay play a crucial role in demand.
• Economists use the term demand to refer to the amount of some good or service consumers
are willing and able to purchase at each price.
What a buyer pays for a unit of the specific good or service is called price.
The total number of units purchased at that price is called the quantity demanded.
An increase in the price of a good or service almost always decreases the quantity demanded of
that good or service.
Conversely, a decrease in price will increase the quantity demanded.
 Demand (Contd.)
• Demand is a concept that consumers and businesses are quite
familiar with.

• For example, shoppers with an eye on products that they want

will buy more when the product prices are less.

• When something happens to raise the prices, such as a change of

season, shoppers buy fewer or perhaps none at all.
 Demand (Contd.)
• The law of demand states that a higher price leads to a lower quantity
demanded and that a lower price leads to a higher quantity demanded
(Economists call this inverse relationship between price and quantity
demanded the law of demand. The law of demand assumes that all
other variables that affect demand are held constant).

• Demand curves and demand schedules are tools used to summarize

the relationship between quantity demanded and price.
 Demand (Contd.)
•A demand schedule is a table that shows the quantity demanded at each price.
 Demand (Contd.)
• The demand schedule shows that as price rises, quantity demanded decreases and vice versa.

• These points are then graphed and the line connecting them is the demand curve.

• The downward slope of the demand curve again illustrates the law of demand—the inverse
relationship between prices and quantity demanded.
 Demand (Contd.)
• The difference between demand and quantity demanded:

In economic terminology, demand is not the same as quantity demanded.

When economists talk about demand, they mean the relationship between
a range of prices and the quantities demanded at those prices, as illustrated
by a demand curve or a demand schedule.
When economists talk about quantity demanded, they mean only a certain
point on the demand curve or one quantity on the demand schedule.
In short, demand refers to the curve, and quantity demanded refers to a
specific point on the curve.
 Supply
•Supply in economics refers to the number of units of goods or services a supplier is willing and able to
bring to the market for a specific price.

•More the prices, greater will be the supply, ceteris paribus.

•The law of supply is a fundamental principle of economic theory which states that, keeping other
factors constant, an increase in sales price results in an increase in quantity supplied OR a higher price
leads to a higher quantity supplied and that a lower price leads to a lower quantity supplied.

•In other words, there is a direct relationship between price and quantity: quantities respond in the same
direction as price changes.

• Supply refers to the curve and quantity supplied refers to a specific point on the curve.
 Supply (Contd.)
• For example, when the price of gasoline rises, it encourages profit-
seeking firms to take several actions:

Expand exploration for oil reserves,

drill for more oil, invest in more pipelines and oil tankers to bring the oil
to plants where it can be refined into gasoline, build new oil refineries,
purchase additional pipelines and trucks to ship the gasoline to gas stations
and open more gas stations or keep existing gas stations open longer
hours.
 Supply (Contd.)
• A supply schedule is a table that shows the quantity supplied at each price.
 Supply (Contd.)
• The supply curve is created by graphing the points from the supply
schedule and then connecting them.
• The upward slope of the supply curve illustrates the law of supply—
that a higher price leads to a higher quantity supplied and vice versa.
 Determinants of Demand
• Product cost: Demand of the product changes as per the change in the price of

the commodity. People deciding to buy a product remain constant only if all the

factors related to it remain unchanged.

• The income of the consumers: When the income increases, the number of

goods demanded also increases. Likewise, if the income decreases, the demand

also decreases.
 Determinants of Demand (Contd.)
• Costs of related goods and services: For a complement , an increase in the cost of one commodity will
decrease the demand for a complement. Example: An increase in the rate of bread will decrease the
demand for butter. Similarly, an increase in the rate of one commodity will generate the demand for a
substitute to increase. Example: Increase in the cost of tea will raise the demand for coffee and
therefore, decrease the demand for tea.

• Consumer expectations: High expectation of income or expectation in the increase in price of a good
also leads to an increase in demand. Similarly, low expectation of income or low pricing of goods will
decrease the demand.

• Buyers in the market: If the number of buyers for a commodity are more or less, then there will be a
shift in demand.
 Determinants of Supply
• Techniques of production
The kind of production techniques utilized impacts the availability of commodities. Low output
due to outdated processes further reduces the supply of commodities. Technological advancements
assist in lowering production costs and increasing profit, resulting in increased supply.
• Production costs
It is the expense undertaken to produce goods that will be supplied. The cost of production and the
supply of goods is inversely proportional because profit maximization is the primary purpose of
most private businesses. Higher production costs reduce profit, limiting supply. Production costs
are influenced by the cost of raw materials, wage rates, government licensing, taxation and so on.
• Type of economy
The institutional structure in which an industry works impacts the supply of goods. If a monopoly
exists in the industry, the manufacturer may control the supply of their goods to boost prices and
profits. The market supply tends to grow as more sellers enter the market.
 Determinants of Supply (Contd.)
• A product’s cost
The price of a product is one of the most important drivers of its supply.
While other parameters stay constant, an increase in the price of a
product raises its supply and likewise.

• Future pricing expectations

If producers foresee future prices to be higher, they will want to retain
their supplies and sell the products later, allowing them to profit from
the higher price. The greater the chance of profit, the higher the price of
the good. As a result, the stronger the temptation to make more and sell
it on the market.
 Determinants of Supply (Contd.)
• Price of complementary goods

The prices of other items may influence the supply of a product, particularly
if the commodities are complementary. A complementary good enhances the
value of another or one that cannot exist without the other.
Complementary goods have a negative association, which indicates that when
the price of product X rises, the demand for product Y decreases.
 Determinants of Supply (Contd.)

• Government policies

Environmental and health restrictions, hour and wage legislation, taxes,

electric and natural gas tariffs, and transportation and land use regulations are
only a few examples of government policies and regulations. These rules can
impact a product’s availability and thus, can be both a boost and a deterrent in
determining the production.
 Shift in the Demand Curves
• A variable that can change the quantity of a good or service demanded at
each price is called a demand shifter.
• When these other variables change, the all-other-things-unchanged
conditions behind the original demand curve no longer hold.
• When a change in some economic factor (other than price) causes a
different quantity to be demanded at every price.
• The demand shifters are :
(1) Consumer preferences,
(2) The prices of related goods and services,
(3) Income,
(4) Demographic characteristics,
(5) Buyer expectations
Shift in the Demand Curves (Contd.)
 Shift in the Demand Curves (Contd.)
• Consumer preferences
Changes in preferences of buyers can have important consequences for demand. An example is
reduced demand for cigarettes caused by a concern about the effect of smoking on health. A change
in preferences that makes one good or service more popular will shift the demand curve to the right.
A change that makes it less popular will shift the demand curve to the left.
• The prices of related goods and services
 Shift in the Demand Curves (Contd.)
• Income
As incomes rise, people increase their consumption of many goods and services, and as
incomes fall, their consumption of these goods and services falls.
For example, an increase in income is likely to raise the demand for gasoline, ski trips,
new cars and jewellery.
There are, however, goods and services for which consumption falls as income rises—and
rises as income falls.
As incomes rise, for example, people tend to consume more fresh fruit but less canned
fruit.
A good for which demand increases when income increases is called a normal good.
A good for which demand decreases when income increases is called an inferior good.
An increase in income shifts the demand curve for fresh fruit (a normal good) to the
right; it shifts the demand curve for canned fruit (an inferior good) to the left.
 Shift in the Demand Curves (Contd.)
• Demographic characteristics

The number of buyers affects the total quantity of a good or service that
will be bought; in general, the greater the population, the greater the
demand.
Other demographic characteristics can affect demand as well.
E.g., as the share of population over age 65 increases, the demand for
medical services increases.
Demand can thus, shift as a result of changes in both the number and
characteristics of buyers.
 Shift in the Demand Curves (Contd.)
• Buyer expectations

 The consumption of goods that can be easily stored, or whose consumption can be postponed, is strongly affected
by buyer expectations.

 The expectation of newer TV technologies, such as high-definition TV, could slow down sales of regular TVs.

 If people expect gasoline prices to rise tomorrow, they will fill up their tanks today to try to beat the price increase.

 The same will be true for goods such as automobiles and washing machines: an expectation of higher prices in
the future will lead to more purchases today.

 If the price of a good is expected to fall, however, people are likely to reduce their purchases today and await
tomorrow’s lower prices.

 The expectation that computer prices will fall, for example, can reduce current demand.
 Shift in the Supply Curves
• When a change in some economic factor (other than price) causes a different quantity to be
supplied at every price.

• The supply shifters are :

(1) Changes in input prices

(2) Innovations in technology

(3) Changes in prices of related goods

(4) Changes in the number of producers

(5) Changes in producers’ expectations

(6) Government regulations, taxes and subsidies

Shift in the Supply Curves (Contd.)

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 Shift in the Supply Curves (Contd.)
• Changes in input prices

 When coming up with the quantity of any good or service to supply in the market, producers must take the
prices of inputs that they will have to use in the production process into account. Subsequently, any changes
in these input prices would likely cause producers to change the quantities of the good or service that they are
willing to supply.

 E.g., suppose the price of cotton increases. Higher cotton prices would make the production of cotton
clothes costlier for producers, thus, incentivizing them to lower quantities of the end product supplied. This
would be an example of a leftward shift in the supply curve for cotton clothes caused or influenced by an
increase in input prices.
 Shift in the Supply Curves (Contd.)
• Innovations in technology

Developments in technology may help producers reduce their production costs and improve
production efficiency. This will incentivize producers to supply higher quantities of goods,
which will translate to the supply curve shifting rightwards.
Alternatively, if for any reason, producers have to resort to using less advanced technology in
their production process, they will likely end up producing lower quantities. In that case, the
supply curve will shift leftwards.
E.g., a new software allows an accounting firm to automate parts of their data processing
that would previously require hours of hands-on work by their employees. Hence, by
significantly cutting operating costs, this software allows the firm to be more efficient and thus,
be more productive. In this case, an advancement in technology leads to an increase in the
quantity of a service supplied, shifting the supply curve to the right.
 Shift in the Supply Curves (Contd.)
• Changes in prices of related goods

-Substitute goods are products and services that satisfy the same desires or
needs for consumers as the goods that are substituted, thus, serving as a
sufficient alternative.
- Complementary goods are goods that consumers tend to purchase together
with the goods that are complemented, thus, adding value to each other.
E.g., A publishing company printing books in hardcovers and paperbacks
which are substitutes in production. Suppose the price of hardcover
textbooks significantly increases. It incentivizes publishers to produce
more hardcover books rather than paperbacks. As a result, producers are
now likely to reduce the quantities supplied of paperback textbooks, thus,
shifting the supply curve to the left.
 Shift in the Supply Curves (Contd.)
• Changes in the number of producers

If, for any reason, more producers enter the market to supply a product, the
market supply curve will shift rightwards with the quantity supplied increasing
at each price level. On the other hand, a reduction in the number of producers
will translate into lower quantities supplied, reflecting in a leftward shift of the
market supply curve.
E.g., supplying corn syrup becomes a more profitable business after the
price of corn, being a key input, falls significantly. This change attracts more
producers to start supplying corn syrup due to its increase in profitability. As a
result, the quantity of corn syrup supplied increases and the market supply
curve will shift rightwards.
 Shift in the Supply Curves (Contd.)
• Changes in producers’ expectations

 If producers foresee unfavourable market conditions in the future such as

decreases in the price of their product, they may decide to reduce the
quantities they supply, thus, shifting the supply curve leftwards. Inversely,
if producers have an optimistic outlook on the future market conditions in
relation to the products they supply, they may increase quantities supplied
in anticipation of higher profitability.
E.g., as sea levels continue to rise, environmentalists predict that
increasing areas of coastline territories will go underwater. This outlook
will serve as a disincentive to real estate developers to build more
properties close to the coastline. In this case, a grim outlook for the future
compels the producers (developers) to reduce quantities of their product
(properties) supplied.
 Shift in the Supply Curves (Contd.)
• Government regulations, taxes and subsidies

Whether certain regulations enforced by the authorities are meant to have direct
economic effect or not, depending on what these regulations are, they may affect
the cost and capacity of production for various goods and services.
• Any taxes that affect the inputs and/or the production process of any goods or
services will increase production costs. If such taxes are introduced, they will
likely force producers to reduce quantities of their products that they are able to
supply, thus, shifting their supply curve leftwards.
• Subsidies, on the other hand, are likely to reduce production costs for producers.
Saving on the expenses in the production process with the help of subsidies would
enable producers to supply higher quantities of their goods, which would then
shift the supply curve rightwards.
• E.g., strict regulations reduce supply and higher taxes on silk lead to less supply
for the same.
 Market Equilibrium and Comparative
Statics
• Comparative statics is a tool used to predict the effects of exogenous
variables on market outcomes. Exogenous variables shift either the
market demand curve (for example, news about the health effects of
consuming a product) or the market supply curve (for example, weather
effects on a crop).

• By market outcomes, we mean the equilibrium price and the

equilibrium quantity in a market.

• Comparative statics is a comparison of the market equilibrium before

and after a change in an exogenous variable.
 Market Equilibrium and Comparative Statics
(Contd.)
• A comparative statics exercise consists of the following five steps:
Begin at an equilibrium point where the quantity supplied equals the
quantity demanded.
Based on a description of the event, determine whether the change in the
exogenous variable shifts the market supply curve or the market demand
curve.
Determine the direction of this shift.
After shifting the curve, find the new equilibrium point.
Compare the new and old equilibrium points to predict how the exogenous
event affects the market.
 Market Equilibrium and Comparative Statics
(Contd.)
•If the market demand curve shifts, then the new and old equilibrium points lie on a fixed market supply curve.
•If the market supply curve shifts, then the new and old equilibrium points lie on a fixed market demand curve.

0 0

A Shift in the Demand Curve A Shift in the Supply Curve

 Elasticity of Demand
• Elasticity of demand refers to the variation in demand for an item or service when a
purchase-decision variable changes (E.g., own price of the good, price of related
goods, income of its buyer, tastes and preferences etc.).
• When a change in any one of those variables causes a significant change in demand,
the elasticity of demand is high — the customer’s buying behaviour is flexible.
• When changes in these variables have little or no effect on demand, the product is
having inelastic demand.
• The value of elasticity of demand ranges from zero to infinity (perfectly inelastic,
inelastic, unitary elastic, elastic and perfectly elastic demand).
• Broadly, there are three types of elasticity of demand.
1. Price elasticity of demand
2. Income elasticity of demand
3. Cross Price Elasticity of demand
 Elasticity of Demand (Contd.)
• Price elasticity of demand: Price elasticity of demand means degree of
responsiveness of demand for a commodity to the change in its price.

• For example, if demand for a commodity rises by 10% due to 5% fall in

its price, price elasticity of demand (ep)

• Note that ep will always be negative due to inverse relationship of price

and quantity demanded.
 Elasticity of Demand (Contd.)
• Income elasticity of demand: Income elasticity of demand refers to
the degree of responsiveness of demand for a commodity to the
change in income of its buyer.

• Suppose, income of buyer rises by 10% and his demand for a

commodity rises by 20%, then,

• Income elasticity of demand (ey)= Income elasticity of demand

(YED) = Percentage change in quantity demanded/Percentage
change in buyer’s income
Or
• YED = % ∆ in Qd/% ∆ in Y= 20%/10%=2
 Elasticity of Demand (Contd.)
• Cross Price Elasticity of demand: Cross price elasticity of demand means
the degree of responsiveness of demand for a commodity to the change in
price of its related goods (substitute goods or complementary goods).

• Suppose, demand for a commodity rises by 10% due to 5% rise in price of

its substitute good, then

• Cross price elasticity of demand (ec )

 Elasticity of Demand (Contd.)
• Nature of Commodity
• Availability of Substitutes
• Habits and Customs
• Alternative Uses
• Complementary Goods
• Income Levels of the Household
• Time Period
• Level of price and Extent of Change
• Proportion of income spent
• Postponement of Consumption
Applications of Elasticity of Demand
 Review Questions
Q1. Explain the law of demand.

Q2. Explain the law of supply.

Q3. Discuss the concept and applications of cross price elasticity of demand.

Q4. What are the factors that cause a shift in the demand curve?
Thank You