Concepts of Demand & Supply in Economics

Demand is the quantity of goods and services that consumers are willing and able to purchase at various prices during a particular period of time. There are five elements of Demand:

1. Desire or want for a commodity or service
2. Means of Purchase
3. Willingness or readiness to pay
4. Certain price
5. Certain period of time

Determinants of Demands

The demand is a function of the following factors:

D=f (P, Pr, Y, T, E, O)

Here is a brief discussion about these:

Price (P)

If the price of a commodity increases, the demand falls and vice versa. However, this rule is not valid for high value goods, whose demand increases when price rises.

Price of Relative Commodities (Pr)

There are two types of relative commodities viz. Complimentary and Substitute. Complementary commodities are those which are used together. For example Tea and Sugar; Bikes & petrol; Pen and Ink etc. A fall in the price of one commodity would cause the demand of the complimentary commodity to rise. For example, other things being equal, fall in prices of sugar would increase demand for tea and vice versa.

Substitute goods or competing goods are those which can be used in place of a commodity. Tea and coffee are substitute goods. If there is a rise in the prices of tea, the demand for coffee will increase. This is called Substitution effect.

Income (Y)

If the income of households increases, the demand for inferior goods would fall and luxury/ normal goods would rise. This is also known as law of demand which says that cateris paribus there is an inverse relation between the price and demanded quantity of a commodity. For example a person, when earns more can afford to eat in a restaurant if his income increases. However, for necessary goods, the demand increases in the beginning and later becomes constant.

Taste and Preference of Consumers (T)

The positive change in taste increases the demand. The demonstration effect also plays an important role here. A demonstration effect is the change in behavior of individuals caused by observation of the actions of others.

Future Expectation (E)

If there is a future expectation about the rise in the price of a commodity, the demand would rise. For example, the Bullion prices keep fluctuating and when there is expectation that the prices of Gold or Silver may raise in the near future, the demand increases

Other Factors (o)

Other factors include composition of the population, distribution of income etc.

Exception to Law of Demand

Conspicuous / Luxury Goods

Higher the prices of the luxury / conspicuous goods – higher are demand. This is because such goods or services are acquired mainly for display of wealth and to attain a social status. Such goods are an exception to the law of demand.

Giffen Goods

Giffen Goods refer to those goods which are considered inferior compared to the substitutes. To be qualified as a Giffen good, a good must be inferior and must lack a close substitute and must constitute a substantial fraction of income of buyer.

Examples of Giffen Good

For a person who has diet made of only bread and chicken would consume more bread if prices of bread increases because bread is more necessary than chicken and increase in price of bread would render chicken out of his reach. Thus, in this case, bread is a Giffen good.  In some cases, Kerosene can behave like a Giffen good.

Conspicuous Necessities

This is again an exception to the law of demand. The lavish spending does not decrease because people spend to attain or maintain a social status.

Elasticity of Demand

Elasticity is the ratio of the percent change in one variable to the percent change in another variable. It is denoted as follows:

Price elasticity of demand

Price Elasticity of demand is defined as the percentage of change in quantity demanded divided by percentage change in price.

We suppose that 10 oranges are demanded by an individual at a price of Rs. 2 each. If the price comes to Re. 1 each, the oranges demanded are 16. The price elasticity of the demand will be as follows:

1.2 in the above solution is called Elasticity coefficient. It ranges between 0 to infinity.

• Perfectly Inelastic: If the value is 0, the Type of price elasticity of demand is perfect inelastic.
• Inelastic: If it is <1 then called inelastic but less than unit elastic
• Unit Elastic: If it is 1 then it is unit elastic
• More Elastic : More than Unit Elastic: If it more than 1 (>1),then it is more elastic
• Perfectly elastic: when the elasticity coefficient is

For salt, increasing the price will not affect its demand because it is required by everybody among us. So we imagine that at Rs. 2 per kgs, salt is demanded 2 kgs and at Rs. 10 per kgs also salt is demanded 2 kgs. In such a case, the above equation would be as follows:

This is an example of perfectly inelastic demand. The price elasticity of demand depends upon the nature of the commodity, available substitutes, share in total expenditure, and possibility of postponing the consumption, several uses of a particular commodity, Consumer habits and range of prices.

Income Elasticity of Demand

Income elasticity of demand is defined as the responsiveness of demand for a commodity to change in income, other determinants remaining constant.

It can be denoted as

We suppose that a family demands 30 liters of milk when its monthly income is Rs. 3000. If the Income of the family increases to 5000, then the demand for mil increases to 40 liters. The Income Elasticity of the demand will be as follows:

This represents that family’s demand for milk is income elastic.

Income Elasticity of demand may be of 3 types:

• Positive: In case of the normal or luxury goods there will be a potivie relations between the income and demand because as the income increases demand increases and vice versa. It can be unitary when Ei=1, greater than 1 or less than 1 .
• Negative: In case of Inferior goods the Income elasticity of demand is negative because there will be a reverse relation between the income and demand for inferior goods. As Income increases demand for inferior goods decreases and vice versa.
• Zero : This is valid of necessary goods such as cloth, rice, salt etc. which are basic necessities of life. Whether the come increases or decreases the quantity demanded is always constant.

Cross Elasticity of Demand

Cross Elasticity of demand refers the responsiveness to a change in the prices of related commodities. It is defined as responsiveness to demand for commodity X to a change in the price of commodity Y. It is represented as follows:

This is very important as well as confusing for a student with no economics background.  The cross elasticity can indicate whether the two products are substitutive (as in case of Tea or Coffee) or complementary (as in case of ball pens or refills).

• If the cross elasticity of demand for commodity X and Y is infinity, the commodity X is nearly a perfect substitute to commodity.
• If the cross elasticity of demand for commodity X and Y is Greater than Zero, commodity X is a substitute to commodity Y
• If the cross elasticity of demand for commodity X and Y is 0, both of the commodities are not related to each other.
• If the cross elasticity of demand for commodity X and Y is negative, both are complementary.

The following example tries to make it clear:

We suppose that Tea is Rs. 50 per kg, and Coffee is 100 per kg. At a given point / period of a time, a family buys 3 kgs of Tea and 3 kgs of coffee at given prices. Now we imagine that coffee becomes expensive and now it is selling at Rs. 200 per kgs. The family now decided to drink more tea and less coffee and purchases 5 kgs of tea and 1 kgs of Coffee.

We denote tea by T and Coffee by C.  The ratio of demand of the above two in the beginning is as follows:

The ratio of the prices of the Tea and Coffee is as follows:

After Changes in the price, the values will be as follows:

The proportionate Change in the demand for Tea and Coffee will be as follows:

The proportionate Change in the prices for Coffee & Tea will be as follows:

Ec would be as follows:

This shows that Tea and coffee are substitutes. There is one more type of elasticity of demand mostly studied in managerial economics i.e. Promotional elasticity. It is the responsiveness of demand for a commodity to changes in the advertisement budget of its producers.

Law of Supply

The law of supply says that other things being equal, when price increases then supply for a commodity increases and when price decreases then supply of a commodity decreases.  Thus, supply has positive relations with the price.

This law takes into account the following assumption:

1. There is no change in price of related Goods.
2. There is No change in factors of production
3. There is no change in technology
4. There is no change in Government policy
5. There is no change in future expectation about prices.

Like demand schedule, the tabulation of supply is also called supply schedule which can be either the Individual supply schedule (single seller ) or market supply schedule (number of sellers).

When there is a rise in the supply because of rise in the prices, it is called “Expansion in Supply”. When there is a fall in the supply due to fall in price it is called contraction in supply.

However if supply increases due to other factors than price it is called “increase in supply” and if it falls due to other factors than price, it is called “ decrease in supply”.

Elasticity of Supply

Elasticity of supply refers to the responsiveness of the quantity supplied of a good to change in its price.

For example if as a result of 20% change in the price of sugar, the suppliers are willing to supply 10 5 more sugar then the supply elasticity will be = 2

• Perfectly elastic supply: In such case the elasticity coefficient would be . The situation in which supply of a commodity continuously change without any change in the price.
• More than Unitary Elastic Supply: It refers to a situation by which the percentage in supply of a commodity is equal to percentage in change in prices.
• Unit Elastic Supply: when percentage change in supply of commodity is equal to percentage change in price.
• Negative Elastic supply: When percentage change in supply of a commodity is less than percentage change in prices.
• Perfectly Inelastic supply: When price of the commodity does not influence the supply of the commodity.

Important Notes on Demand & Supply

• The Law of demand says that when all things remain constant the demand for a particular commodity falls with rise in price. The following graph represents this idea:

• For necessary commodities the demand remains unaffected by the price change and this is represented by the following Graph. In this case the demand curve is vertical and ed=0.

• In such a situation where the demand of a commodity continuously change without any change in the price. It is called the perfect price elasticity and the following graph represents this situation:

• If a commodity has low price (Inferior good), it shall tend to keep the low price elasticity.
• In the case of inferior goods the income elasticity of the demand is Negative. There is an inverse relationship between the demand for inferior goods and the income of the consumer. Thus income elasticity of demand for inferior goods is negative.
• If the price of Pepsi decreases in relative to the price of Coke, the demand for Coke will also decrease because Both Pepsi and Coke are substitute Goods and there is a positive relationship between demand and price of the substitute goods.
• If the price of Burger increases by some extent and quantity of burger demanded falls to some extent this means that demand is elastic. If price for wheat increased but demand for wheat does not fall this means demand is inelastic.
• If quantity demanded of mutton increases by 5% when the price of Chicken increases by 20% , then cross elasticity of demand would be 5% divided by 20% =+ 0.25. In such question divide the %change in demand of one commodity by % change in price of another commodity. + sign denotes that these commodities are substitutive.
• If demand is inelastic and the prices increase, the consumer will suffer because an inelastic demand means that he has to buy in any condition.
• If demand is elastic and the price increase, the consumer will less suffer because he will either decrease the consumption or shift to other products.
• The demand for restaurant meals is elastic, but the demand for meal cooked at home is inelastic.
• If the percentage change in the quantity demanded is greater than the percentage change in price , then a decrease in price will result in increase in revenues. In other case, if the percentage change in the quantity demanded is less than the percentage change in price, the increase in prices will result in increase of total revenue.
• If a good has many substituted, its demand is more elastic, if it has lesser substitutes, its demand is less elastic.
• Law of diminishing utility says that first unit of consumption of a good or service yields more utility than the second and subsequent units. One common example says that a thirsty person is less satisfied in drinking second bottle /glass of coke or Pepsi or lemonade. Utility means satisfaction gained from consuming a good. After reaching  saturation, the total utility will fall and marginal utility will become negative.  The concept of marginal utility was given by Alfred Marshall.
• The demand curve is vertical in case of the Giffen goods.
• The difference between the maximum amounts a person wishes to pay for something and the market price of that particular thing is called the consumer surplus. For example, if the price of a Car is 500,000 and a consumer is able to pay only 470,000 then the consumer surplus would be 30,000. The law of the consumer surplus is based upon the diminishing utility.
• Supply of the good does not meant by the actual production. It means the amount of the good offered for sale at a particular price per unit of time.
• The vertical supply curve implies that elasticity of supply is zero and an horizontal supply curve parallel to the quantity axis implies that elasticity of supply is infinite.
• Supply of a commodity is a Flow Concept and NOT a Stock Concept.
• The necessity of a good is defined a good having an income elasticity of demand less than 1.