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Dr. M. Nusrate Aziz Graduate School of Management Multimedia University

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Law of Demand and Supply

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Determinants of market demand include Price of own of the commodity or service Income Consumer Preference / Taste Price of substitute and complementary goods and so on. The functional form can be given as follows

where, Qd is quantity demanded, P is own price, Y is income of consumer, T is taste/preference and Pr is price of other related commodities/services.

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Assume that all the determinants except own price of the considered commodity/service are unchanged. Then, we find an inverse relationship between price and demand of the commodity/service, which is known as law of demand. The following equation represents the law of demand

where Q is quantity demanded and P is the price of the considered goods or service.
If you plot the above equation, you will find a downward sloping demand curve.

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Lets talk about price and demand of a novel.

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The location of Emmas demand curve for novels depends on how much income she earns. The more she earns, the more novels she will purchase at any given price, and the farther to the right her demand curve will lie. Curve D1 represents Emmas original demand curve when her income is $30,000 per year. If her income rises to $40,000 per year, her demand curve shifts to D2. If her income falls to $20,000 per year, her demand curve shifts to D3.

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Supply

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Production cost: Since most private companies goal is profit maximization. Higher production cost will lower profit, thus hinder supply. Factors affecting production cost are: input prices, wage rate, government regulation and taxes, etc. Technology: Technological improvements help reduce production cost and increase profit, thus stimulate higher supply. Number of sellers: More sellers in the market increase the market supply. Expectation for future prices: If producers expect future price to be higher, they will try to hold on to their inventories and offer the products to the buyers in the future, thus they can capture the higher price. A specific supply function can be written as follows -

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A supply curve can be shown as follows -

This supply curve, which graphs the supply schedule, shows how the quantity supplied of the good changes as its price varies. Because a higher price increases the quantity supplied, the supply curve slopes upward.

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Market Equilibrium

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General form of demand and supply curve -

We notice a negative relationship between price and demand; while a positive relationship between prices and supply of commodity. Equilibrium Price and Quantity: When market demand is equal to market supply we then find market equilibrium (i.e., Qd = Qs). This gives us market price and equilibrium quantity -

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Can you decide about price of your product as a manager? Market Price -

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Market Demand

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The market demand curve

15 10 D1 4 D2 Qd 2 DM

Qd

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Qd

Determinants of market demand (similar to simple demand) Consumer Preference Income Price of own Price of other substitute and complementary goods

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Suppose Raihan, a graduating senior, has accumulated impressive case studies during his university career which have market value. Now he needs to sell them to obtain money for his impending marriage. Three of his wealthy friends express interest in buying some of them. Their individual demand functions can be expressed as follows:

where the quantity subscripts denote each of the three friends and price is measured in dollar per test (a) What is the market demand equation for Raihans case studies? (b) How many more case studies can he sell for each one dollar decrease in price? (c) If he has a file of 60 case studies what price should he charge to sell his entire collection?

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Governments Role
Suppose, the market demand and market supply equations are Qd = 90 3P ---- (3) Qs = -10 + 2P ---- (4) Suppose, government impose a price restriction on supplier that supplier cannot charge more that RM15 per unit of commodity. (i) What will then be market demand and supply? (ii) Is there any excess supply or demand? If yes, how much? (iii) What will be the market price , if government does not intervene?

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Elasticity of Demand

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There are two approached of elasticity computation: (i) Point elasticity (which we usually derive from demand/supply equations) and (ii) Arc Elasticity (which includes discrete values of price and demand/supply). Arc Elasticity: The percentage change in price is the change in price divided by price. Similarly, the percentage change in quantity demanded is the change in quantity divided by quantity. Thus the price elasticity can be expressed as: Suppose, P Q Where, Ep = price elasticity of demand, 5 6 P = P2 P1 (change in price) Q = Q2 Q1 (change in demand) 1 10 Q = Q1 (initial quantity) Elasticity, Ep = -0.83 P = P1 (initial price)

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The higher price do not always result in greater revenue. A change in price can either increase or decrease or keep the total revenue constant depending on the nature of demand function (i.e., elasticity of demand). Price Elasticity of Demand: it is measured by percentage change in quantity demanded divided by percentage change in price.

Implication of elastic, inelastic and unitary elastic demand: Suppose that a firm increases the price of its product by 2 percent and quantity demanded subsequently decreases by 3 percent, the price elasticity would be -

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Implication of price elasticity: Elastic Unitary elastic Inelastic Consider the following demand function. Find price elasticity of demand of this function. Also find the inverse demand function of it.

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Price elasticity is important for decision making. In case of inelastic demand we can earn more revenue by increasing price. When there is elastic market demand, if we increase price total revenue will fall. If we reduce price total revenue will be increased. When there is unitary elastic demand for a particular commodity, increase or decrease of price does not increase total revenue.

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Let us derive the relationship between price, revenue and elasticity. We know,

Now, suppose the elasticity is greater than one or less than one or exactly unity. What are the impact of price changes on total revenue?

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In case of unitary elastic demand, marginal revenue is zero. A change in price would have no real effect on total revenue. (Check it!) In case of elastic demand, a reduction in price would increase total revenue. (Check!) In case of inelastic demand, increase in price would increase total revenue. (Check!) Read the Case Study [How much tuition for college students?] at page 85 of Managerial Economics, (4th Edition), by Petersen, Lewis and Jain.

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How the change in income may affect the demand? Income Elasticity: ratio of percentage change in quantity demanded and percentage change in income.

where, y = income; q = quantity demanded; dy = change in income Find income elasticity from the following equation when initial income was Tk. 10,500. Is the changes are positive or negative?: Income elasticity can be positive or negative. It can be less or greater than unity.

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Inferior Goods: If an increase in income is associated with a fall in demand for any particular commodity, we say that the good (or service) is inferior in nature. For example, when income increases consumers buy quality rice by paying more. Hence, the demand for the earlier type of rice falls. The earlier type of rice is called inferior good. Normal Goods: Income elasticity of demand for Normal Goods or services are positive. For example, for a poor family, the demand for bread is increased with the increase in its income. But it increase less than proportionate. Luxurious Goods: Demand elasticity of luxurious goods and services are more than unity. For example, if you become more wealthier, you buy better branded car, right? Thus, spend more and more in luxuries.

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You know, whether you are a manger in a normal goods (or services), inferior or luxurious commodity producing firm. Think about the recession which has been affecting economies from the late-2007 till now. What do you think about the demand of your commodity? Suppose, the commodity is luxurious or normal or inferior. You are a manager in a remote area of the country. You have both high quality and less quality products. Of course, production cost differs for producing the products. Do you decide to sell the high or low quality products to sale there?

Suppose, you are going to start a business in Kuala Lumpur. Do you introduce a quality but expensive business or just a normal grocery (less quality and cheaper business).

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Demand of a commodity is also influenced by the price of other commodities. The responsiveness of quantity demanded to the change in price of other goods is measured by cross-elasticity of demand.

Suppose, demand of x in terms of y can be given as follows:

How to find the cross-elasticity of demand of x for y.

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Decisions rules for cross-elasticity of demand: 1. If, the value of cross-elasticity EC = 0, commodity (or service) x and y are uncorrelated. 2. If the value of EC > 0 (is positive), x and y are substitute goods. 3. If the value of EC < 0 (is negative), x and y are complementary goods. Practice: Suppose, there are demand for tea and price of coffee are interrelated. The relationship can be expressed as follows:

Suppose, initial price of coffee was Tk. 20 per cup. Find the cross-elasticity of demand of tea for coffee.

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Practice 1

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Market Equilibrium

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Practice 2

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Market Equilibrium

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Practice 3

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Elasticity

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Practice 4

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Elasticity

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Practice 5

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Elasticity

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What is Next? Output Decision From Market Demand Function