Microeconomics: DEMAND AND SUPPLAY

 

Definition of ‘Microeconomics’

The branch of economics that analyzes the market behavior of individual consumers and firms in an attempt to understand the decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in individual markets

The field of economics is broken down into two distinct areas of study: microeconomics and macroeconomics. Microeconomics looks at the smaller picture and focuses more on basic theories of supply and demand and how individual businesses decide how much of something to produce and how much to charge for it. People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area.

What is Demand?

Demand for a commodity refers to the quantity of the commodity that people are willing to purchase at a specific price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising, etc.) being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it and sufficient purchasing power to purchase it. For instance-Everyone might have willingness to buy “Mercedes-S class” but only a few have the ability to pay for it. Thus, everyone cannot be said to have a demand for the car “Mercedes-s Class”.

Demand may arise from individuals, household and market. When goods are demanded by individuals (for instance-clothes, shoes), it is called as individual demand. Goods demanded by household constitute household demand (for instance-demand for housing, washing machine). Demand for a commodity by all individuals/households in the market in total constitute market demand.

Demand Function

Demand function is a mathematical function showing the relationship between the quantity demanded of a commodity and the factors influencing demand.

Dx = f (Px, Py, T, Y, A, Pp, Ep, U)In the above equation,
Dx = Quantity demanded of a commodity
Px = Price of the commodity
Py = Price of related goods
T = Tastes and preferences of consumers
Y = Income level
A = Advertising and promotional activities
Pp = Population (Size of the market)
Ep = Consumers’ expectations about future prices
U = Specific factors affecting demand for a commodity such as seasonal changes, taxation policy, availability of credit facilities, etc.

Law of Demand

The law of demand states that there is an inverse relationship between quantity demanded of a commodity and it’s price, other factors being constant. In other words, higher the price, lower the demand and vice versa, other things remaining constant.

Demand Schedule

Demand schedule is a tabular representation of the quantity demanded of a commodity at various prices. For instance, there are four buyers of apples in the market, namely A, B, C and D.

Demand schedule for apples

PRICE (Rs. per dozen) Buyer A (demand in dozen) Buyer B (demand in dozen) Buyer C (demand in dozen) Buyer D (demand in dozen) Market Demand (dozens)
10 1 0 3 0 4
9 3 1 6 4 14
8 7 2 9 7 25
7 11 4 12 10 37
6 13 6 14 12 45

The demand by Buyers A, B, C and D are individual demands. Total demand of the four buyers is market demand. Therefore, the total market demand is derived by summing up the quantity demanded of a commodity by all buyers at each price.

Demand Curve

The demand curve is a diagrammatic representation of demand schedule. It is a graphical representation of the price – quantity relationship. Individual demand curve shows the highest price which an individual is willing to pay for different quantities of the commodity. While, each point on the market demand curve depicts the maximum quantity of the commodity which all consumers taken together would be willing to buy at each level of price, under given demand conditions.

Demand curve has a negative slope, i.e, it slopes downwards from left to right depicting that with increase in price, quantity demanded falls and vice versa. The reasons for a downward sloping demand curve can be explained as follows-

  1. Income effect- With the fall in price of a commodity, the purchasing power of consumer increases. Thus, he can buy the same quantity of commodity with less money or he can purchase greater quantities of the same commodity with the same money. Similarly, if the price of a commodity rises, it is equivalent to a decrease in income of the consumer as now he has to spend more for buying the same quantity as before. This change in purchasing power due to price change is known as income effect.
  2. Substitution effect- When the price of a commodity falls, it becomes relatively cheaper compared to other commodities whose price have not changed. Thus, the consumer tends to consume more of the commodity whose price has fallen, i.e, they tend to substitute that commodity for other commodities which have not become relatively dear.
  3. Law of diminishing marginal utility- It is the basic cause of the law of demand. The law of diminishing marginal utility states that as an individual consumes more and more units of a commodity, the utility derived from it goes on decreasing. So as to get maximum satisfaction, an individual purchase in such a manner that the marginal utility of the commodity is equal to the price of the commodity. When the price of commodity falls, a rational consumer purchases more so as to equate the marginal utility and the price level. Thus, if a consumer wants to purchase larger quantities, then the price must be lowered. This is what the law of demand also states.

Exceptions to Law of Demand

The instances where a law of demand is not applicable are as follows-

  1. There are certain goods which are purchased mainly for their snob appeal, such as, diamonds, air conditioners, luxury cars, antique paintings, etc. These goods are used as status symbols to display one’s wealth. The more expensive these goods become, more valuable will be they as status symbols and more will be there demand. Thus, such goods are purchased more at higher prices and are purchased less at lower prices. Such goods are called as conspicuous goods.
  2. The law of demand is also not applicable in case of giffen goods. Giffen goods are those inferior goods, whose income effect is stronger than the substitution effect. These are consumed by poor households as a necessity. For instance, potatoes, animal fat oil, low quality rice, etc. An increase in price of such good increases its demand and a decrease in price of such good decrease its demand.
  3. The law of demand does not apply in case of expectations of change in the price of the commodity, i.e, in the case of speculation. Consumers tend to purchase less or tend to postpone the purchase if they expect a fall in the price of commodity in future. Similarly, they tend to purchase more at high price expecting the prices to increase in future.

Supply and Low of supply

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demmand  refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply  represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of resources. In market econmy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply.

The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the The supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on.

Supply and Demand Relationship

Now that we know the laws of supply and demand, let’s turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company’s previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.

Definition of ‘Equilibrium’

The state in which market supply and demand balance each other and, as a result, prices become stable. Generally, when there is too much supply for goods or services, the price goes down, which results in higher demand. The balancing effect of supply and demand results in a state of equilibrium.

The equilibrium price is where the supply of goods matches demand. When a major index experiences a period of consolidation or sideways momentum, it can be said that the forces of supply and demand are relatively equal and that the market is in a state of equilibrium.

Sources:

  1. Investopedi
  2. Express: Macroeconomics by  Dean Garratt
  3. http://www.textbookmedia.com/Media/46f97fc9-c107-44ff-81be-3cea6203b16d.pd

 

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