CHAPTER 1 MANAGERIAL ECONOMICS – DEMAND ANALYSIS The Concept of Market: The word market generally means a place or an area where good and services are sold like Bombay stock exchange, vegetable market, etc. in economics the word market is used in a rather abstract sense. The market means a system by which sellers and buyers of a commodity interact to settle its price and the quantity to be bought and sold.

Features of Market: 1. A market need not be situated in a particular place or locality. 2. Buyers and sellers need not come into personal contact with each other 3. The word market may refer to a commodity or service example, fruit market, car market, share market, money market, paper market, labor market, etc.

Market System: The market for a product works on certain market principles that is the laws that govern the working of the market system, also called market mechanism. The working of the market system is governed by certain fundamental laws of market called the laws of demand and supply. The laws of demand and supply play a crucial role in determining the price of a commodity and the size of the market. The market system works by two kinds of market forcesdemand and supply. The demand and supply forces represent two sides of the market (i) demand side, and (ii) supply side.

Demand Side of the Market: The demand side of the market for a product refers to all its consumers and the price that they are willing to pay for buying certain quantity of the product during a period of time. The quantity that consumers buy at a given price determines the market size. The demand side of the market is governed by the law of demand. The law of demand governs the market in the sense that when prices go up demand goes down and size of the market is reduced, all other things remaining the same. Similarly, when prices decrease demand increases causing a rise in sales and market size tends to increase. 1 Managerial Economics-Demand Analysis

Law of Demand: Marshall, the originator of the law, has stated the law of demand as “the amount demanded increases with a fall in price and diminishes with a rise in price.” This law holds under ceteris paribus assumption, that is, all other things remain unchanged.

Demand Schedule: A demand Schedule is a tabular presentation of different prices of a commodity and its corresponding quantity demanded per unit of time. A hypothetical annual market demand schedule for Tables. This table presents prices of tables (Pc) and the corresponding number of tables demand (Qc). It illustrates the law of demand. As data given in the tables shows, the demand for tables (Qc) increases as its price (Pc) decreases. Demand Schedule for Tables Qc Pc (Price in ) 800 10 600 15 400 30 300 40 200 60 100 80

Demand Curve: A demand curve is a graphical presentation of the demand schedule. A demand curve is obtained by plotting a demand schedule. 990 800

D

Price of Tables (Rs.)

700 J

600 500

K

400 300

L

200 M

100

D’

0 10

20

30

40

50

60

70

80

No. of Tables (in’000) The Demand Curve for Tables 2 Managerial Economics-Demand Analysis

90

The resulting curve DD‟ is the demand curve. The curve DD‟ depicts the law of demand. It slopes downward to the right. It has a negative slope. The negative slope of the demand curve DD‟ shows the inverse relationship between the price of tables and their quantity demanded. Downward movement on the demand curve DD‟ from point D towards D‟ shows fall in price and rise in demand. Similarly, an upward movement from point D‟ towards D reads rise in price and fall in demand.

Supply Side of the Market: In a market economy, while buyers of a product constitute the demand side of the market, sellers of that product make the supply side of the market. In this section, we discuss the supply side of the market beginning with the law of supply.

Market Supply: Supply means the quantity of a commodity that its producers or sellers offer for sale at a given price, per unit of time. Market supply, is the sum of supplies of a commodity made by all individual firms or their supply agencies. The market supply of a product is governed by the law of supply.

The Law the Supply: The supply of a commodity depends on its price and cost of its production. In other words, supply is the function of price and product cost. The law of supply is expressed in terms of price quantity relationship. The law of supply can be stated as follows: The supply of a product increases with the increase in its price and decreases with decrease in its price, other things remaining constant. It implies that the supply of a commodity and its price are positively related. This relationship holds under the assumption that “other things remain the same”. “Other things” include technology, price of related goods (substitute and complements), and weather and climatic conditions in case of agricultural products.

Supply Schedule: A supply schedule is a tabular presentation of the law of supply. A supply schedule is a table showing different prices of a commodity and the corresponding quantity that suppliers are willing to offer for sale. It presents a hypothetical supply schedule of tables i.e., number of tables supplied per week at different prices.

3 Managerial Economics-Demand Analysis

Supply Schedule of Tables Supply (Tables) Price in ( ) 100 8 200 30 300 40 400 60 600 70 800 80

Supply Curve: The supply curve, SS”, depicts the law of supply.

The upward slope of the supply curve

indicates the rise in the supply of tables with the rise in its price and fall in the supply with fall in prices. 900

S’

700 600

T

500

)

400

R

200 100

Q

abn

300 T

Price of tables ( 𝑅𝑠. )

800

P

S

0 10

20

30

40

50

60

70

80

90

No. of Tables Supply Curve of Tables The positive slope or upward movement of the supply curve is caused by the rise in cost of production and seller‟s effort to make a larger profit. The rise in cost of production results from the law of diminishing returns.

Other Factors Influence the Supply of a Commodity: Although price of a commodity is the most important determinant of its supply, it is not the only determinant. Many other factors influence the supply of a commodity. Given the supply curve of a commodity, when there is change in its other determinants, the supply curve shifts rightward or leftward depending on the effect of such change.

4 Managerial Economics-Demand Analysis

(i)

Change in Input Prices: When input prices decrease, the use of inputs increases. As a result, product supply increases and the supply curve SS shifts to the right to SS”.

Similarly, when input

prices increase, product supply curve shifts leftward from SS to SS”. (i)

Technological Progress: Technological changes that reduce cost of production or increase efficiency in production cause increase in product supply.

For instance, introduction of high

yielding variety of paddy and new techniques of cultivation increased per acre yield of rice in India in the 1970s. Such changes make the supply curve shift to the right. (ii)

Price of Product Substitutes: Given its technology and production capacity, a firm can produce more than one good which require a similar technology. For example, a refrigerator company can also produce ACs, Tatas, famous for truck production can also produce are Maruti Udyog can produce trucks, and so on.

Fall in the price of one of the product

substitutes may lead to the rise in the supply of other due to capacity utilisation for profit maximisation. This may cause shift in the supply curve. (iii)

Nature and Size of the Industry: The supply of a commodity depends also on whether an industry is monopolized or competitive. Under monopoly, supply is fixed. When a monopolized industry is made competitive, the total supply increases. Besides, if size of an industry increases due to new firms joining the industry, the total supply increases and industry supply curve shifts rightward.

(iv)

Government Policy: When government imposes restrictions on production, eg., import quota on inputs, rationing of or quota imposed on input supply, etc., production tends to fall. Such restrictions make supply curve shift leftward.

(v)

Non-Economic Factors: Factors like labour strikes and lock-outs, war, drought, flood, communal riots, epidemics, etc. also adversely affect the supply of commodities and make the supply curve shift leftward.

Supply Function: The supply function is a mathematical statement which states the relationship between the quantity supplied of a commodity and its price. Supply function is based on the law of supply.

Q = 10 Px 5 Managerial Economics-Demand Analysis

Where Qx denotes the quantity supplied of commodity X per unit of time and P x denotes its price.

Market Equilibrium: Equilibrium of Demand and Supply Determination of Price in a Free Market: A free market is one in which market forces of demand and supply are free to take their own course and there is no outside control on price, demand and supply. 1. The Concept of Market Equilibrium: The term equilibrium means the „state of rest‟. In general sense, it means balance in forces working in opposite direction. In the context of market analysis, equilibrium refers to a state of market in which quantity demanded of a commodity equals the quantity supplied of the commodity. The equality of demand and supply produces an equilibrium price. The equilibrium price is the price at which quantity demanded of a commodity equals its quantity supplied.

That is, at equilibrium price, demand and

supply are in equilibrium. Equilibrium price is also called market clearing price. Market is cleared in the sense that there is no unsold stock and no unsupplied demand. 2. Determination of Market Price: Equilibrium price of a commodity in a free market is determined by the market forces of demand and supply. In order to analyse how equilibrium price is determined, we need to integrate the demand and supply curves. As the table shows, there is only one price of table ( week equals the quantity supplied at 40. equilibrium at price

300) at which quantity demanded per

It means that the table market in Delhi is in

300. At all other prices, the table market is in disequilibrium – the state

of imbalance between supply and demand. When market is in the state of disequilibrium, either demand exceeds supply or supply exceeds demand. Weekly Demand and Supply Schedules for Tables Price per Table 100 200 300 400 500 600

Demand 000 tables 80 55 40 28 20 15

Supply (000 tables) 10 28 40 50 55 60

Market Position Shortage Shortage Equilibrium Surplus Surplus Surplus

6 Managerial Economics-Demand Analysis

Effect on Price Rise Rise Stable Fall Fall Fall

In a free market, disequilibrium itself creates the condition for equilibrium. When there is excess supply, it forces downward adjustments in the price and quantity supplied. When there is excess demand, it forces upward adjustments in the price and quantity demanded.

Market Mechanism: How Market Brings about Balance: Equilibrium of Demand and Supply: Price Determination

Shift in Demand and Supply Curves and Market Equilibrium: Whenever there is a shift in the demand and / or supply curve, there is also a shift in the equilibrium

Shift in Demand Curve: The supply curve remaining the same, a rightward shift in the demand curve results in a higher equilibrium price and quantity.

D

D

S

Price

P

M

D” S O

D‟ Q

N

Quantity

Suppose that the initial demand curve is given by the curve DD and supply curve by SS. The demand and supply curves intersect at point P. The equilibrium price is determined at PQ and 7 Managerial Economics-Demand Analysis

equilibrium quantity at OQ. Let the demand curve now shift from its position DD to DD, supply curve remaining the same. The demand curve DD” intersects the supply curve SS at point M. Thus, shift in the demand curve causes a shift in the equilibrium from point P to point M. At the new equilibrium, quantity demanded and supplied increases from OQ to ON and price increases from PQ to MN.

Shift in Supply Curve: A rightward shift in the supply curve, demand curve remaining the same, causes a equilibrium price to fall and output to increase

D‟

S‟

P

S”

Price

M

S

D

S O

Q

N

Quantity Shift in Supply curve and Equilibrium

Suppose that the demand curve is given as DD‟ and the initial supply curve as SS‟. The curves DD‟ and SS‟ intersect at point P, determining equilibrium price at PQ and equilibrium quantity at OQ. Let the supply curve now shift from its position SS‟ to SS”, demand curve remaining unchanged. The new supply curve SS” intersects the demand curve at point M. Thus, a new equilibrium is struck at point M where equilibrium price is MN and equilibrium quantity is ON. Note: A right ward shift in the demand curve causes a rise in market price and how a rightward shift in the supply curve causes a fall in the market price.

8 Managerial Economics-Demand Analysis

Simultaneous Shift in Demand and Supply Curves: The effect of a simultaneous and parallel rightward shift in demand and supply curves on demand and supply curves on the equilibrium price and output depends on how big or small is the relative shift in demand and supply curves. The simultaneous and parallel shift in demand and supply curves in different measures and its effect on equilibrium price and output are illustrated in parts (a) and (b).

a. When the shift in the supply curve is bigger than that in the demand curve, then equilibrium price decreases and output increases.

D

S1 S2 S3 E2

PricePrice

D E3

P1 P0 S S

D2 S

O

D1

Q1

Q2 Q3 Quantity

Parallel Shift in Demand Supply Curves and its effect on the equilibrium Price and Output.

Suppose that initial demand and supply curves are given by DD1 and SS1, respectively,

Q1

Q2 Q3

intersecting at point E1 and determining equilibrium price at P1 and output at Q1. Let the demand curve shift to DD2 and supply curve from SS1 to SS3 intersecting at point E3. As a result, equilibrium price falls to P0 and output increases to Q3. But if demand and supply curves shift in equal measures, as shown by DD2 and SS2, equilibrium price remains unchanged though output increases to Q2.

9 Managerial Economics-Demand Analysis

(a) The effect of a bigger shift in the demand curve on the equilibrium price and output.

D D

S1

Price

S2 P2 P1

E2 S

E1

D2 D1

S O

Q1

Q2

Quantity

10 Managerial Economics-Demand Analysis

Elasticity of Demand Concept: The concept of elasticity of demand refers to the degree of responsiveness of quantity demanded of a good to a change in its price, consumers‟ income and prices of related goods.

Elasticities of Demand: Importance of the Elasticity Concept: The concepts of demand elasticities used in business decisions are: (i)

Price elasticity

(ii)

Cross-elasticity

(iii)

Income elasticity

(iv)

Advertisement elasticity

(v)

Elasticity of price expectation.

Price Elasticity of Demand: It is generally defined as the responsiveness or sensitiveness of demand for a commodity to the changes in its price.

More precisely, elasticity of demand is the

percentage change in demand as a result of one per cent change in the price of the commodity. A formal definition of price elasticity of demand (ep) is given as

ep = i.

Percentage change in quantity demanded Percentage change in price

A general formula8 for calculating coefficient of price elasticity, derived from this definition of elasticity, is gives as follows:

ep = =

∆𝑄 𝑄

∆𝑄 ∆𝑃

÷ x

∆𝑃 𝑃

=

∆𝑄 𝑄

x

𝑃 ∆𝑃

𝑃 𝑄

Where Q = original quantity demanded P = original price, ∆𝑄 = change in quantity demanded and ∆P = change in price. The elasticity can be measured between any two points on a demand curve (called arc elasticity) or at a point (called point elasticity). a. Arc Elasticity:

11 Managerial Economics-Demand Analysis

The elasticity can be measured between any two points on a demand curve (called arc elasticity) or at point (called point elasticity).

The measure of elasticity of demand

between any two finite points on a demand curve is known as arc elasticity. Formula as follows:

ep = =

∆Q P

, (with minus sign)

∆P Q

−32 20 10

,

43

= 1.49

b. Point Elasticity on a Linear Demand Curve: Point elasticity is also a way to resolve the problem in measuring the elasticity. The concept of point elasticity is used for measuring price elasticity where change in price is infinitesimally small.

Price

M

R

P B

O Q

N

Quantity Point elasticity is the elasticity of demand at a finite point on a demand curve, eg., at point P or B on the linear demand curve MN. This is in contrast to the arc elasticity between points P and B. A movement from point B towards P implies change in price (∆P) becoming smaller and smaller, such that point P is almost reached. Here the change in price is infinitesimally small. Measuring elasticity for an infinitesimally small change in price is the same as measuring elasticity at a point. The formula for measuring point elasticity is given below. 𝑃 𝜕𝑄

Point elasticity (ep) = 𝑄 , 𝜕𝑃

12 Managerial Economics-Demand Analysis

MCQs 1. In case of a superior commodity, the income elasticity of demand is (a) Positive (b) Negative (c) Unitary (d) Infinity 2. If both supply and demand increase by the same proportion (a) Quantity remains constant (b) Price increases (c) Quantity increases (d) None of these 3. A rightward shift in supply curve indicates: (a) A decrease in supply (b) An increase in quantity demanded (c) An increase in supply (d) Law of variable proportion 4. In the case of Veblen Goods, demand curve will slope: (a) Upwards (b) Downwards (c) Horizontal (d) Vertical 5. Consumer‟s willingness to pay minus (-) actual payment is called (a) Producer‟s surplus (b) Consumer‟s surplus (c) Supplier‟s surplus (d) None these ANSWERS 1

2

3

4

5

A

C

C

A

B

13 Managerial Economics-Demand Analysis