Economics notes unit-2

Theory of Demand and Supply

1. Theory of Demand
Meaning of Demand:

Demand refers to the quantity of a good or service that consumers are willing
and able to buy at different prices, during a specific period of time.

For demand to exist, consumers must both want the product and have the
ability to pay for it.

Determinants of Demand:
The following factors influence the demand for a good or service:

1. Price of the Good: As the price of a good decreases, the quantity demanded
generally increases (and vice versa), assuming all other factors remain
constant.

2. Income of the Consumer: As income increases, demand for normal goods

tends to increase. Conversely, demand for inferior goods may decrease as
income rises.

3. Tastes and Preferences: Changes in consumer preferences can shift demand

(e.g., increased demand for electric cars due to environmental concerns).

4. Prices of Related Goods:

Substitute Goods: If the price of a substitute (e.g., tea for coffee) rises,
the demand for the other good (coffee) increases.

Complementary Goods: If the price of a complement (e.g., printers for

computers) rises, the demand for the related good (computers) may
decrease.

5. Expectations: If consumers expect prices to rise in the future, current demand

may increase, as they try to buy now before the price goes up.

Demand Function:
A demand function is a mathematical representation of the relationship between
the quantity of a good demanded and its various determinants (like price, income,
etc.). It is typically written as:
\[ Q_d = f(P, Y, T, P_s, P_c, E) \]
Where:

\( Q_d \) = Quantity demanded

\( P \) = Price of the good

\( Y \) = Income of consumers

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\( T \) = Tastes and preferences

\( P_s \) = Prices of substitutes

\( P_c \) = Prices of complements

\( E \) = Expectations

Law of Demand:
The Law of Demand states that, all else being equal, as the price of a good or
service increases, the quantity demanded decreases, and as the price
decreases, the quantity demanded increases.

Example: If the price of ice cream decreases, people are likely to buy more ice
cream.

Expansion and Contraction of Demand:

Expansion of Demand: When the price of a good falls and quantity demanded
increases.

Contraction of Demand: When the price of a good rises and quantity

demanded decreases.

Increase and Decrease in Demand:

Increase in Demand: Caused by factors such as a rise in consumer income or
a change in consumer preferences. This shifts the demand curve to the right.

Decrease in Demand: Caused by factors such as a fall in income or a

decrease in the popularity of a product. This shifts the demand curve to the
left.

Usefulness of the Law of Demand:

It helps businesses and policymakers understand how price changes affect
consumer behavior.

It guides pricing strategies for firms in competitive markets.

It forms the basis for many economic models and policy decisions.

Exceptions to the Law of Demand:

While the Law of Demand holds in most cases, there are some exceptions:

1. Giffen Goods: Inferior goods for which an increase in price may lead to an
increase in demand (e.g., basic staple foods like bread or rice in very poor
areas).

2. Veblen Goods: Luxury goods for which demand increases as the price
increases, because higher prices make the good more desirable due to its
status symbol (e.g., designer clothing).

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3. Speculative Bubbles: When people expect prices to rise, they may buy more
at higher prices, expecting to sell at even higher prices (e.g., real estate or
stock market bubbles).

Utility Analysis
Concept of Utility:

Utility refers to the satisfaction or pleasure that a consumer derives from

consuming a good or service.

Law of Diminishing Marginal Utility:

The Law of Diminishing Marginal Utility states that as a person consumes
more units of a good, the additional satisfaction (or marginal utility) derived
from each additional unit decreases.

Example: The first slice of pizza may provide high satisfaction, but by the
fourth or fifth slice, the satisfaction from each additional slice decreases.

Derivation of the Demand Curve from Utility Analysis:

The demand curve can be derived from utility analysis. As the price of a good
falls, the consumer is willing to purchase more of the good, as the marginal
utility (satisfaction) derived from each unit is higher relative to its price.

Example: If a consumer derives more satisfaction from an additional unit of a

good than the price they pay for it, they will demand more.

Consumer's Surplus:
Consumer's Surplus is the difference between what a consumer is willing to
pay for a good (based on the utility it provides) and what they actually pay.

Example: If a person is willing to pay $50 for a product, but the product is
priced at $30, the consumer's surplus is $20.

2. Theory of Supply
Meaning of Supply:

Supply refers to the quantity of a good or service that producers are willing
and able to sell at different prices over a period of time.

Determinants of Supply:
1. Price of the Good: As the price of a good rises, the quantity supplied generally
increases.

2. Cost of Production: Higher production costs (e.g., wages, raw materials) may
reduce supply, while lower costs increase supply.

3. Technology: Technological advancements make production more efficient,

increasing supply.

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4. Government Policies: Taxes, subsidies, and regulations can affect supply.
Higher taxes or stricter regulations may reduce supply.

5. Expectations: If producers expect prices to rise in the future, they may

withhold supply to sell at higher prices later.

Expansion and Contraction of Supply:

Expansion of Supply: When the price of a good increases, producers are
willing to supply more.

Contraction of Supply: When the price of a good decreases, producers are

willing to supply less.

Increase and Decrease in Supply:

Increase in Supply: Caused by factors such as lower production costs,
technological improvements, or favorable government policies. This shifts the
supply curve to the right.

Decrease in Supply: Caused by factors such as higher production costs,

adverse weather conditions, or unfavorable government policies. This shifts
the supply curve to the left.

Demand and Supply as Determinants of Price:

Market Price is determined by the interaction of demand and supply.

If demand increases and supply remains constant, the price will rise.

If supply increases and demand remains constant, the price will fall.

3. Market and Types of Market

Meaning of Market:

A market is a place or system where buyers and sellers interact to exchange

goods and services at mutually agreed prices.

Types of Market:
1. Perfect Competition:

Characteristics: Many buyers and sellers, homogeneous products, free

entry and exit from the market, and perfect information.

Example: Agricultural markets, where products like wheat or rice are

identical, and no single farmer has the power to affect prices.

2. Monopoly:

Characteristics: A single seller controls the entire supply of a product or

service, with no close substitutes.

Example: Utility companies (like water or electricity) in some regions,

where there is only one provider.

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3. Monopolistic Competition:

Characteristics: Many firms sell similar but differentiated products. There

is some degree of market power due to product differentiation.

Example: Restaurants, clothing brands, and electronics, where businesses

differentiate their products through branding, quality, and features.

4. Oligopoly:

Characteristics: A small number of firms dominate the market. Products

may be either homogeneous or differentiated. Firms in oligopoly markets
are interdependent and may engage in strategic behavior.

Example: The automobile industry, where a few large firms like Ford,
Toyota, and Honda dominate the market.

Conclusion
The Theory of Demand and Supply provides the foundation for understanding
how prices are determined in a market economy. The behavior of consumers
(demand) and producers (supply) and their interactions in the market determine
the equilibrium price and quantity. Various market structures (perfect competition,
monopoly, monopolistic competition, and oligopoly) reflect the degree of
competition and the nature of the goods and services sold, shaping the dynamics
of pricing and production in the economy.

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