PGP I

Term I

Demand function

Income and Substitution effect

When price rises: Consumer feels worse of in terms of real income-income effect Goods become relatively expensivesubstitution effect

Inverse demand function

Demand relation
p

8 4

B 4 12
qx

Demand curve
p

10
8 4

B 4 12 20
qx

How to read the demand curve

At point A, consumers are willing to pay at the most Rs.8 per piece to buy 4 units of the product.
For 4 units the consumers willingness-to-pay is Rs.8 per unit.

If the price is Rs.8, the consumers will buy at most 4 units.

A movement from A to B is possible only if the price falls, and vice versa.

A linear Demand curve

Change in income: normal vs. inferior

Violation of law of demand?

1. Stock prices and demand, gold prices and demand go up simultaneously- shift in the demand curve due to expectation. 2. People are willing to pay more for luxury products when their price increases: Veblen goods (designer watch, luxury cars, designer perfumes)-Consumers perception of quality change 3. Giffen good : Generally staple food, inferior goods, a large amount of income is spent on it

Complements
An increase in the price of a complement causes a downward shift of the demand curve
Price

Price of sugar has increased

Quantity Demand curve for Coffee

Substitute products
An increase in the price of a substitute product will cause an upward shift of the demand curve.
Coffee price

Price of tea has increased

Quantity of coffee

Change in income
An increase in consumer income will cause an upward shift of the demand curve.

Price

Normal good: Income has increased

Quantity

Taste, preference and expectations

Taste and preference Fashion and lifestyle, apart from needs, shape our demand. Price expectations When price is expected to fall in future, some consumers prefer to wait.

Market demand curve

p 10 6 6 3

p 10 6 3

Consumer 1

Consumer 2

Market demand

3
10 15

10

23

Supply relationship
Supply curve summarises information from the production side.

Quantity supplied is positively related to price.

A point on the supply curve tells us at a given price how much the firms are willing to supply,

or, alternatively to supply a given level of output how much price the firms are willing to accept as minimum.

A linear supply curve

Supply curve

p S 2

Market supply
Market supply is a horizontal sum of individual supply curves
Single firms supply
4
2

Market supply of 2 firms

10 15

30

Market supply curve is flatter than the single firms supply curve.

Shift of the supply curve

Suppose wage rate increases
S2 p S1

Wage increase causes the supply curve to move leftward. This indicates a fall in supply. That is, at a given p firms are willing to supply less.

Market equilibrium
When demand and supply are matched. p P1 Pe P2 Shortage Q1 Qe Q2 D Q E

Surplus

Change in the exogenous factors

Demand and supply curve Equilibrium Equilibrium Price Quantity

Demand curve shifts rightward Demand curve shifts leftward Supply curve shifts rightward Supply curve shifts leftward

increases
decreases decreases increases

increases
decreases increase decreases

Exercise 1
1. The price of good A goes up. As a result the demand for good B shifts to the left. From this we can infer that: A) good A is a normal good. B) good B is an inferior good. C) goods A and B are substitutes. D) goods A and B are complements. 2. Which of the following events will cause a leftward shift in the supply curve of petrol? A) A decrease in the price of petrol B) An increase in the wage rate of refinery workers C) Decrease in the price of crude oil D) An improvement in oil refining technology

Exercise 2
The inverse demand curve for product X is given by: PX = 25 - 0.005Q + 0.15PY, where PX represents price in dollars per unit, Q represents rate of sales in pounds per week, and PY represents selling price of another product Y in dollars per unit. The inverse supply curve of product X is given by: PX= 5 + 0.004Q. a. Determine the equilibrium price and sales of X. Let PY = $10. b. Determine whether X and Y are substitutes or complements.

Answer

Consumer and producer Surplus

P A 50 40 Consumer surplus S1 B

30 E
Producer surplus 20 10 C

D1 Q