Hi all, from this post we start a new subject – economics and also start a seires of posts covering the analysis of demand and supply. Hope you will find them informative and useful…so let’s begin our first post….
Demand and Supply Analysis: Introduction
There are two types of markets, markets for finished goods and services and markets for the factors of production. Factors of production are the inputs that go into producing the final goods. For example, labour, crude oil and any other raw material.
A market is a place where goods are bought and sold at a price where demand meets supply. Quantity demanded typically depends upon the price and in addition to price it depends on other factors such as income, price of alternative products and other factors.
The demand function is generally given as,
Q_{d x} = f (P_{x }, I, P_{y})
Which is read as, quantity demanded of good x, is a function of the price of x and the independent variables i.e., income and the price of an alternative good y.
Consider a person’s demand for petrol. His demand, along with the price of petrol depends upon the price of purchasing an automobile, price of bus travel and his income. If the price of automobiles goes up the demand for petrol falls as using the public transport is cheaper than buying a vehicle. If income increases the disposable income goes up and therefore the demand for petrol goes up and so on and so forth.
Consider the demand function,
Q_{D petrol}= 18 – 1.50P_{petrol} + 0.05 I +0.15 P_{BT } – 0.01 P_{automobile}
Assuming the price of bus travel is Rs.15, price of automobile is Rs. 50000 and income is Rs.75000, then the equation becomes
Q_{D petrol}= 18 – 1.50P_{petrol} + 0.05 (75) +0.15 (15) – 0.01 (50)
The equation boils down to an equation between quantity and price as,
Q_{D petrol}= 23.50 – 1.50P_{petrol}
There will be different demand equations for different values of income, bus travel and price of automobiles.
From this equation we can see that all else remaining equal, if the price of petrol increases by Re.1 the quantity demanded decreases by 1.50 litres.
The fact that more quantity is demanded at lower prices is called as the law of demand. Law of demand states that the quantity demanded decreases as price increases.
Supply function
Supply of a good is a function of the selling price and the independent variables i.e., costs of production. Consider the supply function of tables,
Q_{S tables}= -150 + 0.50 P_{tables} – 8.00 Wages – 0.50 P_{wood}
Assuming the wages are Rs.15 per hour and price of wood is Rs.150 per kilo, the equation boils down to an equation between quantity supplied and price as,
Q_{S tables}= -345 + 0.50 P_{tables}
From this equation we can see that if the price of tables goes up by Re.1 the quantity supplied increases by 0.50 tables.
The fact that more quantity is supplied at higher prices is called as the law of supply. Law of supply states that as price increases supply also increases.
Movements and shifts in the curves:
A demand or supply curve is represented by a demand function or supply function. A change in the price which causes the quantity demanded or supplied to increase or decrease is represented by a movement up or down the curve. However a change in the independent variables that go into a demand or supply function causes the entire demand and supply function to change and therefore causes a shift in the demand and supply curves that they represent.
Diagram depicting movement along the curve |
From the above diagram you can see that the demand curve is a downward sloping curve. Quantity demanded moves up and down the curve as price changes.
From the above diagram you can see that the supply curve is a upward sloping curve. Quantity supplied moves up and down the curve as price changes.
The above diagram depicts a shift in the demand curve due to change in the independent variables. Let us go back to our old demand function Q_{D petrol} = 18 – 1.50P_{petrol} + 0.05 I +0.15 P_{BT } – 0.01 P_{automobile. } Taking our old values if income is Rs 75000, the equation is Q_{D petrol} = 23.50 – 1.50P_{petrol. } Now assuming that income increases by Rs.1000, the equation becomes, 28.80 – 1.50P_{petrol. } This represents the new demand curve. With an increase in income the demand curve shifts upward and the quantity demanded increases by 5.30 (gap between the bold and dotted lines) at every price point on the curve. For every price point on the new demand curve the quantity demanded has increased by 5.30 compared to the same price point on the old curve. This gap remains constant at every price point on the axis and therefore the demand curves are parallel to each other.
Similarly for a decrease in income, the demand curve shifts downwards and the quantity demanded decreases by an X amount for every price point on the curve.
Similarly for a decrease in income, the demand curve shifts downwards and the quantity demanded decreases by an X amount for every price point on the curve.
From the above diagram it can be seen that a change in the independent variables causes a complete shift in the original supply curve. Therefore with an increase in wages the supply curve shifts downward and the quantity supplied decreases by an X amount (gap between the bold and dotted lines) at every price point on the curve. Similarly for a decrease in wages, the supply curve shifts upwards and the quantity supplied increases by an X amount for every price point on the curve.
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That’s all in this post …..Thanks for reading….watch out for the next post where we would learn about equilibrium price and quantity & stable and unstable equilibrium…
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For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
To be continued….
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