Market Dynamics: Demand, Supply, and Consumer Behavior
Demand and supply are the fundamental forces that drive a market economy. They determine what is produced, in what quantity, and at what price.
1. Understanding Demand
Demand is the quantity of a good that consumers are willing and able to purchase at various prices.
* Individual Demand: The quantity of a commodity that a single consumer is willing to buy at a specific price during a given period.
* Market Demand: The total sum of all individual demands for a particular good in the market. It is calculated by adding up the quantities demanded by every consumer at each price level.
* The Law of Demand: This law states that, ceteris paribus (all other factors being equal), there is an inverse relationship between price and quantity demanded. As price rises, demand falls; as price falls, demand rises.
2. Types of Goods
Economists classify goods based on how demand changes in response to changes in income or price:
| Good Type | Relationship with Income/Price | Example |
|—|—|—|
| Normal Good | Demand increases as income rises. | Branded clothes, organic food, smartphones. |
| Inferior Good | Demand decreases as income rises (consumers switch to better alternatives). | Instant noodles, public bus transport, coarse grains. |
| Giffen Good | A rare type of inferior good where demand increases as its price rises (violating the Law of Demand). | Staple foods like bread or rice during periods of extreme poverty. |
3. Demand Determinants
Apart from price, several “shifters” can cause the entire demand curve to move left (decrease) or right (increase):
* Income: For normal goods, more income = more demand. * Tastes and Preferences: Trends and advertising can boost or lower demand.
* Prices of Related Goods: * Substitutes: If the price of Coffee rises, the demand for Tea increases. * Complements: If the price of Cars rises, the demand for Petrol decreases.* Expectations: If people expect prices to
* Population Size: More consumers generally mean higher market demand.
4.
Supply and its Determinants -Supply is the quantity of a good that producers are willing to offer for sale at various prices.* The Law of Supply: There is a direct relationship between price and quantity supplied. As price rises, producers want to sell more to increase profit. As price falls, supply decreases.
* Supply Determinants: * Input Prices: If the cost of raw materials or labor rises, supply decreases. * Technology: Improved technology lowers production costs and increases supply. * Number of Sellers: More firms in the market increase total supply. * Government Policy: Taxes reduce supply; subsidies increase it.
5. Market Equilibrium -Market Equilibrium occurs when the quantity demanded by consumers exactly equals the quantity supplied by producers. * Equilibrium Price: The “market-clearing” price where there is no shortage or surplus.
* Disequilibrium:
* Surplus: If the price is above equilibrium, supply > demand. Sellers must lower prices to clear stock.
While the Law of Demand tells us the direction of change (prices go up, demand goes down), Elasticity tells us the magnitude—exactly how much consumers and producers respond to those changes.
1. Types of Elasticity -Elasticity measures the responsiveness of one variable to change in another.
A. Price Elasticity of Demand (PED) -Measures how much the quantity demanded of a good responds to a change in the price of 그 good. * Formula: PED = \frac{\% \text{ Change in Quantity Demanded}}{\% \text{ Change in Price}}
* Degrees: * **Perfectly Inelastic (E=0): Quantity doesn’t change regardless of price (e.G., life-saving medicine). * Inelastic (0 < E < 1): Small response (e.G., salt, electricity). * Unitary (E=1): Change in quantity equals change in price. * **Elastic (E > 1): Large response (e.G., luxury cars, specific brand of snacks).**Perfectly Elastic (E = \infty): Any price increase drops demand to zero.B. Income Elasticity of Demand (YED) -Measures how demand changes as consumer income changes. * Positive YED: Normal Goods (Demand rises with income). * Negative YED: Inferior Goods (Demand falls as you get richer and buy better quality).C. Cross-Price Elasticity (XED) -Measures how the demand for Good A changes when the price of Good B changes. * Positive XED: Substitutes (Price of Coke goes up, demand for Pepsi goes up). * Negative XED: Complements (Price of Printers goes up, demand for Ink goes down).
D. Price Elasticity of Supply (PES) -Measures how much the quantity supplied responds to a change in price. This often depends on time; supply is more elastic in the long run as firms can build new factories.
2. Measurement of Price Elasticity of Demand-Economists use four primary methods to calculate the specific value of elasticity:
* Percentage (Proportionate) Method: The standard formula comparing percentage changes. * Total Outlay (Expenditure) Method: Developed by Alfred Marshall. It looks at whether total spending goes up or down after a price change.
* If Price \downarrow and Total Spending \uparrow, demand is Elastic. * Point Method: Measures elasticity at a specific point on a demand curve using the formula: \frac{\text{Lower Segment}}{\text{Upper Segment}}.
* Arc Method: Used for measuring elasticity between two points on a curve by taking the average (midpoint) of prices and quantities.
3. Determinants of Elasticity of Demand
Why are some goods more “sensitive” to price than others?
* Availability of Substitutes: More substitutes = higher elasticity. If your favorite juice gets expensive, you just buy another brand.
* Nature of the Good: Necessities (bread) are inelastic; Luxuries (diamonds) are elastic.
* Proportion of Income Spent: If a product is very cheap (like a box of matches), a 10% price hike doesn’t change your behavior (inelastic). A 10% hike on a car does (elastic).
* Time Period: In the short term, demand is inelastic (you still need gas for your car today). In the long term, it’s elastic (you can buy an electric bike or move closer to work).
* Addictiveness: Goods like cigarettes or coffee tend to be price inelastic because consumers “need” them regardless of price.
Consumer equilibrium is the state where a consumer derives maximum satisfaction from their limited income. Economists analyze this through two distinct lenses: the older Cardinal approach and the modern Ordinal approach.
1. Cardinal Utility
Analysis
This approach, championed by Alfred Marshall, assumes that satisfaction can be measured in exact numerical units called “utils.”
A. Law of Diminishing Marginal Utility (LDMU)
This law states that as a consumer consumes more units of a specific commodity, the additional satisfaction (Marginal Utility) derived from each successive unit decreases.
* Total Utility (TU): The sum of satisfaction from all units. It increases at a decreasing rate.
* Marginal Utility (MU): The addition to TU from one extra unit. It eventually falls to zero and can become negative (disutility).
B. Law of Equi-Marginal Utility
Also known as the Law of Substitution, it explains how a consumer allocates a limited budget across multiple goods.
* The Rule: A consumer is in equilibrium when the ratio of marginal utility to price is equal across all goods:
2. Ordinal Utility Analysis
Developed by Hicks and Allen, this approach argues that utility cannot be measured numerically; it can only be ranked (e.G., “I prefer Apple over Orange”).
A. Indifference Curve (IC)
An IC represents all combinations of two goods that give the consumer the same level of satisfaction.
* Properties of IC:
* Downward Sloping: To get more of one good, the consumer must give up some of the other.
* Convex to the Origin: Due to the Diminishing Marginal Rate of Substitution (MRS)—the rate at which a consumer is willing to trade one good for another decreases as they get more of it.
* Higher IC = Higher Satisfaction: An “Indifference Map” shows multiple curves; those further from the origin represent more goods.
* Never Intersect: Each curve represents a unique level of satisfaction.
B. The Budget Line
The budget line shows all combinations of two goods a consumer can afford with their given income (M) and prices (P_x, P_y):
C. Equilibrium of the Consumer
The consumer reaches equilibrium at the point where the Budget Line is tangent to the highest possible Indifference Curve. At this point:
3. Consumer Surplus
Consumer Surplus is the difference between what a consumer is willing to pay and what they actually pay.
* Marshallian Approach: Measured as the area under the demand curve and above the price line. It assumes the marginal utility of money is constant.
* Hicksian Approach: Uses indifference curves to measure the “compensating variation”—the amount of money you would have to take away from or give to a consumer to keep them at the same level of satisfaction after a price change. It is considered more realistic because it accounts for the “income effect.”