Nature, Scope & the Theory of Demand and Supply

Weightage: Chapters 1 and 2 of ICAI's Paper 4 syllabus, roughly 22 marks. Demand and supply is the largest chapter in the paper, and elasticity is its most heavily examined single topic.

The economic problem

Economics exists because of a single fact: human wants are unlimited while the resources to satisfy them are scarce and have alternative uses. If resources were unlimited there would be no need to choose, and no need for a discipline studying choice.

Scarcity forces choice, and every choice has a cost. The opportunity cost of any decision is the value of the next best alternative forgone. It is not the money spent; it is what was given up. The opportunity cost of using a factory to make shoes is the value of the shirts it could have made instead.

The central problems

Every economy, however organised, must answer three questions:

• What to produce, and in what quantities.
• How to produce — which combination of resources and which technique.
• For whom to produce — how the output is distributed.

To these are sometimes added the problems of efficient use of resources and of growth.

The production possibility curve

The PPC shows the maximum combinations of two goods an economy can produce with its given resources and technology, all resources being fully and efficiently employed.

Its features carry marks:

• It is downward sloping, because producing more of one good requires producing less of the other — resources are scarce.
• It is concave to the origin, because opportunity cost increases as more of one good is produced. Resources are not equally suited to both uses, so the resources transferred first are those least suited to their original use, and progressively less suitable ones must follow.
• A point on the curve is efficient; a point inside indicates unemployment or inefficiency; a point outside is unattainable with current resources.
• Growth in resources or improvement in technology shifts the curve outward.

The slope of the PPC is the marginal rate of transformation, which is the opportunity cost of one good in terms of the other.

Economic systems

A capitalist economy relies on private ownership and the price mechanism. Prices signal scarcity and profitability, and self-interested decisions by producers and consumers coordinate without central direction. Its merits are efficiency and innovation; its defects are inequality, the neglect of public goods and instability.

A socialist economy relies on state ownership and central planning. It can pursue equity and social priorities directly, but lacks the information that prices convey and tends to inefficiency.

A mixed economy combines both, with a private sector operating through markets and a public sector directing certain activities. India is a mixed economy.

Positive economics describes what is; normative economics prescribes what ought to be. "A rise in the minimum wage reduces employment among the low-skilled" is positive and can be tested; "the minimum wage ought to be raised" is normative and cannot.

Microeconomics studies individual units — a consumer, a firm, a market. Macroeconomics studies aggregates — national income, the general price level, total employment. Chapters 1 to 5 of this paper are microeconomic and chapters 6 to 10 are largely macroeconomic.

Demand

Demand is the quantity of a good a consumer is willing and able to buy at a given price during a given period. Willingness alone is desire; backed by ability to pay, it is demand.

The law of demand

Other things being equal, the quantity demanded of a good varies inversely with its price. The demand curve therefore slopes downward.

The reasons are three, and stating them distinguishes a full answer:

• The income effect — a fall in price raises real income, so more can be bought.
• The substitution effect — a fall in price makes the good cheaper relative to substitutes, so buyers switch to it.
• The law of diminishing marginal utility — successive units give less satisfaction, so a buyer will take more only at a lower price.

Movement along versus shift of the curve

This is the most examined distinction in the chapter.

A change in the good's own price produces a movement along the demand curve — an extension of demand when price falls and a contraction when it rises. This is a change in quantity demanded.

A change in any other determinant shifts the entire curve. This is a change in demand. The determinants are income, the prices of related goods, tastes and preferences, expectations of future prices, the number of buyers, and the distribution of income.

For related goods, the direction of the shift depends on the relationship. A rise in the price of a substitute increases demand for the good; a rise in the price of a complement decreases it.

For income, the direction depends on the type of good. Demand for a normal good rises with income; demand for an inferior good falls.

Exceptions to the law of demand

Cases in which quantity demanded rises with price:

• Giffen goods — strongly inferior goods forming a large part of a poor consumer's budget. When the price rises, the consumer becomes so much poorer in real terms that they buy more of the cheap staple and less of anything better. The income effect overwhelms the substitution effect.
• Veblen or conspicuous goods — bought for the prestige of the price itself, so a higher price makes them more desirable.
• Expectation of further price rises, which prompts buying now.
• Necessities, where a rise in price cannot much reduce consumption.
• Ignorance, where a higher price is taken as a signal of higher quality.

Elasticity of demand

Elasticity measures the responsiveness of demand to a change in one of its determinants. It is the single most examined idea in the paper.

Price elasticity

$E_p=\frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$

The value is negative by the law of demand, but the sign is conventionally ignored and the magnitude discussed.

• $E_p>1$ — elastic: quantity responds more than proportionately.
• $E_p<1$ — inelastic: quantity responds less than proportionately.
• $E_p=1$ — unitary elastic.
• $E_p=0$ — perfectly inelastic, a vertical demand curve.
• $E_p=\infty$ — perfectly elastic, a horizontal demand curve.

The determinants of price elasticity are the availability of close substitutes (the most important — more substitutes means more elastic), the nature of the good as a necessity or a luxury, the proportion of income spent on it, the number of uses it has, the time period allowed for adjustment, and whether consumption can be postponed.

Elasticity and total revenue

This relationship is examined constantly and is worth reasoning through rather than memorising.

Total revenue is price times quantity. When price falls, the price component falls and the quantity component rises, so what happens to revenue depends on which moves proportionately more — which is exactly what elasticity measures.

• Demand elastic: a price cut raises total revenue, because quantity rises proportionately more than price falls.
• Demand inelastic: a price cut lowers total revenue.
• Demand unitary elastic: total revenue is unchanged.

The total outlay method of measuring elasticity inverts this: observe what happens to total expenditure when price changes, and infer the elasticity.

Note also that along a straight-line demand curve elasticity is not constant. It is greater than 1 above the midpoint, equal to 1 at the midpoint, and less than 1 below it — which is why "the demand curve is elastic" is meaningless without specifying the point.

Income and cross elasticity

$E_y=\frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}}$

• $E_y>0$ — normal good. Within this, $E_y>1$ indicates a luxury and $0<E_y<1$ a necessity.
• $E_y<0$ — inferior good.

$E_c=\frac{\text{Percentage change in quantity demanded of X}}{\text{Percentage change in price of Y}}$

• $E_c>0$ — substitutes. Tea and coffee: a rise in the price of coffee raises the demand for tea.
• $E_c<0$ — complements. Cars and petrol: a rise in the price of petrol lowers the demand for cars.
• $E_c=0$ — unrelated.

The sign carries the information in cross elasticity and the sign carries it in income elasticity too, which is why these two are the elasticities whose sign must never be dropped.

Consumer behaviour

The cardinal approach

Utility is assumed measurable in units called utils.

The law of diminishing marginal utility states that as a consumer takes successive units of a good, the marginal utility of each additional unit falls. This is why the demand curve slopes downward: a consumer will pay less for a unit that gives less satisfaction.

Total utility rises while marginal utility is positive, is maximum when marginal utility is zero, and falls when marginal utility becomes negative.

The law of equi-marginal utility states that a consumer maximises satisfaction by allocating expenditure so that the marginal utility per rupee is equal across all goods:

$\frac{M{U}_x}{P_x}=\frac{M{U}_y}{P_y}$

If the ratios are unequal, shifting expenditure towards the good with the higher ratio raises total satisfaction, so equality is the condition for equilibrium.

The ordinal approach

Utility is treated as rankable but not measurable, which is a weaker and more defensible assumption.

An indifference curve joins combinations of two goods giving equal satisfaction. Its properties:

• Downward sloping, since more of one good requires less of the other for satisfaction to be unchanged.
• Convex to the origin, because the marginal rate of substitution diminishes — the more of a good a consumer has, the less of the other they will give up for one more unit of it.
• Higher curves represent higher satisfaction.
• Indifference curves never intersect, since intersection would imply that two different satisfaction levels are equal.

The budget line shows the combinations affordable at given prices and income. Consumer equilibrium occurs where the budget line is tangent to the highest attainable indifference curve, at which point the marginal rate of substitution equals the price ratio.

Consumer surplus is the difference between what a consumer is willing to pay and what they actually pay, and it is the area below the demand curve and above the price.

Supply and market equilibrium

Supply is the quantity of a good producers are willing to offer at a given price during a given period.

The law of supply states that, other things being equal, quantity supplied varies directly with price, so the supply curve slopes upward. A higher price makes production more profitable and covers the higher marginal costs of expanding output.

The determinants of supply, whose change shifts the curve, are the prices of inputs, technology, taxes and subsidies, the prices of related goods, the number of sellers, and expectations. As with demand, a change in the good's own price causes a movement along the curve.

Elasticity of supply is the responsiveness of quantity supplied to price, and it is greater the longer the time allowed for adjustment — which is why supply is inelastic in the very short run and elastic in the long run.

Market equilibrium occurs where quantity demanded equals quantity supplied. Above the equilibrium price there is a surplus, which pushes price down; below it there is a shortage, which pushes price up. The price mechanism therefore corrects disequilibrium automatically.

Predicting the effect of a shift is a standard question type. An increase in demand raises both equilibrium price and quantity. An increase in supply lowers price and raises quantity. Where both shift, the effect on one variable is determinate and on the other depends on the relative magnitudes — which is why the diagram must be drawn rather than the answer recalled.

How this chapter is examined

Expect questions on opportunity cost and the shape of the production possibility curve; identification of movement against shift; the exceptions to the law of demand, particularly Giffen goods; the computation or classification of price, income and cross elasticity; the relationship between elasticity and total revenue; the properties of indifference curves; and the effect of a shift in demand or supply on equilibrium.

The recurring errors are treating a change in the good's own price as a shift, dropping the sign in cross or income elasticity, and confusing a Giffen good with a Veblen good — the first is bought by the poor because they have become poorer, the second by the rich because the price is high.