ECN02 — Demand and Supply

Law of Demand: inverse (negative) relationship between price and quantity demanded, all else constant. As price rises → Qd falls; as price falls → Qd rises. Demand curve slopes downward. Exceptions: Giffen goods (price rises → demand rises), Veblen goods (status goods).

Substitute goods: goods that can replace each other in consumption. As price of tea rises → demand for coffee rises (positive cross-price elasticity). Examples: tea/coffee, Pepsi/Coke, butter/margarine. Complementary goods: used together (car + petrol — negative cross-price elasticity).

Rightward shift of demand = INCREASE in demand at every price level. Caused by: rise in consumer income (normal goods), rise in population, favourable change in tastes, rise in price of substitutes, fall in price of complements, positive price expectations. Distinct from movement along the curve.

Inferior Good: demand falls as consumer income rises (negative income elasticity). As people earn more, they switch to superior alternatives. Examples: coarse grains, public transport, cheap noodles. Contrast: Normal good — demand rises with income (positive income elasticity).

Law of Supply: positive relationship between price and quantity supplied. As price rises → producers are more motivated to supply more (higher profit). Supply curve slopes upward. Exceptions: backward-bending labour supply curve.

Price Floor = minimum legal price set ABOVE the equilibrium market price. Creates surplus (Qs > Qd). Purpose: protect producers/workers from low prices. Examples: Minimum Support Price (MSP) for farmers, minimum wage laws. Contrast: Price Ceiling = maximum price BELOW equilibrium → creates shortage.

MSP = Price Floor — set above the market equilibrium to protect farmers from price crashes during bumper harvests. Announced by the Government on CACP recommendations. Currently covers 23 crops including wheat, rice, and pulses.

Perfectly Inelastic Demand: PED = 0. Quantity demanded does not change regardless of price changes. Demand curve is vertical. Examples: life-saving medicines for critical patients, insulin for diabetics. In practice, no good is truly perfectly inelastic, but some necessities approach zero elasticity.

Cross-Price Elasticity of Demand: Negative for complements (used together). If petrol price rises → demand for cars falls (negative cross-elasticity). Positive for substitutes: if tea price rises → demand for coffee rises. Zero for unrelated goods.

Giffen Good: demand rises when price rises (upward-sloping demand curve) — violating the law of demand. This happens when the income effect (consumers become poorer, buy more of the cheap necessity) outweighs the substitution effect. Named after Robert Giffen. Classic example: bread for very poor consumers.

Petrol and cars are complementary goods (used together). If petrol price rises → cost of car ownership rises → demand for cars falls. Negative cross-price elasticity between complements. This is the standard NDA example of cross-price elasticity of demand for complementary goods.

Leftward shift of supply curve = DECREASE in supply — at every price, producers supply less. Causes: rise in input costs (wages, raw materials, energy), natural disasters, new taxes on producers, adverse regulations. Rightward shift = increase in supply (technology improvement, subsidies, more producers).

Market Equilibrium: price at which quantity demanded = quantity supplied. Determined by the intersection of demand (D) and supply (S) curves. At equilibrium there is no surplus or shortage. Any other price creates market pressure that moves price toward equilibrium — Alfred Marshall's 'scissors' model.

Supply decreases (leftward shift of S curve) + Demand unchanged → new equilibrium: higher price and lower quantity. Classic example: drought reduces crop supply → food prices rise and quantity consumed falls. NDA tests this supply-demand analysis directly.

Luxury foreign holidays have elastic demand (PED > 1) — consumers are sensitive to price changes and will reduce purchases significantly if prices rise. Salt, insulin, emergency medical treatment = inelastic (necessities or no close substitutes). Luxury goods are more price-sensitive than necessities.

Negative income elasticity of demand = Inferior goods. As income rises, demand falls because consumers switch to superior alternatives. Examples: bajra (replaced by wheat), bus travel (replaced by personal car). Normal goods have positive income elasticity; luxuries have income elasticity > 1.

Price Ceiling below equilibrium → quantity demanded exceeds quantity supplied → shortage. Examples: rent control (shortage of rental housing), essential goods price caps (black markets emerge). Contrasts with Price Floor (above equilibrium) → surplus.

Demand curve for normal goods shifts rightward (demand increases) when: price of substitutes rises (consumers switch to this good), consumer income rises, population grows, tastes change favorably, positive price expectations. Rise in price of the good itself → movement along curve (not a shift).

Producer Surplus = Market Price Received − Minimum Price Willing to Accept (= cost of production). It represents the extra benefit producers gain above their opportunity cost. Total PS = area above supply curve and below market price. Consumer Surplus + Producer Surplus = Total Surplus.

Life-saving medicine = nearly perfectly inelastic demand — patients must buy it regardless of price (no substitute, critical need). Salt = inelastic but not perfectly so. Luxury watches = elastic (PED > 1). Foreign holidays = elastic (price-sensitive). Correct pair: life-saving medicine → inelastic demand.