 Good afternoon, last class we were discussing on the broader issues of economics as a subject of study and then we just traversed along the contours of the economic landscape where I gave you an understanding at a very broad level what constitutes a nation's economy and why that economics as a subject of study is very important because we need to create a balance between the societies needs and wants and the availability of the resources which is scarce. So it is the challenge to arrive at a balance between these scarce resources and the needs and wants of the society that makes the subject of study this subject namely the economics a very interesting one and we saw how a nation's output is measured by way of what we call the GDP which is the aggregate sum of the monetary value of all the goods and services that a nation produces within its boundary within its geographical boundary and that the GDP of a country is symbolic of the economic strength of the country and countries with high GDP levels are assumed to be the ones that have richness in them at the end of the day since the GDP represents the monetary value of the goods and services we need to understand that these goods and services reaches an end user who uses it for whatever purpose the end user needs it for. So when these goods and services get traded we need a formal mechanism that provides a platform for the trade of such goods and services and we call this formal platform as the market. So a market in which there is an interaction between the buyer and seller of these goods and services will follow certain rules and regulations and a market is supposed to be efficient the efficient market hypothesis is on the fundamental principle that everybody has equal access to information equal access to resources and there are various factors that determine the supply and demand of the goods and services. The interaction between the buyer and seller of these goods and services happen in this market place and assuming that there are a number of factors that determine the various market movements we would like to understand the relationship of a supply or demand of goods and services vis-a-vis the price of those goods and services. The reason that we are going to restrict our discussion with price is because price of a product or a service by and large reflects the supply and demand of a particular the extent to which a particular product or service can be supplied and the extent to which it can be consumed. So it is good to assume that price is the key determinant that determines the way in which market moves and how the demand or supply of the goods and services change with prices is an interesting subject that constitutes the theory of supply and demand. Now before we understand these relationships we must first understand what is supply and demand and how that there are certain laws that govern demand there are certain laws that govern supply and the relationship with price and how that an effective market in which there is a fine balance between supply and demand functions is going to be the discussion for this class. Now demand to put it in very simple terms is how much of how much means the quantity of a product or service is desired. So how much is desired by the buyer is the demand for a particular product or service it means that the quantity that is demanded the quantity that is demanded is the amount of a product or a service that a buyer is willing to buy at a certain price and this the relationship between price and the quantity that is demanded is known as the demand relationship. So it is the price and quantity demanded this relationship is the demand relationship the quantity that is demanded at a particular price and how this quantity changes with the relationship between price and the quantity demanded is the demand relationship. Likewise supply represents how much can be offered how much can the market offer how much can market offer that is the quantity supplied refers to the amount of certain product certain good or a service that producers are willing to supply at a given price. Here again the interlinking factor is the price so the correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. So price to quantity supplied this relationship is the supply relationship. So we need to understand from the behavior of demand and supply of products and services with changes in price and this behavior is the fundamental for the allocation of resources in a market and this we will do by understanding independently the law of demand the law of supply and then try to understand how supply and demand within a given market is interlinked. Let us begin with the law of demand the law of demand very clearly states that if all other factors remain equal all things being equal the higher the price of a good or a service the less people will demand that good higher price less people demanding in other words the higher the price lower is the quantity demanded lower quantity demanded. So the amount of a good that the buyers purchase at a higher price is less because the price of as the price of the good keeps on going up so does the opportunity cost of buying that particular good so as the price keeps going the opportunity cost of buying the good also keeps increasing as a result people will naturally avoid buying a product because that will force them to forego the conception of something else that they value more so as the price increases so does the opportunity cost of buying that also increases as a result of which higher the price lower will be the quantity that is demanded. This can be represented by a downward slope because of the inverse relationship very simply the demand relationship is represented by let us say this is the quantity demanded and a rise it just is a downward slope. So at three price levels we can see at these points A B or C are points on the demand curve with each of them representing the quantity that is demanded at different prices and you would see at higher prices the quantity that is demanded is lower now this is the demand relationship between the quantity demanded and the price likewise the supply relationship is also pretty straightforward except that it is just opposite to the demand relationship the law of supply demonstrates the quantities that will be sold at a certain price unlike the law of demand the supply relationship is an upward sloping one which means that higher the price higher the quantity that is been supplied higher price higher quantity supplied what is the rational opportunity cost was the rational for law of demand in this case produces will supply more at a higher price because for a from a producer's perspective selling at a higher quantity means higher revenues. So from a seller's perspective if you sell more at higher prices it means more revenues as a result of which the supply relationship is an upward slope which means that higher the price higher is the quantity that is been supplied. So if we try to plot the relationship graphically it is just an upward slope quantity price at three different price levels P1 P2 P3 so ABC are points on the supply curve each point on the curve reflects a direct correlation between the quantity supplied and price of the quantity. So in this we notice the upward slope which governs the relationship between the quantity supplied and price and this relation relationship is the supply relationship. There is another intervening variable that we need to understand properly is how supply is related to time time and supply unlike the demand relationship supply relationship is also a factor of time now time is very important because to for suppliers especially is because the suppliers must though they cannot always react quickly to a change in demand or price if you look at whether the change in demand or a price is short term or long term if the demand or price change in demand or price is short term or long term is important from a suppliers perspective because let us say there is for example if there is a sudden increase in the demand and price for umbrellas due to a sudden rainy season now from a suppliers perspective I can meet this sudden increase by just trying to use the existing resources available more optimally intensify the usage of such resources to meet the sudden increase in demand of umbrellas as against let us say we are going to experience a longer duration of rainy season then using the existing resources to accommodate a longer period of such high demand and prices it becomes impossible from a suppliers perspective. So suppliers will have to change their production facilities get additional resources to meet the long term levels of demand so we need to understand that unlike demand relationship the supply relationship is a factor of time as well now we understand from the fundamental law of demand and supply that demand is also related to price and supply is also related to price as a result of which the common variable here is price which mean and both supply and demand are related to price which means supply and demand relationship between demand and supply is very interesting to study the reason is because this is the relationship that underlie the forces behind the allocation of resources now this supply and demand relationship forms the basis forms the basis for resource allocation. So in market economics the demand and supply theory will allocate resources in the most efficient possible way and hence it is very essential to understand the supply and demand relationship now since price is the common variable understanding the supply price supply and demand relationship becomes easier I will just give you a small example for you to understand how supply and demand affect price now let us for example take that there is going to be a special edition an audio CD of air humans favorite songs and this is going to be released for let us say rupees 20 per CD and HMV is the audio company that is going to release the CD now historically the experience of HME has been that consumers will not demand CDs at a price higher than 20 and if the price of the CD is 20 then there is going to be only you know 10 CDs that are required because only 10 consumers can buy the CD for 20 so the sustainable level is 10 because the opportunity cost is too high for suppliers to produce more now if this is the base case scenario and there are 10 CDs but if there are 20 people demanding now let us see how the price varies now originally the price was 20 and 10 CDs now we have 20 people demanding CDs now these 10 CDs are demanded by 20 people the price will subsequently rise because now it is according to the demand relationship the competition is between these 20 for only a limited number of 10 CDs which means only 10 people can be given these CDs and only prices higher than 20 can support this 10 number because that is how the demand price relationship works so consequently the rise in price as a result of this limitation will encourage more supply because an increase in price should result in a prompt increase in the supply of CDs now that explains how when the price increases there will be a natural tendency to increase the supply of CDs because that is how the supply price relationship is governing so at higher price more will be the supply now if however let us assume that there are 30 CDs that are produced and let us not change the demand the demand still remains at 20 now here is a different case where 30 CDs are produced and demand is still at 20 the price will not be pushed up in this case because the supply the existing supply more than accommodates the demand in fact the after the 20 consumers have been satisfied at the existing price level of 20 the price of the leftover CDs will actually drop because the CD producers will attempt to sell the remaining 10 CDs as a result of which the price gets lowered and the CDs become available to people who previously decided that the cost of the original cost of CD which was 20 that opportunity cost of buying was too high now when the price gets lowered people start buying so this is one example for you to understand how the supply and demand affect price now let us see if graphically what it means how does supply and demand attain a stage of equilibrium the supply and demand are assumed to be equal when the supply function and the demand function let us represent it graphically intersect at that point of intersection let us for example take up the usual quantity price we know that this is the supply this is the demand relationship now the economy is said to be at a stage of equilibrium when the supply function and the demand function intersect at this point the allocation of the goods is at its most efficient because the amount of good that is being supplied at a given price is exactly the same as the amount of good that is demanded at the same price as a result of which every firm every individual or the nation as a whole is satisfied with this stage of equilibrium which means at that given price the suppliers are selling all their goods that they have produced and at the same price the consumers are getting all the goods that they are demanding so this represents the stage of equilibrium so this is the equilibrium price and this is the equilibrium quantity but market economics do not operate as simple as this graphical illustration is more often than not we have stages of this equilibrium what does it mean which means the prevailing price or quantity is not equal to the equilibrium price or equilibrium quantity now equilibrium will this equilibrium will occur if there is excess supply or excess demand excess supply or excess demand what do I mean by this it means let us for first take excess supply as an example quantity price if the price is set too high excess supply will be created within the economy and there will be allocative inefficiency now how will the graph look in such a case now let us say this is in any this is demand this is supply and this is the equilibrium price now if the price level is higher than the equilibrium price so at this new price of p1 the quantity of goods that the producer wish to supply is indicated by q2 because that is the point of intersection with the supply curve but at p1 however the quantity that the consumers would want to consume is q1 because that is the point of intersection with the demand curve here we see that q2 is greater than q1 which means too much of goods is being produced and too little is being consumed the suppliers are trying to produce too much goods because there is more incentive to produce goods at higher prices but those consuming the goods will find the product less attractive and purchase less because the price is very much above the equilibrium price now this is the excess case of an excess supply this equilibrium due to excess supply now the same this equilibrium can happen if there is an excess demand now when will excess demand happen same example quantity price demand supply this is the equilibrium price so an excess demand will happen if when the set price is below the equilibrium price now if this is the condition then q1 q2 now the quantity of the goods demanded by consumers at the new set price which is lower than the equilibrium price is q2 because that is the point of intersection that with the demand curve while the quantity that suppliers are willing to produce at this lower price is q1 and in this case q2 is greater than q1 in this case q2 is the demand and q1 is the supply so it is just the opposite case of the excess supply in this case there are too few goods that are being produced on the other hand more number of consumers who compete amongst themselves to get these few goods now when more number of consumers compete to get these few goods the demand will push the price up making suppliers to again want to supply more because of this increasing price as a result of which the prices move towards the equilibrium so it is this push from the demand side that moves the prices towards the equilibrium price and this relationship actually governs the demand supply relationship that always tries to push the market towards the equilibrium stage so that the prices settle at the equilibrium price and the quantity that is demanded and supplied settles at the equilibrium quantity but this is an ideal case scenario there are also shifts and movements in the market the movements and shifts in relation to supply and demand curves they represent different market phenomena let us first begin with movements a movement occurs when a change in the quantity demanded or supplied is caused only by a change in price and vice versa what do I mean by that it means that if I take the movement along the demand curve as an example quantity price so a movement refers to a change along the curve and in this case it is the demand curve it demonstrates the consistent relationship between demand and price and if this change is only because of the price then it is along this curve which means it keeps moving it follows this relationship where as the price keeps changing the quantity demanded also lies on the same curve likewise the supply the movement on the supply curve will also be identical movement on supply curve is also identical at different prices the movement will be supply so this movement along the supply curve will follow this curve because the when a change in quantity supplied is caused only by a change in price then the relation to demonstrate the consistency of the relationship that movement will be only along the supply curve but shifts on the supply and demand curve is a little different from movements a shift is different from a movement because in shift a shift in a demand or a supply shift can happen in both demand as well as supply it occurs when a goods quantity demanded or supply changes even when the price remains the same for example if I need to just graphically illustrate this let us take for example the shift in the demand curve quantity price this was the original demand this price this is the quantity now if the demand curve itself shifts here is a case where price remaining same the demand shifts to a new curve for example if let us say the price of a lemonade was 2 rupees and the quantity of lemonade demand increased from q1 to q2 then there would be a shift in the demand for this lemonade this is the shift now why does this happen this happens because the quantity that is demanded is affected by a factor which is other than the price that explains why even if price is same there is a shift in the demand and in this case as we took the example of a lemonade it just means that lemonade if suddenly that became the only type of juice available for conception and there is no other juice that is available for conception then a factor other than price could cause the shift in the demand for lemonade if we take the supply side shift in supplies likewise a factor other than the price could cause a shift of the supply curve itself for the same price for example quantity price this was the first supply curve let us say this is shifted to new one so this becomes the new quantity now let us take the same example of a lemonade let us assume that there is a natural disaster as a result of which the supply of lemons itself is severely affected now this will explain the shift in the supply curve for the lemonade because lemonade manufacturers would be forced to supply less lemonade for the same price and that explains why at the same price the shift in the supply curve explains why there will be less quantity of lemonade that is being supplied at the same price so movements and shifts are a little different because in shift factors other than the price will cause a change in the supply or the demand curve as a result of which at the same price you will have two different quantities that are demanded or supply now this law of demand law of supply and how supply and demand tries to achieve a state of equilibrium forms the very fundamental that establishes a relationship between price and demand and price and supply but there are cases where the degree to which a particular quantity a particular good or a service is demanded changes with price now that can be understood by the term elasticity the degree to which a demand or supply curve reacts to a change in price is the curves elastics elasticity so curves elasticity whether it is supply or demand is determined by understanding the extent to which it changes with price now elasticity varies across the products because some products are very essential to a consumer while some products are not that essential so the sensitivity of the quantity that is supplied or demanded with price is based on how critical that particular product or services to the consumer now products that are necessities are very critical would be more insensitive to changes in price when compared to products that are not so critical which means they are not indispensable which will change the quantity of the products applied or the quantity that is been demanded if it is not a critical necessity then they are more sensitive to changes in price because the price increase of a good or a service that is considered less of a necessity will deter more consumers because the up to either demand them or produce them because opportunity cost of buying the product will become too high now let us understand this by understanding two new terminologies that explains the difference between elastic goods versus in elastic ones a good or a service is highly elastic elastic good means if a slight change in price leads to a sharp increase in price in price not necessarily increase leads to a sharp change in the quantity demanded or supplied and such a good is an elastic good slight change in price results in sharp change in quantity demanded or supplied on the other hand and in elastic good is just the converse change in price change in price will witness only modest changes in the change in price will witness modest changes in the quantity demanded or supplied now classically these these these goods tend to be the things that are more a necessity to the consumer in his or her daily life so these are all critical goods and services now how do we determine elasticity this is a small equation because we are trying to measure how much proportional change happens in the quantity that is demanded or supplied when a change in price happens so the percentage change in quantity to a percentage change in price and that is elasticity so elasticity will be per percentage change in quantity to percentage change in price now since this is a ratio if elasticity is greater than one or equal to one the curve is considered to be elastic if it is less than one curve is in elastic so how will the curve look like in elastic demand let us say we are talking the demand curve to see how elastic a demand curve is quantity price the proportionate change in the quantity that is demanded vis a vis the small dip in the price makes the demand this demand curve elastic as against an inelastic demand where this is the quantity and price for huge changes in price the quantity is not that sharply affected there is only a modest change this explains the inelasticity of the demand likewise the supply inelastic supply curve will look this way inelastic supply will look this way so elasticity curve measures the extent to which a particular good or a service reacts to changes in price and based on what type of goods and services that we are talking about we will understand whether that particular good or service is an elastic or an inelastic relationship critical services are insensitive to price and hence goods and services which are of critical use are inelastic goods conversely those that are very sensitive to price changes which means that have a number of other substitutes and hence not that critical are elastic because a small change in price causes huge differences in the quantity that is demanded or supplied. So what we will try to do next class is we will try to understand the factors now actually the elasticity curve that I just mentioned assumes that the income level is constant assuming that there is no change in the disposable income that is available at the hands of the end user and let us understand how what are the different factors that affect this demand elasticity and whether the elasticity behavior changes with changes in income levels in hand here we assume that the income level is same if the income that is available in hand increases then is there a change in the elasticity characteristics whether it is supply or demand curve whether there is change in the elastic behavior of the demand or supply curve with changes in income that is available is something that we will see in next class. Thank you.