Demand, Supply, Cost and Markets

Demand is not just wanting something. It is the quantity of a good that a consumer is willing and able to buy at a given price in a given time. A student may wish for a smartphone costing a lakh, but with no money, that is a wish, not demand. The law of demand says: other things remaining the same (ceteris paribus), when the price of a good rises, its quantity demanded falls, and when the price falls, the quantity demanded rises. Price and quantity demanded move in the opposite direction, so the demand curve slopes downward from left to right.

Why does the demand curve slope downward? Three reasons. (1) Law of diminishing marginal utility: each extra unit gives less satisfaction, so you pay only a lower price for it. (2) Income effect: when price falls, your money buys more, as if your income rose. (3) Substitution effect: when a good gets cheaper, you switch to it from costlier substitutes.

The law of demand tells us the direction (price up, demand down). Elasticity tells us how much. Price elasticity of demand measures how strongly buyers react to a price change: Ed = % change in quantity demanded ÷ % change in price. We ignore the minus sign and look at the size. Think of salt and a smartphone. If the price of salt doubles, you will still buy about the same, so demand is inelastic. If the price of one phone brand shoots up, you switch to another, so demand is elastic.

Worked example. Price rises by 10% and quantity demanded falls by 20%. Ed = 20 ÷ 10 = 2. Since 2 is greater than 1, demand is elastic. If instead quantity had fallen by only 5%, Ed = 0.5 and demand would be inelastic. Quick rule: if the quantity changes more than the price in percentage terms, it is elastic.

Elasticity and total revenue (total outlay method). A seller or the government always asks: if I change the price, will total revenue (price × quantity) go up? If demand is elastic, a price cut raises quantity so much that total revenue rises. If demand is inelastic, a price cut makes revenue fall, so sellers can raise price and earn more. At unit elasticity, total revenue is at its maximum. This is why governments tax goods with inelastic demand (petrol, cigarettes, salt) to raise revenue.

Supply is the quantity of a good that sellers are willing and able to offer at a given price in a given time. The law of supply says: other things remaining the same, when price rises, quantity supplied rises, and when price falls, quantity supplied falls. Price and quantity supplied move in the same direction, so the supply curve slopes upward. The reason is simple: a higher price means a higher profit per unit, so sellers want to produce and sell more.

Equilibrium is the price at which the quantity buyers want exactly equals the quantity sellers want to sell. At that price there is no pressure to change. This is the market-clearing price. When demand increases (curve shifts right), both equilibrium price and quantity rise. When supply increases (curve shifts right), equilibrium price falls and quantity rises.

Utility is the satisfaction a consumer gets from using a good. It sits in the mind of the consumer, not in the good. Hungry, the first chapati gives you huge satisfaction. By the fifth, you barely want it. That is the whole story behind the downward-sloping demand curve. Total utility (TU) is the satisfaction from all units; marginal utility (MU) is the extra satisfaction from the last unit, MU = change in TU ÷ change in quantity.

Law of Diminishing Marginal Utility (Gossen's first law, refined by Marshall): as a consumer consumes more units of a commodity, the marginal utility derived from each additional unit decreases. It is the marginal utility that falls, not the total utility, which keeps rising until MU hits zero. The law holds when units are of the same kind, consumed continuously, and tastes remain unchanged.

An indifference curve joins all combinations of two goods that give the consumer equal satisfaction, so the consumer is 'indifferent' between them. That is why it is also called an iso-utility curve. Its properties: (1) slopes downward, (2) is convex to the origin because of the diminishing marginal rate of substitution, (3) two curves never intersect, and (4) a curve farther from the origin gives higher satisfaction. The budget line shows all combinations the consumer can afford. Consumer's equilibrium is at the point where the budget line is tangent to the highest possible indifference curve.

Production is the creation of value by combining inputs, called factors of production. There are four: land, labour, capital and entrepreneurship. Each earns a reward for its service. Think of a tailoring shop: the shop floor is land, the tailors are labour, machines and cloth stock are capital, and the owner who brings all this together and bears the risk is the entrepreneur.

Revenue and profit. Total revenue TR = price × quantity. Average revenue AR = TR ÷ quantity, which equals price. Marginal revenue MR = extra revenue from one more unit. A firm maximises profit at the output where MC = MR (with MC rising). Profit = TR − TC. At break-even, TR = TC; normal profit means AR = AC; a firm shuts down in the short run when price falls below AVC.

A market is any arrangement where buyers and sellers deal with each other. Economists classify markets by how many buyers and sellers there are, how alike the products are, and how easy it is to enter. This decides who controls the price. In perfect competition nobody controls it, in monopoly one seller controls it, and the other forms lie in between.

Why perfect competition is the benchmark: the firm is so small that it cannot change the price. It takes the market price as given, so its demand curve is a horizontal line and AR = MR = Price. A firm in a perfectly competitive market earns only normal profit in the long run, because new firms enter whenever profits are high. Monopoly is the opposite: the firm faces the entire market demand, so to sell more it must cut the price on all units, which makes MR less than AR. A monopolist can also practise price discrimination: charging different prices to different buyers for the same good (for example, student and senior citizen tickets, or electricity charged differently to homes and factories).