Engineering Economics| ME 2001 | 3 Credits | 3 0 0 3

Lecture 2

Theory of demand and supply analysis

Course Instructor
Dr. ANKUR SRIVASTAVA
Assistant Professor, Department of Mechanical Engineering
)
School of Automobile, Mechanical and Mechatronics Engineering (SAMME)
Manipal University Jaipur
Ph: +91-9828384492

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Nature of Demand Lecture 2

The desire,
ability, and
willingness
to buy a
product or
service

Desire? Ability? Willingness?

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Nature of Demand Lecture 2

Desire There are three important points to remember

about the quantity demanded:
Desire is just a wish on the part of the consumer to
o First, the quantity demanded is the quantity
possess a commodity.
desired to be purchased. It is the desired
purchase. The quantity actually bought is
referred to as actual purchase.
Want
o Secondly, quantity demanded is always
If the desire to take a commodity is backed by the considered as a flow measured over a period
purchasing power and the consumer is also willing of time.
to buy that commodity, it becomes want.  if the quantity demanded of oranges is 10, it
must be per day or per week, etc.

Demand o Thirdly, the quantity demanded will have an

economic meaning only at a given price.
Demand is the wish of the consumer to get a  For example, the demand for oranges equal to
definite quantity of a commodity at a given price in 10 units per week at a price of Rs. 100 per
the market backed by a sufficient purchasing dozen is a full and meaningful statement, as
power. used in micro-economic theory.
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 Economic Analysis Lecture 2
o Variables are not dated
Economic o The demand-supply model of market behaviour is a

Static Model
Analysis static model.
o In this model, demand depends on own price, supply
Static Dynamic depends on own price, with an equilibrium condition
model model that demand must equal supply, time does not enter into
the picture at all and the variables are all undated.

o Variables are dated o According to some economists, even if the variables

are dated the model does not become dynamic.
Dynamic Model

o If the demand-supply model is

restructured as follows, then the o According to this definition, variables must be dated
model would become dynamic and a time lag must exist in their relationships.
according to this criterion: With this criterion, a dynamic model would be:
𝐃𝐭 = 𝐟 𝐏𝐭 𝐃𝐭 = 𝐟 𝐏𝐭
𝐒𝐭 = 𝐠 𝐏𝐭 𝐒𝐭 = 𝐠 𝐏𝐭−𝟏
𝐃𝐭 = 𝐒𝐭 𝐃𝐭 = 𝐒𝐭
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• Where, ‘t’ is the relevant time unit.
Determinants of Demand by a Consumer Lecture 2
 The demand for commodity is dependent on a number of factors. These are mentioned as
follows:
o Price of the commodity: Normally, higher the price of the commodity, the lower the
1 demand of the commodity. This is the law of demand.

Price Per # of CDs 30

CD Demanded
$1 300 25

$2 162 20
$3 94
$4 58 15
$5 37
10
$6 25
$10 18 5
$15 13
$20 10 0
0 100 200 300
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Determinants of Demand by a Consumer Lecture 2

Law of demand.

P= Price QD= Quantity Demanded

P QD

Price
P QD 
Quantity Demanded
Determinants of Demand by a Consumer Lecture 2

o Size of consumers income/ Buyer’s income: When the increase in income leads to an
2 increase in the quantity demanded, the commodity is called a ‘normal good’. If an
increase in income leads to a fall in the quantity demanded, we call that commodity an
‘inferior good’.

Income  Demand
Income  Demand

Examples:
- Minimum wage increases
- Economic Recession
- The Great Depression

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Determinants of Demand by a Consumer Lecture 2

o Prices of other related commodities: A consumer’s demand for a commodity may also
3 be influenced by the prices of some other commodities. Some are complementary
goods, which are consumed along with the commodity, while others may be used in
place of this commodity. This category is called substitutes.

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Determinants of Demand by a Consumer Lecture 2

o Taste of the consumers: If a consumer has developed a taste for a particular commodity,
4 he/she will demand more of that commodity. Similarly, if a consumer has changed his taste
against a particular commodity, less of it will be demanded at any particular price. This
development of tastes may be related to seasons of the year as well.

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Determinants of Demand by a Consumer Lecture 2

o Demand function refers to the rule that shows how the quantity demanded depends
upon above factors.

o A demand function can be shown as:

𝐃𝐱 = 𝐟 𝐏𝐱 , 𝐏𝐲 , 𝐏𝐳 , 𝐌, 𝐓

where,
 If all the factors influencing the
Dx is quantity demanded of X commodity
demand for a commodity X vary
Px is the price of X commodity simultaneously, the picture would be
highly complicated.
Py is the price of substitute commodity
Pz is price of a complement good  Therefore, normally we allow only
one of the factors to change, assuming
M stands for income
that all other factors remain
T is the taste of the consumer unchanged

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Determinants of Market Demand Lecture 2

 The factors determining the demand for a commodity in a market are the same as those
which determine the demand for the commodity on the part of a consumer.

 Besides that two additional factors are also to be included. These two factors are:

o Size of the population: All other factors

remaining unchanged, the greater is the
size of the population, more of a
commodity will be demanded. o Income distribution: : People in different
income groups show marked differences in
their preferences. So if larger share out of
national income goes to the rich, demand for
the luxury goods may rise and a rise in
income share of the poor will increase
demand for the wage goods.

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Engineering Economics Lecture 2
Engineering economics deals with the methods that enable one to take economic decisions
towards minimizing costs and/or maximizing benefits to business organizations.
Key points
Produce  Example: Technical efficiency of a
Physical goods/services diesel engine is less than 100%.
environment depending on  This is mainly due to frictional loss
and incomplete combustion of fuel
Engineering

physical law
𝑺𝒚𝒔𝒕𝒆𝒎 𝑶𝒖𝒕𝒑𝒖𝒕 o Technical efficiency can never be more
𝑻𝒆𝒄𝒉𝒏𝒊𝒄𝒂𝒍 𝑬𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒄𝒚 =
𝑺𝒚𝒔𝒕𝒆𝒎 𝑰𝒏𝒑𝒖𝒕 than 100%.

 Worth: Annual revenue generated by way

Economic Assessing the of operating the business.
environment worth of these  Cost: Total annual expenses incurred in
products in carrying out the business.
economic terms o For the survival and growth of any
𝑺𝒚𝒔𝒕𝒆𝒎 𝑾𝒐𝒓𝒕𝒉 business, the economic efficiency should
𝑬𝒄𝒐𝒏𝒐𝒎𝒊𝒄 𝑬𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒄𝒚 = be more than 100%.
𝑺𝒚𝒔𝒕𝒆𝒎 𝑪𝒐𝒔𝒕 12
Law of Demand Lecture 2
o The inverse relationship between the quantity of a commodity and its price, given all
other factors that influence the demand is called ‘law of demand’.

o It gives us a demand curve that slopes downwards to the right. We can explain this idea
with help of a demand schedule
Demand curve

o The demand curve graphically shows

the relationship between the quantity
of a good that consumers are willing to
buy and the price of the good.
Price of Apple per Kg. Quantity Demanded of
(in Rs.) Apples
(in Kg. per week)
100 15
200 12
300 8
400 3 13
Why does a Demand Curve Slope Downwards? Lecture 2
o Substitution Effect: Substitution effect results o Income Effect: This is the effect of a
from a change in the relative price of a change in total purchasing power of the
commodity. money income of the consumer.
o Suppose a Pepsi Can and a Coke Can both are o As price of mango falls the purchasing
priced at Rs. 90 and Rs. 20 each. If the price power of the given money income rises, or
of Coke is raised to Rs. 25, and the price of his real income rises. Thus, he can buy
Pepsi is not changed, Pepsi will become more of the mangoes with the same money
relatively cheaper to Coke, i.e. although the income.
absolute price of Pepsi has not changed, the o His demand for any other commodities
relative price of Pepsi has gone down. may also rise. This is called the ‘income
o The change in the relative price of effect’.
commodity causes substitution effect.
o It is important to note that substitution effect
Price Effect: Price Effect is the sum total of the and income effect operate simultaneously with
the change in the price of the commodity.
substitution effect and income effect, i.e.
o ‘Substitution effect’, and ‘income effect’ taken
PE = SE + IE
Where PE = Price Effect. together give ‘price effect.’
SE = Substitution Effect
IE = Income Effect
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CHANGE IN QUANTITY DEMANDED Vs. CHANGE IN DEMAND
o When the demand for a commodity changes Change in Demand
because of the change in its price, it is called The shift of the demand curve to the right shows
‘change in quantity demanded’. On the other ‘increase in demand’ and a movement of the
hand, when the change in demand is due to demand curve to the left of the initial demand
the factors other than its price cause a curve is a ‘decrease in demand’.
change it is called ‘change in demand’.
Expansion and Contraction in Demand (Change in
quantity demanded)

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Concept of Supply Lecture 2

o Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.
 A higher price would mean more profits. The producer will supply more at a higher price.
 Similarly, a producer will supply smaller quantity at a lower price.
 This is a direct relationship between the price and the quantity supplied of a commodity and is
called the ‘Law of Supply’.

 A producer aims to maximize profits

 Therefore, profit is estimated through difference between total revenue and total cost.
 Total revenue is the price of the product multiplied by its quantity sold.
 Total cost is the cost of production.
Profit = TR – TC
TR = Total Revenue (q.p)
TC = Total Cost (q.AC)
where AC is average cost.

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Determinants of Supply Lecture 2

1. Price of the commodity supplied

o The price is most immediate determinant of supply.
o A person or firm will make quick check whether the costs will be covered by
the price. As the price goes up, a firm/person will be willing to sell larger
quantity.
2. The prices of factors of production or cost of production
o These affect the cost of production and possible profits of the firm. A rise in the
prices of factors of production discourages the production and supply of the
commodity.
3. Prices of other goods
o As the prices of other commodities rise, they become more attractive to
produce for a profit maximising firm. Hence supply of commodity whose price
is unchanged will decline.

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Determinants of Supply Lecture 2
4. The state of technology
o The improvement in the knowledge about the means and the methods of
production lead to lower costs of production and helps increasing output.
5. Goals of the producer
o The objective with which the producer undertakes production also influences
his production and supply decisions.

Price (in Rs) per Pen Quantity Supplied (in thousand per Month

2 25
3 40
4 50
5 60
6 70

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Concept of Supply Lecture 2
o Supply refers to the quantity of a commodity that producers are willing to sell
at different prices per unit of time.
𝐒𝐭 = 𝐠 𝐏𝐭

o The supply of a commodity is a function of its price, the price of all other
commodities, the prices of factors of production, technology, the objectives of
producers and other factors remaining unchanged. So:
𝐒𝐭 = 𝐠 𝐏𝟏, 𝐏𝟐, 𝐏𝟑. . . 𝐏𝐧, 𝐅𝟏 … 𝐅𝐚, 𝐓, 𝐆, … .
Where: Qs stands for the quantity of the commodity supplied;
P1 is the price of that commodity, P2, P3...Pa are the prices of other
commodities;
F1 …… Fn are the prices of all factors of production;
T is the state of technology;
G is the goal of the producer.
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