Chapter 2_demand and Supply

7/28/2019 Chapter 2_demand and Supply

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CHAPTER 2

DEMAND AND SUPPLY

LECTURE OUTLINE

1 INTRODUCTION

2 DEMAND

2.1 Definition of demand2.2 Relationship between price and quantity demanded2.3 Demand schedule and demand curve2.4 Movement along the demand curve versus shift in the demand curve2.5 Non-price determinants of demand

3 SUPPLY

3.1 Definition of supply3.2 Relationship between price and quantity supplied3.3 Supply schedule and supply curve3.4 Movement along the supply curve versus shift in the supply curve3.5 Non-price determinants of supply

4 EQUILIBRIUM

4.1 Equilibrium price and equilibrium quantity4.2 Effects of a change in demand on price and quantity4.3 Effects of a change in supply on price and quantity4.4 Effects of a change in demand and supply on price and quantity

5 SURPLUS

5.1 Consumer surplus5.2 Producer surplus

ReferencesJohn Sloman, EconomicsWilliam A. McEachern, EconomicsRichard G. Lipsey and K. Alec Chrystal, Positive EconomicsG. F. Stanlake and Susan Grant, Introductory EconomicsMichael Parkin, EconomicsDavid Begg, Stanley Fischer and Rudiger Dornbusch, Economics





1 INTRODUCTION

We have learnt that the allocation of factor inputs under the market system is determined by the interaction between the market forces of demand and supply. Therefore, it isimportant to have an understanding of the concepts of demand and supply to have a full

understanding of the allocation of factor inputs under the market system. This chapter gives an exposition of the concepts of demand and supply.

2 DEMAND

2.1 Definition of demand

The demand for a good is the quantity of the good that consumers are able and willing to buy, known as the quantity demanded, at each price over a period of time, ceteris paribus.

2.2 Relationship between price and quantity demanded

When the price of a good falls, the quantity demanded will rise. Conversely, when the priceof a good rises, the quantity demanded will fall. The inverse relationship between price andquantity demanded is the essence of the law of demand.

The law of demand states that there is an inverse relationship between

price and quantity demanded.

The law of demand can be explained with the concept of diminishing marginal utility.

Marginal utility is the additional satisfaction resulting from consuming one more unit of agood. The more a consumer has of a good, the less he will value it at the margin. This phenomenon is known as diminishing marginal utility. Due to diminishing marginal utility,consumers will only increase the consumption of a good if the price falls.

The law of demand can also be explained with the concepts of substitution effect andincome effect. Consider what will happen if the price of a good falls. First, the real incomeof consumers will rise because they will be able to buy a larger amount of goods andservices with the same amount of nominal income which will induce them to buy more of the good. This effect is known as the income effect of a price fall. Second, the good whose price has fallen will become relatively cheaper than other goods which will induce

consumers to substitute the good for other goods. This effect is known as the substitutioneffect of a price fall.

2.3 Demand schedule and demand curve

The quantity of a good that consumers are able and willing to buy at each price can beshown by the demand schedule.





Price Quantity demanded(John)

Quantity demanded(Peter)

Quantity demanded(Market)

10 1 2 3

5 2 4 6

The first two columns show the demand schedule of John and the first and the thirdcolumns show the demand schedule of Peter. The first and the last columns show themarket demand schedule, which is the summation of the demand schedules of John andPeter, assuming they are the only two consumers in the market.

The demand schedule can be represented graphically by the demand curve. The demandcurve shows the quantity demanded at each price and is downward-sloping due to the lawof demand. The market demand curve is the horizontal summation of the demand curves of all the consumers in the market and hence is also downward-sloping.

Market demand curve

2.4 Movement along the demand curve versus shift in the demand curve

A change in quantity demanded occurs when quantity demanded changes due to a change

in price and this can be shown by a movement along the demand curve. It is assumed thatother than price, all non-price determinants of demand have remained unchanged (knownas “ceteris paribus” in Latin and “other things being equal” in English).





In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a decreasein the price (P) from P0 to P1. This is known as an increase in quantity demanded.

A change in demand occurs when quantity demanded changes due to a change in anon-price determinant of demand. In other words, quantity demanded changes at the same price and this can be shown by a shift in the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price(P0) due to a change in a non-price determinant of demand. This is known as an increase indemand.





2.5 Non-price determinants of demand

Tastes and preferencesA change in tastes and preferences in favour of a good will lead to an increase in thedemand for the good. Tastes and preferences are affected by a number of factors such as

advertisements and fashions. For example, if Apple Corporation increases its expenditureon advertising, the demand for its products will increase.

Prices of substitutes and complementsSubstitutes are goods that are alternatives to one another such as Coke and Pepsi. A rise inthe prices of substitutes for a good will induce consumers to buy less of the substitutesresulting in an increase in the demand for the good. For example, if the price of Pepsi rises,consumers will buy less Pepsi and more Coke. Complements are goods that are consumedtogether such as car and petrol. A fall in the prices of complements for a good will induceconsumers to buy more of the complements resulting in an increase in the demand for thegood. For example, if the prices of cars fall, consumers will buy more cars and more petrol.

Number of substitutes and complementsAn increase in the number of substitutes for a good will lead to a decrease in the demandfor the good and vice versa. For example, if scientists found that beer could be used as asubstitute for milk to feed babies, the demand for milk would decrease. An increase in thenumber of complements will lead to an increase in the demand for a good and vice versa.For example, if more models of digital cameras are introduced onto the market, the demandfor memory cards will increase.

Level of incomeWhen consumers’ income rises, the demand for most goods will increase. These goods areknown as normal goods. There are, however, exceptions to this general rule. Whenconsumers’ income rises, the demand for some low quality goods will decrease. Thesegoods are known as inferior goods and are typically low quality goods.

Distribution of incomeIf income is redistributed from the rich to the poor, the demand for luxuries, which aretypically consumed by the rich, and the demand for inferior goods, which are typicallyconsumed by the poor, will decrease. However, the demand for necessities will increase.

Expectations of price changesIf consumers expect the price of a good to rise, they will buy more of the good to avoid paying a higher price in the future which will lead to an increase in the demand for the good.For example, if Dell announces that it will increase the prices of its personal computers, thedemand will increase.

Size of the populationAn increase in the size of the population will lead to an increase in the demand for somegoods.





Structure of the populationIf the population is graying, the demand for pharmaceutical products will increase.

Government policiesThe government is the biggest spender in every economy. Hence, if the government

increases spending, the demand for some goods will increase. The government can alsoaffect private spending by changing interest rates and tax rates in the economy.

Weather conditionsIn winter, the demand for coats and sweaters will increase and the demand for ice-creamwill decrease.

3 SUPPLY

3.1 Definition of supply

The supply of a good is the quantity of the good that firms are able and willing to sell,known as the quantity supplied, at each price over a period of time, ceteris paribus.

3.2 Relationship between price and quantity supplied

When the price of a good falls, the quantity supplied will fall. Conversely, when the priceof a good rises, the quantity supplied will rise. The direct relationship between price andquantity supplied is the essence of the law of supply.

The law of supply states that there is a direct relationship between price

and quantity supplied.

The law of supply can be explained with the concept of profit maximisation. A rise in the price of a good will increase the profitability of selling the good. Therefore, firms whichseek to maximise profit will sell more of the good.

The law of supply can also be explained with the concept diminishing marginal returns.Marginal cost is the additional cost resulting from producing one more unit of a good.Consider what will happen to marginal cost when production increases. For simplicity,suppose that a firm employs two factor inputs: capital and labour. Although labour is avariable factor input, capital is a fixed factor input. As the quantity of capital is fixed in the

short run, the firm can only increase production by employing more labour. However, aseach additional unit of labour will have less capital to work with, the additional outputresulting from employing one more unit of labour will fall. In other words, each additionalunit of labour will add less to total output than the previous additional unit. This phenomenon is known as diminishing marginal returns. Therefore, to produce eachadditional unit of output, more units of labour will be needed which will lead to an increasein the additional cost resulting from producing one more unit of output. Due to diminishingmarginal returns, firms will only increase the production of a good if the price rises.





3.3 Supply schedule and supply curve

The quantity of a good that firms are able and willing to sell at each price can be shown bythe supply schedule.

Price Quantity supplied(Firm X) Quantity supplied(Firm Y) Quantity supplied(Market)

10 4 8 12

5 2 4 6

The first two columns show the supply schedule of firm X and the first and the thirdcolumns show the supply schedule of firm Y. The first and the last columns show themarket supply schedule, which is the summation of the supply schedules of firm X andfirm Y, assuming they are the only two firms in the market.

The supply schedule can be represented graphically by the supply curve. The supply curve

shows the quantity supplied at each price and is upward-sloping due to the law of supply.The market supply curve is the horizontal summation of the supply curves of all the firmsin the market and hence is also downward-sloping.

Market supply curve

3.4 Movement along the supply curve versus shift in the supply curve.

A change in quantity supplied occurs when quantity supplied changes due to a change in price and this can be shown by a movement along the supply curve. It is assumed that other than price, all non-price determinants of supply have remained unchanged (known as“ceteris paribus” in Latin and “other things being equal” in English).





In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to an increasein the price (P) from P0 to P1. This is known as an increase in quantity supplied.

A change in supply occurs when quantity supplied changes due to a change in a non-pricedeterminant of supply. In other words, quantity supplied changes at the same price and thiscan be shown by a shift in the supply curve.

In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price(P0) due to a change in a non-price determinant of supply. This is known as an increase insupply.





3.5 Non-price determinants of supply

Cost of productionA rise in the cost of production will lead to a decrease in supply and vice versa. When thecost of production rises, firms will increase the price at each quantity to maintain

profitability. In other words, they will reduce the quantity supplied at each price which willlead to a decrease in supply. The converse is also true. There are several factors that canlead to a change in the cost of production.

- A fall in factor prices will lead to a fall in the cost of production and vice versa.- Technological advancements will decrease the cost of production.- A government subsidy will decrease the cost of production and a government tax will

have the opposite effect.

Expectations of price changesIf firms expect the price of a good to rise, they will hoard some of the output that they

currently produce to sell it at a higher price in the future. Thus, the supply of the good willfall. The converse is also true.

Government regulationIf the government removes restrictive official barriers to competition, the number of firmsin some industries will increase which will lead to an increase in the supply of the goods inthe industries. The converse is also true.

Profitability of goods in joint supplySometimes, when a good is produced, other goods are produced at the same time. Thegoods are known as goods in joint supply. An example is the refining of crude oil to produce petrol. In the process of refining crude oil to produce petrol, other grade fuels suchas diesel and paraffin are also produced. Therefore, if more petrol is produced, the supplyof other grade fuels will also increase. The converse is also true.

Profitability of substitutes in supplyIf the substitutes in supply for a good become more profitable to produce, firms may switchfrom the good to the substitutes which will lead to a decrease in the supply of the good. For example, if the demand for carrots increases, some of the farmers who are currently producing potatoes will switch to the production of carrots which will lead to a decrease inthe supply of potatoes. The converse is also true.

Disasters (natural and man-made) Natural disasters such as floods, earthquakes and drought can greatly reduce the supply of agricultural products. Man-made disasters such as wars can kill workers and destroyfactories and machinery and hence reduce the supply of goods.

Weather conditionsWhen weather conditions become more favourable, the supply of agricultural products willrise. The converse is also true.





4 EQUILIBRIUM

4.1 Equilibrium price and equilibrium quantity

An equilibrium is a state where there is no tendency to change. The equilibrium of a market

is determined by the market forces of demand and supply.

In the above diagram, given the demand curve (D) and the supply curve (S), theequilibrium price and the equilibrium quantity are PE and QE. If the price is above PE, suchas P1, the quantity supplied (QS) will be greater than the quantity demanded (QD) and this isknown as a surplus or excess supply (QS – QD). When firms cannot sell all the output thatthey produce, their stocks will build up. Therefore, they will lower price to reduce their stocks. The lower price will lead to a decrease in the quantity supplied and an increase inthe quantity demanded and this process will continue until the price falls to PE where thesurplus is eliminated.





If the price is below PE, such as P2, the quantity demanded (QD) will be greater than thequantity supplied (QS) and this is known as a shortage or excess demand (QD – QS). Whenfirms do not produce enough to sell, they can raise price without losing sales. Therefore,they will raise price to increase their profits. The higher price will lead to an increase in thequantity supplied and a decrease in the quantity demanded and this process will continue

until the price rises to PE where the shortage is eliminated. If the price is equal to PE, thequantity demanded will be equal to the quantity supplied. There will be neither surplus nor shortage and hence there will be no incentive for firms to change the price.

4.2 Effects of a change in demand on price and quantity

A change in demand will lead to a shift in the demand curve which will result in a newequilibrium price and a new equilibrium quantity.

An increase in demand will lead to a rightward shift in the demand curve which will result

in an increase in price and quantity.

In the above diagram, an increase in demand leads to a rightward shift in the demand curve(D) from D0 to D1. At the initial price (P0), the quantity demanded is greater than thequantity supplied. The shortage induces firms to increase the price and hence the quantitysupplied which results in a rightward movement along the supply curve. The higher pricealso induces consumers to decrease the quantity demanded which results in a leftwardmovement along the new demand curve. This process continues until the new equilibrium price (P1) is reached.





A decrease in demand will lead to a leftward shift in the demand curve which will result ina decrease in price and quantity.

In the above diagram, a decrease in demand leads to a leftward shift in the demand curve(D) from D0 to D1. At the initial price (P0), the quantity supplied is greater than the quantitydemanded. The surplus induces firms to decrease the price and hence the quantity suppliedwhich results in a leftward movement along the supply curve. The lower price also inducesconsumers to increase the quantity demanded which results in a rightward movement alongthe new demand curve. This process continues until the new equilibrium price (P1) isreached.

Note: It is important to know that when there is a change in demand, price and quantitywill change in the same direction.





4.3 Effects of a change in supply on price and quantity

A change in supply will lead to a shift in the supply curve which will result in a newequilibrium price and a new equilibrium quantity.

An increase in supply will lead to a rightward shift in the supply curve which will result ina decrease in price and an increase in quantity.

In the above diagram, an increase in supply leads to a rightward shift in the supply curve (S)from S0 to S1. At the initial price (P0), the quantity supplied is greater than the quantitydemanded. The surplus induces firms to decrease the price and hence the quantity suppliedwhich results in a leftward movement along the new supply curve. The lower price alsoinduces consumers to increase the quantity demanded which results in a rightwardmovement along the demand curve. This process continues until the new equilibrium price(P1) is reached.





A decrease in supply will lead to a leftward shift in the supply curve which will result in anincrease in price and a decrease in quantity.

In the above diagram, a decrease in supply leads to a leftward shift in the supply curve (S)from S0 to S1. At the initial price (P0), the quantity demanded is greater than the quantitysupplied. The shortage induces firms to increase the price and hence the quantity suppliedwhich results in a rightward movement along the new supply curve. The higher price alsoinduces consumers to decrease the quantity demanded which results in a leftwardmovement along the demand curve. This process continues until the new equilibrium price(P1) is reached.

Note: It is important to know that when there is a change in supply, price and quantity willchange in opposite directions.





4.4 Effects of a change in demand and supply on price and quantity

If demand and supply change simultaneously, the new equilibrium price and the newequilibrium quantity will be determined by the intersection of the new demand and the newsupply curves.

Suppose that demand and supply increase which lead to a rightward shift in the demandand the supply curves. In this instance, although quantity will increase, the effect on pricewill depend on whether the increase in demand is greater than the increase in supply or viceversa.

In the above diagram, an increase in demand and supply leads to a rightward shift in thedemand curve (D) and the supply curve (S) from D

0and S

0to D

1and S

1. As the increase in

demand is greater than the increase in supply, the price (P) and the quantity (Q) increasefrom P0 and Q0 to P1 and Q1.





In the above diagram, an increase in demand and supply leads to a rightward shift in thedemand curve (D) and the supply curve (S) from D0 and S0 to D1 and S1. As the increase insupply is greater than the increase in demand, although the quantity (Q) increases from Q0 to Q1, the price (P) falls from P0 to P1.

5 SURPLUS

5.1 Consumer surplus

The consumer surplus is the difference between the maximum amount that consumers areable and willing to pay and the amount that they actually pay.

In the above diagram, consumers are able and willing to pay $10 for the first unit of thegood, $9 for the second unit, $8 for the third unit and $7 for the fourth unit. Suppose thatconsumers buy 4 units of the good. When the quantity is 4 units, the price is $7. In this case,although the maximum amount that consumers are able and willing to pay is $34 ($10 + $9+ $8 + $7 = area of trapezium), the amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the consumer surplus is $6 ($34 - $28 = area trapezium – area of rectangle) and is represented by the area below the demand curve and above the price.




5.2 Producer surplus

The producer surplus is the difference between the minimum amount that firms are ableand willing to receive and the amount that they actually receive.

In the above diagram, firms are able and willing to receive $4 for the first unit of the good,$5 for the second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms produce 4 units of the good. When the quantity is 4 units, the price is $7. In this case,although the minimum amount that firms are able and willing to receive is $22 ($4 + $5 +$6 + $7 = area of trapezium), the amount that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer surplus is $6 ($28 - $22 = area trapezium – area of rectangle) and is represented by the area below the price and above the supply curve.

Chapter 2_demand and Supply

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