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Group 1

Leader: Buena-agua, Gillian Alyssa a.

Members:Alejandro, Rachel ann T.

Nicolas, jedideahSabas, jonalyn

Samarita, ginevaSantos, krizelle Camille

Prof. Eleonor de jesus

Introducti

on tomicroeconomictheo

ryandpractice

Polytechnicuniversity of

thePhilippines

E

CO

N20

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CHAPTER II – DEMAND AND SUPPLY

DEMAND

In economics, demand is the desire to own anything, the ability to pay for it, and

the willingness to pay. The term demand signifies the ability or the willingness to buy a

particular commodity at a given point of time.

Other Definitions of Demand

The demand for a product is defined as the quantity of the product demanded by

a consumer or an aggregate of consumers at any given price.

An economic principle that describes a consumer’s desire and willingness to pay

a price for a specific good or service. Holding all other factors constant, the price

of a good or service increases as its demand increases and vice versa.

The amount of a particular economic good or service that a consumer or group

of consumers will want to purchase at a given price.

Think of demand as your willingness to go out and buy a certain product. For

example, market demand is the total of what everybody in the market

wants. The demand curve is usually downward sloping, since consumers will want

to buy more as price decreases. Demand for a good or service is determined by many

different factors other than price, such as the price of substitute

goods and complementary goods. In extreme cases, demand may be completely

unrelated to price, or nearly infinite at a given price. Along with supply, demand is one

of the two key determinants of the market price.

Businesses often spend a considerable amount of money in order to determine the

amount of demand that the public has for its products and services. Incorrect

ECON 2023 – INTRODUCTION TO MICROECONOMIC THEORY ANDPRACTICE

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estimations will either result in money left on the table if it’s underestimated or losses if

it’s overestimated.

Demand is a relationship between two variables, price and quantity demanded, with

all other factors that could affect demand being held constant.

Demand Schedule and Demand Curve

A table which contains values for the price of a good and the quantity that would

be demanded at that price is called a demand schedule. If the data from the table is

charted, it is known as a demand curve.

Demand Schedule

A demand schedule is typically used in conjunction with a supply schedule

showing the quantity of a good that would be supplied to the market at given price

levels. It is a table listing showing the number of units of a single type of good (or

service) that potential purchasers would offer to buy at each of a number of varying

prices during some particular time period. Demand schedules may be drawn up to

reflect the behavioral propensities of a single unique individual, household, or firm -- or,

more frequently encountered in microeconomic analysis, composite demand schedules

for the particular good may be derived by adding up all the demand schedules of the

large number of individuals, households or firms that are active or potentially active as

purchasers in the market under consideration.

Example of a Demand Schedule

Price of Sugar (per kilo) Quantity Demanded

P 45 100


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40 150

35 200

30 250

25 300

Demand Curve

The demand curve is the graph depicting the relationship between the price of a

certain commodity, and the amount of it that consumers are willing and able to

purchase at that given price. It is a graphic representation of a demand schedule. The

demand curve for all consumers together follows from the demand curve of every

individual consumer: the individual demands at each price are added together.

Demand curves are used to estimate behaviors in competitive markets, and are often

combined with supply curves to estimate the equilibrium price and the equilibrium

quantity of that market.

According to convention, the demand curve is drawn with price on the vertical

axis and quantity on the horizontal axis. The function actually plotted is the inverse

demand function. The demand curve usually slopes downwards from left to right; that is,it has a negative association. The negative slope is often referred to as the " law of

demand", which means people will buy more of a service, product, or resource as its

price falls. The demand curve is related to the marginal utility curve, since the price one

is willing to pay depends on the utility. However, the demand directly depends on the

income of an individual while the utility does not.

Example of a Demand Curve

THE LAW OF DEMAND


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In economics, the law of demand is an economic law that states

that consumers buy more of a good when its price decreases and less when its price

increases .The greater the amount to be sold, the smaller the price at which it is offered

must be, in order for it to find purchasers.

Law of demand states that the amount demanded of a commodity and its price

are inversely related, other things remaining constant. That is, if the income of the

consumer, prices of the related goods, and tastes and preferences of the consumer

remain unchanged, the consumer’s demand for the good will move opposite to the

movement in the price of the good.

Assumptions

Every law will have limitation or exceptions. While expressing the law of demand, the

assumptions that other conditions of demand were unchanged. If remain constant, the

inverse relation may not hold well. In other words, it is assumed that the income and

tastes of consumers and the prices of other commodities are constant. This law

operates when the commodity’s price changes and all other prices and conditions do

not change. The main assumptions are:

Habits, tastes and fashions remain constant.

Money, income of the consumer does not change.

Prices of other goods remain constant.

The commodity in question has no substitute or is not competed by other.

The commodity is a normal good and has no prestige or status value.

People do not expect changes in the prices.

Exceptions to the law of demand

Generally, the amount demanded of good increases with a decrease in price of

the good and vice versa. In some cases, however, this may not be true. Such situations

are explained below.


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Giffen goods

As noted earlier, if there is an inferior good of which the positive income effect is

greater than the negative substitution effect, the law of demand would not hold. For

example, when the price of potatoes (which is the staple food of some poor families)

decreases significantly, then a particular household may like to buy superior goods

out of the savings which they can have now due to superior goods like cereals, fruits

etc., not only from these savings but also by reducing the consumption of potatoes.

Thus, a decrease in price of potatoes results in decrease in consumption of potatoes. Such basic good items (like bajra, barley, grain etc.) consumed in bulk by

the poor families, generally fall in the category of Giffen goods. It should be noted

that not all inferior goods are giffen goods, but all giffen goods are inferior goods.

This is similar to how all men are humans but not all humans are men. A walkman is

considered an inferior good but would not be a Giffen good.

Commodities which are used as status symbols

Some expensive commodities like diamonds, air conditioned cars, etc., are used

as status symbols to display one’s wealth. The more expensive these commodities

become, the higher their value as a status symbol and hence, the greater the

demand for them. The amount demanded of these commodities increase with an

increase in their price and decrease with a decrease in their price. Also known as

a Veblen good.

Expectation of change in the price of commodity

If a household expects the price of a commodity to increase, it may start

purchasing greater amount of the commodity even at the presently increased price.


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Similarly, if the household expects the price of the commodity to decrease, it may

postpone its purchases. Thus, law of demand is violated in such cases.

In the above circumstances, the demand curve does not slope down from left to

right instead it presents a backward sloping from top right to down left as shown in

diagram. This curve is known as exceptional demand curve.

Changes in Quantity Demanded and Movements along the Demand Curve

There is movement along a demand curve when a change in price causes the

quantity demanded to change. It is important to distinguish between movement along ademand curve, and a shift in a demand curve. Movements along a demand curve

happen only when the price of the good changes. When a non-price determinant of

demand changes the curve shifts. These "other variables" are part of the demand

function. They are "merely lumped into intercept term of a simple linear demand

function." Thus a change in a non-price determinant of demand is reflected in a change

in the x-intercept causing the curve to shift along the x axis.

After having understood the nature of demand and law of demand, it is easy to

ascertain the determinants of demand. We have mentioned above that an individual

demand for a commodity depends on desire for the commodity and the capability to

purchase it. The desire to purchase is revealed by tastes and preferences of the

individuals. The capability to purchase depends upon his purchasing power, which in

turn depends upon his income and price of the commodity. Since an individual

purchases a number of commodities, the quantity of a particular commodity he chooses

to purchase depends on the price of that particular commodity and prices of the other

commodities, as well as the relative amount of his income, or purchasing power.

Innumerable factors and circumstances could affect a buyer's willingness or

ability to buy a good. Some of the more common factors are:


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Prices of related commodities

When a change in price of the other commodity leaves the amount demanded

of the commodity under consideration unchanged, we say that the two commodities

are unrelated, otherwise these are related. The related commodities are of two

types’ substitutes and complements. For substitutes if price of one will increase the

demand of other will increase and for compliments if the price of one will increase

the demand for other will decrease.

Income of the individual

The amount demanded of a commodity also depends upon the income of an individual. With an increase in income, there will be increased amount of most

of the commodities in his consumption bundle, though the extent of the increase

may differ between commodities.

Tastes and preferences

It is quite well that the change in tastes and preferences of consumers in favour

of a commodity results in smaller demand for the commodity. Modern business

firms, which sell product with different brand names, rely a great deal on influencing

tastes and preferences of households in favour of their products (with the help of

advertisements, etc.) in order to bring about increase in demand of their products.

The amount demanded also depends on consumer’s taste. Tastes include fashion,

habit, customs, etc. A consumer’s taste is also affected by advertisement. If the taste

for a commodity goes up, its amount demanded is more even at the same price and

vice-versa.

Wealth

The amount demanded of a commodity is also affected by the amount of wealth

as well as its distribution. The wealthier are the people, higher is the demand for


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normal commodities. If wealth is more equally distributed, the demand for

necessaries and comforts is more. On the other hand, if some people are rich, while

the majority is poor, the demand for luxuries is generally less.

Expectations regarding the future

If consumers expect changes in price of a commodity in future, they will change

the demand at present even when the present price remains the same. Similarly, if

consumers expect their incomes to rise in the near future, they may increase the

demand for a commodity just now.

Climate and weather

The climate of an area and the weather prevailing there has a decisive effect on

consumer’s demand. In cold areas, woollen cloth is demanded. During hot summer

days, ice is very much in demand. On a rainy day, ice is not so much demanded.

State of business

The level of demand for different commodities also depends upon the business

conditions in the country. If the country is passing through boom conditions, therewill be a marked increase in demand. On the other hand, the level of demand goes

down during depression.

Ceteris Paribus

Latin phrase that translates approximately to "holding other things constant" and is

usually in English as "all other things being equal". In economics and finance, the term is

used as a shorthand for indicating the effect of one economic variable on another, holding

constant all other variables that may affect the second variable.

For example, when discussing the laws of supply and demand, one could say that if


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demand for a given product outweighs supply, ceteris paribus, prices will rise. Here, the

use of "ceteris paribus" is simply saying that as long as all other factors that could affect

the outcome (such as the existence of a substitute product) remain constant, prices will

increase in this situation. Contrasts with "mutatis mutandis".

One of the disciplines in which ceteris paribus clauses are most widely used is

economics, in which they are employed to simplify the formulation and description of

economic outcomes. When using ceteris paribus in economics, assume all other variables

except those under immediate consideration are held constant. For example, it can be

predicted that if the price of beef increases—ceteris paribus—the quantity of beef demanded

by buyers will decrease.

In this example, the clause is used to operationally describe everything surrounding the

relationship between both the price and the quantity demanded of an ordinary good.

This operational description intentionally ignores both known and unknown factors that may

also influence the relationship between price and quantity demanded, and thus to assume

ceteris paribus is to assume away any interference with the given example. Such factors that

would be intentionally ignored include: the relative change in price of substitute goods,

(e.g., the price of beef vs pork or lamb); the level of risk aversion among buyers

(e.g., fear of mad cow disease); and the level of overall demand for a good regardless of its

current price level (e.g., a societal shift toward vegetarianism).The clause is often loosely

translated as "holding all else constant."

Characterization given by Alfred Marshall

The clause is used to consider the effect of some causes in isolation, by assuming

that other influences are absent. Alfred Marshall expressed the use of the clause as follows:

The element of time is a chief cause of those difficulties in economic investigations whichmake it necessary for man with his limited powers to go step by step; breaking up a

complex question, studying one bit at a time, and at last combining his partial solutions


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into a more or less complete solution of the whole riddle. In breaking it up, he segregates

those disturbing causes, whose wanderings happen to be inconvenient, for the time in a

pound called Ceteris Paribus.

The study of some group of tendencies is isolated by the assumption other things

being equal: the existence of other tendencies is not denied, but their disturbing effect is

neglected for a time. The more the issue is thus narrowed, the more exactly can it be

handled: but also the less closely does it correspond to real life. Each exact and firm

handling of a narrow issue, however, helps towards treating broader issues, in which that

narrow issue is contained, more exactly than would otherwise have been possible. With

each step more things can be let out of the pound; exact discussions can be made lessabstract, realistic discussions can be made less inexact than was possible at an earlier stage.

Two uses

The above passage by Marshall highlights two ways in which the ceteris paribus

clause may be used: The one is hypothetical, in the sense that some factor is assumed

fixed in order to analyze the influence of another factor in isolation. This would be

hypothetical isolation. An example would be the hypothetical separation of the income

effect and the substitution effect of a price change, which actually go together. The other

use of the ceteris paribus clause is to see it as a means for obtaining an approximate

solution. Here it would yield a substantive isolation.

Substantive isolation has two aspects: Temporal and causal. Temporal isolation requires

the factors fixed under the ceteris paribus clause to actually move so slowly relative to the

other influence that they can be taken as practically constant at any point in time.

So, if vegetarianism spreads very slowly, inducing a slow decline in the demand for

beef, and the market for beef clears comparatively quickly, we can determine the priceof beef at any instant by the intersection of supply and demand, and the changing demand

for beef will account for the price changes over time (→Temporary Equilibrium Method).


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The other aspect of substantive isolation is causal isolation: Those factors frozen under a

ceteris paribus clause should not significantly be affected by the processes under study. If a

change in government policies induces changes in consumers' behavior on the same time

scale, the assumption that consumer behavior remains unchanged while policy changes

is inadmissible as a substantive isolation (→Lucas critique).

Changes in Demand and Shifts in the Demand Curve

The shift of a demand curve takes place when there is a change in any non-price

determinant of demand, resulting in a new demand curve. Non-price determinants of demand are those things that will cause demand to change even if prices remain the

same—in other words, the things whose changes might cause a consumer to buy more or

less of a good even if the good's own price remained unchanged. Some of the more

important factors are the prices of related goods (both substitutes and complements),

income, population, and expectations.

However, demand is the willingness and ability of a consumer to purchase a

good under the prevailing circumstances; so, any circumstance that affects the consumer's

willingness or ability to buy the good or service in question can be a non-price determinant

of demand. As an example, weather could be a factor in the demand for beer at a

baseball game. When income rises, the demand curve for normal goods shifts outward

as more will be demanded at all prices, while the demand curve for inferior shifts inward

due to the increased attainability of superior substitutes. With respect to related goods,

when the price of a good (e.g. a hamburger) rises, the demand curve for substitute goods

(e.g. chicken) shifts out, while the demand curve for complementary goods (e.g. tomato sauce)

shifts in (i.e. there is more demand for substitute goods as they become more attractive in

terms of value for money, while demand for complementary goods contracts in response to thecontraction of quantity demanded of the underlying good).


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Demand shifters

Changes in disposable income

Changes in tastes and preferences - tastes and preferences are assumed to be fixed in

the short-run. This assumption of fixed preferences is a necessary condition for

aggregation of individual demand curves to derive market demand.

Changes in expectations.

Changes in the prices of related goods (substitutes and complements)

Population size and composition

Changes that increase demand

Some circumstances which can cause the demand curve to shift out include: increase in price of a substitute

decrease in price of complement

increase in income if good is a normal good

decrease in income if good is an inferior good

Changes that decrease demand

Some circumstances which can cause the demand curve to shift in include:

decrease in price of a substitute

increase in price of a complement

decrease in income if good is normal good

increase in income if good is inferior good

Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to

The factors which can affect individual demand there are three factors that can affect market

demand (cause the market demand curve to shift):

a change in the number of consumers,

a change in the distribution of tastes among consumers,


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a change in the distribution of income among consumers with different tastes.

SUPPLY

What Supply Is:

Economists have a very precise definition of supply. Economists describe supply as the

relationship between the quantity of a good or service consumers will offer for sale

and the price charged for that good. More precisely and formally supply can be thoughtof as "the total quantity of a good or service that is available for purchase at a given price."

What Supply Is Not:

Supply is not simply the number of an item a shopkeeper has on the shelf, such as

'5 oranges' or '17 pairs of boots', because supply represents the entire relationship

between the quantity available for sale and all possible prices charged for that good.

The specific quantity desired to sell of a good at a given price is known as the

quantity supplied. Typically a time period is also given when describing quantity supplied.

Supply schedule

A supply schedule is a table which shows how much one or more firms will be

willing to supply at particular prices. The supply schedule shows the quantity of goods

that a supplier would be willing and able to sell at specific prices under the existing

circumstances. Some of the more important factors affecting supply are the goods own

price, the price of related goods, production costs, technology and expectations of sellers.

Factors affecting supply


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Innumerable factors and circumstances could affect a seller's willingness or ability to

produce and sell a good. Some of the more common factors are:

Goods own price: The basic supply relationship is between the price of a good

and the quantity supplied. Although there is no "Law of Supply", generally, the

relationship is positive or direct meaning that an increase in price will induce and

increase in the quantity supplied.

Price of related goods: For purposes of supply analysis related goods refer togoods from which inputs are derived to be used in the production of the primary

good. For example, Spam is made from pork shoulders and ham. Both are

derived from Pigs. Therefore pigs would be considered a related good to Spam.

In this case the relationship would be negative or inverse. If the price of pigs

goes up the supply of Spam would decrease (supply curve shifts up or in)

because the cost of production would have increased. A related good may also

be a good that can be produced with the firm's existing factors of production. For

example, a firm produces leather belts. The firm's managers learn that leather

pouches for Smart phones are more profitable than belts. The firm might reduce its

production of belts and begin production of cell phone pouches based on this

information. Finally, a change in the price of a joint product will affect supply. For

example beef products and leather are joint products. If a company runs both a

beef processing operation and a tannery an increase in the price of steaks would

mean that more cattle are processed which would increase the supply of leather.

Conditions of Production. The most significant factor here is the state

of technology. If there is a technological advancement in one's good's production,the supply increases. Other variables may also affect production conditions.

For instance, for agricultural goods, weather is crucial for it may affect the


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production outputs.

Expectations: Sellers expectations concerning future market condition can

directly affect supply. If the seller believes that the demand for his product will

sharply increase in the foreseeable future the firm owner may immediately

increase production in anticipation of future price increases. The supply curve

would shift out. Note that the outward shift of the supply curve may create the

exact condition the seller anticipated, excess demand.

Price of inputs: Inputs include land, labor, energy and raw materials. If the

price of inputs increases the supply curve will shift in as sellers are less willingor able to sell goods at existing prices. For example, if the price of electricity

increased a seller may reduce his supply because of the increased costs of

production. The seller is likely to raise the price the seller charges for each unit

of output.

Number of suppliers - the market supply curve is the horizontal summation

of the individual supply curves. As more firms enter the industry the market

supply curve will shift out driving down prices.

Government policies and regulations: Government intervention can have

a significant effect on supply. Government intervention can take many forms

including environmental and health regulations, hour and wage laws, taxes,

electrical and natural gas rates and zoning and land use regulations.

Supply function and equation

The supply function is the mathematical expression of the relationshipbetween supply and those factors that affect the willingness and ability of a supplier

to offer goods for sale. For example, Qs = f (P , | P rg S ) is a supply function where


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P equals price of the good P rg equals the price of related goods and S equals the number

of producers. The vertical bar means that the variables to the right are being held

constant. The supply equation is the explicit mathematical expression of the functional

relationship. For example, Qs = 325 + P − 30P rg + 20S . 325 is y-intercept it is the

repository of all non-specified factors that affect supply for the product. P is the price

of the own good. The coefficient is positive following the general rule that price and

quantity supplied are directly related. P rg is the price of a related good. Typically the

relationship is positive because the good is an input or a source of inputs.

Supply curve

The relationship of price and quantity supplied can be exhibited graphically as the

supply curve. The curve is generally positively sloped. The curve depicts the relationship

between two variables only; price and quantity supplied. All other factors affecting supply

are held constant. However, these factors are part of the supply curve and are present in

the intercept or constant term.

Movements versus shifts

Movements along the curve occur only if there is a change in quantity supplied

caused by a change in the goods own price. A shift in the supply curve, referred to as a

change in supply, occurs only if a non price determinant of supply changes. For

example, if the price of an ingredient used to produce the good, a related good, were

to increase, the supply curve would shift in.

Inverse Supply Equation


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revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct

correlation between quantity supplied (Q) and price (P). At point B, the quantity

supplied will be Q2 and the price will

be P2, and so on.

Time and Supply

Unlike the demand relationship, however, the supply relationship is a factor of time.

Time is important to supply because suppliers must, but cannot always, react quickly to

a change in demand or price. So it is important to try and determine whether a price

change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an

unexpected rainy season; suppliers may simply accommodate demand by using their

production equipment more intensively. If, however, there is a climate change, and the

population will need umbrellas year-round, the change in demand and price will be


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expected to be long term; suppliers will have to change their equipment and production

facilities in order to meet the long-term levels of demand.

Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show

how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because

he record company's previous analysis showed that consumers will not demand CDs at

a price higher than $20, only ten CDs were released because the opportunity cost is toohigh for suppliers to produce more. If, however, the ten CDs are demanded by 20 people,

the price will subsequently rise because, according to the demand relationship, as demand

increases, so does the price. Consequently, the rise in price should prompt more CDs to be

supplied as the supply relationship shows that the higher the price, the higher the quantity

supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be

pushed up because the supply more than accommodates demand. In fact after the 20

consumers have been satisfied with their CD purchases, the price of the leftover CDs may

drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make

the CD more available to people who had previously decided that the opportunity cost of

buying the CD at $20 was too high.

Equilibrium

When supply and demand are equal (i.e. when the supply function and demand function

intersect) the economy is said to be at equilibrium. At this point, the allocation of goods isat its most efficient because the amount of goods being supplied is exactly the same as

the amount of goods being demanded. Thus, everyone (individuals, firms, or countries)


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is satisfied with the current economic condition. At the given price, suppliers are selling

all the goods that they have produced and consumers are getting all the goods that they

are demanding.


21



As you can see on the chart, equilibrium occurs at the intersection of the demand

and supply curve, which indicates no allocative inefficiency. At this point, the price of

the goods will be P* and the quantity will be Q*. These figures are referred

to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices

of goods and services are constantly changing in relation to fluctuations in demand and

supply.

Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply

If the price is set too high, excess supply will be created within the economy and there

will be allocative inefficiency.


22



At price P1 the quantity of goods that the producers wish to supply is indicated by

Q2. At P1, however, the quantity that the consumers want to consume is at Q1, aquantity much less than Q2. Because Q2 is greater than Q1, too much is being

produced and too little is being consumed. The suppliers are trying to produce more

goods, which they hope to sell to increase profits, but those consuming the goods will

find the product less attractive and purchase less because the price is too high.

2. Excess Demand

Excess demand is created when price is set below the equilibrium price. Because

the price is so low, too many consumers want the good while producers are not

making enough of it.


23



In this situation, at price P1, the quantity of goods demanded by consumers at this

price is Q2. Conversely, the quantity of goods that producers are willing to produce at this

price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of

the consumers. However, as consumers have to compete with one other to buy the

good at this price, the demand will push the price up, making suppliers want to supply

more and bringing the price closer to its equilibrium.

Shifts vs. Movement

For economics, the “movements” and “shifts” in relation to the supply and demand curves

represent very different market phenomena:

1. Movements

A movement refers to a change along a curve. On the demand curve, a movement

denotes a change in both price and quantity demanded from one point to another on the

curve. The movement implies that the demand relationship remains consistent. Therefore,

a movement along the demand curve will occur when the price of the good changes and

the quantity demanded changes in accordance to the original demand relationship. In


24



other words, a movement occurs when a change in the quantity demanded is caused

only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply

curve means that the supply relationship remains consistent. Therefore, a movement

along the supply curve will occur when the price of the good changes and the quantity

supplied changes in accordance to the original supply relationship. In other words, a

movement occurs when a change in quantity supplied is caused only by

a change in price, and vice versa.


25



2. Shifts

A shift in a demand or supply curve occurs when a good's quantity demanded

or supplied changes even though price remains the same. For instance, if the price

for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2,

then there would be a shift in the demand for beer. Shifts in the demand curve imply

that the original demand relationship has changed, meaning that quantity demand is

affected by a factor other than price. A shift in the demand relationship would occur if,

for instance, beer suddenly became the only type of alcohol available for consumption.


26



Conversely, if the price for a bottle of beer was $2 and the quantity supplied

decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a

shift in the demand curve, a shift in the supply curve implies that the original supply

curve has changed, meaning that the quantity supplied is effected by a factor other

than price. A shift in the supply curve would occur if, for instance, a natural disaster

caused a mass shortage of hops; beer manufacturers would be forced to

supply less beer for the same price.


27



MARKET EQUILIBRIUM

-Is a condition where quantity supplied equals quantity demanded.

-Introduced by Alfred Marshall, a British economist.

-A kind of pricing scheme combining the law of demand and the law of supply.


28



Price Equilibrium

-Is the price level that both buyers and sellers agree to have a transaction in the

market.

Quantity Equilibrium

-Refers to the quantity of products that buyers and sellers are willing to transact

at a specified price.

If the interaction of demand and supply is put into a graphic representation, theintersection of price and quantity s called the point of equilibrium.

The Dynamics of Demand and Supply


29



P0Q1 D0Q0

The equilibrium price and quantity in a market are determined by the intersection

of demand and supply curves. At the point of intersection, quantity demanded equals

quantity supplied, and the market clears. Since the location of the demand and supply

curves is determined by the five determinants of demand and the five determinants of

supply, a change in any one of these 10 variables will result in a new equilibrium point.

Change in Demand While Supply is Constant

When demand increases and supply remains constant, price and quantity soldboth rise. A decrease in demand, supply constant, causes both price and quantity sold

to fall.

A. Increase in Demand B. Decrease in Demand


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sD1

P10Quantity

PRICE



Change in Supply While the Demand Is Constant

When supply increases and demand remains constant, price falls and quantity soldrises. A decrease in supply, demand constant, causes price to rise and quantity sold to

fall.

A.

B. Decrease in Supply

C. Increase in Supply


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P0Q0D0Q1S0S1


32

P10Quantity

PRIC

E



Simultaneous Change of Supply and Demand

A. Increase in Demand and Decrease in Supply

Violations of the Law of Supply and Demand

One law that Congress Indeed cannot repeal, nor by a dictator is that of Supply

and Demand. But it has been violated on several occasions.A common way of

attempting to go against the law is the use of price controls. Republic Act 7581, which

is known as the Price Act was approved to help the government in the implementation

of price control on basic commodities. The National Price Coordinating Council was

formed to support the Price Act. Its main objective and function is to guard and monitor

the prices after the announcement of a price ceiling.

Price Ceiling refers to the highest price or maximum price declared by the

government for a particular product. The government is doing this to help and protect

the consumers against the abuses of businessmen and sellers. Basic commodities like

rice, sugar, milk, oil, soap, fish, chicken, pork and other products are under price controlduring calamities and state of emergencies. The price declared is lower than the

equilibrium price in the market. It is the government’s way to make the basic

commodities affordable to everybody. Another possible violation which works in the

reverse is the setting of price support or floor price. Floor price refers to the lowest price

in buying the products of producers. Price support s implemented to help the producers



PEDQESSHORTAGESURPLUS

}}

recover their production cost and gain some profit. Price support is higher than the

equilibrium price in the market. Producers assume that the equilibrium price is not

enough to support their production cost and their needs.

Effect of Price Ceiling and Floor Price

Government regulations will create surpluses and shortages in the market.

When a price ceiling is set, there will be a shortage. Price is set below the equilibrium

price, thus suppliers would feel bad and lose interest in supplying more in the market.

The supply decreases and consumers, because of low price, would tend to increase

demand.

At this point, there is shortage of supply in the market. The government, in order

to make the price control effective and attain the goal of helping the consumers in times

of need, would assume the role of a supplier to solve the problem brought by price

control.

On the other hand, when there is a price floor, there will be a surplus. Price isset above the equilibrium price, as a result, producers are motivated to supply more in

the market. The supply increases but the new price of goods is too high for the


34

0Quantity

PRICE



consumer so they would decrease their demand. At this point, there is surplus of

supply in the market.

The government will act as a consumer in order to make the price supporteffective. If the market price is above the equilibrium price, quantity supplied is greater

than quantity demanded, creating a surplus. Market price will fall. If the market price is

below the equilibrium price, quantity supplied is less than quantity demanded, creating a

shortage. The market is not clear. It is in shortage. Market price will rise because of this

shortage.

If a surplus exists, price must fall in order to entice additional quantity demanded

and reduce quantity supplied until the surplus is eliminated. If a shortage exists, price

must rise in order to entice additional supply and reduce quantity demanded until the

shortage is eliminated.

CHAPTER III – ELASTICITY OF DEMAND AND SUPPLY

PRICE ELASTICITY OF DEMAND

Elasticity is the measurement of how changing one economic variable affects

others. It measures the degree of responsiveness of demand/supply to a change in its

determinants.

Price elasticity of demand (PED or Ed) is a measure used in economics to

show the responsiveness, or elasticity, of the quantity demanded of a good or service to


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http://en.wikipedia.org/wiki/Elasticity_(economics)



a change in its price. More precisely, it gives the percentage change in quantity

demanded in response to a one percent change in price (holding constant all the other

determinants of demand, such as income). It was devised by Alfred Marshall. Price

elasticities are almost always negative, although analysts tend to ignore the sign eventhough this can lead to ambiguity. Thus,

Types of Price Elasticity

1. Perfectly inelastic demand (ep = 0)

This describes a situation in which demand shows no response to a

change in price. In other words, whatever be the price the quantity demanded

remains the same. It can be depicted by means of the alongside diagram.

The vertical straight line demand curve as shown alongside reveals that with a

change in price (from OP to Op1) the demand remains same at OQ. Thus,


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demand does not at all respond to a change in price. Thus ep = O. Hence,

perfectly inelastic demand. Fig a

2. Inelastic (less elastic) demand (e < 1)In this case the proportionate change in demand is smaller than in price.

The alongside figure shows this type.

In the alongside figure percentage change in demand is smaller than that in

price. It means the demand is relatively c less responsive to the change in price.

This is referred to as an inelastic demand. Fig e

3. Unitary elasticity demand (e = 1)

When the percentage change in price produces equivalent percentage

change in demand, we have a case of unit elasticity. The rectangular hyperbola

as shown in the figure demonstrates this type of elasticity. In this case

percentage change in demand is equal to percentage change in price, hence e =

1. Fig c

4. Elastic (more elastic) demand (e > 1)

In case of certain commodities the demand is relatively more responsive

to the change in price. It means a small change in price induces a significant

change in, demand. This can be understood by means of the alongside figure.It can be noticed that in the above example the percentage change in demand is

greater than that in price. Hence, the elastic demand (e>1) Fig d

5. Perfectly elastic demand (e = ∞)

This is experienced when the demand is extremely sensitive to the

changes in price. In this case an insignificant change in price produces

tremendous change in demand. The demand curve showing perfectly elastic

demand is a horizontal straight line. Fig b

It can be noticed that at a given price an infinite quantity is demanded. A

small change in price produces infinite change in demand. A perfectly

competitive firm faces this type of demand.


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Arc Elasticity

Arc elasticity is the elasticity of one variable with respect to another betweentwo given points.

The P arc elasticity of Q is calculated as

The percentage is calculated differently from the normal manner of percent

change. This percent change uses the average (or midpoint) of the points, in lieu of the

original point as the base.

Suppose that you know of two points on a demand curve (Q1,P 1) and (Q2,P 2).

(Nothing else might be known about the demand curve.) Then you obtain the arc

elasticity (a measure of the price elasticity of demand and an estimate of the elasticity of

a differentiable curve at a single point) using the formula

Suppose we measure the demand for hot dogs at a football game. Let's say that

after halftime we lower the price, and quantity demanded changes from 80 units to 120

units. The percent change, measured against the average, would be (120-80)/

((120+80)/2))=40%.

Normally, a percent change is measured against the initial value. In this case,

this gives (12-8)/8= 50%. The percent change for the opposite trend, 120 units to 80

units, would be -33.3%. The midpoint formula has the benefit that a movement from Ato B is the same as a movement from B to A in absolute value. (In this case, it would be

-40%.)


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Suppose that the change in the price of hot dogs was from $3 to $1. The percent

change in price measured against the midpoint would be -100%, so the price elasticity

of demand is (40%/-100%) or -40%. It is common to use the absolute value of price

elasticity, since for a normal (decreasing) demand curve they are always negative. Thusthe demand of the football fans for hot dogs has 40% elasticity, and is therefore

inelastic.

Point Elasticity

When we measure Arc Elasticity, we are measuring the price elasticity of

demand between two points on the demand curve.

We can also measure the elasticity of any one point on the curve. The formula, because

we are measuring only one point on the demand curve, does not have to take account

of P1 or P2 or of Q1 or Q2. The elasticity of demand on a particular point of demand

curve can be mathematically calculated as below:

Point Elasticity will be different at each point of the demand curve. How is it

calculated? How is there even a "very small change in Price" or a "very small change inQuantity" if we are measuring at a given point. Depending on the scaling of your graph,

each point is, by definition, the sum of many other small points on the curve. Hence,

when examining the elasticity of a point, you could establish a microscopic difference in

the width of the point.

Price Elasticity and Total Revenue

The more essential a good is to the consumer, the more inelastic will be the

demand for the good.the less the necessity a good is, the more elastic is the demand

for it.

Generally any change in price will have two effects:


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• The price effect : For inelastic goods, an increase in unit price will tend to

increase revenue, while a decrease in price will tend to decrease revenue. (The

effect is reversed for elastic goods.)

• the quantity effect : an increase in unit price will tend to lead to fewer units sold,while a decrease in unit price will tend to lead to more units sold.

For inelastic goods, because of the inverse nature of the relationship between price and

quantity demanded (i.e., the law of demand), the two effects affect total revenue in

opposite directions. But in determining whether to increase or decrease prices, a firm

needs to know what the net effect will be. Elasticity provides the answer: The

percentage change in total revenue is approximately equal to the percentage change in

quantity demanded plus the percentage change in price. (One change will be positive,

the other negative. The percentage change in quantity is related to the percentage

change in price by elasticity: hence the percentage change in revenue can be

calculated by knowing the elasticity and the percentage change in price alone.

As a result, the relationship between PED and total revenue can be described for any

good:

• When the price elasticity of demand for a good is perfectly inelastic (Ed = 0),

changes in the price do not affect the quantity demanded for the good; raising

prices will cause total revenue to increase.

• When the price elasticity of demand for a good is relatively inelastic (-1 < Ed < 0),the percentage change in quantity demanded is smaller than that in price.

Hence, when the price is raised, the total revenue rises, and vice versa.

• When the price elasticity of demand for a good is unit (or unitary) elastic (Ed =

-1), the percentage change in quantity is equal to that in price, so a change in

price will not affect total revenue.

• When the price elasticity of demand for a good is relatively elastic ( -∞ < Ed < -1),

the percentage change in quantity demanded is greater than that in price. Hence,

when the price is raised, the total revenue falls, and vice versa.

• When the price elasticity of demand for a good is perfectly elastic (Ed is − ∞), any

increase in the price, no matter how small, will cause demand for the good to

drop to zero. Hence, when the price is raised, the total revenue falls to zero.


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http://en.wikipedia.org/wiki/Good_(economics_and_accounting)

http://en.wikipedia.org/wiki/Infinity_(mathematics)



Hence, as the accompanying diagram shows, total revenue is maximized at the

combination of price and quantity demanded where the elasticity of demand is unitary.

It is important to realize that price-elasticity of demand is not necessarily constant over all price ranges. The linear demand curve in the accompanying diagram illustrates that

changes in price also change the elasticity: the price elasticity is different at every point

on the curve.

Substitution and Price Elasticity of Demand

Price elasticity of demand refers to the way prices change in relationship to the

demand, or the way demand changes in relationship to pricing. Price elasticity can also

reference the amount of money each individual consumer is willing to pay for

something. People with lower incomes tend to have lower price elasticity, because they

have less money to spend.

A person with a higher income is thought to have higher price elasticity, since he

can afford to spend more. In both cases, ability to pay is negotiated by the intrinsic

value of what is being sold. If the thing being sold is in high demand, even a consumer

with low price elasticity is usually willing to pay higher prices.

Elasticity implies stretch and flexibility. The flexibility or the price elasticity of demand

will change based on each item. Changing nature of both price and demand areaffected by a number of factors. Generally, goods or services offered at a lower price

lead to a demand for greater quantity. If you can get socks on sale you might buy

several pairs or several packages, instead of just a pair.

This means that though the seller offers the socks at a lower price, he usually

ends up making more money, because demand for the product has increased. However

if the price is set too low, the retailer may lose money by selling too many pairs of socks

at a reduced rate.


41



Likewise, an increase in price due to higher production cost or cost of business

would increase earnings if demand were price inelastic enough to stretch price and

revenue in order to offset the said increase in cost. The price inelasticity of demand to

maximize revenue and earnings is also true even without a change in cost.

Increasing Qd without changing price highlights the effect of decreasing price

and increasing Qd with a very elastic demand on revenue and earnings. Conversely,

increasing price without changing Qd highlights the effect of increasing price and

decreasing Qd with a very inelastic demand on revenue and earnings. Thus, revenue

increases as price decreases when the increase in Qd offsets the decrease in price with

an elasticity coefficient of more than one (elastic). The opposite is true when price

increases with an inelastic demand.

To drive home the point, the seller can increase earnings with a decrease in

price if the product were substitutable enough to wrest considerable demand from rival

products to maximize elasticity and earnings. An example is when retailers of the same

rice variety under price one another in the public market for bigger market shares. On

the other hand, a seller can increase earnings with an increase in price if the product

were exclusive enough to be sold even at a higher price to maximize earnings. An

example is the only grocery in a subdivision which can increase prices without suffering

a decrease in sales volume in the absence of competitors in the area. Thus, a changein price and quantity demanded can increase revenue and earnings depending on the

substitutionality of the product.

The Tax Burden

When a good is sold, a sales tax has to be paid to the government o the sale of

that commodity. The question on who between the buyer and the seller shoulders the

burden is dependent mostly on the degree of elasticity of the demand for that good.

Let us take as example, a bottle of soft drinks on which the government levies a

100% sales tax. IF the price per bottle is P5.00, the consumer has to pay P10.00 on


43



account of the tax. However, that consumer does not always have to shoulders the

entire tax burden by himself. The tax of P5.00 was shared equally between the buyer

and the seller, with an equal tax share of P2.50.

However, it is also possible for a buyer to shoulder a bigger portion of the tax

burden. This happens when the buyer cannot do away with the consumption of a good

and thus considers it essential. Therefore, in spite of a tax levy that could jack up the

price of the good, he would still be willing to buy it and the producer can afford to pass

on a bigger portion of the tax to the buyer.

Deadweight Loss of Taxation

We saw earlier how taxes on goods and services of businesses can change the

demand by citizens, supply, and equilibrium price and quantity. Taxes provide revenues

to the government and are usually paid by both buyers and sellers. To see the welfare

effect of taxes, we need to compare the revenue received by the government, and the

dead weight loss (also known as "excess burden" or "distortionary cost") to the

consumers and producers.

Recall that in a competitive market, a given tax surcharge added to the price of each

unit of a particular good (gasoline tax, food tax, federal tax) will:

• lower the price received by the seller and;

• increase the price paid by the buyer.

This allows us to use supply and demand diagram to analyze the effects of a tax on

total surplus. We see that the tax places a wedge between the gross price and net

prices, and the equilibrium quantity will fall as a result of the tax. What are the gains and

losses as a result of a tax? The government receives tax revenue of T x Q, where T is

the amount of tax per unit, and Q is the quantity sold. This is a benefit to those on whom

the government spends the tax revenue.


44



To see the welfare losses, consider the total surplus before and after the tax.

Deadweight loss, also known as "excess burden", is a pure loss to society. It represents

lost value to consumers and producers due to the reduction in the sales of the good, butnot captured by government revenue. In other words, the loss to consumers and

producers from the tax is larger than the size of the tax revenue.

Determinants of Deadweight Loss

How large will the deadweight loss be from a particular tax? It depends on how much a

given tax reduces the amount that:

• consumers are willing to purchase and;

• Producers are willing to supply.

What determines how much the market will shrink? Reduction in quantity supplied

as a result of a tax depends on the elasticity of supply. Generally, the more inelastic the

supply, the smaller the reduction in quantity, and the smaller the deadweight loss.

Reduction in quantity demanded depends on the elasticity of demand. Generally, the

more elastic the demand, the more quantity demanded decreases and the greater the

deadweight loss.

In general, the smaller the decrease in quantity, the smaller the deadweight loss.

This occurs since the main cost of a tax is that it shrinks the size of a market below its

optimum level. Overall, the more elastic the supply and demand, the larger the dead

weight loss of a tax.

Deadweight Loss and Tax Revenue

For the most part, tax revenue will first increase as we raise taxes but as the gross

price keeps rising, the quantity decreases more and more. Eventually, the tax revenue

will also begin to decrease. the more inelastic the demand, the slower the tax revenue


45



falls. This helps to explain why governments often put taxes on goods in inelastic

demand like tobacco and gasoline. Overall, taxes on specific items will:

1. Influence people’s behavior by inducing them away from the goods that aretaxed.

2. Raise revenue for the government to spend, making those who receive the

expenditures better off.

3. Create a dead weight loss.

INCOME ELASTICITY OF DEMAND

The coefficient of income elasticity of demands measures a product’s percentage

as the ratio of the percentage change in income which caused the shift in the demand

curve.

EY is given as = Change in Demand ( D) Percentage Change in Demand (%

D)

Demand (D) OR Percentage Change in Income ( % Y)

Change in Income ( Y) Income (Y)

The absolute value of the coefficient of the income elasticity is also a measure of

how responsive the demand is to change in income. As income increases, the

coefficient of:

- Greater than 1 means demand is elastic and the good is superior;

- Less than 1 means demand is inelastic and the good is inferior; and

- Equal to 1 means demand is unitary and the good is normal.

A study of income elasticity for food was made by Ernest Engel. The findings of

his study are depicted in what is now accepted as ENGEL’S LAW. According to Engel,


46



when income increases, the percentage that is spent for food tends to decrease. The

resulting coefficient is less than one because the food is a necessity. When income

increases, the increase goes mostly to the purchase of luxury items, education, travel

and leisure. An analysis of income elasticity figure is shown in table below:

Income

Elasticity

Degree of Demand Elasticity Type of Good

2 Elastic Normal luxury

1.5 Elastic Normal luxury

.75 Inelastic Normal necessity

.50 Inelastic Normal necessity

.30 Inelastic Inferior

.22 Inelastic Inferior

However, an elasticity greater than 1 means that the product gains more

importance in the allocation of incremental income and therefore, in the allocation of

total income.

On the other hand, some products some products lose importance because

others do otherwise as income increases. A product of such nature is inferior as its

elasticity is less than 1 and its share in the allocation of incremental and therefore, in

the allocation of total income diminishes instead.

The Consumption Line

The figure below presents a hierarchy of budget lines and indifferent curves

which determine different levels of consumption through the point of tangency

represents the consumption of the two commodities at varying levels of income,

otherwise known as the CONSUMPTION LINE.

Consumption line


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The consumption line is upward sloping from the point of origin of the graph. The

increase in consumption of goods in (Y-axis) accelerates for every unit increase in the

consumption of the goods in (X-axis).

It should already be clear at this point that as income increases, some products

gains importance (superior goods) while some do otherwise (inferior goods) in the

consumption basket. Moreover, superior goods will eventually become inferior as

income continues to increase to give way to new superior goods.

There are two underlying reasons for the change in the relative importance of the

commodity items as income continues to increase. One is the gradual satisfaction of the

consumer’s hierarchy of needs from the basic to non basic. Thus, the consumer shifts

the emphasis of consumption towards shelter at a certain level of income after

satisfying up to some degree, the need for clothing and good. This makes shelter a

superior good and the others, inferior goods at the said level of income. On the other

hand, a smaller budget can constrain a consumer from consuming goods of better

quality due to high prices and the consumption of which is only possible at a higher

level of income. Thus, those who belong to the higher income groups can afford to buy

imported shoes and clothing making these products superior over their local

counterparts in their expenditure basket.Finally, the theory of diminishing marginal utility is the cornerstone of the concept

of income elasticity of demand. The shift in consumption from inferior goods to superior

goods as income increases implies that the marginal utility of the latter is greater than of

the former. Marginal spending shifts to those commodity items with higher marginal

utilities due to the relative scarcity, thus making them superior as substitutes to their

inferior goods. However, these commodity items will eventually lose their superiority as

income continues to increase due to the law of diminishing marginal utility and their

individual elasticity decrease at most to zero. This is the point of maximum satisfaction

and incremental spending shifts instead to the consumption of new and relative scarce

goods.


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CROSS ELASTICITY OF THE DEMAND

The coefficient of cross elasticity of demand measures the percentage change inthe demand of good X which is the shift of the demand curve, in response to a

percentage change in price of good Y, thus:

Ec = Qx % Qx

Qx OR % Py

Py

Py

EC may also have a coefficient of greater than 1, less than 1 or equal to one,

indicating a demand sensitivity.

Good X and Good Y may be related in two ways, first as substitutes, and second

as complements. If the coefficient EC is positive, this means commodities X and Y are

substitutes. An increase in Py will cause the consumer to purchase more of Good X, the

substitute goods, thus causing Qx to increase. On the other hand, if EC is negative,

Good X and Y are complements and are thus, used together. If the price of Y increases,

the demand for Y and, hence, the demand for X decreases. Thus, the coefficient of the

cross elasticity of demand practically measures the degree of substitution between

products.

Demand curves and elasticity


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As a result of the different degree of elasticity, there are different ways of

presenting the demand curve.

D1 is relatively elastic, a change in price leads to a significant change in quantity

demanded.P

D1 Qd

D2 is relatively inelastic, a change in price leads to a very slight change in the

quantity demanded.

P

D2 Qd

D3 is perfectly elastic. At a given price, quantity demanded can change infinitely.

P

D3


50



Qd

D4 is perfectly inelastic. At any price, the quantity demanded will remain the

same. Qd is equal to Zero.

P D4

Qd

Price elasticity of supply

If demand varies in response to a change in its determinants, so does supply.

The coefficient of the price elasticity of supply measures the percentage change in the

quantity supplied of a commodity compared to a percentage change in the price of such

commodity.

The difficulty or ease of increasing or decreasing the supply of goods determines

its elasticity. Goods which are relatively easy to manufacture tend to have elastic

supplies; whereas goods which are difficult to produce have inelastic supplies. Just as

in the demand curve, the supply curve is elastic if es is greater than 1, inelastic if es is

less than 1 and unitary elastic when es is equal to 1. Normally, the coefficient of es is

positive, because of the direct relationship between price and quantity supplied.As a result of varying degrees of elasticity of supply, the following supply curves

are also possible:


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S1 is relatively elastic: a change in price results in a significant change in quantity

supplied.

PS1

Qs

S2 is relatively inelastic: a change in price results in a slight change in quantity

supplied.

P

S2

Qs

S3 is perfectly inelastic: at a given price, quantity supplied may change infinitely.

P

S3

Qs

S4 is perfectly inelastic: At a given price, quantity supplied remains constant or

Qs is equal to zero.


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P S4

Qs

Projecting the future

Important decisions about what and how many goods to produce depend very

much on the entrepreneur’s estimate of future demand. If the entrepreneur producesmuch more than what is demanded, he would have an inventory on hand. If this

inventory is much more than what is necessary, this becomes an added cost in the form

of money tied up with too much inventory in addition to storage and spoilage costs.

However, if the entrepreneur produces much less than what is demanded, he would be

missing out on what could have been an additional profits earned. Thus it is very

important that the entrepreneur knows some forecasting techniques.

There are different methods of making a forecast. Let us just use the two

methods. The simplest way is the use of the average arithmetical method called

regression analysis or the least squares regression method.

The Average Arithmetic of Growth Rate Method

The computation of this method is carried out by getting the percentage change

between two values which is simply the ratio of the change between two years

expressed in percentage form. The average growth rate is then computed by getting the

sum of the percentage changes divided by the period covered.

The trend line using Least squares regression method


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This method uses statistical tools and is the most commonly used method of

computing the long-term trend of time series. The least square method, as the name

implies, fits a trend line to the date in a manner such that sum of the squared deviations

of actual data from estimated or trend data at a minimum. On these grounds, theresulting trend line can be characterized as a “line of the best fit” since the sum of the

squared deviations is at a minimum. The trend values, thus, best approximates the

actual values.

The equation for the straight line trend is Y= a + bx where x is the independent

variable. Since their values must be determined for each of the series analyzed, a and b

are referred to as unknowns. They are also called constants because once their values

are determined, they do not change.

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