Chapter 2 Demand and Supply

Written by: Edmund Quek
CHAPTER 2 DEMAND AND SUPPLY
LECTURE OUTLINE 1 2 2.1 2.2 2.3 2.4 2.5 3 3.1 3.2 3.3 3.4 3.5 4 4.1 4.2 4.3 4.4 5 5.1 5.2 INTRODUCTION DEMAND Definition of demand Relationship between price and quantity demanded Demand schedule and demand curve Movement along the demand curve versus shift in the demand curve Non-price determinants of demand SUPPLY Definition of supply Relationship between price and quantity supplied Supply schedule and supply curve Movement along the supply curve versus shift in the supply curve Non-price determinants of supply EQUILIBRIUM Equilibrium price and equilibrium quantity Effects of a change in demand on price and quantity Effects of a change in supply on price and quantity Effects of a change in demand and supply on price and quantity SURPLUS Consumer surplus Producer surplus
References John Sloman, Economics William A. McEachern, Economics Richard G. Lipsey and K. Alec Chrystal, Positive Economics G. F. Stanlake and Susan Grant, Introductory Economics Michael Parkin, Economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
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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 is important 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 2.1
DEMAND 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 price of a good rises, the quantity demanded will fall. The inverse relationship between price and quantity 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 a good. 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 and income effect. Consider what will happen if the price of a good falls. First, the real income of consumers will rise because they will be able to buy a larger amount of goods and services 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 substitution effect 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 be shown by the demand schedule.
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Price 10 5
Quantity demanded (John) 1 2
Quantity demanded (Peter) 2 4
Quantity demanded (Market) 3 6
The first two columns show the demand schedule of John and the first and the third columns show the demand schedule of Peter. The first and the last columns show the market demand schedule, which is the summation of the demand schedules of John and Peter, assuming they are the only two consumers in the market. The demand schedule can be represented graphically by the demand curve. The demand curve shows the quantity demanded at each price and is downward-sloping due to the law of 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 that other than price, all non-price determinants of demand have remained unchanged (known as ceteris paribus in Latin and other things being equal in English).
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In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a decrease in 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 a non-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 in demand.
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2.5
Non-price determinants of demand
Tastes and preferences A change in tastes and preferences in favour of a good will lead to an increase in the demand 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 expenditure on advertising, the demand for its products will increase. Prices of substitutes and complements Substitutes are goods that are alternatives to one another such as Coke and Pepsi. A rise in the prices of substitutes for a good will induce consumers to buy less of the substitutes resulting 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 consumed together such as car and petrol. A fall in the prices of complements for a good will induce consumers to buy more of the complements resulting in an increase in the demand for the good. For example, if the prices of cars fall, consumers will buy more cars and more petrol. Number of substitutes and complements An increase in the number of substitutes for a good will lead to a decrease in the demand for the good and vice versa. For example, if scientists found that beer could be used as a substitute for milk to feed babies, the demand for milk would decrease. An increase in the number 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 demand for memory cards will increase. Level of income When consumers income rises, the demand for most goods will increase. These goods are known as normal goods. There are, however, exceptions to this general rule. When consumers income rises, the demand for some low quality goods will decrease. These goods are known as inferior goods and are typically low quality goods. Distribution of income If income is redistributed from the rich to the poor, the demand for luxuries, which are typically consumed by the rich, and the demand for inferior goods, which are typically consumed by the poor, will decrease. However, the demand for necessities will increase. Expectations of price changes If 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, the demand will increase. Size of the population An increase in the size of the population will lead to an increase in the demand for some goods.
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Structure of the population If the population is graying, the demand for pharmaceutical products will increase. Government policies The government is the biggest spender in every economy. Hence, if the government increases spending, the demand for some goods will increase. The government can also affect private spending by changing interest rates and tax rates in the economy. Weather conditions In winter, the demand for coats and sweaters will increase and the demand for ice-cream will decrease.
3 3.1
SUPPLY 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 price of a good rises, the quantity supplied will rise. The direct relationship between price and quantity 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 which seek 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 a variable 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, as each additional unit of labour will have less capital to work with, the additional output resulting from employing one more unit of labour will fall. In other words, each additional unit of labour will add less to total output than the previous additional unit. This phenomenon is known as diminishing marginal returns. Therefore, to produce each additional unit of output, more units of labour will be needed which will lead to an increase in the additional cost resulting from producing one more unit of output. Due to diminishing marginal returns, firms will only increase the production of a good if the price rises.
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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 by the supply schedule. Price 10 5 Quantity supplied (Firm X) 4 2 Quantity supplied (Firm Y) 8 4 Quantity supplied (Market) 12 6
The first two columns show the supply schedule of firm X and the first and the third columns show the supply schedule of firm Y. The first and the last columns show the market supply schedule, which is the summation of the supply schedules of firm X and firm 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 firms in 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).
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In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to an increase in 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-price determinant of supply. In other words, quantity supplied changes at the same price and this can 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 in supply.
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3.5
Non-price determinants of supply
Cost of production A rise in the cost of production will lead to a decrease in supply and vice versa. When the cost 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 will lead to a decrease in supply. The converse is also true. There are several factors that can lead 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. Number of firms If the number of firms in the industry increases, the supply of the good will increase. The converse is also true. Expectations of price changes If 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 will fall. The converse is also true. Profitability of goods in joint supply Sometimes, when a good is produced, other goods are produced at the same time. The goods 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 such as diesel and paraffin are also produced. Therefore, if more petrol is produced, the supply of other grade fuels will also increase. The converse is also true. Profitability of substitutes in supply If the substitutes in supply for a good become more profitable to produce, firms may switch from 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 in the 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 destroy factories and machinery and hence reduce the supply of goods. Weather conditions When weather conditions become more favourable, the supply of agricultural products will rise. The converse is also true.
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4 4.1
EQUILIBRIUM 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), the equilibrium price and the equilibrium quantity are PE and QE. If the price is above PE, such as P1, the quantity supplied (QS) will be greater than the quantity demanded (QD) and this is known as a surplus or excess supply (QS QD). When firms cannot sell all the output that they 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 in the quantity demanded and this process will continue until the price falls to PE where the surplus is eliminated.
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If the price is below PE, such as P2, the quantity demanded (QD) will be greater than the quantity supplied (QS) and this is known as a shortage or excess demand (QD QS). When firms 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 the quantity 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, the quantity 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 new equilibrium 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 the quantity supplied. The shortage induces firms to increase the price and hence the quantity supplied which results in a rightward movement along the supply curve. The higher price also induces consumers to decrease the quantity demanded which results in a leftward movement along the new demand curve. This process continues until the new equilibrium price (P1) is reached.
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A decrease in demand will lead to a leftward shift in the demand curve which will result in a 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 quantity demanded. The surplus induces firms to decrease the price and hence the quantity supplied which results in a leftward movement along the supply curve. The lower price also induces consumers to increase the quantity demanded which results in a rightward movement along the new 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 demand, price and quantity will change in the same direction.
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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 new equilibrium price and a new equilibrium quantity. An increase in supply will lead to a rightward shift in the supply curve which will result in a 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 quantity demanded. The surplus induces firms to decrease the price and hence the quantity supplied which results in a leftward movement along the new supply curve. The lower price also induces consumers to increase the quantity demanded which results in a rightward movement along the demand curve. This process continues until the new equilibrium price (P1) is reached.
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A decrease in supply will lead to a leftward shift in the supply curve which will result in an increase 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 quantity supplied. The shortage induces firms to increase the price and hence the quantity supplied which results in a rightward movement along the new supply curve. The higher price also induces consumers to decrease the quantity demanded which results in a leftward movement 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 will change in opposite directions.
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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 new equilibrium quantity will be determined by the intersection of the new demand and the new supply curves. Suppose that demand and supply increase which lead to a rightward shift in the demand and the supply curves. In this instance, although quantity will increase, the effect on price will depend on whether the increase in demand is greater than the increase in supply or vice versa.
In the above diagram, an increase in demand and supply leads to a rightward shift in the demand curve (D) and the supply curve (S) from D0 and S0 to D1 and S1. As the increase in demand is greater than the increase in supply, the price (P) and the quantity (Q) increase from P0 and Q0 to P1 and Q1.
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In the above diagram, an increase in demand and supply leads to a rightward shift in the demand curve (D) and the supply curve (S) from D0 and S0 to D1 and S1. As the increase in supply 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 5.1 SURPLUS Consumer surplus
The consumer surplus is the difference between the maximum amount that consumers are able 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 the good, $9 for the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers 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.
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5.2
Producer surplus
The producer surplus is the difference between the minimum amount that firms are able and 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.
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Chapter 2 Demand and Supply

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Written by: Edmund Quek