1

Demand

Chapter 3 Notes
DEMAND ............................................................................................................................................................... 1 SUPPLY .................................................................................................................................................................. 5 MARKET EQUILIBRIUM .......................................................................................................................................... 8

Demand
Quantity Demanded refers to the quantity of a product that buyer is willing and able to buy at given price during a particular period of time, other things being equal. Effective demand means demand that is backed up with a willingness and ability to pay. The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons: Substitution Effect: (choice between two substitutes) When the relative price of good changes, the opportunity cost of the good changes. An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes.

Income Effect: (Purchasing Power) A change the price of a good changes the amount that a person can afford to buy. When the price of a good rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease. Normally the good whose price rises is one of the goods for which less is purchased. The demand for a good refers to the entire relationship between the price of the good and the quantity demanded of the good

Compiled By: Saima Munawar

2

Demand

You can see in the diagram above, the demand for CDs is fairly low at the relatively high price of fifteen pounds, but at the bargain price of five pounds demand is much higher. A demand curve shows the relationship between the quantity demanded of a good and its price, other things being equal. The figure illustrates the demand curve resulting from the demand schedule.

The demand curve is a willingness-and- ability-to-pay curve for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve.

Factors Influencing Demand
It is fairly obvious so far that the price of a good is a pretty strong determinant of its demand, but there are many other things that will affect demand too. Real income. If one s real income rose (real means allowing for inflation ), one should be able to afford more CDs. The price of other goods. If the price of CD players rose then one would expect demand for CD players to fall, and so would the demand for CDs. These goods are complements. If the prices of rock concerts rose then one would expect the demand for these concerts to fall. Perhaps those who decided against the concert might buy a CD instead. These goods are substitutes. Tastes and preferences. It is a slightly obscure but very important determinant. As you get older, you may lose interest in the repetitive music currently in the charts and try some original sounds from the 60s, 70s or 80s. Changing preferences will affect your demand for a product regardless of its price. Expectations of future prices. If you think that the price for CDs is likely to fall in the near future, perhaps because of reduced production costs or competition from the US, you may delay some purchases which will reduce demand in the current time period. Alternatively, you may feel that

Compiled By: Saima Munawar

3

Demand CD prices are likely to rise in the near future, perhaps due to the lack of competition in the retail market, so you may increase your demand in the current time period. Advertising. Although many of you probably doubt the effectiveness of some of the appalling adverts on the TV, one assumes that these companies would not spend fortunes on these adverts if they did not expect to see a significant rise in demand for the product in question (Virgin and Our Price are always trying to sell you CDs via the TV). Population. Quite obviously, a significant rise in the number of people in a given area or country will affect the demand for a whole host of goods and services. Note that a change in the structure of the population (we have an ageing population) will increase the demand for some goods but reduce the demand for others. Interest rates and credit conditions. If interest rates are relatively low then it is cheaper to borrow money that can then be spent. This is not so applicable to CDs, but will certainly affect the demand for big ticket items such as cars and major electrical goods. In boom time (like the late 80s) it is often easier to obtain credit regardless of the rate of interest.

Now that you understand that there are many things that affect the demand for a good other than its price, I hope you can see the importance of the ceteris paribus assumption. The normal downwardsloping demand curve shows the relationship between the price of the good and its demand, all other things being equal. Those all other things are the list above: incomes, prices of other goods, etc. If you do not make this assumption, then you could have a situation when the price of CDs falls, but at the same time one s income falls by such a large amount that one actually demands fewer CDs. In other words, one does not want to confuse shifts in the demand curve and movements along a demand curve.

Movements along a Demand Curve (Change in Quantity Demanded)
A movement along a demand curve only occurs when there is a change in the price of the good in question. When the price of CDs falls (from P1 to P2) there is a rise in demand (from Q1 to Q2), ceteris paribus. The movement along the curve is from point A to point B. When the price rises (from P1 to P3) there is a fall in demand (from Q1 to Q3), ceteris paribus. The movement along the curve is from point A to point C

Compiled By: Saima Munawar

4

Demand

Shifts of a Demand Curve (Change in Demand)
A shift in the demand curve occurs if one of the other (i.e. non-price) determinants of demand change. This means that for a given price level the quantity demanded will change. This is illustrated in the diagram below

Note that the price has not changed (P1) and yet demand has increased (in the case of the shift to D2) to Q2. This could be due to a rise in real incomes, a rise in the price of a substitute good, a fall in the price of a complement, etc. (In the case of the shift to D3, demand has fallen even though the price has remained constant. Can you tick on the way the factor needs to move, in order to make the demand line move to D3 ?

Compiled By: Saima Munawar

5

Supply

Supply
Quantity Supplied refers to the quantity of a product that a firm is willing and able to sell at a price during a period of time, other things being equal. When it comes to supply, we are talking about how much of a given product the sellers, or firms, or producers are prepared to supply to the market at any given price The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce.

Compiled By: Saima Munawar

6

Supply

Why the supply curve should be upward sloping? Basically, the producer will make higher profits as the price per unit sold increases. Suppose a carpenter is making tables and chairs. If prices of chairs go up the carpenter would prefer to make more chairs rather than tables.

Factors influencing Market Supply,
As with the demand curve, there are many things that affect supply as well as the price of the good in question. Notice how similar many of these factors are in comparison to the factors that affect demand. Notice also that nearly all of these factors affect the firms costs. Given that the firms supply curve is its marginal cost curve (see the costs and revenues topic) then it is of no surprise that a cost changing measure will shift the supply curve. y Prices of other factors of production. An increase in the price of, say, hops, will increase the costs of a brewing firm and so for any given price the firm will not be able to brew as much beer. Hence, the firm s supply curve will shift to the left. The same would be true for changes in wage costs or fuel costs. Technology. The supply curve drawn above assumes a constant state of technology. But as we know, there can be improvements in technology that tend to reduce firms unit costs. These reduced costs mean that more can be produced at a given price, so the supply curve would shift to the right. Indirect taxes and subsidies. When the chancellor announces an increase in petrol tax (again!), it is the firm who actually pays the tax. Granted, we end up paying the tax indirectly when the price of petrol goes up, but the actual tax bill goes to the firm. This again, therefore, represents an increase in the cost to the firm and the supply curve will shift to the left. The opposite is true for subsidies as they are handouts by the government to firms. Now the firm can make more units of output at any given price, so the supply curve shifts to the right. Labour productivity. This is defined as the output per worker (or per man-hour). If labour productivity rises, then output per worker rises. If you assume that the workers have not been given a pay rise then the firm s unit costs must have fallen. Again, this will lead to a shift to the right of the supply curve. Price expectations. Just as consumers delay purchases if they think the price will fall in the future, firms will delay supply in they think prices will rise in the future. It s the same point but the other way round.

y

y

y

y

Compiled By: Saima Munawar

7 y

Supply Entry and exit of firms to and from an industry. If new entrants are attracted into an industry, perhaps because of high profit levels, then the supply in that industry will rise at all price levels and the supply curve will shift to the right. If firms leave the industry then the supply curve will shift to the left. As with demand, we must now look at the difference between a movement along a supply curve and a shift of a supply curve.

Movements along Supply Curve (Change in Quantity Supplied)
A movement along a supply curve only occurs when the price changes, ceteris paribus. In other words, the price changes but the other non-price determinants remain constant. The diagram below shows that a price rise will cause a movement up the supply curve, from point A to point B, whilst a price fall will cause a movement down back down the supply curve, from point A to point C

Shifts of a supply curve (Change in Supply)
When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. As stated above, nearly all the determinants of supply affect the costs of the firm and, therefore, its supply curve, which is its marginal cost curve.

Compiled By: Saima Munawar

8

Market Equilibrium

Note that the price remains unchanged at P1; the shifts in the supply curve are caused by various changes in the determinants of supply. Try the following exercise to make sure that you understand why a firm s supply curve shifts. Remember that the initial position of the supply curve is S1. Select the curve to which you think the supply curve shifts.

Market Equilibrium Meaning of Equilibrium and Disequilibrium
The market for any good or service needs buyers and sellers. The demand curve represents the actions, at any price level, of the buyers (or consumers). The supply curve represents the actions, at any price level, of the sellers (or firms, or producers). To find out what the price level will actually be, we need to see what happens when we combine the demand and supply curves. The price mechanism is the mechanism through which the price is determined in a market system. Basically, the price will adjust until supply equals demand, at which point we have the equilibrium price. The dictionary definition of equilibrium is a state of physical balance , or put more simply, a state of rest , or equilibrium is a situation in which opposing forces balance. As you will see in the following

Compiled By: Saima Munawar

9

Market Equilibrium

diagrams, any given market is only at rest when supply equals demand, which is where the two curves cross. y y The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price.

Surplus
If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above P1 and so the price is forced lower, toward the equilibrium price. In the diagram above, let us assume that the price is P2 temporarily. At this price, demand is quite low (Q3) but firms wish to supply quite a lot (Q2). We have excess supply equal to Q2 Q3. Firms find that they have a glut of unsold goods. Firm would probably reduce the price a little (have a sale, maybe?) until It could sell off all its excess stock. Applying this to the diagram, the price would fall until firms reached a position where they no longer experienced excess supply. This occurs where supply equals demand, price P1, quantity Q1.

Compiled By: Saima Munawar

10

Market Equilibrium

Shortage:
If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below P1 and so the price is forced higher, toward the equilibrium price. Now let us assume that the price is P3 temporarily. Now we have a situation when the price is relatively low, so the demand for the product (Q4) is much higher than the amount firms wish to supply (Q5). We have excess demand equal to Q4 Q5. Now firms find that they sell their stock very easily and there are customers queuing at the door wanting more! Firm would be thinking that it could get away with raising its price given the popularity of the good. It would keep doing this until there were no longer queues outside my door and the demand for my product matched the amount it supplied. Again, this will occur where supply equals demand, price P1, quantity Q1. THE PRICE CONTINUES TO ADJUST UNTIL THE QUANTITY SUPPLIED EQUALS QUANTITY DEMANDED.

Predicting Changes in Price and Quantity
In the earlier sections, we looked at why supply and demand curves might shift. We can now look at how these shifts can affect the equilibrium price.

Compiled By: Saima Munawar

11

Market Equilibrium

A Change in Demand

The original equilibrium price is P1, quantity Q1. We are at a state of rest . Now assume that one of the determinants of demand changes. For instance, there may have been an increase in advertising in the industry. This will shift the demand curve to the right, ceteris paribus (D2). The price will not stay at P1 for much longer. We have an excess demand situation (A to C). As stated above, this will cause the price to be bid up, and this will keep going until we reach the new equilibrium price where the new demand curve crosses the supply curve (at point B). Note that there has been a shift in the demand curve, but only a movement along the supply curve. None of the determinants of supply have changed.

Summary
y y y If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases. If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases. Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve.

Earlier, we called this process the price mechanism . From the analysis above, we can see that the price itself has the most important role. The rising price has acted as a signal to possible new firms who might want to join this expanding industry. It acted as an incentive, encouraging existing firms to produce more (the movement along the supply curve). It also acted as a sort of rationing device in the sense that it put off some existing buyers and helped make sure that demand matched supply.

Compiled By: Saima Munawar

12

Market Equilibrium

A Change in Supply

y y y

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases. If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases. Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the demand curve.

Demand and Supply Change in the Same Direction
It is not unreasonable to think of a situation where both the demand and supply curves shift. Think of the market for computers over the last decade or so. The demand curve for computers has definitely shifted to the right for several reasons. Real incomes have risen, there has been a rise in their preferences and the marketing of computers has increased, to name just three factors. But there has also been a huge shift to the right in the supply curve for computers. There have been immense leaps in technology so that any given computer can be produced at a fraction of the cost compared with a decade ago.

If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous. Compiled By: Saima Munawar

13 y y y

Market Equilibrium If the increase in demand is greater than the increase in supply, the price rises. If the increase in demand is the same size as the increase in supply, the price does not change. If the increase in demand is less than the increase in supply, the price falls.

If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous. y y y If the decrease in demand is greater than the decrease in supply, the price falls. If the decrease in demand is the same size as the decrease in supply, the price does not change. If the decrease in demand is less than the decrease in supply, the price rises.

Demand and Supply Change in the Opposite Directions

If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous.

Compiled By: Saima Munawar

14 y y y

Market Equilibrium If the decrease in demand is greater than the increase in supply, the quantity decreases. If the decrease in demand is the same size as the increase in supply, the quantity does not change. If the decrease in demand is less than the increase in supply, the quantity increases.

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous. y y y If the increase in demand is greater than the decrease in supply, the quantity increases. If the increase in demand is the same size as the decrease in supply, the quantity does not change. If the increase in demand is less than the decrease in supply, the quantity decreases.

Compiled By: Saima Munawar

Sign up to vote on this title
UsefulNot useful

Master Your Semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master Your Semester with a Special Offer from Scribd & The New York Times

Cancel anytime.