Chapter 2: Application of Demand and Supply

I. Basic Principles of Demand and Supply

The principle of supply and demand is one of the most important concepts in
microeconomics. It helps us understand how and why transactions on markets take
place and how prices are determined. To learn more about supply and demand we
mainly need to look at consumers and producers.
Consumers
In this case, consumers are all the economic units that are potentially willing to buy a
certain good or service. The actual demand for said good or service depends on
different variables. For now we will focus only on the most important one, the price. For
most goods and services we can say that demand will increase as the price falls and
vice versa. This actually seems pretty obvious: Just think about how many people would
buy a Ferrari if they were not that expensive.

Producers
Producers on the other hand are the ones that are potentially willing to produce and sell
a certain good or service. The actual supply again depends on multiple variables, yet as
we did before we will focus only on the price for now. For most goods and services this
implies that supply will decrease as the price falls and vice versa. Again, the reasoning
behind this is rather simple: If you were to sell ice cream you would probably try and sell
as much as you could if prices were high, because you could make a good profit.
However, if prices were to fall (maybe even beyond your production cost) it would not
be profitable to sell ice cream anymore and you would produce less.

Illustration
Now these relationships are a lot easier to understand if we look at a simple illustration
(see below). The x-axis of this graph represents quantity (Q) and the y-axis stands for
price (P).

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 If we look back at the behavior of the consumers, we said they were willing to buy more
(i.e. a higher quantity) of a good or service if the price falls. So for every price there is a
quantity demanded, which will be higher the lower the price is. Now if we plot all these
quantity-price combinations we get a graph called the demand curve (D).

Now we can do the same thing for the producers. But since they are willing to produce
less (i.e. a lower quantity) as the price falls, the graph we receive is somewhat similar to
a mirror image of the demand curve. We call this the supply curve (S).

The point where both curves (D and S) intersect is called the market equilibrium (E*).
At this point (and price) the consumers are willing to buy exactly as much of a good or
service as the producers are willing to sell, and the market clears. This is the best
possible situation for all actors, thus they will always tend to get to this outcome. This
means the two curves will keep shifting until the equilibrium quantity and price are
reached.

II. The Market

In Economics, the term “Market” does not refer to a particular place as such but it refers
to a market for a commodity or commodities. It refers to an arrangement whereby
buyers and sellers come in close contact with each other directly or indirectly to sell and
buy goods.

For the existence of a market, buyers and sellers need not personally meet each other
at a particular place. They may contact each other by any means such as a telephone
or telex. Thus, the term “Market” is used in economics in a typical and specialized
sense, it does not refer only to a fixed location. It refers to the whole area of operation of
demand and supply along with the conditions and commercial relationships facilitating
transactions between buyers and sellers.

Types of Markets
Markets vary widely for a number of reasons, including the kinds of products sold,
location, duration, size, and constituency of the customer base, size, legality, and many
other factors. Aside from the two most common markets—physical and virtual—there
are other kinds of markets where parties can gather to execute their transactions.
1. Black Market
A black market refers to an illegal market where transactions occur without the
knowledge of the government or other regulatory agencies. Many black markets
exist in order to circumvent existing tax laws. This is why many involve cash-only
transactions or other forms of currency, making them harder to track.

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 2. Auction Market
An auction market brings many people together for the sale and purchase of specific
lots of goods. The buyers or bidders try to top each other for the purchase price. The
items up for sale end up going to the highest bidder.

3. Financial Market
The blanket term financial market refers to any place where securities, currencies,
bonds, and other securities are traded between two parties. These markets are the
basis of capitalist societies, and they provide capital formation and liquidity for
businesses. They can be physical or virtual.

III. Demand
Demand is an economic principle referring to a consumer's desire to purchase goods
and services and willingness to pay a price for a specific good or service. Holding all
other factors constant, an increase in the price of a good or service will decrease the
quantity demanded, and vice versa. Market demand is the total quantity demanded
across all consumers in a market for a given good. Aggregate demand is the total
demand for all goods and services in an economy. Multiple stocking strategies are often
required to handle demand.

 Demand schedule
a table describing all of the quantities of a good or service; the demand schedule is the
data on price and quantities demanded that can be used to create a demand curve.

 Demand curve
a graph that plots out the demand schedule, which shows the relationship between
price and quantity demanded.

IV. The Law of Demand

All other factors being equal, there is an inverse relationship between a good’s price
and the quantity consumers demand; in other words, the law of demand is why the
demand curve is downward sloping; when price goes down, people respond by buying a
larger quantity.

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 Markets have two agents: buyers and sellers. Demand represents the buyers in a
market. Demand is a description of all quantities of a good or service that a buyer would
be willing to purchase at all prices.
According to the law of demand, this relationship is always negative: the response to an
increase in price is a decrease in the quantity demanded.
For example, if the price of scented erasers decreases, buyers will respond to the price
decrease by increasing the quantity of scented erasers demanded. A market for a good
requires demand and supply.

V. Non-Price Determinants of Demand

Here are examples of how the five determinants of demand other than price can shift
the demand curve.

1. Income of the buyers: If you get a raise, you're more likely to buy more of both
steak and chicken, even if their prices don't change. That shifts the demand curves
for both to the right.
2. Consumer trends: During the mad cow disease scare, consumers preferred
chicken over beef. Even though the price of beef hadn't changed, the quantity
demanded was lower at every price. That shifted the demand curve to the left.
3. Expectations of future price: When people expect prices to rise in the future, they
will stock up now, even though the price hasn't even changed. That shifts the
demand curve to the right. For this reason, the Federal Reserve sets up an
expectation of mild inflation. Its target inflation rate is 2%.
4. The price of related goods: If the price of beef rises, you'll buy more chicken even
though its price didn't change. The increase in the price of a substitute, beef, shifts
the demand curve to the right for chicken. The opposite occurs with the demand for
Worcestershire sauce, a complementary product. Its demand curve will shift to the
left. You are less likely to buy it, even though the price didn't change, since you have
less beef to put it on.
5. The number of potential buyers: This factor affects aggregate demand only. When
there's a flood of new consumers in a market, they will naturally buy more product at
the same price. That shifts the demand curve to the right. That happened when
standards were lowered for mortgages in 2005. Suddenly, people who hadn't been
eligible for a home loan could get one with no money down. More people bought
homes until the demand outpaced supply. At that point, prices rose in response to
the shift in the demand curve.

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VI. Shifts of the Demand Curve

A shift in the demand curve is when a determinant of demand other than

price changes. It occurs when demand for goods and services changes even though the
price didn't.

o The curve shifts to the left if the determinant causes demand to drop. That means
less of the good or service is demanded at every price. That happens during a
recession when buyers' incomes drop. They will buy less of everything, even though
the price is the same.
o The curve shifts to the right if the determinant causes demand to increase. This
means more of the good or service are demanded at every price. When the
economy is booming, buyers' incomes will rise. They'll buy more of everything, even
though the price hasn't changed.

VII. Supply

Supply is a fundamental economic concept that describes the total amount of a specific
good or service that is available to consumers. Supply can relate to the amount
available at a specific price or the amount available across a range of prices if displayed
on a graph. This relates closely to the demand for a good or service at a specific price;
all else being equal, the supply provided by producers will rise if the price rises because
all firms look to maximize profits.

o Supply curve

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 A graphical representation of the quantity producers are willing to make when the
product can be sold at a given price.

VIII. The Law of Supply

The law of supply is the microeconomic law that states that, all other factors being
equal, as the price of a good or service increases, the quantity of goods or services that
suppliers offer will increase, and vice versa. The law of supply says that as the price of
an item goes up, suppliers will attempt to maximize their profits by increasing the
quantity offered for sale.
The chart below depicts the law of supply using a supply curve, which is upward
sloping. 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). So, at point A, the
quantity supplied will be Q1 and the price will be P1, and so on.

The supply curve is upward sloping because, over time, suppliers can choose how
much of their goods to produce and later bring to market. At any given point in time
however, the supply that sellers bring to market is fixed, and sellers simply face a
decision to either sell or withhold their stock from a sale; consumer demand sets the
price and sellers can only charge what the market will bear. If consumer demand rises
over time, the price will rise, and suppliers can choose devoted new resources to
production (or new suppliers can enter the market) which increases the quantity
supplied. Demand ultimately sets the price in a competitive market, supplier response to
the price they can expect to receive sets the quantity supplied.

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 The law of supply is one of the most fundamental concepts in economics. It works with
the law of demand to explain how market economies allocate resources and determine
the prices of goods and services.

IX. Non-Price Determinants of Supply

Changes in non-price factors that will cause an entire supply curve to shift (increasing or
decreasing market supply)

1. Resource prices—a rise in resource prices will cause a decrease in supply or

leftwardshift in supply curve; a decrease in resource prices will cause an increase in
supply orrightward shift in the supply curve.
2. Technology—a technological improvement means more efficient production and
lowercosts, so an increase in supply, or rightward shift in the curve results.
3. Taxes and subsidies—a business tax is treated as a cost, so decreases supply;
asubsidy lowers cost of production, so increases supply.
4. Prices of related goods—if price of substitute production good rises, producers
mightshift production toward the higher priced good, causing a decrease in supply of
theoriginal good.
5. Producer expectations—expectations about the future price of a product can
causeproducers to increase or decrease current supply
6. Number of sellers—generally, the larger the number of sellers the greater the
supply.

X. Shifts of the Supply Curve

The supply curve depicts the supplier’s positive relationship between price and quantity.

 Price changes and movement along supply curve

If the price of the good or service changes, all else held constant such as price of
substitutes, the supplier will adjust the quantity supplied to the level that is consistent
with its willingness to accept the prevailing price. The change in price will result in a
movement along the supply curve, called a change in quantity supplied, but not a shift in
the supply curve. Changes in supply are due to non-price changes.

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 Non-price changes and shifts of the supply curve

If production costs increase, the supplier will face increasing costs for each quantity
level. Holding all else the same, the supply curve would shift inward (to the left),
reflecting the increased cost of production. The supplier will supply less at each quantity
level.

If production costs declined, the opposite would be true. Lower costs would result in an
increase in output, shifting the supply curve outward (to the right) and the supplier will
be willing sell a larger quantity at each price level. The supply curve will shift in relation
to technological improvements and expectations of market behavior in very much the
same way described for production costs.

Technological improvements that result in an increase in production for a set amount of

inputs would result in an outward shift in supply.

Supply will shift outward in response to indications of heightened consumer enthusiasm

or preference and will respond by shifting inward if there is an assessment of a negative
impact to production costs or demand.

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REFERENCES:
Ehrbar A. (1941). Supply (Eds). Basic Concepts of Economics (pp.97-99).

Blaug M. (1986). Great Economists before Keynes (Atlantic Highlands, N.J.: Humanities Press
International), p. 262.

Harberger, A. (1998). Microeconomics (Eds). Basic Concepts, Economic Regulation,

Government Policy Taxes (pp. 301-317).

Marshall, A. (1920). Equilibrium of Normal Demand and Supply (Eds). Principles of Economics
(pp.135-149). London: Macmillan and Co., Ltd.