CHAPTER 2

DEMAND, SUPPLY & MARKET EQUILIBRIUM

 All societies face the economic problem, which is the problem of

how to make the best use of limited, or scarce, resources. The
economic problem exists because, although the needs and wants
of people are endless, the resources available to satisfy needs and
wants are limited.
Resources are limited in two essential ways:

- Limited in physical quantity, as in the case of land, which

has a finite quantity.
- Limited in use, as in the case of labour and machinery,
which can only be used for one purpose at any one time.
Simple explanation of the economic problem :

- What to Produce?
Societies have to decide the best combination of goods
and services to meet their needs. For example, how many
resources should be allocated to consumer goods, and
many resources to capital goods, or how many resources
should go to schools, and how many to defence, and so
on.
- How to Produce?
Societies also have to decide the best combination of
factors to create the desired output of goods and services.
For example, precisely how much land, labour, and capital
should be used produce consumer goods such as
computers and motor cars.
- For whom to Produce?
Finally, all societies need to decide who will get the
output from the country’s economic activity, and how
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 much they will get. For example, who will get the
computers and cars that have been produced? This is often
called the problem of distribution.

 Circular Flow Diagram

(or circular-flow model) is a graphical representation of the flows

of goods and money between two distinct parts of the economy:
- market for goods and services, where households
purchase goods and services from firms in exchange for
money;
- market for factors of production (such as labour or
capital), where firms purchase factors of production from
households in exchange for money.
 Demand
o The law of demand indicates a negative relationship between
price level and quantity of demand in a period so when price
level increased causes quantity of demand decreased, vice
versa.

o Quantity demanded may change due to changes in the price

level that caused movement along the demand curve, while the
demand for most goods may change due to changes in income,
wealth, tastes, prices of other goods, and expectations that
caused a shift in the demand curve.

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 Supply
o The law of supply indicates a positive relationship
between price level and quantity of supply in a period so
when price level increased causes quantity of supply
increased, vice versa.
o Quantity supplied may change due to changes in the price
level that causes movement along the supply curve, while
the supply for most goods may change due to changes in
cost of production, and prices of related goods that caused
a shift in the supply curve.

 Market Equilibrium
o Market equilibrium occurs when the quantity demanded
equals the quantity supplied which resulting equilibrium
price level and equilibrium output. When the quantity
demanded exceeds the quantity supplied will occur excess
demand (shortage), could be caused by a price ceiling
which the price level is below the equilibrium price.
When the quantity supplied exceeds the quantity
demanded will occur excess supply (surplus), could be
caused by a price floor which the price level is above the
equilibrium price.

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 Consumer Surplus
Producer Surplus

o Consumer surplus is the difference between the

maximum amount a person is willing to pay for a good
and its current market price, the area is below a demand
curve and above a price level. Producer surplus is
difference between the full cost of production for the firm
and the current market price, the area is above a supply
curve and below a price level.
o The dead weight loss (DWL) is the net loss in consumer
surplus and producer surplus due to reduced production or
excess in production.