Lesson 3: Demand and Supply and the Market Equilibrium

Consumers and producers react differently to price changes. Higher prices tend to reduce demand while
encouraging supply, and lower prices increase demand while discouraging supply.

Economic theory suggests that, in a free market there will be a single price which brings demand and supply into balance,
called equilibrium price. Both parties require the scarce resource that the other has and hence there is a considerable
incentive to engage in an exchange

In its simplest form, the constant interaction of buyers and sellers enables a price to emerge over time. It is often difficult
to appreciate this process because the retail prices of most manufactured goods are set by the seller. The buyer either
accepts the price. or does not make the purchase. While an individual consumer in a shopping mall might haggle over the
price, this is unlikely to work, and they will believe they have no influence over price. However, if all potential buyers
haggled, and none accepted the set price, then the seller would be quick to reduce price. In this way, collectively, buyers
have influence over market price. Eventually a price is found which enables an exchange to take place. A rational seller
would take this a step further, and gather as much market information as possible in an attempt to set a price which
achieves a given number of sales at the outset. For markets to work, an effective flow of information between buyer and
seller is essential.
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 is closely related to supply. While consumers try to pay the lowest prices they can for goods and services,
suppliers try to maximize profits. If suppliers charge too much, the quantity demanded drops and suppliers do not sell
enough product to earn sufficient profits. If suppliers charge too little, the quantity demanded increases but lower prices
may not cover suppliers’ costs or allow for profits. Some factors affecting demand include the appeal of a good or service,
the availability of competing goods, the availability of financing, and the perceived availability of a good or service.

Law of Demand
The law of demand is one of the most fundamental concepts in economics. The law of demand states that quantity
purchased varies inversely with price. In other words, the higher the price, the lower the quantity demanded. This occurs
because of diminishing marginal utility. That is, consumers use the first units of an economic good they purchase to serve
their most urgent needs first, and use each additional unit of the good to serve successively lower valued ends.
Economics involves the study of how people use limited means to satisfy unlimited wants. The law of demand
focuses on those unlimited wants. Naturally, people prioritize more urgent wants and needs over less urgent ones in their
economic behavior, and this carries over into how people choose among the limited means available to them. For any
economic good, the first unit of that good that a consumer gets their hands on will tend to be put to use to satisfy the
most urgent need the consumer has that that good can satisfy.
Demand Function
A demand function is a mathematical equation which expresses the demand of a product or service as a function
of the its price and other factors such as the prices of the substitutes and complementary goods, income, etc.

A demand functions creates a relationship between the demand (in quantities) of a product (which is a dependent
variable) and factors that affect the demand such as the price of the product, the price of substitute and complementary
goods, average income, etc., (which are the independent variables).

Demand Schedule
A demand schedule is a table that shows the quantity demanded of a good or service at different price levels. A
demand schedule can be graphed as a continuous demand curve on a chart where the Y-
axis represents price and the X-axis represents quantity.

A demand schedule most commonly consists of two columns. The first column
lists a price for a product in ascending or descending order. The second column lists the
quantity of the product desired or demanded at that price. The price is determined based
on research of the market.

When the data in the demand schedule is graphed to create the demand curve, it supplies
a visual demonstration of the relationship between price and demand, allowing easy
estimation of the demand for a product or service at any point along the curve.
Demand Curve
The demand curve is a graphical representation of the relationship between the price of a good or service and
the quantity demanded for a given period of time. In a typical representation, the price will appear on the left vertical axis,
the quantity demanded on the horizontal axis.
The demand curve will move downward from the left to the right, which expresses the law of demand — as the
price of a given commodity increases, the quantity demanded decreases, all else being equal.

DETERMINANTS OF DEMAND
When price changes, quantity demanded will change. That is a movement along the same demand curve. When
factors other than price changes, demand curve will shift. These are the determinants of the demand curve.

1. Income: A rise in a person’s income will lead to an increase in demand (shift demand curve to the right), a fall will lead
to a decrease in demand for normal goods. Goods whose demand varies inversely with income are called inferior goods
(e.g. Hamburger Helper).
A normal good is a good that experiences an increase in its demand due to a rise in consumers' income. In other
words, if there's an increase in wages, demand for normal goods increases while conversely, wage declines or layoffs lead
to a reduction in demand.
A normal good, also called a necessary good, doesn't refer to the quality of the good but rather, the level of
demand for the good in relation to wage increases or declines.
A normal good has an elastic relationship between income and demand for the good. In other words, changes in
demand and income are positively correlated or move in the same direction. Income elasticity of demand measures the
magnitude with which the quantity demanded for a good change in reaction to a change in income. It is used to understand
changes in consumption patterns that result from changes in purchasing power.
An inferior good is an economic term that describes a good whose demand drops when people's incomes rise.
This occurs when a good has more costly substitutes that see an increase in demand as incomes and the economy improve.
Inferior goods—which are the opposite of normal goods—are anything a consumer would demand less of if they
had a higher level of real income. They may also be associated with those who typically fall into a lower socio-economic
class.
In economics, the demand for inferior goods decreases as income increases or the economy improves. When this
happens, consumers will be more willing to spend on more costly substitutes. Some of the reasons behind this shift may
include quality or a change to a consumer's socio-economic status.
Conversely, the demand for inferior goods increases when incomes fall or the economy contracts. When this
happens, inferior goods become a more affordable substitute for a more expensive good. Most often than not, there is
not a quality difference.

THINK

Complete the table by providing examples of normal and inferior goods.

Normal goods Inferior goods

2. Consumer Preferences: Favorable change leads to an increase in demand, unfavorable change lead to a decrease.

3. Number of Buyers: the more buyers lead to an increase in demand; fewer buyers lead to decrease.
4. Price of related goods:
Related products are products whose demand is influenced by a price change of another related product.

A substitute, or substitutable good, in economics and consumer theory refers to a product or service that
consumers see as essentially the same or similar-enough to another product. Put simply, a substitute is a good that can
be used in place of another.

Substitutes play an important part in the marketplace and are

considered a benefit for consumers. They provide more choices for
consumers, who are then better able to satisfy their needs. Bills of materials
often include alternate parts that can replace the standard part if it's
destroyed.
When consumers make buying decisions, substitutes provide them
with alternatives. Substitutes occur when there are at least two products
that can be used for the same purpose, such as an iPhone vs. an Android
phone. For a product to be a substitute for another, it must share a
particular relationship with that good. Those relationships can be close, like
one brand of coffee with another, or somewhat further apart, such as coffee and tea.

A complementary good or service is an item used in conjunction with another good or service. Usually, the
complementary good has little to no value when consumed alone, but when combined with another good or service, it
adds to the overall value of the offering. A product can be considered a complement when it shares a beneficial
relationship with another product offering, for example, an iPhone and the apps used with it.
The joint demand nature of
complementary goods causes an interplay
between the consumer need for the second
product as the price of the first product
fluctuates. In economics, this connection is
called negative cross-elasticity of demand. So,
as the cost of a product increases, the user's
demand for the complement product decreases
as consumers are unlikely to use the
complement product alone. Further, as consumer demand weakens, the market price of the complementary good or
service may fall.
5. Expectation of future:
a. Future price: consumers’ current demand will increase if they expect higher future prices; their demand will decrease if
they expect lower future prices.
b. Future income: consumers’ current demand will increase if they expect higher future income; their demand will
decrease if they expect lower future income.

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.
Supply and demand trends form the basis of the modern economy. Each specific good or service will have its own
supply and demand patterns based on price, utility and personal preference. If people demand a good and are willing to
pay more for it, producers will add to the supply. As the supply increases, the price will fall given the same level of demand.
Ideally, markets will reach a point of equilibrium where the supply equals the demand (no excess supply and no shortages)
for a given price point; at this point, consumer utility and producer profits are maximized.
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 law of supply says that a higher price will induce producers to supply a higher quantity to the market.
Supply in a market can be depicted as an upward sloping supply curve that shows how the quantity supplied will respond
to various prices over a period of time. Because businesses seek to increase revenue, when they expect to receive a higher
price, they will produce more.
Supply Function
A supply function is a mathematical expression of the relationship between quantity demanded of a product or
service, its price and other associated factors such as input costs, prices of related goods, etc.
A supply function can be used to find out the expected quantities of a product which will enter the market if we
know the market price, input costs and other variables. If we have a demand function and supply function for a market,
we can solve them to find out the equilibrium price (i.e. the market clearing price) and the equilibrium quantity.

Supply Schedule

Supply schedule is a chart or table that shows how much product a supplier will have to produce to meet
consumer demand at a specified price based on the supply curve. In other words, it’s basically a supply graph in
spreadsheet form listing the quantity that needs to be produced at each product price level.

Supply Curve
The supply curve is a graphic representation of the
correlation between the cost of a good or service and the
quantity supplied for a given period. In a typical
illustration, the price will appear on the left vertical axis, while the
quantity supplied will appear on the horizontal axis.
DETERMINANTS OF SUPPLY
When price changes, quantity supplied will change. That is a movement along the same supply curve. When
factors other than price changes, supply curve will shift. Here are some determinants of the supply curve.

1. Production cost: Since most private companies’ goal is profit maximization. Higher production cost will lower profit,
thus hinder supply. Factors affecting production cost are: input prices, wage rate, government regulation and taxes, etc.

2. Technology: Technological improvements help reduce production cost and increase profit, thus stimulate higher
supply.

3. Number of sellers: More sellers in the market increase the market supply

4. Expectation for future prices: If producers expect future price to be higher, they will try to hold on to their inventories
and offer the products to the buyers in the future, thus they can capture the higher price

MARKET EQUILIBRIUM

Market equilibrium is the state in which market supply and demand balance each other, and as a result prices
become stable. Generally, an over-supply of goods or services causes prices to go down, which results in higher demand—
while an under-supply or shortage causes prices to go up resulting in less demand. The balancing effect of supply and
demand results in a state of equilibrium.
A market is said to have reached equilibrium price when the supply of goods matches demand.
A market in equilibrium demonstrates three characteristics: the behavior of agents is consistent, there are no incentives
for agents to change behavior, and a dynamic process governs equilibrium outcome. Disequilibrium is the opposite of
equilibrium and it is characterized by changes in conditions that affect market equilibrium.
The equilibrium price is where the supply of
goods matches demand. When a major index
experiences a period of consolidation or sideways
momentum, it can be said that the forces of supply
and demand are relatively equal and the market is
in a state of equilibrium.
SHORTAGE and SURPLUS

Sometimes the market is not in equilibrium-that is quantity supplied doesn't equal quantity demanded. When
this occurs there is either excess supply or excess demand.

A Market Surplus occurs when there is excess supply- that is quantity supplied is greater than quantity demanded. In this
situation, some producers won't be able to sell all their goods. This will induce them to lower their price to make their
product more appealing. In order to stay competitive many firms will lower their prices thus lowering the market price
for the product. In response to the lower price, consumers will increase their quantity demanded, moving the market
toward an equilibrium price and quantity. In this situation, excess supply has exerted downward pressure on the price of
the product.

A Market Shortage occurs when there is excess demand- that is quantity demanded is greater than quantity supplied. In
this situation, consumers won't be able to buy as much of a good as they would like. In response to the demand of the
consumers, producers will raise both the price of their product and the quantity they are willing to supply. The increase
in price will be too much for some consumers and they will no longer demand the product. Meanwhile the increased
quantity of available product will satisfy other consumers. Eventually equilibrium will be reached.