 INPUT 3.

The Demand and Supply Theory

In a market system, the interaction of supply and demand is relied on to determine price.
Consumers express demand through the prices they are willing to pay for various
products. Firms seeking profit cater to consumer demand by offering goods and services
at various prices. Consequently, a market is established in which the final price of the
good or service is determined on the basis of costs to the producer and utility to the
buyer.

I. The Demand Concept

a. Definition

Demand for a good is defined as the various quantities of the product that
consumers will take off the market at all possible alternative prices, other
things being equal or constant. The foregoing definition singles out the
relationship between possible alternative prices of the good and the quantities
of it that consumers will take.

The term demand is used refers to an entire demand schedule or demand

curve. A demand curve is shown in Fig. 2. The vertical axis of the graph
measures price per unit time and the horizontal axis measure quantity of the
good per unit of time. The inverse relationship between price and quantity
sold makes the demand curve slope downward to the right. Thus, a lower
price for a product increases the quantity demanded of that product, whereas a
higher price decreases the quantity demanded of that product.

Price/unit
D
0
Quantity/unit of time

Figure 2. A hypothetical example of a Demand Curve

b. Determinants of Demand

Aside from price, the quantity of the product that consumers will take will
be affected by the following factors:

1. changes in income - when people earn higher incomes, they are to afford
not only more of the same goods and services, but also more expensive
products they previously could not afford.
 2. change in taste and preferences of the consumers - tastes change over time
due to changes in the interest of people to the different kinds of product.

3. prices of related goods - a rise in the price of one good can cause a change
in the demand for another good. For substitute goods like pork and beef
which satisfy similar needs or desires, an increase in the price of beef
would encouraged people to buy pork instead of beef. For complements
or complementary goods which are used together as a package like
automobiles and gasoline, an increase in the price of gasoline would result
to a decrease in the demand for automobiles.

4. consumer expectations - a change in demand can occur in consumers

believe price changes are forthcoming. Consumers will speed up
purchases if prices are expected to rise and postpone purchases if prices
are expected to fall.

5. number of consumers - an increase in demand for a certain product will

occur as the number of people using a particular product increased while a
decrease in the number of consumers will cause a consequent decrease in
demand for a particular product.

6. range of goods available to consumers - the greater the number of

available product from which the consumers can choose from can cause a
decrease in the demand for a particular product.

c. Change in Demand Curve vs. Movement Along a Given Demand Curve

Change in demand curve occurs when any of the circumstance held

constant in defining a given state of demand is changed. This will cause the
demand curve to shift either to the right in case of an increase in demand even
without price changes and to the left in case of a decrease in demand. In figure
3, an increase in consumer incomes will shift the demand curve to the right
from DD to D1D1. With higher incomes, consumers will usually be willing to
increase their rate of purchase at each alternative price. A shift in consumer's
taste and preferences toward the commodity and an increase in the number of
consumers will have the same results. On the other hand, an increase in the
range of goods available may cause them to allocate less of their incomes to
the commodity, thus shifting the demand curve to the left position (D2D2).
 D2 D D2

Price/unit
D2 D D2
0
Quantity/unit of time
Figure 3. Changes in Demand for a Commodity

Movement along a given demand curve represents a change in quantity

taken resulting from a change in price of the good itself when all the other
circumstances influencing the quantity taken remain unchanged. In figure 4, a
decrease in price from p to p1 increases the quantity taken from q to q1. Since
the change occurs on a single curve, this is called movement along a given
demand curve. Due to the decrease in price, there is movement from point A
to B.

D
p

p1
Price/unit
0 D
q q1
Quantity/unit of time

Figure 4. Movement along a demand curve

II. The Supply Concept

a. Definition

The supply of good is defined as the various quantities of it that sellers

will place on the market at all possible alternative prices, other things being
equal. It is the relationship between prices and quantities per unit of time that
sellers are willing to sell. Usually the supply curve will be upward sloping to
the right (Fig. 5), since a higher price will induce sellers to place more of the
good on the market and may induce additional sellers to come into the field.
 S

Price/unit
S
0
Quantity/unit of time

Figure 5. A hypothetical example of a demand curve.

b. Determinants of Supply

1. changes in the cost of productive resources - since production of goods

and services entails the use of productive resources, changes in the cost of
these resources can result in a change in supply. If for example the price of
wood increases sharply, the price of manufacturing wooden furnitures will
rise appreciably and the supply of wooden furnitures will decrease.

2. change in technology - with improvements in technology, products can be

produced at a lower cost which results in an increase in supply. In
agriculture, for example, sophisticated farm machinery, powerful
fertilizers and scientific applications have lowered the cost of production
and increase the supply of farm products

3. expectations of future prices - the supply forestry graduates, for example,

by the year 2004 will be influenced by the salaries expected in the field by
college students selecting academic career programs in the year 2000.

4. prices of related products - if the supplier has the opportunity of using

productive resources for more than one purpose, the relative market prices
may determine supply. If for example the price of corn is rising and the
farmer has to choice of planting corn or soybean, the supply of soybeans
will decrease. Supply will decrease when the price of alternative goods
increase, and the supply will increase when the price of alternative goods
decrease

III. Market Price Determination

Placing the demand curve and the supply curve for any given good or
services on a single diagram highlights the forces determining its market price. In
figure 6, market price determination is illustrated. At price level p1 consumers are
willing to take quantity X1 per unit of time. However, suppliers will bring quantity
X1' per unit of time to the market; thus surpluses or excess supply of X1X1' per unit
of time accumulate. Any seller with surplus believes that if he undercuts other
sellers a little, he can dispose of his surplus. Thus, an incentive exists for seller to
lower their prices and cut back the quantity supplied. The price will be driven
 down by the sellers; quantities supplied will decrease; and quantities consumed
will increase. Eventually, when the price has dropped to p, consumers will be
willing to take exactly the amount that the sellers want to place on the market at
that price.

At price p2 consumers want quantity X2 per unit of time but sellers will
place only X2' per unit of time in the market. Therefore, shortage or excess
demand equal to the differences between X2 and X2' per period occur. Faced by the
shortages, consumers bid against each other for the available supply and will
continue to do so as long as shortages exist. When the price has been driven up to
p by consumers, the shortages will have disappeared and buyers will be taking the
quantity that the seller want to sell.

Price p is called the equilibrium price. Given the conditions of demand and
supply for commodity X, it is the price, that if attained will be maintained. A price
above the equilibrium price brings about surpluses while a price below the
equilibrium level results in shortages.

D S
Surplus

p1

Price/unit
p2
Shortage
S D
0
X2' X1 X X2 X1'

Quantity/unit of time
Figure 6. Equilibrium price determination

IV. Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of quantity that

will be taken to changes in the price of a good or service. Given the demand curve
for it. If the quantity taken is highly responsive to a price change, a price increase
will cause the total expenditure on the good to decrease; and a price decrease will
cause them to rise. If the quantity is not very responsive to price changes, an
increase in the price will increase total expenditures on the good, whereas a price
decrease will cause them to fall.

a. measurement of price elasticity

 Price elasticity of demand can be computed by the formula:

Percentage change in quantity taken

E = ———————————————
Percentage change in price

Or

X/X
E = ————
P/P

Where:
E = elasticity of demand
X = change in quantity taken
X = the lower of the two quantities
P = change in price
P = the lower of the two prices

Suppose that the elasticity of demand for bamboo poles between points A
and B with the following coordinates will be computed:

Price (P) X (pole)

A P25.00 150
B P15.00 200

Substituting the values in the given formula, elasticity will be computed

as:

50/150
E = ———
10/15

0.33
E = ———
0.67

E = 0.49

When the computed elasticity is greater than one, demand is said to be

elastic. When elasticity equals one, it is said to be unitary elasticity. When
elasticity is less then one, demand is said to be inelastic. Elastic demand
exists when a percentage change in price causes a greater percentage change
in quantity demanded, unitary elasticity when a percentage change in price
causes an equal percentage change in quantity demanded and inelastic demand
 when a percentage change in price is greater than the percentage change in the
quantity demanded.

b. factors influencing the elasticity of demand

1. availability of good substitutes

If a good substitute is available, demand for a given product will

tend to be elastic. If the price of lumber is increased while the price of
substitute products remain the same, consumers will shift rapidly from
lumber to other substitute goods like steel.

2. the range of uses for a product or resource

The wider the range of uses for a product or resource, the more
elastic demand for it will tend to be. The greater the number of uses,
the greater the possibility there is for variation in quantity taken as its
price varies. Bamboo, for example can be put to hundreds of uses,
therefore, the possible variation in quantity taken is quite large.
Increases in its price subtract from and decreases in its price add to the
list of its economically desirable uses.

3. the price relative to buyers purchasing power

Demand for goods that a large amount of the buyers' purchasing

power is more likely to be elastic than demand for goods that are
relatively unimportant in this respect. Goods such as refrigerators,
which require large outlays, make consumers' price-conscious and
substitute conscious. An increase in the price of refrigerator causes
shifts towards the use of ice chest, quantity taken, therefore, is likely to
vary considerably in response to price changes. For goods such as
matches, which take a negligible part of consumers' incomes, changes
in price are likely to have little effect on the quantity taken.

4. Whether the price established is toward the upper end of the demand
curve or toward the lower end of the demand curve.

If the ruling price is toward the upper end of the demand curve,
demand is more likely to be elastic than if it were toward the lower
end. However, its validity depends on the shape of the curve.
NOTE: To determine how much you learn from the lessons presented, try to answer the
Practice Task 2 in the next page. After answering all the questions, compare your
answer to the Feedback to Practice Task.

 Practice Task 3
1. Put check mark on all the correct statement and a cross mark on the wrong ones.
___ a. An increase in price will subsequently increase the quantity supplied of a
particular product.

___ b. Wood and steel are examples of substitute goods.

___ c. At the equilibrium price of the product, quantity supplied is greater than the
quantity demanded.

___ d. An increase in the number of consumers will cause the demand curve to shift
to the left.

___ e. An increase in the price of automobiles will result to an inelastic demand for
this for this particular product.

___ f. Elastic demand exists when a percentage change in rice causes a greater
percentage in quantity demanded.

2. Explain why normal supply curve slopes upward to the right.

3. In economic analysis, what do the terms shortage and surplus mean?

4. If 46, 000 units of a good can be sold at a price of p22, but 54, 000 units can be sold
at a price of p18, is the demand for the good elastic or inelastic?

Note: Compare your answer with feedback section of the practice task.
 Feedback to the Practice Task 3
1. Put a check mark on the correct statement and a cross mark on the wrong ones.
__√_ a. An increase in price will subsequently increase the quantity supplied of a
particular product.
__√_ b. Wood and steel are examples of substitute goods.
 __X_ c. At the equilibrium price of the product, quantity supplied is greater than the
quantity demanded.
_X_ e. An increase in the price of automobiles will result to an inelastic demand for
this for this particular product.
_X_ d. An increase in the number of consumers will cause the demand curve to shift
to the left.
__√_ f. Elastic demand exists when a percentage change in rice causes a greater
percentage in quantity demanded.

2. a normal supply curve slopes upward to the right since a higher price will induce
sellers to place more of the good in the market and may induce additional sellers to
come into the market

3. Shortage of a particular good occurs when the existing market price is below the
equilibrium price. This is the case when the quantity demanded for a product is
greater than the quantity supplied because of the low price set for the product. on the
other hand, surplus occurs when the market price of a particular product is higher
than the equilibrium price. At a higher price, sellers will place goods in the market
more than the amount demanded by the consumers, thus surpluses accumulate.

4. Elasticity for that particular good can be computed as:

54,000-22,000/22,000
E = ———————————
P22-P18/P18
E = 6.54

Therefore, the demand for that particular product is elastic.

Did you get all the answers correctly? If you did, CONGRATULATION!!! You can now
proceed to input 4 of this module.

If you missed items in the test, read again the part that you have not fully understand.