The Market Forces of Demand and Supply

Supply and demand are the two terms that economists use most often. Supply and demand are the
forces that make market economics work. They determine the quantity of each good produced and the
price at which it is sold. If you want to know how any event or policy will affect the economy, you
must think first about how it will affect supply and demand.

Demand
Demand doesn’t necessarily mean the desire or need. A beggar desires to get a horse; a poor person
desires to have a TV set. But such needs and desires do not constitute demand. In economics demand
means
1. willingness to get the commodity;
2. ability to get the commodity.

The Determinants of Individual Demand

The demand for a particular commodity of an individual consumer is called individual demand.
Consider you own demand for ice-cream, it depends on
1. Own Price: Suppose the price per unit of ice-cream is Tk. 20, now if the price rises to Tk. 30
you would buy less ice-cream, you might buy frozen yogurt instead. If the price of ice-cream
falls to Tk. 10 you would buy more. That is quantity demand is inversely (negatively) related
to the own price of the commodity. This relationship is true for almost all commodities of the
world, and is called the law of demand. The law of demand says that other things being equal
(ceteris paribus), when the price of a good rises, the quantity demanded of the good falls and
vice-versa.
2. Price of the Related Goods: There can be two types of related goods of a commodity:
 Substitutes: Two goods are said to be substitutes for which an increase in the price of
one good leads to an increase in the demand for the other good. For example- tea vs.
coffee, rice vs. wheat.
 Complements: Two goods are said to be complement for which an increase in the
price of one good leads to a decrease in the demand for the other good. For Example-
tea vs. sugar, gasoline vs. automobile.
3. Income: Generally there is a positive relationship between quantity demand of a commodity
and individual’s income.
  For normal goods, other things being equal, an increase in income leads to an increase
in quantity demanded.
 A good for which, other things being equal, an increase in income leads to a decrease
in quantity demanded is called an inferior good. For example: if your income increase
you are less likely to ride a bus rather you will ride on a taxicab.
4. Tastes: Generally, there is a positive relationship between tastes and quantity demanded. If
you like ice-cream most, you buy more of it.
5. Expectations (about future): Your expectations about future may affect your demand for a
good or service today. For example- if you expect to earn more in future you will spend to earn
more money to buy ice cream today. If you expect the price of ice cream to fall tomorrow you
will be less willing to buy ice cream at today’s price.

The Demand Schedule and the Demand Curve

The demand schedule is a table that shows the relationship between price of a commodity and its
quantity demanded.
The demand curve is a graph that shows the relationship between price of a commodity and its quantity
demanded.

Table: Mr. Rahim’s Demand Schedule and Demand Curve for Ice cream
Price of ice-cream (Tk) Quantity demanded
12
1 10
2 8
3 6
4 4
5 2
6 0

Price

6
Demand Curve
 12 Quantity
Figure: Mr. Rahim’s Demand Curve
Market Demand Curve for ice cream can be found by adding horizontally the individual
demand curve.
Table: Market Demand Schedule for Ice
Cream

Price of Rahim's Karim's Market

Ice Cream Demand Demand Demand
1 10 6 16
2 8 5 13
3 6 4 10
4 4 3 7
5 2 2 4

P P P

Rahim’s Demand Karim’s DD Market DD

Curve Curve Curve

QR QK Q= QR+ QK
Movement along the Demand Curve and Shift of the Demand Curve
Movement along the demand curve means the change in quantity demand, which is due to the
change in price keeping other things unchanged.
Shift of the demand curve means the change demand, which is due to the change in other things
keeping price unchanged.

P P

A
 B

Q Q
Figure: Change in Quantity Demanded Figure: Change in Demand

Exception to the Law of Demand

1. Conspicuous Consumption
2. Giffen Goods
3. Speculation

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‘Supply’ means the amount that the producer wants to sell at a given price. Thus it differs from the
production. Producers may not necessarily bring the total production in the market. They keep some
portion of the production as stock. So,

Production = supply + stock.

Whether a producer will supply the commodity in the market depends on some factors. These are
known as the Determinants of Supply. These Determinants are:

1. Own price of the commodity: In general there is a positive relationship between the quantity
supplied of a commodity and its own price. If price is high producers intend to supply more and
vice versa. This positive relationship is known as the law of supply. The law states that, if
other things remain unchanged, an increase in the price of a commodity leads to an increase in
the quantity supplied and vice versa.

2. Input price: Generally, there is a negative relationship between input prices and the quantity
supplied of a commodity. If input price goes up, production cost increase so the producers
intend to supply less and vice versa.

3. Technology: In general there is a positive relationship between technology and the quantity
supplied of a commodity. A technological improvement leads to a decrease of quantity supplied
so the producers plan to supply more.
 4. Expectation: If producers believe that price will increase in future, they supply less in the
current period and vice versa.

5. Weather condition: The special nature of agricultural commodities is that they are dependent
on weather condition. A good weather condition leads to a bumper production, while a bad
weather condition leads to production loss.

The Supply Schedule and the Supply Curve

The supply schedule is a table that shows the relationship between the price of a commodity and its
quantity supplied.
The supply curve is a graph that shows the relationship between price of a commodity and its quantity
supplied.
Table: Igloo Ice Cream Company’s Supply Schedule
Price of ice-cream (Tk) Quantity Supplied
0
1 2
2 3
3 5
4 7
5 9

Market Supply Curve for ice cream can be found by adding horizontally the individual supply
curves.
Table: Market Supply Schedule for Ice Cream
 Price of Igloo's Quality's Market
Ice Cream Supply Supply Supply
1 2 1 3
2 3 3 6
3 5 4 9
4 7 6 13
5 9 8 17

Movement along the Supply Curve and Shift of the Supply Curve

Movement along the supply curve means the change in quantity supplied, which is due to the
change in the own price of the commodity keeping other things unchanged.

Shift of the supply curve means the change in supply, which is due to the change in other things
keeping own price of the commodity unchanged.
Exception to the Law of supply

1. Fixed in Supply

2. Backward bending supply

Market Equilibrium: Equilibrium means state of balance between opposing forces or action. Market
equilibrium is determined by the intersection of market demand and market supply curves. Market
demand curve shows the consumers willingness to purchase a commodity at different prices, while the
supply curve shows the willingness of suppliers to supply of a commodity at different price.
Consumers want to buy at lower price while producers want to supply at higher price. So there is
always haggling between buyers and sellers. Market equilibrium is determined at a point where the
perception of buyers and sellers met at the same point. That is consumers want to buy exactly the
amount that the sellers want to sell. The following table shows the market equilibrium for a
commodity.

Table: Market Equilibrium for Ice Cream

Price Quantity Quantity Supplied State of the Market Pressure on Price

Demanded
5 9 18 Surplus Downward
4 10 16 Surplus Downward
3 12 12 Equilibrium Neutral
2 15 7 Shortage Upward
1 20 0 Shortage Upward
Changes of Market Equilibrium:
1. Changes of demand
2. Changes of supply
3. Changes of both demand and supply
Elasticity of Demand and Supply

The degree to which a demand or supply curve reacts to a change in price is the curve's
elasticity. Elasticity varies among products because some products may be more essential to
the consumer. Products that are necessities are more insensitive to price changes because
consumers would continue buying these products despite price increases. Conversely, a
price increase of a good or service that is considered less of a necessity will deter more
consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a

sharp change in the quantity demanded or supplied. Usually these kinds of products are
readily available in the market and a person may not necessarily need them in his or her
daily life. On the other hand, an inelastic good or service is one in which changes in price
witness only modest changes in the quantity demanded or supplied, if any at all. These
goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this simple
equation:

Elasticity = (% change in quantity demanded / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less
than one, the curve is said to be inelastic.
As we mentioned previously, the demand curve is a negative slope, and if there is a large
decrease in the quantity demanded with a small increase in price, the demand curve looks
flatter, or more horizontal. This flatter curve means that the good or service in question is
elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity
changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the
amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this
case would be greater than or equal to one.
On the other hand, if a big change in price only results in a minor change in the quantity
supplied, the supply curve is steeper and its elasticity would be less than one.

A. Factors Affecting Demand Elasticity

There are three main factors that influence a demand's price elasticity:

1. The availability of substitutes - This is probably the most important factor influencing
the elasticity of a good or service. In general, the more substitutes, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers
could replace their morning caffeine with a cup of tea. This means that coffee is an elastic
good because a raise in price will cause a large decrease in demand as consumers start
buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little
change in the consumption of coffee or tea because there are few substitutes for caffeine.
Most people are not willing to give up their morning cup of caffeine no matter what the
price. We would say, therefore, that caffeine is an inelastic product because of its lack of
substitutes. Thus, while a product within an industry is elastic due to the availability of
substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds
are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand
elasticity refers to the total a person can spend on a particular good or service. Thus, if the
price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that
is available to spend on coke, which is $2, is now enough for only two rather than four cans
of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus
if there is an increase in price and no change in the amount of income available to spend on
the good, there will be an elastic reaction in demand; demand will be sensitive to a change
in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a
smoker with very few available substitutes will most likely continue buying his or her daily
cigarettes. This means that tobacco is inelastic because the change in price will not have a
significant influence on the quantity demanded. However, if that smoker finds that he or
she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of
time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand

In the second factor outlined above, we saw that if price increases while income stays the
same, demand will decrease. It follows, then, that if there is an increase in income, demand
tends to increase as well. The degree to which an increase in income will cause an increase
in demand is called income elasticity of demand, which can be expressed in the following
equation:

If EDy is greater than one, demand for the item is considered to have a high income
elasticity. If however EDy is less than one, demand is considered to be income inelastic.
Luxury items usually have higher income elasticity because when people have a higher
income, they don't have to forfeit as much to buy these luxury items. Let's look at an
example of a luxury good: air travel.
Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per
annum. With this higher purchasing power, he decides that he can now afford air travel
twice a year instead of his previous once a year. With the following equation we can
calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as income
increases. These are considered goods and services of inferior quality that will be dropped
by a consumer who receives a salary increase. An example may be the increase in the
demand of DVDs as opposed to video cassettes, which are generally considered to be of
lower quality. Products for which the demand decreases as income increases have an
income elasticity of less than zero. Products that witness no change in demand despite a
change in income usually have an income elasticity of zero - these goods and services are
considered necessities.

A NORMAL GOOD has a positive income elasticity of demand

– an increase in income leads to an increase in the quantity Demanded • e.g. dairy produce

• An INFERIOR GOOD has a negative income elasticity of demand

– an increase in income leads to a fall in quantity demanded • e.g. coal

• A LUXURY GOOD has an income elasticity of demand greater than 1 e.g. cosmetics

Cross Elasticity of Demand

A measure of the extent to which the demand for a good changes when the price of the
related goods changes.

Percentage changes in the quantity demanded for good X

E XY 
Percentage changes in the price of good Y

The cross elasticity of demand for a substitute is positive.

• A fall in the price of a substitute brings a decrease in

the quantity demanded of the good.
 • The quantity demanded of a good and the price of its
substitute change in the same direction.

The cross elasticity of demand for a complement is negative.

• A fall in the price of a complement brings an increase in

the quantity demanded of the good.

• The quantity demanded of a good and the price of one

of its complements change in opposite directions

Utility Maximization and Consumers’ Demand

The consumer theory is to explain the consumption behaviour of consumers. Starting from the
postulates, economists build up a process of logical deduction to form the theory of consumers so as to deduce
and explain the so-called law of demand.

In reality a consumer is faced with various kinds of goods under its subjective level of preference and
choice. At the same time, he could only be satisfied by the presence of enough money or the effective
demand, i.e. sufficient purchasing power.

With an aim of “ utility “ maximization, the consumer will be in an optimum state if and only if the
purchasing power of money can effectively bring the consumer to a higher ranking of preference ( a state
of higher & higher level of satisfaction ) until all money income is used up.

From here the consumer behaviour is view from 2 aspects :

1. The subjective choice and level of preference are condensed under the concept of indifference curve in the
ordinal utility theory.

2. The objective purchasing power is revealed by the budget constraint.

These two aspects together give the equilibrium and optimum state of the consumer - the state of utility
maximization. From the optimal state of the consumer, the analysis can go further to seek the relation
between price and quantity demanded of a consumer within a given price range.
II The Cardinal Approach In Utility Theory

1 The Law of Diminishing Marginal Utility

Based on this theory, utility is the satisfaction of consumer from consumption which can be measurable (
i.e. be quantified ) and discernible ( i.e. comparable ).

From the observation of real life situation, the theory suggests that,

the total utility of a consumer will increase through consumption, but for successive units of the
goods consumed, the additional or extra units of utility got - the marginal utility will gradually
diminish.

The economists at that time ( 1870s ) believed it so the law is in fact an assertion rather than a scientific
theory. This is our familiar law of diminishing marginal utility. When anyone uses the term “marginal utility”
it already implies that utility is assumed to be measurable. Otherwise the concept of marginality cannot be
applied. The relationship among total utility (TU) and Marginal utility (MU) is shown in the present schedule
and diagram:
II The Ordinal Approach In Utility Theory

The ordinal theory suggests that utility is only relatively discernible but not quantifiable.
Utility is, in fact, a series of assigned numbers to rank options by the consumer preference. The assigned
numbers reveal what is more preferred but cannot tell how much the difference is.
In other words, utility can only be ranked by an order or a scale of preference to show the degree of
willingness of a consumer.
Consumer preference denotes an observation pattern of choice, while utility is an ordinal scale
constructed to represent that regular pattern.

From here, it comes the axioms or propositions on the assumption of rationality :

(1) Consumer is capable of comparison and makes substitution on goods to show his indifference
on the goods consumed.
(2) Consumer must have a scale of preference in mind before he purchases. He is consistent in
buying and also clear about his different level of satisfaction ( but he cannot tell how much )
satisfaction can be obtained through the consumption of different goods, i.e. there is the possibility of
transitivity.
(3) Utility maximization and a state of optimum are revealed by the very fact that consumer always
prefers more to less.

The Ordinal Approach to Utility is Presented by the Indifference Curve

Based on these assertions, Edgeworth F. Y. ( 1845 - 1926 ) first suggested the indifference curve to
represent the level of preference ( satisfaction ? ) a consumer have when two goods are consumed with
different amount, but each combination of these two goods yields the same level of preference.
 The properties of the indifference curve include :

(1) It is the locus of the combination of two goods that are equally satisfied to a consumer, or to
which the consumer is indifferent.

(2) The slope of this curve is negative : there is some degree of substitution between the two goods.

(3) The curve is convex to the origin, i.e. the marginal rate of substitution of two goods is
diminishing. M R S in consumption ( =  Y /  X ) = the number of a good Y that had to be
given up for each unit of good X to maintain the same level of utility, along any point on the
indifferent curve.

(4) A curve further away from the origin means that it stands for a higher level of preference than
the one near to the origin. Again, the magnitude between any two indifference curves does not
matter.

(5) As a consumer changes his choice in a continuous process, so there must have at least another
curve between any two indifference curves, i.e. there may have infinite number of curves for
a single consumer on a good.

(6) There is no intersection for any two curves in the indifference map. It is therefore only useful to
compare points on the same curve. The marginal rate of substitution in consumption is a measure of
change along the curve only, not the shift of the curve because different curves represent different
levels of preference and cannot be compared.
 Budget Constraint Or Budget Line

The objective purchasing power in the form of money income is represented by the budget line between 2 oods.
The slope of the line gives the relative price of any one good. It tells what the consumer must give up in
terms of another good in order to buy one good. The slope of the budget line is called the marginal rate of
substitution in exchange = PX / PY.

The concept of relative price is important because a rise in relative price would encourage the producer
to put more resources in production. The concept also conveys the market information of relative scarcity of
those resources.

The budget line rotates when the relative price changes.

The shift of the line means that either the income changes or there is a change in the price of both goods.
Both cases also imply a change in the purchasing power of the consumer.

Consumer Optimum

The indifference curve and the budget line together constitute the consumption behaviour. Graphically speaking,
the two curves meet at a point where the indifference curve is tangent by the budget line to get an unique or
internal solution. This point of tangency represents the highest level of preference obtained by a person given a
fixed amount of money income.

This point is also the point of optimum condition or utility maximization. In mathematics, the slopes of
the indifference curve and the budget line are the same.
 Slope of the budget line = PX / PY
Slope of the indifference curve = Y/X

In equilibrium, PX / PY =  Y /  X

Market Structure

In general market means a place where goods are bought and sold. But in economics market means market for
each good or input. It is an institution where
-there is a commodity / input
-there are buyers and sellers
-there is competition between buyers and sellers in determining the price and quantity
of the commodity.

Based on competition market has been divided into various categories. We shall discuss following two types of
market.

Perfectly Competitive Market

Characteristics

1. There are a large numbers of buyers and sellers in the market. However, each buyer and seller is a price
taker, that is, they cannot affect the market price. Market price is determined by the joint interaction of
all buyers and sellers in the market. Individual buyer or a seller can buy or sell whatever amount they
want at the market price. Therefore, demand by individual buyer or a firm is perfectly elastic that is
parallel to the horizontal axis as shown below:
 2. The commodity is homogeneous, identical or perfect substitutes, so that the output of each producer is
indistinguishable from the output of the others. For example, Cataribog rice. Thus buyers are indifferent
as to the output of which producer they purchase.

3. There is free entry and exit in the market. So that resources are perfectly mobile meaning that resources
are free to move among the various industries and locations within the market in response to monetary
incentives.

4. Consumers, firms and resource owners have perfect knowledge of all relevant prices and cost in the
market. This ensures that the same price prevails in each part of the market for the commodity and for
the inputs required in the production of the commodity.

Equilibrium of the firm

Equilibrium level of output is determined at the point where the following conditions are satisfied:

1. Marginal revenue (MR) = Marginal cost (MC)

2. MC curve cut the MR curve from below.
In the short run following situations can happen:
Monopoly
Monopoly is a market structure where there is only one firm sells a commodity for which there are no
close substitutes. Thus a monopolist is a price maker. It can control price or quantity in the market but
not both at the same time. If it charges a higher price quantity sold will automatically decrease, but if it
wants to sell a higher amount price will automatically goes down. Thus monopolist faces a downward
slopping demand curve.

Why monopoly arise?

1. A firm may own or control the entire supply of a raw material required in the production of a
commodity, or the firm may possess some unique managerial talent. For example, South Africa
is controlling the whole amount of diamond in the world.
2. A firm may won a patent for the exclusive right to produce a commodity or to use a particular
production process.
3. Economies of scale may operate over a sufficiently large range of outputs as to leave a single
firm supplying the entire market. Such a firm is called a natural monopoly. For example, public
utilities such as electrical, water, gas companies etc.
4. Some monopolies are created by government franchise itself. For example, terrestrial
operations of a television channel.

Equilibrium of the monopoly firm

Equilibrium level of output is determined at the point where the following conditions are satisfied:

1. Marginal revenue (MR) = Marginal cost (MC)

2. MC curve cut the MR curve from below.
This situation is shown in the following diagram:

Price Discrimination
Monopoly enjoys some market power since it is the only one seller in the market. Therefore it can sell
its commodity at different prices in different market. This is called price discrimination. The rule is the
lower the price elasticity of demand the higher will be the price. There are three different degree of
price discrimination:

1. First degree: Monopolist sells the commodity to that individual who is willing to pay the
highest price.
2. Second degree: Charge lower price for bulk amount while higher price for lower amount.
3. Third degree: Charge lower price to a particular class of buyers whatever amount they
purchase, while higher price to other class of buyers.

Monopolistic Competition
Monopolistic competition is a blend of perfect competition and monopoly. It is a market structure
where there are a large number of buyers but only a limited number of sellers. Goods are not different
but differentiated, meaning that they satisfy the same basic consumption needs. That is closer
substitutes but not perfect substitutes. For example, different bands of toothpaste, detergents etc. Since
products are differentiated producer try to capture the market share by advertisement. Since the product
of each seller is similar but not identical, each seller has a monopoly power over the specific product it
sells. The monopoly power is however severely limited by the existence of close substitutes.
Monopolistic competition is most common in the retail and service sectors of the economy. On the
national level clothing, cotton textiles and food processing are the industries that come closet to
monopolistic competition. On the local level, gasoline stations, barber shops, grocery stores are the
example of monopolistic competition due to the uniqueness of its product, better location, slightly
lower prices, better service or greater range of products and so on. Yet, the market power is limited due
to the availability of close substitutes.