Demand and supply

CONTENTS 1. Demand
2. Demand curve
3. Movement along the demand curve
4. Factors influencing demand
5. Shifts in the demand curve
GO
6. Supply
7. Supply curve
8. Movement along the supply curve
9. Factors influencing supply
10. Shifts in the supply curve
11. Markets in equilibrium
12. Markets disequilibrium
13. Consumer surplus
14. Producer surplus
 Demand

Demand refers to both the willingness and the ability of customers to pay a given price to buy a good or
service.

Effective demand

This is sometimes referred to as effective demand to distinguish genuine demand from want or a desire to
buy something.

For example, a million households might wish that they owned a luxury yacht, but there might only be
actual attempts to buy 100 luxury yachts at a given price. Economic demand needs to be effective.

Law of demand

When the price of a good rises, the quantity demanded will fall. This relationship is known as the law of
demand.

There are two reasons for this law:

The income effect

People will feel poorer following a rise in the price of a good. They will not be able to afford to buy so
much of the good with their money. The purchasing power of their income (their real income) has
fallen. This is called the income effect of a price rise.

The substitution effect

Following a rise in price, a good will now cost more than alternative or ‘substitute’ goods, and people
will switch to these. This is called the substitution effect of a price rise.

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 Demand curve

Demand curves

Diagrammatically, the demand curve is shown as a downward-sloping curve.

There is an inverse relationship between price and quantity demanded.

As the price falls from P1 to P2

Quantity demanded rises from Q1 to Q2

The market demand curve

The market demand curve refers to the sum of all individual demand for a product. It is found by
adding up all individual demand at each price level.

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 Movement along demand curve

A change in the price of a good or service causes a movement along the demand curve.

A price rise will cause a decrease (contraction) in the quantity demanded of the product.

A rise in price from P2 to P1 causes demand to fall from Q2 to Q1.

A reduction in price will cause an increase (expansion) in the quantity demanded.

A fall in price from P2 to P3 causes demand to expand from Q2 to Q3.

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 Factors influencing demand

Income

As people’s incomes rise, their demand for most goods will rise. Such goods are called normal goods.
There are exceptions to this general rule, however. As people get richer, they spend less on inferior
goods, such as supermarket ‘value’ ranges, and switch to better quality goods.

The number and price of substitute goods

Substitutes are alternative goods and can satisfy the same want or need.

The higher the price of substitute goods, the higher will be the demand for this good as people switch
from the substitutes.

Example: Tea and coffee

Example
If tea goes up in price, the demand for coffee will rise.
!

The number and price of complementary goods.

Complements are goods that tend to be bought and used together so that an increase in the demand
for one is likely to cause an increase in the demand for the other.

Example
Examples: cars and petrol, cricket bats and balls, and headphones and electronic devices for playing !
music.

Fashion, taste and attitudes:

A change in fashion or tastes will also alter the demand for a product. For example, if it becomes
fashionable for middle-class households in the UK to wear jeans, expenditure on jeans will increase.
And tastes can be affected by advertisers and suppliers trying to 'create' demand for their products.

Government policies

Rules and regulations such as the imposition of taxes on tobacco and alcohol will affect the demand for
certain products. Sales taxes cause prices to increase, thereby reducing the level of demand.

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 Shifts in the market demand curve

The figure above depicts a rise in demand at each price level, with the demand curve
shifting to the right, from D0 to D1.

For example, at price P1, demand for the good would rise from X to Y.

This shift could be caused by any of the following factors influencing demand.

A rise in household income

A rise in the price of substitutes
A fall in the price of complements
A change in tastes towards this product
An expected rise in the price of the product
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Factors
influencing Demand curves

and
Shiftsments
M ov e
 Supply

Supply refers to the quantities of a product that suppliers are willing and able to sell at various
prices per period of time, other things being equal.

Firms will have more incentives to supply their products at higher prices.

The law of supply states that there is a positive relationship between price and quantity
supplied.

The quantity of a good supplied to a market varies up or down for two reasons.

Existing suppliers may increase or reduce their output quantities.

Firms may stop production altogether and leave the market, or new firms may enter the
market and start to produce the good.

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 Supply curve
A supply curve can be created both for an individual supplier and for all firms which produce the
good.

A supply curve shows the quantity suppliers are willing to produce at different price levels. It is an
upward sloping curve from left to right because greater quantities will be supplied at higher prices.

As the price increases from P1 to P2, the quantity supplied rises from Q1 to Q2.

Individual supply

An individual firm's supply shows the quantity of the good that the individual firm would want to
supply to the market at any given price.

Market supply

The market supply is the total quantity of the good that all firms in the market would want to
supply at a given price

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 Movement in the supply curve

A change in the price of a good or service causes a movement along the supply curve.

A price rise will cause an increase (expansion) in the quantity supplied of a product

A price rise from P2 to P3 causes the quantity supplied to expand from Q2 to Q3.

A price fall will cause a decrease (contraction) in the quantity supplied

A fall in price from P2 to P1 will cause quantity supplied to contract from Q2 to Q1.

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 Factors influencing supply

Costs:

The higher the costs of production, the less profit will be made at any price. As costs rise, firms will cut
back on production, probably switching to alternative products whose costs have not risen so much

Examples: cost of energy, labour and transport.

Example
!

Size and nature of the industry:

If an industry is growing in size, then more will be supplied to the market.

If new firms enter the market, supply is likely to increase.

The profitability of alternative products (substitutes in supply).

If a product which is a substitute in supply becomes more profitable to supply than before, producers
are likely to switch from the first good to this alternative.

Government policy

Taxes imposed on the supplier of a product add to the costs of production. Therefore the imposition of
taxes on a product reduces its supply, shifting the supply curve to the left. Subsidies are a form of
financial assistance from the government to help encourage output by reducing the costs of
production.

Change in technology

Technological advances such as automation, computers and wireless internet mean that there can be
greater levels of output at every price level. Hence, technological progress will tend to shift the supply
curve to the right.

Other factors

Other factors would include the weather and diseases affecting farm output, wars affecting the supply
of imported raw materials, the breakdown of machinery, fire etc.

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 Shifts in the supply curve

A shift of the market supply curve occurs when supply conditions (other than the price of the good itself) change.

The figure above shows a shift in the supply curve from S0 to S1.

If the price of the good is P1, suppliers would be willing to increase supply from Q0 to Q1 under the new supply
conditions.

A rightward (or downward) shift of the curve may be caused by the factors influencing supply:

A fall in the cost of factors of production

A fall in the price of other goods; the production of other goods becomes relatively less attractive as their price
falls
Technological progress

Conversely

We might see a leftward (or upward) shift in the supply curve if the cost of supply increases. This would mean that
at the existing price, a firm's output will decrease and less will be supplied.

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Factors
influencing Supply curves

and
Shiftsments
M ove
 Markets in equilibrium
Interaction of demand and supply– markets in equilibrium

The equilibrium price (also known as the market-clearing price) is determined where the demand for a
product is equal to the supply of the product. This means that there is neither excess quantity demanded
nor excess quantity supplied at the equilibrium price

Equilibrium will exist when the plans of consumers (as represented by the market demand curve)
match the plans of suppliers (as represented by the market supply curve).

Diagram 1 : Market equilibrium

Diagram 2 : Total consumer expenditure and total revenue

=$100

=150
Total consumer expenditure (and therefore total revenue) will be $15,000. ($100 * 150 units)

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 Markets disequilibrium
Interaction of demand and supply– markets disequilibrium

Diagram 1 : Market disequilibrium - excess supply

If for some reason companies thought that consumers were prepared to pay a price of P1 and supplied Q1
units to the market, the market would be in disequilibrium. At a price of P1 under present circumstances,
consumers are only planning to buy Q0 units.

As such companies will build up excess stocks, there is disequilibrium due to excess supply.

Diagram 2 : Market disequilibrium - excess demand

If the price was set at P0, there will be disequilibrium – this time of excess demand.

Consumers are now keen to snap up what they consider to be a pretty good deal. However, given the low
prices, supplies are fairly low and this is not enough to meet demand. Suppliers will run out of stocks far
quicker than they had expected.

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Demand
and
supply

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equilib equ
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 Consumer surplus

Consumer surplus

Consumer surplus arises because some consumers are willing to pay more than the given price for all but the last unit they buy.

Diagram 1 : Consumer surplus

This is represented in the figure below where consumer surplus is the shaded area under the demand curve and above the price line.

It is the difference between the total value consumers place on all the units consumed and the payments they need to make in order to
actually purchase that commodity

Diagram 2 : Fall in consumer surplus

When the market price changes, then so does consumer surplus. For example, if the price increases, then consumer surplus is reduced
as some consumers are unwilling to pay the higher price.

The loss of consumer surplus is shown by the area P1P2E 1E.

Diagram 3 : Rise in consumer surplus

A fall in the market price will lead to an increase in consumer surplus. This is because consumers who were previously willing to pay
above the new market price now end up paying less

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 Producer surplus

Producer surplus

Producer surplus and the difference between the price a producer is willing to accept and what is actually
paid.

Diagram 1: Producer surplus

Producer surplus is shown by the shaded area above the supply curve but below the price line at P2.
Anything the firm sells below price P2 is because it is willing to sell to consumers at that price. There is,
however, a point P below that the producer is unwilling to supply since it would not be covering the cost of
production.

Diagram 2: Fall in producer surplus

Producer surplus changes with a change in the quantity supplied.

Producers only willing to produce at quantity Q1 for a price P1 still receive price P2. This is their producer
surplus, although it is less than if they had been willing to increase their quantity supplied to Q2.

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