CHAPTER 2 APPLICATIONS OF SUPPLY AND DEMAND

LESSON 1 BASIC PRINCIPLES OF DEMAND AND SUPPLY

INTRODUCTION

In general, many believe that prices are determined by the government. Though there is a
proven truth that it exists in some basic goods and services like rice, oil, sugar or rent of apartment. But
in a market economy like ours, prices of goods and services are determined by the interaction between
demand and supply of goods and services without government interference.

MEANING OF DEMAND AND SUPPLY DEMAND

Demand is referred to as the desire for a particular good backed up by sufficient purchasing
power. It indicates the ability or the willingness to buy a particular commodity at a given point of time.
In economics, demand does not mean mere need or desire, which is not backed up by the ability to
pay or no purchasing power is called potential demand. While the demand, which is backed up by the
ability to pay is called effective demand. In our discussion of demand, we will always assume the
effective demand. Demand then refers to the actual purchase of a good or service.

Supply pertains to the quantity of a commodity that is in the market and available for purchase
at particular price. In other words, supply is the amount of goods and services available for sale at given
prices in a given period of time and place. It implies the ability and willingness of sellers to sell.

Demand and Supply Schedule

The vital economic problem demands for making definite decisions on what goods to produce,
how they shall be produced, and for whom they shall be produced. To respond to such problems, the
market is used as the principal mechanism.

A market is a place where buyers and sellers interact with each other and that exchange takes
place among them. In the market, there are different buyers and sellers who will buy or sell different
quantities of a commodity. Due to this situation, different behaviors between buyers and sellers exist,
thus, a demand/supply schedule also has to exist.

A demand schedule shows the quantities of goods and services demanded by a consumer or
an aggregate of consumers at any given price. To understand this fully, let us analyze a hypothetical
demand schedule of beef in the market as shown in Table 1.
 In Table 1, it is shown that an individual would tend to buy more when its price is
low than when the price is high. At a price of P300.00, quantity demanded by the consumers
is 20 kilos while a decrease of price to P50.OO increases the quantity demanded of the
consumers to 120 kilos.

The supply schedule shows the different quantities that are offered for sale at various prices.
The supply schedule may reflect the individual schedule of only one producer or the market schedule
showing the aggregate supply of a group of sellers or producers. Table 2 gives you an idea of a supply
schedule.

Table 2 indicates that a seller offers a big quantity of rice supply in the market if the price is
high and likewise, sells only a few sacks of rice when the price is low.

The Law of Demand and Supply

The law of demand may be stated as "the quantity of a commodity which buyers will buy at
a given time and place will vary inversely with the price." This means that as price increases, quantity
demanded decreases, and as price decreases, quantity demanded increases other things are constant.
Such general tendencies of consumers can be explained by two reasons as follows:

1. Income effect -At lower prices, an individual has a greater purchasing power. This means, he
can buy more goods and services. But at higher prices, naturally, he can buy less.

2. Substitution effect - Consumers tend to buy goods with lower prices. In case the price of a
product that they are buying increases, they look for substitutes whose prices are lower. Thus,
the demand for higher priced goods will decrease.

The law of supply states that the quantity offered for sale will vary directly with price. This
means that as price increases quantity supplied also increases; and as price decreases, quantity supplied
also decreases. This direct relationship between price and quantity supplied is the law of supply.
Producers are willing and able to produce and offer more goods at a higher price than at a lower price.
Obviously, sellers offer more goods at higher prices because they make more profits. Such behavior of
sellers or producers is a natural inclination. No businessman is willing to produce goods if he makes no
profit.

Demand and Supply Curve

The demand schedule shown in Table 1 can also be understood through graphical illustration
known as the demand curve. In many instances, it is more convenient to express the relation between
prices and quantity demanded by means of a demand curve.

Figure 1 shows the translation of Table 1 into a graphical illustration.

The supply schedule, as shown in Table 2, can also be illustrated in graphical form known as
the supply curve, which shows the quantity of a good or service that the producers want to sell at any
given price. This is shown in Figure 2.
 In Figure 1, price is presented on the vertical axis and quantity demanded on the horizontal
axis. The points can be connected in a continuous curve. We label our demand curve with D, which
means demand, to indicate that it is the entire demand schedule.

It can be noted that the demand curve is sloping down. It shows that price and quantity
demanded are inversely proportional producing negative relationship. This inverse relationship between
prices and quantity demanded depicts e law of demand.

In Figure 2, it can be noted that the supply curve has an upward slope. It shows that price and
quantity supplied are proportional to each other. This kind of relationship depicts the law of supply. We
label our supply curve with S to indicate the entire supply schedule. In graphical illustration, supply
refers to the entire supply curve because a supply curve tells how much will be offered for sale at various
prices.
Note: The points in each demand/supply curve shows their relationship with price.

DETERMINANTS OF DEMAND
The determinants of demand also known as non-price factor that also affect a buyer's
willingness or ability to buy a good. These include the following:

1. Income - People buy more goods and services when their income increases, but will buy
less if their income decreases, thus, affecting the demand for goods and services. Changes
Of incomes of people will change their demand for goods and services. An increase in
income will either increase or decrease demand depending upon the kind of commodity.

2. Population - More people mean more demand for goods and services. That is why; it can
be observed that there are more buyers in the city stores than in the barrio stores.
Conversely, less population means less demand for goods and services Clearly, business is
poor in the rural areas compared to business in the urban areas.

3. Tastes and Preferences - Demand for goods and services increases when people like or
prefer them. Such tastes or preferences are greatly influenced by advertisement or fashion.
On the other hand, if a certain product is out of fashion, the demand for it decreases.

4. Price Expectations - When people expect the prices of goods, especially basic
Expectations commodities like rice, soap, cooking oil or sugar to increase tomorrow or next
week, they will buy more of these goods. In the same manner, they decrease their demand
for each product if they expect price to decline tomorrow or in a few days. The reason for
such consumer's behavior is to economize. This is a general tendency of buyers.

5. Prices of Related Goods -. When the price of a certain good increases, people tend to buy
substitute products. For example, if the price of Colgate increases, consumers buy less of
Colgate and more of the close substitute like Close-up or Hapee. This means, the demand
for Colgate decreases while the demand for substitutes increases. This means, if the price
of one good increases, the demand for the other good increases. For substitutes then, P and
QD are directly related.

But for complimentary products (those that go together) like bow and arrow or sugar and coffee,
is different. If the price of sugar increases, the price of coffee increases. But, if the demand for sugar
decreases, the demand for coffee also decreases. Conversely, if the price of sugar decreases, the demand
for coffee increases. P and QD are said to be inversely proportional.
Determinants of Supply

Just like demand, supply has also its own determinants. These include the following:

1.Technology - This refers to techniques or methods of production. Modern technology which

uses modern machines increases supply of goods. In contrast, traditional
technology which uses animal and people is very slow in producing goods. In
addition, technology reduces cost of production, and this encourages the
producers to increase their supply.

2.Cost of Production - When we speak of the cost of production, we take into Production
consideration the price of raw materials which are needed together
with the cost of labor, As the price of raw materials or the salaries of
laborers increases, it means higher cost of production. Higher cost of
production decreases supply because the viability or profitability of
the business decreases. Generally, businessmen are not willing to
offer more goods if they are not sure of profit.

3. Number of Sellers - More sellers or more factories mean an increase in supply. On the other
hand, less sellers or factories mean less supply.

4. Taxes and Subsidies - Certain taxes increase cost of production. Higher taxes discourage
production because it reduces the earnings of businessmen. That is
why the government extends tax exemptions to some new and
necessary industries to stimulate their growth. In like manner, tax
incentives are granted to foreign investors in order to increase foreign
investment in the Philippines. This will result to more goods.

5.Weather - Production of goods also depends on weather conditions. A businessman will

produce more sweaters during cold season, more umbrellas during rainy season
and light clothing materials and walking shorts during summer.

The Ceteris Paribus Assumption

The law of demand states that as price increases, quantity demanded decreases, and as price
decreases, quantity of demanded increases. Such theory is true if we apply the Ceteris Paribus
assumption wherein it assumes that “all other things equal or constant.” Meaning, the determinants
of demand are constant and are not considered as factors that will affect demand in the market. Thus,
the law of demand, using the Ceteris Paribus, can be restated as “assuming that the determinants of
demand are constant, price and quantity demanded are inversely proportional to each other.”

However, if the determinants of demand are considered major factors or greatly affects the
demand in the market, then, the Ceteris Paribus assumption is dropped.

The law of supply is only correct if we apply the consumption of ceteris paribus. This means
the law of supply is valid if the determinants of supply like cost of production, technology, number of
sellers and so forth, are held constant.

Changes in Demand and Supply

Changes in demand refer to the shift of demand curve which is brought about by the changes
in the determinants of demand, like income, population, price expectation and so forth. For instance,
an increase in population also increases demand for goods and services, or a decrease in income
also reduces demand. In a graph, an increase in demand shifts the demand curve to the right while a
decrease in demand shifts the demand curve to the left as shown in Figure 3.

Changes in Supply pertains to a shift of supply curve brought by changes the determinants of
supply. Through graphical presentation, an increase in apply shifts the supply curve to the right, while
a decrease in supply shifts the apply curve to the left. Figure 4 illustrates changes in supply.
Changes in Quantity Demanded/Quantity Supplied

Changes in the quantity demanded indicate the movement from one point to another point. This
means, the demand curve does not change its position like that of the demand curve in the changes in
demand. The change in quantity demanded is brought about by changes in prices. Whenever there is a
change in price, there is corresponding change in quantity demanded. Change in quantity demanded is
graphically illustrated in Figure 5. For example, a change in price from 200 to 150 will correspondingly
change the quantity demand from 60 to 80, and vice-versa.

Changes in quantity supplied show the movements from one point to another point in a constant
supply curve. Change in quantity supplied is brought about by a change in price. For example, if the
price decreases from P400 to P300, there is a corresponding decrease in quantity supplied from 200
to 150, and vice-versa as shown in Figure 6.
 Like a movement along the demand curve, a movement along the supply curve means that the
supply relationship remains consistent. Therefore, a movement along the supply curve will occur when
the price of the good changes and the quantity supplied changes in accordance to the original supply
relationship. In other words, a movement occurs when a change in quantity supplied is caused only by
a change in price, and vice versa.

Equilibrium of Demand and Supply

Alfred Marshall, a British economist, introduced a kind of pricing scheme by combining the
law of demand and the law of supply. With this combination, an equilibrium price and equilibrium
quantity is formulated. This is known as the market equilibrium.

In the market, supply and demand interact freely. Supply is represented by producers or sellers,
while demand is represented by the buyers. In the process of interaction between buyers and sellers, an
equilibrium price and equilibrium quantity or market equilibrium is established. The market equilibrium
comes at that price and quantity where the supply and demand forces are in balance. This is the situation
where quantity supplied and quantity demanded are equal. This means that the amount that buyers want
to pay is just equal to the amount that sellers want to sell. In Table 3, the equilibrium price is PHP8.00;
the market price in which both sellers and buyers decision are mutually consistent.

Let us work through the supply and demand schedules in Table 3 to see how supply and demand
determine market equilibrium. To find the market price and quantity, we find a price at which the
amount desired to be bought and sold just match. If we try a price of PHP9.00, a producer would like
to sell 9 units while consumers want to buy 16 units. Here, we see a shortage of 7 units of supply. The
quantity demanded exceeds quantity supplied. At price PHP15.00, a quick look shows that quantity
supplied which is 15 units exceed the quantity demanded which is 8 units. Accordingly, there is a
surplus of 7 items of supply.

We could try other process, but we can easily see that the equilibrium price is PHP12.00. At
PHP12.00, consumers' desired demand of 12 units is equal with the desired supply which is also 12
units. This denotes that supply and demand orders are filled, and consumers and suppliers are satisfied.
Whenever there is a balance of demand and supply irrespective of price, we can positively state that
there is an equilibrium.

In Figure 7, an illustration through graph of demand and supply can be seen.

Above the equilibrium price is a SURPLUS and below the equilibrium price is a
SHORTAGE. In the process of interaction between buyers and sellers, prices tend to move towards
the equilibrium price.

Note: The equilibrium price (Pe) and equilibrium quantity (Qe) are determined by the meeting
point between demand and supply curves

The Law of Demand and Supply

The law of supply and demand states that when supply is greater than demand, price decreases.
When demand is greater than supply, price increases. When supply is equal to demand, price remains
constant. This is the market equilibrium.