ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Chapter 2: Market Forces

Rational Decision Making
• When analysing markets, a range of assumptions are made about
the rationality of economic agents involved in the transactions

• In classical economic theory, the word 'rational' means that economic agents are able to
consider the outcome of their choices and recognise the net benefits of each one.
Rational agents will select the choice which presents the highest benefits

o Consumers are assumed to act rationally. They do this by maximising

their utility

o Producers are assumed to act rationally. They do this by selling

goods/services in a way that maximises their profits

o Workers are assumed to act rationally. They do this by balancing welfare at

work with consideration of both pay and benefits

o Governments are assumed to act rationally. They do this by placing the interests
of the people they serve first in order to maximise their welfare

• In many ways, the assumption of rational decision making is flawed. For example,
consumers are often more influenced by emotional purchasing decisions than a
rational computation of net benefits

Demand
• Demand is the amount of a good/service that a consumer is willing and able to
purchase at a given price in a given time period

o If a consumer is willing to purchase a good, but cannot afford to, it is

not effective demand

• A demand curve is a graphical representation of the price and quantity demanded

(QD) by consumers

o If data were plotted, it would be an actual curve, however economists simplify

curves in their sketches into straight lines so as to make analysis easier

Movements Along A Demand Curve

• If price is the only factor that changes (ceteris paribus), there will be a change in the QD

o This change is shown by a movement along the demand curve

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

A demand curve showing a contraction in quantity demanded (QD) as prices increase and an extension in
quantity demanded (QD) as prices decrease

Diagram Analysis

• An increase in price from £10 to £15 leads to a movement up the demand curve from
point A to B

o Due to the increase in price, the QD has fallen from 10 to 7 units

o This movement is called a contraction in QD

• A decrease in price from £10 to £5 leads to a movement down the demand curve from
point A to point C

o Due to the decrease in price, the QD has increased from 10 to 15 units

o This movement is called an extension in QD

• The law of demand captures this fundamental relationship between price and QD

o It states that there is an inverse relationship between price and QD

▪ When price rises the QD falls

▪ When prices fall the QD rises

• This relationship partly explains why the demand curve is downward sloping

Conditions of Demand

Shifts of The Entire Demand Curve

• There are numerous factors that will change the demand for a
good/service, irrespective of the price level. Collectively these factors are called
the conditions of demand
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

• Changes to each of the conditions of demand, shifts the entire demand curve (as
opposed to a movement along the demand curve)

A graph that shows how changes to any of the conditions of demand shifts the entire demand curve left or
right, irrespective of the price level

• For example, if a firm increases their Instagram advertising, there will be an increase in
demand as more consumers become aware of the product

o This is a shift in demand from D to D1. The price remains unchanged at £7 but
the demand has increased from 15 to 25 units

An Explanation of How Each of the Conditions of Demand Shifts the Entire Demand
Curve at Every Price Level

Condition Explanation Condition Shift Condition Shift

• Real Income determines how many

goods/services can be enjoyed by consumers Income D Shifts D Shifts
Income
Changes in Real Right Left
• There is a direct relationship between Increases Decreases
Income (D→D1) (D→D2)
income and demand for normal goods

• If goods/services become
more fashionable then demand for them Good
Changes in becomes D Shifts Good D Shifts
increases becomes less Left
taste/fashion more Right
• There is a direct relationship between fashionable (D→D1) fashionable (D→D2)
changes in taste/fashion and demand
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

• If more money is spent

on advertising or branding, then demand
Advertising/ for goods/services will increase as more Advertising D Shifts Advertising D Shifts
consumers are aware of the product Increases Right Decreases Left
branding
(D→D1) (D→D2)
• There is a direct relationship
between branding/advertising and demand

• Changes in the price of substitute goods will

influence the demand for a product/service

• There is a direct relationship between D for D for

Changes in the Price of
the price of good A and demand for good Good B Price of Good B
prices of Good A Shifts Good A Shifts
B
substitute goods Increases Right Decreases Left
• For example, the price of a Sony 60" TV (D→D1) (D→D2)
increases so the demand for LG 60" TV
increases

• Changes in the price

of complementary goods will influence the
demand for a product/service
Changes in the D for D for
Price of Good B Price of Good B
prices of • There is an inverse relationship between
Good A Shifts Good A Shifts
complementary the price of good A and demand for good
Increases Left Decreases Right
goods B
(D→D2) (D→D1)
• For example, the price of printer ink increases
so the demand for ink printers decreases

• If the population size of a country changes

over time, then the demand for
goods/services will also change

• There is a direct relationship between the

Changes in
changes in population size and demand Population D Shifts Population D Shifts
population Right Left
Increases Decreases
size/distribution • Demand will also change if there is a change (D→D1) (D→D2)
to the age distribution in a country as
different ages demand different
goods/services e.g an ageing population will
buy more hearing aids

Exam Tip: The difference between a movement along the demand curve and a shift in demand is essential to
understand. You will be repeatedly examined on this and it is important that you use the correct language to show that
you understand the difference between a change in quantity demanded and a change in demand.

When price changes (ceteris paribus), there is a movement along the demand curve resulting in a change
to quantity demanded. When a condition of demand changes, there is a shift of the entire demand curve
resulting in a change to demand.
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Supply
• Supply is the amount of a good/service that a producer is willing and able to
supply at a given price in a given time period

• A supply curve is a graphical representation of the price and quantity supplied by

producers

o If data were plotted, it would be an actual curve, however economists simplify

curves in their sketches into straight lines so as to make analysis easier

o The supply curve is sloping upward as there is a positive relationship between

price and quantity supplied

▪ Rational profit maximising producers would want to supply more as

prices increase in order to maximise their profits

A supply curve showing an extension in quantity supplied (QS) as prices increase and a contraction in quantity
supplied (QS) as prices decrease

Diagram Analysis

• If price is the only factor that changes (ceteris paribus), there will be a change in
the quantity supplied (QS)

o This change is shown by a movement along the supply curve

• An increase in price from £7 to £9 leads to a movement up the supply curve from point
A to B

o Due to the increase in price, the quantity supplied has increased from 10 to 14
units

o This movement is called an extension in QS

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

• A decrease in price from £7 to £4 leads to a movement down the supply curve from
point A to C

o Due to the decrease in price, the quantity supplied has decreased from 10 to 7
units

o This movement is called a contraction in QS

The Conditions of Supply

• There are several factors that will change the supply of a good/service, irrespective of
the price level. Collectively these factors are called the conditions of supply

• Changes to any of the conditions of supply shifts the entire supply curve (as opposed
to a movement along the supply curve)

A graph that shows how changes to any of the conditions of supply shifts the entire supply curve left or right,
irrespective of the price level

• For example, if a firm's cost of production increases due to the increase in price of a key
resource, then there will be a decrease in supply as the firm can now only afford to
produce fewer products

o This is a shift in supply from S to S1. The price remains unchanged at £7 but
the supply has decreased from 10 to 2 units
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

An Explanation of How Each of the Conditions of Supply Shifts the Entire Supply
Curve at Every Price Level

Condition Explanation Condition Shift Condition Shift

Costs of If the price of raw materials or other S Shifts S Shifts

COP COP
Production costs of production change, firms Left Right
Increases Decreases
(COP) respond by changing supply (S→S1) (S→S2)

Any changes to specific taxes or ad

S Shifts S Shifts
valorem taxes change the cost of Taxes
Indirect Taxes Taxes Increase Left Right
production for a firm and impact Decrease
(S→S1) (S→S2)
supply

Changes to producer S Shifts S Shifts

Subsidy Subsidy
Subsidies subsidies directly impact the cost of Right Left
Increases Decreases
production for the firm (S→S2) (S→S1)

New technology
increases productivity and lowers S Shifts S Shifts
New Technology Technology
costs of production. Ageing Right Left
Technology Increases Decreases
technology can have the opposite (S→S2) (S→S1)
effect

The entry and exit of firms into the

Change in the market has a direct impact on the
number of supply. If ten new firms start selling No. of Firms S Shifts No. of Firms S Shifts
firms in the building materials in Nuneaton, the Increases Right Decreases Left
supply of building material (S→S2) (S→S1)
industry
will increase

Exam Tip: Several of the conditions of supply change the costs of production. However, be sure to explain
each condition as its own point before linking it to the cost of production (for example, a change in indirect
taxation).

A common error by students is to explain that a subsidy (for example, £3,000 subsidy for each electric
vehicle produced) shifts the demand curve for electric vehicles to the right. This is incorrect. The subsidy will
shift the supply curve to the right. Then due to the lower price, there will be a movement along the
demand curve (extension of quantity demanded) to create a new market equilibrium.
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Price Determination & Equilibrium

Price Determination

• In a free market economy, prices are determined by the interaction of demand and
supply in a market

o A market is any place that brings buyers and sellers together

o Markets can be physical (e.g. Waterstones) or virtual (e.g. eBay)

• Buyers and sellers meet to trade at an agreed price

o Buyers agree the price by purchasing the good/service

o If they do not agree on the price then they do not purchase the good/service
and are exercising their consumer sovereignty

• Based on this interaction with buyers, sellers will gradually adjust their prices until there
is an equilibrium price and quantity that works for both parties

o At the equilibrium price, sellers will be satisfied with the rate/quantity of sales

o At the equilibrium price, the utility/price combination is maximised for the

buyers

Equilibrium

• Equilibrium in a market occurs when demand = supply and there is no tendency to

change

• At this point the price is called the market clearing price

o This is the price at which sellers are clearing their stock at an acceptable rate

A graph showing a market in equilibrium with a market clearing price at P and quantity at Q

• Any price above or below P creates disequilibrium in this market

o Disequilibrium occurs whenever there is excess demand or supply in a market

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Market Disequilibrium

Disequilibrium - Excess Demand

• Excess demand occurs when the demand is greater than the supply

o It can occur when prices are too low or when demand is so high that supply
cannot keep up with it

A graph that depicts the condition of excess demand in the market for electric scooters

Diagram Analysis

• At a price of P1, the quantity demanded of electric scooters (Qd) is greater than
the quantity supplied (Qs)

• There is a shortage in the market equivalent to QsQd

Market response

• This market is in disequilibrium

o Sellers are frustrated that products are selling so quickly at a price that is
obviously too low

o Some buyers are frustrated as they will not be able to purchase the product

• Sellers realise they can increase prices and generate more revenue and profits

• Sellers gradually raise prices

o This causes a contraction in QD as some buyers no longer desire the

good/service at a higher price

o This causes an extension in QS as sellers are more incentivised to supply at

higher prices

• In time, the market will have cleared the excess demand and arrive at a position
of equilibrium (PeQe)
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

o Different markets take different lengths of time to resolve disequilibrium. For

example, retail clothing can do so in a few days. Whereas the housing market
may take several months

Disequilibrium - Excess Supply

• Excess supply occurs when the supply is greater than the demand

o It can occur when prices are too high or when demand falls unexpectedly

• During the later stages of the pandemic the market for face masks was in disequilibrium

A graph that depicts the condition of excess supply in the market for Covid-19 face masks during the later
stages of the pandemic

Diagram Analysis

• At a price of P1, the quantity supplied of face masks (Qs) is greater than the quantity
demanded (Qd)

• There is a surplus in the market equivalent to QdQs

Market Response

• This market is in disequilibrium

o Sellers are frustrated that the masks are not selling and that the price is
obviously too high

o Some buyers are frustrated as they want to purchase the masks but are not
willing to pay the high price

• Sellers will gradually lower prices in order to generate more revenue

o This causes a contraction in QS as some sellers no longer desire to supply

masks

o This causes an extension in QD as buyers are more willing to purchase masks

at lower prices
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

• In time, the market will have cleared the excess supply and arrive at a position
of equilibrium (PeQe)

Use of Diagrams to Show Market Changes

• Real world markets are constantly changing and are referred to as dynamic markets

• Market equilibrium can change every few minutes in some markets (e.g. stocks and
shares), or every few weeks or months in others (e.g clothing)

• Any change to a condition of demand or supply will temporarily

create disequilibrium and market forces will then seek to clear the excess demand or
supply

Real World Example: Changes to Demand That Increase Price

• During lock downs associated with the Covid-19 pandemic, furniture retailers
experienced unexpectedly high demand for their products (especially desks and sofas)

Diagram showing an increase in demand for desks due to a temporary change in tastes/fashions

Diagram Analysis

• Due to the Covid mandated change of working from home, consumers experienced a
temporary change in taste as they sought to set up comfortable home offices

o This led to an increase in demand for desks from D1→D2

• At the original market clearing price of P1, a condition of excess demand now exists

o The demand for desks is greater than the supply

• In response, suppliers raise prices

o This causes a contraction of demand and an extension of supply leading to

a new market equilibrium at P2Q2

o Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher
than before

o The excess demand in the market has been cleared

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Real World Example: Changes to Supply That Increase Price

• Ukraine is one of the world's largest producers of wheat. During the Russian-Ukrainian
war, exports of wheat have been halted

• India imported 13% of the nation's wheat requirements from the Ukraine

Diagram showing a decrease in supply of wheat in India due to a supply shock caused by the war in Ukraine

Diagram Analysis

• Due to the war in the Ukraine, India is experiencing a supply shock in its wheat market

o This causes a decrease in supply of S1→S2

• At the original market clearing price of P1, a condition of excess demand now exists
(shortage)

o The demand for wheat is greater than the supply

• In response, sellers in India raise prices

o This causes a contraction of demand and an extension of supply leading to

a new market equilibrium at P2Q2

o The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower
than before

o The excess demand in the market has been cleared

Real World Example: Changes to Demand That Decrease Price

• Demand for lobsters in Maine, USA has been falling steadily in recent months

• This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35 /pound on
the 1st May
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Diagram showing a decrease in demand for lobsters due to a decrease in real income

Diagram Analysis

• In recent months the USA has been experiencing an increasing rate of inflation

o Inflation lowers the purchasing power of money in a consumer's pocket and so

effectively reduces their real income

o With reduced real income fewer luxuries are consumed

o This led to a decrease in demand for lobsters from D1→D2

• At the original market clearing price of P1, a condition of excess supply now exists

o The demand for lobsters is less than the supply

• In response, suppliers gradually reduce prices

o This causes a contraction of supply and an extension of demand leading to

a new market equilibrium in P2Q2

o Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower
than before

o The excess supply in the market has been cleared

Real World Example: Changes to Supply That Decrease Price

• In order to help meet their climate targets and to lower energy costs for households,
the EU is providing subsidies for solar panels
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Diagram showing an increase in supply of solar panels in the EU due to a per unit subsidy

Diagram Analysis

• To help meet its climate change targets and lower household energy bills the EU has
provided a subsidy to solar panel retailers

o This causes an increase in supply of S1→S2

• At the original market clearing price of P1, a condition of excess supply now exists
(surplus)

o The supply of solar panels is greater than the demand

• In response, sellers in the EU lower prices

o This causes an extension of demand and a contraction of supply leading to

a new market equilibrium at P2Q2

o The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher
than before

o The excess supply in the market has been cleared

Exam Tip: MCQ, short answer and essay questions frequently require you to explain dynamic changes in markets.
Explaining the steps in the change is often referred to as chains of analysis and students frequently leave out some steps
in the chain.

Step 1: From the scenario, identify if the change in condition is on the demand side or supply side.

Step2: State which way the demand or supply curve moves and use notation e.g. S 1→S2.

Step 3: State the disequilibrium that now exists at the original market price.

Step 4: State if sellers raise or lower prices to clear the disequilibrium.

Step 5: Explain the relevant contraction and extension that occurs on the demand and supply curves due to the
change in price.

Step 6: State the new market equilibrium points e.g. P2Q2.

Step 7: Explain the market outcome (is the new price/quantity higher/lower than the original?)

Functions of The Price Mechanism

• The price mechanism is the interaction of demand and supply in a free market

o This interaction determines prices which are the means by which scarce
resources are allocated between competing wants/needs
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

• The price mechanism fulfils three functions in the relationship between buyers and
sellers

o Rationing: prices allocate (ration) scarce resources. When resources

become scarcer the price will rise further. Only those who can afford to pay for
them will receive them. If there is a surplus then prices fall and more consumers
can afford them

o Signalling: prices provide information to producers & consumers where

resources are required (in markets where prices increase) & where they are not
(in markets where prices fall)

o Incentive: when prices for a good/service rise, it incentivises producers to

reallocate resources from a less profitable market to this market in order
to maximise their profits. Falling prices incentivise reallocation of resources to
new markets

• Adam Smith referred to the functions of the price mechanism as the 'mystery of the
invisible hand'

Price Mechanism at Work in Different Markets

• The price mechanism operates in all markets including local, national and global

Price Mechanism in a Local Market

• Long Island, USA has a rich history of agriculture and many producers set up farm shops
selling directly to the public. In recent years, honey consumption has increased

A diagram showing the increase in demand for honey in a local market, Long Island

• Due to a change in one of the conditions of demand (most likely change in tastes), the
demand for honey in the local market has increased from D1→D2 and the price has
increased from $15 to $18

o The higher price serves to ration a valuable product. Those consumers who can
afford to purchase it at $18, receive it
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

o The higher price incentivises producers to allocate more factors of

production to producing honey and this is evident from the extension in
supply from Q1 to Q2

o The shift in demand signals to other producers that demand for honey is
strong and they should consider entering the market

Exam Tip: It can get confusing explaining some of the differences between the three functions. Thinking
about it in the following way helps to simplify the process. If there is shift in demand/supply the market is
sending a signal to consumers and producers. If there is a movement along one of the curves, this is as a
result of the incentive function.

Price Mechanism in a National Market

• The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell

A diagram showing an increase in the supply of T-shirts in the UK market

• Due to a change in one of the conditions of supply (a decrease in costs of production),

the supply of T-shirts in the UK has increased from S1→S2 and the price has fallen from
P1 to P2

o The lower price increases the number of consumers who can access this product.
It is rationed more widely as there is an excess in supply

o The lower price incentivises consumers to purchase more T-shirts and this is
evident from the increase in demand from Q1 to Q2

o The shift in supply signals to other producers that there is excess supply and
they should consider leaving the market

Price Mechanism in a Global Market

• Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown using the
same factors of production

o Many countries export excess crops into the world market

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

o Producers use world prices to guide their production decisions

A diagram showing the price mechanism at work in two related global markets, corn and potatoes

• Farmers in France have been producing corn for many years and the market price is
$2/kg. The price of potatoes in global markets has until recently been steady at $2/kg

• Due to a change in one of the conditions of demand (possibly an increase in global

population), the demand for potatoes has increased from D1→D2 and the price has
increased from $2/kg to $3/kg

o The higher price serves to ration the potatoes. Those consumers who can
afford to purchase it for $3, receive it

o The higher price incentivises producers to allocate more factors of

production to producing potatoes and this is evident from the extension in
supply from Q1 to Q2

o The shift in global demand signals to producers in France that demand for
potatoes is strong and they should consider switching some of their
production from corn to potatoes

Exam Tip: Whenever you are faced with questions on the functions of the price mechanism, remember
that all three functions are built on the principle of self-interest. This will help you to explain each function.

For example, lower prices incentivises consumers to purchase more of the product with the same income.
Conversely, the incentive for producers is the opposite encouraging them to reallocate their factors of
production to producing more profitable products.

Each party acts in their self interest

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

Producer & Consumer Surplus

• Consumer surplus is the difference between the amount the consumer is willing to
pay for a product and the price they have actually paid

o For example, if a consumer is willing to pay £18 to watch a movie and the price is
£15, their consumer surplus is £3

• Producer surplus is the difference between the amount that the producer is willing to
sell a product for and the price they actually do

o For example, if a producer is willing to sell a laptop for £450 and the price is £595,
their producer surplus is £145

A market diagram illustrating consumer and producer surplus

Diagram Analysis

• The area between the equilibrium price and the demand curve represents
the consumer surplus in the market (ABPe)

o The consumer surplus lies underneath the demand curve

• The area between the equilibrium price and the supply curve represents the producer
surplus in the market (CBPe)

o Producer surplus lies above the supply curve

• When the market is at equilibrium the producer and consumer surplus are maximised

• Consumer surplus + producer surplus = social/community surplus

o Any disequilibrium reduces the social surplus

ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

How Market Changes Affect Producer & Consumer Surplus

• Any change to the condition of supply or demand will cause a shift in the relevant curve

• This shift will change the consumer and producer surplus in the market

An Increase in Supply

The condition of supply has changed and the diagram on the left shows the resulting change to consumer
surplus while the diagram on the right shows the change to producer surplus

Diagram Analysis

• Prior to the change in the condition of supply

o Consumer surplus was equivalent to ACE and producer surplus was equivalent
to ACF

o Social surplus was equivalent to ECF

• After the change, supply increased S1→S2

o Consumer surplus was equivalent to BED and producer surplus was equivalent
to BDG

o Social surplus was equivalent to DEG

• Both the consumer surplus and producer surplus have increased as a result of the
increased supply in the market

An Increase in Demand
ASL Notes – Demand & Supply Nabeel Ismail Economics - 03008578998

The condition of demand has changed and the diagram on the left shows the resulting change to producer
surplus while the diagram on the right shows the change to consumer surplus

Diagram Analysis

• Prior to the change in the condition of demand

o Producer surplus was equivalent to ACE and consumer surplus was equivalent
to ACF

o Social surplus was equivalent to ECF

• After the change, demand increased D1→D2

o Producer surplus was equivalent to BED and consumer surplus was equivalent
to BDG

o Social surplus was equivalent to DEG

• Both the producer surplus and consumer surplus have increased as a result of
the increased demand in the market

Exam Tip: MCQ frequently tests your ability to identify changes to consumer and producer surplus. In
essay responses, even if it is not explicitly mentioned, you can refer to these concepts when evaluating
dynamic markets and the impacts on different stakeholders. It demonstrates excellent economic
knowledge and analysis.

Changes to consumer and producer surplus become slightly more complicated when analysing the impact
of government intervention such as indirect taxes, subsidies and price controls.