Application of Supply and

Demand Analysis

Slides prepared by Leigh Lim

 Price
• Price is the monetary value of a unit of
commodity
• From the point of view of consumers, price is a
payment for the purchase of a commodity whose
value reflects the satisfaction or utility derived
from the consumption of a good or service
• From the point of view of producers, price is the
revenue earned for a commodity sold whose
value reflects the cost of producing a unit of good
or service
 What is a Demand Curve?
• A schedule of the willingness and capacity of a
consumer to buy a commodity at alternative
prices at a given point in time ceteris paribus
(other things constant)
• The only factor that influences the level of
demand or consumption is the price of the
commodity itself
• Refer to graph 2.1 in the book
Other Factors Affecting the Demand of
a Commodity
• Income
– a higher level of income will give a person a higher
capacity to consume and vice versa
• Prices of Other Commodities
– If the other good is a substitute, the increase in
the price of the substitute good may increase the
demand for the commodity at hand and vice versa
– If the other good is a complementary good, a
decrease in its price will have a positive impact on
the demand of the good at hand and vice versa
Other Factors Affecting the Demand of
a Commodity
• Expectation
– If you believe that the price of gasoline will
increase tomorrow, there is a tendency for
consumers to increase their consumption today
• Taste
– Shaped by cultural values, peer pressure or the
power of advertising
• Market
– Population and demographic changes
 Why is the Demand Curve Downward
Sloping?
• Substitution Effect
– Decision of a consumer to substitute an expensive
good with cheaper goods when there is a price
change
• Income Effect
– An increase in purchasing power will enable the
customer to buy more of the good and vice versa
 Principle of Diminishing Marginal
Utility
• This implies that the additional satisfaction
(utility) provided by an additional commodity
consumed is lower than the additional
satisfaction given by the previous level of
consumption of the commodity
• The optimal demand for a commodity is
attained when its price is equal to the
marginal utility derived from the last unit
consumed
 Changes in Demand Curve
• Movement along the demand curve
– Change in quantity demand resulting from the
change in the price of the commodity
– As the price of a commodity decreases, the
movement along the curve will lead to an increase
in the quantity demand and vice versa
– See graph 2.2
 Changes in Demand Curve
• Shifts in demand curve
– Changes in demand curve cased by any of the
other factors beside the price of the commodity
– A positive effect will shift the demand curve to the
right (increase in the demand for a commodity)
– A negative effect will shift the demand curve to
the left (decrease in the demand for the
commodity)
– See graph 2.3
 What is a Supply Curve?
• A schedule showing a direct or positive
relationship between the price of the
commodity and the level of output that the
seller is willing to supply at a given point in
time ceteris paribus
• As the price of the commodity increases,
there will be more sellers that will be willing
to supply the good
• See graph 2.4
 Other Factors Affecting Supply of a
Commodity
• Price of Production Inputs
– The production of any commodity will require the
use of 2 major inputs – intermediate inputs or raw
materials and factor inputs (land, labor, capital
and entrepreneurship)
– When the price of production inputs increases,
there will be an increase in the cost of production
and sellers will be reluctant to maintain their
previous level of supply
 Other Factors Affecting Supply of a
Commodity
• Taxes
– An increase in sales tax, real estate tax and other
business taxes can increase the cost of supplying a
commodity which will in turn discourage sellers from
increasing their supply
• Technology
– Labor-intensive technology is used if the cost of labor
is relatively cheap; Capital-intensive technology is
used if wages are high
– Improvements in technology can lower production
cost and encourage firms to supply more
 Other Factors Affecting Supply of a
Commodity
• Expectation
– If there is an expectation that the price of rice will
increase next season, this will encourage farmers
to plant more rice now in anticipation of higher
price in the future. This expectation can also
discourage rice dealers to sell rice currently and
some of them will keep a higher inventory of rice
currently so they can sell it in the future with
higher returns.
 Why is the Supply Curve Upward
Sloping?
• Variations in the unit cost of production
Producer Cost of Production
A 5 per unit
B 7 per unit
C 10 per unit
D 13 per unit
E 15 per unit
– Who can supply the good, if the market price is 6?; if
the market price is 16?
– The previously ineffective producers at lower prices
have become more efficient and competitive as the
price of the commodity increases
 Principle of Diminishing Marginal
Productivity & Increasing Marginal Costs
• A fixed factor input (capital, land) is mixed with a
variable factor input (labor), the employment of
additional labor will increase the total production
but at a decreasing rate
• As the firm employs additional variable inputs, it
also increases its total cost of production. Since
each additional variable input is less productive
than the previous ones, they become costlier to
employ (increasing marginal costs with the
increase in output production)
 Principle of Diminishing Marginal
Productivity & Increasing Marginal Costs
• Profit – difference between total revenue and
total costs
• Maximum Profit – attained when the
difference between total revenue and total
costs is the widest or marginal revenue is
equal to marginal costs (marginal profit is
zero)
– As long as marginal profit is positive, there is
motivation to increase production as this will
increase profit
 Changes in the Supply Curve
• Movement along the supply curve
– Change in the price of the commodity
– An increase in the price of the commodity will
increase the quantity supplied as shown by
movement northeast along the supply curve and
vice versa
– See graph 2.5
 Changes in the Supply Curve
• Shift in the supply curve
– Changes in other factors affecting supply except
the price of the commodity
– A positive effect will shift the supply curve to the
right (increase in the supply of a commodity)
– A negative effect will shift the supply curve to the
left (decrease in the supply of the commodity)
– See graph 2.6
 Determination of the Prices of
Commodities
• Equilibrium Price
– When buyers and sellers transact in the market
and they agree on the price of the commodity and
the amount to be sold and bought
– See graph 2.7
• Disequilibrium
– Cases when there are disagreements among
buyers and sellers on the price and quantity
(excess demand and excess supply)
– See graph 2.8
 Changes in Equilibrium Price and
Output
• Shift in the Demand Curve to the Right
– See graph 2.9
• Shift in the Demand Curve to the Left
– See graph 2.10
• Shift in the Supply Curve to the Right
– See graph 2.11
• Shift in the Supply Curve to the Left
– See graph 2.12
Simultaneous Changes in Demand and
Supply
• Shift of the Demand Curve to the Right and
Shift of the Supply Curve to the Right (equal
proportion)
– See graph 2.13
• Shift of the Demand Curve to the Right and
Shift of the Supply Curve to the Left (unequal
proportion)
– See graph 2.14
 Other Applications of Supply and
Demand Analysis
• Price Ceiling
– Government imposed price control (prices cannot
go higher than the mandated price ceiling)
– See graph 2.15
• Price Floor
– Government imposed price control (prices cannot
go lower than the mandated price floor)
– See graph 2.16
 Other Applications of Supply and
Demand Analysis
• Applications in the Labor Market
– Those buying labor services are the firms and
firms will hire laborers if the monetary value of
the labor productivity (marginal benefit) is equal
to the wage rate (marginal cost)
– The laborers are the ones supplying the labor
services and to them, the wage rate is the
opportunity cost of leisure
– See graph 2.17
 Other Applications of Supply and
Demand Analysis
• Minimum Wage as Price Floor
– If the equilibrium price in graph 2.17 is considered
too low by the laborers, they may demand the
government to impose a minimum wage
– See graph 2.18
 Other Applications of Supply and
Demand Analysis
• Application in the Foreign Exchange Market
– Demand for USD is influenced by demand for
imports. At higher USD price, imports becomes
expensive and our demand for USD decreases
– Supply of USD is based on the inflows of USD
brought by exports and remittances. At higher
USD price, it motivates exporters and Filipinos to
work overseas
– See graph 2.19
 Other Applications of Supply and
Demand Analysis
• Labor Migration and the OFWs
– Supply of OFWs increases when foreign wage rate
increases or when the exchange rate increases
even if the foreign wage rate does not change
– Demand for OFWs increases when foreign wage
rate decreases
– Even at lower foreign wage rate, there will be
more OFWs willing to go abroad because the peso
value of their foreign wage is still high with the
depreciated peso
– See graph 2.20
 Other Applications of Supply and
Demand Analysis
• Determination of Rent
– Rent refers to the price of using land in the
process of production
– Supply curve of land is vertical because land is
fixed and cannot be increased with increase in
rent or price of land
– Low demand of land Do = idle
– High demand of land D1 = agriculture
– Very high demand of land D2 = business, high rises
and condominiums
– See graph 2.21
Contemporary Economic Issues Facing
the Filipino Entrepreneur
• There are 4 types of Market Structures based
on the Market Power of the actors in any
transaction
• Market Power
– The ability of any actor or group of actors in the
market to significantly influence the price in the
market and the quantity to be produced and sold
– Aim of every actor is to enhance its market power
 Perfect Competition
• A market structure where no single seller or
buyer has power to determine the price and the
level of output in the market
• Large number of buyers and sellers
• Suppliers sell similar or undifferentiated products
• Free entry and exit
• Mobility of resources
• Perfect information
• Ideal market structure since it leads to an
efficient use of resources
 Monopoly
• A market structure characterized by a single seller
in the market
• Exact opposite of a perfect competition
• Enormous market power
• Unique product
• Huge profit (limiting production and setting
higher price)
• Restrictions to entry (scale barriers and legal
barriers)
• If there is only a single buyer, the market is known
as a monopsony
 Oligopoly
• A market structure characterized by few sellers
producing similar and differentiated products
• Imperfect competition (there is competition
among the few sellers, but it is imperfect since
the excess profit is only reduced but not
eliminated)
• Interaction of these few sellers:
– Independent actions – mimics a competitive market
– Collusion – forming a cartel and monopolizing the
market
– Since collusion is not allowed here, firms opt to react
to their fellow firms decisions or follow the industry
leader
 Monopolistic Competition
• This market structure has the elements of
both competitive and monopolistic markets
• Imperfect competition
• Competitive (numerous sellers and buyers
that can freely enter and exit the market)
• Monopolistic (product although similar, can be
differentiated through advertising and
packaging, which leads to brand loyalty)
 Market Structures an Implications for
Entrepreneurs
• If you have limited resources and productive
capacity…
• The firm may enter the perfectly competitive
market, but the ability to expand and find a niche
is very limited
• Thus, a monopolistically competitive market is
better, although the firm must be cautious of
potential rivals
• Difficult in entering the monopolistic and
oligopolistic market
 Investment and Interest Rate
• External funds can be sourced from the capital
market
– Demand curve for funds shows and indirect
relationship between interest rate and the
amount being borrowed
– Supply of funds (savings) is positively related with
the interest rate
– If the price of capital is high, it may discourage
potential entrepreneurs to engage in business and
existing entrepreneurs may postpone their
expansion and investment plans, and vice versa
 Rentals and the Cost of Business
Operations
• It may not be wise for a small and beginning
enterprise with limited resources to locate its
office in high-end commercial districts because
rental rates can eat up a huge part of its revenues
• BUT there are several benefits of having an office
in those areas
– Gives legitimacy and prestige
– Savings – attracting a lot of customers, accessible to
workers and near to clients and service providers
– Commercial districts are well planned and designed
for business with their good infrastructure and
adequate support services
 Minimum Wage
• Example of floor price that prevents the market
to seek its equilibrium condition because of a
government policy
• For labor intensive industries, minimum wage can
discourage firms to hire additional workers, since
the wage rate has become prohibitive.
• As a result, some of these firms locate their
manufacturing plants in regions or countries
where labor is relatively inexpensive
 Taxes
• Taxes can increase the cost of business
operations and can threaten the profitability
of business enterprises at their initial stage of
operations
• In order to attract pioneer, foreign and local
firms to establish their presence in the
country, governments can give tax incentives
 Synthesis
• Every commodity has a price. The price is a
monetary value of a unit of commodity. For
consumers, it reflects the value of satisfaction on
the good consumed. For producers, it reflects the
costs of producing a unit of commodity.
• This price is determined by the interaction of
demand and supply. Equilibrium price is the
agreed price consumers are willing to purchase
and producers are willing to sell the same
quantity of the commodity.
 Synthesis
• Changes in the price is influenced by changes in
the factors affecting demand and supply
• Disequilibrium is a condition when consumers
and producers are not in agreement on the
quantity to be bought and sold at a given price
• The analysis of demand and supply can be
applied in the determination of prices of various
markets and changes in factors affecting demand
and supply
• The price of a commodity is also influenced by
the market power of actors in the market