Basic Concept

 Supply and demand, in economics,

relationship between the quantity of a
commodity that producers wish to sell
at various prices and the quantity that
consumers wish to buy. It is the main
model of price determination used in
economic theory.
 The price of a commodity is determined by
the interaction of supply and demand in
a market. The resulting price is referred to as
the equilibrium price and represents an
agreement between producers and
consumers of the good. In equilibrium the
quantity of a good supplied by producers
equals the quantity demanded by
consumers.
Demand Curve
 The quantity of a commodity demanded
depends on the price of that commodity
and potentially on many other factors,
such as the prices of other commodities,
the incomes and preferences of
consumers, and seasonal effects.
EXAMPLE: Demand Schedule for
Milk
PRICE QUANTITY DEMANDED

50 10

40 20

30 30

20 50

10 80
PRICE
50

40

30

20

10

10 20 30 50 80
QUANTITY
Downward Sloping Curve Reasons:
 Substitution Effect
Changes in price motivate consumers to buy
relatively cheaper substitutes goods.
 Income Effect
Changes in price affect the purchasing power of
consumers’ income.
 Law of Diminishing Marginal Utility
As you continue to consume a given product, you
will eventually get less additional utility (satisfaction)
from each unit you consume.
PRICE
50

D2
40

30

20

10

10 20 30 50 80
QUANTITY
PRICE
50

D2
40

30

20

10

10 20 30 50 80
QUANTITY
5 SHIFTERS OF DEMAND
Tastes/Preferences
Number of Consumers
Price of Related Goods
Income
Expectations
 Supply Curve
 The quantity of a commodity that is
supplied in the market depends not only
on the price obtainable for the
commodity but also on potentially many
other factors, such as the prices of
substitute products, the production
technology, and the availability
and cost of labour and other factors of
production.
 Competitive markets
 A competitive market is one in which a large
numbers of producers compete with each
other to satisfy the wants and needs of a large
number of consumers. In a competitive market
no single producer, or group of producers, and
no single consumer, or group of consumers,
can dictate how the market operates. Nor can
they individually determine the price of goods
and services, and how much will be exchanged.
Competitive markets will emerge under certain
circumstances.
 Profit Motive
 Diminishability of private goods
 Rivalry
 Excludability
 Rejectability
 Ability to charge
 No information failure
 No time lags
 No externalities
 Property rights
 Incentives for entrepreneurs
The profit motive
Free markets form when the possibility of profits
provides an incentive for firms to enter the market.
Basic economic theory states that profits are earned
when firms gain a revenue which exceeds the costs of
production. However, more advanced micro-economic
theory offers two definitions of profit - normal and
super-normal. When revenue exceeds costs
supernormal profit is earned, and when revenue
equals costs the firm makes normal profits
 Diminishability of private goods
 A further condition for market formation is
that stocks of goods will diminish as the good is
purchased. For example, the purchase of a
laptop computer by one consumer means there
is one less available for other consumers. This is
referred to as the principle of diminishability.
Eventually, stocks will diminish to zero and as
this happens, price will be driven up. Higher
prices create an incentive for the producer to
increase production.
 Rivalry
 In addition, free markets will only form when
consumers are forced to compete with obtain the
benefit of the the good or service. For example, to be
guaranteed a good seat at a restaurant, or at a music
venue, consumers need to book in advance, or get
there early - there is clearly a need to be competitive
to secure the benefit of the good. This is called the
principle of rivalry, and is clearly closely related to
the principle of diminishability. Indeed, many
consider it to be just another way to explain the need
for consumers to compete when stocks diminish.
 Excludability
 For markets to form it is essential that consumers can
be excluded from gaining the benefit that comes from
consumption. A storekeeper can stop consumers
gaining the benefit of a product if they are unable or
unwilling to pay. For example, a market for music can
only be formed if the musicians perform in a venue
where access is denied to those without a ticket, or
where the songs can be recorded and sold through
shops, via downloads, or through other media. This is
called the principle of excludability. If consumers
cannot be excluded they may become free-riders and,
as will be seen later, the possibility of free riders can
prevent the formation of fully fledged market.
 Rejectability
 It is also necessary that consumers can
reject goods if they do not want or need
them. For example, a supermarket
employee could not place an unwanted
product into a shopper’s basket and
expect the shopper to pay for it at the
checkout. This is called the principle
of rejectability.
 Ability to charge
 When the conditions of
diminishability, rivalry, excudability
and rejectability are present it is
possible for a market to form and for
the seller to charge the buyer a price
and for the buyer to accept or reject
that price. It is also possible for the
buyer to make a bid for a good or
service, and for it to be accepted or
rejected by the seller.
 No information failure
 For markets to work effectively there can be no
significant information failureaffecting the
decisions of consumers and producers. It is
assumed that the consumer of a private good or
service knows what they are getting - they are able
to estimate accurately the net benefit they are
likely to derive. Net benefit is the private benefit to
a consumer in terms of satisfaction, or utility, less
the private cost associated with buying the
product. It equates to the concept of consumer
surplus.
 No time lags
 For markets to form and work effectively
there will be no significant time lags
between the purchase of the private product
and the net benefit derived by the
consumer. For example, if a consumer buys a
newspaper with their morning coffee they
can read it immediately. Who would bother
to purchase a newspaper if they could not
read it for several days? Of course, where
mail order or online deliveries are
concerned, a short time lag is acceptable.
 No externalities
 Markets are said to work at their best
when there are no effects on parties not
involved in the market transaction.
This means that during the production
of the good, and during its
consumption and disposal after use,
there is no positive or negative impact
on other citizens.
 Property rights
 For markets to form and operate
successfully, consumers and
producers must haveproperty rights.
Property rights mean that they have the
right to own private property and protect it
from theft or damage, or from other people’s
waste, and from the pollution of others. If
property rights cannot be established, the
good is not a pure private good.
 Incentives for entrepreneurs
 The combined effects of the above
characteristics means that markets will form
because entrepreneurs will be willing to take
risks associated with producing and
supplying pure private goods. This is
because consumers would be prepared to
pay for the good, and producers can charge
consumers at the point of consumption,
from which they can earn revenue and make
a profit.
Market Equilibrium
Market equilibrium is a market state where the supply
in the market is equal to the demand in the market.
The equilibrium price is the price of a good or service
when the supply of it is equal to the demand for it in
the market. If a market is at equilibrium, the price will
not change unless an external factor changes the
supply or demand, which results in a disruption of the
equilibrium.
 Market Equilibrium-Demand and
Supply
 It is the function of a market to equate demand and supply through the price
mechanism. If buyers wish to purchase more of a good than is available at the
prevailing price, they will tend to bid the price up. If they wish to purchase less
than is available at the prevailing price, suppliers will bid prices down. Thus,
there is a tendency to move toward the equilibrium price. That tendency is
known as the market mechanism, and the resulting balance between supply
and demand is called a market equilibrium.
 As the price rises, the quantity offered usually increases, and the willingness of
consumers to buy a good normally declines, but those changes are not
necessarily proportional. The measure of the responsiveness of supply and
demand to changes in price is called the price elasticity of supply or demand,
calculated as the ratio of the percentage change in quantity supplied or
demanded to the percentage change in price.
 Firms faced with relatively inelastic demands for their products may increase
their total revenue by raising prices; those facing elastic demands cannot.
 Supply-and-demand analysis may be applied to markets for final goods and
services or to markets for labour, capital, and other factors of production. It can
be applied at the level of the firm or the industry or at the aggregate level for the
entire economy.
Demand Shift Graph
 Normal Goods
 Is a good that experiences an increase in its demand due
to a rise in consumer’s income. In other words, if there’s
a increase in wages, demand for normal goods increases
while conversely, wage declines or layoffs lead to a
reduction in demand.
 Also known as necessary goods, are products for which
demand goes up when income rises. However, demand
increases at a slower rate than the rate of income growth.
Normal goods contrast with inferior goods, for which
demand declines as people becomes richer.
 Inferior Goods
Inferior goods refer to those goods
whose demand decreases with an
increase in income. It means that
there exists an inverse relationship
between income and the demand
for inferior goods. So, income effect
is negative in case of inferior goods.
Normal Goods

Income Demand

Inferior Goods

Income Demand
 Quantity Supplied
In economics, quantity supplied
describes the amount of goods or
services that are supplied at a
given market price. How supply
changes in response to changes in
prices is called the price elasticity of
supply.
 Market Forces
 Theoretically, markets should strive
for equilibrium, but there are many
forces that pull them away from this
point. Many markets do not operate
freely; instead, they face external forces,
such as government rules and
regulations that influence how much of
a product suppliers have to provide.
 Government Intervention in
Supply and Demand
Governments are trying to see that
the “economic problem” is
answered as effectively as possibly.
To put it as simply as possible, the
“economic problem is how to use
limited resources to meet unlimited
wants as efficiently and effectively
as possible.
Price ceiling is a government- or
group-imposed price control, or
limit, on how high a price is
charged for a product, commodity,
or service. Governments use price
ceilings to protect consumers from
conditions that could make
commodities prohibitively
expensive.
Price Ceilings
 Other Problems of Price Ceilings
1. Inefficient distribution to consumers- not
all who need it can get the product, some who
could and would pay more get an advantage
2. Wasted resources- Time, money, and effort
dealing with shortages
3. Inefficient Low Quality-Because prices are
held low, there is no incentive to offer high
quality
4. Illegal activity- “Black market” transactions to
get around controls
Price floor is a situation
when the price charged is
more than or less than the
equilibrium price
determined by market
forces of demand and
supply.
Other Problems of Price Floors
1. Inefficiently Low Quantity-Fewer sell than would
sell in an uncontrolled market
2. Wasted resources- Governments tend to buy up
surpluses (which they destroy or use inefficiently) or
pay producers not to produce
3. Inefficiently High Quality- No incentive to lower
prices to compete, so producers offer higher quality
than consumers want
4. Illegal Activity- Transactions occuring below the
“price floor” level