STUDY UNIT 2.

1
CHAPTER 5[8]

Demand and Supply in action

Ms. Precious Mncayi

B4 - 213
(016) 910-3384
Precious.Mncayi@nwu.ac.za
LEARNING OUTCOMES

Once you have studied this chapter you should be able to:

 Explain how changes in demand and/or supply will affects the equilibrium
price and quantities in the market and illustrate it graphically

 Predict the effects of simultaneous changes in demand and supply and

illustrate it by means of graphs

 Explain the interaction between related markets and illustrate it graphically

 Indicate what happens if the government intervenes in the market, for

example by setting minimum or maximum prices
1) INTRODUCTION

 In chapter 4 we mentioned a number of factors which can cause a change in

market demand as well as those which can cause a change in market supply

 Remember a change in any of the determinants of demand or supply except

the price of the product will cause a change in demand or supply, illustrated
by a shift of the demand curve or supply curve

 In this chapter, we examine what happens to the equilibrium price and

quantity when an underlying force (i.e. a non-price determinant of
demand and supply) changes.
2) CHANGES IN DEMAND

2.1) What would cause an increase in demand?

(determinants of demand)

 Increase in the price of the related goods

 Increase in consumers income
 Greater Tastes/preferences
 Increased Population
 Expected increase in the future prices of the goods
 EXCEPT THE PRICE OF THE PRODUCT
An increase in demand
(rightward shift)
• ↑ demand → ↑ price → ↑ quantity exchanged

• This is represented by a rightward shift from

DD to D1

• The increase in demand is a result of an

increase in any of the determinants of
demand except the price.

• What happens to supply?

It remains unchanged but the Qs ↑ as the price ↑

(shown by an upward movement from E to E1)
 2.2) What would cause an decrease in demand?
(determinants of demand)

 Decrease in the price of the related goods

 Decrease in consumers income
 Reduced tastes/preferences
 Reduced Population
 Expected fall in the future prices of the goods
 EXCEPT THE PRICE OF THE PRODUCT
A decrease in demand
(leftward shift)
• ↓ demand → ↓ price → ↓ quantity exchanged

• This is represented by a leftward shift from

DD to D2

• The decrease in demand is a result of a

decrease in any of the determinants of
demand except the price.

• What happens to supply?

It remains unchanged but the Qs ↓ as the price ↓

(shown by an movement from E to E2)
A range of possible changes in the demand for product X

Figure 5-2
Examples of changes in demand
(Textbook page 85/138)
3) Changes in supply

3.1) What would cause an increase in supply?

(determinants of supply)

 A fall in the price of an alternative product /a rise in the price of a joint

product
 A reduction in the price of any of the factors of production or other inputs
 An improvement in the productivity of the factors of production
An increase in supply
(rightward/downward)

• ↑ supply → ↓ price → ↑ quantity exchanged

• Such an increase in supply means more goods

are supplied

• Shift in supply could be the result of a change

in any of the determinants of supply other
than the price of the product

• What happens to demand?

It remains unchanged but the Qd ↑ as the price ↓

(shown by a movement from E to E1)
 3.2) What would cause an decrease in supply?
(determinants of supply)

 An increase in the price of an alternative product /a fall in the price of a joint

product

 An increase in the price of any of the factors of production or other inputs

 A deterioration in the productivity of the factors of production

A decrease in supply
(leftward/upward)
• ↓ supply → ↑ price → ↓ quantity exchanged

• Such a decrease in supply means fewer goods

are supplied

• The shift could be the result in any of the

determinants of supply other than the price of
the product

• What happens to demand?

It remains unchanged but the Qd ↓ as the price ↑

(shown by a movement from E to E2)
A range of possible changes in the supply of product X

Figure 5-4
Examples of changes in Supply
(Textbook page 86/140)
4) Simultaneous Changes in Demand and Supply

Table 5 – 1: Simultaneous changes in demand and supply

Changes in Changes in Changes in Changes in

demand supply price quantity
Increase Increase Uncertain Increase
Increase Decrease Increase Uncertain
Decrease Increase Decrease Uncertain
Decrease Decrease Uncertain Decrease

Textbook page 88[139]

4.1) Possibility 1
Increase in demand → increase in supply → change in price is uncertain →
quantity will increase
4.2) Possibility 2
 Increase in demand → Decrease in supply → price will increase → change in
quantity is uncertain
 As indicated in by Figure 5-5, the equilibrium quantity could ↑, remain unchanged, or
fall depending on the relative magnitude of changes in demand and supply
4.3) Possibility 3
Decrease in demand → Increase in supply → price will decrease → change
in quantity is uncertain
4.4) Possibility 4
Decrease in demand → Decrease in supply → change in price is uncertain →
quantity will decrease
5) Interaction between related markets
5.1) Substitutes – Taste and preference (Figure 5-6)
 Restriction on meat removed (Before, meat was banned and Catholics used to eat fish
only)

 Impact of the decision on the prices and sales of meat & fish?

o Fish – Demand for fish will decrease during the week, causing the price and
quantity to decrease.
o Meat – Demand will increase during the week, causing the price and the quantity to
increase.
5.2) Complements – cost price increase (Figure 5-7)
 Cost of producing cars increased (e.g. ↑ in costs of FOP)

 Impact of the decision on the prices and sales of cars and tyres?

o Moto cars – The supply for motor cars will ↓, causing an ↑ in price and a ↓ in the
quantity supplied
o Tyres – With fewer cars being produced, Demand will ↓, causing a ↓ in the price
and quantity of tyres
6) Government Intervention

 In previous sections – Market forces being demand and supply determined

the price

 However, economic agents are not always satisfied with market outcomes

 Dissatisfaction often puts pressure on the government to intervene

 This intervention can take different forms:

• Price ceiling (maximum prices)

• Price floors (minimum prices)

• Subsidies

• Tax
6.1) Maximum prices: price ceilings, price control

 Maximum price or price ceiling is set when the government sets a maximum legal
limit of a price of a particular good or service.

 For this to have an effect on market, the price ceiling must be set below the
market clearing price.

 If a government decides that the market clearing price of a good or service is too high
and needs to be reduced, a price ceiling maybe imposed.

 Reasons for setting Maximum prices (price ceilings, price control)

• Help the poor by keeping the prices of basic foodstuff low
• Avoid consumer exploitation by producers (avoid unfair pricing)
• Combat inflation
• Limit the production of certain goods and services
 Figure 5-8 Maximum prices (Textbook page 91 [144])

• If maximum price is set above the equilibrium

(P1), it will have no effect on the market

• However, when maximum price is set below the

equilibrium (Pm) – there will be significant
impact

• At lower price Pm consumers will demand Q2

while suppliers will only be willing to supply Q 1

• As a result, there is a market shortage or excess

demand which is equal to the difference between
Shortage
Q1 and Q2

How do we solve the problem of excess demand?

 Fixing prices below the equilibrium price will:
• Creates shortages (excess demand)

• Prevents the market mechanism from allocating the available quantity among
consumers

• Stimulates black market activityby providing an incentive for people to

obtain the good and resell it at a higher price to those consumers who are
willing to pay higher prices to obtain it

 Dealing with excess demand (Solutions):

• Serve consumers on a first come first served basis

• Informal rationing system (e.g. limiting quantity sold to each customer)

• Government may introduce an official rationing system by issuing ration

tickets or coupons that must be submitted when purchasing
6.1.1) The welfare costs of maximum price fixing
• A maximum price Pm is set below the market clearing
price P1 (Figure 5-9 page 94[147])
• As a result, quantity exchanged falls from Q1 to Qm

• In the absence of minimum price, Producer surplus is

0P1E and the Consumer surplus was P1DE

• At the new fixed price, the CS is now PmDRU and PS

is now 0PmU

• Consumers have lost the shaded triangle by A, since

only Qm is exchanged  But they have gained
rectangle B (which used to be part of PS), since those
who can obtain the product now pay less for it than
before.

• Shaded area A and C both disappear.

• The total deadweight loss to the society is equal to A

plus C
6.2) Minimum Prices (Price Supports, Price Floors)

 Minimum price or price floor is set when the government sets a minimum legal limit of
a price of a particular good or service.

 For this to have an effect on market, the price must be set above the equilibrium price.

 Price floors are set by the government for certain commodities and services that it believes
are being sold in an unfair market with too low of a price and thus their producers deserve
some assistance.

 Some situations in which price floors are imposed:

• To attempt to raise incomes for producers of goods and services which are essential.
e.g. agricultural products —serve as guaranteed prices to producers given the unstable
and uncertain nature of prices and income of farmers.

• To protect workers by setting minimum wage — ensuring workers earn enough to lead
a reasonable life.
 Figure 5-10: A minimum price (pg. 94 [149])

• If minimum price is set below the

equilibrium (i.e. at prices < R30), no
effect on market – still in disequilibrium

• However, if minimum price is set above

the equilibrium (i.e. at R40) – there will
be significant impact

• At R40, suppliers are supplying 9 mil.

(i.e. point b) while consumers are
demanding 4 mil. (i.e. point a)

• The introduction of a price floor of R40

results in a market surplus or excess
supply of R5 million kg of beef
 Problems of price floors:
• All consumers have to pay artificially higher prices including the poor

• Bulk of the benefit accrues to large producers or big companies

• Inefficient producers are protected and manage to survive

• The disposal of the market surplus usually entails further cost to taxpayers and welfare
losses to society

 Thus if the government wants to assist certain producers, the direct cash subsidies paid only to
those producers is a better alternative than fixing price floors

 Dealing with excess supply – Governments and/or producers can:

• Purchasing the surplus and export it

• Purchasing the surplus and storing it (provided its non-perishable)

• Purchasing the surplus and destroying it

• Government may even introduce production quotas to limit the quantity supplied to the
quantity demanded at the minimum price.
6.2.1) The welfare costs of minimum price fixing
• The equilibrium price and quantity are P1 and Q1
respectively

• The government now fixes the minimum price Pm

above the equilibrium price

• If producers respond to actual demand, the

quantity supplied and exchanged will fall to Qm

• In the absence of price fixing, the CS was P 1DE

and PS was 0P1E.

• After minimum price, the CS is PmDR, consumers

thus lose area A (to producers)

• Area B (which used to be part of CS) and C

(which used to be part of PS) both disappear

• Total deadweight loss to the society is equal to B

plus C

Figure 5-11 (page 95/150)

Conclusion

In this chapter, we have:

 explained how a change in demand affects the equilibrium price and quantity in
the market

 explained how a change in supply affects the equilibrium price and quantity in
the market

 predicted the effects of simultaneous changes in demand and supply

 analysed the interaction between related markets

 showed what happens if the government interferes in the market, for example
by setting minimum or maximum prices
Next class: 29 March 2018

PREPARE Chapter 6