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Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 1
CHAPTER 2
DEMAND AND SUPPLY
LECTURE OUTLINE
1 INTRODUCTION
2 DEMAND
2.1 Definition of demand
2.2 Relationship between price and quantity demanded
2.3 Demand schedule and demand curve
2.4 Movement along the demand curve versus shift in the demand curve
2.5 Non-price determinants of demand
3 SUPPLY
3.1 Definition of supply
3.2 Relationship between price and quantity supplied
3.3 Supply schedule and supply curve
3.4 Movement along the supply curve versus shift in the supply curve
3.5 Non-price determinants of supply
4 EQUILIBRIUM
4.1 Equilibrium price and equilibrium quantity
4.2 Effects of a change in demand on price and quantity
4.3 Effects of a change in supply on price and quantity
4.4 Effects of a change in demand and supply on price and quantity
5 SURPLUS
5.1 Consumer surplus
5.2 Producer surplus
References
John Sloman, Economics
William A. McEachern, Economics
Richard G. Lipsey and K. Alec Chrystal, Positive Economics
G. F. Stanlake and Susan Grant, Introductory Economics
Michael Parkin, Economics
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 2
1 INTRODUCTION
We have learnt that the allocation of factor inputs under the market system is determined
by the interaction between the market forces of demand and supply. Therefore, it is
important to have an understanding of the concepts of demand and supply to have a full
understanding of the allocation of factor inputs under the market system. This chapter
gives an exposition of the concepts of demand and supply.
2 DEMAND
2.1 Definition of demand
The demand for a good is the quantity of the good that consumers are able and willing to
buy, known as the quantity demanded, at each price over a period of time, ceteris paribus.
2.2 Relationship between price and quantity demanded
When the price of a good falls, the quantity demanded will rise. Conversely, when the price
of a good rises, the quantity demanded will fall. The inverse relationship between price and
quantity demanded is the essence of the law of demand.
The law of demand states that there is an inverse relationship between
price and quantity demanded.
The law of demand can be explained with the concept of diminishing marginal utility.
Marginal utility is the additional satisfaction resulting from consuming one more unit of a
good. The more a consumer has of a good, the less he will value it at the margin. This
phenomenon is known as diminishing marginal utility. Due to diminishing marginal utility,
consumers will only increase the consumption of a good if the price falls.
The law of demand can also be explained with the concepts of substitution effect and
income effect. Consider what will happen if the price of a good falls. First, the real income
of consumers will rise because they will be able to buy a larger amount of goods and
services with the same amount of nominal income which will induce them to buy more of
the good. This effect is known as the income effect of a price fall. Second, the good whose
price has fallen will become relatively cheaper than other goods which will induce
consumers to substitute the good for other goods. This effect is known as the substitution
effect of a price fall.
2.3 Demand schedule and demand curve
The quantity of a good that consumers are able and willing to buy at each price can be
shown by the demand schedule.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 3
Price Quantity demanded
(John)
Quantity demanded
(Peter)
Quantity demanded
(Market)
10 1 2 3
5 2 4 6
The first two columns show the demand schedule of John and the first and the third
columns show the demand schedule of Peter. The first and the last columns show the
market demand schedule, which is the summation of the demand schedules of John and
Peter, assuming they are the only two consumers in the market.
The demand schedule can be represented graphically by the demand curve. The demand
curve shows the quantity demanded at each price and is downward-sloping due to the law
of demand. The market demand curve is the horizontal summation of the demand curves of
all the consumers in the market and hence is also downward-sloping.
Market demand curve
2.4 Movement along the demand curve versus shift in the demand curve
A change in quantity demanded occurs when quantity demanded changes due to a change
in price and this can be shown by a movement along the demand curve. It is assumed that
other than price, all non-price determinants of demand have remained unchanged (known
as “ceteris paribus” in Latin and “other things being equal” in English).
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 4
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a decrease
in the price (P) from P0 to P1. This is known as an increase in quantity demanded.
A change in demand occurs when quantity demanded changes due to a change in a
non-price determinant of demand. In other words, quantity demanded changes at the same
price and this can be shown by a shift in the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price
(P0) due to a change in a non-price determinant of demand. This is known as an increase in
demand.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 5
2.5 Non-price determinants of demand
Tastes and preferences
A change in tastes and preferences in favour of a good will lead to an increase in the
demand for the good. Tastes and preferences are affected by a number of factors such as
advertisements and fashions. For example, if Apple Corporation increases its expenditure
on advertising, the demand for its products will increase.
Prices of substitutes and complements
Substitutes are goods that are alternatives to one another such as Coke and Pepsi. A rise in
the prices of substitutes for a good will induce consumers to buy less of the substitutes
resulting in an increase in the demand for the good. For example, if the price of Pepsi rises,
consumers will buy less Pepsi and more Coke. Complements are goods that are consumed
together such as car and petrol. A fall in the prices of complements for a good will induce
consumers to buy more of the complements resulting in an increase in the demand for the
good. For example, if the prices of cars fall, consumers will buy more cars and more petrol.
Number of substitutes and complements
An increase in the number of substitutes for a good will lead to a decrease in the demand
for the good and vice versa. For example, if scientists found that beer could be used as a
substitute for milk to feed babies, the demand for milk would decrease. An increase in the
number of complements will lead to an increase in the demand for a good and vice versa.
For example, if more models of digital cameras are introduced onto the market, the demand
for memory cards will increase.
Level of income
When consumers’ income rises, the demand for most goods will increase. These goods are
known as normal goods. There are, however, exceptions to this general rule. When
consumers’ income rises, the demand for some low quality goods will decrease. These
goods are known as inferior goods and are typically low-quality goods.
Distribution of income
If income is redistributed from the rich to the poor, the demand for luxuries, which are
typically consumed by the rich, and the demand for inferior goods, which are typically
consumed by the poor, will decrease. However, the demand for necessities will increase.
Expectations of price changes
If consumers expect the price of a good to rise, they will buy more of the good to avoid
paying a higher price in the future which will lead to an increase in the demand for the good.
For example, if Dell announces that it will increase the prices of its personal computers, the
demand will increase.
Size of the population
An increase in the size of the population will lead to an increase in the demand for some
goods.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 6
Structure of the population
If the population is graying, the demand for pharmaceutical products will increase.
Government policies
The government is the biggest spender in every economy. Hence, if the government
increases spending, the demand for some goods will increase. The government can also
affect private spending by changing interest rates and tax rates in the economy.
Weather conditions
In winter, the demand for coats and sweaters will increase and the demand for ice-cream
will decrease.
3 SUPPLY
3.1 Definition of supply
The supply of a good is the quantity of the good that firms are able and willing to sell,
known as the quantity supplied, at each price over a period of time, ceteris paribus.
3.2 Relationship between price and quantity supplied
When the price of a good falls, the quantity supplied will fall. Conversely, when the price
of a good rises, the quantity supplied will rise. The direct relationship between price and
quantity supplied is the essence of the law of supply.
The law of supply states that there is a direct relationship between price
and quantity supplied.
The law of supply can be explained with the concept of profit maximisation. A rise in the
price of a good will increase the profitability of selling the good. Therefore, firms which
seek to maximise profit will sell more of the good.
The law of supply can also be explained with the concept diminishing marginal returns.
Marginal cost is the additional cost resulting from producing one more unit of a good.
Consider what will happen to marginal cost when production increases. For simplicity,
suppose that a firm employs two factor inputs: capital and labour. Although labour is a
variable factor input, capital is a fixed factor input. As the quantity of capital is fixed in the
short run, the firm can only increase production by employing more labour. However, as
each additional unit of labour will have less capital to work with, the additional output
resulting from employing one more unit of labour will fall. In other words, each additional
unit of labour will add less to total output than the previous additional unit. This
phenomenon is known as diminishing marginal returns. Therefore, to produce each
additional unit of output, more units of labour will be needed which will lead to an increase
in the additional cost resulting from producing one more unit of output. Due to diminishing
marginal returns, firms will only increase the production of a good if the price rises.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 7
3.3 Supply schedule and supply curve
The quantity of a good that firms are able and willing to sell at each price can be shown by
the supply schedule.
Price Quantity supplied
(Firm X)
Quantity supplied
(Firm Y)
Quantity supplied
(Market)
10 4 8 12
5 2 4 6
The first two columns show the supply schedule of firm X and the first and the third
columns show the supply schedule of firm Y. The first and the last columns show the
market supply schedule, which is the summation of the supply schedules of firm X and
firm Y, assuming they are the only two firms in the market.
The supply schedule can be represented graphically by the supply curve. The supply curve
shows the quantity supplied at each price and is upward-sloping due to the law of supply.
The market supply curve is the horizontal summation of the supply curves of all the firms
in the market and hence is also downward-sloping.
Market supply curve
3.4 Movement along the supply curve versus shift in the supply curve.
A change in quantity supplied occurs when quantity supplied changes due to a change in
price and this can be shown by a movement along the supply curve. It is assumed that other
than price, all non-price determinants of supply have remained unchanged (known as
“ceteris paribus” in Latin and “other things being equal” in English).
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 8
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to an increase
in the price (P) from P0 to P1. This is known as an increase in quantity supplied.
A change in supply occurs when quantity supplied changes due to a change in a non-price
determinant of supply. In other words, quantity supplied changes at the same price and this
can be shown by a shift in the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price
(P0) due to a change in a non-price determinant of supply. This is known as an increase in
supply.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 9
3.5 Non-price determinants of supply
Cost of production
A rise in the cost of production will lead to a decrease in supply and vice versa. When the
cost of production rises, firms will increase the price at each quantity to maintain
profitability. In other words, they will reduce the quantity supplied at each price which will
lead to a decrease in supply. The converse is also true. There are several factors that can
lead to a change in the cost of production.
- A fall in factor prices will lead to a fall in the cost of production and vice versa.
- Technological advancements will decrease the cost of production.
- A government subsidy will decrease the cost of production and a government tax will
have the opposite effect.
Expectations of price changes
If firms expect the price of a good to rise, they will hoard some of the output that they
currently produce to sell it at a higher price in the future. Thus, the supply of the good will
fall. The converse is also true.
Government regulation
If the government removes restrictive official barriers to competition, the number of firms
in some industries will increase which will lead to an increase in the supply of the goods in
the industries. The converse is also true.
Profitability of goods in joint supply
Sometimes, when a good is produced, other goods are produced at the same time. The
goods are known as goods in joint supply. An example is the refining of crude oil to
produce petrol. In the process of refining crude oil to produce petrol, other grade fuels such
as diesel and paraffin are also produced. Therefore, if more petrol is produced, the supply
of other grade fuels will also increase. The converse is also true.
Profitability of substitutes in supply
If the substitutes in supply for a good become more profitable to produce, firms may switch
from the good to the substitutes which will lead to a decrease in the supply of the good. For
example, if the demand for carrots increases, some of the farmers who are currently
producing potatoes will switch to the production of carrots which will lead to a decrease in
the supply of potatoes. The converse is also true.
Disasters (natural and man-made)
Natural disasters such as floods, earthquakes and drought can greatly reduce the supply of
agricultural products. Man-made disasters such as wars can kill workers and destroy
factories and machinery and hence reduce the supply of goods.
Weather conditions
When weather conditions become more favourable, the supply of agricultural products will
rise. The converse is also true.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 10
4 EQUILIBRIUM
4.1 Equilibrium price and equilibrium quantity
An equilibrium is a state where there is no tendency to change. The equilibrium of a market
is determined by the market forces of demand and supply.
In the above diagram, given the demand curve (D) and the supply curve (S), the
equilibrium price and the equilibrium quantity are PE and QE. If the price is above PE, such
as P1, the quantity supplied (QS) will be greater than the quantity demanded (QD) and this is
known as a surplus or excess supply (QS – QD). When firms cannot sell all the output that
they produce, their stocks will build up. Therefore, they will lower the price to reduce their
stocks. The lower price will lead to a decrease in the quantity supplied and an increase in
the quantity demanded and this process will continue until the price falls to PE where the
surplus is eliminated.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 11
If the price is below PE, such as P2, the quantity demanded (QD) will be greater than the
quantity supplied (QS) and this is known as a shortage or excess demand (QD – QS). When
firms do not produce enough to sell, they can raise the price without losing sales. Therefore,
they will raise the price to increase their profits. The higher price will lead to an increase in
the quantity supplied and a decrease the quantity demanded and this process will continue
until the price rises to PE where the shortage is eliminated. If the price is equal to PE, the
quantity demanded will be equal to the quantity supplied. There will be neither surplus nor
shortage and hence there will be no incentive for firms to change the price.
4.2 Effects of a change in demand on price and quantity
A change in demand will lead to a shift in the demand curve which will result in a new
equilibrium price and a new equilibrium quantity.
An increase in demand will lead to a rightward shift in the demand curve which will result
in an increase in price and quantity.
In the above diagram, an increase in demand leads to a rightward shift in the demand curve
(D) from D0 to D1. At the initial price (P0), the quantity demanded is greater than the
quantity supplied. The shortage induces firms to increase the price and hence the quantity
supplied which results in a rightward movement along the supply curve. The higher price
also induces consumers to decrease the quantity demanded which results in a leftward
movement along the new demand curve. This process continues until the new equilibrium
price (P1) is reached.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 12
A decrease in demand will lead to a leftward shift in the demand curve which will result in
a decrease in price and quantity.
In the above diagram, a decrease in demand leads to a leftward shift in the demand curve
(D) from D0 to D1. At the initial price (P0), the quantity supplied is greater than the quantity
demanded. The surplus induces firms to decrease the price and hence the quantity supplied
which results in a leftward movement along the supply curve. The lower price also induces
consumers to increase the quantity demanded which results in a rightward movement along
the new demand curve. This process continues until the new equilibrium price (P1) is
reached.
Note: It is important to know that when there is a change in demand, price and quantity will
change in the same direction.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 13
4.3 Effects of a change in supply on price and quantity
A change in supply will lead to a shift in the supply curve which will result in a new
equilibrium price and a new equilibrium quantity.
An increase in supply will lead to a rightward shift in the supply curve which will result in
a decrease in price and an increase in quantity.
In the above diagram, an increase in supply leads to a rightward shift in the supply curve (S)
from S0 to S1. At the initial price (P0), the quantity supplied is greater than the quantity
demanded. The surplus induces firms to decrease the price and hence the quantity supplied
which results in a leftward movement along the new supply curve. The lower price also
induces consumers to increase the quantity demanded which results in a rightward
movement along the demand curve. This process continues until the new equilibrium price
(P1) is reached.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 14
A decrease in supply will lead to a leftward shift in the supply curve which will result in an
increase in price and a decrease in quantity.
In the above diagram, a decrease in supply leads to a leftward shift in the supply curve (S)
from S0 to S1. At the initial price (P0), the quantity demanded is greater than the quantity
supplied. The shortage induces firms to increase the price and hence the quantity supplied
which results in a rightward movement along the new supply curve. The higher price also
induces consumers to decrease the quantity demanded which results in a leftward
movement along the demand curve. This process continues until the new equilibrium price
(P1) is reached.
Note: It is important to know that when there is a change in supply, price and quantity will
change in opposite directions.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 15
4.4 Effects of a change in demand and supply on price and quantity
If demand and supply change simultaneously, the new equilibrium price and the new
equilibrium quantity will be determined by the intersection of the new demand and the new
supply curves.
Suppose that demand and supply increase which lead to a rightward shift in the demand
and the supply curves. In this instance, although quantity will increase, the effect on price
will depend on whether the increase in demand is greater than the increase in supply or vice
versa.
In the above diagram, an increase in demand and supply leads to a rightward shift in the
demand curve (D) and the supply curve (S) from D0 and S0 to D1 and S1. As the increase in
demand is greater than the increase in supply, the price (P) and the quantity (Q) increase
from P0 and Q0 to P1 and Q1.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 16
In the above diagram, an increase in demand and supply leads to a rightward shift in the
demand curve (D) and the supply curve (S) from D0 and S0 to D1 and S1. As the increase in
supply is greater than the increase in demand, although the quantity (Q) increases from Q0
to Q1, the price (P) falls from P0 to P1.
5 SURPLUS
5.1 Consumer surplus
The consumer surplus is the difference between the maximum amount that consumers are
able and willing to pay and the amount that they actually pay.
In the above diagram, consumers are able and willing to pay $10 for the first unit of the
good, $9 for the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that
consumers buy 4 units of the good. When the quantity is 4 units, the price is $7. In this case,
although the maximum amount that consumers are able and willing to pay is $34 ($10 + $9
+ $8 + $7 = area of trapezium), the amount that they actually pay is $28 ($7 x 4 = area of
rectangle). Therefore, the consumer surplus is $6 ($34 - $28 = area trapezium – area of
rectangle) and is represented by the area below the demand curve and above the price.
Written by: Edmund Quek
© 2011 Economics Cafe All rights reserved. Page 17
5.2 Producer surplus
The producer surplus is the difference between the minimum amount that firms are able
and willing to receive and the amount that they actually receive.
In the above diagram, firms are able and willing to receive $4 for the first unit of the good,
$5 for the second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms
produce 4 units of the good. When the quantity is 4 units, the price is $7. In this case,
although the minimum amount that firms are able and willing to receive is $22 ($4 + $5 +
$6 + $7 = area of trapezium), the amount that they actually receive is $28 ($7 x 4 = area of
rectangle). Therefore, the producer surplus is $6 ($28 - $22 = area trapezium – area of
rectangle) and is represented by the area below the price and above the supply curve.