Chapter 1

DEMAND AND SUPPLY

Markets, Goods, and Prices

1. Goods and services cannot be produced without compensating resources owners for their contribution to the productive efforts.

2. One must pay for what one wants to consume; there is no free lunch.

3. One has to rank his wants and decide the extent of satisfying each of them because income is limited.

4. In the market, we have prices at which consumers may want to buy (demand goods), and prices at which producers could sell (supply them).

5. Markets link between demand and supply of goods, business firms operate as a go-between. Markets keep prices, demand and supply in balance like three balls placed in a bowl. Change in the position of the balls forces the others to change theirs.

Demands for Commodities

• The existence of a want is a necessary but not a sufficient condition that gives rise to market demand for a commodity. Demand for anything cannot independent of price.

• In addition to want, the consumer must have the purchasing power to pay for the commodity and should be willing to do so.

• Demand is not a “one-price-one-quantity” notion. It is a schedule concept which is defined that demand for a commodity is a schedule of quantities the consumers are willing to buy at all possible prices at a given point of time.

• Table 1 presents a market demand schedule giving alternative combinations of price P and quantity Q. It also shows that market demand for a commodity is a horizontal summation of individual schedules such as A, B, and C.

Demand for Commodity XPrice Rp

per Unit PIndividual demand (units) Market demand units

A+B+C Q

A B C

10 - - 20 209 - 10 30 408 - 20 40 607 - 30 50 806 10 30 60 1005 15 35 70 1204 20 40 80 1403 25 45 90 1602 30 50 100 1801 35 55 110 200

The Law of Demand

• The law of demand says: “ other things remaining the same, people purchase more of commodity if its price falls and less if it rises”.

• Thus, a demand curve has a negative slope; Table 1 gives the equation: Q = 220 – 20P; (0 < P < 11).

P Q = f(P)

10 T2 Demand curve

Slope TT1/TT2

1 T T1

0 20 200 Q

Assumptions

• The law of demand focuses only on the relationship between price and quantity demanded. It rests on assumptions that isolate influences other than price that may cause a change in quantity demanded of a commodity even when there is no change in its price; they are:

• That the tastes or preferences of consumers for any good X in the market remain unchanged.

• That the income of any consumers do not change.• That the prices of all goods other than X remain constant.• That the number of consumers in the group buying X does not

change.

Why most Demand Curves have Negative Slope

• Common sense explanation: Price is a barrier to purchase.• Utility and demand:• Income effect:• Substitution effect:

Changes in Demand

• A change in demand means increase or decrease in all Qs, while Ps remain unchanged. The demand curve shifts upwards or downwards.

• Table 2 illustrates the concept of a change in demand

Price per unit P

Change in demand (Q)Decrease in demand Q1

Initial demand Q0

Increase in demand Q2

10 11 20 368 33 60 1086 44 100 1804 55 140 2522 66 180 324

• People purchase more quantity of X than before at the same price. In Table 2 they buy 324 units of it instead of 180 units at price 2. This shown in Figure 2 as the movement from T to T1.

• People continue to purchase the same quantity of X when its price has gone up; they continue to buy the same 180 units of it though the price rises from 2 to 6. The movement from T to T2.

Price P

10 increase in demand

6 T2

2 T T1 D1 D0 D2

0 Quantity Q

Causes• Changes in taste• Changes in income: superior, normal, and inferior good• Change in the prices of related goods: substitution and

complementary goods• Figure 3: even as the height of Px remains the same in the three

blocks A, B, and C, it becomes smaller in B and larger in C relative to Py as Py increases or decreases as shown by its broken portion.

Px = Py Px < Py Px > Py

Px Py Px Py Px Py

A B C

Supply of Commodities• Supply of any commodity X may be defined as a schedule of its

quantities that the sellers are able and willing to sell at each of the possible prices at any point in time.

Price per unit P

Individual Supply (units) Market Supply ( Q-units)R + W + Z

R W Z

10 40 50 70 160

9 35 45 65 145

8 30 40 60 130

7 25 35 55 115

6 20 30 50 100

5 15 25 45 85

4 10 20 40 70

3 5 25 35 55

2 - 10 30 40

1 - 5 20 25

Law of Supply

• The law of supply says: “other things remaining the same, sellers will be willing to supply more of a commodity as its price goes up and less if its price goes down.

• So, there is positive relationship between price P and quantity supplied Q. The supply function for the table can be written as:Q = f(P), Q = 10 + 15P, where P > 0.

P 10 S1

Slope S1T/ST

2 S T 0 10 160 Q

Assumptions

• Other things remain the same means:1. Input prices remain unchanged2. Technology for production remains the same.3. Prices of other commodities do not change.4. Taxes and subsidies remain fixed.5. The number of sellers in the market do not change.6. Expectations of sellers do not become speculative.

Changes in Supply

• Table 4 illustrates us to define a change in supply along the same lines as we defined earlier a change in demand. For example, a decrease in supply of commodity X takes place if:

1. Sellers are willing to sell less than before, price of X remaining the same. This is shown in the figure by the movement from T2 on the original supply curve S0 to T on the S1 curve. The quantity sellers are now willing to supply decreases from 52 to 36 units of X while the price stays at Rp. 6 per unit. Or,

2. Sellers are not willing to sell more than the initial quantity of X even when its price goes up. This is shown in the figure by the movement from T1 to T showing again a movement off the supply curve S0 to S1. In the table, sellers sell the same quantity of X as before, i.e. 36 units, while the price of X rose from Rp 4 to 6.

P S1

10 Decrease in supply S0

8 S2

6 T T2

4

2 T1

0 36 52 Q

Price per unit P

Change in Supply (Q units)

Decrease in supply Q1 Initial Supply Q0 Increase in supply Q2

10 68 84 90

8 52 68 84

6 36 52 68

4 20 36 52

2 4 20 36

Causes

• Change in the prices of inputs• Improvement in technology• Change in prices of other goods• Impact of taxes and subsidies• Change in the number of sellers• Change in price expectations

Market Equilibrium• The market for commodity is in a state of equilibrium when price

equates its demand with supply. Let us put together the price, demand, and supply data for X given earlier in Table 5:

Price per unit P

Quantity demanded Qd

Quantity supplied Qs

Surplus/deficit Qs - Qd

10 20 160 +140

9 40 145 +105

8 60 130 +70

7 80 115 +35

6 100 100 0

5 120 85 -35

4 140 70 -70

3 160 55 -105

2 180 40 -140

1 200 25 -180

• Qd = Qs 220 – 20P = 10 + 15P 35P = 210 P = 6 Q = 100 P S 10 Surplus

8

6 Equilibrium

4

2 Shortage D 0 40 100 180

Q

Demand & Supply: Relative Important• Regarding the relative importance of demand and supply in price

determination, Alfred Marshall thought that demand can change fast, but supply takes time to respond. By using the fishing industry, Marshall illustrated his argument as follows:

1. Very short period (VSP): This period is by definition so short that the supply of fish is limited just to its stock available in the market. The supply of the fish on a day is limited to the overnight catch the fishermen put on the market for sale. Supply being fixed for the day, the price of fish will be completely dominated by change in demand.

2. Short Period (SP): It is defined as the one which would allow increase or decrease in supply within the existing production capacity of the industry without change in the technique of production.

• Long Period (LP): If the increase for fish still persists for several months, more people will enter the industry, more modern ways improved nets. Thus, the long period is long enough to allow fresh entrants into the industry and absorb improvements in technology. Now, the influence of supply will dominate the determination of price and corresponding volume of output of fish in the market. In the long run, price could even be P0.

Price P Svsp

Ssp

P1

SLp

P0

D1

D0

0 Q0 Q1 Q2 Q