LEARNING OUTCOME 2 & 3

DEMAND AND SUPPLY

DEMANDEFFECTIVE DEMAND

• desire to purchase backed by the ability to pay

DETERMINANTS OF DEMAND: Price Tastes Income Fashion Advertising Availability and price of substitutes Price of compliments Time of year Consumers’ expectations Availability of credit Population Utility yielded

UTILITYUTILITY• the satisfaction which we obtain from goods and services

MARGINAL UTILITY• the satisfaction obtained from the last unit • will diminish with each successive unit consumed - the law of

diminishing marginal utility

TOTAL UTILITY• the satisfaction obtained from all units consumed

CONSUMER OPTIMUM• maximising total utility - the theory of equi-marginal returns:

MU A = MU B = MU C = MU n Price A Price B Price C Price n

THE LAW OF DEMANDMore will be demanded at lower prices and less at higher price.

Reasons for slope of Demand Curve:

• Law of Diminishing Marginal Utility• Substitution Effect• Income Effect

When price rises from P to P1 quantity demanded contracts from Q to Q1.

When price falls from P to P2 quantity demanded extends from Q to Q2

D

Quantity

Price

D

Quantity

Price

P1

P

Q

Q1

P

P2

Q Q2

QUIZWhat is meant by effective demand?

How do we refer to the satisfaction yielded by the last unit consumed?

How can individuals maximise theirtotal satisfaction?

What happens to satisfaction as weconsume more of a commodity?

Name any 4 determinants of demand

Describe the relationship betweenprice and quantity demanded.

What explains this relationship?

What happens on the demand curve when price rises?

What happens on the demand curve when price falls?

Wants backed up by moneyPrice, tastes, availability of substitutes and the price of compliments

Marginal Utility

Marginal utility decreases with eachunit consumed

By equalising the marginal utility: price ratio for all goods consumed

It is an inverse relationship

Law of Diminishing Marginal UtilityThe Substitution EffectThe Income effect

There is a contraction of demand

There is an extension of demand

PRICE ELASTICITY OF DEMAND

E = % change in Quantity Demanded

% change in Price

> 1 is relatively price elastic< 1 is relatively price inelastic= 1 is unit price elasticity

Price

Quantity Demanded

D

Products which are price elastic have a relatively flat demand curve so that in response to even a relatively small price change, quantity demanded changes more than in proportion to price.

Measures the responsiveness of demand to price changes

Products which are price inelastichave a relatively steep demand curve so that even relatively large price changes generate proportionately smaller changes in quantity demanded.

Price

Quantity Demanded

D

PRICE ELASTICITY OF DEMAND

Perfectly Elastic Demand Perfectly Inelastic Demand

Price

Quantity Demanded

D

Price

Quantity Demanded

D

With straight line demand curves elasticity will vary along the length of the curve.

5 4 3 2 1

10 20 30 40 50 60

D

E=% Change in Quantity Demanded % Change in Price

10 x 10010 = 100% 1 x 100 = 20% =

5 5Relatively Elastic

10 x 10040 = 25% 1 x 100 = 50% = 0.5 2Relatively Inelastic

PRICE ELASTICITY OF DEMAND

When using the formula for price elasticity of demand, the sign is assumed to be negative (-).

This is because normal goods follow the law of demand and have anormal, downward sloping demand curve.

If a positive (+) value is obtained this is an exceptional good – one which does not follow the law of demand ie one which has anexceptional demand curve.

An example of this could be the demand for a painting by a particularartist, which only becomes desirable as an investment by a collector, when the price starts to rise.

Products whose quantity demanded increases when price increaseswould give a positive (+) value for price elasticity and have an exceptional demand curve.

QUIZWhat is the price elasticity of demand if the price of Commodity X rises from 80p to 85p and, as a result, the demand falls from 100 per week to 75 per week?

25 x 100100 1 = 25% = 4 ie fairly elastic 5 x 100 6.25%80 1If the demand for commodity Y rises from 1,200 to 1,500 in response

to a price reduction from £2.00 to £1.50, calculate the price elasticity of demand.

300 x 1001200 = 25% = 1 ie unit elasticity 50 x 100 25% 200

INCOME ELASTICITY OF DEMANDMeasures the responsiveness of demand to changes in incomeE = % change in Quantity Demanded

% change in Income

> 1 is relatively income elastic< 1 is relatively income inelastic

= 1 is unit income elasticityProducts for which quantity demanded increases when income increases and vice versa have a positive(+) income elasticity value.These would be normal goods ie goods which follow the law of demandeg steak.Products for which quantity demanded increases when income decreases and vice versa have a negative (-) income elasticity

value. These would be giffen goods ie of inferior quality eg sausages

QUIZCalculate the income elasticity of demand for commodity A if, in response to an increase in income of 5%, quantity demanded increases from 200 per week to 275 per week.

+ 75 x 100 200 1 = + 37.5% =

+ 7.5 + 5% + 5% What is the income elasticity of demand for

commodity B if demand increases from 5,000 to 5,500 units per week when when real income falls by 2.5%. +500 X 100 5,000 1 = + 10% = - 4 -2.5% - 2.5%

What kind of commodity is A?

A normal good eg biscuits

What kind of commodity is B?

A giffen good eg bread

CHANGES IN DEMANDWhen there is a change in a determinant of demand otherthan price then the demand curve shifts .

If tastes change in favourof a commodity then more is demanded at all pricesand the demand curve shiftsforward to the right.

Price

Quantity Demanded

D D1

D

D1

If the price of a substitute fallsthen less of the commodity willbe demanded at all prices and thedemand curve shifts backward tothe left.

Price

Quantity Demanded

D D1 D1 D

QUIZSay what happens to demand in each of the following cases:The demand for a normal good

when its price rises.

The demand for a luxury goodwhen its price falls.

The demand for a giffen goodwhen income rises.

The demand for a good whenthe price of its complement falls.

The demand for a good when the price of a close substitute rises.

The demand for a good which hasrecently been declared bad forhealth.

A contraction in quantity demanded.

An extension in quantity demanded

A backward shift in demandto the left.

A forward shift in demandto the right.

A forward shift in demandto the right.

A backward shift in demandto the left.

SUPPLY the willingness to sell a commodity at a given price

THE LAW OF SUPPLYMore will be supplied at higher prices and less at lower prices.

s

s

Price

Quantity Supplied

There is a direct relationship between price and quantity supplied resulting ina supply curve sloping upwards fromleft to right.A fall in price results

ina contraction of

supply

An increase in price results inan extension of supply

Price

Quantity Supplied

Price

Quantity Supplied

ELASTICITY OF SUPPLY measures the responsiveness of supply to changes in price

E = % change in Quantity Supplied % change in Price

Depends on the ability of suppliers to respond to price changestherefore depends on:

the time it takes to alter production levels availability of stocks availability of factors of production

the ease of entry of new firms into the market

An increase in costs will shift supply to the left.

A decrease in costs willshift supply to the right.

Price

Quantity Supplied

S S1 P rice

Quantity Supplied

S S1

THE PRICE MECHANISMPrices are determined by market forces ie the interaction of supply and demand.

D

D S Price

QuantityDemanded & Supplied

Ep

Eq

The interaction of supply and demand determines the market clearing price ie equilibrium price – the price at which all goods supplied are

demanded. Any price above this will mean excess supply which will force price down.

Any price below this will mean excess demand which will push up price.

Equilibrium price will change with changes in demand and/or supply inResponse to changes in the determinants of demand and supply.

INTERVENTION IN THE MARKET

This happens when there is market failure or the price system is not working properly ie the price is too low or too high for those involvedThe Government may set a maximum price to protect the purchasers.

The Government may set a minimum price to protect the incomes of the suppliers eg the minimum wage in the labour market.

If the maximum price set (Maxp) is below equilibrium price, there will be excess demand which could result in a “black market” for the commodity.

Price

Quantity

S

S D

D

E

MinP

Price

Quantity

S

S D

D

E

MaxP

If the minimum price set (Minp) isabove equilibrium price, there will beexcess supply which, in the labour market, too high a minimum wage would cause unemployment.

TAXES AND SUBSIDIESIntervention in the market can also be by means of government taxes and subsidies.

Indirect taxes eg excise duty are placed on products in order to raise revenue for the government and/or to discourage consumptionof certain commodities such as cigarettes and alcohol.

Taxes have the effect of shifting the

supply curve to the left thereby increasing price.

P

Q

S1 S

S1 S

D

P1 P

Subsidies are given to producers to encourage the production of certain products.

Subsidies have the effect of shifting the supplycurve to the right thereby lowering price.

P

Q

S S1

S S1

D

P P1

CHANGES IN EQUILIBRIUM PRICEEquilibrium price will change whenever there is a change in any of the determinants of demand and/or supply. Any of these changes in determinants (other than price) cause shifts in the demand and/or supply curves, altering the market clearing price.FORWARD SHIFT IN DEMAND INCREASES EQUIL PRICE

P

Q

S D1

D1

D

BACKWARD SHIFT IN DEMAND DECREASES EQUIL PRICE

P

Q

S D

D

D1

FORWARD SHIFT IN SUPPLY DECREASES EQUIL PRICE

P

Q

S D

D

S1 P

BACKWARD SHIFT IN SUPPLYINCREASES EQUIL PRICE

COMBINATION OF SHIFTSINCREASING EQUIL PRICE

COMBINATION OF SHIFTS DECREASING EQUIL PRICE

Q

S D

D

S1

P

D1 D1

P

Q

S D

D

S1 P

Q

S1

D

D

S

P D1 D1

AND FINALLY …… Complements such as CDs and CD players are said to be in joint demand since one is no use without the other.

Close substitutes such as butter and margerine are said to be in competitive demand since they both perform the same function and consumers will choose between them.

Joint supply is where the production of one producteg oil automatically leads to the production of another eg petrol or paint or plastics

Where the total supply of one commodity is fixed because of limited resources, a reduction in the supplyof one necessitates the reduction of another – theseare said to be in competitive supply eg milk and cheese.

QUIZ

Name 2 products in joint demand.

Name 2 products in joint supply.

Give an example of products in competitive demand.

Give an example of competitivesupply.

What factors changes equilibriumprice?

Why might governments intervenein markets?

Give 2 examples of marketintervention.

Changes in any of the determinants of demand and/or supply.

The minimum wage and pricecapping.

To encourage the consumption ofsome products and discourage others.Tennis racquets and tennis balls.

Beef and leather

Gas and electricity

Land for housing and land forrecreation