demandandsupply

Demand

What is meant by demand?

  • Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a given time period.
  • Each of us has an individual demand for particular goods and services and our demand at each price reflects the value that we place on a product, linked usually to the enjoyment or usefulness that we expect from consuming it. Economists give this a term – utility

Effective demand

Demand is different to desire! Effective demand is when a desire to buy a product is backed up by an ability to pay for it

Latent Demand

Latent demand exists when there is willingness to buy among people for a good or service, but where consumers lack the purchasing power to be able to afford the product.

Derived Demand

The demand for a product X might be connected to the demand for a related product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly linked to the demand for new vehicles and other manufactured products, so that when an economy goes into a recession, so we expect the demand for steel to decline likewise.

Steel is a cyclical industry which means that market demand for steel is affected by changes in the economic cycle and also by fluctuations in the exchange rate.

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The demand for new bricks is derived from the demand for the final output of the construction industry- when there is a need to building more flats in Singapore, so the market demand for bricks will increase

Zinc is a good example of a product with a strong derived demand. It has a wide-range of end uses such as galvanised zinc used in cars and new buildings, die-casting used in door furniture and toys, brass and bronze used in taps and pipes. And also rolled zinc (used in roofing, guttering and batteries) and in chemicals used in making tyres and zinc cream.

The Law of Demand

There is an inverse relationship between the price of a good and demand.

  • As prices fall, we see an expansion of demand.
  • If price rises, there will be a contraction of demand.

Ceteris paribus assumption

Many factors affect demand. When drawing a demand curve, economists assume all factors are held constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable

The Demand Curve

A demand curve shows the relationship between the price of an item and the quantity demanded over a period of time. There are two reasons why more is demanded as price falls:

The Income Effect: There is an income effect when the price of a good falls because the consumer can maintain the same consumption for less expenditure.  Provided that the good is normal, some of the resulting increase in real income is used to buy more of this product.

The Substitution Effect: There is a substitution effect when the price of a good falls because the product is now relatively cheaper than an alternative item and some consumers switch their spending from the alternative good or service.

The Substitution Effect

  • As price falls, a person switches away from rival products towards the product
  • As price falls, a person’s willingness and ability to buy the product increases
  • As price falls, a person’s opportunity cost of purchasing the product falls
  • Note: Many demand curves are drawn as straight lines to make the diagrams easier to interpret.

 Tastes and preferences: A successful social media campaign increased sales of Qoo10 products by >100% in just one week!

 Changes in the Conditions of Demand – Shifts in the demand curve

There are two possibilities: either the demand curve shifts to the right or it shifts to the left.

  • D1 – D3 would be an example of an outward shift of the demand curve (or an increase in demand). When this happens, more is demanded at each price.
  • A movement from D1 – D2 would be termed an inward shift of the demand curve (or decrease in demand). When this happens, less is demanded at each price

 

 Remember – a change in price leads to a movement along the curve not a shift.

The conditions of demand for a product in a market can be summarised as follows:

Changing prices of a substitute good

  • Substitutes are goods in competitive demand and act as replacements for another product
  • For example, a rise in the price of Esso petrol should cause a substitution effect away from Esso towards competing brands such as Shell.

Changing price of a complement

Two complements are in joint demand – e.g. DVD players and DVDs, iron ore and steel.

  • A rise in the price of a complement to Good X should cause a fall in demand for X. For example an increase in the cost of bread would cause a decrease in the demand for butter.
  • A fall in the price of a complement to Good Y should cause an increase in demand for Good Y. For example a reduction in the price of the new iPhone should lead to an expansion in demand for the iPhone and a complementary increase in demand for download applications.

Changes in the income of consumers

  • Most of the things we buy are normal goods. When income goes up, our ability to purchase goods and services increases, and this causes an outward shift in the demand curve. But when incomes fall there will be a decrease in the demand, except for inferior goods
  • Discretionary income is disposable income less essential payments like electricity & gas and mortgage repayments. An increase in interest rates often means an increase in monthly mortgage payments reducing demand. In recent years we have seen a sharp rise in the cost of utility bills with a series of hikes in the prices of gas and electricity. This has eaten into the discretionary incomes of millions of households across Singaporeans.

The effects of advertising and marketing: Heavy spending on advertising and marketing can help to bring about changes in consumer tastes and fashions.

Interest rates and demand

  • Many products are bought on credit using borrowed money, thus the demand for them may be sensitive to the rate of interest charged by the lender. Therefore if the Federal Reserves decides to alter interest rates – the demand for many goods and services may change.
  • Examples of “interest sensitive” products include cars and especially the demand for housing which is affected by changes in mortgage interest rates.

Supply

Definition of Supply

Supply is defined as the quantity of a product that a producer is willing and able to supply onto the market at a given price in a given time period.

Note: Throughout this study companion, the terms firm, business, producer and seller have the same meaning.

The basic law of supply is that as the price of a commodity rises, so producers expand their supply onto the market. A supply curve shows a relationship between price and quantity a firm is willing and able to sell.

The basic law of supply is that as the price of a commodity rises, so producers expand their supply onto the market. A supply curve shows a relationship between price and quantity a firm is willing and able to sell.

A supply curve is drawn assuming ceteris paribus – ie that all factors influencing supply are being held constant except price. If the price of the good varies, we move along a supply curve. In the diagram above, as the price rises from P1 to P2 there is an expansion of supply. If the market price falls from P1 to P3 there would be a contraction of supply in the market. Businesses are responding to price signalswhen making their output decisions.

Explaining the Law of Supply

There are three main reasons why supply curves for most products are drawn as sloping upwards from left to right giving a positive relationship between the market price and quantity supplied:

  1. The profit motive: When the market price rises (for example after an increase in consumer demand), it becomes more profitable for businesses to increase their output. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market.
  2. Production and costs: When output expands, a firm’s production costs rise, therefore a higher price is needed to justify the extra output and cover these extra costs of production.
  3. New entrants coming into the market: Higher prices may create an incentive for other businesses to enter the market leading to an increase in supply.

Shifts in the Supply Curve

The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is an increase in supply; more is provided for sale at each price. If the supply curve moves inwards from S1 to S3, there is a decrease in supply meaning that less will be supplied at each price.

The supply curve can shift position. If the supply curve shifts to the right (from S1 to S2) this is an increase in supply; more is provided for sale at each price. If the supply curve moves inwards from S1 to S3, there is a decrease in supply meaning that less will be supplied at each price.

Changes in the costs of production

Lower costs of production mean that a business can supply more at each price.  For example a magazine publishing company might see a reduction in the cost of its imported paper and inks. A car manufacturer might benefit from a stronger exchange rate because the cost of components and new technology bought from overseas becomes lower. These cost savings can then be passed through the supply chain to wholesalers and retailers and may result in lower market prices for consumers.

Conversely, if the costs of production increase, for example following a rise in the price of raw materials or a firm having to pay higher wages to its workers, then businesses cannot supply as much at the same price and this will cause an inward shift of the supply curve.

fall in the exchange rate causes an increase in the prices of imported components and raw materials and will (other factors remaining constant) lead to a decrease in supply in a number of different markets and industries. For example if the Sing Dollar falls by 10% against the USD, then it becomes more expensive for travelling to USA or importing products from USA.

Changes in production technology

Production technologies can change quickly and in industries where technological change is rapid we see increases in supply and lower prices for the consumer.

Government taxes and subsidies

Government taxes and subsidies

Government taxes and subsidies

Changes in climate

For commodities such as coffee, oranges and wheat, the effect of climatic conditions can exert a great influence on market supply. Favourable weather will produce a bumper harvest and will increase supply. Unfavourable weather conditions will lead to a poorer harvest, lower yields and therefore a decrease in supply.

Changes in climate can therefore have an effect on prices for agricultural goods such as coffee, tea and cocoa. Because these commodities are often used as ingredients in the production of other products, a change in the supply of one can affect the supply and price of another product. Higher coffee prices for example can lead to an increase in the price of coffee-flavoured cakes. And higher banana prices as we see in the article below, will feed through to increased prices for banana smoothies in shops and cafes.

Change in the prices of a substitute in production

substitute in production is a product that could have been produced using the same resources.  Take the example of barley. An increase in the price of wheat makes wheat growing more financially attractive. The profit motive may cause farmers to grow more wheat rather than barley.

The number of producers in the market and their objectives

The number of sellers (businesses) in an industry affects market supply. When new businesses enter a market, supply increases causing downward pressure on price.

Competitive Supply

Goods and services in competitive supply are alternative products that a business could make with its factor resources of land, labour and capital.  For example a farmer can plant potatoes or maize.

Market Equilibrium

What do we mean by the concept of a market equilibrium?

Equilibrium means a state of equality or balance between market demand and supply

Without a shift in demand and/or supply there will be no change in price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At price P3, supply exceeds demand and at P2, demand exceeds supply.

Prices where demand and supply are out of balance are termed points of disequilibrium.

Changes in the conditions of demand or supply will cause changes in the equilibrium price and quantity in the market.

Diagrams to show Changes in Market Demand and Equilibrium Price

  • The outward shift in the demand curve causes an expansion along the supply curve and a rise in theequilibrium price and quantity.  Firms in the market will sell more at a higher price and therefore receive more total revenue
  • The reverse effects will occur when there is an inward shift of demand
  • A shift in the demand curve does not cause a shift in the supply curve!
  • Demand and supply factors are usually assumed to be independent of each other although some economists claim this assumption is no longer valid!
  • Equilibrium price represents a trade-off for buyer and seller – higher prices are good for the producer (higher revenues and profits) but they make the product more expensive for the buyer

Changes in Market Supply and Equilibrium Price

Important note for the exams:

A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down) the demand curve to the new equilibrium position.

To really understand this topic it is essential for you to understand the difference between shifts and movements along demand and supply curves

The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:

In the left-hand diagram above, we see an inward shift of supply together with a fall in demand. Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price.

The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market from Q1 to Q3.

Moving from one market equilibrium to another

  • Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams before are reflective of changes in conditions in the market.
  • So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks.
  • The higher price is an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point.

Diagrams are a simplification of reality!

  • We tend to use supply and demand diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis
  • The reality in most markets and industries is more complex. For a start, many businesses have imperfect knowledge about their demand curves – they do not know precisely how consumer demand reacts to changes in price or the true level of demand at each and every price
  • Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be readily available.

Regulated prices

Not all prices are set by the free-market forces of supply and demand. In Britain, a number of prices are affected by industry regulators – good examples are rail fares, the cost of postage stamps and water bills.

In the rail market, some of the fares are unregulated allowing train operating companies to set their own prices. But around half of the fares charged for UK rail travellers are determined by the rail regulator

You can see from the chart below that average rail fares in the UK have grown faster than the overall consumer price index. The result is that the real cost or price of travel has increased over recent years.

Rising cost of UK rail fares

A Summary of Changes in Market Equilibrium Price

Here is a summary when there is a unique change in one of the conditions of market demand or supply

Shift

Equilibrium Price

Equilibrium Quantity

Demand increases

Higher

Higher

Demand decreases

Lower

Lower

Supply increases

Lower

Higher

Supply decreases

Higher

Lower

The possible outcomes for price and quantity are less certain when there is more than one change in demand and supply conditions

Demand

Supply

Equilibrium Price

Equilibrium Quantity

+

+

?

+

+

0

+

+

+

+

?

0

+

+

0

0

0

0

0

+

+

+

0

?

  • (+) signifies increase in demand / supply
  • signifies no change in conditions of demand / supply
  • (-) signifies a fall in demand / supply

The outcome for market price is often uncertain because it depends on the size of the relative changes in supply and demand in a given time period.

For example:

  • A 20% rise in demand and a 8% rise in supply will cause prices to rise
  • A 10% rise in demand and a 30% rise in supply will cause prices to fall
  • A 25% rise in demand and a 25% rise in supply will cause prices to remain constant

Price Mechanism

Adam Smith, one of the Founding Fathers of economics described the “invisible hand of the price mechanism” in which the hidden-hand of the market operating in a competitive market through the pursuit of self-interest allocated resources in society’s best interest.

This remains a view held by free-market economists who believe in the virtues of an economy with minimalgovernment intervention.

The price mechanism describes the means by which millions of decisions taken by consumers and businesses interact to determine the allocation of scarce resources between competing uses

The price mechanism plays three important functions in a market:

1/ Signalling function

  • Prices perform a signalling function – they adjust to demonstrate where resources are required, and where they are not
  • Prices rise and fall to reflect scarcities and surpluses
  • If prices are rising because of high demand from consumers, this is a signal to suppliers to expand production to meet the higher demand
  • If there is excess supply in the market the price mechanism will help to eliminate a surplus of a good by allowing the market price to fall.

price mechanism

In the example on the right, an increase in market supply causes a fall in the relative prices of digital cameras and prompts an expansion along the market demand curve

2/ Transmission of preferences

  • Through their choices consumers send information to producers about the changing nature of needs and wants
  • Higher prices act as an incentive to raise output because the supplier stands to make a better profit.
  • When demand is weaker in a recession then supply contracts as producers cut back on output.

One of the features of a market economy system is that decision-making is decentralised i.e. there is no single body responsible for deciding what is to be produced and in what quantities. This is a remarkable feature of an organic market system.

3/ Rationing function

  • Prices serve to ration scarce resources when demand in a market outstrips supply.
  • When there is a shortage, the price is bid up – leaving only those with the willingness and ability to pay to purchase the product. Be it the demand for tickets among England supporters for an Ashes cricket series or the demand for a rare antique, the market price acts a rationing device to equate demand with supply.
  • The popularity of auctions as a means of allocating resources is worth considering as a means of allocating resources and clearing a market.

Mixed and Command Economies and Prices

  • Most economies are mixed economies, comprising not only a market sector, but also a non-market sector, where the government (or state) uses planning to provide public goods and services such as police, roads and merit goods such as education, libraries and health.
  • In a command economy, planning directs resources to where the state thinks there is greatest need. Following the collapse of communism in the late 1980s and early 1990s, the market-based economy is now the dominant system in most countries – even though we are increasingly aware of many imperfections in the operation of the market.

Prices and incentives

  • Incentives matter! For competitive markets to work efficiently all ‘economic agents’ (i.e. consumers and producers) must respond to appropriate price signals in the market.
  • Market failure occurs when the signalling and incentive functions of the price mechanism fail to operate optimally leading to a loss of economic and social welfare. For example, the market may fail to take into account the external costs and benefits arising from production and consumption.  Consumer preferences for goods and services may be based on imperfect information on the costs and benefits of a particular decision to buy and consume a product.

Secondary markets

  • Secondary markets occur when buyers and sellers are prepared to use a second market to re-sell items that have already been purchased.
  • Perhaps the best example is the secondary market in tickets for concerts and sporting-events.

Do ticket touts provide a valuable service to a market? Or should they be banned by law?

Government intervention in the market mechanism

  • Often the incentives that consumers and producers have can be changed by government intervention in markets
  • For example a change in relative prices brought about by the introduction of government subsidies and taxation.

Government subsidies and taxation

Agents may not always respond to incentives in the manner in which textbook economics suggests.


Consumer surplus

When there is a difference between the price that you pay in the market and the value that you place on the product, then the concept of consumer surplus becomes a useful one to look at.

  • Consumer surplus is a measure of the welfare that people gain from consuming goods and services
  • Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually do pay (i.e. the market price).
  • Consumer surplus is shown by the area under the demand curve and above the equilibrium price as in the diagram below.

Consumer surplus

Consumer surplus and price elasticity of demand

  1. When the demand for a good or service is perfectly elastic, consumer surplus is zero because the price that people pay matches what they are willing to pay.
  1. In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand does not respond to a price change. Whatever the price, the quantity demanded remains the same. Are there any examples of products that have such zero price elasticity of demand?
  1. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential consumer surplus because there are some buyers willing to pay a high price to continue consuming the product. This is shown in the next diagram.

Consumer surplus

Changes in demand and consumer surplus

 

  • When there is a shift in the demand curve leading to a change in the equilibrium market price and quantity, then the level of consumer surplus will change too
  • In the left hand diagram, following an increase in demand from D1 to D2, the equilibrium market price rises to from P1 to P2 and the quantity traded expands. There is a higher level of consumer surplus because more is being bought at a higher price than before.
  • In the diagram on the right we see the effects of a cost reducing innovation which causes an outward shift of market supply, a lower price and an increase in the quantity traded in the market. As a result, there is an increase in consumer welfare shown by a rise in consumer surplus.

Consumer surplus can be used frequently when analysing the impact of government intervention in any market – for example the effects of indirect taxation on cigarettes consumers or the introducing of road pricing schemes such as the London congestion charge or a rise in air passenger duty.

Producer surplus

 

Producer surplus

Producer surplus is a measure of producer welfare

It is measured as the difference between what producers are willing and able to supply a good for and the price they actually receive

The level of producer surplus is shown by the area above the supply curve and below the market price and is illustrated in the diagram below

Pm is the minimum price that this producer requires to supply the product to the market

As the price rises, there is a great incentive to supply – production will expand as a business moves up their supply curve

Assuming the the market has reached an equilibrium at quantity Q1 and price P1, then the level of producer surplus is shown by the shaded/labelled area.

Total revenue = price per unit x quantity sold = P1 x Q1

Producer surplus

Producer surplus and changes in demand and supply

We first consider the effects of a change in market supply – for example caused by an improvement in production technology or a fall in the cost of raw materials and components used in the production of a good or service

Producer surplus

We now consider the effects on producer surplus of a rise in market demand

Producer surplus