TOPIC 2 :DEMAND, SUPPLY AND PRICE: THE THEORY

DEMAND The buying side is usually referred to as the demand side. The selling side is usually referred to as the supply side. We start with a discussion of demand. Demand means the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific time period. Example: We can express part of John's demand for magazine by saying that he is willing and able to buy ! magazines a month at "#$ per magazine. Quantity demanded is the number of units of a good that indi%iduals are willing and able to buy at a particular price during some time period. E.g. suppose indi%iduals are willing and able to buy && no%els per wee' at the price of "#( per unit. Therefore) && units is the quantity demanded of no%els at "#(. The law of demand *tates that as the price of a good rises) the quantity demanded of the good falls and as the price of a good falls) the quantity demanded of the good rises) ceteris paribus. The higher the price) the smaller the quantity demanded The lower the price) the larger the quantity demanded What explains the law of demand: o Substitution Effect When a +rice of a good increases) its relati%e price ma'es consumers less willing to purchase this good. o Income Effect "eal income is person,s income measured in terms of the goods and ser%ices it can buy purchasing power When the price of a good increases real income declines reduces the ability to buy a good decline in quantity demanded Why quantity demanded goes down as price goes up? The law of demand states that price and quantity demanded are in%ersely related. -ne ma.or reason is that people substitute lower/priced goods for higher/priced goods. When +rice increases) the quantity demanded decreases Eg.0f the absolute price of orange .uice rises and the price of grapefruit .uice remain constant) this will lead to a decrease in the quantity demanded of orange .uice because some people will substitute grapefruit .uice for orange .uice due to relati%ely lower/priced of grapefruit .uice.

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2 demand schedule is the numerical tabulation of the quantity demanded of a good at different prices. 2 downward sloping demand cur%e is the graphical representation of the in%erse relationship between price and quantity demanded specified by the law of demand. Example 1: +rice 3"#4 ( $ 7 5uantity 6emanded & 7& $& (&
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2 change in demand %ersus change in quantity demanded A change (increase or decrease in demand refers to a shift in the demand cur%e. :or example if income increase the demand for apple will increase) the demand cur%e for apple will shift rightward. A change in quantity demanded refers to a mo%ement along a demand cur%e. The only factor that can directly cause a change in the quantity demanded of a good is a change in the price of the good/that is) its own price. 9hanges in 6emand) *hifts in demand cur%es The demand for a good can increase or decrease. The demand for a good increases if people are willing and able to buy more of the good at all prices. The demand for a good decreases if people are willing and able to buy less of the good at all prices.

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"ightward shift in demand cur%e 3increase in demand4 The !ar"et Demand #ur$e

;eftward shift in demand cur%e 3decrease in demand4

2n indi%idual demand cur%e represents the price/quantity combinations for a single buyer. :or example) a demand cur%e could show Jone's demand for 96s. 2 mar'et demand cur%e represents the price quantity combinations for all buyers of a particular good. 0n this case) the demand cur%e would show all buyers' demand for 96s. +rice 3"#4 ! ( $ 7 & Jones 7 $ ( ! < *mith 7 $ ( ! < = -ther buyers 7& (! =& && $& <& 2ll buyers 7$ !& == &> ( =$

Determinants of Demand . 7. $. (. !. <. =. @. +rice of the good itself +rice of related good 0ncome +reference ?umber of buyers Expectation of future price 2d%ertising Weather

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What :actors cause the demand cur%e to shiftA Income 2s a person's income rises) he or she can buy more at any particular goo at a gi%en price 3say blue .eans4. 8ut the ability to buy more blue .eans does not necessarily imply the willingness to do so. 0f the demand for blue .eans rises as income rises) then blue .eans are called a normal goo . The demand for a normal good rises as income rises and falls as income falls. The demand for a normal good and income are directly related. *uppose a person's income increases and she buys fewer blue .eans. This time blue .eans are an !n"er!or goo . The demand for an inferior good falls as income rises and rises as income falls. The demand for an inferior good and income are in%ersely related. ?ormal good: demand increases when income increases and decreases when income decreases. 0nferior good: a good for which the demand decreases when income increases

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%reference +eople's preferences affect the amount of a good they are willing to buy at a particular price. 2 change in preferences in fa%or of a good shifts the demand cur%e rightward. 2 change in preferences away from the good shifts the demand cur%e leftward. %rices of related goods# There are two types of goods) substitutes and complements.

Two good are substitutes if they satisfy similar needs or desires. 9oca/cola and +epsi/cola are substitutes. The price of one and the demand for the other are directly related. 2s the price of 9oca/cola rises) the demand for +epsi/cola increases. Two goods are complements if they consumed .ointly. Tennis rac'ets and tennis balls are complements. The price of one and the demand for the other are in%ersely related. 2s the price of tennis rac'ets rises) the demand for tennis balls decreases. &umber of buyers The demand for a good in a particular mar'et area is related to the number of buyers in the area. The more buyers) the higher the demand B the fewer buyers) the lower the demand. E'pectations of future price 8uyers who expect the price of a good to be higher next month may buy the good now/thus increasing the current demand for the good. 8uyers who expect the price of a good to be lower next month may wait until next month to buy the good/thus decreasing the current demand for the good. %opulation 6emand also depends on the size and the age structure of the population. -ther remaining the same) the larger 3smaller4 the population) the larger 3smaller4 is the demand for all goods. (d$ertising 2n increase in a firm's effecti%e ad%ertising will cause an increase in demand for the product being ad%ertised.
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Weather *ome goods are demanded seasonally and at certain times of the year demand for these goods will increase. :or example) there is a greater demand for ice/cream in the summer than in the winter. Ex$ep%!onal Deman C&r'e( 0n some cases) the demand sometimes might %ary directly with price 3unusual demand cur%es) more quantity will be demanded at a higher price4. a) The reason for this include: *iffen+s %arado'

The English economist Ciffen is credited with the idea that in subsistence economies) if the price of basic foodstuffs such as bread) rice) corn) and potatoes increases) quantity demanded will also increase. The reason is that as price rises) the higher price ma'es it impossible for consumers to purchase better quality foodstuffs. They therefore substitute the poorer quality foodstuffs despite the fact that the price of these has increased. There is no empirical e%idence to support this hypothesis. a) ,eblen *oods

0t is argued that the attracti%eness of some goods increases as their price increase. *ome people buy expensi%e things because they are expensi%eB the ownership of such goods puts them in a rather exclusi%e class. When goods are purchased for ostentatious purposes and as their price rises so does their attracti%eness because they pro%ide a means of displaying superior wealth. 2 fall in price might cause them to lose some of their appeal and the quantities demanded might fall because they will not be so effecti%e as a means of displaying wealth. 2lternati%ely it is possible to argue that if consumers belie%e that the price of a goods reflects its quality then quantity demanded might increase as price increases. 9onsumer ignorance might pro%ide an explanation for exceptional demand cur%es. b) -esti$e Seasons

6emand for certain goods still increase despite the increase in price. This beha%iour caused by the festi%e spirit or for religious purposes. c) #risis Situation

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 6uring crisis1emergency situation price of certain goods 3 especially basic necessities li'e rice) sugar) oil4 will increase but the demand for certain goods will also increase. . Speculation/E'pected -uture %rice

*peculator will increase their demand if they speculate that the price of goods will increase further. This is to a%oid they ha%e to pay more in future for that goods or they want to ma'e more profit. SUPPLY Supply means the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period. "efers to the relation between the + and the quantity supplied as reflected by the supply schedule or the supply cur%e. Quantity supplied is the numbers of units of good sellers are willing and able to produce and offer to sell at a particular price. +articular point on ** cur%e The 0aw of supply *tates that as the price of a good rises) the quantity supplied of the good rises) and as the price of a good falls) the quantity supplied of the good falls. Two reasons producers tend to offer more for sale when the + rises: o :irst) as the price increases) other things constant) a producer becomes more willing to supply the good. +rices act as signals to existing and potential suppliers about the rewards for producing %arious goods D higher prices attract resources from lower/%alued uses. o *econd) higher price also increase the producer,s ability to supply the goods. *ince producers face higher marginal cost of production) they must recei%e a higher price for that output in order to be able to increase the quantity supplied. *upply schedule is the numerical tabulation of the quantity supplied of a good at different prices. *upply cur%e is the graphical representation of the law of supply. Example:

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The #ar'et *upply 9ur%e 2n indi%idual supply cur%e represents the price/quantity combinations for a single seller. The mar'et supply cur%e represents the price/quantity combinations for all sellers of a particular good. *upply schedule is the numerical tabulation of the quantity supplied of a good at different prices. 6eterminants of *upply . 7. $. (. !. <. =. @. +rice of the good itself +rice of related good +rice of rele%ant resources Technology ?umber of sellers Expectation of future price Taxes and subsidies Co%ernment restrictions

( change in supply $ersus a change in quantity supplied 2 change in supply refers to a shift in the supply cur%e. 2 change in quantity supplied refers to a mo%ement along a supply cur%e.

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What factors cause the supply cur$e to shift? 1 %rices of rele$ant resources

"esources are needed to produce goods. :or example. Wood is needed to produce doors. 0f the price of wood falls) it become less costly to produce doors) and the supply of doors increases . Technology

Technology is defined as the body of s'ills and 'nowledge of rele%ant to the use of inputs or resources in production. 0f there is an ad%ance in technology) the quantity supplied of a good at each price increases. This is because the lower costs increase profitability and therefore pro%ide producers with an incenti%e to produce more. 2 &umber of sellers

0f more sellers begin producing a particular good) perhaps because of high profits) the supply cur%e shifts rightward. 3 E'pectations of -uture %rice

0f the price of a good is expected to be higher in the future) producers may hold bac' some of the product today. Then) they will ha%e more to sell at the higher future price. Therefore the current supply cur%e shifts leftward. 4 Ta'es and subsidies *ome taxes increase per/unit costs. *uppose a manufacture has to pat tax of "#7 per good) the manufacturer would sell fewer goods at each price. *ubsidies ha%e the opposite effect. 0f the go%ernment subsidize the production of one good) the quantity supplied of the good would be greater at each price. 5 *o$ernment 6estrictions *ometimes go%ernment acts to reduce supply. 9onsider E.* import quota on Japanese tele%ision sets. 2n import quota) or quantitati%e restriction on foreign goods reduces the supply of Japanese tele%ision sets.

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0ncrease in supply

6ecrease in supply

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SUPPLY AND DEMAND TO)ETHER +rice is determined by the interaction of demand and supply . EQ7I0I86I7! Equilibrium is a situation in which supply and demand has been brought into balance. The point where the supply cur%e and demand cur%e intersect is called the mar*e%+( e,&!l!-r!&m# The price is called the equilibrium price and the quantity is called the equilibrium quantity. Equilibrium price is the relati%e price at which the quantity demanded equals the quantity supplied . Equilibrium quantity is the amount bought and sold at the equilibrium price . ( situation whereby quantity supplied is greater than quantity demanded) 0f the price is abo$e equilibrium 3quantity supplied exceeds quantity demanded4 surplus will occur # *uppliers will be obliged to lower prices in order to clear their stoc's . 2s price falls) producers will cut bac' production and consumers will purchase more until surplus disappear . 0f the price is below equilibrium 3quantity demanded exceeds quantity supplied4 a shortage will result . This shortage will cause buyers to bid up the price . 2n increase in price will both persuade firms to expand output and discourage consumption until the new equilibrium is established . #hanges in Equilibrium Equilibrium can only change if there is a change in one of demand or supply conditions or both. There are three steps to analyze how some e%ents affecting the mar'et: . 6ecide whether the e%ent shifts the supply or demand cur%e 3or perhaps both4 7. 6ecide which direction the cur%e shifts $. Ese the supply and demand diagram to see how the shifts changes the equilibrium. ( #hange in Demand with supply held constant . 2n increase in demand will rise the price and increase the quantity traded . 7. 2 decrease in demand will lower the price and reduce the quantity traded .

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0ncrease in demand ( #hange in Supply with demand held constant

6ecrease in demand

. 2n increase in supply will lower the price and increase the quantity . 7. 2 decrease in supply will increase the price and reduce the quantity .

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0ncrease in supply Changes in both Demand and Supply

6ecrease in supply

0f demand and supply change in the same direction ) it is possible to 'now the changes in quantity ) but the effect on price is uncertain . eg if the price of a complement falls) and also the firm,s technology ad%ances) the demand and supply cur%es both shift rightward. 2s a result) the quantity increases) but the price may rise 3if the demand shift is larger4 fall 3if the supply shift is larger4 stay the same 3if the shifts are of equal size4

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0f supply and demand change in opposite directions ) we can always determine the effect on price but the impact on the quantity is ambiguous. :or example) if the price of a substitute falls 3so that the demand cur%e shifts leftward4 while simultaneously technology ad%ances 3which causes the supply cur%e shifts rightward4) the price will definitely fall but the quantity may increase 3if the supply shift is larger4 decrease 3if the demand shift is larger4 not change 3if the shifts are of equal size4

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