demand, supply and price 1

8/8/2019 Demand, Supply and Price 1

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DEMAND

Individuals and Motives

In formulating demand theory, the agents areall assumed to be adult individuals who earn

income,

and They spend this income purchasing various

goods and services.


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In economics, it is generally assumed that

each individual consumer seeks maximum

satisfaction, orutility.

The consumer maximizes utility within thelimits set by his or her available resources.


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The nature of demand

Quantity demanded : The amount of aproduct that consumers wish to purchase.

Quantity actually purchased: Actual

purchase of a commodity.


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Quantity demanded is a desiredquantity.

Quantity demanded is a flow.


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Stocks and Flows

Aflow variable has a time dimension: it is so

much per unit of time.

Astock variable has no time dimension: it isjust so much.


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The determinants of quantity

demanded: the demand function

The quantity of each product demanded byeach individual consumer is influenced byfive main variables:

1. The price of the product

2. The prices of other products

3. The consumers income and wealth 4. The consumers tastes

5. Various individual-specific or

environmental factors


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This can be conveniently summarized in a

demand function:

qdn = D (pn, p1, .,pn-1,Y,S)


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The term qdn stands for the quantity that the

consumer demands of some product, which

we call product n. The term pn stands for the price of this

product.

p1, .,pn-1 is a short hand notation for the

prices of all other products.

Y denotes consumers income.


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There are also some environmental factors

affecting demand patterns, such as

The state of weather and

The time of the year.


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Demand and Price

A basic economic hypothesis is that the lower

the price of a product, the larger the quantity

that will be demanded, other things beingequal.

This negative relationship between the price

of a product and the quantity demanded issometimes referred to as the law of

demand.


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This law might be true.

A major reason for this is that there is usually

more than one product that will satisfy anygiven desire or need.

It can be determined what happens when

income, tastes, population, and the prices ofall other products are held constant and the

price of only one product is varied.


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First, let the price of the product rise.

The product then becomes a more expensiveway of satisfying a want.

Some consumers will stop buying italtogether.


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Others will buy smaller amounts.

Still others may continue to buy the sameamount.

But no rational consumer will buy more of it.


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As many consumers will switch wholly, orpartially, to other products to satisfy the samewant, less will be bought of the product

whose price has risen.

Second, let the price of the product fall.

This makes the product a cheaper method ofsatisfying any given want.


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Consumers will buy more of it and less of

other similar products whose prices have not

fallen.

These other products have become

expensive relative to the product in question.


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The demand schedule and the

demand curve

An individuals demand

Ademand sch

edule is one way of showingthe relationship between quantity demandedand price.

It is a numerical tabulation that shows thequantity that will be demanded at someselected prices.


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The data from the demand schedule of an

individual consumer can be plotted with price

on the vertical axis and quantity on thehorizontal axis.

The smooth curve drawn through these

points is called the demand curve.


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It shows the quantity that a consumer would

like to buy at every possible price.

Its negative slope indicates that the quantity

demanded increases as the price falls.

A single point on thedemandcurve indicates

a single price-quantity relationship.


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The wholedemandcurve shows the

complete relationship between quantity

deman

dedan

dpric

e.

Economists often speak of the conditions of

demand in a particular market as given or as

known.


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When they do so they are referring not just to

the particularquantity that is being demanded

at the moment but to the whole demand

curve.

The whole demand curve remains in one

place so long as all variables other than theprice of the product itself remain unchanged.


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The market demand curve

To explain market behaviour, the total

demand of all consumers has to be known.

To obtain a market demand schedule, the

quantities demanded by each consumer at a

particular price are summed to obtain the

total quantity demanded at that price.


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The process is repeated for each price to

obtain a schedule of total, or market, demand

at all possible prices.

A graph of this schedule is called the market

demandcurve.


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The market demand curve is thus the

horizontal sum of the demand curves ofall

the individuals who buy in the market.

In practice, knowledge of market demand is

usually derived by observing total quantities

of sales directly.


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The derivation of market demand curves by

summing individual curves is a theoretical

operation.

It is done to understand the relation between

curves for individual consumers and market

curves.


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The total quantity demanded depends on the

price of the product being sold,

the prices of all other products,

the incomes of the individuals buying in that

market,

and

on their tastes.


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The market demand curve relates the total

quantity demanded to the products own

price, on the assumption that

all other prices,

total income,

and

all other environmental factors

are held constant.


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Shifts in the demand curve

The demand schedule and the demand curve

are constructed on the assumption ofceteris

paribus (other things held constant).

A demand curve shifts to a new position

in response to a change in any of the

variables that were held constant whenthe original curve was drawn.


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Any change that increases the quantity of a

product that consumers wish to buy at each

price will shift the demand curve to the right.

Any change that decreases the quantity that

consumers wish to buy at each price will shift

the demand curve to the left.


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Changes in other prices

The demand curves have negative slopes

because the lower a products price, the

cheaper it becomes relative to other products

that can satisfy the same needs.

Those other products are called substitutes.


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A product becomes cheaper relative to its

substitutes if its own price falls.

This also happens if the substitutes pricerises.

A rise in the price of a products substituteshifts the demand curve for the product to the

right.

More will be purchased at each price.


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Products that tend to be used jointly with

each other are called complements.

For example:

Cars and petrol

Electric cookers and electricity etc.


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Complements tend to be consumed together.

Hence, a fall in the price of either willincrease the demand for both.

A fall in the price of one product that iscomplementary to a second product will shiftthe second products demand curve to the

right.

More will be purchased at each price.


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Change in total income

If consumers receive more income, they can

be expected to purchase more of most

products even though product prices remain

the same.

A product whose demand increases when

income increases is called a normal good.


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A rise in consumers incomes shifts the

demand curves for normal products to theright.

This indicates that more will be demanded at

each possible price.


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For a few products, called inferior goods, a

rise in consumers income leads them to

reduce their purchases.

This is because, they can switch to a more

expensive, but superior, substitute.


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A rise in income will shift the demand for

inferior goods to the left.

This indicates that less will be demanded at

each price.


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The distribution of income

Suppose total income and all other

determinants of demand are held constant

while the distribution of income changes.

Then the demand for normal goods

will rise for consumers gaining income

and

fall for consumers losing income.


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If both gainers and losers buy a good in

similar proportions, these changes will tend to

cancel out.

However, this will not always be the case.


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When the distribution of income changes,

demands will rise for those goods favoured

by those gaining income

and

fall for those goods favoured by those losing

income.


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Individual characteristics

Changes in the characteristics of theindividuals who make up the market will

cause demand curves to shift.


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Environmental factors

Demand for some products is different at

different times of the year.

Some of this is due to weather.

Other variations may be due to traditionsassociated with annual festivals.


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From the point of view of theory of demand,

these are exogenous forces.

In other words, these are things that lie

outside the theory, affecting demand,

sometimes greatly, but not themselves being

explained by the theory.


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Changes in tastes

If there is a change in tastes in favour of a

product, more will be demanded at each

price.

This will cause the demand curve to shift to

the right.


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In contrast, if there is a change in tastes

away from a product, less will be demanded

at each price.

This will cause the entire demand curve to

shift to the left.


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Quantity

Price

D0 D1D2

SHIFTS IN DEMAND CURVE


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A shift in the demand curve from D0 to D1indicates an increase in demand.

A shift from D0 to D2 indicates a decrease in

demand.


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Movements along demand

curves versus shifts

Shifts of curves are different from movements

along curves.

Demand refers to one whole demand curve.

Change in demand refers to a shiftin the

whole curve, that is, a change in the amount

that will be bought at everyprice.


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An increase in demand means that the

whole demand curve has shifted to the

right .

A decrease in demand means that the

whole demand curve has shifted to the

left.


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Any one point on a demand curve representsa specific amount being bought at a specifiedprice.

It represents, therefore, a particularquantitydemanded.

A movement along a demand curve isreferred to as a change in the quantitydemanded.


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A movement down a demand curve is

called an increase (or a rise) in the

quantity demanded.

A movement up the demand curve is

called a decrease (or a fall) in the quantity

demanded.


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Supply

The suppliers in a market are the firms.

The firms are in business to make the goodsand services that consumers want to buy.


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Firms motives

According to economic theory, firms haveseveral attributes.

First, each firm is assumed to makeconsistent decisions.

Second, firms hire workers and invest capitaland entrepreneurial talent to produce goodsand services that consumers wish to buy.


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Third, firms are assumed to make their

decisions with a single goal in mind: to make

as much profit as possible.

In other words, they are driven by the goal of

profit maximization.


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The nature of supply

The amount of a product that firms are able

and willing to offer for sale is called the

quantity supplied.

Supply is a desired flow: how much firms are

willingto sell per period of time, not how

much they actually sell.


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The determinants of quantity

supplied: the supply function

Three major determinants of the quantity

supplied in a particular market are:

1. The price of the product

2. The prices of inputs to production

3. The state of technology


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This list can be summarized in a supplyfunction:

qs

n = S (pn, F1,.,Fm), where qsn is the quantity supplied of product

n;

pn is the price of that product;

F1,.,Fm represent prices of all inputs intoproduction;

and the state of technology determines theform of the function S.


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Supply and price

It has to be known how quantity supplied

varies with a products own price, all other

things being held constant.

The focus is therefore, only on the ceteris

paribus relation,

qsn = S (pn)


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Ceteris paribus, the quantity of any product

that firms will produce and offer for sale is

positively related to the products own price,

rising when price rises and falling when price

falls.

The basic reason behind this relationship isthe way in which costs behave as output

changes.


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The cost of increasing output by another one

unit tends to be higher the higher is the

existing rate of output.

The firm will not find it profitable to increase

output if it cannot at least cover the additional

costs that are incurred.


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As the price of the product rises, the firm can

cover the rising costs of more and more

additional units of output.

As a result, higher and higher prices are

needed to induce firms to make successive

increases in output.


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The result is a positive association between

market price and the firms output.

The supplyschedule records the quantity all

producers wish to produce and sell at a

number of alternative prices, rather than the

quantities consumers wish to buy.


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The supplycurve relates the quantity of acommodity supplied to the price of thecommodity.

In other words, it shows the quantityproduced and offered for sale at each price.

Its positive slope indicates that quantitysupplied increases as price increases.


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O

SPrice

QuantityA supply curve


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Shifts in the supply curve

A shift in the supply curve means that, at

each price, a different quantity is supplied.

If there is an increase in quantity supplied,

there is a rightward shift in the supply curve.

A decrease in the quantity supplied at each

price causes a leftward shift.


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When there is a change in any of the

variables (other than the products own

price) that affect the amount of a product

that firms are willing to produce and sell,

the whole supply curve for that product

will shift.


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The major possible causes of such shift areas follows:

Prices of inputs

All things that a firm uses to produce itsoutputs are called the firms inputs.

Other things being equal, the higher the priceof any input used to make a product, the lesswill be the profit from making that product.


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Thus, the higher the price of any input used

by a firm, the lower will be the amount thatthe firm will produce and offer for sale at any

given price of the product.

A rise in the price of any input shifts the

supply curve to the left.

This indicates that less will be supplied at any

given price.


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A fall in the price of inputs shifts the supplycurve to the right.


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Technology

At any time, what is produced and how it isproduced depend on the technologies in use.

Over time, knowledge and productiontechnologies change.

The quantities of individual products that canbe supplied also change.


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A technological change that decreases costs will

increase the profits earned at any given price of

the product.

Increased profitability leads to increased

production.

This change shifts the supply curve to the right,

indicating an increased willingness to produce the

product and offer it for sale at each possible price.

M t l l


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Movements along supply

curve versus shifts

Quantity supplied refers to a particular

quantity actually supplied at a particular price

of the product.

Supply refers to the whole relation between

price and quantity supplied.


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Thus, increase ordecrease in supply

refers to shifts in the supply curve.

Change in the quantitysuppliedmeans a

movement from one point on the supply

curve to another point on the same curve.


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The Determination of Price The concept of a market

A market may be defined as an area over

which buyers and sellers negotiate theexchange of some product or related group ofproducts.

Therefore, it must be possible for buyers andsellers to communicate with each other andto make meaningful deals over the wholemarket.

The graphical analysis of


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The graphical analysis of

market

Both the demand and supply curves can be

shown on a single graph.

Let us consider the following diagram.

D i i f h ilib i


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Price

Quantity

E

DS

O

Determination of the equilibrium

price of a commodity


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The equilibrium price corresponds to the

intersection of the demand and supply

curves.

Point E indicates the equilibrium.


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At prices above equilibrium there is excess

supply and downward pressure on price.

At prices below equilibrium there is excess

demand and upward pressure on price.

The pressures on price are represented by

the vertical arrows.


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The amount by which the quantity demanded

exceeds the quantity supplied is called the

excess demand.

It is defined as quantity demanded minus

quantity supplied (qd qs).


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When quantity supplied exceeds the quantity

demanded, there is negative excess demand

(qd qs)


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Changes in price when quantity

demanded does not equal quantity

supplied Whenever there is excess demand,

consumers are unable to buy all they wish tobuy.

Whenever there is excess supply, firms areunable to sell all they wish to sell.

In both cases, some agents will not be able todo what they would like to do.


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There is a key driving force in markets which

may be referred to as the law of price

adjustment.

This law predicts what will happen to the

market price when there is either excess

demand or excess supply.


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When supply exceeds demand, the market

price will fall.

When demand exceeds supply, the market

price will rise.


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If there is excess supply, it means that

producers cannot sell all that they wish to sell

at the current price.

They may then begin to offer to sell at lower

prices, for example, through clearance sales

or discounts.


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If purchasers observe the glut of unsold

output they may begin to offer lower prices.

For either or both of these reasons, the price

in the market will fall.


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If, at the current price, consumers are unable

to buy as much as they would like to buy,they may offer higher prices in an effort to get

more of the available supply for themselves.

Suppliers are unable to produce a greater

quantity of the product in the short run.

But they can ask higher prices for the

quantities that they are producing.


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This law of price adjustment makes

considerable sense and conforms with the

common experiences of how markets work.

Shortages of any product tend to lead to price

rises

while

gluts tend to lead to price falls.


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This means that the market will exhibit

stability.

Whenever the current price is not the one

that equates demand and supply, the law of

price adjustment ensures that the price will

move towards the market-clearing pricerather than away from it.


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Thus, it is not enough that there exists a price

for which demand is equal to supply.

Stability of the market also requires some

mechanism to return the price to the market-

clearing level whenever it is away from that

point.


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The combination of a negatively slopeddemand curve and a positively sloped supply

curve with the law of price adjustment will

guarantee a stable market, so long as any

market in this product exists.


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The equilibrium price

Once supply and demand are equal, there isno tendency for the price to change becausesuppliers are just able to sell all that they

want And demanders are just able to buy all that

they want.

Nobody has any incentive to change theprice.


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The price where the supply and demand

curves intersect, is the price towards which

the actual market price will tend.

It is called the equilibrium price: the price at

which quantity demanded equals quantity

supplied.


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The amount that is bought and sold at theequilibrium price is called the equilibriumquantity.

The term equilibrium means a state ofbalance.

It occurs when desired purchases equaldesired sales and

there are no forces tending to make anythingchange.


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When quantity demanded equals quantity

supplied, we say that the market is in

equilibrium.

When quantity demanded does not equal

quantity supplied, we say that the market is in

disequilibrium.

The predictions of demand


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The predictions of demand

and supply analysis

Aquestion arises how a shift in either

demand or supply curve affects price and

quantity.

The answers to this question constitute the

predictions of supply and demand theory.


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The purpose is to see what happens when an

initial position of equilibrium is upset by some

shift in either the demand or supply curve,

and a new equilibrium position is then

established.


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To discover the effects of the demand andsupply shifts, the method that is used, isknown as comparative statics.

After starting from a position of equilibrium,the change to be studied is introduced.

The new equilibrium position is determinedand compared with the original one.


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The differences between the two positions of

equilibrium must result from the change that

was introduced, for everything else has been

held constant.


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The predictions of supply and demand theory

are:

1. A rise in the demand for a product (a

rightward shift of the demand curve)

causes an increase in both the

equilibrium price and the equilibriumquantity bought and sold.


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2. A fall in the demand for a product (a leftward

shift of the demand curve) causes a decrease in

both the equilibrium price and the equilibrium

quantity bough

t and sold.

3. A rise in the supply of a product (a rightward

shift of the supply curve) causes a decrease in

the equilibrium price and an increase in theequilibrium quantity bought and sold.


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4. A fall in the supply of a product (a

leftward shift of the supply curve) causes

an increase in the equilibrium price and a

decrease in the equilibrium quantity

bought and sold.

References:


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1. Lipsey & Chrystal. Economics, Oxford

University Press.

2. Dominick Salvatore. Managerial

Economics in a GlobalEconomy, McGraw-

Hill, Inc.

demand, supply and price 1

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