interaction of demand and supply

demand

defined as the quantity of good that consumers are willing and able to purchase in a given time period at every price level, ceteris paribus

law of demand

states that there is an inverse relationship between price and quantity demanded, ceteris paribus

law of diminishing marginal utility

• states that beyond a certain point of consumption, as more and more units of a good or service are consumed, the additional utility a consumer derives from successive units decrease

diminishing marginal utility ⇒ why the demand curve is downward sloping

• when making consumption decisions, consumers consider the utility they derive from consuming the good or service

• increase in utility from the consumption of each additional unit of good or service (marginal utility) is less that that from the consumption of the previous unit, even though the total utility of consumption increases

• marginal utility curve slopes downwards ⇒ marginal utility gained from each successive unit falls

• the maximum price any consumer would be willing to pay for a unit of good is the marginal utility he/she would derive from it → reflected in the marginal utility curve [maximum that a consumer is willing to pay for each unit of the good]

rational decision making by consumers: deriving the individual demand curve from the marginal utility curve

• for any given price, the quantity that the consumer will consume (individual demand curve) can be derived from the marginal curve ⇒ demand curve reflects the maximum that a consumer is willing to pay for each unit of the good

• the consumer will consume up to the point where his/her marginal utility = marginal cost ⇒ utility is maximised

market demand curve

• downward-sloping

• it is the horizontal summation of all the individual buyer’s demand curves for the good at each and every price

• the more people there are, the greater the demand for a good or service in a country

movement along the demand curve

• change in the own price of the good will result in a change in its quantity demanded, ceteris paribus

  • decrease in price of good → increase in quantity demanded → downward movement along the demand curve

  • increase in price of good → decrease in quantity demanded → upward movement along the demand curve

shifts of the demand curve

• change in factors other than the own price of the good (non-price determinants) will result in the change in demand of the good

  • when demand increases, the demand curve shifts rightwards

  • when demand decreases, the demand curve shifts leftwards

tastes and preferences → affect willingness to buy certain goods

• a favourable change in taste or preference towards a good increases the demand for that good

• influenced by reasons: advertising, changes in product quality and/or fashion trends

• increased advertising, improvement in product quality, or a product currently in fashion will likely influence tastes and preferences favourably, causing the demand for the good to increase, ceteris paribus

• weather conditions can also cause demand to change in favour of a good, e.g. increase in demand for ice cream during summer

level of income

• due to economic growth, people’s incomes rise, their purchasing power increases and their demand for most goods will rise, ceteris paribus

  • for normal goods (necessities and luxury good), the demand will increase as incomes increase

  • for inferior good, the demand will decrease as incomes increase ⇒ as people are richer, they spend less and reduce their demand for inferior goods, and switch to better quality goods

definition of goods

• normal good: a good whose demand rise as people’s incomes rise, ceteris paribus

• necessities: a good whose demand increases less than proportionately for a given increase in people’s incomes, ceteris paribus

• luxury goods: a good whose demand increases more than proportionately for a given increase in people’s incomes, ceteris paribus

• inferior good: a good whose demand falls as people’s incomes rise, ceteris paribus

price of related goods → demand

• price of substitute goods

  • when goods are substitutes to each other, an increase in the price of one good will increase the demand for the other, ceteris paribus

• price of complementary goods

  • when goods are complements to each other, an increase in the price of one good will lower the demand for the other, ceteris paribus

• [factor of production] demand for its final good or service - derived demand

  • it is the demand for goods which are not demanded for its own sake but is used to facilitate the production of another

  • a change in demand for a good will affect the derived demand for its factor of production

definition of substitutes and complements

• substitutes: goods which are considered to be alternatives to each other, and are in competitive demand

• complements: goods that when consumed together, gives rise to a higher combined utility than if the goods were consumed individually by the same consumer, and are in joint demand

ease of acquiring credit

• easier credit conditions would encourage borrowing for consumption ⇒ demand for goods and services to increase, ceteris paribus

  • e.g.: lower interest rates which result in lower cost of borrowing, relaxation of financing rules

  • e.g. of more difficult credit conditions: higher interest rates, increase in investment payments

government policies

can affect the demand for goods and services

population

1. population size → increase in the size of population causes the demand for all goods and services to increase (assuming average income available for every person remains unchanged)

2. population structure → changes in population structure can affect demand patterns

   • e.g.: in an ageing population, demand for goods consumed by elderly increases while the demand for goods consumed by youths decreases, ceteris paribus

expectation of future prices

• if price of a good is expected to increase in the future, buyers may decide to bring forward their purchases and buy more of the good before the price actually increases, increasing the current demand for the good, ceteris paribus

• if price of a good is expected to decrease in the future, buyers may choose to hold back their purchases and only buy the good when the price is lower, decreasing the current demand for the good, ceteris paribus

• these speculations exacerbate any price fluctuations and volatility present in a market, and is commonly witnessed in asset markets, and commodity markets

exchange rates

exchange rate: the rate at which a country’s currency can be exchange for another currency

• an appreciation/strengthening of the domestic currency makes imported substitutes relatively cheaper, causing a decrease in the demand for locally produced goods

• a depreciation/weakening of the domestic currency makes imported substitutes relatively more expensive, causing an increase in the demand for locally produced goods, as consumers switch from consuming foreign imported goods to locally produced goods instead

supply

defined as the quantity of the good that producers are able and willing to sell in a given time period at every price level, ceteris paribus

law of supply

there is a direct relationship between price and quantity supplied, ceteris paribus

increasing marginal costs ⇒ why supply curve is upward sloping

• as firms produce increasing amounts of a good, the total costs of production will rise more and more rapidly ⇒ workers have to be paid for working overtime and the maintenance costs of machines increase as they are used continuously for longer time periods

• cost of producing each additional unit (marginal cost) is more than the last

• minimum amount of money that a producer would accept as payment for a good is the cost of production ⇒ marginal cost curve shows the minimum price that producers expect to receive for each additional output

rational decision making by producers: deriving the individual supply curve from the marginal cost curve

• assume producers are rational economic agents with primary objective to maximise profits

• for any given price, the quantity that the producer will produce (the producer’s individual supply curve) can be derived from the marginal cost curve ⇒ supply curve reflects the minimum that a producer is willing to accept for each unit of the good

• the producer will produce up to the point where the marginal revenue = marginal cost ⇒ total profits are maximised

market supply curve

• upward sloping

• horizontal summation of all individual firm’s supply curves for the good

movement along the supply curve

• change in the own price of the good will result in a change in quantity supplied, ceteris paribus

  • increase in market price → increase in quantity supplied → upward movement along the supply curve

  • decrease in market price → decrease in quantity supplied → downward movement along the supply curve

shifts of the supply curve

• change in factors other than the own price of the good (non-price determinants) will result in a change in the supply of the good → illustrated by a shift of the supply curve

  • when supply increases, the supply curve shifts rightwards

  • when supply decreases, the supply curve shifts leftwards

change in input prices

• an increase in price of factor inputs increases the cost of production → production becomes less profitable and level of output that producers are willing and able to produce at each price level decrease ⇒ supply of good decreases, ceteris paribus

• a decrease in price of inputs decreases the cost of production ⇒ supply of goods increases

change in technology

improvement in technology can lead to higher productivity, and more output can be produced with the same amount of resources → this lowers the cost of production, causing production to become more profitable and increases the supply of the good, ceteris paribus

government policies

• indirect subsidies provided by the government help to offset the cost of production for producers → production becomes more profitable and increases the supply of a good, ceteris paribus

• indirect taxes raise the cost of production because the producer will need to incur the additional costs of paying the tax, reducing its profits → can cause the supply of a good to decrease, ceteris paribus

number and size of firms

• entry of new firms into the market causes the supply of the good to increase

• increase in the size of existing firms will increase the total capacity of the industry, increasing the supply of the good, ceteris paribus

price of related goods → supply

• prices of goods in joint supply

  • for goods in joint supply, an increase in the price of one good increases the supply for the other

• prices of goods in competitive supply

  • for goods in competitive supply, an increase in the price of one good decreases the supply of the other

definition of joint supply and competitive supply

• joint supply: goods are in joint supply when the production of one good leads to the production of the other good

• competitive supply: goods in competitive supply compete for the use of the same inputs

supply shocks

• unexpected events like wars and natural disasters destroy resources like crops, livestock, labour and capital + industrial disputes (e.g. strikes) and financial disrupt production ⇒ adverse impact on supply, causing the supply of goods to decrease, ceteris paribus

• unexpected harvest is also a supply shock ⇒ supply of goods will increase, ceteris paribus

expectations of future prices → supply

if the price of a good is expected to increase in the future, producers may temporarily hold back their stocks in order to sell them at a higher price eventually to earn more profits in future → reduces current supply of good, ceteris paribus

market equilibrium

• equilibrium price and quantity are determined by the interaction of market demand and market supply

• equilibrium price and equilibrium quantity of the market occurs when the quantity demanded is equal to the quantity supplied ⇒ market price and quantity have no tendency to change as there is no shortage or surplus at this price

definition of shortage and surplus

• shortage: a situation which exist at any price below the equilibrium price where quantity demanded exceeds quantity supplied

• surplus: a situation which exist at any price above the equilibrium price where quantity supplied exceeds quantity demanded

change in market demand → single shift

• when demand for the good increases/decreases, the increase/decrease in demand is illustrated by rightward/leftward shift of the demand curve a

• at initial equilibrium price, the quantity demanded/supplied is greater than quantity supplied/demanded, resulting in a shortage/surplus, putting an upward/downward pressure on price

• as price increases/decreases, quantity demanded decreases/increases and quantity supplied increases/decreases until the new equilibrium point is reached

• equilibrium price increased/decreased, and equilibrium quantity increased/decreased

change in market supply → single shift

• when supply for the good increases/decreases, the increase/decrease in supply is illustrated by a rightward/leftward shift of the supply curve

• at initial equilibrium price, the quantity supplied/demanded is greater than quantity demanded/supplied, resulting in a surplus/shortage, putting downward/upward pressure on price

• as price decreases/increases, quantity demanded increases/decreases and quantity supplied decreases/increases until the new equilibrium point is reached

• equilibrium price decreased/increased, and equilibrium quantity increased/decreased

changes in both market demand and market supply → increase in both market demand and market supply

• equilibrium quantity increases but the effect on equilibrium price is indeterminate as it is dependent on the relative extent of change in demand and supply

  • if both supply and demand increase by the same extent, the equilibrium price remains unchanged

1. demand increases more than the increase in supply

   • at initial equilibrium price, the quantity demanded is greater than quantity supplied, resulting in shortage ⇒ upward pressure on price

   • as price increases, quantity demanded decreases and quantity supplied increases until the new market equilibrium is reached where the shortage is eliminated

   • equilibrium price increased

2. supply increases more than the increase in demand

   • at initial equilibrium price, the quantity supplied is greater than quantity demanded, resulting in surplus ⇒ downward pressure on price

   • as price decreases, quantity demanded increases and quantity supplied decreases until the new market equilibrium is reached where the surplus is eliminated

   • equilibrium price decreases

changes in both market demand and market supply → increase in market supply and decrease in market demand

• at initial equilibrium price, the quantity supplied is greater than quantity demanded, resulting in surplus ⇒ downward pressure on price

• as price decreases, quantity demanded increases and quantity supplied decreases until the new market equilibrium is reached where the surplus is eliminated

• equilibrium price decreases in both cases but the effect on equilibrium quantity is indeterminate as it is dependent on the relative extent of change in demand and supply

  • if the extent of rise in supply and fall in demand is the same, the equilibrium quantity remains unchanged

1. decrease in demand exceeds the increase in supply

   • the equilibrium quantity decreased

2. increase in supply exceeds the decrease in demand

   • the equilibrium quantity increased

for simultaneous shifts in the demand and supply curves

• when demand and supply change in the same direction, equilibrium quantity can be determined, but the effect on equilibrium price is indeterminate and depends on relative extent of change in demand and supply

• when demand and supply change in opposite directions, equilibrium price can be determined but he effect on equilibrium quantity is indeterminate and depends on relative extent of change in demand and supply

price mechanism → definition

describes the process by which consumers and producers interact through prices to determine the allocation of scarce resources between competing uses

resource allocation via the price mechanism

• increase in demand causes the rightward shift of the demand curve, and at the initial equilibrium price, the quantity demanded is greater than quantity supplied, resulting in a shortage, putting an upward pressure on price ⇒ signals to producers that consumers want more than what is currently produce

• as price increases, quantity demanded decreases and quantity supplied increases ⇒ disincentivises consumers from consumption and incentivises producers to produce more to earn greater profit respectively

• overall, more will be produced ⇒ more resources are allocated and fewer resources will be allocated to other markets

• price of factors of production also guid producers on how to produce

  • as producers aim to maximise profits, they have the incentive to adopt the least cost method of production ⇒ using processes that employ more of the relatively cheaper factor and less of the relatively costlier factor

• as price increased, there is a decrease in quantity demanded ⇒ consumers who are unwilling or unable to purchase the goods at the higher price will drop out of the market, only consumers who are willing and able to pay a price will get it → rationed to the consumers who are willing to pay the price for them

three functions of price → answer questions of what, how, and for whom to produce

1. signalling function → price changes send contrasting signals to consumers and producers about whether to enter or leave a market

   • rising prices: signal to consumers to reduce quantity demanded or withdraw from a market completely, and signal to potential producers to enter a market

   • falling prices: positive message to consumers to enter a market while negative signal to producers to leave a market

2. incentive function → incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour as it increases their welfare

   • rising prices: higher potential profits provide incentive for producer to sell more, raising total profit and welfare

   • falling prices: consumer has incentive to buy more, increasing consumption and welfare

3. rationing function → prices serve to ration goods and services to consumers who are most willing and able to pay for them

   • when there is a shortage of good, consumers will bid up the price of it

   • as price increases, those who are unwilling or unable to pay more will drop out of the market, whereas those who are willing and able to pay the higher price will get to purchase the good

   • price changes allow goods in shortage to be rationed to those with effective demand (able and willing to pay for the good at the market price determined by demand and supply