Chapter 4: Demand and Supply (The Basics)

Demand an the Law of Demand

Demand for a product is the quantity the customers are willing and able to pay for each and every price
The law of demand states that as price increases, demand for that product decreases (inverse the relationship)
The curve also helps identify what price the customers would be willing to pay

Reasons for the Law of Demand (why people buy less when price increases)

Income effect: when prices are low, people are easily able to afford it since their budget would allow it
1. As prices increase, people’s budget would tend to become tighter, as they wouldn’t be willing to spend more on a product
Substitution effect: when products price increase, they tend to increase in relative to other products
1. If product A were to become expensive, product B would most likely be cheaper than A
2. Due to the existence of substitutes, customers immediately leave product A for B
Diminishing marginal utility: As more units of a product are consumed, the satisfaction/utility it provides tends to decline
1. Apple users would purchase at maximum, a limited phones-they wouldn’t purchase a new iPhone every month since that extra phone would offer them no utility or not as much

Change in Quantity Demanded vs. Change in Demand

Change is the quantity demanded only occurs due to change in price-movement along the curve
If product A would become expensive(P2 to P1), the quantity demanded would fall (D2 toD1)
Changes in demand are when the entire curve would shift upwards or downwards
These are the determinants of demand which are variables causing consumers to buy more or less of a product, irrespective of the price

Determinants of the demand curve

Substitutes Available
1. 2 goods would be considered substitutes if an increase in the price of one good causes an increase in demand for the other good
2. Assuming brown bread is a substitute for white bread
3. If the price of white bread increases, people would tend to buy more brown bread in response
4. This would cause the demand curve for brown bread to shift upwards
Population preference
1. This is the consumer’s taste for a product at any point
2. If consumers like a product, the demand curve for that product shifts upwards and vice versa if they dislike it
3. A good example is when the trend of vegetarianism hit the public, the consumption of plant-based food drastically increased
Population/number of consumers
1. The bigger the market for a product, the more likely the demand curve would shift upwards
2. If country A has a low birth rate in a particular year, the demand curve for baby-related products would shift downwards
Income
1. Goods are usually categorized into 2 types, inferior and normal
2. Demand tends to decline (shift downwards) for inferior goods with an increase in consumer income
3. Demand for normal goods increases (shifts upwards) with an increase in consumer income
  1. Assuming a middle-class family purchases 2 products only, margarine and bread
  2. With an increase in income, the family would cut down the spending on margarine and move towards better-quality butter
  3. Spending on bread would increase slightly (perhaps now the family buys 2 packets of bread)
  4. In this scenario, the margarine is the inferior good and the bread’s the normal good
Complementary good
1. These goods are purchased separately but used together
2. The relation here is inverse of that of substitute goods
3. If 2 products are substitutes, an increase in the price of one good causes demand for the other good to decline as wellA good example would be that if razor blades became really expensive, demand for shaving cream would also decline
4. Notice here that no price change causes demand to fall for the cream but rather the fact that it was a complement to the razor blades
Expectation
1. Consumer expectation pays a major role in the determination of the price
2. if consumers expect that the price of something would increase in the future, they would buy the product at a larger scale leading to the demand curve shifting upwards
3. A good example would be when government warns of the possible chances of future inflation, leading to people stocking up on goods at their homes

Supply and the Law of Supply

Since price has a different impact on both buyers and sellers, the supply curve is different than a demand curve
The market supply shows the quantity a supplier is willing and able to offer at various prices at a given time
The law of supply states that when prices increase, the supply increases as well (direct relation)

Reasons for the Law of Supply

Rising prices give greater opportunities to suppliers to earn a profit
With every additional unit, suppliers face an increase in the marginal cost of production
1. Charging higher prices provides them with the easiest way to cover the cost
2. The vice versa is also true; lower prices wouldn’t provide the incentive to motivate the supplier and thus reduces the quantity of product

Change in Quantity Supplied vs. Change in Supply

Change in quantity supplied only takes place when price change takes place
As price increases (P1-P2), the quantity supplied also increases from Q1 to Q2
The change occurs along the supply curve
Shift in supply is due to the determinants of supply
Determinants of supply are the factors that influence the supplier to offer more or fewer goods at the same price

Determinants of Supply

Resource costs and availability
1. The cost of production (land, labor, capital) has an inverse impact on the supply
2. When the cost of these increases, the supplier decides to produce less of the products since he is unable to afford the production cost
Other goods and services
1. Suppliers who produce more than one product (profit-maximizing firms) have an easier time switching to the production of another product if issues do arise in prices
2. E.g. A farmer has land where he is able to produce corn and earn a profit
3. If his land is capable to produce wheat as well, in case the price of wheat increases to that of corn, he would switch to wheat production to earn better
4. The supply curve in this situation for wheat would shift outwards(more supply) and vice versa for corn(reduced supply)
Technology
1. Newer technology causes the cost of production to decline and helps improve the efficiency of the supplier
2. This allows the supplier to produce more, shifting the supply curve outwards(toward right)
3. E.g. machines on the production line help reduce unit costs due to which more products are affordable by the supplier
Taxes and Subsidies
1. Taxes are added up to the unit cost of production, thus making it more expensive
2. Due to this, heavily taxed products are produced in less quantity by suppliers(supply curve shifts towards left)
3. Subsidies are the opposite of taxes and help reduce price per unit
4. This allows suppliers to produce more of the product(supply curve shifts towards the right)
Expectation
1. If suppliers expect prices to increase in the future, they would hold back supply for the current time with the future goal of earning more profit later (and vice versa)
Number of sellers
1. As the number of sellers increases in the market, the supply automatically increases
2. This allows consumers more choices at a lower price due to an increase in competition

Market Equilibrium: Supply and Demand Together

The market equilibrium price is that price which the market sets, where buyers buy the exact amount which the sellers are willing to produce
It’s also known as market-clearing price
A surplus would only exist when the quantity supplied is greater than the quantity demanded
In a competitive market where a surplus exists, prices eventually fall back to the equilibrium
A shortage would only exist when the quantity demanded is greater than the quantity supplied
In a competitive market where a shortage exists, prices eventually get pulled back up to equilibrium
This is because the shortage creates more demand from buyers
The suppliers utilize this and supply more at higher prices, thus bringing prices back up

Disequilibrium

This occurs when there is a shortage or surplus in the market
Consider the price $8 where the demand is 100 and the corresponding supply is 350
This surplus is what creates market disequilibrium

Changes in Equilibrium (solving demand and supply-related questions)

Is it supply, demand, or both?
Is it an increase (shift to the right) or a decrease (shift to the left)?
1. Supply increases towards the right and decreases towards left
2. Demand increases towards the right (moves upwards) and decreases towards the left (moves downwards)
3. Just shift it, noting your new equilibrium price and quantity

When supply is constant and only demand increases, equilibrium price and quantity increases
When supply is constant and only demand decreases, equilibrium price and quantity decreases
When demand is constant and only supply increases, equilibrium price and quantity decreases
When demand is constant and only supply decreases, equilibrium price and quantity increases