Republic of the Philippines

SORSOGON STATE UNIVERSITY

Sorsogon Campus
Sorsogon City

LEARNING MODULE
MANAGERIAL ECONOMICS

Chapter 3: MARKET SUPPLY AND EQUILIBRIUM

I. OVERVIEW
It is true that economy runs on demand but that demand has to be fulfilled with corresponding supply as
well. Say, if there is a huge demand for mobile phones in an economy, there has to be corresponding supply to fulfill
that demand. If adequate supply is not there, then the demand would not be fulfilled.

II. LEARNING OUTCOMES

After reading and studying this chapter, you will be able to:
• State the law of supply;
• Enumerate the determinants of supply;
• Explain how market equilibrium is reached;
• Explain price controls, price ceilings, and price floors; and
• Analyze demand and supply as a social adjustment mechanism.

III. LEARNING EXPERIENCE

Market Supply
• Supply is the specific quantity of output that the producers are willing and able to make available to
consumers at a particular price over a given period of time.
• In one sense, supply is the mirror image of demand. Individuals’ supply of the factors of production or inputs
to market mirrors other individuals’ demand for these factors.
• Supply is not simply the number of a commodity a shopkeeper has on the shelf, such as ’10 mangoes’ or ’50
kilos of rice’, because supply represents the entire relationship between the quantity available for sale and
all possible prices charged for that good.

Quantity Supplied - is the specific quantity of goods the seller is willing and able to sell at a given price.
Typically, a time table is also given when describing quantity supplied.
Example: With the price of umbrella at P100 each, the quantity supplied is 500 umbrellas a week

• The supply of produced goods (tangibles) is usually indirect and the supply of non-produced goods
(intangibles) is more direct. Individuals supply their labor in the form of services directly to the goods
market

Supply schedule - shows the different quantities the seller is willing to sell at various prices

Table 1. Supply Schedule of Pedro for Fish in One Week

Price of Fish (per Kilo) Supply (in kilos)

P20 200

40 300

60 400

80 500

100 600

As can be seen in Table 1, the relationship between the price of fish and the quantity that Pedro is willing to
sell is direct. The higher the price, the higher the quantity supplied. When plotted into a graph, we obtain the supply
curve.
Price of Fish per kilo
120

100

80

60

40

20

0
12345

Quantity Supplied (in hundred kilos)

We derived a supply curve that is upward sloping, indicating the direct relationship between the price of
good and the quantity supplied of that good.

The Law of Supply

• After observing the behavior of price and quantity supplied in the above schedule, we can now state the Law
of Supply. Using the same assumption of “ceteris paribus” (other things constant), there is a direct
relationship between the price of good and the quantity supplied of that good.
• As the price increases, the quantity supplied of that product also increases. The high price of the good serves
as motivation for the seller to offer more of that product. The seller will take this opportunity to increase
his/her income.

Non-Price Determinants of Supply

• In the above analysis (Figure 1.1), the only factors that vary are price and quantity supplied. However, in real
life, supply is influenced by factors other than price. These factors were assumed constant for the purpose
of simplifying the study of the relationship between price and the quantity supplied.
• If the assumption of ceteris paribus is dropped, non-price variables are now allowed to influence supply.
These non-price factors are cost of production, technology, and availability of raw materials and resources.
These non-price determinants can cause an upward or downward change in the entire supply of the
product, and this change is referred to as shift of the supply curve.
Shifts of the Supply Curve
• Just like in the case of demand, there are also movements along and shifts of the supply curve. • In Figure 1.1,
what we see are changes in the quantities supplied due to different prices of fish. These changes are reflected
on a single supply curve and are changes from one point to another point on the same curve. This is referred to
as a movement along the supply curve. The reason for a movement along the supply curve is the change in the
price of good.
• Once supply increases due to a non-price determinant, the entire supply curve will shift to the right to reflect
an increase, or to the left to reflect a decrease as shown in Figure 1.2.

Non-Price Determinants:
• Cost of Production refers to the expenses incurred to produce the good. An increase in cost would normally
result in a lower supply of the good even when price will not change since the producer has to shell out
more money to come up with the same amount of output. With the same budget and a higher cost, the
producer will only produce a smaller amount of the good, and therefore, the supply of the good in the
market will decrease. This is reflected in a rightward shift of the supply curve from S 1 to S2, in Figure 1.2.
• Technology is another significant non-price determinant of supply. The use of improved technology in the
production of good will result in the increased supply of that good. On the other hand, the use of obsolete
or improper technology in production will result in a downward shift of the supply curve from S 1 to S3.
• Improved availability of raw materials and resources can cause an upward shift of the curve from S 1 to S2.
Since more resources can be used to produce a bigger output of the good, then supply increases.

Law of Supply and Demand

• If the forces of demand and supply operate together, we can show how price is determined in a market
economy
• Adam Smith explained the concept of supply and demand in his epic work “The Wealth of Nations (1776),” as
an invisible hand that naturally guides the economy. He described a society where bakers and butchers
provide products that individuals need and want, providing a supply that meets demand and developing an
economy that benefits everyone.
• In 1890, Alfred Marshall’s Principle of Economics developed a supply-and-demand curve that is still used to
demonstrate the point at which the market is in equilibrium.
• Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the
horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same
graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a
market.
• Figure 2 below shows the interaction of demand and supply in the market for gasoline.
Figure 2. Interaction of Demand and Supply of Gasoline
The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40
and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity
supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so
there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity
supplied, so there is excess demand.

Market Equilibrium
• Is a state of balance when demand is equal to supply
• The equality means that the quantity that sellers are willing to sell is also the quantity that buyers are
willing to buy for a price
• Is an implicit agreement between buyers and sellers on how much they are willing to transact • When the
market is in equilibrium, there is no tendency for the price to increase or to decrease • If a market is at its
equilibrium price and quantity, then it has no reason to move away from that point.
However, if a market is not at equilibrium, then economic pressures arise to move the market toward the
equilibrium price and the equilibrium quantity.

If Price is Above the Equilibrium

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead
of $1.40 per gallon, the price is $1.80 per gallon. This above-equilibrium price is illustrated by the dashed horizontal
line at the price of $1.80 in Figure 2. At this higher price, the quantity demanded drops from 600 to 500. This decline
in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the
higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity
demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500
gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity
supplied exceeds the quantity demanded. We call this an excess supply or a surplus.

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This
accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and
selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation,
some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all.
Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will
stimulate a higher quantity demanded. So, if the price is above the equilibrium level, incentives built into the
structure of demand and supply will create pressures for the price to fall toward the equilibrium.
If the Price is Below the Equilibrium

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line
at this price in Figure 2 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take
longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and
buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’
incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the
quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had
been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many
stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make
higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium
level.
Price Ceilings and Price Floors
Controversy sometimes surrounds the prices and quantities established by demand and supply, especially
for products that are considered necessities. In some cases, discontent over prices turns into public pressure on
politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low.”
The demand and supply model shows how people and firms will react to the incentives provided by these
laws to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often
achieve the desired goals of price control laws, while avoiding at least some of their costs and tradeoffs.

Price Controls - are laws the government enacts to regulate prices

Two Kinds of Price Control:

• Price Ceiling - keeps a price from rising above a certain level (ceiling)
• Price Floor - keeps a price from falling below a certain level (floor)

An example of Price Ceiling:

In a beautiful town by the sea, rent was fairly stable. But then, the town was featured on a top-ten-places
to-live article in a popular magazine. Eventually, rent control laws were passed. In the beginning, before the article
was published, the equilibrium, E0, lay at the intersection of supply curve S0 and demand curve D0 corresponding to
an equilibrium price of $500 and an equilibrium quantity of 15,000 units of rental housing. When the article inspired
more people to want to move to our imaginary town, it shifted the demand curve for rental housing to the right, as
shown by the data in the table below and the shift from D0 to D1. In the new market, at the new equilibrium E1, the
price of a rental unit rose to $600 and the equilibrium quantity increased to 17,000 units.
Rent Control
Price Original quantity supplied Original quantity demanded New quantity demanded $400 12,000
18,000 23,000 $500 15,000 15,000 19,000 $600 17,000 13,000 17,000 $700 19,000 11,000 15,000
$800 20,000 10,000 14,000
Now, let's suppose that a bunch of residents were pretty unhappy with paying a 20% increase in their rent.
They pressured local politicians to pass a rent control law to keep the price at the original equilibrium of $500 for a
typical apartment.
In the demand and supply model above, the horizontal line at the price of $500 shows the legally fixed
maximum price set by the rent control law. However, the underlying forces that shifted the demand curve to the
right are still there. At the fixed maximum price of $500, the quantity supplied remains at the same 15,000 rental
units, but the quantity demanded is 19,000 rental units. In other words, the quantity demanded exceeds the
quantity supplied, so there is a shortage of rental housing.
The effects of price ceilings are complex and sometimes unexpected. In the case of rent control, the price
ceiling doesn't simply benefit renters at the expense of landlords. Rather, some renters—or potential renters—lose
their housing as landlords convert apartments to co-ops and condos. There are actually fewer apartments rented
out under the price ceiling—15,000 rental units—than would be the case at the market rent of $600—17,000 rental
units. And, even when housing remains in the rental market, landlords tend to spend less on maintenance and on
essentials like heating, cooling, hot water, and lighting.
The first rule of economics is you do not get something for nothing—everything has an opportunity cost. So
if renters get “cheaper” housing than the market requires, they tend to also end up with lower quality housing. Price
ceilings are enacted in an attempt to keep prices low for those who demand the product—be it housing,
prescription drugs, or auto insurance. But when the market price is not allowed to rise to the equilibrium level,
quantity demanded exceeds quantity supplied, and thus a shortage occurs.
Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but
sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also
likely to deteriorate.

Price floor
• A price floor is the lowest legal price that can be paid in a market for goods and services, labor, or financial
capital. Perhaps the best-known example of a price floor is the minimum wage, which is based on the
normative view that someone working full time ought to be able to afford a basic standard of living. The
present minimum wage in the Philippinesis P537.00 per day. As the cost of living rises over time,
Government periodically raises the minimum wage.
• Price floors are sometimes called price supports because they support a price by preventing it from falling
below a certain level. Around the world, many countries have passed laws to create agricultural price
supports. Farm prices, and thus farm incomes, fluctuate—sometimes widely. So even if, on average, farm
incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these
swings.
• The most common way price supports work is that the government enters the market and buys up the
product, adding to demand to keep prices higher than they otherwise would be.

We can take a look at the demand and supply model below to understand better the effects of a
government program that creates a price above the equilibrium. This particular model represents the market for
wheat in Europe. In the absence of government intervention, the price of wheat would adjust so that the quantity
supplied would equal the quantity demanded at the equilibrium point E0, with price P0 and quantity Q0. However,
policies to keep prices high for farmers keep the price above what would have been the market equilibrium level—
the price Pf shown by the horizontal line in the diagram. The result is a quantity supplied in excess of the quantity
demanded—Qd. When quantity supplied exceeds quantity demanded, a surplus exists.
The graph shows an example of a price floor which results in a surplus. The intersection of demand, D, and
supply, S, would be at the equilibrium point E0. However, a price floor set at Pf holds the price above E0 and
prevents it from falling. The result of the price floor is that the quantity supplied, Qs, exceeds the quantity
demanded, Qd. There is excess supply, also called a surplus.

Our example is hypothetical, but the concept plays out in the real world as well. If a government is willing to
purchase excess agricultural supply—or to provide payments for others to purchase it—then farmers will benefit
from the price floor, but taxpayers and consumers of food will pay the costs.

Do Price Ceilings and Floors Change Demand or Supply?

• Neither price ceilings nor price floors cause demand or supply to change. They simply set a price that limits
what can be legally charged in the market.
• Remember, changes in price do not cause demand or supply to change. Price ceilings and price floors can
cause a different choice of quantity demanded along a demand curve, but they do not move the demand
curve. Price controls can cause a different choice of quantity supplied along a supply curve, but they do not
shift the supply curve.

SUMMARY
• A supply schedule is a table that shows the quantity supplied at different prices in the market. A supply curve
shows the relationship between quantity supplied and price on a graph. The law of supply says that a higher
price typically leads to a higher quantity supplied.

• The equilibrium price and equilibrium quantity occur where the supply and demand curves cross. The
equilibrium occurs where the quantity demanded is equal to the quantity supplied. If the price is below the
equilibrium level, then the quantity demanded will exceed the quantity supplied. Excess demand or a
shortage will exist. If the price is above the equilibrium level, then the quantity supplied will exceed the
quantity demanded. Excess supply or a surplus will exist. In either case, economic pressures will push the
price toward the equilibrium level.

• Price ceilings prevent a price from rising above a certain level. When a price ceiling is set below the
equilibrium price, quantity demanded will exceed quantity supplied, and excess demand or shortages will
result. On the other hand, price floors prevent a price from falling below a certain level. When a price floor
is set above the equilibrium price, quantity supplied will exceed quantity demanded, and excess supply or
surpluses will result. Price floors and price ceilings often lead to unintended consequences.
V. ASSESSMENT ACTIVITIES: (Posted in Google Classroom)
VI. REFERENCES
• Dinio, R.P., & Villasis, G.A. (2017). Applied Economics. Rex Bookstore, Manila.
• Viloria, et al. (2019). Managerial Economics. Anvil Education, Mandaluyong City •
https://opentextbc.ca/principlesofeconomics/chapter/3-1-demand-supply-and-equilibrium-in-markets-for
goods-and-services/

Prepared by:

MARIA LUISA P. MIRASOL

Assistant Professor II
[email protected]