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Demand and Supply and

Market Equilibrium

Demand – Relationship between demand and

price

 The law of demand: when the price of a good rises,

the quantity demanded will fall. Two reasons for
this:

- People will feel poorer. They will not be able to afford

to buy so much of the good with their money. The
purchasing power of their income (their real income)
has fallen. This is called the income effect of a price
rise.

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Demand – Relationship between demand and

price

- The good will now cost more than alternative or

‘substitute’ goods, and people will switch to these.
This is called the substitution effect of a price rise.

Similarly, when the price of a good falls, the quantity

demanded will rise. People can afford to buy more (the
income effect), and they will switch away from
consuming alternative goods (the substitution effect).

The Demand Curve

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Other Determinants of Demand

 Price is not the only factor that determines how

much of a good people will buy. Demand is also
affected by:

- Tastes - The more desirable people find the good,

the more they will demand. Tastes are affected by
advertising, by fashion, by observing other consumers,
by considerations of health and by the experiences
from consuming the good on previous occasions.

Other Determinants of Demand

 The number and price of substitute goods (i.e.

competitive goods). The higher the price of
substitute goods, the higher will be the demand for
this good as people switch from the substitutes.

For example, the demand for coffee will depend on the

price of tea. If tea goes up in price, the demand for
coffee will rise.

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Other Determinants of Demand

 The number and price of complementary goods

Complementary goods are those that are consumed
together: cars and petrol, shoes and polish, fish and chips.
The higher the price of complementary goods, the fewer of
them will be bought and hence the less will be the demand
for the good under consideration.

For example, the demand for batteries will depend on the

price of handheld games. If the price of handheld games
comes down, so that more are bought, the demand for
batteries will rise.

Other Determinants of Demand

 Income - As people’s incomes rise, their demand for

most goods will rise. Such goods are called normal
goods.

There are exceptions to this general rule, however. As

people get richer, they spend less on inferior goods,
such as supermarket ‘value’ ranges, and switch to
better quality goods.

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Other Determinants of Demand

 Expectations of future price changes - If

people think that prices are going to rise in the
future, they are likely to buy more now before the
price does go up.

Movements along and shifts in the demand

curve

 A demand curve is constructed on the assumption

that ‘other things remain equal’ (ceteris
paribus). In other words, it is assumed that none of
the determinants of demand, other than price,
changes.

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Movements along and shifts in the demand

curve

 The effect of a change in price is then simply

illustrated by a movement along the demand curve:
for example, from point B to point D in Figure 2.1
when the price of potatoes rises from 40p to 80p per
kilo.

Movements along and shifts in the demand

curve

 If a change in one of the other determinants causes

demand to rise – say, income rises – the whole curve
will shift to the right. This shows that at each price
more will be demanded than before.

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Movements along and shifts in the demand

curve

Supply and Price

 The Law of Supply - when the price of a good rises, the

quantity supplied will also rise. There are three
reasons for this:

- Beyond a certain level of output, costs are likely to rise

rapidly as workers have to be paid overtime and as
machines approach capacity working. If higher output
involves higher costs of producing each unit, producers
will need to get a higher price if they are to be persuaded
to produce extra output.

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Supply and Price

- The higher the price of the good, the more profitable

it becomes to produce. Firms will thus be encouraged
to produce more of it by switching from producing less
profitable goods.

- Given time, if the price of a good remains high new

producers will be encouraged to set up in production.
Total market supply thus rises.

The Supply Curve

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Other Determinants of Supply

 The costs of production - The higher the costs of

production, the less profit will be made at any price.
As costs rise, firms will cut back on production,
probably switching to alternative products whose
costs have not risen so much.

Other Determinants of Supply

 The profitability of alternative products

(substitutes in supply) - If a product which is a
substitute in supply becomes more profitable to
supply than before, producers are likely to switch
from the first good to this alternative. Supply of the
first good falls. Other goods are likely to become
more profitable if their prices rise and/or their costs
of production fall.

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Other Determinants of Supply

 The profitability of goods in joint supply -

Sometimes when one good is produced, another
good is also produced at the same time. These are
said to be goods in joint supply.

Other Determinants of Supply

 Nature, ‘random shocks’ and other

unpredictable events - In this category we would
include the weather and diseases affecting farm
output, wars affecting the supply of imported raw
materials, the breakdown of machinery, industrial
disputes, earthquakes, floods and fire, etc.

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Other Determinants of Supply

 The aims of producers - A profit-maximising

firm will supply a different quantity from a firm that
has a different aim, such as maximising sales. For
most of the time we shall assume that firms are
profit maximisers.

Other Determinants of Supply

 Expectations of future price changes - If price

is expected to rise, producers may temporarily
reduce the amount they sell. They are likely to build
up their stocks and only release them on to the
market when the price does rise. At the same time
they may install new machines or take on more
labour, so that they can be ready to supply more
when the price has risen.

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Other Determinants of Supply

 The number of suppliers - If new firms enter the

market, supply is likely to increase.

Movements along and shifts in the

supply curve

 The effect of a change in price is illustrated by a

movement along the supply curve: for example, from
point d to point e in Figure 2.3 when price rises from
80p to 100p. Quantity supplied rises from 530 000
to 700 000 tonnes per month.

 If any other determinant of supply changes, the

whole supply curve will shift. A rightward shift
illustrates an increase in supply. A leftward shift
illustrates a decrease in supply.

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Movements along and shifts in the

supply curve

Equilibrium Price and Output

 Only one price is sustainable – the price where demand

equals supply: namely, 60p per kilogram, where both
demand and supply are 350 000 tonnes.

 At this price there is no shortage and no surplus.

 If the price starts at anything other than 60p per

kilogram, it will tend to move towards 60p. The
equilibrium price is the only price at which producers’
and consumers’ wishes are mutually reconciled: where
the producers’ plans to supply exactly match the
consumers’ plans to buy.

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Demand and Supply Curves

Movement to a new equilibrium – Change in

Demand

 If either of the curves shifts, a new equilibrium will

be formed.

 If one of the determinants of demand changes (other

than price), the whole demand curve will shift. This
will create a new equilibrium point

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Movement to a new equilibrium – Change in

Demand

Movement to a new equilibrium – Change in

Demand

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The Control of Prices (Max/Min)

 At the equilibrium price, there will be no shortage or

surplus. The equilibrium price, however, may not be
the most desirable price. The government, therefore,
may prefer to keep prices above or below the
equilibrium price.

The Control of Prices (Max/Min)

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The Control of Prices (Max/Min)

 If the government sets a minimum price above the

equilibrium (a price floor), there will be a surplus: Qs
− Qd in Figure 2.10. Price will not be allowed to fall
to eliminate this surplus.

 If the government sets a maximum price below the

equilibrium (a price ceiling), there will be a shortage:
Qd − Qs in Figure 2.11. Price will not be allowed to
rise to eliminate this shortage

Government Intervention in providing Merit

Goods

 Merit goods are those goods and services that the

government feels that people will under-consume, and
which ought to be subsidised or provided free at the
point of use so that consumption does not depend
primarily on the ability to pay for the good or service.

 Ex Education and Health

 A merit good is one with high social positive

externalities, such as education, health and pensions. In
this case, the market still works but market intervention
by the government can be justified on social grounds

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Government Intervention in providing Public

Goods

 Public goods:
 Goods which are non-rival and non-excludable

 Non-rival in consumption: one unit of the good can

be consumed simultaneously by all consumers (MC
of an extra user is zero)

 Non-excludable (free-rider): it is impossible to

prevent consumers consuming the good when they
have not paid for it.

Government Intervention in providing Public

Goods

 Public goods:
 Ex: national defence, street lightning

 A pure public good has both characteristics.

 Governments overcome the free-rider problem by providing public

goods on behalf of society.

 Governments will generally finance the provision of public goods by

levying taxes.

 In this case the market does not work, as in the case of a lighthouse.
In this case intervention by the government to supply the good in
question can be justified.

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Price Elasticity of Demand

 When the price of a good rises, the quantity

demanded will fall. We will want to know by just how
much the quantity demanded will fall. In other
words, we will want to know how responsive
demand is to a rise in price.

 The price elasticity of demand - the

responsiveness of demand to a change in price

Measuring the price elasticity of demand

 Formula for the price elasticity of demand for a

product: percentage (or proportionate) change
in quantity demanded divided by the
percentage (or proportionate) change in
price.

 Putting this in symbols gives:

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Measuring the price elasticity of demand

 Thus if a 40 per cent rise in the price of oil caused the

quantity demanded to fall by a mere 10 per cent, the
price elasticity of oil over this range will be

−10%/40% = −0.25

whereas, if a 5 per cent fall in the price of cabbages caused

a 15 per cent rise in the quantity demanded, the price
elasticity of demand for cabbages over this range would be

15%/−5% = −3

Interpreting the figure for elasticity - The use of

proportionate or percentage measures

 Elasticity is measured in proportionate or percentage

terms for the following reasons:

- It allows comparison of changes in two qualitatively

different things, which are thus measured in two
different types of unit: i.e. it allows comparison of
quantity changes with monetary changes.

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Interpreting the figure for elasticity - The sign

(positive or negative)

 Demand curves are generally downward sloping.

This means that price and quantity change in
opposite directions. A rise in price (a positive figure)
will cause a fall in the quantity demanded (a negative
figure).
 Similarly a fall in price will cause a rise in the
quantity demanded. Thus when working out price
elasticity of demand, we either divide a negative
figure by a positive figure, or a positive figure by a
negative.

Interpreting the figure for elasticity - The value

(greater or less than 1)

 If we now ignore the negative sign and just

concentrate on the value of the figure, this tells us
whether demand is elastic or inelastic.

- Elastic (ε > 1). This is where a change in price causes

a proportionately larger change in the quantity
demanded. In this case the value of elasticity will be
greater than 1, since we are dividing a larger figure by a
smaller figure.

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Interpreting the figure for elasticity - The value

(greater or less than 1)

 Inelastic (ε< 1). This is where a change in a price

causes a proportionately smaller change in the
quantity demanded. In this case elasticity will be less
than 1, since we are dividing a smaller figure by a
larger figure.

 Unit elastic (ε = 1). Unit elasticity of demand occurs

where price and quantity demanded change by the
same proportion. This will give an elasticity equal to
1, since we are dividing a figure by itself.

Income elasticity of demand (YεD )

 This measures the responsiveness of demand to a

change in consumer incomes (Y). It enables us to
predict how much the demand curve will shift for a
given change in income.

 The formula for the income elasticity of demand is:

the percentage (or proportionate) change in demand
divided by the percentage (or proportionate) change
in income.

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Income elasticity of demand (YεD )

 Thus if a 2 per cent rise in income caused an 8 per

cent rise in a product’s demand, then its income
elasticity of demand would be:

8%/2% = 4

Cross-price elasticity of demand

 It is a measure of the responsiveness of demand for

one product to a change in the price of another
(either a substitute or a complement). It enables us
to predict how much the demand curve for the first
product will shift when the price of the second
product changes.

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Cross-price elasticity of demand

 The formula for the cross-price elasticity of demand

is: the percentage (or proportionate) change in
demand for good A divided by the percentage (or
proportionate) change in price of good B.

Cross-price elasticity of demand

 If good B is a substitute for good A, A’s demand will

rise as B’s price rises. In this case, cross elasticity will
be a positive figure. For example, if the demand for
butter rose by 2 per cent when the price of margarine
(a substitute) rose by 8 per cent, then the cross
elasticity of demand for butter with respect to
margarine would be

2%/8% = 0.25

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Cross-price elasticity of demand

 If good B is complementary to good A, however, A’s

demand will fall as B’s price rises and thus as the
quantity of B demanded falls. In this case, cross
elasticity of demand will be a negative figure. For
example, if a 4 per cent rise in the price of bread led
to a 3 per cent fall in demand for butter, the cross
elasticity of demand for butter with respect to bread
would be

−3%/4% = −0.75

Cross-price elasticity of demand

 The major determinant of cross elasticity of demand

is the closeness of the substitute or complement. The
closer it is, the bigger will be the effect on the first
good of a change in the price of the substitute or
complement, and hence the greater the cross
elasticity – either positive or negative.

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Consumer Surplus
51

 consumer surplus is the

monetary gain obtained by consumers
because they are able to purchase a
product for a price that is less than the
highest price that they would be
willing to pay.
 Thus as the price increases, consumer
surplus decreases resulting in lower
demand.
 As price decreases, consumer surplus
increases, increasing the demand for
the product.

Consumer surplus
52

 This explains why as price rises, Quantity Demanded

decrease and as price falls, Quantity Demanded
increases.

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