Supply and Demand

1. Law of Demand
The law of demand is a fundamental principle in economics that states that, all else being equal,
there is an inverse relationship between the price of a good and the quantity demanded by
consumers. This means that as the price of a good increases, the quantity demanded by consumers
decreases, and conversely, as the price decreases, the quantity demanded increases.

2. Law of Supply
This is a fundamental principle in economics that states that, ceteris paribus (all other factors being
constant), the quantity of a good supplied increases as the price of the good increases, and
decreases as the price decreases. The supply relationship is typically shown as an upward-sloping
curve on a graph, indicating that higher prices incentivize producers to increase production.

3. Ceteris Paribus
A Latin phrase meaning "all other things being equal." This concept is crucial in economic analysis
to isolate the effect of one variable on another when other variables are held constant. It helps in
understanding the direct relationship between variables without interference from external changes.

4. Equilibrium
In economics, equilibrium refers to a state where the quantity of a good or service demanded by
consumers equals the quantity supplied by producers. This balance occurs at a specific price called
the equilibrium price. At this price, there is neither excess supply (surplus) nor excess demand
(shortage).

5. Surplus
Also known as excess supply, a surplus occurs when the quantity of a good or service supplied is
greater than the quantity demanded at a given price. This typically happens when the price is set
above the equilibrium price, leading suppliers to reduce prices to clear the excess stock.

6. Shortage
Opposite to surplus, a shortage or excess demand occurs when the quantity of a good or service
demanded exceeds the quantity supplied at the current price. This situation usually arises when the
price is below the equilibrium level, causing producers to raise prices until the market reaches
equilibrium.

7. Demand Shifters:
Demand shifters are factors that cause the demand curve for a product or service to shift either to
the right (indicating an increase in demand) or to the left (indicating a decrease in demand). These
shifters change the quantity demanded at every price level. Here’s how each of the listed demand
shifters affects demand:
a. Normal Good: As income increases, demand for normal goods increases because people
can afford to buy more of these goods. Conversely, demand decreases as income falls.
Inferior Good: As income increases, demand for inferior goods decreases because people
can afford to replace these goods with more desirable alternatives. Conversely, demand
increases as income falls.
b. Substitutes: If the price of a substitute good (a good that can be used in place of another)
increases, the demand for the original good will increase because consumers will switch to
the cheaper option.

Complements: If the price of a complementary good (a good used in conjunction with

another) increases, the demand for the original good will decrease because the higher total
cost will reduce consumption of both goods.

c. Effective advertising can increase consumer awareness and favorable perceptions of a

product, thus increasing demand. Similarly, positive information about a product (such as
health benefits) can increase demand, whereas negative information can decrease it.
d. Changes in consumer preferences, fads, and tastes can significantly affect demand. If a
product becomes fashionable or is preferred more, demand increases. Conversely, if a
product goes out of fashion or tastes change unfavorably, demand decreases.
e. Changes in the size or composition of the population can affect demand. For example, an
aging population may increase the demand for healthcare services. An increase in the
overall population increases demand across a wide range of products.
f. If consumers expect prices to rise in the future, they might increase their current demand.
Conversely, if prices are expected to fall, consumers might delay their purchases, decreasing
current demand.

8. Supply Shifters:
Supply shifters are factors that cause the supply curve for a product or service to shift either to the
right (indicating an increase in supply) or to the left (indicating a decrease in supply). These shifters
change the quantity supplied at every price level. Here’s how each of the listed supply shifters
affects supply:

a. When the costs of inputs (such as raw materials, labor, and energy) used to produce a good
increase, the supply of that good decreases because it becomes more expensive to produce
the same amount. Conversely, a decrease in input costs increases supply, as producers can
afford to produce more at the same price.
b. Advances in technology typically increase supply because they often reduce the cost of
production and increase efficiency. For example, new machinery or software can enable
faster production or less waste, which allows producers to offer more goods at each price
level.
c. Favorable natural conditions, such as good weather for crop production, can increase
supply. Unfavorable conditions, like natural disasters or poor weather, can decrease supply
by damaging production capacity or reducing the availability of natural resources.
d. Taxes: Imposing taxes on a product increases production costs, leading to a decrease in
supply.

Subsidies: Subsidies reduce production costs, encouraging producers to increase supply.

Regulations: Depending on their nature, regulations can either decrease supply (if they
make production more difficult or expensive) or increase supply (if they provide incentives
or support for production).
9. Extension, contraction of demand or supply

a. Tax effect
● A specific tax: This is a specific, or fixed, amount of tax that
is imposed upon a product; for example, a tax of $1 per unit. It thus
has the effect of shifting the supply curve vertically upwards by the
amount of the tax, in this case, by $1.
● A percentage tax (ad valorem tax): The tax is a percentage
of the selling price and so the supply curve will shift as shown in (b).
It is clear from this that the gap between S1 and S + tax will get
bigger as the price of the product rises.
b. Subsidy effect
If a subsidy is granted to a firm on a certain
product, then the supply curve for the product will
shift vertically downwards by the amount of the
subsidy, because it reduces the costs of production
for the firm, and more will be supplied at every
price. As with indirect taxes, the amount of the
subsidy that is passed on to the consumers in the
form of lower prices, and the amount that is
retained by the producers, will depend upon the
relative elasticities of demand and supply.

c. Price ceiling
Maximum prices are usually set to help
consumers and they are normally imposed
in markets where the product in question is
a necessity and/or a merit good (a good
that would be underprovided if the market
were allowed to operate freely). The figure
on the left shows a situation that may exist
if the govt were to implement a max price
in the market for bread. Without govt
interference, the equilibrium quantity
demanded and supplied would be Qe, at the price of Pe. The government impose a max price of
Pmax in order to help the consumers of bread. However, at the price of Pmax, Q2 will be demanded
because the price has fallen, but only Q1 will be supplied. Thus, we have a situation of excess
demand. If the govt does not intervene further, they will find that consumption of bread actually
falls from Qe to Q1, even though it is at a lower price.

d. Price floor
This is a situation where the govt sets a
minimum price, above the equilibrium price,
which then prevents producers from reducing
the price below it. Minimum prices are mostly
set to attempt to raise incomes for producers
of g/s that the govt thinks are important,
such as agricultural products or to protect
workers by setting a minimum wage, to
ensure that workers earn enough to lead a
reasonable existence.
Without govt interferences, the equilibrium quantity demanded and supplied would be Qe, at a price
of Pe. The govt imposes a minimum price of Pmin in order to increase the revenue of the producers
of wheat. However, at the price of Pmin, only Q1 will be demanded because the price has risen, but
Q2 will now be supplied. Thus, we have a situation of excess supply. If the government does not
intervene further, they will find that consumption of wheat actually falls from Qe to Q1, albeit at a
higher price.
e. Social costs and benefits
Social costs and benefits refer to the total impact of an activity on society, including both private
(internal to the transaction) and external (affecting third parties) effects.

f. Externalities
Externalities are the positive or negative consequences of economic activities experienced by
unrelated third parties. They can be negative (e.g., pollution) or positive (e.g., the benefit to the public
from a well-maintained park).

g. Social cost = private cost + external cost

This formula represents the total cost of production, including both the costs directly incurred by
the producer (private costs) and the costs incurred by others outside the production process
(external costs). The true economic cost of a good should include both these aspects to reflect the
full economic impact on society.

h. Social Benefit = Private Benefit + External Benefit

Social Benefit refers to the total benefit from producing or consuming a good or service, including
both the direct benefits to the consumer or producer (Private Benefit) and the benefits that accrue
to other members of society (External Benefit). For example, the social benefit of education
extends beyond the individual gaining knowledge; it also includes the broader societal advantages
such as a more informed citizenry and higher economic productivity.
Private Benefit is the direct benefit received by the consumer or producer from a transaction. For
instance, the enjoyment and utility a consumer gets from consuming a product.
External Benefit is the benefit that is not captured by the market price and is enjoyed by third
parties; for example, the reduced healthcare costs society enjoys when more people are vaccinated.

i. Efficiency = Produce only if Benefits Cover Costs

This principle of economic efficiency states that an activity should be expanded as long as the
additional benefits (marginal benefits) exceed the additional costs (marginal costs). Production is
efficient when no additional net benefit can be obtained by increasing or decreasing the level of
production. If the benefits of producing one more unit of a good or service cover the costs of
producing it, then it is efficient to do so. When applied to the entire economy, this concept helps in
determining the optimal allocation of resources, where goods and services are produced at their
lowest possible cost and where they yield the highest benefit to consumers and society as a whole.

j. Forms of Market Failure:

Market failure occurs when the allocation of goods and services by a free market is not efficient,
often leading to a net social welfare loss. Market failures can occur due to several reasons:
● Public Goods: Non-excludable and non-rivalrous goods like public parks or national defense
where the market may fail to provide them in sufficient quantities.
● Externalities: When the production or consumption of goods and services imposes costs or
benefits on others which are not reflected in the market prices. For example, pollution from
a factory affects the health of residents in surrounding areas.
● Monopolies and Other Market Powers: A single firm or a group having significant control
over market prices can lead to higher prices and reduced output compared to competitive
markets.
● Information Asymmetry: When one party in a transaction has more or better information
than the other, leading to decisions that do not maximize welfare. Examples include sellers
knowing more about product defects which buyers are unaware of.
● Immobility of Factors: Sometimes factors of production (like labor and capital) do not move
freely to where they are needed most, leading to inefficiencies.