Economics Lecture Notes – Chapter 2
DEMAND AND SUPPLY will be taught in economics tuition in the second and third weeks of term 1.
Students can refer to Economics – A Singapore Perspective for the diagrams. The book is available in the major bookstores in Singapore.
1 INTRODUCTION
In Chapter 1, we learnt that the allocation of resources in the market system is determined by the market forces of demand and supply. Therefore, to have a good understanding of the allocation of resources in the market system, we need to understand the concepts of demand and supply. Indeed, as demand and supply are two fundamental economic concepts which permeate the study of economics, a good understanding of the concepts is essential for understanding economics. To draw an analogy, the importance of demand and supply in economics is equivalent to the importance of the four mathematical operations of addition, subtraction, multiplication and division in mathematics. This chapter provides an exposition of the concepts of demand and supply.
2 DEMAND
2.1 Relationship between Price and Quantity Demanded
The demand for a good is the quantity of the good that consumers are willing and able to buy at each price over a period of time, ceteris paribus. The quantity demanded of a good refers to the quantity of the good that consumers are willing and able to buy. The law of demand states that there is an inverse relationship between price and quantity demanded. When the price of a good falls, the quantity demanded will rise. Conversely, when the price of a good rises, the quantity demanded will fall. The demand curve of a good shows the quantity demanded of the good at each price over a period of time, ceteris paribus. The demand curve is downward sloping due to the law of demand.
Demand Curve
In the above diagram, when the price (P) is P0, the quantity demanded (Q) is Q0. A fall in the price from P0 to P1 leads to an increase in the quantity demanded from Q0 to Q1.
The law of demand can be explained with the concept of diminishing marginal utility. Utility refers to the satisfaction obtained by consumers from consuming a good. Marginal utility is the additional satisfaction resulting from consuming one more unit of a good. The more a consumer has of a good, the less they will value it at the margin and this is known as diminishing marginal utility. Due to diminishing marginal utility, consumers will only increase the consumption of a good if the price falls. The law of demand can also be explained with the concepts of substitution effect and income effect. When the price of a good falls, the real income of consumers will rise as they will be able to buy a larger amount of goods and services with the same amount of nominal income. This will induce them to buy more of the good. This effect is known as the income effect of a price fall. Furthermore, when the price of a good falls, the good will become relatively cheaper than other goods. This will induce consumers to substitute the good for other goods. This effect is known as the substitution effect of a price fall.
Note: Ceteris paribus is Latin which means other things being equal.
The demand curve of a consumer is downward sloping due to the law of demand. The market demand curve is the horizontal summation of the demand curves of all the consumers in the market and hence is also downward sloping.
Students are not required to explain the inverse relationship between price and quantity demanded in the examination unless the question specifically asks so.
2.2 Movements along versus Shifts in the Demand Curve
A change in quantity demanded occurs when quantity demanded changes due to a change in price. This is shown by a movement along the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 due to a fall in the price (P) from P0 to P1. This is called an increase in quantity demanded.
A change in demand occurs when quantity demanded changes due to a change in a non-price determinant of demand. In other words, quantity demanded changes at the same price. This is shown by a shift in the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price (P0) due to a change in a non-price determinant of demand. This is called an increase in demand.
Note: Students should not mix up a change in quantity demanded which is shown by a movement along the demand curve and a change in demand which is shown by a shift in the demand curve as failure to do so will lead to a great loss of marks in the examination.
2.3 Non-price Determinants of Demand
Tastes and Preferences
A change in tastes and preferences towards a good will lead to an increase in the demand and vice versa. Tastes and preferences are affected by a number of factors such as technological advancements and campaigning. For example, the inventions of smartphones and tablets have led to a change in tastes and preferences from print publications to digital publications. Healthy living campaigns have led to a change in tastes and preferences from non-diet soft drinks to diet soft drinks. These have increased the demand for digital publications and diet soft drinks and decreased the demand for print publications and non-diet soft drinks.
Prices of Substitutes and Complements
Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. A rise in the prices of substitutes for a good will induce consumers to buy less of the substitutes resulting in an increase in the demand for the good and vice versa. For example, if the price of Pepsi rises, consumers will buy less Pepsi and more Coke. Complements are goods which are consumed in conjunction with one another such as car and petrol. A fall in the prices of complements for a good will induce consumers to buy more of the complements resulting in an increase in the demand for the good and vice versa. For example, if the prices of cars fall, consumers will buy more cars and more petrol. Substitutes and complements will be explained in greater detail in Chapter 3.
Number of Substitutes and Complements
An increase in the number of substitutes for a good will lead to a decrease in the demand for the good and vice versa. For example, if scientists found out that milk could be used as a substitute for shampoo, the demand for shampoo would decrease. An increase in the number of complements will lead to an increase in the demand for a good and vice versa. For example, if more models of digital cameras are introduced onto the market, the demand for memory cards will increase.
Level of Income
When consumers’ income rises, the demand for some goods will increase and these goods are called normal goods. A normal good is a good whose demand rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. A necessity is a good whose demand rises by a smaller proportion when consumers’ income rises. Examples of necessities include agricultural products and stationery. A luxury is a good whose demand rises by a larger proportion when consumers’ income rises. Examples of luxuries include private cars and branded watches. When consumers’ income rises, the demand for some goods will decrease and these goods are called inferior goods. An inferior good is a good whose demand falls when consumers’ income rises. Inferior goods are typically relatively low in quality. Examples of inferior goods include public transport and Daiso Products.
Distribution of Income
If income is redistributed from the rich to the poor, the demand for luxuries which are typically consumed by the rich will fall as the rich will become less rich. The demand for inferior goods which are typically consumed by the poor will also fall as the poor will become less poor. However, the demand for necessities will increase as both the rich and the poor will buy more necessities.
Expectations of Price Changes
If consumers expect the price of a good to rise, they will bring forward the purchase to avoid paying a higher price in the future. If the good can be resold such as residential properties, consumers will also buy the good to sell it at a higher price later. When these happen, the demand for the good will increase. Conversely, if consumers expect the price of a good to fall, they will put off the purchase to enjoy a lower price in the future which will lead to a decrease in the demand.
Size of the Population
An increase in the size of the population will lead to an increase in the demand for certain goods and services. With the exception of a few countries such as Japan, most countries have been experiencing an increase in the size of the population.
Structure of the Population
If the population is greying, the demand for pharmaceutical products will increase. An example is Singapore. If the birth rate rises, the demand for infant products will increase.
Government Policies
The government is the biggest spender in every economy. Therefore, if the government increases expenditure on goods and services, the demand for certain goods and services will increase and vice versa. The government can also affect private expenditure by changing interest rates and tax rates. For example, if the government cuts income taxes, consumers will experience a rise in their disposable incomes which will lead to an increase in the demand for certain goods and services.
Weather Conditions
In winter, the demand for coats and sweaters will increase and the demand for ice creams will decrease. The opposite is true in summer.
Note: The non-price determinants of demand will be discussed in greater detail in economics tuition by the Principal Economics Tutor.
3 SUPPLY
3.1 Relationship between Price and Quantity Supplied
The supply of a good is the quantity of the good that firms are willing and able to sell at each price over a period of time, ceteris paribus. The quantity supplied of a good refers to the quantity of the good that firms are willing and able to sell. The law of supply states that there is a direct relationship between price and quantity supplied. When the price of a good falls, the quantity supplied will fall. Conversely, when the price of a good rises, the quantity supplied will rise. The supply curve of a good shows the quantity supplied of the good at each price over a period of time, ceteris paribus. The supply curve is upward sloping due to the law of supply.
Supply Curve
In the above diagram, when the price (P) is P0, the quantity supplied (Q) is Q0. A rise in the price from P0 to P1 leads to an increase in the quantity supplied from Q0 to Q1.
The law of supply can be explained with the concept of profit maximisation. A rise in the price of a good will increase the profitability of selling the good. Therefore, firms which are profit-oriented will sell more of the good. The law of supply can also be explained with the concept of diminishing marginal returns. Suppose that a firm employs two factor inputs: capital and labour. Although labour is a variable factor input, capital is a fixed factor input. As the quantity of capital is fixed in the short run, the firm can increase production only by employing more labour. However, as each additional unit of labour will have less capital to work with, it will add less to total output than the previous additional unit and this is known as diminishing marginal returns. Due to diminishing marginal returns, to produce each additional unit of output, more units of labour will be required which will lead to an increase in marginal cost. Marginal cost is the additional cost resulting from producing one more unit of output. Therefore, firms will increase the production of a good only if the price rises.
Note: The supply curve of a firm is upward sloping due to the law of supply. The market supply curve is the horizontal summation of the supply curves of all the firms in the market and hence is also upward sloping.
Students are not required to explain the direct relationship between price and quantity supplied in the examination unless the question specifically asks so.
3.2 Movements along versus Shifts in the Supply Curve.
A change in quantity supplied occurs when quantity supplied changes due to a change in price. This is shown by a movement along the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to a rise in the price (P) from P0 to P1. This is called an increase in quantity supplied.
A change in supply occurs when quantity supplied changes due to a change in a non-price determinant of supply. In other words, quantity supplied changes at the same price. This is shown by a shift in the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price (P0) due to a change in a non-price determinant of supply. This is called an increase in supply.
Note: Students should not mix up a change in quantity supplied which is shown by a movement along the supply curve and a change in supply which is shown by a shift in the supply curve as failure to do so will lead to a great loss of marks in the examination.
3.3 Non-price Determinants of Supply
Cost of Production
A rise in the cost of production will lead to a decrease in supply and vice versa. When the cost of production rises, firms will increase the price at each quantity to maintain profitability. In other words, they will reduce the quantity supplied at each price which will lead to a decrease in supply. The converse is also true. There are several factors that can lead to a change in the cost of production. For example, a fall in factor prices such as wages will lead to a fall in the cost of production and vice versa. Subsidy will decrease the cost of production and tax will have the opposite effect. Labour productivity refers to output per hour of labour. When labour productivity rises, which may be due to an increase in the skills and knowledge of labour or the efficiency of capital, firms will need a smaller amount of labour to produce any given amount of output. Therefore, the cost of production will fall.
Production Capacity
If the production capacity in the industry increases, which may occur due to an increase in the number of firms in the industry or an expansion of the production capacities of the existing firms, the supply of the good will increase. The converse is also true.
Expectations of Price Changes
If firms expect the price of a good to rise, they will hoard some of the output that they currently produce to sell it at a higher price in the future. This will lead to a fall in the supply of the good. The converse is also true.
Profitability of Goods in Joint Supply
Goods in joint supply refer to goods that are produced in the same production process. An example is petrol and diesel. In the process of refining crude oil to produce petrol, other grade fuels such as diesel are also produced. Therefore, if the demand for petrol increases which will lead to an increase in the profitability, more petrol will be produced. When this happens, the supply of diesel will also increase. The converse is also true.
Profitability of Substitutes in Supply
Substitutes in supply refer to goods that are produced using the same factor inputs. An example is potatoes and tomatoes. If the demand for tomatoes increases which will lead to an increase in the profitability, some farmers who are currently producing potatoes will switch to the production of tomatoes which will lead to a decrease in the supply of potatoes. The converse is also true.
Disasters (Natural and Man-made)
Natural disasters such as floods and earthquakes, and man-made disasters such as wars which may kill workers and destroy factories and machinery, may lead to a decrease in the supply of certain goods including agricultural products.
Weather Conditions
When weather conditions become less favourable, the supply of agricultural products will fall as harvests will decrease. The converse is also true. In the event of severe weather conditions, the supply of air travel will fall as airlines will be forced to cancel flights.
Note: The non-price determinants of supply will be discussed in greater detail in economics tuition by the Principal Economics Tutor.
4 EQUILIBRIUM
4.1 Equilibrium Price and Equilibrium Quantity
An equilibrium is a state where there is no tendency to change. The equilibrium of a market is determined by the market forces of demand and supply. If consumers demand more of a good than what firms supply at a particular price, the quantity demanded will exceed the quantity supplied. The resultant shortage will push up the price. This is because when firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will do so to increase their profits. A rise in the price of the good will incentivise firms to increase the production due to the higher profitability and consumers to decrease the consumption due to the higher relative price and the lower real income. Therefore, the quantity supplied will rise and the quantity demanded will fall. The price will continue rising until the quantity demanded is equal to the quantity supplied, at which point the shortage is eliminated and an equilibrium is established.
In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the equilibrium quantity are PE and QE. At a price below PE, such as P1, the quantity demanded (QD) is greater than the quantity supplied (QS) and this results in a shortage (QD – QS). As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to PE where the quantity demanded and the quantity supplied are equal at QE. Similarly, if firms supply more of a good than what consumers demand at a particular price, the quantity supplied will exceed the quantity demanded. The resultant surplus will push down the price. This is because when firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the price to reduce their stocks. A fall in the price of the good will incentivise firms to decrease the production due to the lower profitability and consumers to increase the consumption due to the lower relative price and the higher real income. Therefore, the quantity supplied will fall and the quantity demanded will rise. The price will continue falling until the quantity demanded is equal to the quantity supplied, at which point the surplus is eliminated and an equilibrium is established.
In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the equilibrium quantity are PE and QE. At a price above PE, such as P2, the quantity supplied (QS) is greater than the quantity demanded (QD) and this results in a surplus (QS – QD). As the price falls, the quantity demanded rises and the quantity supplied falls and this process continues until the price falls to PE where the quantity demanded and the quantity supplied are equal at QE. At PE, the quantity demanded is equal to the quantity supplied. There is neither surplus nor shortage and hence there is no incentive for firms to change the price.
4.2 Effects of a Change in Demand on Price and Quantity
Increase in Demand
An increase in demand will lead to a rise in price and quantity.
In the above diagram, an increase in the demand (D) from D0 to D1 leads to a rise in the price (P) from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although the quantity demanded rises at the same price (P0), the quantity supplied remains at Q0 and this results in a shortage. When firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to P1 where the quantity demanded and the quantity supplied are equal at Q1.
Decrease in Demand
A decrease in demand will lead to a fall in price and quantity.
In the above diagram, a decrease in the demand (D) from D0 to D1 leads to a fall in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the quantity demanded falls at the same price (P0), the quantity supplied remains at Q0 and this results in a surplus. When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the price to reduce their stocks. As the price falls, the quantity demanded rises and the quantity supplied falls and this process continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at Q1.
Note: When demand changes, price and quantity will change in the same direction.
4.3 Effects of a Change in Supply on Price and Quantity
Increase in Supply
An increase in supply will lead to a fall in price and a rise in quantity.
In the above diagram, an increase in the supply (S) from S0 to S1 leads to a fall in the price (P) from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the supply increases from S0 to S1, although the quantity supplied rises at the same price (P0), the quantity demanded remains at Q0 and this results in a surplus. When firms cannot sell all the output that they produce, their stocks will build up. Therefore, they will lower the price to reduce their stocks. As the price falls, the quantity demanded rises and the quantity supplied falls and this process continues until the price falls to P1 where the quantity demanded and the quantity supplied are equal at Q1.
Decrease in Supply
A decrease in supply will lead to a rise in price and a fall in quantity.
In the above diagram, a decrease in the supply (S) from S0 to S1 leads to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0) and the supply (S0), the price and the quantity are P0 and Q0. When the supply decreases from S0 to S1, although the quantity supplied falls at the same price (P0), the quantity demanded remains at Q0 and this results in a shortage. When firms do not produce enough to sell, they can raise the price without losing sales. Therefore, they will do so to increase their profits. As the price rises, the quantity demanded falls and the quantity supplied rises and this process continues until the price rises to P1 where the quantity demanded and the quantity supplied are equal at Q1.
Note: When supply changes, price and quantity will change in opposite directions.
4.4 Effects of Simultaneous Changes in Demand and Supply on Price and Quantity
Same Directional Changes in Demand and Supply
Suppose that demand and supply rise simultaneously. An increase in demand will lead to a rise in price and quantity. An increase in supply will lead to a fall in price and a rise in quantity. Therefore, quantity will rise and price will be indeterminate. In this case, the effect on price will depend on the relative changes in demand and supply. If the increase in demand is greater than the increase in supply, price will rise.
In the above diagram, given the demand (D0) and the supply (S0), the price (P) and the quantity (Q) are P0 and Q0. A larger increase in the demand from D0 to D1 and a smaller increase in the supply from S0 to S1 lead to a rise in the price from P0 to P1 and a rise in the quantity from Q0 to Q1. However, if the increase in supply is greater than the increase in demand, price will fall.
In the above diagram, given the demand (D0) and the supply (S0), the price (P) and the quantity (Q) are P0 and Q0. A larger increase in the supply from S0 to S1 and a smaller increase in the demand from D0 to D1 lead to a fall in the price from P0 to P1 and a rise in the quantity from Q0 to Q1.
Similarly, when demand and supply fall simultaneously, quantity will fall and price will be indeterminate. The effect on price will depend on the relative changes in demand and supply. If the decrease in demand is greater than the decrease in supply, price will fall. However, if the decrease in supply is greater than the decrease in demand, price will rise.
Different Directional Changes in Demand and Supply
The above analysis is based on the assumption that demand and supply change in the same direction. However, if demand and supply change in opposite directions, the analysis will be a little more complicated. As the analysis of such a case involves the concepts of price elasticity of demand and price elasticity of supply which have not been covered, it will be explained in Chapter 3.
Note: The effects of simultaneous changes in demand and supply on price and quantity will be discussed in greater detail in economics tuition by the Principal Economics Tutor.
5 SURPLUS
5.1 Consumer Surplus
Consumer surplus is the difference between the maximum amount that consumers are willing and able to pay for a good and the amount that they actually pay.
In the above diagram, consumers are willing and able to pay $10 for the first unit of the good, $9 for the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers buy 4 units of the good. When the quantity demanded is 4 units, the price is $7. In this case, although the maximum amount that consumers are willing and able to pay is $34 ($10 + $9 + $8 + $7 = area of trapezium), the amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the consumer surplus is $6 ($34 – $28 = area of trapezium – area of rectangle) and is represented by the area below the demand curve and above the price.
Consumers pursue self-interest by maximising utility through maximising consumer surplus. Recall that consumer surplus is the difference between the maximum amount that consumers are willing and able to pay for a good and the amount that they actually pay. This means that consumer surplus of a unit of a good occurs when the maximum price that consumers are willing and able to pay for it is higher than the price they actually pay. Recall that the demand for a good is the quantity of the good that consumers are willing and able to buy at each price over a period of time, ceteris paribus. The demand curve shows the quantity demanded at each price and is downward sloping due to the law of demand. It follows that the demand curve shows the maximum price that consumers are willing and able to pay at each quantity. Consumers seek to maximise utility which refers to the satisfaction obtained from consuming a good. To maximise utility, consumers will maximise consumer surplus by consuming up to the point where the maximum price that they are willing and able to pay is equal to the price they actually pay.
In the above diagram, given the demand curve (D) and the price (P0), the maximum price that consumers are willing and able to pay for each unit of the good is higher than the price they actually pay from the first unit to Q0. Therefore, consumers will maximise consumer surplus by consuming the quantity (Q0) as each unit of the good from the first unit to Q0 produces a consumer surplus. The consumer surplus is represented by the shaded area.
Note: Consumer surplus will be discussed in greater detail in economics tuition by the Principal Economics Tutor.
5.2 Producer Surplus
Producer surplus is the difference between the minimum amount that firms are willing and able to receive for a good and the amount that they actually receive.
In the above diagram, firms are willing and able to receive $4 for the first unit of the good, $5 for the second unit, $6 for the third unit and $7 for the fourth unit. Suppose that firms produce 4 units of the good. When the quantity supplied is 4 units, the price is $7. In this case, although the minimum amount that firms are willing and able to receive is $22 ($4 + $5 + $6 + $7 = area of trapezium), the amount that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer surplus is $6 ($28 – $22 = area of rectangle – area of trapezium) and is represented by the area below the price and above the supply curve.
Firms pursue self-interest by maximising profit through maximising producer surplus. Recall that producer surplus is the difference between the minimum amount that firms are willing and able to receive for a good and the amount that they actually receive. This means that producer surplus of a unit of a good occurs when the minimum price that firms are willing and able to receive from it is lower than the price they actually receive. Recall that the supply of a good is the quantity of the good that firms are willing and able to sell at each price over a period of time, ceteris paribus. The supply curve shows the quantity supplied at each price and is upward sloping due to the law of supply. It follows that the supply curve shows the minimum price that firms are willing and able to receive at each quantity. Firms generally seek to maximise profit which is the excess of total revenue over total cost. To maximise profit, firms will maximise producer surplus by producing up to the point where the minimum price that they are willing and able to receive is equal to the price they actually receive.
In the above diagram, given the supply curve (S) and the price (P0), the minimum price that firms are willing and able to receive from each unit of the good is lower than the price they actually receive from the first unit to Q0. Therefore, firms will maximise producer surplus by producing the quantity (Q0) as each unit of the good from the first unit to Q0 produces a producer surplus. The producer surplus is represented by the shaded area.
Note: Producer surplus will be discussed in greater detail in economics tuition by the Principal Economics Tutor.
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