TOPIC 2 :DEMAND, SUPPLY AND PRICE: THE THEORY

DEMAND The buying side is usually referred to as the demand side. The selling side is usually referred to as the supply side. We start with a discussion of demand. Demand means the willingness and ability of buyers to purchase different quantities of a good at different prices during a specific time period. Example: We can express part of John's demand for magazine by saying that he is willing and able to buy 15 magazines a month at RM3 per magazine. Quantity demanded is the number of units of a good that individuals are willing and able to buy at a particular price during some time period. E.g. suppose individuals are willing and able to buy 100 novels per week at the price of RM4 per unit. Therefore, 100 units is the quantity demanded of novels at RM4. The law of demand States that as the price of a good rises, the quantity demanded of the good falls and as the price of a good falls, the quantity demanded of the good rises, ceteris paribus. The higher the price, the smaller the quantity demanded The lower the price, the larger the quantity demanded What explains the law of demand: o Substitution Effect When a Price of a good increases, its relative price makes consumers less willing to purchase this good. o Income Effect Real income is persons income measured in terms of the goods and services it can buy purchasing power When the price of a good increases real income declines reduces the ability to buy a good decline in quantity demanded

Why quantity demanded goes down as price goes up? The law of demand states that price and quantity demanded are inversely related. One major reason is that people substitute lower-priced goods for higher-priced goods. When Price increases, the quantity demanded decreases Eg.If the absolute price of orange juice rises and the price of grapefruit juice remain constant, this will lead to a decrease in the quantity demanded of orange juice because some people will substitute grapefruit juice for orange juice due to relatively lowerpriced of grapefruit juice. How to present the Law of Demand? schedule graph equation
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A demand schedule is the numerical tabulation of the qty demanded of a good at different prices. A downward sloping demand curve is the graphical representation of the inverse relationship between price and quantity demanded specified by the law of demand. Example 1: Price (RM) 4 3 2 1
P

Quantity Demanded 10 20 30 40

Point A B C D

D Q

A change in demand versus change in quantity demanded A change (increase or decrease) in demand refers to a shift in the demand curve. For example if income increase the demand for apple will increase, the demand curve for apple will shift rightward.

A change in quantity demanded refers to a movement along a demand curve. The only factor that can directly cause a change in the quantity demanded of a good is a change in the price of the good-that is, its own price.

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Changes in Demand, Shifts in demand curves The demand for a good can increase or decrease. The demand for a good increases if people are willing and able to buy more of the good at all prices. The demand for a good decreases if people are willing and able to buy less of the good at all prices.
P D1 P D D1

Rightward shift in demand curve (increase in demand) The Market Demand Curve

Leftward shift in demand curve (decrease in demand)

An individual demand curve represents the price-quantity combinations for a single buyer. For example, a demand curve could show Jone's demand for CDs. A market demand curve represents the price quantity combinations for all buyers of a particular good. In this case, the demand curve would show all buyers' demand for CDs. Price (RM) 15 14 13 12 11 10 Jones 1 2 3 4 5 6 Smith 2 3 4 5 6 7 Other buyers 20 45 70 100 130 160 All buyers 23 50 77 109 141 173

Determinants of Demand 1. 2. 3. 4. 5. 6. 7. 8. Price of the good itself Price of related good Income Preference Number of buyers Expectation of future price Advertising Weather

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What Factors cause the demand curve to shift? Income As a person's income rises, he or she can buy more at any particular goo at a given price (say blue jeans). But the ability to buy more blue jeans does not necessarily imply the willingness to do so. If the demand for blue jeans rises as income rises, then blue jeans are called a normal good. The demand for a normal good rises as income rises and falls as income falls. The demand for a normal good and income are directly related.

Suppose a person's income increases and she buys fewer blue jeans. This time blue jeans are an inferior good. The demand for an inferior good falls as income rises and rises as income falls. The demand for an inferior good and income are inversely related.

Normal good: demand increases when income increases and decreases when income decreases. Inferior good: a good for which the demand decreases when income increases

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Preference People's preferences affect the amount of a good they are willing to buy at a particular price. A change in preferences in favor of a good shifts the demand curve rightward. A change in preferences away from the good shifts the demand curve leftward. Prices of related goods.

There are two types of goods, substitutes and complements.

Two good are substitutes if they satisfy similar needs or desires. Coca-cola and Pepsi-cola are substitutes. The price of one and the demand for the other are directly related. As the price of Coca-cola rises, the demand for Pepsi-cola increases. Two goods are complements if they consumed jointly. Tennis rackets and tennis balls are complements. The price of one and the demand for the other are inversely related. As the price of tennis rackets rises, the demand for tennis balls decreases.

Number of buyers The demand for a good in a particular market area is related to the number of buyers in the area. The more buyers, the higher the demand ; the fewer buyers, the lower the demand. Expectations of future price Buyers who expect the price of a good to be higher next month may buy the good now-thus increasing the current demand for the good. Buyers who expect the price of a good to be lower next month may wait until next month to buy the good-thus decreasing the current demand for the good. Population Demand also depends on the size and the age structure of the population. Other remaining the same, the larger (smaller) the population, the larger (smaller) is the demand for all goods. Advertising An increase in a firm's effective advertising will cause an increase in demand for the product being advertised. Weather Some goods are demanded seasonally and at certain times of the year demand for these goods will increase. For example, there is a greater demand for ice-cream in the summer than in the winter.
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Exceptional Demand Curves In some cases, the demand sometimes might vary directly with price (unusual demand curves, more quantity will be demanded at a higher price). a. The reason for this include: Giffen's Paradox

The English economist Giffen is credited with the idea that in subsistence economies, if the price of basic foodstuffs such as bread, rice, corn, and potatoes increases, quantity demanded will also increase. The reason is that as price rises, the higher price makes it impossible for consumers to purchase better quality foodstuffs. They therefore substitute the poorer quality foodstuffs despite the fact that the price of these has increased. There is no empirical evidence to support this hypothesis. a. Veblen Goods

It is argued that the attractiveness of some goods increases as their price increase. Some people buy expensive things because they are expensive; the ownership of such goods puts them in a rather exclusive class. When goods are purchased for ostentatious purposes and as their price rises so does their attractiveness because they provide a means of displaying superior wealth. A fall in price might cause them to lose some of their appeal and the quantities demanded might fall because they will not be so effective as a means of displaying wealth. Alternatively it is possible to argue that if consumers believe that the price of a goods reflects its quality then quantity demanded might increase as price increases. Consumer ignorance might provide an explanation for exceptional demand curves. b. Festive Seasons

Demand for certain goods still increase despite the increase in price. This behaviour caused by the festive spirit or for religious purposes. c. Crisis Situation

During crisis/emergency situation price of certain goods ( especially basic necessities like rice, sugar, oil) will increase but the demand for certain goods will also increase. 2) Speculation/Expected Future Price Speculator will increase their demand if they speculate that the price of goods will increase further. This is to avoid they have to pay more in future for that goods or they want to make more profit.
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SUPPLY Supply means the willingness and ability of sellers to produce and offer to sell different quantities of a good at different prices during a specific time period. Refers to the relation between the P and the quantity supplied as reflected by the supply schedule or the supply curve.

Quantity supplied is the numbers of units of good sellers are willing and able to produce and offer to sell at a particular price. Particular point on SS curve The Law of supply States that as the price of a good rises, the quantity supplied of the good rises, and as the price of a good falls, the quantity supplied of the good falls. Two reasons producers tend to offer more for sale when the P rises: o First, as the price increases, other things constant, a producer becomes more willing to supply the good. Prices act as signals to existing and potential suppliers about the rewards for producing various goods higher prices attract resources from lower-valued uses. o Second, higher price also increase the producers ability to supply the goods. Since producers face higher marginal cost of production, they must receive a higher price for that output in order to be able to increase the quantity supplied. How to present the Law of supply? i. schedule ii. graph iii. equation

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Supply schedule is the numerical tabulation of the quantity supplied of a good at different prices. Supply curve is the graphical representation of the law of supply. Example:

The Market Supply Curve An individual supply curve represents the price-quantity combinations for a single seller. The market supply curve represents the price-quantity combinations for all sellers of a particular good. Supply schedule is the numerical tabulation of the quantity supplied of a good at different prices. Determinants of Supply 1. 2. 3. 4. 5. 6. 7. 8. Price of the good itself Price of related good Price of relevant resources Technology Number of sellers Expectation of future price Taxes and subsidies Government restrictions

A change in supply versus a change in quantity supplied A change in supply refers to a shift in the supply curve. A change in quantity supplied refers to a movement along a supply curve.

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What factors cause the supply curve to shift? 1) Prices of relevant resources Resources are needed to produce goods. For example. Wood is needed to produce doors. If the price of wood falls, it become less costly to produce doors, and the supply of doors increases 2) Technology Technology is defined as the body of skills and knowledge of relevant to the use of inputs or resources in production. If there is an advance in technology, the quantity supplied of a good at each price increases. This is because the lower costs increase profitability and therefore provide producers with an incentive to produce more. 3) Number of sellers If more sellers begin producing a particular good, perhaps because of high profits, the supply curve shifts rightward. 4) Expectations of Future Price If the price of a good is expected to be higher in the future, producers may hold back some of the product today. Then, they will have more to sell at the higher future price. Therefore the current supply curve shifts leftward. 5) Taxes and subsidies Some taxes increase per-unit costs. Suppose a manufacture has to pat tax of RM2 per good, the manufacturer would sell fewer goods at each price. Subsidies have the opposite effect. If the government subsidize the production of one good, the quantity supplied of the good would be greater at each price. 6) Government Restrictions Sometimes government acts to reduce supply. Consider U.S import quota on Japanese television sets. An import quota, or quantitative restriction on foreign goods reduces the supply of Japanese television sets.
P S P S1 S1 S

S1 Q 9/12

S1

S Q

Increase in supply

Decrease in supply

SUPPLY AND DEMAND TOGETHER Price is determined by the interaction of demand and supply . EQUILIBRIUM Equilibrium is a situation in which supply and demand has been brought into balance. The point where the supply curve and demand curve intersect is called the market's equilibrium. The price is called the equilibrium price and the quantity is called the equilibrium quantity. Equilibrium price is the relative price at which the quantity demanded equals the quantity supplied . Equilibrium quantity is the amount bought and sold at the equilibrium price . A situation whereby quantity supplied is greater than quantity demanded. If the price is above equilibrium (quantity supplied exceeds quantity demanded) surplus will occur . Suppliers will be obliged to lower prices in order to clear their stocks . As price falls, producers will cut back production and consumers will purchase more until surplus disappear . If the price is below equilibrium (quantity demanded exceeds quantity supplied) a shortage will result . This shortage will cause buyers to bid up the price . An increase in price will both persuade firms to expand output and discourage consumption until the new equilibrium is established . Changes in Equilibrium Equilibrium can only change if there is a change in one of demand or supply conditions or both. There are three steps to analyze how some events affect the market: 1. Decide whether the event shifts the supply or demand curve (or perhaps both) 2. Decide which direction the curve shifts 3. Use the supply and demand diagram to see how the shifts changes the equilibrium. A Change in Demand with supply held constant 1. An increase in demand will rise the price and increase the quantity traded . 2. A decrease in demand will lower the price and reduce the quantity traded .
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P D1 D S

P D D1 S

Increase in demand A Change in Supply with demand held constant

Decrease in demand

1. An increase in supply will lower the price and increase the quantity . 2. A decrease in supply will increase the price and reduce the quantity .

P S S1

P S1 S

D Q

D Q

Increase in supply Changes in both Demand and Supply

Decrease in supply

If demand and supply changes in the same direction , it is possible to know the changes in quantity , but the effect on price is uncertain . eg if the price of a complement falls, and also the firms technology advances, the demand and supply curves both shift rightward. As a result, the quantity increases, but the price may rise (if the demand shift is larger) fall (if the supply shift is larger) stay the same (if the shifts are of equal size)
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If supply and demand change in opposite directions , we can always determine the effect on price but the impact on the quantity is ambiguous. For example, if the price of a substitute falls (so that the demand curve shifts leftward) while simultaneously technology advances (which causes the supply curve shifts rightward), the price will definitely fall but the quantity may increase (if the supply shift is larger) decrease (if the demand shift is larger) not change (if the shifts are of equal size)

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