Ch.2 Supply & Demand

PLEASE READ THE DISCLAIMER FIRST before proceeding

Demand

Supply & demand	- The amount firms can supply, depending on resources & wants.
Scarcity	- Potential demands will exceed potential supplies. ® society deal with this problem so that at the level of the economy overall: aggregate demand will need to be balanced against aggregate supply ® totally spending balances total production in the economy. Also, at the level of individual goods & services which need to be balanced.
Perfect Competition	- A Situation where the consumers and producers of a product are price takers
Price takers	- A household or firm with no power to influence the market price.
*Supply & Demand*	- The study of the determinants of supply & demands, the relationship between demand, supply & price which transmit information, the roles of price as incentives & how supply & demand respond to them & the effects of government intervention. The markets examined in economics are in perfect competition.
Are firms price takers?	- This assumption is probably wrong. Firms set the price in manufacturing, but they have to consider the demand and their competitors’ prices. Nevertheless, they have flexibility in choosing their prices.
Perfectly competitive market	- Individual producers have no influence over prices. - Too small or too much competition to raise prices. - If individual producers sell products above market price, then, no one will buy, and they become price takers. Its analysis give useful insight into real-world market. -The predicted effects of a market economy claimed can be examined.
*The Law of Demand*	- The quantity of a good demanded per period of time will fall as price rises, and will rise as price falls, other things being usual: Ceteris Paribus.

Quantity of demand is inversely proportional to price, because of:

-income effect- consumers feel richer. They can buy more with the same amount of money they possess. The purchasing power of their income (real income) increase. Hence, they buy more.
-substitution effect: The product will be cheaper relative to substitutes. So, consumer switch from other substitutes. The quantity demanded changes depends on the size of the income & substitution effect. A rise in income will cause increase in demand:
-at price P1, a rise in income causes Q1 to Q3
-at price P2, a rise in income causes Q2 to Q4

A rise in demand is assumed that the product is a normal product. If it is an inferior product (e.g. cheap wine), a rise in income will decrease the demand (shifting the demand curve to the left).

The income effect of a product depends on the amount of income spent on purchasing. The bigger is the proportion of income spent on the good, the bigger will be the effect of a price change on people’s real income.

The Substitution effect depends primarily on the number and closeness of substitute goods.

Note that a movement along the curve (schedule) is only caused by a change in the price of that product. It is refer to as a change in quantity demand. This is the amount of a good that a consumer is willing and able to buy at a given price over a given period of time. A shift to the schedule is caused by a change in a determinant other than the price of that product. It is refer to as a change in demand.

Demand schedule for an individual	- A table showing the different quantities of a good that a person is willing and able to buy at various prices over a period of time.
Market demand schedule	- A table showing different total quantities of a good that consumers are willing and able to buy at various prices over a given time.
Effective Demand	- Demand backed by abilities to purchase. - Demand is only relevant if it is effective demand, not of desire

Determinants of households for products

Tastes	- Preference, style - The more desirable people find the product, the more they buy - Affected by trend, fashion and brand loyalty(from advertising),by observing other consumers, considerations of health, experience of from consuming the product previously.
No./price of substitutes	- Rises with demands (Schedule moves to the right) - Drops with demands (Schedule moves to the right)
No. & price of complements	- Demands drop as price of complements rises (Schedule shifts to the left) - Demand rises as price of complement drops(Schedule shift to the right)
Income	- Increases & decreases with demand proportionately. - With exceptions of inferior & satiation products -Normal products: e.g. leisure activities, clothing whose demands always increase with income. - Inferior products: e.g. cheap wine, junk food whose demands only increase with income up to a certain limit of income, when customers will switch to better products. Hence, after that limit, demands drop. - Satiation products: e.g. salt, whose demand only increase up to a satiation point of a household, after which point the demands remain level. - Vablen goods- conspicuous consumption goods. Peoplebuy them because they are expensive - Giffen goods - Basic goods whose consumption increases with price.

Distribution of income

- How the wealth are distributed among the population affects the market demand only. E.g. If the wealth of the rich are distributed to the poor through taxation, the demand for prestigious and luxurious goods will fall.

Population	- This affects the market demand only. The larger it is, the larger is the demand.
Price (of the products)	- Influenced by brand loyalty, availability of substitutes, complements.
Competition	- Caused by availability of substitutes
Expectation of future prices	- If people expect the price to fall, the demand will drops temporarily, and vice versa.

Relationship between Price & Quantity Demanded for Complimentary & Substitutes Goods

Conclusions: The determinants of household demand are the price of the product, income, price of substitute and complementary products, expectation of future prices and tastes.
The determinants of market demand are that of the household demand, the distribution of income and the size of the population.
A Demand function represents the relationship between market demand and the determinants of demand as follow:

Where Q_d is the quantity demanded, P_a is the price of the product concerned, T is tastes,

is the price of substitute goods,

is the price of complementary goods, Y is the total consumer incomes, Yd is the distribution of income,

is the expected price of the product concerned at some future time, represented by t + 1. Using statistical techniques called regression analysis, a demand equation can be estimated.

The branch of economics applying statistical techniques to economic data is called econometrics, though its graphs and equations produced are not often totally reliable.

SUPPLY

The Determinants of supply:

The Price of the product	- The quantity supplied rises with the price of the product:- - As profitability increases, firms are ready to supply more,exceeding the level of output when cost rises rapidly. - The higher the price of the good, the more profitable it becomes to produce. - Given time, new producers are encouraged to join in, if price remains high, thus, supply increases. N.B. The 1st two determinants are short term, the 3rd one is long term.
The Cost of production	- The higher it is, the less profit will be made at any price. - Firms cut supply as cost increases, switching to substitutes:- - Change in input prices: wages, raw material prices, rents,interest rate, tax rate, etc. - Change in technology: technological advances alter costs fundamentally. - Organisational changes: cost saved through reorganisation of production - Government policy: Altered by government subsidies & taxes
The profitability of alternative products	- When a substitute product in supply becomes more profitable to supply than before, producers may switch from others to producing it. Substitutes become more profitable if their prices rise or their costs if production fall.
Substitutes in supply	- 2 goods where an increased production of one means diverting resources away from producing others.
The profitability of goods in joint supply	- When the production of a product in joint supply increase, the production of the product itself will also rise.
Goods in joint supply	- 2 goods where the production of more of one leads to the production of more of the other.
Nature, random shocks, & other unpredictable events	- Weather & diseases affecting farm output, war affecting imported raw materials supply, breakdown of machinery, industrial disputes, earthquakes, floods & fire etc.
Aims of producers	- E.g. A profit maximising firm supplies a different quantity from a sales maximising firm. At A-Level, the aims of producers are assumed to be profit-maximising.
Expectation of future price changes	- If price is expected to rise, producers temporarily reduce market supply, stocking up their supply, releasing them to the market only when the price rises. Meanwhile, more are produced through, installing machines and using more labour.
Supply & Demand Curves	- For both types of curves, price (P) is measured in the vertical axis, while the quantity demanded(Qd) is measured in the horizontal axis. - The term curve is used even when the graph is a straight line. - Demand curves are generally negatively sloped, supply curve are usually positively sloped, though they could be vertical, horizontal or even downward sloped sometimes. - A shift in both types of curves are resultant from a change in one or more determinants other than the price of the product, causing a change in demand/supply. - A movement along the curves is resultant from a change in the price of the product, causing a change in quantity demanded/supplied.

A supply equation represents the relationship between the market supply and the determinants of supply as follow:

where Qs is quantity supplied, Pa is the price of the product concerned, Ca is the cost of production of the product concerned,

is the profitability of alternative substitute products,

is the profitability of complementary goods in joint supply, R is random shocks, A is the aims of production, Pea is the expected price of the good at some future time t+1.

Price & Output Determination

Market Clearing	- A market ‘clears’ when the supply demand matches the demand, with no shortage or surplus.
Equilibrium price	- The price where the quantity demand equal s the quantity supplied, ceteris paribus.
Equilibrium	- A position of balance. A position where there is usually no inherent tendency to move away.
Movements in equilibrium	- Equilibrium price remains unchanged unless the demand or supply curves change. If either of them shifts, a new equilibrium is formed. - If either of the curves shift, there will be a movement along the other curve to the new intersection (equilibrium) point. - When both curves, the curves move to the new intersection point along the curves.

Market Equilibrium

The point of equilibrium (Pe) is where the Qd of consumers matches the Qs of producers

D= The quantity consumers are willing to buy at various prices, as other determinants are unchanged.
S= The quantity producers are willing to produced at various prices, as other determinants are unchanged.

Where D increases, and S is unchanged, the price will rise. Where D decreases and S is unchanged, the price will drop.

Where S increases, and D in unchanged, the price will drop. Where S decreases & d is unchanged, the price will rise. However, the effect on the quantity produced & traded depends on the relative shifts of S & D.

Identification problem

- The problem if identifying the relationship between two variables (E.g. Price & Qd), from evidence not showing whether or how the variables have been affected by other determinants. E.g., having little data, it is difficult to identify whether the curve is shifted or there is a movement along the curve.

UK House Prices- A Case Study

Between 1939 & 1993, house prices vary. Since 1983, house prices climbed as the recession was being recovered. By 1989, house prices doubled, although the increase was relatively slow at first. By 1988, house prices rise at 40 % per year.

In 1989, house price boom halted in the south & fell until early 1993, & slowed down in the north. By 1992, house prices fall everywhere, leaving over 1.5M households with greater mortgages then the value of their properties- ‘negative equity’ in their property

House Price Boom: 1983- 89

The recession was recovered quicker in the south where people have higher incomes, so house prices rise faster there than in the north, where the recession was deeper and longer lived, with slow recovery, and high unemployment. Therefore, in the south, there is a large rightward shift in the demand curve for house. The already high house price, thus, increases. There is also a smaller rightward shift in the demand curve for the north. Thus, it experiences a smaller price boom.

The high mortgage interest rate fell after 1985, and mortgages are more easily obtainable, with banks competing with building societies. Price rose as demand increased with people seeing house as a good investment. These effects were bigger in the south.

The house price slump: 1989-93

By mid-1988, the house prices were extremely high, in the south. With the government raising the interest rate, many people could no longer afford their mortgages. Thus, the demand for house fell in the south.

Before the rise in interest rate in 1988, many moved out of London to commute, avoiding London house prices. Businesses were at the same time attracted to the north with plenty of labour, cheaper land, cheaper housing for employees. Thus, the demand & price of property in the north began to rise faster than in the south by mid-1988.

Early 1989-early 1992: house prices fell by 25% in the SE, 30% in E Anglia, but rise by 30% in Scotland & 40% in N England.

The then deepening recession in all parts of the country in 1992, the demand curves shifted to the left, as house prices fell generally.

The 1992 fall in mortgage interest rates, combined with a slow recovery in the economy in 1993 led to a rise in price and demand again.

Elasticity

By knowing how responsive are quantity demanded to a change in price, firms can predict what will happen if they put up or down prices:

- A firm can increase the price of a product, say from £6-£10, its quantity traded may just fall from 100 to 90 units, but a significantly more profit on each unit sold, ceteris paribus.

- However, another firm may want to raise the price of the same kind of product from £6 to just £7, and yet, the quantity traded may fell from 100 to 40 units.

- Economist can, at the same time, predict the effects of a shift in supply on the market price of a product.

Price Elasticity

The above diagram illustrates two different effects on demand with a shift in supply curve. Initially, S1 intersects both D1 and D2 at the point of equilibrium a, at price P1 and quantity Q1. When the supply curve shifts to S2, the price is bound to change, but to judge the magnitude of the variation, the shape of the demand curves has to be considered. Along D, there is a relative large rise in price to P2. But there is only a relatively small change in price to P3 along D’.

Elasticity	- A measure of the responsiveness of a variable (e.g. quantity demanded/supplied), to a change in one of its determinants (e.g. price or income). - Four particular types of elasticity: Price elasticity of demand, price elasticity of supply, income elasticity of demand & cross-price elasticity of demand.
Price Elasticity of supply (PÎ s)	- Measure the responsiveness of quantity supplied to a change in price:
Price Elasticity of demand (PÎ d)	- Measure the responsiveness of quantity demanded to a change in price:
Income elasticity of demand (YÎ d)	- Measure the responsiveness of demand to a change in consumer incomes:
Cross price elasticity of demand ()	- Measure the responsiveness of demand for one good to a change in the price of another: - Useful for firms to see how responsive the demand for its product will be with a change in price of its rivals’ products.
The use of proportionate measures	- It allows comparison of two qualitatively different things with different units. - It avoids problems of what size units to use (pounds & pence) - Only sensible way of deciding the magnitude of a change in price or quantity.
The sign	-If demand/supply increases and decreases with the determinant, elasticity is positive - price elasticity of supply, income elasticity of demand, cross-price elasticity of demand (substitutes). - If demand/supply increases when the determinant decreases, and vice versa, elasticity will be negative- price elasticity of demand, cross price elasticity of demand (complements)
The Value	- Indicate elasticity, inelasticity, or unit elasticity.
Elastic demand/supply	- Where the quantity demanded/supplied changes proportionately more than the determinant. e>1.
Inelastic demand/supply	- Where the quantity demanded/supplied changes proportionately less than the determinant. e<1.
Unit elasticity	- Where the quantity demanded/supplied changes by the same proportion as the determinant.
Determinants of the Price elasticity of Supply	- the amount that costs rise as output rises: The less additional cost needed to produce extra, the more firms are encouraged to produce for a given price rise: the more elastic will the supply be. So, elastic supply arises from firms with plenty of spare capacity, raw materials, can switch easily away from producing alternatives & avoid paying overtime working which prevent a rise in production cost. - Time period: Immediate time period: firms are unlikely to increase supply which is virtually fixed Even demand increases, only the price will rise, but the quantity is unchanged. - Short Term: Inputs like raw materials could be increased, while others like machinery are fixed. Supply becomes more elastic, a new equilibrium is formed as the price fall and the quantity rises. - Long Term: All inputs are increased & new firms enter. Supply is then highly elastic. The price drops as quantity increases. Price Elasticity of Supply at different Time Periods
	- Unlike the price elasticity of demand, any straight line curve passing through the curve are unit elastic curves. - Other curves have varying elasticity throughout
Determinants of price elasticity of demand	- The no. & closeness of substitute goods - most important - the closes they are, the greater will be the elasticity, as consumers can easily switch to other substitutes as price rises. - the more numerous is the substitutes, the more people will switch to substitutes as price rises. - Note that only the price elasticity of demand for a particular brand of a product may be high, the demand for a product in general will normally be pretty inelastic. Consumers only buy less due to the income effect, but not the substitution effect. - The proportion of income spent on the good - The higher the proportion of consumers’ income spent on a good, the more they are forced to change their consumption habit when price changes, the bigger will the income effect and the more elastic will be the demand. -E.g. salt has a low price elasticity of demand, as people have little problem paying more for salt- it is only a tiny fraction of consumers’ total expenditure. More elastic demand are on major expenditure like mortgages. - Time period - People adjust their consumption patterns & find alternatives as price rises® The longer is the time period after the price change, the more elastic will be the demand.
Total Sales Revenue (TR)	- Price elasticity is one of its main determinants - The amount a firm earns from its sales of a particular product at a particular price is price times quantity [TR=P x Q]
Elastic demand	- Quantity demanded changes proportionately more than price - The change in quantity as a bigger effect on TR than does the change in price.
Inelastic demand	- Price changes proportionately more than quantity. - A change in price has a bigger effect on TR then does the change in quantity
Elasticity	- Note that the elasticity may not be the same throughout the curve. - The elasticity of a section could be solved by finding the gradient of a cord of a curve, giving an arc elasticity - The point elasticity could be solved by differential calculus.

Elastic & Inelastic Demand Schedules

The elasticity could also be solved by observing the tangents to the demand/supply curve: If it tends not to cut the y-axis, it is inelastic
If it tends to cut the y-axis. it is elastic.

Totally inelastic demand	- Illustrated by a vertical straight line - The quantity demanded is not affected by the price.
Infinitely elastic demand	- Illustrated by a horizontal straight line - Happens when firms a price takers, accepting price given by supply & demand in the whole market. Qd does not affect price.
Unit elasticity	- Happens where price & quantity change in the same proportion. TR is the same at any point on the curve. - The curve is a rectangular hyperbola. - It is not illustrated by a straight line cutting the horizontal axis at 45° .

Why Demand Schedules for Unit Elasticities must be Rectangular Hyperbolas?

a ® b: [D q/q₁] / [D p/p₁] ® Large / Small ® Large
c ® d : [D q/q₃] / [D p/p₃] ® Small / Large ® Small
Therefore, the demand curve for unit elasticity must be of a rectangular hyperbola: as demand moves down the curve, there is an increasing absolute rise in Qd and a decreasing absolute fall in price.

Demand schedules of different Elasticities

PÎ _d: a ® b [7/25] / [15/45] = 0.778
PÎ _d: b® a [7/34] / [15/30] = 0.412

The above illustrated that for elasticity of the same curve between the same points, different changes in direction along the same section of the curve give different elasticity.

Using the idea of income elasticity of demand,

A normal product	- Defined as having a positive price elasticity.
An inferior product	- Defined as having a negative price elasticity.
A satiation product	- A satiation product is a product with zero price elasticity.
Determinants	- Degree of necessity of the product. In DCs, demand for luxurious good is more than that of necessities, Some inferior products’ demand even drops as income rises. - Rate at which the desire for products is satisfied as income rises: the quicker consumers are satisfied , the less demand will expand as income rises. - The level of income of consumers: Rich people react differently from poor people to changes in income.

Note that the curve for income elasticity for demand is plotted differently: the Q is plotted on the vertical axis, and the income is plotted on the horizontal axis.
Using the idea of cross elasticity of demand

Substitution products	- Defined as products with positive price elasticity
Complementary products	- Defined as products with negative price elasticity.
Determinants	- The number and closeness of the products.
Uses	- Allow easier production plans for firms, through knowing possible changes in their products’ demand to change in prices of other goods. - Government could use those information for international trade & balance of payments, knowing the effects of change in domestic products on demands for imports. Balance of payments may orsen if there’s an increasing demand for imports, due to high price elasticity for imports goods (close substitutes), and home products rise due to inflation.

Advertising:

Shift the product’s demand curve to the right		- Occur is the advertising brings the product to more people’s attention or increases people’s desire for that product.
Make the demand curve less elastic	- Occurs when advertising creates brand loyalty. - Occurs when people are convinced that competitors’ products are inferior. allowing firms to rise price of products above its rivals with no significant fall. in sales.
Arc elasticity	- Elasticity usually varies along the curve. So, only the elasticity along a portion of the curve can be referred to. - Elasticity between two points is know as the arc elasticity.

The Time Dimension

The full adjustment of price, demand & supply to a situation of disequilibrium is not instantaneous. The longer is the time period, the bigger is the response, & the greater is the elasticity of supply & demand.

Time Lag	- Between production decisions and a change in actual supply can causes price fluctuations.
Cobweb diagram	Illustrates the path of P & Q adjustment over time, given a time lag between production decision & actual supply adjustments in the market. The path has a cobweb shape. Assumed that firms produced exactly as planned -Assumed an Initial disequilibrium in the market
Convergent cobweb	- Known as damped oscillations, converging to the equilibrium point . Price oscillates less over time. - Happens when the supply curve is steeper than the demand curve.
Divergent Cobweb	- Known as an explosive cobweb, diverging from the equilibrium point. Price oscillates more over time. - Happens when the demand curve is steeper than the supply curve.

Cobwebs do not illustrate the situation clearly, because:

Producers could fluctuate price no simply relying on current prices.
Demand &/or supply curves could shift in the meantime.
There could be a demand lag as well.
Planes may not be fulfilled, due to weather or other unexpected events.
Producers may use stocks to stabilise price fluctuations

Speculations	-Where people make buying or selling decisions based on their future anticipation of future prices. - Often based on current trends in price behaviour. - E.g. If price is rising, sellers may wait for the peak. - Affect supply & demand, & thus price. - Often happens in the stock exchange, foreign exchange & the housing markets. - Can either reduce or aggravate price fluctuations.
Self-fulfilling speculation	- Where the actions of speculators tend to cause the very effect they anticipated.

Stabilising speculations - Where speculator’s actions tend to reduce price fluctuations:

D_{1 ®}D₂causes equilibrium to move: a ® b Suppliers believe fall is temporary: S_{1 ®}S₂ Buyers increase purchase: D₂ ® D₃ b ® c, towards original price at a
D₁ ® D₂ : Price rises S₁ ® S₂ :Make more money until price falls Demanders hold back for price falls: D₂ ® D₃.: Equilibrium to c, towards original price.

Destabilising speculations -Where the speculators’ actions tend to make price movements larger.

	Initial fall in price: D₁ ® D_2,price falls Anticipate further fall in price: S₁ ® S₂. Demanders await price fall: D₂ ® D₃. Price falls further.
	Initial rise in price: D₁ ® D₂Suppliers await price rises: S₁ ® S₂. > Demanders buy now before any price rises: D₂ ® D₃. Price rises further.

Sometimes, mostly in a relatively stable market, with moderate shifts in demand and supply curves, speculators help to stabilise price fluctuations. On the other hand, in times of uncertainty, with significant changes in the determinants of supply & demand, speculator may aggravate price fluctuations.

Risk	- An outcome which may or may not occur, but its probability of occurring is known.
Uncertainty	- An outcome which may or may not occur, but its probability of occurring is unknown.

Suppliers can reduce risks by holding stocks, like farmers holding stocks of wheat when the price is low. They wait until the price rises, but if the price is already high, they can sell it straight away. However, stock keeping cannot eliminate uncertainty. For a farmer, harvest results could not be predicted, farmers are also all anxious to sell at the moment the price starts to rise. Storage may also costs.

Previous Chapter | Next Chapter
Return to Patrick Lam's Homepage | Return to Patrick Lam's Economics Resources Homepage | My church
Go to 'Make Money On Internet?'