Objectives
Upon completing this chapter,
students should be able to:
1. Understand the
concepts of supply and demand
2. Interpret and
construct supply and demand curves
3. Analyze market
equilibrium
4. Evaluate the
impact of changes in supply and demand
5. Understand the
concept of elasticity
By achieving these
objectives, students will develop a solid understanding of supply and demand,
the forces that drive market outcomes, and the concept of elasticity. This
knowledge will enable them to analyze market behavior, predict the impact of
various factors on prices and quantities, and evaluate the effectiveness of
economic policies.
Definition
In economics, demand refers to the quantity of a good
or service that consumers are willing and able to purchase at various prices
during a specific period. It reflects the desire for a product backed by the
ability to pay for it.
Factors Affecting Demand
Several factors can influence
the demand for a good or service. Let's delve into some of the key
determinants:
1. Price of the Good:
○ The
most fundamental factor, the law of demand states that as the price of a good
increases, the quantity demanded decreases, and vice-versa, assuming other
factors remain constant. This inverse relationship is represented graphically
by a downward-sloping demand curve.
2. Income of Consumers:
○ For
normal goods, an increase in income
leads to an increase in demand, while a decrease in income leads to a decrease
in demand.
○ For
inferior goods, an increase in
income leads to a decrease in demand, as consumers switch to higher-quality
alternatives.
3. Prices of Related Goods:
○ Substitute goods: If the price of a substitute good (one
that can be used in place of another) increases, the demand for the original
good increases.
○ Complementary goods: If the price of a complementary good
(one that is used together with another) increases, the demand for the original
good decreases.
4. Tastes and Preferences:
○ Consumer
preferences and tastes are constantly evolving. If a good becomes more popular
or fashionable, its demand increases. Conversely, if it falls out of favor, its
demand decreases.
5. Expectations:
○ Consumer
expectations about future prices or income can also influence current demand.
If consumers expect prices to rise in the future, they may increase their
current demand. Similarly, if they anticipate a decrease in income, they may
reduce their demand.
6. Number of Buyers:
○ The
size of the market or the number of potential buyers affects the overall
demand. An increase in population or the entry of new consumers into the market
will likely increase demand.
7. Other Factors:
○Several
other factors can influence demand, such as changes in demographics, government
policies, seasonal variations, and advertising or marketing efforts.
Understanding these factors
is crucial for businesses and policymakers to analyze market trends, predict
consumer behavior, and make informed decisions about production, pricing, and
resource allocation.
What is a Demand Curve?
A demand curve is a graphical
representation of the relationship between the price of a good and the quantity
of that good that consumers are willing and able to purchase, holding all other
factors constant (ceteris paribus). It essentially visualizes the law of
demand, which states that as the price of a good increases, the quantity
demanded decreases, and vice-versa.
Characteristics of a Demand Curve
● Downward Sloping: The demand curve typically slopes
downwards from left to right, reflecting the inverse relationship between price
and quantity demanded.
● Change in Quantity Demanded: A movement along the demand curve
occurs when the price of the good changes, leading to a change in the quantity
demanded.
● Change in Demand: A shift of the entire demand curve
occurs when one of the non-price determinants of demand changes (e.g., income,
tastes, prices of related goods).
How to Construct a Demand Curve
1. Gather Data: Collect data on the quantity of a good
that consumers are willing and able to buy at various prices. This can be done
through market research, surveys, or analyzing historical sales data.
2. Plot the Points: On a graph, with price on the vertical
axis and quantity on the horizontal axis, plot the data points representing the
different price-quantity combinations.
3. Connect the Points: Draw a line or curve that best fits the
plotted points. This line or curve represents the demand curve for the good.
Illustration
Let's say we have the
following data on the demand for apples:
|
Price per Apple ($)
|
Quantity Demanded (Apples)
|
|
1.00
|
80
|
|
1.50
|
60
|
|
2.00
|
40
|
|
2.50
|
20
|
Plotting these points on a
graph and connecting them would result in a downward-sloping demand curve for
apples.
Interpretation
The demand curve shows that
as the price of apples increases, consumers are willing and able to buy fewer
apples. For example, at a price of $0.50 per apple, consumers demand 100
apples, but at a price of $2.00 per apple, they only demand 40 apples.
Key Points to Remember
● The
demand curve is a snapshot in time, representing demand at a specific point,
assuming all other factors remain constant.
● Changes
in any of the non-price determinants of demand will cause the entire demand
curve to shift.
● The
demand curve is a useful tool for analyzing consumer behavior, market trends,
and the impact of price changes on the quantity demanded.
By understanding how to
construct and interpret demand curves, we can gain valuable insights into the
dynamics of markets and the factors influencing consumer choices.
Definition
Price elasticity of demand
measures the responsiveness of the quantity demanded of a good to a change in
its price. It quantifies how sensitive consumers are to price fluctuations. In
essence, it tells us the percentage change in quantity demanded resulting from
a one percent change in price.
Calculation
The price elasticity of
demand is calculated using the following formula:
|
Price Elasticity of
Demand (PED)
|
= (% Change in Quantity
Demanded)
|
/ (% Change in Price)
|
Where:
● %
Change in Quantity Demanded = [(New Quantity Demanded - Old Quantity Demanded)
/ Old Quantity Demanded] x 100
● % Change
in Price = [(New Price - Old Price) / Old Price] x 100
Interpretation
● Elastic Demand (PED > 1): A price change leads to a
proportionally larger change in quantity demanded. Consumers are very sensitive
to price changes. Examples include luxury goods, goods with many close
substitutes.
● Inelastic Demand (PED < 1): A price change leads to a
proportionally smaller change in quantity demanded. Consumers are less
sensitive to price changes. Examples include necessities like gasoline,
insulin.
● Unit Elastic Demand (PED = 1): A price change leads to a
proportionally equal change in quantity demanded.
● Perfectly Inelastic Demand (PED = 0): Quantity demanded does not change at
all in response to a price change. This is a theoretical concept and rarely
occurs in reality.
● Perfectly
Elastic Demand (PED = ∞):
A small price increase leads to a complete elimination of demand. This occurs
in perfectly competitive markets.
Significance
Understanding price
elasticity of demand is crucial for businesses and policymakers for several
reasons:
1. Pricing Decisions: Businesses can use PED to determine
optimal pricing strategies.
○ For
goods with elastic demand, lowering prices can lead to a significant increase
in revenue.
○ For
goods with inelastic demand, raising prices can increase revenue, as the
decrease in quantity demanded is proportionally smaller.
2. Taxation: Governments can use PED to estimate the
impact of taxes on consumer behavior and tax revenue.
○ Taxes
on goods with inelastic demand are likely to generate more revenue as consumers
are less likely to reduce consumption significantly.
3. Market Analysis: PED helps analyze market dynamics and consumer
responsiveness to price changes.
4. Policy Making: Policymakers can use PED to evaluate
the potential impact of price controls or subsidies on consumer welfare and
market efficiency.
Factors Affecting Price Elasticity of Demand
Several factors influence the
price elasticity of demand for a good:
● Availability of substitutes: Goods with many close substitutes tend
to have more elastic demand, as consumers can easily switch to alternatives if
the price increases.
● Necessity vs. Luxury: Necessities like food and housing tend
to have inelastic demand, while luxury goods have more elastic demand.
● Time horizon: Demand tends to be more elastic in the
long run as consumers have more time to adjust their behavior and find
substitutes.
● Proportion of income spent on the good: Goods that take up a larger proportion
of income tend to have more elastic demand, as price changes have a greater
impact on consumer budgets.
In conclusion, price elasticity of demand is a vital concept in understanding
consumer behavior and market dynamics. It helps businesses make informed
pricing decisions, governments design effective tax policies, and policymakers
analyze the impact of various economic interventions.
Definition
In economics, supply refers to the quantity of a good
or service that producers are willing and able to offer for sale at various
prices during a specific period. It reflects the willingness of producers to
bring their goods or services to the market, given the prevailing market
conditions.
Factors Affecting Supply
Several factors can influence
the supply of a good or service. Let's delve into some of the key determinants:
1. Price of the Good:
○ The
law of supply states that as the price of a good increases, the quantity
supplied increases, and vice-versa, assuming other factors remain constant.
This positive relationship is represented graphically by an upward-sloping
supply curve.
2. Input Prices:
○ The
cost of inputs used in production, such as labor, raw materials, and capital,
significantly affects supply. An increase in input prices raises production
costs, leading to a decrease in supply. Conversely, a decrease in input prices
lowers production costs, resulting in an increase in supply.
3. Technology:
○ Technological
advancements can improve production efficiency, allowing producers to produce
more output with the same amount of inputs. This leads to an increase in
supply.
4. Expectations:
○ Producer
expectations about future prices or market conditions can also influence
current supply. If producers anticipate higher prices in the future, they may
reduce their current supply to sell more later at a higher price.
5. Number of Sellers:
○ The
number of firms or sellers in the market affects the overall supply. An
increase in the number of sellers leads to an increase in supply, while a
decrease in the number of sellers results in a decrease in supply.
6. Other Factors:
○ Several
other factors can influence supply, such as changes in government policies
(taxes, subsidies, regulations), natural disasters or weather conditions
affecting production, and the availability of credit or financing for
producers.
Understanding these factors
is crucial for businesses and policymakers to analyze market trends, anticipate
changes in supply, and make informed decisions about production, pricing, and
investment.
What is a Supply Curve?
A supply curve is a graphical
representation of the relationship between the price of a good and the quantity
of that good that producers are willing and able to offer for sale, holding all
other factors constant (ceteris paribus). It essentially visualizes the law of
supply, which states that as the price of a good increases, the quantity
supplied increases, and vice-versa.
Characteristics of a Supply Curve
● Upward Sloping: The supply curve typically slopes
upwards from left to right, reflecting the positive relationship between price
and quantity supplied.
● Change in Quantity Supplied: A movement along the supply curve
occurs when the price of the good changes, leading to a change in the quantity
supplied.
● Change in Supply: A shift of the entire supply curve
occurs when one of the non-price determinants of supply changes (e.g., input
prices, technology, number of sellers).
How to Construct a Supply Curve
1. Gather Data: Collect data on the quantity of a good
that producers are willing and able to sell at various prices. This can be done
through market research, surveys, or analyzing historical production and sales
data.
2. Plot the Points: On a graph, with price on the vertical
axis and quantity on the horizontal axis, plot the data points representing the
different price-quantity combinations.
3. Connect the Points: Draw a line or curve that best fits the
plotted points. This line or curve represents the supply curve for the good.
Illustration
Let's say we have the
following data on the supply of oranges:
|
Price per Orange ($)
|
Quantity Supplied
(Oranges)
|
|
0.50
|
20
|
|
1.00
|
40
|
|
1.50
|
60
|
|
2.00
|
80
|
|
2.50
|
100
|
Plotting these points on a
graph and connecting them would result in an upward-sloping supply curve for
oranges.
Interpretation
The supply curve shows that
as the price of oranges increases, producers are willing and able to supply
more oranges. For example, at a price of $0.50 per orange, producers supply 20
oranges, but at a price of $2.00 per orange, they supply 80 oranges.
Key Points to Remember
● The
supply curve is a snapshot in time, representing supply at a specific point, assuming
all other factors remain constant.
● Changes
in any of the non-price determinants of supply will cause the entire supply
curve to shift.
● The
supply curve is a useful tool for analyzing producer behavior, market trends,
and the impact of price changes on the quantity supplied.
By understanding how to
construct and interpret supply curves, we can gain valuable insights into the
dynamics of markets and the factors influencing producer decisions.
Definition
Price elasticity of supply
measures the responsiveness of the quantity supplied of a good to a change in
its price. It quantifies how sensitive producers are to price fluctuations. In
essence, it tells us the percentage change in quantity supplied resulting from
a one percent change in price.
Calculation
The price elasticity of
supply is calculated using the following formula:
|
Price Elasticity of
Supply (PES)
|
=(% Change in Quantity
Supplied)
|
/ (% Change in Price)
|
Where:
● %
Change in Quantity Supplied = [(New Quantity Supplied - Old Quantity Supplied)
/ Old Quantity Supplied] x 100
● %
Change in Price = [(New Price - Old Price) / Old Price] x 100
Interpretation
● Elastic Supply (PES > 1): A price change leads to a
proportionally larger change in quantity supplied. Producers are very
responsive to price changes. Examples include goods that are easy to produce or
have readily available inputs.
● Inelastic Supply (PES < 1): A price change leads to a
proportionally smaller change in quantity supplied. Producers are less
responsive to price changes. Examples include goods that are difficult to
produce, have limited inputs, or require a long production time.
● Unit Elastic Supply (PES = 1): A price change leads to a
proportionally equal change in quantity supplied.
● Perfectly Inelastic Supply (PES = 0): Quantity supplied does not change at
all in response to a price change. This occurs when the supply is fixed, such
as in the case of rare artworks or land.
● Perfectly
Elastic Supply (PES = ∞):
A small price increase leads to an infinite increase in quantity supplied. This
is a theoretical concept and rarely occurs in reality.
Significance
Understanding price
elasticity of supply is crucial for businesses and policymakers for several
reasons:
1. Production Decisions: Businesses can use PES to anticipate
how their production levels might need to adjust in response to price changes.
○ For
goods with elastic supply, producers can increase output significantly if
prices rise.
○ For
goods with inelastic supply, producers may face challenges in increasing output
quickly, even if prices rise substantially.
2. Market Analysis: PES helps analyze market dynamics and
producer responsiveness to price changes.
3. Policy Making: Policymakers can use PES to evaluate
the potential impact of price controls, subsidies, or taxes on producer
behavior and market outcomes.
○ For
example, a subsidy on a good with elastic supply might lead to a significant
increase in production.
Factors Affecting Price Elasticity of Supply
Several factors influence the
price elasticity of supply for a good:
● Time horizon: Supply tends to be more elastic in the
long run as producers have more time to adjust their production levels, invest
in new capacity, or enter/exit the market.
● Availability of inputs: If inputs are readily available and can
be easily increased, supply will be more elastic.
● Flexibility of production: If production processes can be easily
adjusted to changes in demand, supply will be more elastic.
● Storage possibilities: Goods that can be stored easily tend to
have more elastic supply, as producers can hold back inventory when prices are
low and release it when prices rise.
In conclusion, price elasticity of supply is a vital concept in understanding
producer behavior and market dynamics. It helps businesses make informed
production decisions, governments design effective policies, and analysts
assess the impact of various economic factors on market outcomes.
Market Equilibrium
In a competitive market, the
interaction of supply and demand determines the equilibrium price and quantity.
● Equilibrium Price: This is the price at which the quantity
demanded by consumers equals the quantity supplied by producers. There is no
tendency for the price to change at this point.
● Equilibrium Quantity: This is the quantity of the good or
service bought and sold at the equilibrium price.
Graphical Representation
The equilibrium price and
quantity can be visualized on a graph where the supply curve and demand curve
intersect.
● The
demand curve slopes downward,
showing the inverse relationship between price and quantity demanded.
● The
supply curve slopes upward, showing
the positive relationship between price and quantity supplied.
● The
point where these two curves intersect is the equilibrium point.
The Process of Reaching Equilibrium
● Excess Supply (Surplus): If the price is above the equilibrium
price, the quantity supplied exceeds the quantity demanded. This creates a
surplus. To sell the excess goods, producers will lower the price, moving the
market towards equilibrium.
● Excess Demand (Shortage): If the price is below the equilibrium
price, the quantity demanded exceeds the quantity supplied. This creates a
shortage. Consumers will compete for the limited goods, driving the price up,
moving the market towards equilibrium.
Changes in Equilibrium
The equilibrium price and
quantity can change due to shifts in either the supply curve or the demand
curve.
● Shift in Demand: If demand increases (the demand curve
shifts to the right), the equilibrium price and quantity will both increase. If
demand decreases (the demand curve shifts to the left), the equilibrium price
and quantity will both decrease.
● Shift in Supply: If supply increases (the supply curve
shifts to the right), the equilibrium price will decrease and the equilibrium
quantity will increase. If supply decreases (the supply curve shifts to the
left), the equilibrium price will increase and the equilibrium quantity will
decrease.
Conclusion
The interaction of supply and
demand is a fundamental concept in economics, driving the allocation of
resources and the determination of prices in a market economy. Understanding
how supply and demand interact to establish equilibrium helps us analyze market
behavior, predict the impact of various factors on prices and quantities, and
evaluate the effectiveness of economic policies.
Understanding Market Dynamics
Market equilibrium, where the
quantity demanded equals the quantity supplied, is not a static state. It is
constantly influenced by shifts in supply and demand curves due to various
economic factors. Analyzing these shifts is crucial to understanding how
markets respond to changes and how prices and quantities adjust to reach a new
equilibrium.
Impact of Changes in Demand
1. Increase in Demand:
○ When
demand increases (the demand curve shifts to the right), it signifies that
consumers are willing and able to buy more of the good at any given price.
○ This
creates a temporary shortage at the original equilibrium price, as the quantity
demanded now exceeds the quantity supplied.
○ To
resolve this shortage, the price will rise, incentivizing producers to supply
more and discouraging some consumers from buying.
○ This
process continues until a new equilibrium is reached at a higher price and a
higher quantity.
2. Decrease in Demand:
○ When
demand decreases (the demand curve shifts to the left), it means consumers are
willing and able to buy less of the good at any given price.
○ This
leads to a temporary surplus at the original equilibrium price, as the quantity
supplied now exceeds the quantity demanded.
○ To
eliminate the surplus, producers will lower the price, encouraging more
consumers to buy and reducing the incentive for producers to supply as much.
○ A
new equilibrium is established at a lower price and a lower quantity.
Impact of Changes in Supply
1. Increase in Supply:
○ When
supply increases (the supply curve shifts to the right), it indicates that
producers are willing and able to offer more of the good at any given price.
○ This
results in a temporary surplus at the original equilibrium price.
○ To
clear the surplus, the price will fall, enticing more consumers to buy and
reducing the quantity supplied by some producers.
○ A
new equilibrium is reached at a lower price and a higher quantity.
2. Decrease in Supply:
○ When
supply decreases (the supply curve shifts to the left), it signifies that
producers are willing and able to offer less of the good at any given price.
○ This
creates a temporary shortage at the original equilibrium price.
○ To
address the shortage, the price will rise, leading to a decrease in quantity
demanded and an increase in the quantity supplied by those producers still in
the market.
○ The
market settles at a new equilibrium with a higher price and a lower quantity.
Simultaneous Shifts in Supply and Demand
In some cases, both supply
and demand curves might shift simultaneously. The net impact on equilibrium
price and quantity will depend on the relative magnitude and direction of the
shifts.
● If
both supply and demand increase, the equilibrium quantity will definitely
increase, but the impact on price is ambiguous. It will depend on whether the
increase in supply or demand is larger.
● If
both supply and demand decrease, the equilibrium quantity will definitely
decrease, but again, the impact on price is ambiguous.
Conclusion
Analyzing the impact of
changes in supply and demand on market equilibrium is essential for
understanding how markets function and how prices and quantities adjust in
response to various economic forces. By recognizing the dynamics of supply and
demand, we can gain valuable insights into market behavior and make more
informed decisions as consumers, producers, and policymakers.
Conceptual Understanding
1. Question: Define demand and supply.
○ Answer:
■ Demand is the quantity of a good or service that consumers are
willing and able to purchase at various prices during a specific period.
■ Supply is the quantity of a good or service that producers are
willing and able to offer for sale at various prices during a specific period.
2. Question: Explain the law of demand and the law
of supply.
○ Answer:
■ The
law of demand states that as the
price of a good increases, the quantity demanded decreases, and vice-versa, all
else being equal.
■ The
law of supply states that as the
price of a good increases, the quantity supplied increases, and vice-versa, all
else being equal.
3. Question: What is meant by market equilibrium?
○ Answer: Market equilibrium is the point where
the quantity demanded by consumers equals the quantity supplied by producers.
At this point, there is no tendency for the price or quantity to change unless
there is a shift in either the supply or demand curve.
4. Question: Define price elasticity of demand and
price elasticity of supply.
○ Answer:
■ Price elasticity of demand (PED) measures the responsiveness of the
quantity demanded of a good to a change in its price.
■ Price elasticity of supply (PES) measures the responsiveness of the
quantity supplied of a good to a change in its price.
Application and Analysis
5. Question: Draw a graph illustrating the market
for coffee. Show the equilibrium price and quantity. Then, analyze the impact
of an increase in the price of tea (a substitute for coffee) on the coffee
market.
○ Answer:
■ Draw
a graph with the demand and supply curves for coffee intersecting at the
equilibrium point.
■ An
increase in the price of tea will lead to an increase in the demand for coffee
(demand curve shifts to the right).
■ The
new equilibrium will be at a higher price and a higher quantity.
6. Question: Suppose the government imposes a tax on
gasoline. Using a supply and demand diagram, explain the impact of this tax on
the gasoline market.
○ Answer:
■ Draw
a graph of the gasoline market.
■ The
tax will increase the cost of production for gasoline suppliers, causing the supply
curve to shift to the left.
■ The
new equilibrium will be at a higher price and a lower quantity.
■ Explain
that the burden of the tax is shared between consumers (who pay a higher price)
and producers (who receive a lower price after the tax).
7. Question: A new technology is developed that
makes it cheaper to produce solar panels. Analyze the impact of this
technological advancement on the market for solar panels.
○ Answer:
■ Draw
a supply and demand diagram for solar panels.
■ The
new technology will decrease the cost of production, causing the supply curve
to shift to the right.
■ The
new equilibrium will be at a lower price and a higher quantity.
8. Question: The price of oranges increases, but the
quantity demanded remains relatively unchanged. What can you infer about the
price elasticity of demand for oranges?
○ Answer: This suggests that the demand for
oranges is relatively inelastic. A price change leads to a proportionally
smaller change in quantity demanded. This could be because oranges are
considered a necessity or have few close substitutes.
Critical Thinking
9. Question: Explain why understanding the concept
of elasticity is important for businesses and policymakers.
○ Answer:
■ Businesses
can use elasticity to make informed decisions about pricing and production.
■ Policymakers
can use elasticity to predict the impact of taxes, subsidies, or price controls
on consumer and producer behavior, market outcomes and government revenue
10. Question: Discuss the factors that can influence
the price elasticity of demand for a good.
○ Answer:
■
Availability
of substitutes
■
Necessity
vs. luxury
■
Time
horizon
■
Proportion
of income spent on the good
