ECO101— PRINCIPLES OF MICROECONOMICS—Notes
Demand and Supply
Overview
This chapter deals with demand and supply, two of the most fundamental concepts in economics.
We will analyse the factors that determine the behaviour of individuals with regard to demand for
goods and services, the respective behaviour of business firms with regard to the supply of goods
and services, as well as show what happens in the market place when demand and supply forces
interact to determine the quantities of goods and services produced and the prices at which each
one is sold at each moment in time.
As we mentioned in Chapter 1, in every market, it is the price mechanism (like an “invisible hand,”
according to Adam Smith) which guides and facilitates a society of individuals in choosing what,
how and for whom to produce.
The Demand Schedule
Demand: This refers to the quantities that would be purchased at every possible price. It represents
and reflects the behaviour of people. The set of alternative quantities and prices is referred to as
the demand schedule. In order to isolate the specific impact that price changes have on quantities
demanded, economists assume that ‘all other things are held (or being) constant or equal’ (or
ceteris paribus, to use the Latin phrase).
Quantity Demanded: This refers to the quantity that is demanded at a given, specific price.
Assume that we conduct a market survey at Cyprus College asking 300 students how many pitas of
souvlaki they will be willing to consume at different prices. For the answers to be valid, each student
“voting” must not only be “willing” to buy the souvlaki, but must also be “able” to purchase it/them,
that is must afford to pay! When we tabulate the various answers we get from the students into a
demand schedule, we will be able to see what happens (in terms of the number of pitas of souvlaki
students will buy) when the price of souvlaki falls.
Let’s assume that the answers we get from the survey are the following:
Price
(£ per pita of souvlaki)
0.50
1.00
1.25
1.50
2.00
2.50
3.00
Demand
(no. of pita of souvlaki)
250
200
150
100
75
50
5
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Notice that even at very low prices some students would not buy a pita of souvlaki. These may be
vegetarians, don’t like souvlaki, may be snobs who don’t like to be seen eating fast food, or for a
number of other reasons. At the other extreme, some students may be willing to buy a pita of
souvlaki even at very high prices!
Drawing the Demand Curve
When we plot the above data on a graph paper we will construct the demand curve. Note that the
demand “curve” does not necessarily have to have a “curvature” (!). It may well be a straight line.
T h e D em a n d C u rve
R e c a ll t h e t h e L a w o f D e m a n d s a y s t h a t t h e r e is a n in v e r s e
r e l a t i o n s h i p b e t w e e n P r ic e ( P ) a n d a n d Q u a n t i t y D e m a n d e d ( Q d ) ,
c e t e r is p a r ib u s
P r ic e
A n in c r e a s e ( d e c re a s e ) in
p r ic e c a u s e s a d e c re a s e
( in c r e a s e ) in q u a n tity
dem anded.
D e m a n d S c h e d u le
P
Qd
£ 2 .5
5 0 u n it s
2 .0 0
75
1 .5 0
100
1 .2 5
150
1 .0 0
200
0 .5 0
250
P1
P0
D e m a n d C u rv e
Q1
Q0
Q u a n tity
D e m a n d C u r v e : S h o w s th e r e la t io n s h ip b e t w e e n P a n d Q , c e te r is p a r ib u s
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The Law of Demand
The law of demand states that there is an inverse relationship between the price of a good and the
quantity of the good demanded per time period.
ÎA decrease in the price of a good, all other things held constant, will cause an increase in the
quantity demanded of the good.
ÎAn increase in the price of a good, all other things held constant, will cause a decrease in the
quantity demanded of the good.
There are two reasons/effects why the relationship between prices and quantities demanded is
inverse:
•
Substitution Effect (If PA increases relative to PB, then DA falls)
•
Income Effect (If PA falls, DA increases as the purchasing power of individual’s incomes
increases).
Non-Price Determinants of Demand
Let’s examine further this concept of ‘other things being equal’. Using the example of the pita of
souvlaki, we can ask the students in our survey sample what would make them buy more pitas of
souvlaki without the price changing, that is, at a constant price. The possible answers we would get
are: The income level of students; the price and number of substitutes ( say of hamburger, or
Dr. Savvas C Savvides-School of Business, EUROPEAN UNIVERSITY CYPRUS
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pizza, etc); the price of complimentary goods (say the price of Coke, of beer, or of French fries!);
the tastes and preferences of students (whether they are health conscious, vegetarians, or plain
fast food lovers, as most young people are these days!). What about the students’ expectations
about future price changes of souvlaki?
In the table below, we summarize the various situations where changes in any of the non-price
determinants would make the demand for souvlaki to change (either to decrease or to increase).
Recall that by change in demand we mean that the behavior of individuals changes over the whole
range of prices, not only for a specific price. Therefore, the assumption is that we keep prices
constant in order to examine the various cases below.
CHANGES IN DEMAND
The demand for souvlaki will:
Increase if:
Decrease if:
Consumers’ (in this case students’) income rises.
(Assuming souvlaki is a normal good).
Consumers’ income falls
The price of substitutes (like hamburger or pizza)
rises
The price of substitutes increases
The number of substitutes decreases. Twenty
years ago pizzas and hamburgers were hardly
available in Cyprus. Now they are all over the place.
The number of substitutes increases
The price of a complement (such as beer, or coke,
or the vegetables that go into the pita of souvlaki)
falls
Consumers expect that the price of souvlaki will
increase in the future
The price of a complement rises
Consumers’ tastes change in favor of souvlaki and
away from fast food items (such as hamburgers,
pizza) because of television advertisements, so that
young people need to feel “in”, etc.
Consumers’ tastes change away from
souvlaki in favour of other fast food items
(such as hamburgers, pizza) because of
the mad cow disease, “ethnic” sentiments,
etc.
The size of the market (population) increases. Also,
the age composition of the population will impact on
demand.
The size of the market (population)
increases
Consumers expect that the price of
souvlaki will fall in the future
Two Ways in which Demand may Increase
A change in any of the above factors (variables) will shift the demand curve (through a change in
something other than price). Again we need to distinguish between a change in the quantity
demanded (brought about by a change in the price of hamburgers and represented by a movement
up or down the demand curve, in the graph above), and a change in demand (brought about by a
change in any of the non-price determinants mentioned above, and shown by a leftward or
rightward shift of the demand curve, in the graph below).
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C h a n g e in D e m a n d
A c h a n g e in a n y o f t h e n o n - p r ic e d e te r m in a n ts o f d e m a n d ( th e
“ o t h e r t h in g s ” ) w ill a ffe c t t h e p o s it io n o f D e m a n d
P ric e
A n in c re a s e (d e c re a s e ) in
d e m a n d re fe rs to a
rig h tw a rd (le ftw a rd )s h ift
in th e m a rk e t d e m a n d
c u rv e .
P0
D
Q0
D
2
Q1
D
0
1
Q u a n tity
8
Supply and Supply Curve
Let’s consider now the case of supply. As with demand, supply is all the quantities which would be
produced at every possible price. It represents how suppliers respond to price changes, that is, how
they behave. As we did with demand, if we ask the sellers of souvlaki how many they would be
willing to offer at alternative prices, we would construct the supply schedule. Assume that the
answers we get are the ones below:
Price
(£ per pita of souvlaki)
0.50
1.00
1.25
1.50
2.00
2.50
3.00
Supply
(no. of pitas of souvlaki)
0
10
50
100
150
200
250
Using the above data we can construct the supply curve by plotting them on a graph paper. As
shown below the supply curve slopes upward. It shows the relationship between price and quantity
supplied holding other things constant.
T h e S u p p ly C u r v e
A n in c re a se (d e c re a se )
in p ric e c a u se s a n
in c re a se (d e c re a se ) in
q u a n t it y s u p p l i e d .
P ric e
S u p p ly S c h e d u le
P
Qd
£ 2 .5
2 0 0 u n its
2 .0 0
150
1 .5 0
100
1 .2 5
50
1 .0 0
10
0 .5 0
0
P0
S u p p ly C u r v e
P1
Q1
Q0
Q u a n tity
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The Law of Supply
The law of supply state that at higher prices, suppliers will be willing to offer more quantities in the
market, since in this way they make more revenue, and ultimately more profits. Thus, contrary to
the law of demand, the law of supply shows that there is a positive relationship between prices
changes and quantities supplied.
ÎA decrease in the price of a good, all other things held constant, will cause a decrease in the
quantity supplied of the good.
ÎAn increase in the price of a good, all other things held constant, will cause an increase in the
quantity supplied of the good.
Quantity Supplied: The amount offered for in the market at a particular price at a given time.
Non-Price Determinants of Supply
In the same way that we asked the consumers (the students in our case) what factor(s) would make
them buy more souvlaki even without lowering the price, we can ask the sellers of souvlaki a similar
question. Put yourself in the place of the owner of a souvlaki restaurant. What factors would make
you (as seller!) supply more souvlaki at the same selling price?
C h a n g e s in S u p p ly
W h a t a r e t h e s e “ o t h e r t h in g s ” fo r S u p p ly ?
N O N -P R IC E D E T E R M IN A N T S O F S U P P L Y
C h a n g e i n P r o d u c t io n T e c h n o lo g y
C h a n g e i n I n p u t P r ic e s
C h a n g e i n t h e N u m b e r o f S e lle r s
T a x e s / s u b s id ie s a n d le g a l r e s t r ic t io n s
F u t u r e P r ic e E x p e c t a t io n s o f S e lle r s
W e a th e r & o th e r “e x o g e n o u s” fa c to rs
Î A c h a n g e in a n y o f t h e s e “ o t h e r t h i n g s ” w ill a f f e c t
t h e p o s it i o n o f t h e S u p p ly C u r v e ( b u t N O T it s s l o p e
11
Better technology would certainly allow the sellers to produce more souvlaki with the same effort
(resources). Similarly, a lowering of costs (of inputs, labour, etc) would produce the same result.
Higher corporate taxes or stricter government regulations (health or safety regulations), on the
other hand, would cause producers to reduce their output, thus shifting the S-curve to the left.
In the table below, we summarize the various situations where changes in any of the non-price
determinants would make the supply of souvlaki to change (either to decrease or to increase).
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Recall that by change in supply we mean that the behavior of individuals changes over the whole
range of prices, not only for a specific price. Therefore, the assumption is that we keep prices
constant in order to examine the various cases below.
CHANGES IN SUPPLY
The supply of souvlaki will:
Increase if:
Decrease if:
The price of the inputs (the factors of production,
The price of the inputs increases
raw materials, etc) needed for the production of
souvlaki decreases.
New, more productive (efficient) methods of
making, cooking, delivering, or serving souvlaki are
found and applied.
The number of (sellers) restaurants serving
The number of sellers decreases
souvlaki increases. As people demand more
souvlaki, and the operation is profitable, more
souvlaki makers would enter the market, attracted by
the profit potential.
The government decides to subsidize the production
The government increase income or
of souvlaki by either reducing the income tax for
sales taxes for souvlaki making / selling,
souvlaki makers, or introducing (or increasing) a
or cuts back on subsidies.
subsidy to them.
The government withdraws any health and
In the context of EU membership, the
hygienic regulations, which used to require souvlaki
government of Cyprus introduces very
makers/sellers to install very modern and expensive
strict health and hygienic regulations,
health and safety equipment.
requiring souvlaki makers/sellers to install
very modern and expensive health and
safety equipment
Makers of souvlaki expect that the price of a pita of
Makers of souvlaki expect that the price
souvlaki will fall in the future.
of a pita of souvlaki will rise in the future.
Good weather increases the production of pork and
Bad weather decreases the production of
vegetables (the key inputs to souvlaki)
pork and vegetables (the key inputs to
souvlaki)
All of the situations in the left panel of the table above would shift the supply curve to the right,
whereas, all the cases in the right side would shift it to the left. These cases are portrayed in the
following graph, where at each price, the supply curve shifts to the right or to the left.
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C h a n g e in S u p p ly
A n in c re a s e (d e c re a s e ) in s u p p ly re fe rs to a
rig h tw a rd (le ftw a rd ) s h ift in th e m a rk e t
su p p ly c u rv e .
P ric e
S0
S2
S1
P0
Q u a n tity
Q
Q
0
1
12
Price and Output Determination: Market Equilibrium
Once we understand the laws of demand and supply, and the behaviour of consumers and
suppliers, respectively, which lie behind these laws, we can proceed to talk about the concept of an
equilibrium and draw the supply and demand curves on the same graph. Always keep in mind the
difference between quantity demanded and demand, and quantity supplied and supply. This
distinction is important.
When demand and supply are combined together in a market there will be one price at which
quantity demanded equals quantity supplied. This is the equilibrium price. The quantity bought and
sold at this price is the equilibrium quantity. Equilibrium is defined as a position of balance, from
which there is no tendency or force to move away.
M a r k e t E q u ilib r iu m
P ric e
D
P
Qd
2 .5 0
50
2 .0 0
75
1 .5 0
100
S
Qs
M a r k e t E q u ilib r iu m
is a t E w h e r e
q u a n t ity d e m a n d e d
e q u a ls q u a n tit y
s u p p lie d .
200
150
100
1 .2 5
150
50
1 .0 0
200
10
0 .5 0
250
0
Po
E
Qo
T h is is a t P o ( £ 1 .5 0 )
a n d Q o ( 1 0 0 u n its )
Q u a n tity
14
As shown in the graph above for the demand and supply of souvlaki, if the equilibrium price for
souvlaki is £1.50, the market is cleared at this price – all pitas of souvlaki offered for sale are sold.
At any price below £1.50 the quantity demanded exceeds the quantity supplied. This results in
excess demand. Conversely, at any price above £1.50, suppliers will be willing to supply more
souvlaki than consumers are willing (and able) to pay. This results in excess supply. When the
market is in disequilibrium the price mechanism acts to help bring it back to equilibrium.
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Price
M a rk e t e q u ilib riu m a n d d ise q u ilib riu m
S u rp lu s o r
excess
s u p p ly
D
•
P1
If p ric e w e re b e lo w P 0
th e re w o u ld b e e x c e s s
dem and
S
c o n s u m e rs w is h to
p u rc h a s e m o re th a n
p ro d u c e rs w is h to s u p p ly
•
E
•
P0
•
P2
S
• If p ric e w e re a b o v e P 0
th e re w o u ld b e e x c e s s
s u p p ly
•
excess
dem and
D
o r s h o rta g e
Q0
p ro d u c e rs w is h to s u p p ly
m o re th a n c o n s u m e rs w is h
to p u rc h a s e
Q u a n tity
17
Changes in Equilibrium Positions
What happens now if demand increases (perhaps increased demand for souvlaki among young
people so as to feel that they are “in”, or because of decreased prices of McDonald’s Big Mac or
Burger King’s Whopper driving people away from souvlaki consumption, or because of a health
problem with pork meat, people don’t eat souvlaki any more thus preferring hamburgers, or pizza,
or for a number of other factors). When this happens, eventually the prices of souvlaki will be bid
down and the market will move to a different equilibrium, as shown in the graph below.
More generally, what happens if demand for something decreases (perhaps as it has gone out of
fashion, or for health reasons)? The result is that prices are lowered in order to clear the market.
Recall what happens during the clearance (or sale) season. Shop owners reduce the prices of
items in order to sell off their “excess supply.” You can relate these concepts to your own personal
experience and possible behaviour when you face these circumstances).
Price
A s h if t in d e m a n d
D1
D0
S
P0
If t h e p r ic e o f a s u b s t it u t e
g o o d d e c r e a s e s ...
… le s s w ill b e d e m a n d e d a t
e a c h p r ic e .
E0
P1
Î T h e d e m a n d c u r v e s h if t s
fro m D 0D 0 to D 1D 1.
E1
D1
S
Q1 Q0
D0
Q u a n tity
If p r ic e s t a y e d a t P 0 t h e r e
w o u ld b e e x c e s s s u p p l y .
S o , th e m a rk e t m o v e s to a
n e w e q u ilib r iu m a t E 1 .
18
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The graph below shows a case where the demand curve shifts to the right due to increased
demand for oil resulting from the expectation that prices may increase (due to war, terrorism, etc).
S h ift in D e m a n d
P ric e
D
D
0
S0
1
P1
E
E
P0
A s s u m e c o n s u m e rs e x p e c t
th e p r ic e o f o il to in c r e a s e
( d u e to t h e p o s s ib ilit y o f a
w a r , s a y t h e w a r in Ir a q . T h is
w ill t e n d t o in c r e a s e t h e ir
c u rre n t d e m a n d .
A n in c r e a s e in d e m a n d w ill
c a u s e th e m a r k e t e q u ilib r iu m
p r ic e a n d q u a n tit y to in c r e a s e .
1
0
Î S o , th e m a rk e t m o v e s to a
n e w e q u ilib r iu m p o in t a t E 1
Q
0
Q
Q u a n tity
1
19
Changes in equilibrium positions may also originate from the supply side. We have already
examined the various factors that may impact on supply (such as technical innovation, changes in
input prices, price expectations, etc).
A s h ift in s u p p ly
Price
S
S
D
E
P
P
S u p p o s e s a fe ty a t w o rk
r e g u la tio n s ( d u e t o E U ) a r e
tig h te n e d , le a d in g to
in c r e a s in g p r o d u c e r s ’ c o s ts
1
0
2
T h e s u p p ly c u rv e
s h ifts to S 1 S 1
1
E
0
S
0
If p r ic e s t a y e d a t P 0 t h e r e
w o u ld b e e x c e s s d e m a n d
1
S
D
0
Q
1
Q
S o th e m a rk e t m o v e s to a
n e w e q u ilib r iu m a t E 2
Q u a n tity
0
O t h e r f a c t o r s le a d in g t o t h e s a m e r e s u lt : O ils s h o r t a g e , w in t e r f r e e z e , d r o u g h t
20
S h ift in S u p p ly
(T e c h n ic a l I n n o v a tio n )
P ric e
D
S0
0
P0
P1
Q
0
Q
S1
A n in c re a s e
in su p p ly
w ill c a u s e
th e m a rk e t
e q u ilib riu m
p ric e to
d e c re a se a n d
q u a n tity to
in c re a se .
Q u a n tity
1
21
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Free Markets versus Controlled Markets
We have examined above the functioning of a free enterprise system where the price mechanism is
able to send the right signals to buyers and sellers in order to “clear” the market, that is bring it to
equilibrium. We have also seen that in the event that “exogenous” factors force the market out of
equilibrium, again free enterprise market forces would come into play to bring the market back to
equilibrium.
But what happens if for a number of reasons prices of goods and services are controlled? This may
be the situation is socialistic economies, or in capitalistic economies where the government
believes that it is socially desirable to keep prices of goods and services at certain prices
(irrespective of demand and supply conditions), such as for instance the minimum wage laws or the
rent control laws.
In the European Union, a lot of agricultural and farm products are supported by governments and
prices for farmers are kept at levels above their equilibrium levels. What is the result of that? We
can see the result in the graph below, that is, surpluses are created. The reason is that at these
prices, buyers are not willing to buy all the products that farmers bring to the market. These farm
price supports in the EU create what has been called “mountains of butter and lakes of wine”
implying the phenomenon of excess supplies (or surpluses) of agricultural and farm products.
P rice Supports
T h e grap h b elow sh ow s th e im pact on the m arket w hen the p rices are kep t
abo ve th e m arket-clearin g eq u ilib rium p rice (e.g ., farm su pp o rt prices,
m in im u m w ag es, etc)
Price
D
Surplus
S
PH
Pe
Qe
Q uantity
23
If on the other hand, governments try to interfere in the market to set prices below the equilibrium
level, the result, which has been observed for many consumer products in the socialist (or
controlled) economies (ex Soviet Union, China, etc), is that shortages develop as sellers do not find
these artificially low prices attractive enough to supply goods to the market.
Dr. Savvas C Savvides-School of Business, EUROPEAN UNIVERSITY CYPRUS
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References for further reading:
Bade, R. and Parkin, (2007). Foundations of Economics 3rd edition (Pearson Education).
Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8th edition (McGraw-Hill).
Mankiew N. Gregory (2007). Principles of Economics 4th edition (Thomson, SouthWestern).
McConnel C. and S. Brue (2005). Economics 16th edition (McGraw-Hill).
Miller, R.L (2006). Economics Today 13th edition (Pearson Addison Wesley).
Sloman John (2006). Economics 6th edition (Prentice Hall).
Dr. Savvas C Savvides-School of Business, EUROPEAN UNIVERSITY CYPRUS
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