CHAPTER 2:
DEMAND, SUPPLY & MARKET EQUILIBRIUM
1.1 Introduction: Market Mechanism Principles
1.2 Demand
1.3 Supply
1.4 Market Equilibrium
1.5 Change in SS & DD
1.6 SS/DD Analysis Example
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Microeconomics scope for UBEA 1013 Economics
Output (Product) Market
DD & SS Interaction
Utility (excluded)
Consumer surplus
Factors effect DD
Elasticity
Changes in DD / SS:
Equilibrium Price &
Quantity
Input (Factor) Market
Production
Supplier surplus
Factors effect SS
Elasticity
Market structure
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1.1 Introduction: Market Mechanism Principles
Market & the circulation flow
Economics decision-making units
Demand &
supply
interaction
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1.2 Demand
Definition: “Demand” can be defined as the purchase of product.
ONE household / individual
ALL Household / Individual
Household / individual demand
Market demand
Demand curve (graph)
Demand function (equation)
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Demand curve (graph):
Demand function (equation):
Quantity of X demanded, QdX = f (PX; PY, I, preference, and others)
Factor effecting
quantity demanded
Factor effecting demand
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Demand function (equation):
Quantity of X demanded, QdX = f (PX; PY, I, preference, and others)
Law of Demand:
– negative, or inverse relationship
between price & quantity
– movement along demand curve
– change in quantity demanded
(i) Relationship of products:
– substitution or complement product: (PY)
– normal, luxury or inferior products: (I)
(ii) Shift of DD curve: (PY, I, preference, and others)
– (later section) new equilibrium price & quantity
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Law of Demand:
Figure 2.3: Price & Quantity
Demanded: The Law of Demand
Law of Demand:
– negative, or inverse relationship
– movement along demand curve
– change in quantity demanded
Why?:
Due to the income constraint
and utility interaction.
Exception?: Giffin product.
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Shift of DD curve & Relationship of products:
PY change: Substitute
– Substitutes are products that can replace one another
– Positive relationship between PY and demand for X
(the substitute product): When (PY) increases,
demand for X increases.
– Examples: Coffee & tea; Coca-cola & Pepsi Cola
Law of demand
Substitution product
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Shift of DD curve & Relationship of products:
PY change: Complement
– Complement are products that are consumed together
– Negative relationship between PY and demand for Z
(the complement product): When (PY) decreases,
demand for Z increases.
– Examples: Car & petrol; coffee & sugar
Law of demand
Complement product
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Shift of DD curve & Relationship of products:
Income change: Normal Product
– Demand increase when income
increase
– Examples: Cloth & movie
Income change: Luxury Product
– Same effect as normal product but
demand increase more when
income increase
– Examples: luxury car.
Income change: Inferior Product
– Low quality products (potato &
secondhand cloth)
– Income increase, demand decrease
(able to buy better quality product).
I↑
Normal product
I↑
Inferior product 10
Shift of DD curve & Relationship of products:
Necessity Product? Insignificant product?
– Their consumption did not effect much by change in
income. Their consumption is only a very small
percentage of total income.
– The demand curve did not shift (or shift too little that
we can ignore)
– Examples: salt
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Shift of DD curve & Relationship of products:
Other factors: Taste / preference
– Demand increase when taste / preference towards the
product increase (DD curve shift to the left)
– Examples: low fat item & fashion
Other factors: Expected future price
– Demand increase when Future price of product is expected
to increase (DD curve shift to the left)
– Examples: If petrol price to increase from 12am tomorrow,
demand for petrol increase immediately (today).
Other factors: Increase of buyer
– Increase in number of buyer, increase demand (DD
curve shift to the left)
… continue
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1.3 Supply
Definition: “Supply” can be defined as selling of product.
ONE firm
Individual (firm) supply
Supply curve (graph)
ALL firms
Market supply
Supply function (equation)
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Supply curve (graph):
Supply function (equation):
Quantity of X supplied, QSX = f (PX; K, L, technology, PY and others)
Factor effecting
quantity supplied
Factor effecting supply
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Supply function (equation):
Quantity of X demanded, QSX = f (PX; K, L, technology, PY and others)
Law of Supply:
– positive relationship between price & quantity
– movement along supply curve
– change in quantity supplied
Shift of SS curve: (K, L, technology, PY and others)
– (later section) new equilibrium price & quantity
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Law of Supply:
Figure 2.7: Price & Quantity
Supplied: The Law of Supply
Law of Supply:
– positive relationship
– movement along supply curve
– change in quantity supplied
Why?:
Due to the higher revenue &
profit (assuming every quantity
supplied can be sold).
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Shift of SS curve:
Change in K, L, technology, PY:
– E.g. reduced in cost of capital, reduced in wages,
technology improvement, price of other product
decline, expected future price to decline >>> shift the
SS curve to the right
Law of supply
Shift of SS curve
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Microeconomics scope for UBEA 1013 Economics
Output (Product) Market
DD & SS Interaction
Utility (excluded)
Consumer surplus
Factors effect DD
Elasticity
Changes in DD / SS:
Equilibrium Price &
Quantity
Input (Factor) Market
Production
Supplier surplus
Factors effect SS
Elasticity
Market structure
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1.4 Market Equilibrium
Output (Product) Market
DD & SS Interaction
3 set of market condition:
(a) The quantity
demanded equal
the quantity
supplied at the
current price. This
situation called
“equilibrium”
(b) The quantity
demanded exceeds
the quantity
supplied at the
current price. This
situation called
“excess demand”
(c) The quantity
supplied exceeds
the quantity
demanded at the
current price. This
situation called
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“excess supply”
(a) Equilibrium
Equilibrium price
(Excess supply or surplus)
Quantity supplied > Quantity demanded
Equilibrium point
Quantity supplied = Quantity demanded
(No tendency for the
market price to change )
Equilibrium quantity
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(b) Excess demand (shortage)
Quantity demanded >
Quantity supplied
Price tend to rise (as buyer
willing to pay more)
Price increases >> quantity
demanded fall (law of
demand) while quantity
supplied rise (law of supply).
Price increase to RM 20 (all
excess demand wipe out by
increased in quantity
supplied and reduced in
quantity demanded.
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(c) Excess supply (surplus)
Quantity supplied > Quantity
demanded
Price tend to drop (as seller
willing to sell at lower price)
Price drop >> quantity
demanded rise (law of
demand) while quantity
supplied drop (law of supply).
Price drop to RM 20 (all
excess supply wipe out by
decreased in quantity
supplied and increased in
quantity demanded.
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1.5 Change in Supply and Demand
Figure 2.12: Changes in Equilibrium
(a) Increase in demand
(b) Increase in supply
(c) Decrease in demand
(d) Decrease in supply
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Figure 2.13: Relative Magnitude Change: Supply Increase & Demand Decrease
(a) Supply change > demand change
(b) Supply change < demand change
Figure 2.14: Relative Magnitude Change: Supply & Demand Increase
(a) Supply change > demand change
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(b) Supply change < demand change
Relative Magnitude Change: Supply Decrease & Demand Increase
Price
↓ SS > ↑ DD
Price
S1
P1
↓ SS < ↑ DD
S0
S1
S0
P1
P0
D0
0
Q 1 Q0
D1
Quantity
(a) Supply change > demand change
Price
D1
D0
Q0 Q1
0
Quantity
(b) Supply change < demand change
Relative Magnitude Change: Supply & Demand Decrease
Price
↓ SS > ↓ DD
↓ SS < ↓ DD
S1
S1
S0
P1
P
P0
P1
D0
0
0
P0
Q1
D1
Q0 Quantity
(a) Supply change > demand change
D1
0
Q1
Q0
D0
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(b) Supply change < demand change
SS
Decrease
Unchanged
Increase
Decrease
Q down
[Note 1]
P down
Q down
P down
[Note 2]
Unchanged
P up
Q down
Unchanged
P down
Q up
Increase
P up
[Note 3]
P up
Q up
Q up
[Note 4]
DD
Note 1: P up if ∆ DD < ∆ SS
Note 3: Q up if ∆ DD > ∆ SS
Note 2: Q up if ∆ DD < ∆ SS
Note 4: P up if ∆ DD > ∆ SS
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Equilibrium: Special Case
Price
(1) Vertical SS curve:
SS
Example of vertical SS is supply of durian.
P1
The equilibrium quantity is determined
entirely by supply condition.
P0
D0
0
Q
D1
Quantity
Price
(2) Horizontal SS curve:
SS
P0
D0
0
The equilibrium price is determined
entirely by demand condition.
Q0
Q1
D1
Quantity
Horizontal SS exist when all suppliers fixed
a price for any quantity.
The equilibrium quantity is determined
entirely by supply condition.
The equilibrium price is determined
entirely by demand condition.
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Equilibrium: Special Case
(3) Vertical DD curve:
DD S
0
Price
S1
P0
P1
The equilibrium price is determined
entirely by supply condition.
0
Q
Quantity
Price
(4) Horizontal DD curve:
S0
S1
P0
0
Example of vertical DD is demand for
necessity products like salt.
The equilibrium quantity is determined
entirely by demand condition.
DD
Q0
Q1
Quantity
Horizontal DD exist when there is only one
market price consumers willing to pay.
The equilibrium quantity is determined
entirely by supply condition.
The equilibrium price is determined
entirely by demand condition.
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1.6 Supply and Demand Analysis: An Example
(a) Proton Berhad decreases the price of its car model,
Proton Savvy from P0 to P1. Explain the law of demand
and based on it, explain what will happen to the quantity
demanded for Proton Savvy car. Sketch a graph to
illustrate your explanation.
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(b) What will be the effect of Proton Savvy car
price drop to its competitor model, the Perodua
MyVi? Sketch a graph to illustrate your
explanation
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(c) Assume that Proton Savvy cars need a specific
regular maintenance service to bring out the
performance of the car. Based on situation in (a),
what will happen to the demand of that specific
regular maintenance service?
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(d) Assume Proton Savvy car has an inelastic
price elasticity of demand. If Proton Berhad drops
the price of its Proton Savvy car to increase its
revenue from its Proton Savvy sales, do you think
it is a wise strategy?
Not a wise strategy.
Percentage of quantity demanded increase is less than
percentage of price drop.
Increase in revenue due to quantity demanded increase is
less than decrease in revenue due to price drop.
Therefore, the net effect is that revenue will drop, not
increase.
End
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