Module 3
Demand and Supply
The third chapter of this module is designed to introduce you to the principles of
microeconomics and familiarize you with supply and demand diagrams, the most basic
tool economists employ to analyze shifts in the economy. After completing this unit, you
will be able to understand shifts in supply and demand and their implications for price
and quantity sold. You will also learn how to analyze how consumers respond to a shift
in the price of the goods they consume. This understanding of the basic forces of supply
and demand will serve as a foundation for the economic analysis you will undertake in
the remainder of this course.
Learning Outcomes
By the end of this chapter, you will be able to:
1) Explain demand, quantity demanded, and the law of demand
2) Identify a demand curve and a supply curve
3) Explain supply, quantity supply, and the law of supply
4) Explain equilibrium, equilibrium price, and equilibrium quantity
5) Explain the determinants of demand
6) Explain the determinants of supply
7) Explain and graphically illustrate market equilibrium, surplus and shortage
8) Analyze the consequences of the government setting a binding price ceiling
9) Analyze the consequences of the government setting a binding price floor
3
3.1
DEMAND
Relationship between Price and Quantity Demanded
The demand for a good is the quantity of the good that consumers are willing and
able to buy at each price over a period of time, ceteris paribus. The quantity demanded of
a good refers to the quantity of the good that consumers are willing and able to buy. The
law of demand states that there is an inverse relationship between price and quantity
demanded. When the price of a good falls, the quantity demanded will rise. Conversely,
when the price of a good rises, the quantity demanded will fall. The demand curve of a
good shows the quantity demanded of the good at each price over a period of time,
ceteris paribus. The demand curve is downward sloping due to the law of demand.
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Demand Curve
The demand schedule shown by Table 1 and the demand curve shown by the graph in
Figure 1 are two ways of describing the same relationship between price and quantity
demanded.
Figure 1. A Demand Curve for Gasoline. The demand schedule shows that as price rises,
quantity demanded decreases, and vice versa. These points are then graphed, and the line
connecting them is the demand curve (D). The downward slope of the demand curve
again illustrates the law of demand—the inverse relationship between prices and quantity
demanded.
Price (per gallon) Quantity Demanded (millions of gallons)
$1.00
800
$1.20
700
$1.40
600
$1.60
550
$1.80
500
$2.00
460
$2.20
420
Table 1. Price and Quantity Demanded of Gasoline
Demand curves will appear somewhat different for each product. They may appear
relatively steep or flat, or they may be straight or curved. Nearly all demand curves share
the fundamental similarity that they slope down from left to right. So demand curves
embody the law of demand: As the price increases, the quantity demanded decreases, and
conversely, as the price decreases, the quantity demanded increases.
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The law of demand can be explained with the concept of diminishing marginal
utility. Utility refers to the satisfaction obtained by consumers from consuming a good.
Marginal utility is the additional satisfaction resulting from consuming one more unit of
a good. The more a consumer has of a good, the less they will value it at the margin and
this is known as diminishing marginal utility. Due to diminishing marginal utility,
consumers will only increase the consumption of a good if the price falls. The law of
demand can also be explained with the concepts of substitution effect and income effect.
When the price of a good falls, the real income of consumers will rise as they will be
able to buy a larger amount of goods and services with the same amount of nominal
income. This will induce them to buy more of the good. This effect is known as the
income effect of a price fall. Furthermore, when the price of a good falls, the good will
become relatively cheaper than other goods. This will induce consumers to substitute the
good for other goods. This effect is known as the substitution effect of a price fall.
Note:
Ceteris paribus is Latin which means other things being equal.
3.2
Movements along versus Shifts in the Demand Curve
A change in quantity demanded occurs when quantity demanded changes due to a
change in price. This is shown by a movement along the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q 0 to Q1 due to a fall in
the price (P) from P0 to P1. This is called an increase in quantity demanded.
A change in demand occurs when quantity demanded changes due to a change in a
non-price determinant of demand. In other words, quantity demanded changes at the
same price. This is shown by a shift in the demand curve.
In the above diagram, the quantity demanded (Q) increases from Q 0 to Q1 at the same
price (P0) due to a change in a non-price determinant of demand. This is called an
increase in demand.
Note: Students should not mix up a change in quantity demanded which is shown by a
movement along the demand curve and a change in demand which is shown by a shift in
the demand curve as failure to do so will lead to a great loss of marks in the
examination.
3.3
Non-price Determinants of Demand
Tastes and Preferences
A change in tastes and preferences towards a good will lead to an increase in the demand
and vice versa. Tastes and preferences are affected by a number of factors such as
technological advancements and campaigning. For example, the inventions of
smartphones and tablets have led to a change in tastes and preferences from print
publications to digital publications. Healthy living campaigns have led to a change in
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tastes and preferences from non-diet soft drinks to diet soft drinks. These have increased
the demand for digital publications and diet soft drinks and decreased the demand for
print publications and non-diet soft drinks.
Prices of Substitutes and Complements
Substitutes are goods which are consumed in place of one another such as Coke and
Pepsi. A rise in the prices of substitutes for a good will induce consumers to buy less of
the substitutes resulting in an increase in the demand for the good and vice versa. For
example, if the price of Pepsi rises, consumers will buy less Pepsi and more Coke.
Complements are goods which are consumed in conjunction with one another such as car
and petrol. A fall in the prices of complements for a good will induce consumers to buy
more of the complements resulting in an increase in the demand for the good and vice
versa. For example, if the prices of cars fall, consumers will buy more cars and more
petrol. Substitutes and complements will be explained in greater detail in Chapter 4.
Number of Substitutes and Complements
An increase in the number of substitutes for a good will lead to a decrease in the demand
for the good and vice versa. For example, if scientists found out that milk could be used
as a substitute for shampoo, the demand for shampoo would decrease. An increase in the
number of complements will lead to an increase in the demand for a good and vice versa.
For example, if more models of digital cameras are introduced onto the market, the
demand for memory cards will increase.
Level of Income
When consumers’ income rises, the demand for some goods will increase and these
goods are called normal goods. A normal good is a good whose demand rises when
consumers’ income rises. There are two types of normal goods: necessity and luxury. A
necessity is a good whose demand rises by a smaller proportion when consumers’
income rises. Examples of necessities include agricultural products and stationery. A
luxury is a good whose demand rises by a larger proportion when consumers’ income
rises. Examples of luxuries include private cars and branded watches. When consumers’
income rises, the demand for some goods will decrease and these goods are called
inferior goods. An inferior good is a good whose demand falls when consumers’ income
rises. Inferior goods are typically relatively low in quality. Examples of inferior goods
include public transport and Daiso Products.
Expectations of Price Changes
If consumers expect the price of a good to rise, they will bring forward the purchase to
avoid paying a higher price in the future. If the good can be resold such as residential
properties, consumers will also buy the good to sell it at a higher price later. When these
happen, the demand for the good will increase. Conversely, if consumers expect the price
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of a good to fall, they will put off the purchase to enjoy a lower price in the future which
will lead to a decrease in the demand.
Size of the Population
An increase in the size of the population will lead to an increase in the demand for
certain goods and services. With the exception of a few countries such as Japan, most
countries have been experiencing an increase in the size of the population.
4
4.1
SUPPLY
Relationship between Price and Quantity Supplied
The supply of a good is the quantity of the good that firms are willing and able to sell at
each price over a period of time, ceteris paribus. The quantity supplied of a good refers
to the quantity of the good that firms are willing and able to sell. The law of supply states
that there is a direct relationship between price and quantity supplied. When the price of
a good falls, the quantity supplied will fall. Conversely, when the price of a good rises,
the quantity supplied will rise. The supply curve of a good shows the quantity supplied
of the good at each price over a period of time, ceteris paribus. The supply curve is
upward sloping due to the law of supply.
Supply Curve
A supply curve is a graphic illustration of the relationship between price, shown on the
vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the
supply curve are just two different ways of showing the same information. Notice that
the horizontal and vertical axes on the graph for the supply curve are the same as for the
demand curve.
Figure 2. A Supply Curve for Gasoline. The supply schedule is the table that shows
quantity supplied of gasoline at each price. As price rises, quantity supplied also
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increases, and vice versa. The supply curve (S) is created by graphing the points from the
supply schedule and then connecting them. The upward slope of the supply curve
illustrates the law of supply—that a higher price leads to a higher quantity supplied, and
vice versa.
Price (per gallon) Quantity Supplied (millions of gallons)
$1.00
500
$1.20
550
$1.40
600
$1.60
640
$1.80
680
$2.00
700
$2.20
720
Table 2. Price and Supply of Gasoline
The shape of supply curves will vary somewhat according to the product: steeper, flatter,
straighter, or curved. Nearly all supply curves, however, share a basic similarity: they
slope up from left to right and illustrate the law of supply: as the price rises, say, from
$1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to
720 gallons. Conversely, as the price falls, the quantity supplied decreases.
The law of supply can be explained with the concept of profit maximisation. A rise
in the price of a good will increase the profitability of selling the good. Therefore, firms
which are profit-oriented will sell more of the good. The law of supply can also be
explained with the concept of diminishing marginal returns. Suppose that a firm employs
two factor inputs: capital and labour. Although labour is a variable factor input, capital is
a fixed factor input. As the quantity of capital is fixed in the short run, the firm can
increase production only by employing more labour. However, as each additional unit of
labour will have less capital to work with, it will add less to total output than the
previous additional unit and this is known as diminishing marginal returns. Due to
diminishing marginal returns, to produce each additional unit of output, more units of
labour will be required which will lead to an increase in marginal cost. Marginal cost is
the additional cost resulting from producing one more unit of output. Therefore, firms
will increase the production of a good only if the price rises.
4.2
Movements along versus Shifts in the Supply Curve.
A change in quantity supplied occurs when quantity supplied changes due to a change in
price. This is shown by a movement along the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q 0 to Q1 due to a rise in
the price (P) from P0 to P1. This is called an increase in quantity supplied.
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A change in supply occurs when quantity supplied changes due to a change in a
non-price determinant of supply. In other words, quantity supplied changes at the same
price. This is shown by a shift in the supply curve.
In the above diagram, the quantity supplied (Q) increases from Q 0 to Q1 at the same price
(P0) due to a change in a non-price determinant of supply. This is called an increase in
supply.
Note: Students should not mix up a change in quantity supplied which is shown by a
movement along the supply curve and a change in supply which is shown by a shift in the
supply curve as failure to do so will lead to a great loss of marks in the examination.
4.3
Non-price Determinants of Supply
Cost of Production
A rise in the cost of production will lead to a decrease in supply and vice versa. When
the cost of production rises, firms will increase the price at each quantity to maintain
profitability. In other words, they will reduce the quantity supplied at each price which
will lead to a decrease in supply. The converse is also true. There are several factors that
can lead to a change in the cost of production. For example, a fall in factor prices such as
wages will lead to a fall in the cost of production and vice versa. Subsidy will decrease
the cost of production and tax will have the opposite effect. Labour productivity refers to
output per hour of labour. When labour productivity rises, which may be due to an
increase in the skills and knowledge of labour or the efficiency of capital, firms will need
a smaller amount of labour to produce any given amount of output. Therefore, the cost of
production will fall.
Production Capacity
If the production capacity in the industry increases, which may occur due to an increase
in the number of firms in the industry or an expansion of the production capacities of the
existing firms, the supply of the good will increase. The converse is also true.
Expectations of Price Changes
If firms expect the price of a good to rise, they will hoard some of the output that they
currently produce to sell it at a higher price in the future. This will lead to a fall in the
supply of the good. The converse is also true.
Profitability of Goods in Joint Supply
Goods in joint supply refer to goods that are produced in the same production process.
An example is petrol and diesel. In the process of refining crude oil to produce petrol,
other grade fuels such as diesel are also produced. Therefore, if the demand for petrol
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increases which will lead to an increase in the profitability, more petrol will be produced.
When this happens, the supply of diesel will also increase. The converse is also true.
Profitability of Substitutes in Supply
Substitutes in supply refer to goods that are produced using the same factor inputs. An
example is potatoes and tomatoes. If the demand for tomatoes increases which will lead
to an increase in the profitability, some farmers who are currently producing potatoes
will switch to the production of tomatoes which will lead to a decrease in the supply of
potatoes. The converse is also true.
Disasters (Natural and Man-made)
Natural disasters such as floods and earthquakes, and man-made disasters such as wars
which may kill workers and destroy factories and machinery, may lead to a decrease in
the supply of certain goods including agricultural products.
Weather Conditions
When weather conditions become less favourable, the supply of agricultural products
will fall as harvests will decrease. The converse is also true. In the event of severe
weather conditions, the supply of air travel will fall as airlines will be forced to cancel
flights.
5
5.1
EQUILIBRIUM
Equilibrium Price and Equilibrium Quantity
Equilibrium—Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis
and quantity on the horizontal axis, the demand curve and supply curve for a particular
good or service can appear on the same graph. Together, demand and supply determine
the price and the quantity that will be bought and sold in a market.
Figure 3.4 illustrates the interaction of demand and supply in the market for gasoline.
The demand curve (D) is identical to Figure 3.2. The supply curve (S) is identical to
Figure 3.3. Table 3.3 contains the same information in tabular form.
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Figure 3.4 Demand and Supply for Gasoline The demand curve (D) and the supply curve
(S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The
equilibrium is the only price where quantity demanded is equal to quantity supplied. At a
price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so
there is excess supply. At a price below equilibrium such as $1.20, quantity demanded
exceeds quantity supplied, so there is excess demand.
Price (per
gallon)
$1.00
$1.20
$1.40
$1.60
$1.80
$2.00
$2.20
Quantity demanded (millions of
gallons)
800
700
600
550
500
460
420
Quantity supplied (millions of
gallons)
500
550
600
640
680
700
720
Table 3.3 Price, Quantity Demanded, and Quantity Supplied
Remember this: When two lines on a diagram cross, this intersection usually means
something. The point where the supply curve (S) and the demand curve (D) cross,
designated by point E in Figure 3.4, is called the equilibrium. The equilibrium price is
the only price where the plans of consumers and the plans of producers agree—that is,
where the amount of the product consumers want to buy (quantity demanded) is equal to
the amount producers want to sell (quantity supplied). Economists call this common
quantity the equilibrium quantity. At any other price, the quantity demanded does not
equal the quantity supplied, so the market is not in equilibrium at that price.
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In Figure 3.4, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium
quantity is 600 million gallons. If you had only the demand and supply schedules, and
not the graph, you could find the equilibrium by looking for the price level on the tables
where the quantity demanded and the quantity supplied are equal.
The word “equilibrium” means “balance.” If a market is at its equilibrium price and
quantity, then it has no reason to move away from that point. However, if a market is not
at equilibrium, then economic pressures arise to move the market toward the equilibrium
price and the equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above the equilibrium
price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed
horizontal line at the price of $1.80 in Figure 3.4 illustrates this above equilibrium price.
At this higher price, the quantity demanded drops from 600 to 500. This decline in
quantity reflects how consumers react to the higher price by finding ways to use less
gasoline.
Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the
600 to 680, as the higher price makes it more profitable for gasoline producers to expand
their output. Now, consider how quantity demanded and quantity supplied are related at
this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while
quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the
quantity supplied exceeds the quantity demanded. We call this an excess supply or a
surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at
oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains
unsold, those firms involved in making and selling gasoline are not receiving enough
cash to pay their workers and to cover their expenses. In this situation, some producers
and sellers will want to cut prices, because it is better to sell at a lower price than not to
sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales.
These price reductions in turn will stimulate a higher quantity demanded. Therefore, if
the price is above the equilibrium level, incentives built into the structure of demand and
supply will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the
dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity
demanded increases from 600 to 700 as drivers take longer trips, spend more minutes
warming up the car in the driveway in wintertime, stop sharing rides to work, and buy
larger cars that get fewer miles to the gallon. However, the below-equilibrium price
reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity
supplied falls from 600 to 550.
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The market is at equilibrium (i.e., clear) at market price of P* = 4 and equilibrium
quantity of Q* = Qd = Qs = 300 and there is no surpluses or shortages.
—Whenever the market price is set above or below the equilibrium price, either a market
surplus or a market shortage will emerge.
—Surplus:oIf P > P* ⇒ Qs > Qd, surplus ⇒ producers ↓ P in attempt to ↓ excess inventory;
Qs↓ and Qd↑.
—Shortage:oIf P < P* ⇒ Qd > Qs, shortage ⇒ producers ↑ P and Qs↑ while Qd
How to Calculate Equilibrium Price and Quantity
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In the following paragraphs, we will look at how to calculate the equilibrium price and
quantity mathematically. To do this, we follow a simple 5-step process: (1) calculate
supply function, (2) calculate demand function, (3) set quantity supplied equal to
quantity demanded and solve for equilibrium price, (4) plug equilibrium price into
supply function, and (5) validate result by plugging equilibrium price into demand
function (optional).
Please note: For the sake of simplicity we use linear supply and demand functions in this
article. However, although a bit more complicated, the same process can be applied to
any other type of supply and demand functions.
1) Calculate Supply Function
In its most basic form, a linear supply function looks as follows: QS = mP + b. In this
equation, x and y represent the independent and dependent variables, m shows the slope
of the function and b represents its y-intersect. We can use this basic form to calculate
actual supply functions. All we need for this is two ordered pairs of price and quantity
(e.g. at a price of a demand is b and at a price of c demand is d). With this information
we can calculate the slope of the function (which is usually positive) and then solve for
the y-intersect by plugging two of the initial values into the updated function. For a more
detailed step-by-step guide on this, check out our article on how to calculate a linear
supply function.
Let’s look at an example to illustrate this. Think of an imaginary burger restaurant (Deli
Burger). At a price of USD 3.00 per burger, Deli Burger is willing and able to sell 600
burgers. If the price of a burger increases to USD 4.00, it becomes more profitable to sell
them, so the restaurant expands production and sells 800 burgers. With this information
we can calculate the firm’s supply function as described above. Hence, Deli Burger’s
supply function looks like this: QS = 200P + 0 (i.e. QS = 200P).
2) Calculate Demand Function
Similar to the supply function, we can calculate the demand function with the help of a
basic linear function QD = mP + b and two ordered pairs of price and quantity. As a
matter of fact, the process of calculating a linear demand function is exactly the same as
the process of calculating a linear supply function. However, unlike most supply
functions the majority of demand functions has a negative slope. To understand why that
is, make sure to read our step-by-step guide on how to calculate a linear demand function
as well.
With that being said, let’s revisit our example from above. So far we already know how
many burgers Deli Burger is willing and able to sell at different prices. Now we need to
find out how many burgers the customers are actually going to buy at those prices. Let’s
assume they are willing and able to buy 1000 burgers at a price of USD 2.00. Meanwhile
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if price increases to USD 4.00, they will only buy 800 burgers. With this information we
can calculate the following market demand function: QD = -100P + 1200.
3) Set Quantity Supplied Equal to Quantity Demanded and Solve for Equilibrium Price
Once we have calculated both the supply and the demand function, we can set quantity
supplied (QS) equal to quantity demanded (QD). By definition, the intersection of the
supply and demand curve represents the market equilibrium. At this point quantity
supplied has to be equal to quantity demanded (i.e. QS = QD). Starting from this simple
equation, we can replace both sides with their corresponding functions (see section 2 and
3). This allows us to solve the resulting equation for P and find the equilibrium price.
So let’s apply this to our example. We know that according to the equilibrium condition
QS = QD. Now we can simply replace QS with 200P (because QS = 200P) and QD with
-100P + 1200 (because QD = -100P + 1200). This results in the following equation:
200P = -100P +1200. If we solve this equation for P we find that P = 4. Or in other
words, the market reaches its equilibrium at a price of USD 4.00.
4) Plug Equilibrium Price into Supply Function
Now that we know equilibrium price, we can finally calculate equilibrium quantity. To
do this, we simply plug the equilibrium price we just calculated (see section 3) back into
the supply function (see step 1). Next, we solve the resulting equation for QS to find the
equilibrium quantity. Please note that it does not matter if we use the supply function or
the demand function for this step. Both functions will return the same equilibrium
quantity because – as we learned above – in the equilibrium QS is always equal to QD.
In the case of our example that means we plug the equilibrium price (i.e. USD 4.00) into
Deli Burger’s initial supply function QS = 200P. This results in the following equation
QS = 200*4. Hence, the equilibrium quantity is 800 burgers.
5) Verify by Plugging Equilibrium Price into Demand Function (optional)
Last but not least, we can verify our result by plugging the quantity and price we just
calculated into the demand function. As mentioned above, the two functions should
always return the same equilibrium quantity and price. This step is optional, but it’s a
great way to validate your result during exams and quizzes and make sure your
calculations are correct.
Thus, to validate the result from our example, we can take the equilibrium quantity (800
burgers) and the equilibrium price (USD 4.00) and plug them back into the demand
function QD = -100P + 1200. This leaves us with the following equation: 800 = -100*4
+ 1200. Fortunately for us, the equation holds true. Therefore we can conclude that our
calculations are correct.
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6
Price Controls
Price floors and price ceilings are government mandated prices that attempt to
control the price of a good or service. Price ceiling is usually imposed to keep down the
price of something perceived as too expensive. To have any effect, it must be imposed
below the market price. Example: Rent control on apartments. What effect do we predict?
As with any below-equilibrium price in the example above, we expect to get a shortage.
But in this case, buyers can’t raise the price by bidding against each other, because by
law the price cannot rise. Using the short-side rule, we discover that rent control actually
reduces the amount of housing made available to the public. Ironically, the price control
may also raise the de facto price paid by consumers.
From the demand curve, we can see that consumers would be willing to pay a very
high price (much higher than the price ceiling or even the market price) for the reduced
quantity (Qs) available. They are willing to pay this money if they can just find a way to
do so – and they do, in the form of bribes, key fees, rental agency fees, etc. N.B.: If the
price ceiling is imposed above the market price, it has no effect.
A price floor is usually imposed to keep up the price of something perceived as too
cheap. To have any effect, it must be set above the market price. Example: Agricultural
price supports. These are imposed, usually, because farm lobbies have convinced the
legislature that they are not earning enough to stay in business. What effect do we predict?
As with any above-equilibrium price, we expect to get a surplus, this time persistent
because sellers can’t bid down the price. And for many years, that’s exactly what the U.S.
had. The government usually bought up the surplus (and dumped it on 3rd World
markets). Note: If the price floor is imposed below the market price, it has no effect.
Note: It’s easy to get confused if you’re not thinking clearly. An effective price
ceiling is below the market price, while an effective price floor is above it. (Imagine a
ceiling being too low and bumping your head, or a floor rising beneath your feet.)
Analyzing Changes in Market Equilibrium
Consider first a rightward shift in Demand. This could be caused by many things: an
increase in income, higher price of substitute, lower price of complements, etc. Such a
shift will tend to have two effects: raising equilibrium price, and raising equilibrium
quantity. [↑P*, ↑Q*]
Example: Consider the market for rental housing, and suppose that a new factory or
industry opens up in the city, attracting more residents. Then there will be a rightward
shift in demand, driving up both price and quantity.
Note: The price of housing does go up, but not by as much as you might think,
because the change in demand induces suppliers to bring more housing to market. This
can be seen in the movement along the Supply curve. A leftward shift of demand would
reverse the effects: a fall in both price and quantity. The general result is that Demand
shifts cause price and quantity to move in the same direction.
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Now consider a rightward shift of supply (caused by lower factor price, better
technology, or whatever). This will tend to have two effects: raising equilibrium quantity,
and lowering equilibrium price. [↓P*, ↑Q*.]
Example: A new immigration policy allows lots of low-wage labor to enter the
steel business. The lower price of steel leads to a right shift in the supply of cars, so the
price of cars falls and the quantity rises. A left shift of supply would reverse the effects,
so the general result is that supply shifts tend to cause price and quantity to move in
opposite directions.
Now, what happens if both demand and supply both shift at once? In general, the
two changes have reinforcing effects on either price or quantity, and offsetting effects on
the other.
Example 1: The computer industry. Incredible improvements in technology, as
well as the entry of many new firms into the industry, have increased supply.
Simultaneously, many people have become very aware of the benefits of computers, and
new software has made computers more useful for a variety of projects, thereby
increasing demand as well. The increase in demand tends to increase both P and Q.
The increase in supply tends to lower P and raise Q. So both effects tend to raise
quantity.
But what happens to price? That depends on the relative size of the two changes.
Observation of the computer industry shows that prices have actually fallen, so we can
conclude that supply shifts have been relatively more important than demand shifts in
this market.
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A similar pattern emerges in many high-tech products (CD players, DVD
players). A possible complication: Much technological change has been in the
form of higher quality, and consumers shift demand from lower quality to higher
quality machines. This is not as easy to think about in the supply-and-demand
framework. The price of a new, cutting edge computer has stayed about the same
over time, at about $2000.
Example 2: Higher education. (This example may not be totally accurate
historically, but it demonstrates the point.) Supply has fallen because higher
education is a labor-intensive business, and educated labor (which has to be attracted
from other industries) has become much more expensive. Meanwhile, demand has
increased because jobs for educated people have become increasingly attractive
relative to other jobs. The increase in demand tends to increase both P and Q. The
decrease in supply tends to raise P while lowering Q.
So both forces tend to raise P, and that is confirmed by observation. But they
work in opposite directions on Q. Our knowledge of the market for higher
education tells us that Q has actually increased, meaning that the shift in demand has
been relatively more important.
When analyzing situations where both supply and demand shift at once, don’t let
yourself be fooled by your graph. Your graph may appear to show clear changes in
both price and quantity. But we know that one variable will experience an
offsetting effect. Whether that variable appears to rise or fall depends entirely on
how large you’ve drawn the curve shifts.
(Take the computer example above. If you drew the demand shift bigger than
the supply shift, you would mistakenly conclude that price should rise.) Unless you
are provided with additional information about the size of the shifts, you can only
make a prediction about one variable.
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Exercise No. 1 Demand and Supply
Name: ____________________________ Course & Section: __________________
1) Many changes are affecting the market for oil. Predict how each of the following
events will affect the equilibrium price and quantity in the market for oil. In each case,
state how the event will affect the supply and demand diagram. Create a sketch of the
diagram if necessary.
A) Cars are becoming more fuel efficient, and therefore get more miles to the gallon.
B) The winter is exceptionally cold.
C) A major discovery of new oil is made off the coast of Norway.
D) The economies of some major oil-using nations, like Japan, slow down.
E) A war in the Middle East disrupts oil-pumping schedules.
F) Landlords install additional insulation in buildings.
G) The price of solar energy falls dramatically.
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H) Chemical companies invent a new, popular kind of plastic made from oil.
2) Consider the demand for hamburgers. If the price of a substitute good (for example,
hot dogs) increases and the price of a complement good (for example, hamburger buns)
increases, can you tell for sure what will happen to the demand for hamburgers? Why
or why not? Illustrate your answer with a graph.
3) Suppose there is soda tax to curb obesity. What should a reduction in the soda tax do
to the supply of sodas and to the equilibrium price and quantity? Can you show this
graphically? Hint: assume that the soda tax is collected from the sellers
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Exercise No. 2 Demand and Supply
Name: ____________________________ Course & Section: __________________
Directions: Each of the questions or incomplete statements below is followed by five
suggested answers or completions. Select the one that is best in each case and write the
correct letter of your anwer in the space provided for.
___1) During a recession, economies experience increased unemployment and a
reduced level of activity. How would a recession be likely to affect the market demand
for new cars?
A) Demand will shift to the right.
B) Demand will shift to the left.
C) Demand will not shift, but the quantity of cars sold per month will decrease.
D) Demand will not shift, but the quantity of cars sold per month will increase.
E) All of the above
___2. Unionized workers may be able to negotiate with management for higher wages
during periods of economic prosperity. Suppose that workers at automobile assembly
plants successfully negotiate a significant increase in their wage package. How would
the new wage contract be likely to affect the market supply of new cars?
A) Supply will shift to the right.
B) Supply will shift to the left.
C) Supply will not shift, but the quantity of cars produced per month will decrease.
D) Supply will not shift, but the quantity of cars produced per month will increase.
E) All of the above
___3. An increase in the demand for a good will cause
A) an increase in equilibrium price and quantity.
B) a decrease in equilibrium price and quantity.
C) an increase in equilibrium price and a decrease in equilibrium quantity.
D) a decrease in equilibrium price and an increase in equilibrium quantity.
E) None of the above
___4. An increase in the supply of a good will cause
A) an increase in equilibrium price and quantity.
B) a decrease in equilibrium price and quantity.
C) an increase in equilibrium price and a decrease in equilibrium quantity.
D) a decrease in equilibrium price and an increase in equilibrium quantity.
E) None of the above
___5. The law of demand states that the quantity of a good demanded varies
A) inversely with its price. B) directly with population.C) directly with income.
D) inversely with the price of substitute goods E) None of the above
___6. Which of the following is consistent with the law of demand?
A) A decrease in the price of a gallon of milk causes a decrease in the quantity of milk
demanded.
B) An increase in the price of a soda causes a decrease in the quantity of soda
demanded.
C) An increase in the price of a tape causes an increase in the quantity of tapes
demanded.
D) A decrease in the price of juice causes no change in the quantity of juice demanded.
E) None of the above
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___7. A drop in the price of a compact disc shifts the demand curve for prerecorded
tapes leftward. Fromthat you know compact discs and prerecorded tapes are
A) normal goods. B) substitutes.C) inferior goods.D) complements. E) luxury
___8. A substitute is a good
A) of higher quality than another good. B) that is not used in place of another good.
B) that can be used in place of another good. D) of lower quality than another good.
E) None of the above
___9. People buy more of good 1 when the price of good 2 rises. These goods are
A) normal goods.B) complements.C) substitutes.D) inferior goods. E) luxury
___10. Which of the following pairs of goods are most likely substitutes?
A) compact discs and compact disc players B) lettuce and salad dressing
B) cola and lemon lime soda D) peanut butter and gasoline E) None of tha above
___11. A complement is a good
A) used in conjunction with another good.
B) used instead of another good.
C) of lower quality than another good.
D) of higher quality than another good.
E) None of the above
___12. Suppose people buy more of good 1 when the price of good 2 falls. These goods
are A) substitutes.B) inferior.C) normal.D) complements. E. luxury
___13. A change in which of the following alters buying plans for cars but does NOT
shift the demandcurve for cars?
A) a 10 percent decrease in the price of car insurance
B) a 20 percent increase in the price of a car
C) a 5 percent increase in people's income
D) an increased preference for walking rather than driving
E) All of the above
___14. Which of the following would NOT shift the demand curve for turkey?
A) a change in tastes for turkey
B) B) a decrease in the price of ham
C) an increase in income
D) a change in the price of a turkey
E) All of the above
___15. Which of the following does NOT shift the supply curve?
A) an increase in the price of the good
B) a fall in the price of a substitute in production
C) a decrease in the wages of labor used in production of the good
D) a technological advance
E) All of the above
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Exercise No. 3 Demand and Supply
Name: ____________________________Course & Section: __________________
CRITICAL THINKING QUESTIONS
1.
Illustration
1.1
Demand: For each of the fallowing cases, state how demand for the
vehicle, “HONDA SIR”, behaves, i.e., whether there is an increase or decrease in
demand or in quantity demanded.
i) The price of gasoline rises because of a shortage in the world petroleum market.
ii) A lower priced “TOYOTA REVO” enters the car market.
iii) The country is hit by another recession, causing a fall in real incomes.
iv) The government imposes a 10 per cent import levy on all imported car parts.
v) A lower rate of fatalities in accidents involving Honda Sir is observed.
1.2 Supply: Indicate whether a movement upward or downward along the
supply curve, or a shift leftward or rightward of the supply curve of MANGOES
occurs for the following cases:
i) The surge in export demand raises price.
ii) The government imposes a price ceiling on mangoes to appease consumers who
have not had enough of the fruit last year.
iii) A new variety is developed which doubles the out per tree.
iv) The current crop of mangoes is infested by fruit files.
v) The price of pesticides against fruit files increases due to the 10 percent import
levy.
1.3 Describe what will happen to equilibrium price and quantity of each of the
commodities given the corresponding hypothetical situations.
i) Coffee: The Philippine Medical Association announces that caffeine in coffee
causes heart attack.
ii) National Bookstore’s Books:
book sale.
Management engages in a one month cut-price
iii) Rice: Government imports rice from Thailand.
iv) Pork: Foot and mouth disease (FMD) hits thousands of pigs resulting in very
high mortality rate.
v) Cigarettes: Taxes on cigarettes are increased from P2.00 to P3.00 per pack.
1.4 Suppose the demand for gasoline is given by Qᴰ = 100 – 2P and the supply by
Qˢ 20 + 6P
i) What will be the equilibrium price and quantity for gasoline?
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