40 CHAPTER 2 SUPPLY AND DEMAND

Section summary
1. When the price of a good rises, the quantity demanded complementary goods, income, distribution of income and
per period of time will fall. This is known as the ‘law of expectations of future price changes.
demand’. It applies both to individuals’ demand and to the 5. If price changes, the effect is shown by a movement along
whole market demand. the demand curve. We call this effect ‘a change in the
2. The law of demand is explained by the income and substi- quantity demanded’.
tution effects of a price change. 6. If any other determinant of demand changes, the
3. The relationship between price and quantity demanded whole curve will shift. We call this effect ‘a change
per period of time can be shown in a table (or ‘schedule’) in demand’. A rightward shift represents an increase
or as a graph. On the graph, price is plotted on the verti- in demand; a leftward shift represents a decrease in
cal axis and quantity demanded per period of time on the demand.
horizontal axis. The resulting demand curve is downward
sloping (negatively sloped). *7. The relationship between the quantity demanded and the
4. Other determinants of demand include tastes, the number various determinants of demand (including price) can be
and price of substitute goods, the number and price of expressed as an equation.

2.2 SUPPLY

Supply and price will need to get a higher price if they are to be persuaded
to produce extra output.
Imagine you are a farmer deciding what to do with your land. ■ The higher the price of the good, the more profitable it
Part of your land is in a fertile valley, while part is on a hill- becomes to produce. Firms will thus be encouraged to
side where the soil is poor. Perhaps, then, you will consider produce more of it by switching from producing less prof-
growing vegetables in the valley and keeping sheep on the itable goods.
hillside. ■ Given time, if the price of a good remains high, new pro-
Your decision will depend to a large extent on the price ducers will be encouraged to enter the industry. Total
that various vegetables will fetch in the market and the price market supply thus rises.
you can expect to get for meat and wool. As far as the val-
ley is concerned, you will plant the vegetables that give the The first two determinants affect supply in the short run. The
best return. If, for example, the price of potatoes is high, you third affects supply in the long run. We distinguish between
might use a lot of the valley for growing potatoes. If the price short-run and long-run supply in section 2.5 on page 69.
gets higher, you may well use the whole of the valley. If the
price is very high indeed, you may even consider growing The supply curve
potatoes on the hillside, even though the yield per acre is
much lower there. The amount that producers would like to supply at various
In other words, the higher the price of a particular farm prices can be shown in a supply schedule. Table 2.2 shows a
output, the more land will be devoted to it. This illustrates monthly supply schedule for potatoes, both for an individ-
the general relationship between supply and price: when the ual farmer (farmer X) and for all farmers together (the whole
price of a good rises, the quantity supplied will also rise. There are market). (Note, however, that the amount they supply at a
three reasons for this: given price may not be the same as the amount they actually
sell. Some supply may remain unsold.)
■ As firms supply more, they are likely to find that beyond a
certain level of output, costs rise more and more rapidly.
In the case of the farm just considered, if more and more
potatoes are grown, then the land which is less suitable Definition
for potato cultivation has to be used. This raises the cost
of producing extra potatoes. It is the same for manufac- Supply schedule A table showing the different quanti-
ties of a good that producers are willing and able to supply
turers. Beyond a certain level of output, costs are likely
at various prices over a given time period. A supply sched-
to rise rapidly as workers have to be paid overtime and ule can be for an individual producer or group of produc-
as machines approach capacity working. If higher output ers, or for all producers (the market supply schedule).
involves higher costs of producing each unit, producers

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 2.2 SUPPLY 41

Table 2.2 The supply of potatoes (monthly) Other determinants of supply

Like demand, supply is not simply determined by price. The
Price of Farmer X’s Total market
potatoes supply supply other determinants of supply are as follows.
(pence per kg) (tonnes) (tonnes: 000s)
The costs of production. The higher the costs of production,
a 20 50 100 the less profit will be made at any price. As costs rise, firms
b 40 70 200 will cut back on production, probably switching to alterna-
c 60 100 350
tive products whose costs have not risen so much.
d 80 120 530
e 100 130 700 The main reasons for a change in costs are as follows:

■ Change in input prices: costs of production will rise if

wages, raw material prices, rents, interest rates or any
The supply schedule can be represented graphically as a other input prices rise.
supply curve. A supply curve may be an individual firm’s sup- ■ Change in technology: technological advances can fun-
ply curve or a market curve (i.e. that of the whole industry). damentally alter the costs of production. Consider, for
Figure 2.3 shows the market supply curve of potatoes. As example, how the microchip revolution has changed
with demand curves, price is plotted on the vertical axis and production methods and information handling in virtu-
quantity on the horizontal axis. Each of the points a–e cor- ally every industry in the world.
responds to a figure in Table 2.2. Thus, for example, a price ■ Organisational changes: various cost savings can be made
rise from 60p per kilogram to 80p per kilogram will cause a in many firms by reorganising production.
movement along the supply curve from point c to point d: ■ Government policy: costs will be lowered by government
total market supply will rise from 350 000 tonnes per month subsidies and raised by various taxes. Government regula-
to 530 000 tonnes per month. tion may also increase costs; examples include minimum
wages and obligations for employers to provide and con-
1. How much would be supplied at a price of 70p per kilo? tribute to employee pensions.
2. Draw a supply curve for farmer X. Are the axes drawn to
the same scale as in Figure 2.3?

Not all supply curves will be upward sloping (positively

sloped). Sometimes they will be vertical, or horizontal or even Definition
downward sloping. This will depend largely on the time period
Supply curve A graph showing the relationship between
over which firms’ response to price changes is considered. This the price of a good and the quantity of the good supplied
question is examined in the section on the elasticity of supply over a given period of time.
(see section 2.4 below) and in more detail in Chapters 6 and 7.

Figure 2.3 Market supply curve of potatoes (monthly)

e
100
Supply
d
80
Price (pence per kg)

c
60

b
40

a
20

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

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 42 CHAPTER 2 SUPPLY AND DEMAND

The profitability of alternative products (substitutes in supply). If a

product which is a substitute in supply becomes more prof- Figure 2.4 Shifts in the supply curve
itable to supply than before, producers are likely to switch
P
from the first good to this alternative. Supply of the first S2 S0 S1
good falls. Other goods are likely to become more profitable
if their prices rise and/or their costs of production fall. For
example, during 2020 many gin distilleries switched to pro-
ducing hand sanitiser.

The profitability of goods in joint supply. Sometimes when one Decrease Increase
good is produced, another good is also produced at the same
time. These are said to be goods in joint supply. An example
is the refining of crude oil to produce petrol. Other grade
fuels will be produced as well, such as diesel and paraffin. If
more petrol is produced due to a rise in demand and hence
its price, then the supply of these other fuels will rise too. O Q
Nature, ‘random shocks’ and other unpredictable events.
In this
category we would include the weather and diseases affect-
ing farm output, wars affecting the supply of imported raw
increase in supply. A leftward shift illustrates a decrease in
materials, the breakdown of machinery, industrial disputes,
supply. Thus in Figure 2.4, if the original curve is S0, the curve
earthquakes, floods and fire, etc. Research suggest that one
S1 represents an increase in supply (more is supplied at each
third of the variation in the annual harvests of maize wheat
price), whereas the curve S2 represents a decrease in supply
and rice is caused by changes in the weather (temperature
(less is supplied at each price).
and rainfall). In one specific example, unexpected frosts in
A movement along a supply curve is often referred to as a
Brazil in July 2019 put upward pressure on coffee prices over
change in the quantity supplied, whereas a shift in the supply
fears it would have a negative impact on harvests.
curve is simply referred to as a change in supply.
The aims of producers. A profit-maximising firm will supply a
different quantity from a firm that has a different aim, such This question is concerned with the supply of oil for central
as maximising sales. For most of the time we shall assume heating. In each case consider whether there is a movement
along the supply curve (and in which direction) or a shift in
that firms are profit maximisers. In Chapter 9, however, we
it (and whether left or right).
consider alternative aims. (a) New oil fields start up in production.
Expectations of future price changes.
If suppliers believe that (b) The demand for central heating rises.
(c) The price of gas falls.
the prices of the goods they produce will rise in the future,
(d) Oil companies anticipate an upsurge in demand for
they may temporarily reduce the amount they sell today. central-heating oil.
They may build up their stocks and only release them on to (e) The demand for petrol rises.
the market when the price does rise. At the same time, they (f) New technology decreases the costs of oil refining.
may install new machines or take on more labour, so that (g) All oil products become more expensive.
they can be ready to supply more when the price has risen.

The number of suppliers. If new firms enter the market, supply

is likely to increase.
Definitions
By referring to each of the above determinants of supply,
identify what would cause (a) the supply of potatoes to fall Substitutes in supply These are two goods where an
and (b) the supply of leather to rise. increased production of one means diverting resources
away from producing the other.
Joint supply goods These are two goods where the pro-
Movements along and shifts in the supply curve duction of more of one leads to the production of more
of the other.
The principle here is the same as with demand curves. The
effect of a change in price is illustrated by a movement along Change in the quantity supplied The term used for
a movement along the supply curve to a new point. It
the supply curve: for example, from point d to point e in
occurs when there is a change in price.
Figure 2.3 when price rises from 80p to 100p. Quantity sup-
Change in supply The term used for a shift in the sup-
plied rises from 530 000 to 700 000 tonnes per month. ply curve. It occurs when a determinant other than price
If any other determinant of supply changes, the whole changes.
supply curve will shift. A rightward shift illustrates an

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 2.3 PRICE AND OUTPUT DETERMINATION 43

*LOOKING AT THE MATHS

Using survey data and regression analysis, equations can be If any determinant other than price changed, a new equation
estimated relating supply to some of its determinants. Note that would result. For example, if costs of production fell, the equa-
not all determinants can be easily quantified (e.g. nature and the tion might then be
aims of firms), and they may thus be left out of the equation.
Qs = 1000 + 1500P (3)
The simplest form of supply equation relates supply to just
one determinant. Thus a function relating supply to price would More complex supply equations would relate supply to more
be of the form than one determinant. For example:
Qs = c + dP (1) Qs = 200 + 80P - 20a1 - 15a2 + 30j (4)
Using regression analysis, values can be estimated for c and d. where P is the price of the good, a1 and a2 are the profitabilities of
Thus an actual supply equation might be something like two alternative goods that could be supplied instead, and j is the
profitability of a good in joint supply.
Qs = 500 + 1000P (2)
1. If P was originally measured in pounds, what would Explain why the P and j terms have a positive sign,
happen to the value of the d term in equation (2) if P whereas the a1 and a2 terms have a negative sign.
were now measured in pence?
2. Draw the schedule (table) and graph for equation (2)
for prices from £1 to £10. What is it in the equation
that determines the slope of the supply ‘curve’?

Section summary
1. When the price of a good rises, the quantity supplied per 4. Other determinants of supply include the costs of pro-
period of time will usually also rise. This applies both to indi- duction, the profitability of alternative products, the
vidual producers’ supply and to the whole market supply. profitability of goods in joint supply, random shocks and
2. There are two reasons in the short run why a higher price expectations of future price changes.
encourages producers to supply more: (a) they are now 5. If price changes, the effect is shown by a movement along
willing to incur the higher costs per unit associated with the supply curve. We call this effect ‘a change in the quan-
producing more; (b) they will switch to producing this tity supplied’.
product and away from products that are now less profit-
6. If any determinant other than price changes, the effect
able. In the long run, there is a third reason: new produc-
is shown by a shift in the whole supply curve. We call this
ers will be attracted into the market.
effect ‘a change in supply’. A rightward shift represents an
3. The relationship between price and quantity supplied per increase in supply; a leftward shift represents a decrease
period of time can be shown in a table (or schedule) or as in supply.
a graph. As with a demand curve, price is plotted on the
vertical axis and quantity per period of time on the hori- *7. The relationship between the quantity supplied and the
zontal axis. The resulting supply curve is upward sloping various determinants of supply can be expressed in the
(positively sloped). form of an equation.

2.3 PRICE AND OUTPUT DETERMINATION

Equilibrium price and output by 600 000 tonnes (A - a). Consumers would be unable
to obtain all they wanted and would thus be willing to
We can now combine our analysis of demand and supply. pay a higher price. Producers, unable or unwilling to sup-
This will show how the actual price of a product and the ply enough to meet the demand, will be only too happy to
actual quantity bought and sold are determined in a free and accept a higher price. The effect of the shortage, then, will
competitive market. be to drive up the price. The same would happen at a price
Let us return to the example of the market demand and of 40p per kilogram. There would still be a shortage; price
market supply of potatoes, and use the data from Tables 2.1 would still rise. But as the price rises, the quantity demanded
and 2.2. These figures are given again in Table 2.3. falls and the quantity supplied rises. The shortage is progres-
What will be the actual price and output? If the price sively eliminated.
started at 20p per kilogram, demand would exceed supply

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 44 CHAPTER 2 SUPPLY AND DEMAND

are mutually reconciled: where the producers’ plans to supply

Table 2.3 The market demand and supply of exactly match the consumers’ plans to buy.
potatoes (monthly)

Price of Total market Total market

KEY Equilibrium is the point where conflicting interests
potatoes demand supply
IDEA are balanced. Only at this point is the amount that
(pence per kg) (tonnes: 000s) (tonnes: 000s) 8
demanders are willing to purchase the same as the
20 700 (A) 100 (a)
amount that suppliers are willing to supply. It is a
40 500 (B) 200 (b)
60 350 (C) 350 (c) point that will be automatically reached in a free
80 200 (D) 530 (d) market through the operation of the price mechanism.
100 100 (E) 700 (e)

Demand and supply curves

Explain the process by which the price of houses would rise The determination of equilibrium price and output can be
if there were a shortage. shown using demand and supply curves. Equilibrium is
where the two curves intersect.
Figure 2.5 shows the demand and supply curves of pota-
What would happen if the price of potatoes started at a toes corresponding to the data in Table 2.3. Equilibrium price
much higher level: say, at 100p per kilogram? In this case is Pe (60p) and equilibrium quantity is Q e (350 000 tonnes).
supply would exceed demand by 600 000 tonnes (e - E). At any price above 60p, there would be a surplus. Thus
The effect of this surplus would be to drive the price down as at 80p there is a surplus of 330 000 tonnes (d - D). More is
farmers competed against each other to sell their excess sup- supplied than consumers are willing and able to purchase at
plies. The same would happen at a price of 80p per kilogram. that price. Thus a price of 80p fails to clear the market. Price
There would still be a surplus; price would still fall. will fall to the equilibrium price of 60p. As it does so, there
In fact, only one price is sustainable – the price where will be a movement along the demand curve from point D
demand equals supply: namely, 60p per kilogram, where to point C, and a movement along the supply curve from
both demand and supply are 350 000 tonnes. When sup- point d to point c.
TC 4 ply matches demand the market is said to clear. There is no
At any price below 60p, there would be a shortage.
p45
shortage and no surplus. Thus at 40p there is a shortage of 300 000 tonnes (B - b).
As we have already seen in section 1.2, the price where
demand equals supply is called the equilibrium price and
we return to this in more detail in Threshold Concept 4. In Definition
Table 2.3, if the price starts at anything other than 60p per kilo-
Market clearing A market clears when supply matches
gram, it will tend to move towards 60p. The equilibrium price demand, leaving no shortage or surplus.
is the only price at which producers’ and consumers’ wishes

Figure 2.5 The determination of market equilibrium (potatoes: monthly)

E e
100
Supply
D SURPLUS d
80
(330 000)
Price (pence per kg)

Cc
60

b SHORTAGE B
40
(300 000)
a A
20
Demand

0
0 100 200 300 400 500 600 700 800
Quantity (tonnes: 000s)

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 2.3 PRICE AND OUTPUT DETERMINATION 45

Price will rise to 60p. This will cause a movement along the
supply curve from point b to point c and along the demand Figure 2.6 Effect of a shift in the demand curve
curve from point B to point C.
P
Point Cc is the equilibrium: where demand equals supply.
S

Movement to a new equilibrium

i
The equilibrium price will remain unchanged only so long as Pe2
KI 5 the demand and supply curves remain unchanged. If either g
p21 of the curves shifts, a new equilibrium will be formed. Pe1 h

A change in demand
If one of the determinants of demand changes (other than D2
price), the whole demand curve will shift. This will lead to a D1
movement along the supply curve to the new intersection point. O Qe1 Qe2 Q
For example, in Figure 2.6, if a rise in consumer incomes
led to the demand curve shifting to D2, there would be a

THINKING LIKE AN
THRESHOLD CONCEPT 4 MARKETS EQUATE DEMAND AND SUPPLY ECONOMIST

‘Let the market decide.’ ‘Market forces will dictate.’ ‘You can’t consumer demand and consumers to respond to changes in
buck the market.’ producer supply.
These sayings about the market emphasise the power of market In many circumstances, markets bring outcomes that people
forces and how they affect our lives. Markets affect the prices of want. As we have seen, if consumers want more, then market
the things we buy and the incomes we earn. Even governments forces will lead to more being produced. Sometimes, however,
find it difficult to control many key markets. Governments market forces can bring adverse effects. We explore these in
might not like it when stock market prices plummet or when oil various parts of the book. It is important, at this stage, how-
prices soar, but there is little they can do about it. ever, to recognise that markets are rarely perfect. Market
failures, from pollution to the domination of our lives by big
In many ways a market is like a democracy. People, by choos-
business, are very real. Understanding this brings us to Thresh-
ing to buy goods, are voting for them to be produced. Firms
old Concept 7 (see page 79).
finding ‘a market’ for their products are happy to oblige and
produce them. The way it works is simple. If people want more
of a product, they buy more and thereby ‘cast their votes’ (i.e. Partial equilibrium
their money) in favour of more being produced. The resulting
shortage drives up the price, which gives firms the incentive to The type of equilibrium we will be examining for the next few
produce more of the product. In other words, firms are doing chapters is known as ‘partial equilibrium’. It is partial because
what consumers want – not because of any ‘love’ for consum- what we are doing is examining just one tiny bit of the economy
ers, or because they are being told to produce more by the at a time: just one market (e.g. that for eggs). It is even partial
government, but because it is in their own self-interest. They within the market for eggs because we are assuming that price is
supply more because the higher price has made it profitable the only thing that changes to balance demand and supply: that
to do so. nothing else changes. In other words, when we refer to equi-
librium price and quantity, we are assuming that all the other
This is a threshold concept because to understand market forces determinants of both demand and supply are held constant.
– the forces of demand and supply – is to go straight to the
heart of a market economy. And in this process, prices are the If another determinant of demand or supply does change, there
key. It is changes in price that balance demand and supply. would then be a new partial equilibrium as price adjusts and
If demand exceeds supply, price will rise. This will choke off both demanders and suppliers respond. For example, if a health
some of the demand and encourage more supply until demand scare connected with egg consumption causes the demand for
equals supply – until an equilibrium has been reached. If sup- eggs to fall, the resulting surplus will lead to a fall in the equi-
ply exceeds demand, price will fall. This will discourage firms librium price and quantity.
from supplying so much and encourage consumers to buy more,
1. If there is a shortage of certain skilled workers in the
until, once more, an equilibrium has been reached.
economy, how will market forces lead to an elimina-
In this process, markets act like an ‘invisible hand’ – a term tion of the skills shortage?
coined by the famous economist Adam Smith (see Box 1.6 on 2. If consumers want more of a product, is it always desir-
page 24). Market prices guide both producers to respond to able that market forces result in more being produced?

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