Demand

Demand it is the willingness and ability of consumers to buy goods and services at given prices, it represents the
behavior of buyers who are concerned with maximizing utility.

Law of demand an increase in price of a good or service will lead to a fall in its quantity demand, ceteris paribus and
vice versa. There are three rationales for this relationship:
 Income effect as price of a good rises the real income of individuals’ falls and their purchasing power
reduces, as a result they will tend to buy a lesser quantity of a good.
 Substitution effect as price rises some buyers may shift to buying cheaper substitutes, leading to a fall in
quantity demand for the good.
 Law of diminishing marginal utility according to the law, as increasing quantities of a good are consumed
lesser utility is gained by buyers, as a result lesser quantity of a good is demanded.

Movement along demand curve extension of the demand is represented by an increase in quantity demanded due to
the fall in price, while contraction of demand curve is represented by a fall in quantity demanded due to a rise in price.

Difference between change in quantity demanded and change in demand quantity demanded changes only when
the price of a good changes, resulting in a movement along a fixed demand curve. However, demand only changes
when a non-price determinant changes, resulting in a shift of the demand curve, either rightwards (increase in demand)
or leftwards (decrease in demand).

Non-price determinants of demand

 Income an increase in income of individuals will increase their ability to buy, resulting in increased spending
on goods and services, resulting in a change in demand.
• Inferior good a good whose demand decreases as consumers’ income increases; this results in
leftwards shift of the demand curve (decrease in demand) e.g., an increase in income may lead to
a decrease in demand for public transportation.
• Normal good a good for whose demand increases as consumers’ income increases, resulting in a
rightwards shift of the demand curve (increase in demand) e.g., an increase in income may
increase demand for new cars.
 Population an increase in the number of buyers due to increased population will increase demand for
goods, as a result the demand curve shifts to the right.
 Fashion and taste as preferences and tastes change in favour of a good its demand increases and the
curve shifts rightwards e.g., launch of a new iPhone model may lead to increase in its demand.
 Substitutes these are goods which can be used in place of each other as they fulfill the same purpose e.g.,
coke is a substitute for pepsi, a fall in price of coke will result in a fall in demand for pepsi.
 Complements these are goods which are jointly demanded with other goods e.g., tea and milk, the demand
for tea will increase with a decrease in the price of milk.

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Supply
Supply is the willingness and ability of producers to sell goods and services at a given prices, it represents the
behavior of sellers who aim to maximize profits.

Law of supply an increase in price of a good will result in an increase in its quantity supplied ceteris paribus and vice
versa.

Movement along the supply curve and shifts in supply extension of supply refers to an increase in quantity
supplied of a good due to an increase in its price. Contraction of supply refers to the fall in quantity supplied of a good
with a fall in its price. A change in quantity supplied occurs due to a change in price, and results in a movement along
the existing supply curve. However, a change in supply results due to change in a non-price determinant, resulting in a
shift of the supply curve. A rightward shift represents an increase in supply, while a leftward shift represents a
decrease.

Non-price determinants of supply

 Cost of production all firms require various factors of production to produce goods or services e.g., rent,
wages, utilities raw material etc. An increase in the cost of production may reduce profit margins. Producer
will be less willing to sell a good resulting in a decrease in supply, represented by a leftward shift of the
supply curve.
 Technology innovation in technology may result in increased productivity, lowering the cost of production.
This may lead to increased profits; new firms may enter the market resulting in an increase in supply.
 Prices of related goods
• Joint supply it refers to production of two goods that are derived from a single good e.g., butter
and skimmed milk are both produced from whole milk. An increase in price of butter may lead to an
increase in its quantity supplied, but also an increase in supply of skimmed milk.
• Competitive supply if goods compete for use of the same resources, producing more of one
means producing less of the other e.g., a farmer may choose to grow wheat or corn. As price of
corn increases, the farmer may allocate more resources to corn production, resulting in a decrease
in supply of wheat.
 Supply shocks these are random events such as natural disasters or wars that may adversely affect supply
e.g. bad weather may adversely affect crops, decreasing supply of agricultural products. However, positive
supply shocks such as discovery of fossil fuels may increase the supply of certain goods.
 Subsidies these are financial payments made to firms by the government, and are considered a decrease in
the cost of production. This increases profit incentive for existing firms to allocate more resources to the
production of a good. Additionally, new firms may also enter the market due profit incentive, resulting in an
increase in supply.
 Indirect taxes these are financial charges imposed on production and consumption of goods and services,
and are considered an increase in the cost of production. Taxes decrease profit incentive for existing firms as
a result some firms may reduce their output while others may leave the market, resulting in a decrease in
supply.
 Number of firms increase in the number of firms producing goods or services in a market will increase
supply resulting in a rightward shift of the supply curve.

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Competitive market equilibrium
Market equilibrium occurs at the intersection of the demand and supply curves which represents the market-clearing
price and quantity traded.

Effect of change in demand on equilibrium an increase in demand creates a situation where quantity demanded
exceeds quantity supplied (shortage), producers increase quantity supplied but raise prices while buyers are be willing
to pay higher prices but buy lesser quantity. This continues till equilibrium is reached. Similarly, if demand falls, quantity
supplied exceeds quantity demanded (surplus), producers reduce prices to clear stocks and reduce their output while
quantity demanded will increase as consumers are willing to buy more at lower prices. This continues till the market
reaches equilibrium.

Effect of change in supply on equilibrium an increase in supply creates a situation where quantity supplied exceeds
quantity demanded, producers reduce prices to clear stocks and reduce their output while quantity demanded will
increase as consumers are willing to buy more at lower prices. This continues till the market reaches equilibrium.
However, a decrease in supply means quantity demanded exceeds quantity supplied, producers increase quantity
supplied and raise prices while buyers are willing to pay higher prices but buy lesser quantity. This continues till
equilibrium is reached.

The price mechanism refers to the means by which the forces of demand and supply determine the allocation of
scarce resources by competing users.
 Resource allocation (signaling and incentive function)
 The rationing function

If there is a shortage in the market, it sends a signal to firms to meet consumer demand. This introduces an incentive
for firms to raise product price in order to earn more revenue. However, as prices rise consumers ration their
resources (money) by buying fewer quantity of a good.

However, if a surplus occurs in a market, it sends a signal to firms that there is low demand. This incentivizes firms to
reduce prices and output. Furthermore, as prices fall, consumers ration the resources (money) towards buying more
quantities of a good.

Market efficiency occurs if maximum amount of goods are being produced with a given level of resources, and if no
additional output is possible without increasing the amount of inputs.
 Consumer surplus is the extra benefit consumers receive when they pay a price below what they are willing
to pay.
 Producer surplus is the extra benefit producers receive when they receive a price above the one at which
they are willing to sell at.

Consumer or producer surplus = ½ x base x height

Community (total/social) surplus is the sum of consumer and producer surplus at a given market price and output.
Total surplus = consumer surplus + producer surplus

Productive efficiency occurs when a firm is producing at the lowes possible cost. This can be shown by any point on
the PPC curve or where when P = min ATC on a profit maximization graph.

Marginal benefit is the benefit a person receives by consuming an additional unit of a good or service.

Marginal cost is the cost incurred by a manufacturer of producing one additional unit of a good or service.

Allocative efficiency occurs when a firm produces a combination of goods that are most wanted by consumers and
this can been shown on a proft maximization grpah where MSB = MSC.

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Elasticity of demand: price elasticity of demand (PED)
Price elasticity of demand measures the change in quantity demanded of a good due to a change in its price.
PED = percentage change in quality demanded
percentage change in price

Example: if the price of an ice cream cone increases from $2 to $2.20 and the amount individuals buy falls from 100 to
80 cones, then PED can be calculated as:

PED = (80 -100) / 100 x 100

(2.20 – 2) / 2 x 100

PED = -20 = -2
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Determinants of PED
 Number of substitute a good with more substitutes has price-elastic demand, if the price of a good rises,
consumers may switch to other substitutes resulting in a relatively large fall in quantity demanded. But, a
good with fewer substitutes has inelastic demand, an increase in price will result in a relatively smaller fall in
quantity demanded.
 Proportion of income goods that consume a larger portion of buyer's income tend to have elastic demand
as the higher cost will cause buyers purchase substitute goods. In contrast, demand will tend to be price-
inelastic when a good consumes a small portion of income.
 Luxury or necessity the greater the necessity for a good the more inelastic its demand. However, luxury
goods tend to have elastic demand as buyers will be more responsive to price changes.
 Addictive nature goods that are addictive in nature will have an inelastic demand due to the fact that they
are habit-forming and can become necessities for consumers.
 Time period if people have more time to adjust to price changes, they may be able to make greater
adjustments and will be more responsive to price changes. But with time, they may buy petrol -efficient car
lowering their demand for petrol.

Total revenue test of PED a total revenue test approximates PED by measuring the change in total revenue from a
change in the price of a good or service.

Example: consider the following demand schedule for ski lift tickets:

The seller of the ski lift can calculate the potential revenue from the
sale of tickets at different price.
TR = price x quantity sold

The total revenue can be calculated as follows:

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Usefulness of PED the knowledge of PED may help a producer to analyze the impact of changes in price levels on
the demand for its goods and consequently on its revenue. Producers can use this to decide the price of their good. If
the demand of the good is price-elastic, by lowering its price, producers may earn greater revenue. However, if
demand of the good is price-inelastic, by raising its price producers may earn greater revenue.

Additionally, producers may use the knowledge of PED to decide whether to bear high burden of indirect taxes
themselves or pass it on to consumers in the form of higher prices. In case of elastic demand, producers’ bear higher
tax burden. But in case of inelastic demand, producers can pass on a higher proportion of tax to consumers.

PED of primary and manufactured goods

 Primary goods are such as rice, coal and crude oil lack close substitutes so their demand is price inelastic
while most manufactured goods have many substitutes so their demand is price elastic
 Primary goods are essentials so their demand is price inelastic while manufactured goods such as furniture
have low degree of necessity so demand is price elastic
 Primary goods consumer a lower proportion of income (price inelastic demand). Manufactured goods such
as cars consume are larger proportion of income (price elastic demand)
 Manufactured goods like laptops can be used continuously over time so PED is high