CHAPTER 2

DEMAND, SUPPLY AND MARKET EQUILIBRIUM

At the end of the chapter the student should be able to:

1. Explain the significant role of supply and demand in the prices of goods and services in
health sector;
2. Become critically familiar with the demand and supply schedules, and graphically
illustrate the demand and supply curves and the intersection of the two curves;
3. Correctly compute, effectively discuss and graphically illustrate the equilibrium price and
quantity.
4. Discuss effectively and graphically the price ceiling and price floor as government
policies.

The concepts of demand and supply are two basic elements in economics. This chapter
introduces and studies the two elements, starting with the law of demand and supply which
relates prices to quantity demanded and quantity supplied, the factors affecting demand and
supply, and how a change in these factors translates into shifts of the demand curve and supply
curve. It also distinguishes between movements along the demand curve and shifts of the
demand curve. This chapter also explains what normal and inferior goods are, as well as
substitutes and complementary goods.
Lastly, this chapter discusses market equilibrium. It illustrates how market equilibrium is
attained. It introduces the concepts of shortage, surplus, price ceilings, and price floor.

Market
- A market is group of buyers and sellers with the facilities for trading with each other.
- A place where buyers and sellers meet to exchange goods and services.
- A large geographic area wherein a set of supply and demand forces operate to set up
prices.
- May be formal or informal markets.

DEMAND

There is a main difference between demand and quantity demanded. Quantity

demanded is the amount of a good or a service that buyers are willing and able to purchase at
a given price, time and place; all other factors are held constant (ceteris paribus). While,
demand is the entire relationship between the various quantities demanded of a particular good
or a service that buyers are willing and able to purchase at each of these prices, all other factors
are held constant (ceteris paribus).

Law of Demand

The most famous law in economics is probably the law of demand. The law of demand
states that, holding all other things constant, the quantity demanded for a commodity or service
is negatively or inversely related to its own price. Thus, when the price of a good rises, the
quantity demanded falls. Conversely, when the price falls, the quantity demanded rises.

Demand Schedule, Demand Curve and Demand Function

The demand-price relationship can be depicted in three different ways: in a tabular form
or demand schedule, in a graphical form or demand curve, and in a functional form or demand
function/equation. A demand schedule is a numerical tabulation of the quantity demanded of a
good or a service at selected prices, holding other factors constant or ceteris paribus. Table 2.1 is
an example of a demand schedule for notebooks. For instance, 120 notebooks are demanded
when its price is ten pesos per notebook but quantity demanded for notebook becomes 105
when its price is fifteen pesos per notebook.

Table 2.1 Demand schedule for notebooks.

Price per unit Quantity Demanded per Week
10 120
15 105
25 75
30 60
35 45

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 A demand curve is a graph of the relationship between the price of a good and the
quantity demanded holding other factors constant or ceteris paribus. Figure 2.1 shows the
demand curve that plotted in the demand schedule in Table 2.1.

Price

50

40

30

20

10 D
Quantity demanded per week
0
20 40 60 80 100 120

Figure 2.1 Demand curve for notebooks

A third way to depict the demand-price relationship is with the use of a demand
function/equation. A demand function/equation is a representation of the relationship
between the quantity demanded and the price expressed in a mathematical language using
functional form, holding other factors constant or ceteris paribus. The function may be written
as:

Qd = a – bP

Where Qd stands for quantity demanded and P is the price. The term a is the intercept or
constant term of the equation. It is the quantity demanded when price is set at zero. The item,
- b is the slope of the function. The negative sign of the slope illustrates the inverse or negative
relationship between price and quantity demanded. The slope also tells us the change in quantity
demanded per unit change in price.

Example: Qdx = 150 – 3Px

Interpretation of the intercept and the slope:

a = 150. This means that if the price of commodity X is zero, the buyer will purchase 150 units
of the commodity.
b = -3. This means that for every one unit increase in the price of commodity X, the quantity
demanded will decrease by 3 units.

Change in Quantity Demanded vs. Change in Demand

All other things remaining unchanged, when price changes, whether in the upward or
downward directions, what happens is a movement along the demand curve. The change in price
results in changes in quantity demanded. If there is an increase in price, buyers respond by
lowering the quantity they want to buy for a good or service. The reverse happens when the
price decreases. In Figure 2.2, when price increases from P1 to P2, quantity demanded decreases
from Qd1 to Qd2, or there is a movement along the demand curve from point a to point b.

b
P2
Change in Quantity
a Demanded
P1
D
0 Qd
Qd2 Qd1
Figure 2.2 Change in Quantity Demanded

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 As economic life evolves, demand changes continually. Demand curve shift due to the
influence of other factors or determinants of demand other than the good’s price change. In
other words, change in demand means an upward (rightward) or downward (leftward) shifting
of demand curve due to different factors except price of the good itself. Let’s say for example,
that there is an increase in the number of students. This means that the demand for notebook
also increases from initial demand curve to new demand curve, so the demand curve will shift
upward or to the right as presented in Figure 2.3 below.

P
D2
D1

Qd
Qd1 Qd2

Figure 2.3 Demand curve for notebooks

Determinants of Demand/Demand Shifters

1. Consumers Income

A higher income generally translates into greater ability to buy, and hence raises the
demand for goods and services.
Normal goods are products whose demand increases as income increases or whose
demand decreases as income decreases. For instance, when the consumer’s income increases,
he/she may demand more pairs of shoes. In general, as citizens register an improvement in their
standard of living, the demand pattern changes. Demand for some goods increases but demand
for others may fall.
Inferior goods are products whose demand decreases when a consumer’s income
increases. For example, a higher income allows a consumer to buy new shirts instead of buying
second-hand clothes at the popular ukay-ukay stores. Hence, second-hand clothes in this case
are inferior goods.

2. Price of related goods in consumption

Prices of related goods in consumption affect our demand for commodities. A change in
the price of a related good may either increase or decrease the demand for another commodity,
depending on whether the related good is substitute or a complementary. A good that can be
used in place of another good is known as a substitute good while a good that is consumed
along with another good is known as a complementary good.
When the price of a tube of glue rises, consumers react by buying less glue, and
increasing their demand for paste. When two goods are substitutes, the change in the price of
one good and the demand for the second good move in the same direction.
Shampoo and conditioner may be considered complementary goods. If the price of
shampoo increases, then the demand of shampoo decreases same with the conditioner that the
demand decreases. When two commodities are complements, the change in the price of one
good and the demand for the second good move in opposite directions.

3. Consumer tastes and preferences

When consumer tastes and preferences shift towards a certain good, greater amounts of
it are demanded. New products and trends or fads may influence consumer tastes. For instance,
the demand for originally grown vegetables has increased because of health concerns. Likewise,
whole-grain bread products are gaining popularity. The preferences of people are also influenced
by their customs, tradition, and history. Geographic condition is also another factor which
influences tastes (Sicat, 2003). People do not wear thick clothing in the tropics; instead, they
wear clothes made of lightweight fabrics like cotton.

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4. Consumer expectations

The demand for specific commodities may also be affected by expectations about the
future, i.e., future prices, future product availability, and future income. An impending recession
may lead to reduce demand by consumers for many non-essential goods as consumers cut down
on their spending or postpone plans of spending. On the other hand, expectations of better times
may translate to increases consumption and larger expenditures.

5. Unexpected events

Acts of nature and other unexpected events alter the demand for a good or service. A
typhoon or a strong earthquake increases the demand for construction materials as well as
blankets and canned goods. An upsurge of dengue fever cases would also raise the demand for
insect repellents and fumigation services.

6. Number of buyers

An increase in the number of consumers affects the market demand for a good and shifts
the market demand curve to the right. However, it is also important that these consumers have
an income that can sustain the demand.

SUPPLY

There is a main difference between supply and quantity supplied. Quantity supplied
refers to any amount of a good or a service that firms are willing and able to sell at a given price,
time and place; holding other factors constant or ceteris paribus. While, supply is the entire
relationship between the various quantities supplied of a particular good or a service that sellers
are willing and able to sell at each of these prices, all other factors are held constant (ceteris
paribus).

Law of Supply

The law of supply states that the higher the price, the higher is the amount or quantity of
a good that will be supplied by firms or producers. Conversely, the lower the price, the lower is
the quantity of a good that will be bought to the market. Thus, the price and quantity supplied of
a good are positively or directly related. An increase in one variable is associated with an increase
in the other.

Supply Schedule, Supply Curve and Supply Function

The supply-price relationship can be depicted into three different ways: in a tabular form
or supply schedule, in a graphical form or supply curve, and in a functional form or supply
function/equation. Table 3.2 is an example of a supply schedule for notebooks. A supply
schedule is a numerical tabulation of the quantity supplied of goods and services at selected
prices, assuming other things are held constant or ceteris paribus. For instance, 60 notebooks are
supplied when its price is ten pesos but quantity supplied becomes 65 pieces when its price is
fifteen pesos.

Table 2.2 Supply schedule for notebooks

Price per unit Quantity Supplied per Week
10 60
15 65
25 75
30 80
35 85

A supply curve is a graph of the relationship between the price of a good and the
quantity supplied holding other factors constant or ceteris paribus. Figure 2.4 shows the supply
curve that plotted in the supply schedule in Table 2.2.

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 Price

50
S
40

30

20

10
0
Quantity supplied per week
20 40 60 80 100

Figure 2.4 Supply curve for notebooks

On the other hand, the supply-price relationship can also be shown by a supply
function/equation. A supply function/equation is a representation of the relationship between
the quantity supplied and the price expressed in a mathematical language using functional form,
holding other factors constant or ceteris paribus. The function may be written as:

Qs = c + dP

Where Qs stands for quantity supplied and P is the price. The terms c is the intercept or
constant term of the equation. It is the quantity supplied when price is set at zero. The item d is
the slope of the function. The positive sign of the slope illustrates the positive relationship
between price and quantity supplied. The slope also tells us the change in quantity supplied per
unit change in price.

Example: Qsx = 50 + Px

Interpretation of the intercept and the slope

c = 50. This means that if the price of commodity X is zero, the seller will sell 50 units of the
commodity. A negative quantity is nothing. This only emphasizes that if there is no price,
the seller will sell nothing.

D = 1. This means that for every one unit increase in the price of commodity X, the quantity
supplied will increase by 1 unit.

Determinants of Supply/Supply Shifters

1. Technology

Anything that changes the amount of outputs that a firm can produce with a given
amount of inputs can be considered a change in technology. Technology gets better with time
because of new ideas and discoveries. Technological improvements shift the supply curve to the
right and increase supply.

2. Changes in the prices of resource inputs

When the prices of resource inputs, such as raw materials, fuel products, and labor
increase, it becomes costlier to produce goods. Firms would, therefore, sell less at any given
price. This causes the supply curve to shift to the left. On the other hand, when the price of
resource inputs like flour becomes cheaper, more bread can be supplied and the supply curve of
bread shifts to the right.

3. Prices of related goods in production

Factors inputs like land, labor, and capital equipment can be used to produce not just
one but several goods and services. Therefore, when the price of a pair of boxing gloves
increases, firms that produce volleyballs can shift factor inputs and produce boxing gloves
instead. McConnell and Brue (2005) call this, substitution in production; in this case, it results in
a decline in the supply of volleyballs and the supply curve of volleyballs shifts to the left.

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4. Number of firms

The larger the number of sellers, the greater the market supply, other things remaining
the same. With more firms in the industry, supply increases and the supply curve shifts to the
right. However, when firms close down following a global recession, for instance, the supply of
goods falls and the supply curve shifts to the left.

5. Expectations of future prices

It is hard to generalize about how expectations of higher prices affect the present supply
of a good. Producers may withhold (i.e., hoard) some of their current output in anticipation of
higher prices in the next period. For example, traders can hoard rice if they think the price of rice
will increase with the onset of the rainy season. On the other hand, an anticipation of lower
output prices in the future may cause firms to either increase supply now or reduce current
production. Firms may try to increase output now and sell even their inventory at the current
price, which they believe to be a better price. However, they may also try to reduce current
output to temporarily drive market prices up.

6. Government taxes, subsidies, and regulations

An increase in sales tax and other forms of taxes is an added cost to production and will
decrease supply. The imposition of a value added tax on cigarettes raises production costs which
may reduce the supply of cigarettes. Subsidies, in contrast, lower producers’ cost and will lead to
an increase in supply. Fertilizer and other farm inputs are often provided by government agencies
to farmers at reduced costs, thus lowering their production costs. Increased subsidies to state
universities lower the cost of higher education. Government regulations, which can increase or
lower the costs of production, also affect the supply of output of firms. The need for correct
labels on food items as required by the government, for instance, means additional costs for
producers.

Change in Quantity Supplied vs. Change in Supply

A movement along the supply curve occurs when the price of the good changes, causing
the quantity supplied by firms to change. Figure 2.5 illustrates this by the movement along the
supply curve from point a to point b as the price increases from P1 to P2 and quantity rises from
Qs1 to Qs2. Economists refer to this as a change in the quantity supplied. The term ‘’supply’’
refers to the entire supply curve while the term ‘’quantity supplied’’ refers to a point on the
supply curve.

P
S

b
P2
Change in Quantity Supplied
a
P1

0 Qs
Qs1 Qs2

Figure 2.5 Change in quantity supplied

Businesses are constantly changing the mix of products and services they provide. When
changes in factors other than a good’s own price affect the quantity supplied, we call these
changes shifts in supply. Let’s say for example, the number of firms producing notebooks
increases the supply of notebooks also increases, as presented in Figure 2.6 below.

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 Price S1 S2

0 Quantity Supplied
Qs1 Qs2

Figure 2.6 Change in quantity supplied

MARKET EQUILIBRIUM

A condition of equilibrium is reached when the quantity of supply and demand are
balanced or equal at a given price level. This means that at one particular price, the buyer are
able to purchase the quantity they are willing to buy and sellers are also able to sell the quantity
they are willing to sell. When a market reaches equilibrium, no changes in the market price will
take place. In other words, the price is stable under the existing market conditions. The
illustration below is an example of market equilibrium condition. At Figure 2.7 below where point
C is the equilibrium of point both the demand and supply curves.

Table 2.3 Supply and Demand Schedule for Notebook

Price per unit Quantity Demanded per Week Quantity Supplied per Week State of market
10 120 60 Shortage (60)
15 105 65 Shortage (40)
25* 75* 75* Equilibrium
30 60 80 Surplus (20)
35 45 85 Surplus (40)

Price

50
S
40 Surplus

30
25* Equilibrium point
20

10 Shortage
D
0 Quantity
20 40 60 75* 80 100 120

Figure 2.7 Market Equilibrium

Mathematical Approach:

Given: Qd = 150 – 3P
Qs = 50 + P

Equate the 2 equations: Substitute P in two equations to get Q*

Qd = Qs Qd = 150 – 3P Qs = 50 + P
150 – 3P = 50 + P Qd = 150 – 3(25) Qs = 50 + 25
– 3P – P = 50 – 150 Qd = 75 Qs = 75
– 4P = – 100
Q* = 75
P* = 25

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Surplus and Shortage

In a competitive market, surplus or shortage may occur when there are movements or
changes within the same supply and demand schedule. Remember that aside from the price,
there are also other determinants that may cause the demand or supply curve to shift. Referring
to Figure 2.7, a surplus is experienced when the price of a good is above the equilibrium point.
Surplus above the point of equilibrium means that at a price more than the equilibrium price, the
quantity supplied of a good in the market exceeds its quantity demanded.
On the other hand, shortage occurs when the quantity demanded exceeds the quantity
being supplied. In other words, there are demands for the commodity that are not being met.
This happens when the price is below its equilibrium level. When shortage exists in the market,
the consumers cannot buy as much of the good as they would like.
To understand further, let us use the example where price is equal to 10 or P=10 as
seen in Figure 2.7, the quantity supplied at P=10 is 60 and quantity demanded is 120. Thus,
Qs=60 and Qd=120 at P=10. A condition of shortage exists because Qd is greater than Qs. If we
subtract Qs from Qd, the amount of shortage is equal to 60 or (Qd-Qs=60).
At P=35, Qd is equal to 45 and Qs is equal to 85. Since Qs is greater than Qd, a
condition of surplus is experienced. The amount of surplus is equal to 40 (Qs-Qd=40).
Hence, if Qd>Qs, there is shortage and if Qs>Qd, there is surplus in the market.

Government Interventions

In view of the limitations in the price system, the government has to regulate and
supervise production, distribution and consumption of goods and services. The government
provides incentives in the production of goods and services that greatly contribute to the socio-
economic development of the country. It interferes in the allocation of goods and services in
order to protect and promote the welfare of the poor. Sometimes, rather than taxing or
subsidizing a commodity, the government legislates maximum or minimum prices known as
price ceiling (price control) and price floor (price support).

Price ceiling

A price ceiling is a maximum price that set by the government or any authority to help
the consumers buy their needs when the price is too high. Price ceiling is intended to prevent
price from rising or protecting the consumers from over pricing. It is presented in Figure 2.8, at
the restricted price or set below equilibrium point; quantity demanded remained greater than
quantity supplied where it will lead to a shortage of the product. Example of price control:
Rationing of gasoline and rent control.

Price floor
As we have in seen, price ceilings, often imposed because price rationing is viewed as
unfair, result in alternative rationing mechanisms that are inefficient and may be equally unfair. A
price floor is a minimum price set by the government or any authority to help the producers sell
their excess products. A presented in Figure 2.8, if a price floor is set above the equilibrium price,
the result will be excess supply or surplus; quantity supplied will be greater than quantity
demanded.

P Price

S S

Pf
Surplus

P* P*

Shortage
Pc
D D
Q Q
0
Qd < Qs Qs < Qd

Price floor Price ceiling

Figure 2.8. Price ceiling and price floor

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References

Bello, Amelia L. et. al 2009. Economics, C&E Pub., Inc, 2009

Gabay, Bon Kristoffer G. et. al, 2007. Economics: Its Concepts & Principles (with Agrarian Reform
and Taxation), Rex Book Store

Manapat, Carlos L. et. al, 2010. Economics Taxation and Agrarian Reform, C & E Pub., Inc

Silon, Elsa T. et.al, 2009. Manual for Economics with Exercises. Rex Book Store.

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