Theory of supply and demand

 The theory of supply and demand is an economic theory that establishes the relationship between the quantity of a
commodity that producers wish to sell and the quantity that consumers wish to buy at various prices. The theory
explains how the price of a commodity is determined by the interaction of supply and demand in a market. The
theory also defines the willingness of the buyers and sellers to either buy or sell that commodity at different prices. In
normal conditions, as the price increases, sellers are willing to supply more and demand less, and vice versa.
The ‘Law’ of Demand
 How consumers decide to enter and exit a market
 The higher the price the less will be demanded (ceteris paribus; we assume nothing else changes in this market
besides price and demand)
 The lower the price the more will be demanded (ceteris paribus)
 Inverse relationship between price and quantity demanded
 Higher the price, the lower quantity demanded and vice versa
 The demand curve shows quantities that consumers would be willing and able to buy at a given price
 Demand is relative to what consumers can afford
Non-price determinants
• Tastes, Number and price of substitute goods, Number and price of complementary goods, Income, Distribution of
income and Expectations
Price
• Changes in price cause changes in quantity demanded
•Substitution effect; consumers switch away to cheaper goods, e.g if the price of coffee went up, consumers may begin
drinking hot chocolate instead
•Income effect; consumers will either have to pay the higher price or do without it. If apples went up in price, people
would buy other fruits which is the substitution effect.

Consumer Tastes – Price and Availability of Other Goods

Substitute goods - Some goods and services have close substitutes e.g. buses and trains;As price of bus travel increases
relative to trains, the demand for train travel increases and vice versa The demand moves in opposite directions.
Complementary goods - Goods that are consumed at the same time e.g. cars and petrol. As the price of cars increases, the
demand for petrol will decrease.The demand moves in the same direction.

Expectations
• If consumers expect a product’s price to fall, they will wait to buy the product when it is cheaper and demand falls
• But if they expect the price to increase, they demand more of the product now, while it’s still cheap and demand rises
• If consumers expect an increase in income, they are more comfortable spending their money now, so demand increases
• But if they expect to make less money in the future, they save more and demand falls

Theory of Supply
• The supply curve shows quantities that producers would be willing and able to buy at a given price
• As the price rises, the quantity demanded will rise (ceteris paribus)• As the price falls, the quantity demanded will
decrease (ceteris paribus)
• There is a positive relationship between price and quantity supplied
• If the price of the good increases, it is more profitable
• It is the opposite of demand
• If price goes up, quantity supplied goes up
Non-Price Determinants
• Costs of the factors of production
• Profitability of alternative products (substitutes in supply)
• Profitability of goods in joint supply (by-products)
• Nature/random shocks
• Expectations of future price changes
• Number of suppliers

Costs of Production
• If costs of production become higher, less profit, less production, supply curve shifts to the left and vice versa
• If tax and subsidiaries such as farming and agriculture, firms are incentivised
•If profit will increase as a result, supply will go up
Nature/Random Shocks
• Weather- If weather causes problems in production, it is more expensive to produce so supply will be less as it is now
less profitable
• Climate change
• Disease -Coronavirus impacts on goods from China
• War - Iraq war impact on oil
• Terrorism
• 9/11
• Floods
• Fire
Other Determinants
• If prices expected to rise, producers may engage in temporary ‘hoarding’, releasing stock later on when prices are higher
• If producers expect the price of goods to go up, they will holdonto their supply and wait for the price to go up
• Number of suppliers = More firms, more supply
• Aims of producers (assume profit maximising but some firms may prioritise sales)