CHAPTER 4: DEMAND, SUPPLY AND PRICES

4.1 INTRODUCTION

In Chapter 3, we studied the interdependence between households and firms in a mixed economy.
We now look at this interaction in more depth by focusing on the process by which these role-players
interact in goods markets: Firms supply their products to be sold, and households in turn display
different levels of demand for these goods. This interaction of demand and supply is what determines
the prices and quantities traded in the goods market in a market economy.

FIGURE 4-1 The interaction between households and firms

4.2 DEMAND

Demand refers to the quantities of a good or service that potential buyers are willing and able to
buy.

In other words, for demand to exist (in an economic sense):

1. There must be an intention to buy

2. There must be the means to buy

When these characteristics are present, we say that there is effective demand.

These two characteristics are what make a demand different from wants, needs or claims – do not
confuse these concepts!

 Demand is also a flow concept – meaning that it is measured over a period of time.
 Note, furthermore, that demand relates to the plans of households, firms and other
participants in the economy – not to events that have already occurred.
 This means that quantity demanded may differ from the quantity actually bought.
 In this chapter, we will take a microeconomic approach to demand – meaning that we focus
on the demand for particular goods and services, as opposed to total demand for all goods
and services in the economy.

Let us look at the determinants and properties of demand.

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Market demand

In the examples below, we will consider the demand for tomatoes in a particular market. Market
demand consists of the combined demand of all the households in a particular market.

The quantity of tomatoes that households plan to purchase in a given period is determined by:

1. The price of the product. The lower the price of tomatoes, the more tomatoes households
will be willing to buy, ceteris paribus.
2. The price of related products. The price of complements (things that are used along with
tomatoes – such as bread and salad leaves) as well as the price of substitutes (things that are
used instead of tomatoes – such as avocadoes) will also influence demand.
3. The income of consumers. Normally, the higher the household’s income, the more tomatoes
they can afford (and plan) to buy.
4. The taste (preferences) of consumers. Taste can have a positive or negative impact. If people
do not like tomatoes, they will not demand as many, and vice versa.
5. The number of households. The more households there are, and the greater the number of
people per household, the greater the quantity of tomatoes that will be demanded.

Note that demand decisions are independent of the supply situation. While the availability (supply) of
a product such as tomatoes can influence the actual outcome in the market, consumers’ plans are
based on information they have available (such as the price of tomatoes, instead of how the price of
tomatoes was determined).

We can summarise the above discussion as follows:

The quantity of a good demanded in a particular period depends on (or is a function of) the price of
the good, the prices of related goods, the income of the households, consumers’ taste, the number
of consumers and any other possible influence.

We will now zoom in on one determinant of demand in particular: The price of the product.

The tendency we see for quantities demanded to increase when prices decrease (and vice versa) is so
strong that economists have formulated the following law of demand:

Other things being equal (ceteris paribus), the higher the price of a good, the lower the quantity
demanded.

Let us stick to the example of tomatoes we have been using (as a consumer, you can imagine different
products you regularly use, too – what do you notice in your own purchasing behaviour when the price
of different goods changes?)

We can illustrate this relationship graphically, as shown in Figure 4-2.

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FIGURE 4-2 Consumers’ weekly demand for tomatoes

The graph above represents a demand curve, which is an analytical tool often employed by
economists.

Things to note about the demand curve:

 The demand curve is drawn on the assumption that all other determinants of demand remain
constant – we are only investigating the relationship between price and quantities demanded.
 The demand curve shows the inverse relationship between price and quantities demanded
(when prices are high, quantities demanded are low).

We must further distinguish between:

1. A movement along a demand curve (change in quantity demanded)

2. A shift of the demand curve (a change in demand)

 This is a movement along the

demand curve.
 We see that there has been a
change in quantity demanded –
as price decreased, the number of
units demanded increased.
 This movement is caused by a
change in price.

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  This is a movement of the demand curve.
 We see that there has been a change in
the demand curve as a whole – the entire
curve either increases or decreases.
 This movement is caused by a change in
any of the determinants of demand other
than price.
 When the curve moves from D to D2, we
say that demand has increased.
 A movement from D to D1 means that
demand has decreased.

Let us look more closely at some of these shifts of the demand curve:

As we said, they are caused by changes in any of the other determinants of demand, other than price.

Earlier, we mentioned that households might choose to buy tomatoes based on not only the price of
tomatoes, but the price of complements and substitutes as well.

We will now look at the mechanisms behind this, using different products as examples.

FIGURE 4-4 Two substitutes: butter and margarine

 Margarine and butter are substitutes – one can be used instead of the other.
 Suppose that the price of butter increases. This will likely mean that consumers will rather buy
more margarine, which is cheaper (ceteris paribus).
 We see this playing out in the margarine market through the increase in demand that takes
place – the demand for margarine increases from Dm to D’m, meaning that a greater quantity
of margarine is demanded at each price than it was before butter became more expensive.

Let us look now at products that are complements – meaning they get used together, such as CDs and
CD players.

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FIGURE 4-5 Two complements: CDs and CD players

 Suppose the price of CD players falls (CD players become cheaper).

 We would expect people to buy more CD players (the quantity demanded of CD players would
increase), and along with that, the demand for CDs would increase too.

THINK IT THROUGH:
In these examples, we worked with price increases in related goods such as complements and
substitutes.

What would happen if:

 Instead of butter becoming more expensive, it became cheaper. What do you expect would
happen to the demand for margarine?
 Instead of CD players becoming cheaper, they become more expensive. What do you
expect would happened to the demand for CDs?

Earlier on, we also listed other determinants of demand such as:

 Consumer income. Normally, when people earn more income, their demand increases. This
would be depicted by a shift to the right of the demand curve. Sometimes, in the case of
inferior goods, the opposite will happen and the demand curve will shift left when incomes
increase.
 Consumer tastes/preferences. Advertising, fashion and new information on the benefits/uses
of different products can influence people’s preferences (taste.) Typically, any advertising,
trends or information that create a positive image of a product will cause demand to increase,
ceteris paribus. Of course, we expect the opposite to happen for anything that negatively
influences perceptions of a product.

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  Population. Other things being equal, the larger the population in a market, the larger the
demand for the product; and the smaller the population, the smaller the demand.

There are also other influences on demand, such as:

 Changes in expected future prices. When consumers expect that prices will change, it can also
change the quantity demanded, ceteris paribus. If the price of a good is expected to fall,
ceteris paribus, consumers will reduce their current demand and rather wait to buy the
product at a lower price. Similarly, expected price increases can cause an increase in current
demand, ceteris paribus.
 The distribution of income. If income is redistributed from high to low-income households,
the demand for goods bought mostly by low-income households will increase, while the
demand for goods purchased by high-income households will decrease, ceteris paribus.

Review:
TABLE 4-2 The market demand curve: A summary

 Table 4-2 summarises what will happen to a demand curve, given a

change in any of the determinants of demand.
 Ensure that you know and understand this table very well.

Words, numbers, graphs & symbols

 The textbook discusses all the ways in which we can represent demand in
a particular market – can you understand and apply each of these?

4.3. SUPPLY

If households are represented graphically through the use of demand curves, we must also remember
to turn the attention to the behaviour of firms in the market. After all, there must be someone who
supplies the products that consumers have a demand for.

We define supply as the quantities of a good or service that producers plan to sell at each possible
price during a certain period.

See how, the same as for demand, we are working here with planned quantities. The quantity that is
actually sold or exchanged will depend on various other things (for instance, whether there is a
demand for the product or not).

In this section, we look again at the supply of a particular good, and not at total supply (which is a
macroeconomic concept).

We previously looked at the demand for tomatoes in a particular market – let us now see what might
determine the supply of tomatoes in a particular year.

Determinants of supply

1. The price of the product. As for demand, the price of the product is an important factor. For
tomatoes, we can say that the higher the price of tomatoes, the greater the quantity that
farmers will plan to grow and sell, ceteris paribus.

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 2. The price of alternative products. Farmers do not have to produce tomatoes – they might
also choose to produce cabbage, cauliflower, etc. If the price of cauliflower increases relative
to the price of tomatoes, farmers might plan to produce more cauliflower and less tomatoes.
If the price of cauliflower declines, however, they might opt to produce more tomatoes and
less cauliflower. These alternative outputs are sometimes referred to as substitutes in
production.
3. Prices of production factors & other inputs. The cost of production is also an important
consideration for suppliers. Tomato farmers, for instance, will need to cover their costs of
production in order to make a profit. If the prices of inputs increase, the quantity of tomatoes
supplied at each price will be lower than before, ceteris paribus.
4. Expected future prices. Producers have to plan far in advance. They are therefore influenced
not only by what is happening in the present, but what they expect will happen in future. In
the case of tomatoes, for instance, the higher farmers expect the future price of tomatoes to
be, the more tomatoes they will plan to produce, ceteris paribus.
5. The state of technology. New technologies that enable producers to produce at lower costs
will increase the quantity supplied at each price. For instance, new fertilisers will tend to
increase the supply of tomatoes.

THINK IT THROUGH
BOX 4-1: OTHER POSSIBLE DETERMINANTS OF SUPPLY

This box in the textbook lists other possible determinants of supply.

 Can you list and explain each of these determinants?

 How are they likely to apply to the case of tomatoes?

NB! Do not confuse supply decisions with demand decisions or actual outcomes in the market.

 When farmers decide how much to supply to the tomato market, they consider the price of
tomatoes. This is the already established market price – so they do not worry about how the
price is determined.
 They consider only how much to supply at determined prices in order to make profit.
 They do not have a guarantee that the tomatoes they supply will actually sell at each price.

Remember that we made a distinction, when talking about demand, between demand and quantity
demanded.

The same applies for supply and quantity supplied.

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  This is a movement along the supply
curve.
 We see that there has been a change in
quantity supplied – as price increased, the
number of units supplied increased.
 This movement is caused by a change in
price.

 This is a movement of the supply curve.

 We see that there has been a change in
the supply curve as a whole – the entire
curve either increases or decreases.
 This movement is caused by a change in
any of the determinants of supply other
than price.

Review:
TABLE 4-4 The market supply curve: A summary

Table 4-4 summarises what will happen to a supply curve, given a change in any of
the determinants of supply.

 Ensure that you know and understand this table very well.

Words, numbers, graphs & symbols

 The textbook discusses all the ways in which we can represent supply in a
particular market – can you understand and apply each of these?

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4.4. MARKET EQUILIBRIUM

In Chapter 3, you learned that households and firms interact with each other via markets – specifically,
goods markets and factor markets.

Let us look at this interaction in goods markets.

The meeting of households and firms on these markets in such a way that goods are exchanged for
money, implies that there must be some agreement about prices in these markets.

This is where the working of the invisible hand comes in, which you learned about in Chapter 2.

In free markets, this meeting of consumers (demand) and firms (supply) in the market leads to market
equilibrium.

A market is in equilibrium when the quantity demanded is equal to the quantity supplied. Another
way to put this is when the plans of the households (buyers, demanders) coincide with the plans of the
firms (sellers, suppliers).

The price at which this occurs is called the equilibrium price, represented in Figure 4-10 as point E.

FIGURE 4-10 Demand, supply and market equilibrium

Qd < Qs
TE VEEL

Qs <
Qd

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  At point E, the market is in equilibrium. Equilibrium is a state of rest in which opposing forces
are balanced and in which there is no tendency for things to change (as long as the
underlying forces remain unchanged).
 Recall from Adam Smith’s ideas that this market price is an important signal for producers and
consumers about how to act. In equilibrium, there is no need to change. But there can be
instances of disequilibrium:
o Excess demand exists when firms sell their total production, but households do not
obtain the quantity of the product that they would like to buy at a particular price.
There is a shortage, in other words. Households seeking this product will offer to pay
more for the product, while firms realise they can charge a higher price. As price rises,
the market reacts to this new signal: quantity supplied increases along the supply
curve (movement from b to E), while the quantity demanded falls along the demand
curve (movement form c to E). This process continues until equilibrium is reached.
o Excess supply happens when firms cannot sell all their products (there is a surplus, in
other words). Firms will cut production and lower prices in an attempt to be
competitive with other firms. This results in a fall of quantity supplied along the supply
curve (movement from f to E), while the lower prices signal to households to increase
the quantity demanded along the demand curve (movement from d to E). Again, this
continues until equilibrium is reached.

4.5 CONSUMER SURPLUS AND PRODUCER SURPLUS

Figure 4-13 Consumer surplus and producer surplus at market equilibrium

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 Consumers are often willing to pay more for goods than the price they ultimately
end up paying in the market. This difference between what consumers pay and
the value they receive (which is indicated by the price they pay) is called
consumer surplus.
 Similarly, producers are often willing to supply goods at lower prices than those
they actually receive in the market. This difference between the lowest prices at
which producers are willing to supply, and the price they actually receive, is
called producer surplus.

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