Lecture 2

The price system:

demand, supply
and markets

Reading:
Sloman and
Garratt,
chapter 2

ECN1014 Prepared by:

INTRODUCTORY Dr. Bawani
ECONOMICS Lelchumanan
(DEF, SBS)
 LEARNING OBJECTIVES
(LO)

After this lecture, you should be able to:

LO1: Describe demand and its determinants
 Differences between a change in quantity demanded and a change
in demand
LO2: Describe supply and its determinants
 Differences between a change in quantity supplied and a change in
supply
LO3: Relate how demand and supply interact to
determine market equilibrium
LO4: Explain how changes in demand and supply
affect equilibrium prices and quantities
 Reading:

DEMAND Sloman and

Garratt,
Chapter 2
 The demand curve:
the demand for potatoes (monthly)

(1) (2) (3) (4)

Price Dean’s John’s Total market
(pence per kg) demand demand demand
(kg) (kg) (tonnes: 000s)

A 20 28 16 700

B 40 15 11 500

C 60 5 9 350

D 80 1 7 200

E 100 0 6 100
 The demand curve:
the demand for potatoes (monthly)

(1) (2) (3) (4)

Price Dean’s John’s Total market
(pence per kg) demand demand demand
(kg) (kg) (tonnes: 000s)

A 20 28 16 700

B 40 15 11 500

C 60 5 9 350

D 80 1 7 200

E 100 0 6 100
 The demand curve:
the demand for potatoes (monthly)

100 Point Price Market demand

(pence per kg) (tonnes 000s)

80 A 20 700
Price (pence per kg)

60

40

A
20
Demand
0
0 50 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
0 0 0 0Quantity
0 0 (tonnes:
0 0 000s)
0 0 0 0 0 0 0
 The demand curve:
the demand for potatoes (monthly)

100 Point Price Market demand

(pence per kg) (tonnes 000s)

80 A 20 700
Price (pence per kg)

B 40 500

60

B
40

A
20
Demand
0
0 50 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
0 0 0 0Quantity
0 0 (tonnes:
0 0 000s)
0 0 0 0 0 0 0
 The demand curve:
the demand for potatoes (monthly)

100 Point Price Market demand

(pence per kg) (tonnes 000s)

80 A 20 700
Price (pence per kg)

B 40 500
C C 60 350
60

B
40

A
20
Demand
0
0 50 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
0 0 0 0Quantity
0 0 (tonnes:
0 0 000s)
0 0 0 0 0 0 0
 The demand curve:
the demand for potatoes (monthly)

100 Point Price Market demand

(pence per kg) (tonnes 000s)
D
80 A 20 700
Price (pence per kg)

B 40 500
C C 60 350
60 D 80 200

B
40

A
20
Demand
0
0 50 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
0 0 0 0Quantity
0 0 (tonnes:
0 0 000s)
0 0 0 0 0 0 0
 The demand curve:
the demand for potatoes (monthly)

E
100 Point Price Market demand
(pence per kg) (tonnes 000s)
D
80 A 20 700
Price (pence per kg)

B 40 500
C C 60 350
60 D 80 200
E 100 100
B
40

A
20
Demand
0
0 50 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80
0 0 0 0Quantity
0 0 (tonnes:
0 0 000s)
0 0 0 0 0 0 0
 The law of demand holds
that there is a negative
relationship between price
and quantity demanded.
Other things being equal, as price
THE LAW falls, the quantity demanded rises
OF (and vice versa).
DEMAND: Quantity demanded is the amount
that consumers are willing and able
PRICE to purchase over a period of time.
AND
DEMAND
The law of demand can be
explained by:
Income effect
Substitution effect
DEMAND CURVE: A CHANGE
IN QUANTITY DEMANDED

The demand curve is a graphical representation

of the negative relationship between price and
quantity demanded.
Its downward slope reflects the law of demand
(i.e. the higher the price, the lower the quantity
demanded).
A change in the price of the goods will lead to a
change in quantity demanded.
 Demand Curve:
A Change in Quantity Demanded
Price

(1) An increase in the price from P1 to P2...

(2) ...reduces the quantity demanded from Q1

to Q2...
(3) ...as reflected by a movement along the
same demand curve from point A to B.
B
P2

A
P1

O Q2 Q1 Quantity
DEMAND CURVE: A
CHANGE IN DEMAND
Apart from the change in the price of the goods,
there are other factors which may influence the
quantity of goods consumers plan to purchase at
each price.
A change in any other factor apart from the
price of the goods will lead to a change in
demand.
OTHER
DETERMINANTS OF
DEMAND:
Tastes and preferences
Number of buyers
Income
• Normal goods
• Inferior goods
Number and prices of related goods
• Substitutes
• Complements
Consumer expectations of future prices
Government policies
 Demand Curve:
A Change in Demand
Price

A change in any other factor apart from the

price of the goods would shift in demand
curve.
P

D0 D1

O Q0 Q1 Quantity
 DEMAND (BRAIN TEASE)

Movements along and shifts in the demand

curve
 change in price

 movement along D curve (change in quantity demanded)

 change in any other determinant of demand

 shift in D curve (change in demand)

 increase in demand  rightward shift

 decrease in demand  leftward shift

DETERMINANTS OF DEMAND: A
SUMMARY

Change in Quantity
Change in Demand
Demanded

(movement along) (shift)

Price of the goods only Tastes and preferences
Number of buyers
Income
Number and price of related
goods
Consumer expectations
Government policies
 Reading:

SUPPLY Sloman and

Garratt,
Chapter 2
 THE SUPPLY CURVE:
THE SUPPLY OF POTATOES
(MONTHLY)

Price of Farmer X’s Total Market

potatoes supply supply
(pence per kg) (tonnes) (tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

 THE SUPPLY CURVE:
THE SUPPLY OF POTATOES
(MONTHLY)

Price of Farmer X’s Total Market

potatoes supply supply
(pence per kg) (tonnes) (tonnes: 000s)

a 20 50 100

b 40 70 200

c 60 100 350

d 80 120 530

e 100 130 700

 Market supply of potatoes (monthly)

100 Supply
e

80 d
P Q
Price (pence per kg)

a 20 100
60 c b 40 200
c 60 350
d 80 530
40 b e 100 700

20 a

0
025711112222333344445555666677778
50502570257025702570257025702570
05050505050505050505050505050
Quantity (tonnes: 000s)
 The law of supply holds that
there is a positive
relationship between price
THE and quantity supplied.
LAW OF
SUPPLY: Other things being equal, as price rises,
the quantity supplied rises (and vice
PRICE versa).
AND To a supplier, price represents revenue,
which serves as an incentive to
SUPPLY produce and sell a product.
The higher the price, the higher the
profit incentive and the higher the
quantity supplied.
 SUPPLY The supply curve is a graphical
CURVE: representation of the positive
relationship between price and
A quantity supplied.
CHANG Its upward slope reflects the law
E IN of supply (i.e. the higher the
price, the higher the quantity
QUANTI supplied).
TY A change in the price of the goods
SUPPLIE will lead to a change in quantity
D supplied.
 Supply Curve:
A Change in Quantity Supplied
Price

(1) An increase in the price from P1 to P2...

S
(2) ...raises the quantity supplied from Q1 to Q2...

(3) ...as reflected by a movement along the

same supply curve from point A to B.

B
P2

A
P1

O Q1 Q2 Quantity
SUPPLY CURVE: A
CHANGE IN SUPPLY
Apart from the change in the price of the goods, there
are other factors which may influence the quantity of
goods producers plan to supply at each price.
A change in any other factor apart from the price of
the goods will lead to a change in supply.
OTHER
DETERMINANTS OF
SUPPLY:
Costs of production
• Input prices
• Technology
• Organisational changes
• Government policies
Profitability of other products
Profitability of goods in joint supply
Random shocks and unpredictable events
Producer expectations
Number of suppliers
 Supply Curve:
A Change in Supply
Price
S0 S1

A change in any other

factor apart from the price
of the goods would shift in
supply curve.

O Q0 Q1 Quantity
DETERMINANTS OF
SUPPLY: A SUMMARY
Change in Quantity Supplied Change in Supply

(movement along) (shift)

Price of the goods only Costs of production

Profitability of other products
Profitability of goods in joint
supply
Random shocks
Producer expectations

 DEMAND,
SUPPLY
AND
MARKET
EQUILIBRI
UM
Reading:
Sloman and Garratt,
Chapter 2
The decisions of buyers and
sellers will interact to
determine the equilibrium
price and quantity.
At the equilibrium level,
 Intentions of buyers exactly match the
intentions of sellers.
 Quantity demanded equals quantity
supplied.
 The market is cleared of any surplus or
shortage.
 Market Equilibrium
Price
S

At the market equilibrium at point

C C, quantity demanded equals
Pe quantity supplied.

O Qe Quantity
At times, shortages or surpluses
will appear in a market.
Under such conditions, prices will
function as allocative
mechanisms.
 Prices will fluctuate until shortages or
surpluses are eliminated and market
equilibrium is again restored.
 Market Surplus and Adjustment to Market Equilibrium

Price
S
Surplus

A B
P1
When there is a surplus,
sellers reduce the price in
order to get rid of the excess
C stock. Price keeps falling until
market equilibrium is again
Pe
established.

O Qd Qe Qs Quantity
WHEN THERE IS A
SURPLUS IN THE MARKET,
 sellers reduce the price so as to get rid of the excess stock.
A price reduction produces two simultaneous results:
 Buyers raise their purchase from Qd to Qe (movement along the demand
curve from point A to C)
 Sellers reduce their production from Qs to Qe (movement along the
supply curve from point B to C)

These actions would continue until market

equilibrium is again established at point C.
 Market Shortage and Adjustment to Market Equilibrium

Price S

When there is a shortage, there

is competition among buyers for
limited amount of goods. Sellers
take advantage of the situation
C by raising the price. Price keeps
rising until market equilibrium is
Pe again established.

A
P1 B
Shortage
D
O Qs Qe Qd Quantity
WHEN THERE IS A
SHORTAGE IN THE MARKET,
 buyers compete with one another for limited amount of
goods, thus driving up the price.
A price increase produces two simultaneous results:
 Buyers reduce their purchase from Qd to Qe (movement along the
demand curve from point B to C)
 Sellers raise their production from Qs to Qe (movement along the supply
curve from point A to C)

These actions would continue until market

equilibrium is again established at point C.
RATIONING
FUNCTION OF
PRICES
Rationing function of prices refers to the ability of
competitive forces of demand and supply to establish
a price and quantity at which both buyers and sellers
mutually agree to undertake an economic transaction.

Buyers purchase what they want at the agreed price and

quantity.
Producers sell what they want at the agreed price and
quantity.
CHANGES IN
SUPPLY,
DEMAND
AND
MARKET
EQUILIBRIU
M
Reading:
Sloman and Garratt,
Chapter 2
 THE CHANGE IN
MARKET EQUILIBRIUM
The market equilibrium is subject to persistent changes as a result
of:

Changes in demand

Changes in supply

Changes in both demand and supply

 THE THREE-STEP
ANALYSIS

Step 1: Demand or supply?

 Identifying whether an event is a demand-side factor or supply-side factor
 Identifying whether an event would raise or reduce market demand or
supply

Step 2: Shortage or surplus?

 Explaining whether an event would create a shortage or surplus

Step 3: Adjustment process

 Explain the role of prices as the rationing mechanism in removing market
excesses and restoring market equilibrium
 A CHANGE IN
DEMAND
Step 1: Demand or Supply?
 Assuming there is an increase in demand, shifting the demand curve rightward from
D1 to D2.

Step 2: Shortage or Surplus?

 At the existing price of P1, there is shortage of AB (quantity demanded at Q2 >
quantity supplied at Q1).

Step 3: Adjustment Process

 As a result of shortage, consumers will compete for limited amount of goods,
pushing up the price from P1 to P2.
 On the supply side, suppliers raise quantity supplied from Q1 to Q3, in accordance to
the law of supply (movement along the supply curve, S, from point A to C).
 On the demand side, buyers reduce quantity demanded from Q2 to Q3, in accordance
with the law of demand (movement along the demand curve, D2, from point B to C).
 The adjustment process continues until market equilibrium is restored at point C.
 A Change in Demand
Price
An increase in demand
S with unchanged supply will
create a market shortage
of AB, pushing up the
price from P1 to P2.

New equilibrium point is

found at point C, with
C equilibrium price at P2 and
P2 quantity at Q3.
A B
P1

Shortage D2

D1

O Q1 Q3 Q2 Quantity
 A CHANGE IN
SUPPLY
Step 1: Demand or Supply?
 Assuming there is an increase in supply, shifting the supply curve rightward from S1
to S2.

Step 2: Shortage or Surplus?

 At the existing price of P1, there is surplus of AB (quantity supplied at Q2 > quantity
demanded at Q1).

Step 3: Adjustment Process

 As a result of surplus, sellers will clear the excess stocks by reducing the price from
P1 to P2.
 On the supply side, suppliers reduce quantity supplied from Q2 to Q3, in accordance
to the law of supply (movement along the supply curve, S, from point B to C).
 On the demand side, buyers raise quantity demanded from Q1 to Q3, in accordance to
the law of demand (movement along the demand curve, D2, from point A to C).
 The adjustment process continues until market equilibrium is restored at point C.
 A Change in Supply
Price
S1
S2
An increase in supply
with unchanged
demand will create a
market surplus of
AB, pushing down
the price from P1 to
P2.
Surplus
A New equilibrium point
P1 B
is found at point C,
C with equilibrium price
P2 at P2 and quantity at
Q3.
D

O Q1 Q3 Q2 Quantity
A CHANGE IN BOTH
DEMAND AND SUPPLY
Assuming there is a simultaneous increase in both
demand and supply, shifting both the demand and
supply curve rightward from D1 to D2 and S1 to S2,
respectively
When there is a simultaneous change in both demand
and supply, the impact on equilibrium price and
quantity is ambiguous, depending on the relative
magnitude of the change in demand and supply.
 OVERALL IMPACT ON
EQUILIBRIUM PRICE AND
QUANTITY

An increase in demand will raise the price and

quantity
An increase in supply will reduce the price but
raise the quantity
Since the increase in demand is larger than the
increase in supply, there is an overall increase
in both price and quantity
Equilibrium point shifts from point A to B.
 Simultaneous Change in Demand and Supply
Price A simultaneous
increase in both
S1 demand and supply
S2 will shift the
equilibrium point to
B. Impact on
equilibrium price and
quantity is
ambiguous,
depending on the
B relative magnitude of
P2 the change in
A demand and supply.
P1
D2

D1

O Q1 Q2 Quantity