Principle of Microeconomics

Chapter 2:
Demand and Supply

Case and Fair (2017) 12th Edition

Chap. 3: pp 79 – 80 , 87 – 90, 94 – 96
Chap. 4: pp 116 - 118
Prepared by : W.K. Yap (Anthony)
Topic Learning Outcomes
By the end of this topic, the students able to:
1. Describe demand and quantity demanded
2. Describe supply and quantity supplied
3. Describe market equilibrium
4. Understand the role of prices

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Demand Curve
1 What is demand?
It is something more than a need or desire.
Just by having a strong desire to buy a sports car is NOT a
demand.
Demand is only effective if you have the ability to pay for it,
whether by cash or credit.
Demand then is formally defined as:
“the desire and ability to consume certain quantities of a
good and service at certain prices at a particular point of
time”
2 The Law of Demand
• Law of Demand states that,
“there is an inverse relationship between
quantity demanded of any good and the price charged”
• When price of a certain good rises, quantity demanded
of that good falls, and ceteris paribus
• When price of a certain good falls, quantity demanded
of that good rises and ceteris paribus
3 Ceteris Paribus Condition
• Ceteris paribus” is a Latin expression that means
- all other things or factors being held
constant or
- everything else is held unchanged
• Therefore in this situation, ONLY price is changed
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 Algebraically, demand curve is
represented as below:

P = a - bQd
The above is known as inverse
Note: ONLY price demand curve, where p is price; a is
is changing, other an intercept, which is the price value
factors when Qd = 0; Qd is quantity demand
are constant. and b is the slope coefficient.

Slope coefficient is interpreted as the

amount, which price decreases when
Qd increases by 1 unit.

Very importantly, demand curve

always has a negative slope.

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A Negatively Sloped Demand Curve
There are two important reasons that explain why a demand curve is negatively sloped.

1. Substitution effect
As the price of good A increases, quantity demanded for good A falls as consumers
switch to its close substitute.

2. Income effect
Real wealth is defined as the amount of goods that one can buy with his wealth.
Therefore, real wealth is given as . Given the nominal wealth, an increase in
price will cause the real wealth to fall. A fall in real wealth indicates a fall in purchasing
power. Hence, quantity demanded will be lesser

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Test your math:

Price (RM) Quantity

Demanded
0 20
0.5 18
1
3
5

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Test you math:

Price Quantity Demanded

(RM)
0 20 units
Can you draw the demand 0.5 18 units
curve?
1 16 units
3 8 units
5 0 units

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Draw the curve: Price Quantity Demanded
(RM)
Price (RM)
0 20 units
0.5 18 units
5
1 16 units
3 8 units
3 5 0 units

Demand curve (DD) is negative (-ve)

1 When the Price ↑, the Quantity Demanded ↓
P & Q move in opposite direction.
0.5
D Quantity
0 8 16 20 (units)
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Market Demand Curve
• Market demand is the sum of all the quantities of a good and
service demanded per period by all the households buying in the
market for that good or service.
• It is obtained by adding up all the individual households’ demand
curve.
• This is known as the horizontal summation

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10
Supply Curve
What is Supply?
Unlike the demand in which it deals with consumer behaviour,
the supply theory deals with the behaviour of firms.
As the objective of business firms is to obtain profits.
Therefore, supply decisions depend on profit potential.
Supply is then formally defined as:
“The quantity of goods and services willing to be produced by
firms or offered for sale at a particular time or particular place
at alternative prices”
Law of Supply
• Positive relationship between price and quantity supplied.
• An increase in the market price, ceteris paribus, leads to
an increase in the quantity supplied.
• Conversely, a decrease in the market price, ceteris
paribus, leads to a decrease in the quantity supplied.
Why a positively sloped supply curve?
• Because there is a minimum production cost, firms will
only start supplying if they earn positive profit i.e. price
– avg cost > 0
• The higher the price, the higher the profit margin.
Firms are more eager to produce and sell more units
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 Algebraically, supply curve is
represented as below:

P = a + bQs
The above is known as inverse
supply curve, where p is price; a is an
intercept, which is the price value
when Qs = 0; Qs is quantity demand
and b is the slope coefficient.

Slope coefficient is interpreted as the

amount, which price increases when
Qs increases by 1 unit.

Very importantly, supply curve

always has a positive slope.

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Test your math:

Price Quantity Supplied

(RM)
1
2
3
4
5

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Test your math:

Price Quantity
(RM) Supplied
1 -1
2 3
3
4
5

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 Test your math:

Price Quantity Supplied

(RM)
1 -1 units
Can you draw the supply
curve? 2 3 units
TRY YOUR SELF.
3 7 units
4 11 units
5 15 units

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Market Supply
• Market supply is the sum of all the quantities of a good and
service willing to be supplied per period by all firms.
• It is obtained by adding up all the individual firms’ supply curve,
known also the horizontal summation.
• The market supply shows the total industry output.

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17
Market Equilibrium

Market equilibrium is a situation in which, at

the current market price, quantity supplied
equals quantity demanded (the buyers’ plan
matches the sellers’ plan). At one specific price:
QS = QD.

When the market is in equilibrium, there is no

tendency for the price to increase or decrease.

Note: Because QS = QD, at equilibrium, there is

no gluts or shortages in goods and services

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Determination of Equilibrium
The equilibrium price and quantity can be determined in three steps using
these two equations. To find the equilibrium price and quantity for these
particular demand and supply curves, you must find the quantity and price
that solve both equations at the same time.

Step 1: Set the quantity demanded equal to quantity supplied:

QS = QD → -5 +2P = 10 - P

Step 2: Solve for the price by rearranging terms. Doing so gives:

3P = 15
P = $5 Thus, equilibrium price is $5.

Step 3: To find equilibrium quantity, you can substitute $5 for P in either the
demand or supply equation. Let’s do it for supply:
QS= -5 + (2 x 5) = 5 units.

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Shortage: Excess Quantity Demanded

• Excess Demand (Shortage) :

A situation in which
consumers are willing to buy
more than producers are
willing to sell. It occurs when
market price is lower than
equilibrium price.

• An increase in the Price

eliminates the shortage by
changing both quantity
demanded and quantity
supplied until the original
equilibrium is established.

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Surplus: Excess Quantity supplied

• Excess Supply (Surplus): A

situation in which producers
are willing to sell more than
consumers are willing to buy.
It occurs when market price is
above equilibrium price.

• A decrease in the Price

eliminates excess supply by
changing both quantity
demanded and quantity
supplied until the original
equilibrium is established.

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Government Intervention and Price Regulation
Price Ceiling
• A price ceiling is a regulation (imposed by the
government) that makes it illegal to charge a price
higher than a specified level (maximum price).
• The implementation of a price ceiling allows consumers
to purchase the basic or essential items that were
previously unaffordable at a higher price.
• A price ceiling is set below the equilibrium price.
• If the price ceiling is set above the equilibrium, it has no
effect. The market works as if there were no price
ceiling.
• But if the price ceiling is set below the equilibrium, it
has powerful effects.

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 Price Floor

• A price floor is a regulation (imposed by the

government) that makes it illegal to trade at a
price lower than a specified level (minimum
price).
• The price floor is implemented to protect
producers of unproductive sectors.
• If the price floor is set below the equilibrium
price, it has no effect. The market works as if
there were no price floor.
• If the price floor is set above the equilibrium
price, it has powerful effects
• Normally, the price floor is set higher than the
equilibrium price.

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Market Efficiency: Consumer Surplus = Producer Surplus

Consumer Surplus
is the difference between
the maximum amount a
person is willing to
pay for a good and its
current market price.

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Consumer Surplus
is the difference between
the minimum amount
(average cost) required
by a firm to be willing to
supply a good and its
current market price.

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Allocative
Efficiency transpires
when both consumer and
producer surplus are
jointly maximized.

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 a

Deadweight loss transpires as b d

a result of market inefficiency,
which causes failure in joint e
c
maximization of both consumer and
producer surpluses

P0 is equilibrium price. P1 is market price. Market price > Equilibrium price – consumer surplus shrinks to area “a”. Producer
surplus becomes the area “b” + “c”. But the area “d” + “e” is nobody’s surplus!!!! It is known as deadweight loss. “d” is the
loss of consumer surplus and “e” is the loss of producer surplus.

Why is it a loss? – look at the quantity exchanged, which is Q1, which is lesser than the equilibrium quantity, Q0. It simply
means lesser people can consume the good, even though, it is economically justified to produce a larger quantity.

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Practice 2.1
Price (RM) Quantity demanded Price (RM) Quantity supplied

(bushels of oats) (bushels of oats)

1.50 100 1.50 400

1.40 150 1.40 350
1.30 200 1.30 300
1.20 250 1.20 250
1.10 300 1.10 200
1.00 350 1.00 150
Table 1 : Demand and Supply Schedule
a) Using Table 1 given above, plot the demand and supply curve on the graph paper. Label the
axes and indicates for each axis the units being used to measure price and quantity.

b) Using the algebra analysis, find the equilibrium price and quantity. All workings must be
clearly shown.

c) If the government sets the maximum market price at RM1.00, will this create a shortage or
surplus in the economy? Compute the size of the shortage or surplus (whichever is relevant).

d) Compute the size of the producer or consumer surplus when the market is in equilibrium.
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