©1986, 1991 & 2002 John Petroff. 

 

CHAPTER 1:

DEMAND AND SUPPLY

LEARNING OBJECTIVES
The purpose of this lesson is to reach an understanding of
how markets operate, how prices are set and transactions occur.
The two market forces of demand and supply are defined and
explained. The equilibrium point is studied. Conclusions and
applications are offered.

MARKET
Markets exist for the purpose of facilitating exchanges of
products, services or resources. Buyers and sellers are brought
together and convey their desire to buy or sell by stating their
offered and asked prices for different quantities. Even if a
transaction does not take place, information if translated in
the pricing of the product.

 An example of a market is that of the New York Stock Exchange.
Its purpose is to facilitate the purchase and sale of
securities. The transactions are not performed by the buyers and
sellers themselves, but by brokers and dealers on their behalf.
Daily transaction prices are reported in many newspapers
nationwide because markets also perform the important function of
pricing of goods, or in this case securities.

DEMAND
Demand is the expression of willingness and ability of a
potential buyer to acquire certain quantities of an item for
various possible prices the buyer can reasonably offer. Demand
can be thought of as a schedule of prices and quantities in the
mind of the buyer.

 Dealers of the New York Stock Exchange keep books in which orders
from various clients are entered: how many shares and at what
price. Such a listing is an illustration of what investors are
willing and able to buy.

LAW OF DEMAND
The law of demand postulates that the relationship between price
and quantity in the mind of buyers is inverse. The law of demand
is represented graphically by a downsloping demand curve. The
law of demand is explained by the diminishing marginal utility,
the income effect, the substitution effect and with the help of
indifference curves analysis.

 A retail store would certainly be most interested to know what
its customers will be willing to pay for what they want to buy.
Such knowledge would allow the store to price its products most
efficiently. This is the reason why market research is conducted
to determine what customers want to buy and at what price.

LAW OF DEMAND REASONS
The law of demand can be explained by
- price being an obstacle to consumption,
- diminishing marginal utility,
- price change income effect and substitution effect.
It can also be derived from the diminishing marginal rate of
substitution of indifference curves.

 All department stores have periodic sale days during which the
prices are reduced substantially. The purpose of this price
reduction is to get rid of old merchandise and stimulate the
buying by customers (who may purchase many other items as well).
Thus, stores take advantage of the law of demand: merchandise
which would otherwise be hard to sell, is sold because customers
are willing to pay a lower price.

INCOME EFFECT
The law of demand can be explained by observing that an
unexpected price change affects the purchasing power of
consumers. If the price is lower than expected, income is
liberated which allows the consumer to buy more. An unexpected
price increase would cause the consumer to buy less.

 When a housewife goes to the supermarket to buy groceries and
finds one of the products she intended to buy being reduced in
price because of a special sale, it makes her feel wealthier.
Indeed, she can buy more with the money she started with. This is
the income effect.

SUBSTITUTION EFFECT
The law of demand can be explained by the substitution effect.
If the price of a good is lower than expected then that good
appears to the consumer as a bargain opportunity in comparison
to the goods which remain at full price. The consumer will
temporarily switch his/her pattern of consumption by
substituting bargain items for full price items.

Suppose a customer is undecided between pork chops and
steak before entering the supermarket. If pork chops have been
put out on special at a reduced price, while steak has not,
that is likely to induce the customer to buy the pork chops
with no remaining hesitation. This is an illustration of the
substitution effect.
 

DEMAND GRAPH
The law of demand is represented graphically by a downsloping
curve showing that when price decreases, quantity increases and
vice versa.

Graph G-MIC1.1

MARKET DEMAND
The market demand is the sum total of individual demands.

DEMAND DETERMINANTS
Price is the major determinant of the quantity demanded.
The nonprice determinants of demand are:
- number of buyers,
- tastes,
- income,
- price of other goods (either complementary or substitute),and
- expectations about future prices.

 Advertising by companies shows that customers can be prompted to
buy products for a great variety of reasons. The foremost
inducement is still price.

INFERIOR GOOD
An increase in income will generally cause the consumption of
most goods to increase: these goods are said to be normal or
superior goods. There are a few goods for which the pattern is
reversed: an increase in income causes a decrease in
consumption. These goods are known as inferior or Giffen goods.
Most often, these inferior goods are tied in the mind of
individuals to hard times.

PRICE OF RELATED GOODS
The price of related goods affects the demand of an item in
two opposite patterns depending if the goods are viewed by the
buyer as complementary or substitute.

COMPLEMENTARY GOODS
Goods are complementary when their consumption is tied to each
other. For instance, automobiles and tires: tires are sold
because automobiles are sold and vice versa. The increase of
the price of automobiles will cause fewer automobiles
to be purchased, and thus, fewer tires as well. The
relationship between the price of automobiles and the quantity
of tires is inverse.

 Tires and cars, bullets and guns, lamps and lamp shades,
cream and coffee, nails and hammer, nuts and bolts,
are all items that go together. They are complementary goods.

SUBSTITUTE GOODS
Substitute goods are goods which can be replaced by each other
in the mind of the consumer. For instance, tea and coffee are
for many (but not all) consumers interchangeable goods. If the
price of tea goes up, the purchases of tea will decrease and the
purchases of coffee will increase. Thus, the relationship
between the price of tea and the quantity of coffee is direct.

 Butter and margarine, tea and coffee, taxi and bus,
pen and pencil, hotel and motel, radio and record player,
are all items which, for most people, can be replaced by
each other. They are substitute goods.

QUANTITY DEMANDED
A change in any of the nonprice determinants will cause the
entire demand of consumers to change. Graphically this can be
shown as a shift of the demand curve to the right or to the
left. These shifts in demand must be distinguished from
movements along the demand curve caused by changes in price:
these changes in price only cause the quantity demanded to
change, but the entire demand schedule remains the same.

 The availability of new products can change the tastes of
consumers. Not long ago, complex calculation used to be done with
slide rules. With the arrival of hand calculators, slide rules
no longer satisfied customers.

SUPPLY
Supply is the willingness and ability of sellers or suppliers to
make available different possible quantities of a good at all
relevant prices.

 Supply is what we have to offer. All of us have our time and
skills to offer to our employers. For some of us, the number
of hours of work may change from day to day or from week to
week. Then, most often, if additional hours are required to be
worked, we can expect a higher price, i.e., overtime pay.

LAW OF SUPPLY
The law of supply postulates that the relationship between
price and quantity in the mind of sellers or producers is
a direct one. When price increases so does quantity.

 The payment of overtime shows that the more one is expected to
supply, the more one can be expected to be paid. In some
professions, extra hours over regular overtime are paid at even
higher wage rates.

LAW OF SUPPLY REASONS
The law of supply is explained by
- price being an inducement for sellers or producers to sell
more, and
- cost of production increasing (because of the law of
diminishing returns).

 

SUPPLY GRAPH
The law of supply can be shown graphically by an upsloping
supply curve. When price increases, quantity increases; thus,
the direct relationship is verified.

Graph G-MIC1.2

SUPPLY DETERMINANTS
Price is the major determinant of supply. Nonprice determinants
are:
- number of sellers or producers,
- costs of production (including taxes),
- technology (since it affects costs),
- prices of other goods (as sources of possible profits),
- expectations (but the effect is ambiguous).

 Returning to the employee supplying his/her hours of work, the
willingness of the employee to accept changing work schedule
is likely to depend on the time devoted to other needs (such as
leisure, family, hobbies). Nevertheless, the major determinant
will be the price or wage expected.

QUANTITY SUPPLIED
A change in any one of the supply nonprice determinants will
change the entire supply schedule and shift the supply curve.
This shift of the supply curve is to be distinguished from the
movement along the supply curve itself when price is changed:
this only changes the quantity supplied (not supply).

EQUILIBRIUM
The price and quantity equilibrium is where demand and supply
intersect. At any price above that equilibrium, the quantity
supplied exceeds the quantity demanded, which results in a
surplus (and no transaction between buyer and seller). At any
price below, the quantity demanded exceeds the quantity
supplied, which results in a shortage. Only at the intersection
of demand and supply are the quantities demanded and supplied
equal. The price and quantity equilibrium is stable.

Graph G-MIC1.3

SHORTAGE
A shortage means that the quantity demanded exceeds the quantity
supplied. A shortage exists if the price is below the
equilibrium. If the market is free, the shortage will disappear
as the price increases. The shortage will continue anytime the
market is not free; for instance, if the government has
instituted a price ceiling. If the price ceiling is above the
equilibrium, it is not relevant and has no bearing on the
market.

Graph G-MIC1.4

 Many cities have rent control laws to make sure that poor people
can find apartments they can afford. But landlords do not find it
profitable to rent at these prices and sometimes convert their
buildings to condominium or cooperative ownership. This reduces
the number of apartments available: it creates a shortage.

SURPLUS
A surplus means that the quantity supplied exceeds the
quantity demanded. The surplus exists only above the
equilibrium. If the market is free, the surplus will tend to
disappear as the price is lowered. The surplus will continue
only if the market is not free; that is, a minimum price has been
instituted by the government. If the minimum price is below
equilibrium, it is irrelevant and has no bearing on the market.

Graph G-MIC1.5

 The prices of many agricultural commodities, such as milk for
instance, are subject to government price support. This higher
price encourages farmers to produce too much: this creates
surpluses. For instance, in the 1980's, the government has been
forced to make cheese from milk surplus and to distribute that
cheese free to poor people.

INDIFFERENCE CURVES
Indifference curves show the combinations of two goods that
an individual would be willing to buy, and which would make
him/her equally satisfied (or indifferent). Indifference curves
assume that more is preferred to less. They are convex as seen
from the origin. The indifference curves form an entire map of
various level of satisfaction.

Graph G-MIC1.6

 The shopping list of any consumer would reveal that, beyond some
minimum basic necessities, purchases are a matter of choosing
between various items that can provide equivalent satisfaction.
This pattern of equivalent satisfaction from the consumption of
two selected goods is what the indifference curves portray.

MARGINAL RATE OF SUBSTITUTION
The quantity of one good an individual must forego in order to
increase the quantity of another good and leave the individual
indifferent, is called the marginal rate of substitution. This
marginal rate of substitution is shown graphically as the
tangent to the indifference curve. The marginal rate of
substitution is decreasing. This verifies that the
indifference curves are convex as seen from the origin.

BUDGET LINE
The budget line is the locus of combinations of two goods an
individual can afford to buy with his/her income. The slope of
the line is the price ratio of the two goods: Pa/Pb or relative
price of each good.

Graph G-MIC1.7

 A housewife going to the supermarket with a specific
amount of money, knows exactly what is the maximum she can
spend. The proportions of the different items can change.

POINT OF TANGENCY
The equilibrium point which will give most satisfaction to the
consumer, and which the consumer can afford, is where the budget
line is tangent to the highest indifference curve.

Graph G-MIC1.8

DERIVATION OF DEMAND
Demand can be derived from the indifference curves by lowering
(increasing) the price of one good and observing that the budget
line will shift as a result, causing the equilibrium point to
reflect a larger (smaller) quantity purchased of that good.

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