DEMAND AND SUPPLY

 
 
 
 
MECHANICS OF MARKET OPERATIONS – DEMAND AND SUPPLY
 
A market exists when a buyer and a seller exchange a “product or an economic resource” for a
price.  The buyer side in a market exchange is known as the demand side and the seller side is
known as the supply side. This section presents the fundamental mechanics of how markets operate. 
 
MARKET PARTICIPANTS
All buyers and sellers who participate in markets can be conveniently classified into four
categories. These categories along with each participant’s goal in conducting a market exchange
are listed below.
 
               Market Participants :                     Goal:
 
                 Consumers                            maximize satisfaction or utility
                 Businesses (producers)         maximize profits
                 Government                           maximize the public welfare 
                 Foreigners                              maximize satisfaction (foreign consumers) and
                                                                      maximize profits (foreign businesses)
 
KEYS TO UNDERSTANDING THE THEORY OF MARKETS      
The theory of markets is really the theory of demand and supply. The terms demand and supply
are concepts, i.e. you can not touch or feel them as they exist in the minds of economists.  And
very importantly, they are separate and independent concepts.  Demand has nothing to do with
supply and vice versa. Further, the demand and supply of a product do not show how much of a
good or service was actually purchased or sold. It is critical to understand that they represent the
“willingness and ability” of a buyer to purchase or a seller to sell quantities of a product at various
“possible” prices.
 
TYPES OF DEMAND AND SUPPLY
 There are three types or levels of demand and supply.
    1). Individual demand and supply – 1 person’s demand or 1 firm’s supply of a single product
   2). Market demand and supply – All persons demand or all firms supply of a single product
    3). Aggregate demand and supply – All persons demand or all firms supply of all products 
 
   Individual and market demand and supply are studied in Microeconomics.  Aggregate demand     
   and supply are studied in Macroeconomics.
 
INDIVIDUAL DEMAND AND SUPPLY:
Definition
 
     The quantity (Q) of a good or service an individual buyer (demand side) or seller (supply side)
     is “willing and able” to purchase (demand side) or sell (supply side) at various “possible”
     prices (P) during a given time frame, ceteris paribus.
  
   Schedules:
 
      Individual Demand and Supply Schedules are tables which show the quantity (Q) of a product
      an individual buyer or seller is “willing and able” to purchase or sell at various “possible”
      prices (P) during a given time frame ceteris paribus.
 
                      INDIVIDUAL DEMAND AND SUPPLY SCHEDULES
 
                             DEMAND                                     SUPPLY
                             Good A                                          Good B
                   Price (P)  Quantity (Q)                  Price (P)   Quantity (Q)
                      $4.00          1 unit                           $10.00       100 units
                        3.00          2                                      9.00         80
                        2.00          4                                      8.00         50
                        1.00          6                                      7.00         10
 
    It is essential to understand the importance of ceteris paribus. Since the assumption is made
    that all variables that could possibly affect the “Q” demanded or supplied in the above tables
    are fixed or frozen in time, we can say that the changes in quantity noted above were “caused
    solely” by a change in price. This is a critical understanding.
 
   Laws of Demand and Supply
   Note that in the above demand and supply schedules, the relationship between the two
   Variables P and Q are opposite. In the case of demand, the relationship is inverse or negative,
   so as price rises quantity demanded falls and vice versa. The relationship in the case of the
   supply schedule is direct or positive i.e. as P rises, Q supplied rises and vice versa. These
 
    relationships are a very important finding in the science of economics and are named the Law
    of Demand and the Law of Supply respectively. KEEP IN MIND THAT THE LAWS OF
    DEMAND AND SUPPLY ARE TRUE ONLY IF WE ASSUME THAT AS THE PRICE
 
    CHANGES ALL OTHER VARIABLES THAT POSSIBLY COULD AFFECT QUANTITY
    DEMANDED OR SUPPLIED ARE FIXED.
 
   Law of Demand Definition
 
        The lower the price of a product the higher the quantity demanded; the higher the price of a
        product the lower the quantity demanded, ceteris paribus.  Demand represents a negative or
        inverse relationship between price and quantity.
       
        Law of Supply Definition
 
        The lower the price of a product the lower the quantity supplied; the higher the price of a
        product the higher the quantity supplied, ceteris paribus. Supply represents a positive or
        direct relationship between price and quantity.
                
Market Demand and Supply Schedules
The market and demand schedules are derived by simply adding horizontally the individual
demand and supply schedule quantities (“Q”) of all persons or all firms in a market for a single
product, market demand and supply schedules for that product can be found.

 
                              MARKET DEMAND SCHEDULE DERIVATION
                                                               Good A
            Buyer #1                   Buyer #2                    Buyer #3                        Market                
    Demand Schedule     Demand Schedule     Demand Schedule       Demand Schedule
         P          Q                    P           Q                   P             Q                    P            Q
      $4.00       1 unit            $4.00     6 units         $4.00       3 units             $4.00      10 units
       3.00        2                     3.00     9                    3.00       5                        3.00      16
       2.00        4                     2.00     14                  2.00       8                        2.00      26
       1.00        6                     1.00    18                   1.00       13                      1.00      37 
 
                          
                                 MARKET SUPPLY SCHEDULE DERIVATION
                                                             Good B
 
           Firm #1                       Firm #2                       Firm #3                        Market
   Supply Schedule         Supply Schedule         Supply Schedule          Supply Schedule
        P            Q                   P          Q                     P          Q                      P          Q
      $10.00   100 units    $10.00    250 units          $10.00   30 units         $10.00    380 units
          9.00     80                 9.00    225                      9.00   25                      9.00    330
          8.00     50                 8.00    175                      8.00   15                      8.00    240
          7.00     10                  7.00   100                      7.00     0                      7.00    110        
 
DEMAND AND SUPPLY CURVES
By plotting the above schedules on a graph (plot P on the vertical axis and Q on the horizontal
axis) and connecting the points, demand and supply curves are created. If the individual
schedules are plotted, individual demand and supply curves are generated. If the market
schedules are plotted, market demand and supply curves are created. The demand and supply
curves show the same information as the schedules. In economics, demand and supply are
usually expressed in terms of graphs because they provide a visual picture of the relationship
between P and Q and are easier to interpret.
 
 
Plotting the Demand and Supply Schedules
By plotting the market demand and supply schedules, the following market demand and supply curves are derived.

                          MARKET DEMAND                                     MARKET SUPPLY     
[You must be registered and logged in to see this image.]    Price                                            Price                                                                                                                            S
 
 
                                                          D          

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                                             Quantity                                                              Quantity
 
 
 
 

DETERMINANTS (NON-PRICE) OF DEMAND AND SUPPLY
Determinants are variables that “cause changes” in quantity demanded and supplied. Technically,
price is a determinant of quantity; in fact it is considered the most important determinant and that
is why it is on the graph. When referring to determinants hereafter, we will be speaking of the non-
price determinants.   There are a multitude of variables that affect the “Q” demanded and
supplied, but we are only going to deal with the following ones which are the most important
determinants.

DETERMINANTS (NON-PRICE) OF DEMAND
-       Taste or preference for a product
-       Income
  superior or normal goods vs. inferior goods
-       Prices of related goods
   substitute vs. complementary goods
-       Expectations of future events
-       # of buyers (applies to market demand only)
 
   DETERMINANTS (NON-PRICE) OF SUPPLY
-       Prices of resources (cost of production)
-       Technology
-       Taxes/subsidies
-       Profitability of producing other products
-       Expectations of future events
-       # of sellers (applies to market supply only) 
 
   IMPORTANCE OF DETERMINANTS (NON-PRICE)
   Non-price determinants of demand and supply are assumed “constant” along a given demand
   or supply curve. The ceteris paribus phrase is used to communicate that the determinants are
   in fact being held constant. If a non-price determinant of demand or supply changes and ceteris
   paribus does not therefore hold, then the respective curve will “shift”.  This is a critical issue to
   understand. “Changes in determinants cause curves to shift”!
 
   MOVEMENT ALONG A CURVE VERSUS A SHIFT IN A CURVE
   In movement along a curve, the determinants of demand or supply are fixed and changes in
   “Q” are “solely” caused by changes in “P”. By assuming ceteris paribus, we are isolating the
   effect that one variable (Price) has on another variable (Quantity) as we move along a curve. If
   ceteris paribus does not apply a shift in the curve  will result from changes in the determinants
   of the curve.
    Graph of Movement Along a Market Demand Curve

                       
[You must be registered and logged in to see this image.]                               Price
 
[You must be registered and logged in to see this image.]                                                                                 Downward Movement Along    
 
[You must be registered and logged in to see this image.]                                                                                          D  

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[You must be registered and logged in to see this image.]                                                                                 Quantity                      
 
               It is important to understand what caused the downward movement along the above
               market demand curve. It was a decrease in the price.  Why?  Because all other
               variables that affect demand are assumed constant or ceteris paribus.  Changes in the
               price of a product, ceteris paribus, cause movement along the curve. This same
               concept applies to the supply curve.
 
 
 
 
 
      Graph of Shifts in a Market Supply Curve
[You must be registered and logged in to see this image.]                                                                                    S2
[You must be registered and logged in to see this image.]                           Price                                 S
[You must be registered and logged in to see this image.]                                                                  
                                                                                              S1

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                                                                     Quantity
 
 
           The shifts in the above market supply curve were caused by a change in the non-price
           determinants of supply.  Shifts are not caused by changes in the price of the product.
           A rightward shift is an increase in supply; a leftward shift is a decrease in supply.
           This same concept applies to the demand curve as well.
 
 
   CHANGE IN “QUANTITY” DEMANDED OR SUPPLIED TERMINOLOGY
 
   A change in “quantity” demanded or supplied” is used by economist to describe movement
   Along a curve which is caused by a change in the price of a product.
 
   CHANGE IN DEMAND OR SUPPLY TERMINOLOGY
 
   A change in demand or supply refers to a shift in the demand or supply curve which is caused
   by a change in the determinants of demand or supply.
 
  WORKING WITH CHANGES IN DETERMINANTS OF DEMAND AND SUPPLY
     Steps in working with determinants:
 
 
          1).  Evaluate whether a variable is a determinant of demand or supply,
          2).  If a determinant, changes in the variable will shift the respective curve it applies
                  to,
          3).  Determine  which direction the change in a determinant will shift the curve.
                 - An increase in demand or supply will always shift the curve to the right for both.
                  - A decrease in demand and supply will always shift the curve to the left for both.
          
   NORMAL GOOD VS. INFERIOR GOOD
       1). A normal good is one whose demand curve will shift to the right (increase) when income
            rises.
       2). An inferior good is one whose demand curve will shift to the left (decrease) when income
            rises.
 
   SUBSTITUTE VS. COMPLEMENTARY GOODS
 
      1).  A substitute good is one that can be used in place of another. If two goods are
           substitutes, a change in the price and quantity demanded of one, will shift  the demand
           curve for the other. If the price of one goes up, the demand for the other will increase and
           vice versa. Butter and margarine are substitute products.
 
      2).  A complementary good is one that used along with another. If two goods are 
           complementary, a change in the price and quantity demanded of one, will shift the
           demand curve of the other. If the price of one goes up, the demand for the other will
           decrease and vice versa.  Butter and bread are complementary goods.
STATIC MARKET CONDITIONS - SURPLUS, SHORTAGE AND EQUILIBRIUM
A static market is one viewed assuming ceteris paribus. By bringing demand and supply together,
a market is created. The relationship between the quantity demanded and the quantity supplied at
each “market price”, establishes whether there is a market surplus, shortage or equilibrium. In a
free market, price adjustments will “automatically” (the invisible hands) occur  to eliminate the
imbalances of surplus or shortage. In market equilibrium, the quantity demanded = the quantity
supplied and there are no imbalances. At equilibrium, both buyer and seller are satisfied with the
price and quantity in the market and a surplus or shortage does not exist.

       SURPLUS
        A surplus of products in a market occurs when the quantity supplied exceeds the quantity
        demanded at a given market price. A surplus will exist when the market price is above the
        equilibrium price.
    
       SHORTAGE
        A shortage in a market occurs when the quantity supplied is less than the quantity
        demanded. Shortages exist when the market price is below the equilibrium price.

       EQUILIBRIUM
        Market equilibrium occurs:
            1). When quantity demanded = quantity supplied
            2). Where the demand and supply curves intersect
            3). When there are no surpluses or shortages in a market.

DYNAMIC MARKET CONDITIONS - CHANGES IN EQUILIBRIUM:
        Changes in equilibrium occur with shifts in the demand curve, the supply curve or both. 
        These shifts are caused by changes in determinants of demand and/or supply. It is very
        important to be able to analyze the effects on equilibrium of a shift in demand and/or supply.
        The best way to do this is to draw a graph and follow the steps in working with determinants
        discussed above. For example, an increase in the cost of wages is a determinant of supply
        which will shift the supply curve to the left, decreasing market supply and therefore 1).
        increasing equilibrium price and 2). decreasing equilibrium quantity.  
        In reality, equilibrium is always changing as demand and supply curves are constantly   
        shifting. This is the case because the determinants of demand and supply in the real world
        are never fixed. In economics we artificially fix the determinants by assuming that they are
        fixed, i.e. ceteris paribus.  This enables economist to view the impact one variable has on a
        second variable which greatly simplifies the process of analyzing prices and quantities
        demanded and supplied.
        Note that depending on whether it’s the demand curve or the supply curve that shifts will
        have a bearing on what happens to equilibrium price (P) and quantity (Q): 1). With an
        increase in supply, equilibrium P decreases while equilibrium Q  increases. From the
        standpoint of the economy this is a positive result. If demand decreases, equilibrium P will
        fall, but equilibrium Q will also fall.
 
GOVERNMENT CONTROL OVER PRICES:
Government can override the outcome of the invisible hand in free markets by setting legal
maximum and minimum prices.
 
     Price Ceilings are legally established maximum prices that can not be exceeded in the
       marketplace. They are set below market equilibrium and create shortages. These shortages
       lead to:
       1). Rationing problems to determine who gets available supply.
                     a). queing – first come first served.
                     b). lottery
                     c). ration coupons
         2). Black markets where higher prices are illegally charged for the products in short
                     supply.
       An example of a price ceiling is rent control.
 
   Price Floors are minimum prices below which prices are not legally permitted.  They are set
   above equilibrium and create surpluses. An example of a price floor is an agricultural crop
  price support.     
 
DEMAND/SUPPLY PROBLEMS INVOLVING EQUATIONS OF STRAIGHT LINES:
What is the equation for a straight line supply curve on a graph with the following coordinates?
 
    Q = 0, P = 5; Q = 30, P = 20
                  y intercept = 5
                  slope = change in p (20-5=15) divided by change in q (30-0=30) or 15 divided by
                               30=.5.
                  Therefore the supply equation for line is p = 5 + .5q.
 
What is the “equilibrium quantity” for following demand and supply equations?
                 Demand equation: P = 20-.25 Q
                 Supply equation: P = 5 + .5Q
                    Solution: 20 - .25Q = 5 + .5Q
                                   -.5Q - .25Q = 5 – 20
                                          - .75Q = - 15
                                                  Q = 20