EC1002

BLOCK 2: Demand, Supply & the Market

READ: BVFD Chapter 3

1. Demand

2. Supply

3. The market

4. Consumer surplus and Producer Surplus

5. Price controls

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1. Demand
1.1: Definition and concept
• A market exists whenever there are buyers (consumers) and sellers (firms) of a particular
good. Buyers demand goods from the market whilst sellers supply goods on to the market.
• Demand can be defined as the quantity of a particular good which consumers are willing and
be able to purchase at a given price over a given period of time.
• The law of demand states that the quantity of a good demanded (per period of time) will fall as
price rises and will rise as price falls, other things being equal (ceteris paribus). Hence, there is
an inverse relationship between price and quantity demanded.

1.2: Demand schedule and demand curve

• A market demand schedule for a particular good simply by adding the quantities demanded by
each consumer at each of the price level (horizontal summation). It is the sum of total of all
individual consumer demand schedule.
• A market demand curve shows the relationship between price and quantity demanded of a
good in the market by all consumers of the good.

• Example:
The market demand schedule for apple
Quantity Quantity Quantity Total market
Price per
demanded by demanded by demanded by quantity
apple
Alice Bobby Chris demanded
(cents)
(A) (B) (C) (A + B + C)
A 10 10 12 14 36
B 20 8 10 12 30
C 30 6 8 10 24
D 40 4 6 8 18
E 50 2 4 6 12

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The market demand curve

Price

D
Quantity

• Features of the demand curve:

▪ Due to the law of demand, the demand curve is downward sloping, demonstrating the
inverse relationship between price and quantity demanded.
▪ The height of the demand curves measures the willingness to pay for a particular product.

1.3: Demand function

• The linear demand curve can be expressed in the form of equation. The demand function is
given by:
𝑄𝐷 = 𝑎 − 𝑏𝑃
where:
𝑄𝐷 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑔𝑜𝑜𝑑
𝑎 𝑎𝑛𝑑 𝑏 𝑎𝑟𝑒 𝑝𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑠

• The demand equation can also be expressed as an inverse demand function:

𝑎 1 𝐷
𝑃= − 𝑄
𝑏 𝑏

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1.4: Movement along the demand curve vs. shifting of the demand curve
• The effect of a price change of the good will only cause a movement along the demand curve.
The demand curve does not move.
• A rise in the price causes quantity demanded to fall.
• A fall in the price causes quantity demanded to increase.

▪ Initial price and quantity is at P1 and Q1.

▪ As result of a price fall from P1 to P2, the quantity demanded increases (or expands) to Q2.
This is illustrated by a movement along the demand curve from point A to B.
▪ On the other hand, if price rises from P1 to P3, the quantity demanded decreases (or
contracts) to Q3. This is illustrated by a movement along the demand curve from point A to
C.

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• The demand curve will shift when there are changes in any determinant other than the price of
the good itself.
• An increase in demand will result in the demand curve shifting to the right. A decrease in
demand will result in the demand curve shifting to the left.

Price Price

P1 P1

D2 D1
D1 D2
0 Q1 Q2 Quantity 0 Q2 Q1 Quantity

Increase in Demand Decrease in Demand 2. S

1. An increase in the price of 1. A decrease in the price of substitute goods uppl
substitute goods
y
2. A fall in the price of 2. An increase in the price of complementary
2.1:
complementary good good
Defin
3. A rise in income 3. A fall in income
ition
4. Changes in tastes, preferences 4. Changes in tastes, preferences and fashion
and
and fashion in favour of the good that are unfavourable to the good
conc
5. Increase in population size 5. Decrease in population size
ept
6. Consumer expect future price 6. Consumer expect future price fall.
• S
increase
upply
can be defined as the quantity of a particular good which producers (or firms) are willing to
offer for sale at a particular price, during some a particular period.
• The law of supply states that as price rises, quantity supplied rises and if price falls, the
quantity supplied will fall.

2.22: Supply schedule and supply curve

• A market supply schedule and curve can also be obtained in a similar manner. The market’s supply can
be obtained by adding up all the quantity supplied by each producer at each price level.
• Example:

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 The market supply schedule for apple
Price per apple (cents) Quantity supplied in the market
A 10 40
B 20 60
C 30 80
D 40 100
E 50 120

The market supply curve

Price
S

Quantity

• Features of the supply curve:

▪ Due to the law of supply, the supply curve is upward sloping, demonstrating the direct
relationship between price and quantity supplied.
▪ The height of supply curve measures the willingness to supply the product in the market.

2.3: Supply function

• The linear supply curve can be expressed in the form of equation. The supply function is given
by:
𝑄 𝑆 = 𝑐 + 𝑑𝑃
where:
𝑄 𝑆 = 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
𝑃 = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑔𝑜𝑜𝑑
𝑐 𝑎𝑛𝑑 𝑑 𝑎𝑟𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡𝑠; 𝑑 > 0

• The supply equation can also be expressed as an inverse supply function:

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 𝑐 1
𝑃 = − + 𝑄𝑆
𝑑 𝑑

2.4: Movement along the supply curve vs. shifting of the supply curve
• The effect of a price change of the good will only cause a movement along the supply curve.
The supply curve does not move.
• A rise in price causes an increase in quantity supplied. A fall in price causes a decrease in the
quantity supplied.

• If price rises from P to P1, quantity supplied will rise from Q to Q1.
• If now price falls from P to P2; quantity supplied will fall from Q to Q2.

• The supply curve will shift when there are changes in any determinant other than the price of
the good itself.
• An increase in supply will result in the supply curve shifting to the right. A decrease in supply
will result in supply curve shifting to the left.

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 Price Price
S2 S1
S1 S2

P1 P1

0 Q1 Q2 Quantity 0 Q2 Q1 Quantity

Increase in Supply Decrease in Supply

1. Fall in prices of factors of 1. Rise in prices of factors of production 3.
production The
2. Fall in in the profitability of 2. Rise in in the profitability of alternate goods Mar
alternate goods ket
3. Increase in the number of 3. Reduction in the number of firms/producers
3.1:
firms/producers in the in the market/industry.
Equil
market/industry.
ibriu
4. Producers expect future price fall 4. Producers expect future price increase
m
price
5. A good season (agriculture good) 5. A bad season (agriculture good)
(mar
6. Improvement of technology.
ket
price)
• In the market, demand interacts with supply determining the market price, which we call
equilibrium price.
• Equilibrium price = the price where the quantity demanded equals the quantity supplied: the
price where there is no shortage or no surplus. This is the price when market clears.
• Example:
Price of apple Quantity Quantity Shortage (-) or
(cents) Demanded Supplied Surplus (+)
20 2000 400 - 1600
40 1600 800 - 800
60 1200 1200 Equilibrium
80 800 1600 + 800
100 400 2000 + 1600

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 Price (cents)
D S

100
Surplus of 800

80
E
60

40

20
Shortage of 1600 D
S

400 800 1200 1600 2000 Quantity

3.2: Changes in market equilibrium

• Changes in market equilibrium can occur due to:
1. Changes in demand
If one of the determinants of demand changes (other than the price of the good itself), the
whole demand curve will shift, causing a change in the market equilibrium.
2. Changes in supply
If one of the determinants of supply changes (other than the price of the good itself), the
whole supply curve will shift, causing a change in the market equilibrium.
3. Changes in both demand and supply
Both demand curve and supply curve can shift at the same time. In general, depending
upon the extent (i.e. how far is the shifts) the shifts of the two curves, there could be an
increase in price, a fall in price or no change in the price.

• Case 1: Increase in demand

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 Price ($) S

C
P2

A B
P1

D2
D1
S

0 Q1 Q2 Quantity

▪ Initial equilibrium point is at A, where equilibrium price is at P 1 and equilibrium quantity is at

Q1.
▪ A rise in demand (for instance, due to rising consumer income) will cause the demand
curve to shift rightward from D1 to D2. This results in a shortage (AB) in the market, putting
a pressure for the price to rise.
▪ The price will continue to do so until there is no further shortage. This happens when the
new equilibrium at point C is reached, with higher equilibrium price at P2 and higher
equilibrium quantity at Q2.

• Case 2: Decrease in demand

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• Case 3: Increase in supply

Price ($) S1
S2
D

A
P1 B

P2
C

0 Q1 Q2 Quantity

▪ Initial equilibrium point is at A, where equilibrium price is at P 1 and equilibrium quantity is at

Q1.

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 ▪ A rise in supply (for instance, due to falling factor prices) will cause the supply curve to shift
rightward from S1 to S2. This results in a surplus (AB) in the market, putting a pressure for
the price to fall.
▪ The price will continue to do so until there is no further surplus. This happens when the new
equilibrium at point C is reached, with lower equilibrium price at P2 and higher equilibrium
quantity at Q2.

• Case 4: Decrease in supply

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• Case 5: Changes in both demand and supply

Price ($) S1
S2
B
P2

A
P1 C

D2
D1

0 Q1 Q2 Q3 Quantity

▪ Initial equilibrium point is at A, where equilibrium price is at P 1 and equilibrium quantity is at

Q1.

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▪ An initial increase in demand shifts the demand curve from D1 to D2, resulting in higher
equilibrium price and quantity at P2 and Q2, respectively. However, if supply also increases
by the same magnitude shifting the supply curve rightward from S 1 to S2. This causes the
price to fall back to P1 and the quantity to increase further to Q3.
▪ In conclusion, a rise in both demand and supply in this case has caused the equilibrium
price remains unchanged but an increase in the equilibrium quantity.
[Question: Think of the case whereby demand and supply change with different magnitude.
How would the equilibrium price and quantity change?]

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4. Consumer Surplus and Producer Surplus
4.1: Consumer surplus
• Consumer surplus refers to the excess of what a person would have been prepared to pay for
a good over what that person actually pays.
• Consumer surplus = Willingness to pay – Price paid by buyers
• Willingness to pay is the maximum amount that a buyer will pay for a good (reservation price)
and it measures how much that buyer values the good.
• In economics, we use CS as a measure of consumer welfare.
• On a diagram, consumer surplus can be represented by the area below the demand curve but
above the market price.

Price (per unit)

P1 E1

Q1 Quantity

In the diagram above, consumer surplus is given by the AP1E1.

• When P ➔ CS 
• When P ➔ CS 

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4.2: Producer surplus
• Producer surplus refers to the difference between what a seller actually gets and the smallest
amount that the seller would accept in exchange for the good. It is a measure of producer
welfare.
• Producer surplus = Price received by sellers – Willingness to sell.
• For a seller, cost is a measure of his willingness to a good.
• In economics, we use PS as a measure of producer welfare.
• It can be represented by the area below the market price but above supply curve.

Price ($)

E1
P1

Q1 Q

At price P1 and quantity Q1, producer surplus is represented by the shaded area P 1AE1.

• When P ➔ PS 
• When P ➔ PS 

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4.3: Consumer surplus & producer surplus at the market equilibrium

Price ($)

Consumer S
Surplus

E
P*

Producer surplus D

Q* Quantity

• At the market equilibrium, total surplus = consumer surplus + producer surplus.

• Total surplus is given by the area between the supply and demand curves up to the equilibrium
quantity. We use this to measure the total welfare in the market.

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5. Price controls
5.1: Concepts and definitions
• Free markets = markets whereby prices are determined purely by the forces demand and
supply.
• However, governments may intervene in the market to hinder demand and supply to interact
freely in determining the market price.
• Price controls = government rules or laws on prices in the market which does not allow prices
to adjust freely.

5.2: Price Ceiling (maximum price)

• Price ceilings make it illegal for sellers to charge more than a specific maximum price. It is
used to set limits on the returns that producers can make or to help consumers afford products,
often staple necessities such as bread, rice or housing
• The price is not allowed to rise above this level (although it is allowed to fall below this level)
• Example:

P($) S

P1

P2
Price ceiling
Shortage

D
Q
Q2 Q1 Q3
Market for food

▪ Market equilibrium is at price P1 and quantity Q1. At the price P1, the poorest in society are
unable to afford to food.
▪ Government intervenes by fixing a price ceiling at P2. While this allows more quantity
demanded for food at Q3, the quantity sold is at Q2. This creates a shortage (excess
demand) of food (Q3 – Q2).

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5.3: Price Floor (minimum price)
• A minimum price is usually set to help producers increase their incomes.
• The price is not allowed to fall below this level (although it is allowed to rise above it)
• Example:

P($)
S

P2 Surplus
Price floor

P1

Q2 Q1 Q3 Q

Market for agriculture product

3

▪ Market equilibrium is at price P1 and quantity Q1.

▪ However, the government decides that P1 is too low for farmers and sets a minimum price
of P2. While this allows more quantity supplied for food at Q3, the quantity demanded is at
Q2. This creates a surplus (excess supply) of (Q3 – Q2).

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