CHAPTER 2

DEMAND AND SUPPLY

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 2.1 MARKETS, GOODS AND
PRICES
 Goods and services cannot be produced without
compensating the resource owners for their
contribution to the productive effort.
 One must pay for what one wants to consume.
 Markets provide space to buyers and sellers
for contacting each other, and forge linkages
between demand and supply of goods; business
firms operate as a go-between.
 The forces of demand and supply determined
prices at which commodities are bought and
sold.

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 2.2 EARLY MARKETS:
EXAMPLE

 Economics treats what one is willing to pay

for a commodity in the market as the measure
of the intensity of his want.
 For example, if Anees is willing to pay more for
a kilogram of apples in the market than Yunus,
his need for apples is taken to be more urgent
than the latter’s need.

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.

2.3 DEMANDS FOR

COMMODITIES
 Demand for a commodity is a schedule of
quantities the consumers (users) are willing to
buy at all possible prices at a given point of
time.
 The point of time can be anything, e.g. an hour,
a day, a week, a month or a year.

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 2.4 THE LAW OF DEMAND

The law of demand says:

“Other things remaining the same, people

purchase more of a commodity if its price
falls, and less if it rises.”

“There is an inverse relationship between price

and quantity demanded of a
commodity”therefore, the demand curve has
a negative slope.
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 2.4 THE LAW OF DEMAND
(cont.)

Figure 2.1 Market demand for X

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 2.4.1 Assumptions
 The law of demand rests on a number of simplifying
assumptions. The fulfilment of these assumptions keeps
the consumer’s movement restricted to the demand
curve; he cannot leave it despite a change in price.
 That the tastes or preferences of each individual
consumer for any goods X in the market remain
unchanged.
 That the income of any individual consumer does not
change.
 That the prices of all goods other than X remain
constant.
 That the number of consumers in the group buying X
does not change.
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 2.4.2 Why Do Most Demand
Curves Have Negative Slopes?
 Common sense explanation
 Utility and demand
 Income effect
 Substitution effect

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 2.4.3 Exceptions

The law of demand may not apply if people—

rightly or wrongly—take a rise in the price of a
commodity as an indication of further rise in its
price, i.e. the market becomes speculative.

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 2.5 CHANGES IN DEMAND

An increase in demand takes place when:

 People purchase more quantities of the commodity X than
before, at the same price.
 People continue to purchase the same quantities of X as
before, even when its price has gone up. (refer to Table 2.2)
 A change in demand means an increase or decrease in all
quantities in the table, while prices remain unchanged.
 The demand curve shifts upwards or downwards.

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 2.5 CHANGES IN DEMAND
(cont.)

Table 2.2 Change in demand (Imaginary data)

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 2.5 CHANGES IN DEMAND
(cont.)

Figure 2.2 Increase or decrease in demand causes a shift of the entire

curve upwards or downwards.
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 2.5.1 Causes

 Change in tastes

 Change in incomenormal goods: demand

increases as income increases; inferior goods:
demand decreases as income decreases

 Change in the prices of related goods

(substitute goods or complementary goods)

 Number of buyers
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 2.6 SUPPLY OF
COMMODITIES

Supply of any commodity X may be

defined as a schedule of its quantities that
the sellers are able and willing to sell, at
each of the possible prices, at any point in
time.

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 2.6.1 Law of Supply

The law of supply says:

“Other things remaining the same, sellers
will be willing to supply more of a
commodity as its price goes up, and less
if its price goes down.”

There is a direct or positive relationship

between price and quantity supply.

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 2.6.1 Law of Supply (cont.)
Table 2.3 Supply of commodity X (Imaginary data)

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 2.6.1 Law of Supply (cont.)

Figure 2.4 Supply curve for X

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 2.6.2 Assumptions

 Input prices remain unchanged.

 Technology for producing various commodities
remains the same.
 Prices of other commodities do not change.
 Taxes and subsidies remain fixed.
 The number of sellers in the market does not
change.
 Expectations of sellers do not become
speculative.
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 2.7 CHANGES IN SUPPLY

A change in supply implies a shift in the

supply curve. It shifts downwards to the
right if supply increases, and upwards to
the left if it decreases.

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 2.7 CHANGES IN SUPPLY (cont.)

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 2.7 CHANGES IN SUPPLY (cont.)

Table 2.4 Change in supply (Imaginary data)

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 2.7.1 Causes of Change in
Supply

 Change in the prices of inputs

 Improvement in technology
 Change in prices of other goods
 Impact of taxes and subsidies
 Change in the number of sellers
 Change in price expectations

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 2.8 MARKET EQUILIBRIUM

The market for a commodity is in a state of

equilibrium when price equates its demand
with supply. In fact, all the three—price,
demand and supply—are in a state of mutual
balance.
The beauty of market equilibrium is that if it
is disturbed, it tends to get restored
automatically.

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 2.8 MARKET EQUILIBRIUM
(cont.)
Table 2.5 Market demand and supply of X (units)

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 2.8 MARKET EQUILIBRIUM
(cont.)

Figure 2.6 Market equilibrium

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 2.8 MARKET EQUILIBRIUM
(cont.)
 At prices higher than RM6, buyers are not willing to
purchase what sellers want to sell; surpluses of
good X are piling up on their shelves.
 Surpluses put downward pressure on the price;
price falls back to equilibrium level at RM6.
 At prices lower than RM6, buyers are eager to
purchase more than what sellers are willing to sell;
there are shortages in the market.
 Shortages put upward pressure on the price; price
rises until the equilibrium level at RM6.
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 2.9 DEMAND AND SUPPLY:
RELATIVE IMPORTANCE
Demand usually changes faster than the supply
of a commodity.
Very short periodsupply of the commodity is
limited just to its stock available in the market.
Short periodallows increase or decrease in
supply within the existing production capacity of the
industry.
Long periodthe span of time is sufficient to allow
changes in the existing capacity of the industry.

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 2.9.1 Role of Price

 Prices are believed to measure the

intensity of our wants for various goods
and services sold in markets.
 Price mechanism is presumed to allocate
the scarce resources of the economy to
various uses and distribute goods among
consumers in an efficient manner.

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 2.10 EQUILIBRIUM: STATIC
VERSUS DYNAMIC

 Change in demand alone

 Change in supply alone
 Mixed cases

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 2.10 EQUILIBRIUM: STATIC
VERSUS DYNAMIC (cont.)

Figure 2.9 Impact of increase or decrease in demand on equilibrium

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 2.10 EQUILIBRIUM: STATIC
VERSUS DYNAMIC (cont.)

Figure 2.10 Impact of increase in supply and decrease in supply on equilibrium

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 2.10 EQUILIBRIUM: STATIC
VERSUS DYNAMIC (cont.)

Figure 2.11 Illustrative combinations of simultaneous changes in demand and supply,

and their impact on price of the product
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 2.11 APPLICATIONS

Two important limitations of demand and supply

analyses:
The explanatory diagrams that support a
conclusion generally have no time dimension.
The departures from a market solution may be
less efficient on the cost–profit criteria the
economists often use for the purpose.

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 2.11.1 Administered Prices

The prices that government action brings into

existence as a departure from the free market results
in a fall in the administered prices category.
 Price ceilings create shortages.
 Price floors cause surpluses.

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 2.11.1 Administered Prices
(cont.)

Figure 2.12 Price ceiling creates deficit

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 2.11.1 Administered Prices
(cont.)

Figure 2.13 Floor fixing creates surpluses

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