Topic 3: The Interaction

of Demand and Supply

1
 The market forces of
supply and demand
• When there is a longer and colder winter in Florida,
the price of oranges in supermarkets across the US
increases.
• When there is political tension in the Arab world, the
price of fuel increases and there is a drop in car sales.
• When the weather is warm in England, there is a
drop in the price of hotels in Spain.
• All these show the workings of supply and demand.
• Supply and demand are the forces that make market
economies work.
• They determine the quantity of each good produced
and the price at which it is sold.

Source: Bloomberg, Telegraph, Floridacitrus.org

Markets and Competition

• Demand and supply refer to the behaviour of people as they interact with one
another in competitive markets.
• What is a market?
• Group of buyers and sellers of a particular good or service.
• Organised – agricultural commodity markets;
• Often less organised – markets for cakes.
• What is competition?
• Many buyers and sellers, selling similar products.
• Price and quantity are determined by all buyers and sellers.
 • Competitive markets : One which has many
buyers and sellers and no single buyer or seller
Perfectly can influence the price of the good.

Competitive • In this topic, we assume that the markets are

perfectly competitive.

markets • Many buyers and sellers

• All firms selling identical products, and
• No barriers to new firms entering the market.
• All participants in the market takes the price as
given by market conditions.
• Example : Grain market.
• What if a single producer controls the market?
Demand – Examining the behaviour of buyers/consumers
• Quantity demanded - Quantity of a good that
consumers are willing and able to buy at a given
price, holding everything else constant (ceteris The Demand Curve
paribus).
• Many factors determine consumer demand.
Price
Amongst them, price is the most important factor.
• is the price of a good displayed on the vertical axis,
Y. shows the total quantity demanded on the 𝑃2
horizontal axis, X.
• When price decreases – existing consumers can 𝑃1
buy more of the good and consumers who couldn’t
afford the good previously can also start buying it. D’
• The relationship between price and quantity D
demanded is true for most goods and is called the
law of demand. 𝑄1 𝑄2 Quantity
• Because a lower price increases the quantity
demanded, the demand curve slopes downward.
• Market demand: The demand by all the
consumers of a given good or service. Curve labelled represents the demand curve.
Movement Along the Demand Curve – Graphical Representation
Law of demand : The rule that, holding everything else constant, when the price of a product falls,
the quantity demanded of the product will increase, and when the price of a product rises, the
quantity demanded of the product will decrease.

Demand Schedule
Price (in £) Quantity Demanded
10 100
9 120
8 140
7 170
6 200
5 240
4 300
3 370
2 450
What Explains the Law of Demand?

• Substitution effect: The change in the quantity demanded of a good

that results from a change in price, making the good more or less
expensive relative to other goods that are substitutes.

• Income effect: The change in the quantity demanded of a good that

results from the effect of a change in the good’s price on consumers’
purchasing power.
What factors lead to a shift in the demand curve?

• Income
• The income that consumers have to spend affects consumers’ willingness and ability to
buy a good.
• Higher the income –consumers spend more money on any good (most of the time).
• Normal good: A good for which the demand increases as income rises and decreases
as income falls . Examples:
• Inferior good: A good for which the demand increases as income falls and decreases
as income rises. In terms of affordability not quality. Examples :

• If the market price is constant at , there will be an increase in quantity demanded from to
, when the consumers’ income increases.
• Irrespective of the price, quantity demanded increases.
• Demand curve shifts to the right.
• Change in demand refers to shifts in demand curve and change in quantity demanded refers
to movements along the demand curve.
Shifts in demand curve– Graphical
Representation

Price (in £) Quantity Demanded New Quantity Demanded

10 100 150
9 120 170
8 140 190
7 170 230
6 200 270
5 240 330
4 300 400
3 370 480
2 450 590
Other variables that affect demand :
Prices of related goods:
• Substitutes
• When an increase in the price of one good leads to increase in the quantity
demanded of the other.
• Complementary goods/complements
• When an increase in the price of one good leads to a decrease in the quantity
demanded of another good.
• Tastes:
• Consumers can also be influenced by an advertising campaign for a product.
Economists would say that the advertising campaign has affected consumers’
taste for the product. When consumers’ taste for a product increases, the demand
curve will shift to the right, and when consumers’ taste for a product decreases,
the demand curve for the product will shift to the left.
Other variables that affect demand :

• Population and demographics:

• As the population of a country increases, so will the number of consumers,
and the demand for most products will increase.
• As the demographics of a country or region change, the demand for
particular goods will increase or decrease because different categories of
people tend to have different preferences for those goods.

• Expectations – future prices, income:

• Which products to buy? And when to buy them?
• Examples : Phones, face masks.
Holding everything else constant : Ceteris Paribus
• Ceteris paribus (“all else equal”): The requirement that when
analysing the relationship between two variables—such as price and
quantity demanded—other variables must be held constant.

• A shift of a demand curve is an increase or decrease in demand. A

movement along a demand curve is an increase or decrease in the
quantity demanded.
 Supply –Examining the behaviour of sellers/producers

• Quantity supplied - Quantity of a good that

producers are willing and able to sell at a given The Supply Curve
price, holding everything else constant (ceteris
paribus). S
Price S’
• is the price of a good displayed on the vertical axis,
Y. shows the total quantity supplied on the
horizontal axis, X.
• Many factors affect the quantity supplied, but once 𝑃1
again, price is the most important factor.
• The supply curve slopes upward because, other 𝑃2
things being equal, a higher price means a greater
quantity supplied.
• When the price is high, selling is more profitable,
𝑄1 𝑄2 Quantity
so sellers hire more workers, buy more machines,
and work longer hours.
• The relationship between price and quantity
supplied is called the law of supply. Curve labelled represents the supply curve.
Movement Along the Supply Curve – Graphical
Representation
Law of supply : holding everything else constant, increases in price cause increases in the quantity supplied,
and decreases in price cause decreases in the quantity supplied. If only the price of a good changes, there is a
movement along the supply curve, which is an increase or decrease in the quantity supplied.

Supply Schedule
Price (in £) Quantity Supplied
2 50
3 100
4 150
5 200
6 250
7 300
8 350
9 400
10 450
Variables that shift the supply curve

• Input prices:
• To produce a certain good, sellers use various inputs such as labour, machinery, other raw
materials, etc.
• When the price of one or more of these inputs rises, production becomes less profitable.
And firms supply less. If input prices rise substantially, a firm might shut down.
• The supply of a good is negatively related to the price of the inputs used to make the
good.

• Technological Changes:
• Advancement in technology can boost the efficiency with which units are produced
lessening the cost of production. This then has a similar effect to that outlined under
“Input Prices”.
Variables that shift the supply curve
• Expected future prices:
• If a firm expects that the price of its product will be higher in the future, the firm has an
incentive to decrease supply in the present and increase supply in the future.
• Number of sellers:
• When new firms enter a market, the supply curve shifts to the right; when firms exit a
market, the supply curve shifts to the left.
• Legislations:
• Regulatory laws or quotas can limit the quantity of a given product that can be produced.
• Periods of Uncertainty:
• In situations of higher business risk, producers may be inclined to reduce supplies so that
they can offload older inventory.
Making the Connection : Why understanding substitutes and
complements are important for supermarkets?

Frozen Potato Regular Spaghetti

Coffee Pizza Hotdogs IceCream chips Cereal Sauce Yogurt

Total number of
varieties over 5 stores 391 337 128 421 285 242 194 288
Number of products
added in the 2-year
period 113 109 47 129 93 114 70 107
Number of products
removed in the 2-year
period 135 96 32 118 77 75 36 51

Source : Chong, J. K., Ho, T. H., & Tang, C. S. (2001). A modeling framework for category assortment
planning. Manufacturing & Service Operations Management, 3(3), 191-210.