Week 003 Basic Principles of Demand and Supply PDF

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This course deals with the basic principles of applied economics, and its application to contemporary economic issues facing the Filipino entrepreneur such as prices of commodities, minimum wage, rent, and taxes. It covers an analysis of industries for identification of potential business opportunit...

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Lesson 2.1 Basic Principles of Demand and Supply

Objectives: At the end of this module, the students should be able to: 1. Explain the law of supply and demand 2. Discuss and explain the factors that affect demand and supply; 3. Reason effectively how a change in demand or supply or in both can affect equilibrium price and equilibrium quantity;

THE MARKET A market is an interaction between buyers and sellers of trading or exchange. It is where the consumer buys and the seller sells. The goods market is the most common type of market because it is where we buy consumers goods. The labor market is where workers offer service and look for jobs, and where employers look for workers to hire. There is also the financial market which includes the stock market where securities of corporations are traded. The market is important because it is where a person who has excess goods can dispose them to those who need them. This interaction should lead to an implicit agreement between buyers and sellers on volume and price. In a purely competitive market (similar products), the agreed price between a buyer and seller is also the market price or price for all.

DEMAND It is logical for people to expect an increase in the demand for bathing suits, ice cream, suntan lotion, and umbrellas during summer. During the typhoon months, people may start buying raincoats, boats, and cold medicines. In June, when the school years starts, demand for textbooks, school supplies, and uniform normally go up. Valentines’ day cause demand for flowers and chocolates surge. We can therefore see that in various seasons of the year, demand for certain types of goods will increase. On the other hand, demand for rice, fish, salt, and milk tends to be consistent all year. Demand is the willingness of a consumer to buy a commodity at a given price. A demand schedule shows the various quantities the consumer is willing to buy at various prices. A demand function shows how the quantity demanded of a good depends on its determinants, the most important of which is the price of the good itself, thus the equation: Qd = f (P) This signifies that the quantity demanded for a good is dependent on the price of that good. Presented in Table 2.1 is a hypothetical monthly demand schedule for vinegar (in bottles) for one individual, Martha. The quantity demanded is determined at each price with the following demand function: Qd = 6 - P⁄2 Table 2.1. Hypothetical Demand Schedule of Martha for Vinegar (in bottles) Price per bottle 0 2 4 6 8 10

Number of bottles 6 5 4 3 2 1

At price of ₱ 10 per bottle, Martha is willing to buy one bottle of vinegar for a given month. As price goes down to ₱ 8, the quantity she willing to buy goes up two bottles. At a price of ₱2, she will buy five bottles. There is a negative relationship between the price of a good and the quantity demanded for that good. A lower price allows the consumer to buy more, but as price increases, the amount the consumer can afford to buy trends to go down. The demand curve is a graphical illustration of the demand schedule, with the price measured on the vertical axis (Y) and the quantity demanded measured on the horizontal axis (X). The values are plotted on the graph and are represented as connected dots to derive the demand curve (Figure 2.1). The demand curve slopes downward indicating the negative relationship between the two variables which are price and quantity demanded.

Figure 2.1 Hypothetical Demand Curve of Martha for Vinegar (in bottles) for One Month

The downward slope of the curve indicates that as the price of vinegar increases, the demand for his good decreases. The negative slope of the demand curve is due to income and substitutions effects. Income effect is felt when a change in the price of a good changes consumer's real Income or purchasing power is the volume of goods and services one can buy with his/her income. If a good becomes more expensive, real income decreases and the consumer can only buy less goods and services with the same amount of money income. The opposite holds with a decrease in the price of a good and increase in real income. Substitution effect is felt when a change in the price of a good changes demand due to alternative consumption of substitute goods. For example, lower price encourages consumption away from higher-priced substitutes on top of buying more with the budget (income effect). Conversely, higher price of a product encourages the consumption of its cheaper substitutes further discouraging demand for the former already limited by less purchasing power (income effect).

The Law of Demand

After observing the behavior of price and quantity demanded in the above schedule, we can now state the Law of Demand. Using the assumption "ceteris paribus," which means all other related variables except those that are being studied at the moment and are held constant, there is an inverse relationship between the price of a good and the quantity demanded for that good. As price increases, the quantity demanded for that good. As price increases, the quantity demanded for that product decreases. The low price of the good motivates the consumer to buy more. When price increases, the quantity demanded for the good decreases. Non-Price Determinants of Demand If the ceteris paribus assumption is dropped, non-price variables that also affect demand are now allowed to influence demand. These non-price variable that also affect demand are now allowed to influence demand. These non-price factors include income, taste, expectations, prices of related goods, and population. These non-price determinants can cause an upward or downward change in the entire demand for the product and this change is referred to as a shift of the demand curve. The demand function will now read: D = f(P, T, Y, E, PR, NC). which states that demand for a good is a function of Price (P), Taste (T), Income (Y) Expectations (E), Price of Related Goods (PR), and Number of Consumers (NC). Factors other than the price of the product are the non-price factors of demand. If consumer income decreases, the capacity to buy decreases and the demand will also decrease even when price does remain the same. The opposite will happen when income decreases. Improved taste for a product will cause a consumer to buy more of that good even if its price does not change. Anothernon-price determinant is consumer’s expectations of future price and income. Consumers tend to anticipate changes in the price of a good. For example, motorists are always on the lookout for changes in oil prices. When gasoline prices are expected to increase, motorists tend to fill up their gas tank before the price increase; the demand for oil will shift upward. But when a rollback is expected in oil prices, consumers will delay their purchase and wait for prices to decrease. Prices of related goods as substitutes or complements also determine demand. Substitute goods are those that are used in place of each other, like butter and margarine and sugar and artificial sweeteners. In the case of substitute goods, an increase in the demand for one good leads to a decrease in the demand for the other good. So, if the price of a good increases,the demand for that good will decrease while the demand for substitute will increase. Complements are goods that are used together, such as a cellphone and a sim card, a car and car tires, and coffee and creamer. For complementary goods, an increase in the demand for a good lead to an increase in the demand for the complement since they are used together. Thus, if the price of a good increases, the demand for it will decrease and the demand for its complement will likewise decrease.

On the other hand, the number of consumers is also an important determinant that will affect market demand for a good. The population makes up the group of consumers who will buy the product. The higher the population, the more consumers and the higher will be the demand for the good. The effect of an increase in the number of consumers is a rightward shift of the demand curve and should the opposite happen, that is, if a decrease in the number of consumer takes place due to out-migration, this will be reflected in a leftward shift of the demand curve. Shifts of the Demand Curve When a change in the price of a good cause the quantity demanded for that good to change, this is illustrated on the same demand curve and is simply a movement from one point to another on that curve. For example, if price goes down from ₱ 5 to ₱ 4, quantity demanded will increase from 10 to 15 pieces, this is illustrated on the same demand curve. But if the change in demand is caused by a non-price determinant, this will involve a change in the entire demand curve. For example, the demand curve will shift to the right to reflect an increase in demand due to higher income and to the left to show a decrease in demand due to less income.

Figure 2.2. Shift of Manuel’s Demand Curve for Steak Due to a Change in Income

In Figure 2.2, one can see that originally, at an unchanged price the quantity that Manuel will buy is more. Even if the price remains unchanged, an increase in say, preference, will cause Manuel’s demand to increase per week. In the same manner, at various prices, demand increases at each price level due to greater preference for steak. These higher quantities are depicted on the new demand curve Qs₂. What happened in Figure 2.2 is a rightward shift of the entire demand curve. On the other hand, should population increase, the market demand curve representing the totality of all consumers’ demands will shift to the right. In other words, there will be more mouths to feed demanding more goods on the same budget and price.

SUPPLY Demand showed us the side of the consumers and their reactions to change in price and other determinants. We now look at the side of the supplier. Supply refers to the quantity of goods that a seller is willing to offer for sale. The supply schedule shows the different quantities the seller is willing to sell at various prices. The supply function shows the dependence of supply on the various determinants that affect it. Assuming that the supply function is given as: Qs = 100+5P and is used to determine the quantities supplied at the given prices.

Table 2.2: Supply Schedule of Pedro for Fish in One Week Price of Fish (per Kilo) 20 40 60 80 100

Supply (in kilos) 200 300 400 500 600

As can be seen in Table 2.2, the relationship between the price of fish and the quantity that Pedro is willing to sell is direct. The higher the price, the higher the quantity supplied. When plotted into a graph, we obtain the supply curve. Price of fish(per kilo)

Figure 2.3 Supply Curve of Fish of Pedro for One Week

We derive a supply curve that is upward sloping, indicating the direct relationship between the price of the good and the quantity supplied of that good.

The Law of Supply After observing the behavior of price and quantity supplied in the above schedule, we can now state the Law of Supply. Using the same assumption of “ ceteris paribus,”( other things constant) there is a direct relationship between the price of a good and the quantity supplied of that good. As the price increases, the quantity supplied of that product also increases. The high price of the good serves as motivation for the seller to offer more for sale. Thus, when price increases, the quantity supplied of the good increases since the seller will take this as an opportunity to increase his/her income. Non-Price Determinants of Supply In the above analysis (Figure 2.3), the only factors that vary are price and quantity demanded. However, in real-life, supply is influenced by factors other than price. These factors are assumed constant for the purpose of simplifying the study of the relationship between price and the quantity supplied. If the assumption of ceteris paribus is dropped, non-price variables are now allowed to influence supply. These non-price factors are cost of production, technology, and availability of raw materials and resources. These non-price determinants can cause an upward or downward change in the entire supply of the product, and this change is referred to as a shift of the supply curve.

Shifts of the Supply Curve Just like in the case of demand, there are also movements along and shifts of the supply curve. In the curve. In the curve of Figure 2.3, what we see are changes in the quantities supplied due to different prices of fish. These changes are reflected on a single supply curve and are changes from one point to another point on the same curve. This is referred to as a movement along the supply curve. The reason for movement along the supply curve. The reason for a movement along the supply curve is the change in the price of the good. Once supply increases due to a non-price determinant, the entire supply curve will shift to the right to reflect an increase, or the left to reflect a decrease as shown in Figure 2.4 The supply function will now read: S = f(P,C,T,AR), where the Supply (S) of a good is a function of the price of that good (P), the cost of production (C) technology (T), and the availability of raw materials and resources (AR).

As non-price determinant, the cost of production refers to the expenses incurred to produce the good. An increases in cost will normally result in a lower supply of the good even when price will not change since the producer has to shell out more money to come up with the same amount of the good, and therefore, the supply of the good in the market will decrease. This is reflected in a rightward shift of the supply curve from S, to S₂ in Figure 2.4. Technology is another significant non-price determinant of demand. The use of improved technology in the production of a good will result in the increased supply of that good. On the other hand the use of obsolete or improper technology in production will result in a downward shift of the supply curve from S₁ to S₂. Another possible non-price determinant of supply that can cause an upward shift of the curve from S₂ to S₁ is through improved availability of raw materials and resources. Since more can be used to produce a bigger output of the good, then supply increases. Price of fish (per kilo)

Figure 2.4 Rightward Shift in Market Supply Curve for Fish in Quinta Market for One Week

The leftward shift of the curve indicates a decrease in supply and the rightward indicates an increase in supply. In Figure 2.4, we see the shift in the supply curve of fish due to a change in a non-price determinant. For example, the effect of an Increase due to an improved technology in catching fish leads to a rightward shift of thesupply curve to S₂ which means the suppliers will see sell more fish for the same price.

References:

Case, Karl E. and FAIR, Ray C. 2007. An Introduction to Principles of Economics. Pearson 6th Edition, Education International. Rosemary P. Dinio, PhD., and George A. Villasis. Applied Economics, REX Book Store. First Edition Internet Sources: http://www.investopedia.com...