CHAPTER-2 Econ

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2 DEMAND, SUPPLY AND MARKET EQUILIBRIUM

INTENDED LEARNING OUTCOMES:

By the end of the learning experience, students must be able to:

1. Understand the principles behind demand, supply and market equilibrium.


2. Analyze and illustrate graphically the demand and supply shifts that affect the
changes in the equilibrium price and quantity.
3. Compute and illustrate graphically the equilibrium price and quantity.
4. Discuss and illustrate graphically the price ceiling and floor as government
interventions in the market, as well as, the changes happen in the equilibrium.

INTRODUCTION

In a market economy, the forces of demand and supply play a significant role in solving
the three basic economic problems: what should be produced, how goods and services should
be produced and for whom are the goods and services produced. In an attempt to show how
they work together in a market system, this chapter shall analyse the demand and supply
separately in the beginning and be combined later on to create a market equilibrium.

THE MARKET MECHANISM

A market is a mechanism through which buyers and sellers interact in order to


determine the price and quantity of a good or a service. Price is the value of a good or a service
in terms of money. In the market system, prices serve as signal to both the producers and the
consumers. If a consumer wants more goods, this will cause the price of that good to increase.
Rising prices encourage producers to increase the supply of the good. High prices are beneficial
to producers since they normally mean higher profit margins. However, if a good is overstocked,
suppliers of this good will lower their prices so they can dispose of their excess supply. These
low prices will attract consumers to buy the goods. What will ensue is the restoration of balance
or equilibrium between the buyers and sellers.

DEMAND
The demand for a good or a service is the amount or quantity that the buyers are willing
and able to purchase at a given price, all other factors are held constant (ceteris paribus).

Law of Demand

The most famous law in economics is probably the law of demand. The law of demand
states that, holding all other factors constant (ceteris paribus), the quantity demanded for a
good or a service is negatively or inversely related to its own price. This means that as price
increases, the quantity demanded of a good or a service decreases. Conversely, as the price
decreases, the quantity demanded of a good or a service increases, ceteris paribus.

Demand Schedule, Demand Curve and Demand Function

The demand-price relationship can be depicted in three different ways: in a tabular


form or demand schedule, in a graphical form or demand curve, and in a functional form or
demand function/equation. A demand schedule is a numerical tabulation of the quantity
demanded of a good or a service at selected prices, ceteris paribus. Table 2.1 is an example of a
demand schedule for notebooks. For instance, 120 notebooks are demanded when its price is
ten pesos per notebook but quantity demanded for notebook becomes 105 when its price is
fifteen pesos per notebook.

Table 2.1. Demand schedule for notebooks.


Price per unit Quantity Demanded per Week
10 120
15 105
25 75
30 60
35 45

A demand curve is a graph of the relationship between the price of a good and the
quantity demanded holding other factors constant or ceteris paribus. Figure 2.1 shows the
demand curve that plotted in the demand schedule in Table 2.1.
Figure 2.1. Demand Curve for Notebooks.

A third way to depict the demand-price relationship is with the use of a demand
function/equation. A demand function/equation is a representation of the relationship
between the quantity demanded and the price expressed in a mathematical language using
functional form, holding other factors constant or ceteris paribus. The function may be written
as:

Qd = a – bP

Where Qd stands for quantity demanded and P is the price. The term a is the intercept or
constant term of the equation. It is the quantity demanded when price is set at zero. The item,
- b is the slope of the function. The negative sign of the slope illustrates the inverse or negative
relationship between price and quantity demanded. The slope also tells us the change in
quantity demanded per unit change in price.

Example: Qdx = 150 – 3Px


Interpretation of the intercept and the slope:

a = 150. This means that if the price of commodity X is zero, the consumer purchases 150 units
of that commodity.
b = - 3. This means that for every one unit increase in the price of commodity X, the quantity
demanded for that commodity decreases by 3 units.

Change in Quantity Demanded vs. Change in Demand

All other things remaining unchanged, when price changes, whether in the upward or
downward directions, what happens is a movement along the demand curve. The change in
price results in changes in quantity demanded. If there is an increase in price, buyers respond
by lowering the quantity they want to buy for a good or service. The reverse happens when the
price decreases. In Figure 2.2, when price increases from P1 to P2, quantity demanded decreases
from Qd1 to Qd2, or there is a movement along the demand curve from point a to point b.

Change in Quantity Demanded

P2 b

P1 a
D
0 Q
Qd2 Qd1 d

Figure 2.2. Change in Quantity Demanded

As economic life evolves, demand changes continually. Demand curve shift due to the
influence of other factors or determinants of demand other than the good’s price change. In
other words, change in demand means an upward (rightward) or downward (leftward) shifting of
demand curve due to different factors except price of the good itself. Let’s say for example, that
there is an increase in the number of students. This means that the demand for notebook also
increases from initial demand curve to new demand curve, so the demand curve will shift
upward or to the right as presented in Figure 2.3 below.

D2

D1

Qd
Qd1 Qd2
Figure 2.3. Demand Curve for Notebooks

Determinants of Demand/Demand Shifters

1. Consumers’ Income

A change in income will cause a change in demand for goods and services. The direction
in which the demand will change in response to a change in income depends on the types of
goods. Normal goods are goods whose demand increases as income increases or vice versa. As
the income of consumer increases, however, the demand for some goods increases but
demand for others may decrease. Inferior goods are goods whose demand decreases as income
increases or vice versa.

For example, a higher income allows a consumer to buy a branded shirt at supermarket
instead of buying second-hand shirt at popular ukay-ukay store. Hence, a second-hand shirt in
this case is an inferior good while a branded shirt is a normal good. Why? Because buying a
branded shirt increases the consumer’s demand while buying second-hand shirt decreases the
consumer’s demand as income of the consumer increases.

2. Price of Related Goods

Prices of related goods affect our demand for commodities. A change in the price of a
related good may either increase or decrease the demand for another commodity, depending
on whether the related good is substitute or a complementary. A good that can be used in place
of another good is known as a substitute good while a good that is consumed along with
another good is known as a complementary good.
When the price of a tube of glue rises, consumers react by buying less glue, instead
increasing their demand for paste. When two goods are substitutes, the change in the price of
one good and the demand for the second good move in the same direction.

Shampoo and conditioner may be considered complementary goods. If the price of


shampoo increases, then the demand of shampoo decreases same with the conditioner that
the demand decreases. When two commodities are complements, the change in the price of
one good and the demand for the second good move in opposite directions.

3. Consumers’ Tastes and Preferences

When consumer tastes and preferences shift towards a certain good, greater amount of
it are demanded. New products and trends or fads may influence consumer tastes. For instance,
the demand for originally grown vegetables has increased because of health concerns. Likewise,
whole-grain bread products are gaining popularity. The preferences of people are also
influenced by their customs, tradition, and history. Geographic condition is also another factor
which influences tastes (Sicat, 2003). People do not wear thick clothing in the tropics; instead,
they wear clothes made of lightweight fabrics like cotton.

4. Consumers’ Expectations on Future Prices

The demand for specific commodities may also be affected by expectations about the
future prices. If the consumers expect that the price of food items in the future will increase,
they tend to buy or demand these items today because it is cheaper today compare to buy in
the future.
5. Unexpected Events

Acts of nature and other unexpected events alter the demand for a good or service.
Number of typhoons or strong earthquakes hit in the country increases the demand for
construction materials as well as blankets and canned goods. An increase in number of COVID-
19 cases would also raise the demand for face mask and alcohol.

6. Number of Consumers or Population

An increase in the number of consumers or population means more demand for goods
and services and shifts the demand curve to the right or upward or vice versa. China is fast
becoming an economic superpower as investments are continuously flowing to their income.
The main reason for this is its huge market of nearly 2 billion people that has attracted investors
from the U.S. and Europe.

Table 2.2. Summary of Demand Shifters


DETERMINANT CHANGE IN THE SHIFT OF THE CHANGE IN
DETERMINANT DEMAND CURVE DEMAND
Consumers’ Income
a. Normal good (+) Increase Right or upward Increase in demand
Decrease Left or downward Decrease in demand
b. Inferior good (-) Increase Left or downward Decrease in demand
Decrease Right or upward Increase in demand
Price of Related Goods
a. Substitute good (+) Increase Right or upward Increase in demand
Decrease Left or downward Decrease in demand
b. Complementary good (-) Increase Left or downward Decrease in demand
Decrease Right or upward Increase in demand
Tastes and Preferences (+) Increase Right or upward Increase in demand
Decrease Left or downward Decrease in demand
Consumers’ Expectation on Future Increase Right or upward Increase in demand
Prices (+)
Decrease Left or downward Decrease in demand
Unexpected Events (+) Increase Right or upward Increase in demand
Decrease Left or downward Decrease in demand
Number of Consumers (+) Increase Right or upward Increase in demand
Decrease Left or downward Decrease in demand
Legend: (-) negatively related to the demand
(+) positively related to the demand
P Any change that raises the
quantity that buyers wish to
purchase at any given price shifts the
demand curve to the right. Any
change that lowers the quantity that
buyers wish to purchase at any given
price shifts the demand curve to the
left.

Qd
Figure 2.4. Shifts in the Demand Curve

SUPPLY

The supply for a good or a service is the amount or quantity that the sellers are willing
and able to sell at a given price, all other factors are held constant (ceteris paribus).

Law of Supply

The law of supply states that the higher the price of a good or a service, the higher is
the amount or quantity of that good or that service supplied by a firm or producer. Conversely,
the lower the price of a good or a service, the lower is the amount or quantity of that good or
that service sold to the market, holding all other factors constant (ceteris paribus). Thus, the
price and quantity supplied of a good or a service are positively or directly related. An increase
in one variable is associated with an increase in the other.
Supply Schedule, Supply Curve and Supply Function

The supply-price relationship can be depicted into three different ways: in a tabular
form or supply schedule, in a graphical form or supply curve, and in a functional form or supply
function/equation. Table 2.3 is an example of a supply schedule for notebooks. A supply
schedule is a numerical tabulation of the quantity supplied of goods and services at selected
prices, assuming other things are held constant or ceteris paribus. For instance, 60 notebooks
are supplied when its price is ten pesos but quantity supplied becomes 65 pieces when its price
is fifteen pesos.

Table 2.3. Supply schedule for notebooks


Price per unit Quantity Supplied per Week
10 60
15 65
25 75
30 80
35 85

A supply curve is a graph showing the relationship between the price and the quantity
supplied of a good, holding other factors constant (ceteris paribus). Figure 2.5 shows the supply
curve that plotted in the supply schedule in Table 2.3.

Figure 2.5. Supply Curve for Notebooks

On the other hand, the supply-price relationship can also be shown by a supply
function/equation. A supply function/equation is a representation of the relationship between
the quantity supplied and the price expressed in a mathematical language using functional form,
holding other factors constant or ceteris paribus. The function may be written as:

Qs = c + dP

Where Qs stands for quantity supplied and P is the price. The terms c is the intercept or
constant term of the equation. It is the quantity supplied when price is set at zero. The item d is
the slope of the function. The positive sign of the slope illustrates the positive relationship
between price and quantity supplied. The slope also tells us the change in quantity supplied per
unit change in price.

Example: Qsx = 50 + Px

Interpretation of the intercept and the slope


c = 50. This means that if the price of commodity X is zero, the seller will sell 50 units of the
commodity. A negative quantity is nothing. This only emphasizes that if there is no
price, the seller will sell nothing.
d = 1. This means that for every one unit increase in the price of commodity X, the quantity
supplied will increase by 1 unit.

Change in Quantity Supplied vs. Change in Supply

A movement along the supply curve occurs when the price of the good changes,
causing the quantity supplied by firms to change. Figure 2.6 illustrates this by the movement
along the supply curve from point a to point b as the price increases from P1 to P2 and quantity
rises from Qs1 to Qs2. Economists refer to this as a change in the quantity supplied. The term
‘’supply’’ refers to the entire supply curve while the term ‘’quantity supplied’’ refers to a point on
the supply curve.

S
P

P2
b
Change in Quantity Supplied

P1 a

0 Qs
Qs1 Qs2

Figure 2.6. Change in Quantity Supplied

Businesses are constantly changing the mix of products and services they provide.
When changes in factors other than a good’s own price affect the quantity supplied, we call
these changes shifts in supply. Let’s say for example, the number of firms producing notebooks
increases the supply of notebooks also increases, as presented in Figure 2.7.

S1 S2
P

0
Qs

Qs1 Qs2

Figure 2.7. Change in Supply

Determinants of Supply/Supply Shifters

1. Technology

Anything that changes the number of outputs that a firm can produce with a given
number of inputs can be considered a change in technology. Technology gets better with time
because of new ideas and discoveries. Technological improvements shift the supply curve to
the right and increase supply.

2. Price of Resource Inputs

An increase in the price of resource inputs, such as the price of raw materials and fuel
products, wages, rent, interest, it becomes costlier to produce goods. Firms would, therefore,
sell less at any given price. This causes the supply curve to shift to the left. On the other hand,
when the price of resource inputs becomes cheaper, more goods can be supplied and the
supply curve shifts to the right.

3. Prices of Related Goods in Production

Factors inputs like land, labor, and capital equipment can be used to produce not just
one but other related goods and services. Therefore, when the price of a pair of boxing gloves
increases, firms that produce volleyballs can shift factor inputs and produce boxing gloves
instead. McConnell and Brue (2005) call this, substitution in production; in this case, it results in
a decline in the supply of volleyballs and the supply curve of volleyballs shifts to the left.

4. Number of Firms/Sellers

The larger the number of firms/sellers, the greater the market supply, other things
remain the same. With more firms in the industry, supply increases and the supply curve shift to
the right. Conversely, when firms close down following a global recession, the supply of goods
falls and the supply curve shifts to the left.

5. Producers’ Expectations of Future Prices

It is hard to generalize about how expectations of higher prices affect the present
supply of a good. Producers may withhold (i.e., hoard) some of their current output in
anticipation of higher prices in the next period. For example, traders can hoard rice if they think
the price of rice will increase with the onset of the rainy season. On the other hand, an
anticipation of lower output prices in the future may cause firms to either increase supply now
or reduce current production. Firms may try to increase output now and sell even their
inventory at the current price, which they believe to be a better price. However, they may also
try to reduce current output to temporarily drive market prices up.

6. Government taxes, subsidies, and regulations

An increase in sales tax and other forms of taxes is an added cost to production and will
decrease supply. The imposition of a value added tax on cigarettes raises production costs
which may reduce the supply of cigarettes. Subsidies, in contrast, lower producers’ cost and will
lead to an increase in supply. Fertilizer and other farm inputs are often provided by government
agencies to farmers at reduced costs, thus lowering their production costs. Increased subsidies
to state universities lower the cost of higher education. Government regulations, which can
increase or lower the costs of production, also affect the supply of output of firms. The need for
correct labels on food items as required by the government, for instance, means additional
costs for producers.

Table 2.4. Summary of Supply Shifters


DETERMINANT CHANGE IN THE SHIFT OF THE CHANGE IN
DETERMINANT SUPPLLY CURVE SUPPLY
Obsolete Left or downward Decrease in supply
Technology (+)
Advanced Right or upward Increase in supply
Increase Left or downward Decrease in supply
Price of Resource Inputs (-)
Decrease Right or upward Increase in supply
Prices of Related Goods in Increase Left or downward Decrease in supply
Production (-) Decrease Right or upward Increase in supply
Increase Right or upward Increase in supply
Number of Firms/Sellers (+)
Decrease Left or downward Decrease in supply

Producers’ Expectations of Future Increase Left or downward Decrease in supply


Prices (-) Decrease Right or upward Increase in supply
Increase Left or downward Decrease in supply
Government Taxes (-)
Decrease Right or upward Increase in supply
Increase Right or upward Increase in supply
Government Subsidies (+)
Decrease Left or downward Decrease in supply
Strict Left or downward Decrease in supply
Regulation (-)
Lenient Right or upward Increase in supply
Legend: (-) negatively related to the demand
(+) positively related to the demand
P Any change that raises the
quantity that sellers wish to produce at
any given price shifts the supply curve to
the right. Any change that lowers the
quantity that sellers wish to produce at
any given price shifts the supply curve to
the left.

Qs
Figure 2.8. Shifts in the Supply Curve

MARKET EQUILIBRIUM

A condition of equilibrium is reached when the quantity of supply and demand are
balanced or equal at a given price level. This means that at one particular price, the buyers are
able to purchase the quantity they are willing to buy and sellers are also able to sell the quantity
they are willing to sell. When a market reaches equilibrium, no changes in the market price will
take place. In other words, the price is stable under the existing market conditions as shown in
Table 2.5 and Figure 2.9 where point E is the equilibrium point for both the demand and supply
curves.

Table 2.5. Supply and Demand Schedule for Notebook


Price per Quantity Demanded per Quantity Supplied per State of
Unit Week Week Market
10 120 60 Shortage (60)
15 105 65 Shortage (40)
25* 75* 75* Equilibrium
30 60 80 Surplus (20)
35 45 85 Surplus (40)
Figure 2.9. Market Equilibrium
Mathematical Approach:

Given: Qd = 150 – 3P
Qs = 50 + P

Equate the 2 equations: Substitute P in two equations to get Q*

Qd = Qs Qd = 150 – 3P Qs = 50 + P
150 – 3P = 50 + P Qd = 150 – 3(25) Qs = 50 + 25
– 3P – P = 50 – 150 Qd = 75 Qs = 75
– 4P = – 100
–4 Q* = 75
P* = 25

Surplus and Shortage

In a competitive market, surplus or shortage may occur when there are movements or
changes within the same supply and demand schedule. Remember that aside from the price,
there are also other determinants that may cause the demand or supply curve to shift.
Referring to Figure 2.7, a surplus is experienced when the price of a good is above the
equilibrium point. Surplus above the point of equilibrium means that at a price more than the
equilibrium price, the quantity supplied of a good in the market exceeds its quantity demanded.

On the other hand, shortage occurs when the quantity demanded exceeds the quantity
being supplied. In other words, there are demands for the commodity that are not being met.
This happens when the price is below its equilibrium level. When shortage exists in the market,
the consumers cannot buy as much of the good as they would like.
To understand further, let us use the example where price is equal to 10 or P=10 as seen
in Figure 2.7, the quantity supplied at P=10 is 60 and quantity demanded is 120. Thus, Qs=60
and Qd=120 at P=10. A condition of shortage exists because Qd is greater than Qs. If we
subtract Qs from Qd, the amount of shortage is equal to 60 or (Qd-Qs=60).
At P=35, Qd is equal to 45 and Qs is equal to 85. Since Qs is greater than Qd, a condition
of surplus is experienced. The amount of surplus is equal to 40 (Qs-Qd=40). Hence, if Qd>Qs,
there is shortage and if Qs>Qd, there is surplus in the market.

GOVERNMENT INTERVENTIONS

In view of the limitations in the price system, the government has to regulate and
supervise production, distribution and consumption of goods and services. The government
provides incentives in the production of goods and services that greatly contribute to the socio-
economic development of the country. It interferes in the allocation of goods and services in
order to protect and promote the welfare of the poor. Sometimes, rather than taxing or
subsidizing a commodity, the government legislates maximum or minimum prices known as
price ceiling (price control) and price floor (price support).

Price Ceiling
A price ceiling is a maximum price that set by the government or any authority to help
the consumers buy their needs when the price is too high. Price ceiling is intended to prevent
price from rising or protecting the consumers from over pricing. It is presented in Figure 2.8, at
the restricted price or set below equilibrium point; quantity demanded remained greater than
quantity supplied where it will lead to a shortage of the product. Example of price control:
Rationing of gasoline and rent control.

Price Floor
As we have in seen, price ceilings, often imposed because price rationing is viewed as
unfair, result in alternative rationing mechanisms that are inefficient and may be equally unfair.
A price floor is a minimum price set by the government or any authority to help the producers
sell their excess products. A presented in Figure 2.8, if a price floor is set above the equilibrium
price, the result will be excess supply or surplus; quantity supplied will be greater than quantity
demanded.
P P

Surplus S S

Pf
P*
P*

Pc
D Shortage D

0 0
Qd < Qs Q Qs < Qd Q

Price Floor Price Ceiling

Figure 2.8. Price Floor and Price Ceiling


Example:

Suppose that the market demand and supply equations of mobile phone is

Qd = 20 – 2P
Qs = - 10 + 2P

where: Qd = quantity demand for mobile phone (expressed in thousands)


Qs = quantity supplied for mobile phone (expressed in thousands)
P = price of mobile phone (expressed in thousand pesos)
a. Solve for the equilibrium price and quantity for mobile phone.

At equilibrium wherein Qd = Qs. Substitute P in two equations to get Q*


Use this equation to equate:
Qd = 20 – 2P Qs = - 10 + 2P
Qd = Qs Qd = 20 – 2(7.5) Qs = - 10 + 2(7.5)
20 − 2P =− 10 + 2P Qd = 5 Qs = 5
−2P − 2P =− 10 − 20
−4P =− 30
Q* = 5
−4P =− 30
−4
�∗ = �. �

b. Graph the demand and supply curves indicating the equilibrium price and
quantity.
To graph for the demand and supply curves, you need two intercepts: y-
intercept and x-intercept. To solve for the y-intercept, using both demand and
supply equations, you need to let Qd or Qs becomes zero to get the value of P.
For the x-intercept, on the other hand, you need to let P becomes zero to get
the value for Qd or Qs.

For the demand curve, wherein Qd = 20 – 2P, if you substitute Qd = 0 the value
for P = 10 (y-intercept). While, if you substitute P = 0 the value for Qd = 20 (x-
intercept).

For the supply curve, wherein Qs = - 10 + 2P, if you substitute Qs = 0 the value
for P = 5 (y-intercept). While, if you substitute P = 0 the value for Qd = - 10 (x-
intercept).

Qs = - 10 + 2P
P

Qd = 20 – 2P

- 10 0

c. Suppose that a price ceiling of 6 (Pc=6) is imposed. Is there any surplus or


shortage of mobile phone? Show mathematically.

If a price ceiling is imposed at 6, it shows that more buyers will tend to but mobile
phones. This condition will lead to a shortage of mobile phones.

Qs = - 10 + 2P
P

P* = 7.5
Pc = 6
5
Qd = 20 – 2P

- 10 0 2 5 8
Qs Q* Qd
Qd = 20 – 2P Qs = - 10 + 2P At price equals to 6, quantity
Qd = 20 – 2(6) Qs = - 10 + 2(6) demanded for mobile phone is greater
Qd = 20 – 12 Qs = - 10 + 12 than the quantity supplied for mobile
Qd = 8 Qs = 2 phone (Qd = 8 > Qs = 2).

d. Suppose that mobile phone is a normal good and the consumers’ income
increases, thus the new demand function becomes Qd2 = 25 – 2P, holding other
factors remain constant. Do you think that the equilibrium price and quantity
change? How?

P
Qs = - 10 + 2P
12.5

10

P2*=8.75
P1*=7.5
Qd2 = 25 – 2P

Qd1 = 20 – 2P
- 10 0 5 7.5
Q1* Q2*

Use the new demand equation Substitute P2* in two equations to get Q2*
and the supply equation remains
the same. The new equilibrium price Qd = 25 – 2P Qs = – 10 + 2P
becomes: Qd = 25 – 2(8.75) Qs = – 10 + 2(8.75)
Qd = 7.5 Qs = 7.5
Qd2 = Qs Q2 = 7.5
*

25 – 2P = – 10 + 2P
– 2P – 2P = – 10 – 25
– 4P = – 35
–4
P2* = 8.75

Mobile phone is a type of normal good because the demand for mobile phone
increases as the income of consumers increases. We can say that the equilibrium
changes wherein the price of mobile phone increases from 7.5 to 8.5, as well as, the
quantity increases from 5 to 7.5.
REFERENCES

Gabay, B. K. G., Remotin, R.M. Jr.,Uy, E.A. M., and Uy, A.C.D. (2012). Economics Its
Concepts and Principles (with Agrarian Reform and Taxation). Rex Bookstore, Inc.: Manila,
Philippines

Mankiw, G.N. (2015). Principles in Microeconomics, 7th Ed. Cengage Learning: Stamford, CT
06902 USA

Nicholson, W. (1998). Microeconomic Theory, 7th Ed. The Dryden Press: New York, USA

Pagoso, C. M., Dinio, R. P., Villasis, G. A., Pagoso-Meneses, P., & Pagoso-Veloso, P. (2014).
Introductory Microeconomics. Rex Bookstore, Inc.: Manila, Philippines

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