Download Supply and Demand: The demand curve

Supply and Demand: The demand curve
Effective demand
Before we look at the basic demand curve, it is important to understand
that economists only recognise demand when it is effective demand.
This means demand that is backed up with a w___________ and
a_______ to pay. I should think that many of you would demand a
Ferrari, but let’s face it but that’s not really effective demand!
The theory of demand
Now we will look at the theory of demand. At higher prices, a lower
quantity will be demanded than at lower prices. At lower prices,
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Basically, when the price is high demand is low and vice versa. Ceteris
paribus means ‘all other things being equal’. It is very important that
you state this condition when using demand curves. Let’s have a look
at the normal downward-sloping demand curve:
Note that I’ve drawn it as a curve, which is probably a little more
realistic. Many of you will use straight-line demand curves in the exam.
This is perfectly OK, remember that these diagrams are only sketches
that you are using to help you analyse a situation. Anyway, as you can
see in the diagram above, the demand for CDs is fairly ______ at the
relatively high price of ___________ pounds, but at the bargain price of
five pounds demand is much _________.
The demand curve (D) for a good or service is downward sloping from
left to right. Why? _________________________________________
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Complete activity 4.1 on page 54 below
Supply and Demand: The supply curve
When it comes to supply, we are talking about how much of a given
product the sellers, or firms, or producers are prepared to supply to the
market at any given price.
The theory of supply
Just like with demand, where it only became effective if it was backed
up with the ability to pay, supply is defined as the willingness and
a_______ of p________ to supply goods and services on to a market
at a given price in a given period of time. Economists define supply as:
(p54)____________________________________________________
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____. With demand, the downward-sloping curve reflected an inverse
relationship between price and quantity demanded. The opposite is
true of supply. In theory, at higher prices a __________ quantity will
generally be supplied than at __________ __________, and at
lower prices a ___________ quantity will generally be supplied
than at __________ prices. So this time we have higher supply at
higher prices and vice versa. Again, in is important to assume that ‘all
other things remain constant’. Any change in one of the other
determinants of supply will cause the curve to shift.
The upward sloping supply curve can be seen below:
While it is fairly obvious why the demand curve is downward sloping, it
is not so clear why the supply curve should be upward sloping.
Basically, the producer will make higher profits as the price per unit
sold increases. Imagine that a brewer produced a lager and a bitter.
Assume, not unreasonably, that the costs of production are the same
per pint produced, whether it is a pint of lager or a pint of bitter. If the
price of lager then rose relative to the price of bitter, it would seem
sensible for the brewer to transfer r______________ from making bitter
towards the production of l_________, thereby increasing the
s_______ of lager as its price rises.
Complete activity 4.2 on the graph paper provided.
Supply and Demand: The equilibrium price
Now we need to bring these two things together to find the equilibrium
price. After all, the market for any good or service needs buyers and
sellers. The demand curve represents the actions, at any price level, of
the buyers (or consumers). The supply curve represents the actions, at
any price level, of the sellers (or firms, or producers). To find out what
the price level will actually be, we need to see what happens when we
combine the demand and supply curves.
The price mechanism
Some of the textbooks you have read may have referred to the price
mechanism. This is the mechanism through which the price is
determined in a market system. Basically, the price will adjust until
supply equals demand, at which point we have the equilibrium price.
The definition of ‘equilibrium price’ is
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As you will see in the following diagrams, any given market is only in
equilibrium when supply equals demand, which is where the two
curves cross.
In the diagram above, let us assume that the price is P2 temporarily. At
this price, demand is quite low (Q3) but firms wish to supply quite a lot
(Q2). We have excess supply equal to Q2 – Q3. Firms find that they
have a glut of unsold goods. This is disequilibrium. If you were one of
those firms, what would you do? I would probably reduce the price a
little (have a sale, maybe?) until I could sell off all my excess stock.
Applying this to the diagram, the price would fall until firms reached a
position where they no longer experienced excess supply. This occurs
where supply equals demand, price P1, quantity Q1. You may have
heard of the ‘invisible hand’, Adam Smith’s famous metaphor that
tries to explain what is going on here. Nothing physically forces the
price down; it just happens naturally, or ‘invisibly!
Now let us assume that the price is P3 temporarily. Now we have a
situation when the price is relatively low, so the demand for the product
(Q4) is much higher than the amount firms wish to supply (Q5). We
have excess demand equal to Q4 – Q5. Now firms find that they sell
their stock very easily and there are customers queuing at the door
wanting more! What would you do this time if you were one of
those firms? I would be thinking that I could get away with raising my
price given the popularity of the good. I would keep doing this until
there were no longer queues outside my door and the demand for my
product matched the amount I supplied. Again, this will occur where
supply equals demand, price P1, quantity Q1. The invisible hand is at
work again!
Complete Activity 4.3 P57 on graph paper provided.
The determinants/conditions of demand
It is fairly obvious so far that the price of a good is a pretty strong
determinant of its demand, but there are many other things that will
affect demand too. A change in any one of the conditions of demand
will cause the demand curve to shift.
If the demand curve shifts to the _________ this represents an
increase in demand and if the demand curve shifts to the _________
this represents a decrease in demand.
Real income. If one’s real income rose (real means ‘allowing for
inflation’), one should be able to afford more CDs.
Normal goods – demand increases as income increases. E.g. (p58)
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Draw a diagram below to indicate what will happen to the demand for
new cars if incomes rise.
Inferior goods – demand will fall when income rises. E.g.
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Draw a diagram below to show what would happen to the demand for
second hand cars if incomes rose.
The price of other goods. If the price of CD players rose then one
would expect demand for CD players to fall, and so would the demand
for CDs. These goods are complements (goods which are jointly
demanded). When the price of ______ of these goods increases the
demand for the other will __________.
If the prices of rock concerts rose then one would expect the demand
for these concerts to fall. Perhaps those who decided against the
concert might buy a CD instead. These goods are substitutes (goods
in competitive demand). These goods can be used as substitutes for
each other. When the price of _____ of these increases the demand for
the other is likely to ________________.
Tastes and preferences.
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Advertising.
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Population. Quite obviously, a significant rise in the number of people
in a given area or country will affect the demand for a whole host of
goods and services. Note that a change in the structure of the
population (we have an ageing population) will increase the demand for
some goods but reduce the demand for others.
Expectations of future prices.
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Government policy. Changes to legislation can have huge effects on
the demand for a good. Healthy eating in schools may mean that the
sales of Coca Cola and other fizzy drinks may decrease.
Interest rates and credit conditions. If interest rates are relatively low
then it is cheaper to borrow money that can then be spent. This is not
so applicable to CDs, but will certainly affect the demand for ‘big ticket’
items such as cars and major electrical goods. In boom time (like the
late 80s) it is often easier to obtain credit regardless of the rate of
interest.
Now that you understand that there are many things that affect the
demand for a good other than its price, I hope you can see the
importance of the ceteris paribus assumption. The normal downwardsloping demand curve shows the relationship between the price of the
good and its demand, all other things being equal. Those ‘all other
things’ are the list above: incomes, prices of other goods, etc. If you do
not make this assumption, then you could have a situation when the
price of CDs falls, but at the same time one’s income falls by such a
large amount that one actually demands fewer CDs. In other words,
one does not want to confuse shifts in the demand curve and
movements along a demand curve.
Movements along a demand curve
It is very important that you understand the difference shifts of and
movements along demand curves. Examiners often test your
understanding of this point.
A movement along a demand curve only occurs when there is a
change in the price of the good in question. Some textbooks call
these movements extensions and contractions. In the diagram below
(note that it is a straight-line sketch), when the price of CDs falls (from
P1 to P2) there is a rise in demand (from Q1 to Q2), ceteris paribus. The
movement along the curve is from point A to point B. When the price
rises (from P1 to P3) there is a fall in demand (from Q1 to Q3), ceteris
paribus. The movement along the curve is from point A to point C.
Note that we must say ‘ceteris paribus’. If one of the other determinants
of demand changes as well, then the curve would shift. Also note –
always label all of your diagrams very well. Examiners hate poorly
labelled diagrams.
Shifts of a demand curve
A shift in the demand curve occurs if one of the ‘other’ (i.e. non-price)
determinants of demand change. This means that for a given price
level the quantity demanded will change. This is illustrated in the
diagram below:
Note that the price has not changed (P1) and yet demand has
increased (in the case of the shift to D2) to Q2. This could be due to a
rise in real incomes (assuming the good is normal), a rise in the price
of a substitute good, a fall in the price of a complement, etcIn the case
of the shift to D3, demand has fallen even though the price has
remained constant. This is quite a difficult idea to understand, so why
don't you try the exercise below. Assume the product you are
considering is a car. In the left column are a number of factors that may
change. Can you click on the way the factor needs to move, in order to
make the demand line move to D3?
Complete Activity 4.4 on p61 of your textbook.
The determinants/conditions of supply
As with the demand curve, there are many things that affect supply as
well as the price of the good in question. Notice how similar many of
these factors are in comparison to the factors that affect demand.
Notice also that nearly all of these factors affect the firms’ costs. Given
that the firms’ supply curve is its cost curve then it is of no surprise that
a cost changing measure will shift the supply curve.
Prices of other factors of production.
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Technology.
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Indirect taxes and subsidies. When the chancellor announces an
increase in petrol tax (again!), it is the firm who actually pays the tax.
Granted, we end up paying the tax indirectly when the price of petrol
goes up, but the actual tax bill goes to the firm. This again, therefore,
represents an increase in the cost to the firm and the supply curve will
shift to the left. The opposite is true for subsidies as they are handouts
by the government to firms. Now the firm can make more units of
output at any given price, so the supply curve shifts to the right.
Labour productivity. This is defined as the output per worker (or per
man-hour). If labour productivity rises, then output per worker rises. If
you assume that the workers have not been given a pay rise then the
firm’s unit costs must have fallen. Again, this will lead to a shift to the
right of the supply curve.
Price expectations. Just as consumers delay purchases if they think
the price will fall in the future, firms will delay supply in they think prices
will rise in the future. It’s the same point but the other way round.
Entry and exit of firms to and from an industry. If new entrants are
attracted into an industry, perhaps because of high profit levels (much
more on this in the topic ‘Market structure’), then the supply in that
industry will rise at all price levels and the supply curve will shift to the
right. If firms leave the industry then the supply curve will shift to the
left.
Natural factors
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As with demand, we must now look at the difference between a
movement along a supply curve and a shift of a supply curve.
Movements along a supply curve
If you understand this topic when it is related to the demand curve then
you will be fine here as well. The principles are exactly the same. A
movement along a supply curve only occurs when the price changes,
ceteris paribus. In other words, the price changes but the other nonprice determinants remain constant. The diagram below shows that a
price rise will cause an extension up the supply curve, from point A to
point B, whilst a price fall will cause a contraction back down the
supply curve, from point A to point C.
Shifts of a supply curve
As with shifts of demand curves, supply curves shift, at all prices, if
there is a change in one or more of the determinants of supply. As
stated above, nearly all the determinants of supply affect the costs of
the firm and, therefore, its supply curve, which is its marginal cost
curve. Put simply, if something happens that increases a firm’s costs
regardless of the price level (e.g. an increase in the wage rate, of an
increase in government taxes), then the firm’s supply curve will shift to
the ________. If something happens that decreases a firm’s costs
regardless of the price level (e.g. improved technology or a subsidy
from the government), then the firm’s supply curve shifts to the
___________. The diagram below demonstrates these shifts:
Note that the price remains unchanged at P1; the shifts in the supply
curve are caused by various changes in the determinants of supply.
Try the following exercise to make sure that you understand why a
firm’s supply curve shifts. Remember that the initial position of the
supply curve is S1.
Complete activity 4.5 on p64
Shifts in supply and demand
Previously we looked at why supply and demand curves might shift.
We can now look at how these shifts can affect the equilibrium price.
The original equilibrium price is P1, quantity Q1. We are at
_____________________. Now assume that one of the determinants
of demand changes. For instance, there may have been an increase in
advertising in the industry. This will shift the demand curve to the right,
ceteris paribus (D2). The price will not stay at P1 for much longer. We
have an excess demand situation (A to C). As stated above, this will
cause the price to be bid up, and this will keep going until we reach the
new equilibrium price where the new demand curve crosses the supply
curve (at point B). Note that there has been a shift in the demand
curve, but only a movement a___________ the supply curve. None of
the determinants of supply have changed.
Earlier, we called this process the ‘price mechanism’. From the
analysis above, we can see that the price itself has the most important
role. The rising price has acted as a signal to possible new firms who
might want to join this expanding industry. It acted as an incentive,
encouraging existing firms to produce more (the movement along the
supply curve).
You can probably see that there are three other diagrams that I could
draw: a shift to the left of the demand curve; a shift to the right of the
supply curve and a shift to the left of the supply curve, all assuming
ceteris paribus. You should be able to think of reasons why any one of
those curves might shift (ceteris paribus) and then draw the appropriate
diagram yourself. Try this now, but if you do have problems then look
at the diagrams below.
Demand curve shifts to the left
- Initial equilibrium: P1, Q1 (A)
- New equilibrium: P3, Q4 (E)
Why might the demand curve shift to the left?
- ________ in real incomes
- Reduced preferences for the good
- ___________ in the price of a substitute
- _________ in the price of a complement
- _________ in population numbers
- ______________ advertising and marketing
Supply curve shifts to the right
- Initial equilibrium: P1, Q1 (A)
- New equilibrium: P4, Q6 (G)
- Why might the supply curve shift to the right?
- _________ in wage costs
- Fall in raw material costs
- Improved labour p_______________
- Reduced indirect taxes
- Increased s___________
- Improved t________________
- Entry of new firms into the industry
Supply curve shifts to the left
- Initial equilibrium: P1, Q1 (A)
- New equilibrium: P5, Q8 (J)
- Why might the supply curve shift to the left?
- _________ in wage costs
- Rise in raw ___________ costs
- _____________ labour productivity
- An _________________ in indirect taxes
- Reduced, or elimination of, subsidies
- The ________ of existing firms from the industry
When both curves shift
It is not unreasonable to think of a situation where both the demand
and supply curves shift. Think of the market for computers over the last
decade or so.
The demand curve for computers has definitely shifted to the right for
several reasons. Real incomes have risen, there has been a rise in
their preferences and the marketing of computers has increased, to
name just three factors. But there has also been a huge shift to the
right in the supply curve for computers. There have been immense
leaps in technology so that any given computer can be produced at a
fraction of the cost compared with a decade ago. This can be seen in
the diagram above. The equilibrium price has fallen from P 1 to P2, a
fairly large relative drop, and the quantity supplied and demanded has
also risen hugely, from Q1 to Q2. What actually happens in the market
for computers at the moment is that the price remains fairly constant,
but for the same price, a given computer gets technically better and
better as the months go by.
Complete activity 4.6 on P64.
Supply and Demand: Real world applications
So far, we have covered the nuts and bolts required to start analysing.
Although examiners are obviously keen that you understand the
basics, what they really want to see is whether a candidate has the
ability to apply the basics to real world contexts. We will now go
through a few of the old classics, but examiners are continually coming
up with different situations. They want to see if you can apply supply
and demand analysis to an unusual, but fair, situation under timed
conditions. To this end, you should always be trying to apply supply
and demand techniques to any situation that comes your way. Every
night on the news there will be a story to which you can apply some
supply and demand analysis. Practice makes perfect!
The housing market
This is another popular choice, although the question can have some
macro elements to it, such as the effects of a change in interest rates
on the housing market.
Here is another situation where the supply curve will be vertical in the
short run. Although building companies do respond to increases in
demand, this response will not be immediate. This is why one sees the
price of housing rise so quickly when there is a significant shift in the
demand for housing (the late 80s?).
So what factors will cause a shift in the supply and demand curves in
the housing market? On the demand side we have interest rates, tax
relief on mortgages (although this has been phased out recently),
changes in the population (especially if a certain area has a large influx
of people) and, most importantly of all some would say, speculation.
The boom of the late 80s was fuelled, to a large extent, by people
buying houses as investments rather than as places to live.
On the supply side we have to think what will affect the number of
properties available to purchase. In other words, the state of the rental
sector will have a large effect on the owner-occupied sector. Are more
people becoming landlords, especially with the new ‘buy-to-let’
mortgages? Obviously the number of new homes being built will affect
the supply curve. Are builders given incentives by the government?
Perhaps, if they reclaim a ‘brownfield’ site rather than build on the
more convenient ‘greenfield’ sites. They may even be prevented from
building on the latter. What about the cost of building new homes?
Changes in the cost of land, materials and workers will affect the
supply curve.
The market for health care
This is an interesting one. Although there is a private health care
market in this country which follows the rules of supply and demand,
the government funded NHS is an odd case.
There are two points to note. First, the price at the point of use is zero.
Secondly, the supply is more or less fixed at any one time. Although
doctors and nurses are continually being trained, there is a time lag
between when governments decide there needs to be an increase in
the numbers and when those numbers are fully qualified. The
government has been desperately trying to recruit new nurses recently,
but the results will not be felt until after the next election.
So in the short run, one has a rather odd diagram for the NHS:
Again, the supply curve is vertical because, like with coffee, there is
only a fixed amount of health care that the government can supply in
the short run. The demand curve is a normal downward-sloping one,
but because the price is zero, there is a lot of excess demand (A to B).
And the result? Queues and waiting lists! Also, because of increases
in technology creating new wants in the health service (who had a hip
replacement 20 years ago?), the demand curve is continually shifting
to the right, and at a faster rate than the government can force the
supply curve to the right. The NHS is sometimes perceived as being a
bottomless pit for government money!
Research the internet and find an article which illustrates the
theory on demand and supply