The Law of Supply

• states that at higher prices, producers are willing to offer more products for sale than
at lower prices
• states that the supply increases as prices increase and decreases as prices decrease
• states that those already in business will try to increase productions as a way of
increasing profits

The Law of Demand

• states that people will buy more of a product at a lower price than at a higher price, if
nothing changes
• states that at a lower price, more people can afford to buy more goods and more of an item
more frequently, than they can at a higher price

• states that at lower prices, people tend to buy some goods as a substitute for others more
expensive

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the
backbone of a market economy.

Demand refers to how much (quantity) of a product or service is desired by buyers. The
quantity demanded is the amount of a product people are willing to buy at a certain price; the
relationship between price and quantity demanded is known as the demand relationship.

Supply represents how much the market can offer. The quantity supplied refers to the
amount of a certain good producers are willing to supply when receiving a certain price. The
correlation between price and how much of a good or service is supplied to the market is known
as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of
resources. In market economy theories, demand and supply theory will allocate resources in the
most efficient way possible.

A. The Law of Demand

The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the
quantity demanded. The amount of a good that buyers purchase at a higher price is less because
as the price of a good goes up, so does the opportunity cost of buying that good. As a
result, people will naturally avoid buying a product that will force them to forgo the consumption
of something else they value more. The chart below shows that the curve is a downward slope.
A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation
between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1
and the price will be P1, and so on. The demand relationship curve illustrates the negative
relationship between price and quantity demanded. The higher the price of a good the lower the
quantity demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope. This
means that the higher the price, the higher the quantity supplied. Producers supply more at a
higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the
price will be P2, and so on.
Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is
important to supply because suppliers must, but cannot always, react quickly to a change in
demand or price. So it is important to try and determine whether a price change that is caused by
demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy
season; suppliers may simply accommodate demand by using their production equipment more
intensively. If, however, there is a climate change, and the population will need umbrellas year-
round, the change in demand and price will be expected to be long term; suppliers will have to
change their equipment and production facilities in order to meet the long-term levels of
demand.

C. Supply and Demand Relationship

Now that we know the laws of supply and demand, let's turn to an example to show how supply
and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record
company's previous analysis showed that consumers will not demand CDs at a price higher than
$20, only ten CDs were released because the opportunity cost is too high for suppliers to produce
more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise
because, according to the demand relationship, as demand increases, so does the price.
Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship
shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up
because the supply more than accommodates demand. In fact after the 20 consumers have been
satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers
attempt to sell the remaining ten CDs. The lower price will then make the CD more available to
people who had previously decided that the opportunity cost of buying the CD at $20 was too
high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function
intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its
most efficient because the amount of goods being supplied is exactly the same as the amount of
goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the
current economic condition. At the given price, suppliers are selling all the goods that they have
produced and consumers are getting all the goods that they are demanding.
As you can see on the chart, equilibrium occurs at the intersection of the demand and supply
curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P*
and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods
and services are constantly changing in relation to fluctuations in demand and supply.

E. Disequilibrium

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less than
Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed.
The suppliers are trying to produce more goods, which they hope to sell to increase profits, but
those consuming the goods will find the product less attractive and purchase less because the
price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so
low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2.
Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus,
there are too few goods being produced to satisfy the wants (demand) of the consumers.
However, as consumers have to compete with one other to buy the good at this price, the demand
will push the price up, making suppliers want to supply more and bringing the price closer to its
equilibrium.

Source: http://www.investopedia.com/university/economics/economics3.asp
Marginal utility is defined as the increase in utility as a result of consuming one more unit of the
good. It is the additional satisfaction, or amount of utility, gained from each extra unit of
consumption.

Investopedia explains Marginal Utility

For example, if you were really thirsty you'd get a certain amount of satisfaction
from a glass of water. This satisfaction would probably decrease with the second
glass, and then even more with the third glass. The additional amount of
satisfaction that comes with each additional glass of water is marginal utility.

Although total utility usually increases as more of a good is consumed, marginal utility usually
decreases with each additional increase in the consumption of a good. This decrease
demonstrates the law of diminishing marginal utility. Because there is a certain threshold of
satisfaction, the consumer will no longer receive the same pleasure from consumption once that
threshold is crossed.

What Does Law Of Diminishing Marginal Utility Mean?

A law of economics stating that as a person increases consumption of a product - while keeping
consumption of other products constant - there is a decline in the marginal utility that person
derives from consuming each additional unit of that product.

The law of diminishing marginal utility helps economists understand the law of demand
and the negative sloping demand curve. The less of something you have, the more
satisfaction you gain from each additional unit you consume; the marginal utility you gain
from that product is therefore higher, giving you a higher willingness to pay more for it.
Prices are lower at a higher quantity demanded because your additional satisfaction
diminishes as you demand more.

Investopedia explains Law Of Diminishing Marginal Utility

This is the premise on which buffet-style restaurants operate. They entice you
with "all you can eat," all the while knowing each additional plate of food
provides less utility than the one before. And despite their enticement, most
people will eat only until the utility they derive from additional food is slightly
lower than the original.

For example, say you go to a buffet and the first plate of food you eat is very
good. On a scale of ten you would give it a ten. Now your hunger has been
somewhat tamed, but you get another full plate of food. Since you're not as
hungry, your enjoyment rates at a seven at best. Most people would stop before
their utility drops even more, but say you go back to eat a third full plate of food
and your utility drops even more to a three. If you kept eating, you would
 eventually reach a point at which your eating makes you sick, providing
dissatisfaction, or 'dis-utility'.

http://www.investopedia.com/
http://kr.mnsu.edu/~renner/supdem.htm

The market and equilibrium pricing

The market combines in exchange, both buyers and sellers. For economics it combines the
demand and the supply curve to determine price. This price is called an equilibrium price, since
it balances the two forces of supply and demand. An equilibrium price is the price at which the
quantity demanded is equal to the quantity supplied. The quantity supplied and demanded is also
referred to as the equilibrium quantity. Figure 5, shows both demand and supply determining
equilibrium price and quantity.

Figure 5, Demand and supply and equilibrium

In figure 5, “A” is the equilibrium price and “Q” is the corresponding equilibrium quantity. At
the price “A” the quantity supplied and a quantity demanded are equal, and at the “Q” quantity,
demand and supply are equal.

If price were at “B” the quantity that suppliers would like to supply would be larger than
consumers would demand at that price, creating a surplus quantity. A surplus would create forces
among the many competitive suppliers to cut prices (supplier are all relatively small). Those
forces would push the price down to the equilibrium level at “A”.

If prices were at “C” the quantity that suppliers would like to supply, would be less than
consumers would demand at that price, creating a shortage. Because of the shortage and a
competition among consumers, prices would tend to rise. Only at “A” would there be no
tendency for the price to change, and “A” is the equilibrium price.

This graph represents the objective impersonal operation of the market. No one sets the price,
and if the consumers don’t like the price, they have no one to blame, and no recourse (over the
price). If suppliers don’t like the price, they in turn have no one to blame and no recourse (over
the price). This is seen by many as one of the strength of markets.
http://tutor2u.net/economics/revision-notes/as-markets-equilibrium-price.html

Market Equilibrium Price

In this note we bring the forces of supply and demand together to consider the determination
of equilibrium prices.

The Concept of Market Equilibrium

Equilibrium means a state of equality or a state of balance between market demand and
supply. Without a shift in demand and/or supply there will be no change in market price. In
the diagram above, the quantity demanded and supplied at price P1 are equal. At any price
above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other
words, prices where demand and supply are out of balance are termed points of
disequilibrium.

Changes in the conditions of demand or supply will shift the demand or supply curves. This
will cause changes in the equilibrium price and quantity in the market.
Demand and supply schedules can be represented in a table. The example below provides an
illustration of the concept of equilibrium. The weekly demand and supply schedules for T-shirts
(in thousands) in a city are shown in the next table:

Price per unit (£) 8 7 6 5 4 3 2 1

Demand (000s) 6 8 10 12 14 16 18 20
Supply (000s) 18 16 14 12 10 8 6 4
New Demand (000s) 10 12 14 16 18 20 22 24
New Supply (000s) 26 24 22 20 18 16 14 12

1. The equilibrium price is £5 where demand and supply are equal at 12,000 units
2. If the current market price was £3 – there would be excess demand for 8,000 units
3. If the current market price was £8 – there would be excess supply of 12,000 units
4. A change in fashion causes the demand for T-shirts to rise by 4,000 at each price. The
next row of the table shows the higher level of demand. Assuming that the supply
schedule remains unchanged, the new equilibrium price is £6 per tee shirt with an
equilibrium quantity of 14,000 units
5. The entry of new producers into the market causes a rise in supply of 8,000 T-shirts at
each price. The new equilibrium price becomes £4 with 18,000 units bought and sold

Changes in Market Demand and Equilibrium Price

The demand curve may shift to the right (increase) for several reasons:

1. A rise in the price of a substitute or a fall in the price of a complement

2. An increase in consumers’ income or their wealth
3. Changing consumer tastes and preferences in favour of the product
4. A fall in interest rates (i.e. borrowing rates on bank loans or mortgage interest rates)
5. A general rise in consumer confidence and optimism
The outward shift in the demand curve causes a movement (expansion) along the supply curve
and a rise in the equilibrium price and quantity. Firms in the market will sell more at a higher
price and therefore receive more in total revenue.

The reverse effects will occur when there is an inward shift of demand. A shift in the demand
curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be
independent of each other although some economists claim this assumption is no longer valid!

Changes in Market Supply and Equilibrium Price

���� The supply curve may shift outwards if there is

1. A fall in the costs of production (e.g. a fall in labour or raw material costs)
2. A government subsidy to producers that reduces their costs for each unit supplied
3. Favourable climatic conditions causing higher than expected yields for agricultural
commodities
4. A fall in the price of a substitute in production
5. An improvement in production technology leading to higher productivity and efficiency
in the production process and lower costs for businesses
6. The entry of new suppliers (firms) into the market which leads to an increase in total
market supply available to consumers

The outward shift of the supply curve increases the supply available in the market at each price
and with a given demand curve, there is a fall in the market equilibrium price from P1 to P3 and
a rise in the quantity of output bought and sold from Q1 to Q3. The shift in supply causes an
expansion along the demand curve.

Important note:

A shift in the supply curve does not cause a shift in the demand curve. Instead we move
along (up or down) the demand curve to the new equilibrium position.
A fall in supply might also be caused by the exit of firms from an industry perhaps because
they are not making a sufficiently high rate of return by operating in a particular market.

The equilibrium price and quantity in a market will change when there shifts in both market
supply and demand. Two examples of this are shown in the next diagram:

In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs
or a decision by producers to cut back on output at each price level) together with a fall (inward
shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both
factors lead to a fall in quantity traded, but the rise in costs forces up the market price.

The second example on the right shows a rise in demand from D1 to D3 but a much bigger
increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and
an increase in the equilibrium quantity traded in the market.
http://www.econweb.com/MacroWelcome/sandd/notes.html

Factors that Shift the Demand Curve

We list and explain four factors that can shift a demand curve:

1. Change in consumer incomes: As the previous video rental example demonstrated, an

increase in income shifts the demand curve to the right. Because a consumer's demand for
goods and services is constrained by income, higher income levels relax somewhat that
constraint, allowing the consumer to purchase more products. Correspondingly, a
decrease in income shifts the demand curve to the left. When the economy enters a
recession and more people become unemployed, the demand for many goods and
services shifts to the left.
2. Population change: An increase in population shifts the demand curve to the right.
Imagine a college town bookstore in which most students return home for the summer.
Demand for books shifts to the left while the students are away. When they return,
however, demand for books increases even if the prices are unchanged. As another
example, many communities are experiencing "urban sprawl" where the metropolitan
boundaries are pushed ever wider by new housing developments. Demand for gasoline in
these new communities increases with population. Alternatively, demand for gasoline
falls in areas with declining populations.
3. Consumer preferences: If the preference for a particular good increases, the demand
curve for that good shifts to the right. Fads provide excellent examples of changing
consumer preferences. Each Christmas season some new toy catches the fancy of kids,
and parents scramble to purchase the product before it is sold out. A few years ago,
"Tickle Me Elmo" dolls were the rage. In the year 2000 the toy of choice was a scooter.
For a given price of a scooter, the demand curve shifts to the right as more consumers
decide that they wish to purchase that product for their children. Of course, demand
curves can shift leftward just as quickly. When fads end suppliers often find themselves
with a glut of merchandise that they discount heavily to sell.
4. Prices of related goods: If prices of related goods change, the demand curve for the
original good can change as well. Related goods can either be substitutes or
complements.
o Substitutes are goods that can be consumed in place of one another. If the price of
a substitute increases, the demand curve for the original good shifts to the right.
For example, if the price of Pepsi rises, the demand curve for Coke shifts to the
right. Conversely, if the price of a substitute decreases, the demand curve for the
original good shifts to the left. Given that chicken and fish are substitutes, if the
price of fish falls, the demand curve for chicken shifts to the left.
o Complements are goods that are normally consumed together. Hamburgers and
french fries are complements. If the price of a complement increases, the demand
curve for the original good shifts to the left. For example, if McDonalds raises the
 price of its Big Mac, the demand for french fries shifts to the left because fewer
people walk in the door to buy the Big Mac.

Factors that Shift the Supply Curve

We list and explain three factors that shift a supply curve:

1. Change in input costs: An increase in input costs shifts the supply curve to the left. A
supplier combines raw materials, capital, and labor to produce the output. If a furniture
maker has to pay more for lumber, then her profits decline, all else equal. The less
attractive profit opportunities force the producer to cut output. Alternatively, car
manufacturer may have to pay higher labor costs. The higher labor input costs reduces
profits, all else equal. For a given price of a car, the manufacturer may trim output,
shifting the supply curve to the left. Conversely, if input costs decline, firms respond by
increasing output. The furniture manufacturer may increase production if lumber costs
fall. Additionally, chicken farmers may boost chicken output if feed costs decline. The
reduction in feed costs shifts the supply curve for chicken to the right.
2. Increase in technology: An increase in technology shifts the supply curve to the right. A
narrow definition of technology is a cost-reducing innovation. Technological progress
allows firms to produce a given item at a lower cost. Computer prices, for example, have
declined radically as technology has improved, lowering their cost of production.
Advances in communications technology have lowered the telecommunications costs
over time. With the advancement of technology, the supply curve for goods and services
shifts to the right.
3. Change in size of the industry: If the size of an industry grows, the supply curve shifts to
the right. In short, as more firms enter a given industry, output increases even as the price
remains steady. The fast-food industry, for example, exploded in the latter half of the
twentieth century as more and more fast food chains entered the market. Additionally,
on-line stock trading has increased as more firms have begun delivering that service.
Conversely, the supply curve shifts to the left as the size of an industry shrinks. For
example, the supply of manual typewriters declined dramatically in the 1990s as the
number of producers dwindled.
Some Questions on Supply and Demand

Q. Explain factors that could explain a fall in the price coffee

The price of coffee would fall if there was a fall in demand and/ or an increase in supply
The demand for coffee could fall for various reasons such as

i) lower incomes mean that consumers cannot afford to buy as much

ii) Less fashionable
iii) Decrease in the price of substitutes such as tea
The supply of coffee could increase for various reasons such as:

i) Increase in the number of suppliers

ii) Lower costs of production
iii) Govt subsidies
iv) Higher labour productivity in producing coffee, this will decrease the costs of production

Blog Post: The Economics of The Price of Coffee

More Essay Questions

1. With the Aid of Supply and Demand diagrams explain the effect on the market for mobile phones if:
a) Improved technology producing mobile phones
b) An increase in taxes on mobile phones but an increase in advertising for phones with new features
2. What could explain a fall in the price of computers?

1. The Supply Curve is upward-sloping because:

As the price increases, so do costs.

As the price increases, consumers demand less.

As the price increases, suppliers can earn higher levels of profit or justify higher marginal
costs to produce more.

None of the Above

2. Part of the reason that Michael Jordan earns millions of dollars each year while school teachers may earn
$30,000 is because

The supply of superstar basketball players is very low, while the supply of competent
teachers is much larger.

Demand for Michael Jordan's talents is very high since he can generate so much revenue for
a firm.

Consumers enjoy basketball to the point that they are willing to spend lots of money and
time attending games and watching commercials.

All of the Above

3. When college students leave town for the summer, the demand for meals at the local restaurants declines.
This results in

a decrease in equilibrium price and an increase in quantity.

an increase in equilibrium price and quantity.

a decrease in equilibrium price and quantity.

an increase in equilibrium price, and a decrease in quantity.

None of the Above

4. All the following shift the demand curve for automobiles to the right except:

the local factory gives a big raise to its employees.

a brand new automobile dealership opens in town.

the price of gasoline falls.

None of the Above

5. If the cost of computer components falls, then

the demand curve for computers shifts to the right.

the demand curve for computers shifts to the left.

the supply curve for computers shifts to the right

the supply curve for computers shifts to the left

6. What happens in the market for airline travel when the price of traveling by rail decreases?

The demand curve shifts left.

The demand curve shifts right.

The supply curve shifts left.

The supply curve shifts right.

We move along the supply curve.

7. If a sin tax is placed on sales of alcohol,

the demand curve shifts to the left.

the demand curve shifts to the right.

the supply curve shifts to the left.

the supply curve shifts to the right.

8. When a price ceiling is imposed above the equilibrium price,

a shortage results.

a surplus results.

the equilibrium outcome prevails.

there is not enough information to determine the outcome.

9. If the demand curve shifts to the right, then we move up and to the right along our supply curve.

True

False

10. If the cost of making bicycles falls, the price goes down, causing the demand curve to shift to the right.

True

False

1. The Supply Curve is upward-sloping because

As the price increases, suppliers can earn higher levels of profit or justify higher marginal costs to produce
more.
2. Part of the reason that many basketball players earns millions of dollars each year while school teachers
may earn $30,000 is because
All of the above.
3. When college students leave town for the summer, the demand for meals at the local restaurants declines.
This results in
a decrease in equilibrium price and quantity. The demand curve shifts to the left because the town
population declines, resulting in lower prices and quantity.
4. All the following shift the demand curve for automobiles to the right except
a brand new automobile dealership opens in town. This factor will increase the supply curve to the right.
The other two examples do shift the demand curve to the right.
5. If the cost of computer components falls, then
the supply curve for computers shifts to the right. Computer components are inputs into the computer. If
these prices fall, then producers can make more output at the same price.
6. What happens in the market for airline travel when the price of traveling by rail decreases?
The demand curve shifts left. Rail and airline travel are substitutes. If the price of a substitute declines, then
the demand curve for the substitute product shifts to the left.
7. If a sin tax is placed on sales of alcohol,
the supply curve shifts to the left. A sin tax is a sales tax, usually imposed at the point of sale. A sales tax is
treated like an input cost, so the supply curve shifts left.
8. When a price ceiling is imposed above the equilibrium price,
the equilibrium outcome prevails. This is a trick question. Remember that a price ceiling is the maximum
price allowed in the market. If the price ceiling for, say, apartments is imposed at $1,000 per month but the
market price is just $800, then the market outcome prevails. The ceiling is not binding.
9. If the demand curve shifts to the right, then we move up and to the right along our supply curve.
True. As the price increases due to the shifting demand curve, suppliers respond by increasing the quantity
supplied.
10. If the cost of making bicycles falls, the price goes down, causing the demand curve to shift to the right.
False. The lower price of bicycles resulting from cost reductions does make more people purchase bicycles,
but this effect is reflected by a movement along the demand curve.