LEARNING OUTCOME 2

1
LEARNING OUTCOME 2 3

• DEMAND AND SUPPLY

2
DEMAND

• EFFECTIVE DEMAND
• desire to purchase backed by the ability to pay
• DETERMINANTS OF DEMAND
• Price
• Tastes
• Income
• Fashion
• Advertising
• Availability and price of substitutes
• Price of compliments
• Time of year
• Consumers expectations
• Availability of credit
• Population
• Utility yielded

3
UTILITY

• UTILITY
• the satisfaction which we obtain from goods and
  services
• MARGINAL UTILITY
• the satisfaction obtained from the last unit
• will diminish with each successive unit consumed
  - the law of diminishing marginal utility
• TOTAL UTILITY
• the satisfaction obtained from all units consumed
• CONSUMER OPTIMUM
• maximising total utility - the theory of
  equi-marginal returns
• MU A MU B MU C
  MU n
• Price A Price B Price C
  Price n

4
THE LAW OF DEMAND

• More will be demanded at lower prices and less at
  higher price.

• Reasons for slope of Demand Curve
• Law of Diminishing Marginal Utility
• Substitution Effect
• Income Effect

When price rises from P to P1 quantity demanded
contracts from Q to Q1.
When price falls from P to P2 quantity demanded
extends from Q to Q2

5
QUIZ
What is meant by effective demand?
Wants backed up by money
Price, tastes, availability of substitutes and
the price of compliments
Name any 4 determinants of demand
How do we refer to the satisfaction yielded by
the last unit consumed?
Marginal Utility
What happens to satisfaction as we consume more
of a commodity?
Marginal utility decreases with each unit consumed
How can individuals maximise their total
satisfaction?
By equalising the marginal utility price ratio
for all goods consumed
Describe the relationship between price and
quantity demanded.
It is an inverse relationship
Law of Diminishing Marginal Utility The
Substitution Effect The Income effect
What explains this relationship?
What happens on the demand curve when price
rises?
There is a contraction of demand
What happens on the demand curve when price
falls?
There is an extension of demand
6
PRICE ELASTICITY OF DEMAND
Measures the responsiveness of demand to price
changes

• gt 1 is relatively price elastic
• lt 1 is relatively price inelastic
• 1 is unit price elasticity

• E change in Quantity Demanded
• change in Price

• Products which are price elastic have a
  relatively flat demand curve so that in response
  to even a relatively small price change, quantity
  demanded changes more than in proportion to price.

Products which are price inelastic have a
relatively steep demand curve so that even
relatively large price changes generate
proportionately smaller changes in quantity
demanded.
7
PRICE ELASTICITY OF DEMAND
With straight line demand curves elasticity will
vary along the length of the curve.
E Change in Quantity Demanded
Change in Price
10 x 100 10 100 1 x 100 20 5
5 Relatively Elastic
10 x 100 40 25 1 x 100 50 0.5
2 Relatively Inelastic

• Perfectly Elastic Demand

Perfectly Inelastic Demand
8
PRICE ELASTICITY OF DEMAND
When using the formula for price elasticity of
demand, the sign is assumed to be negative (-).
This is because normal goods follow the law of
demand and have a normal, downward sloping demand
curve.
Products whose quantity demanded increases when
price increases would give a positive () value
for price elasticity and have an exceptional
demand curve.
If a positive () value is obtained this is an
exceptional good one which does not follow the
law of demand ie one which has an exceptional
demand curve.
An example of this could be the demand for a
painting by a particular artist, which only
becomes desirable as an investment by a
collector, when the price starts to rise.
9
QUIZ
What is the price elasticity of demand if the
price of Commodity X rises from 80p to 85p and,
as a result, the demand falls from 100 per week
to 75 per week?
25 x 100 100 1 25 4 ie fairly
elastic 5 x 100 6.25 80 1
If the demand for commodity Y rises from 1,200 to
1,500 in response to a price reduction from 2.00
to 1.50, calculate the price elasticity of
demand.
300 x 100 1200 25 1 ie
unit elasticity 50 x 100 25 200
10
INCOME ELASTICITY OF DEMAND
Measures the responsiveness of demand to changes
in income

• gt 1 is relatively income elastic
• lt 1 is relatively income inelastic
• 1 is unit income elasticity

E change in Quantity Demanded
change in Income
Products for which quantity demanded increases
when income increases and vice versa have a
positive() income elasticity value.
These would be normal goods ie goods which follow
the law of demand eg steak.
Products for which quantity demanded increases
when income decreases and vice versa have a
negative (-) income elasticity value.
These would be giffen goods ie of inferior
quality eg sausages
11
QUIZ
Calculate the income elasticity of demand for
commodity A if, in response to an increase in
income of 5, quantity demanded increases from
200 per week to 275 per week.
What kind of commodity is A?
75 x 100 200 1 37.5
7.5 5 5
A normal good eg biscuits
What is the income elasticity of demand for
commodity B if demand increases from 5,000 to
5,500 units per week when when real income falls
by 2.5.

500 X 100 5,000 1 10 - 4
-2.5 - 2.5
What kind of commodity is B?
A giffen good eg bread
12
CHANGES IN DEMAND
When there is a change in a determinant of demand
other than price then the demand curve shifts .
If tastes change in favour of a commodity then
more is demanded at all prices and the demand
curve shifts forward to the right.
If the price of a substitute falls then less of
the commodity will be demanded at all prices and
the demand curve shifts backward to the left.
13
QUIZ
Say what happens to demand in each of the
following cases
The demand for a normal good when its price rises.
A contraction in quantity demanded.
The demand for a luxury good when its price falls.
An extension in quantity demanded
The demand for a giffen good when income rises.
A backward shift in demand to the left.
A forward shift in demand to the right.
The demand for a good when the price of its
complement falls.
The demand for a good when the price of a close
substitute rises.
A forward shift in demand to the right.
The demand for a good which has recently been
declared bad for health.
A backward shift in demand to the left.
14
SUPPLY

• the willingness to sell a commodity at a given
  price

THE LAW OF SUPPLY More will be supplied at higher
prices and less at lower prices.
There is a direct relationship between price and
quantity supplied resulting in a supply curve
sloping upwards from left to right.
A fall in price results in a contraction of
supply
An increase in price results in an extension of
supply
15
ELASTICITY OF SUPPLY

• measures the responsiveness of supply to changes
  in price

E change in Quantity Supplied
change in Price
Depends on the ability of suppliers to respond to
price changes therefore depends on

• the time it takes to alter production levels

• availability of stocks

• availability of factors of production

• the ease of entry of new firms into the market

An increase in costs will shift supply to the
left.
A decrease in costs will shift supply to the
right.
16
THE PRICE MECHANISM
Prices are determined by market forces ie the
interaction of supply and demand.
The interaction of supply and demand determines
the market clearing price ie equilibrium price
the price at which all goods supplied are
demanded.
Any price above this will mean excess supply
which will force price down.
Any price below this will mean excess demand
which will push up price.
Equilibrium price will change with changes in
demand and/or supply in Response to changes in
the determinants of demand and supply.
17
INTERVENTION IN THE MARKET
This happens when there is market failure or the
price system is not working properly ie the price
is too low or too high for those involved
The Government may set a maximum price to protect
the purchasers.
If the maximum price set (Maxp) is below
equilibrium price, there will be excess demand
which could result in a black market for the
commodity.
The Government may set a minimum price to protect
the incomes of the suppliers eg the minimum wage
in the labour market.
If the minimum price set (Minp) is above
equilibrium price, there will be excess supply
which, in the labour market, too high a minimum
wage would cause unemployment.
18
TAXES AND SUBSIDIES
Intervention in the market can also be by means
of government taxes and subsidies.
Indirect taxes eg excise duty are placed on
products in order to raise revenue for the
government and/or to discourage consumption of
certain commodities such as cigarettes and
alcohol.
Taxes have the effect of shifting the supply
curve to the left thereby increasing price.
Subsidies are given to producers to encourage the
production of certain products.
Subsidies have the effect of shifting the
supply curve to the right thereby lowering price.
19
CHANGES IN EQUILIBRIUM PRICE
Equilibrium price will change whenever there is a
change in any of the determinants of demand
and/or supply.
Any of these changes in determinants (other than
price) cause shifts in the demand and/or supply
curves, altering the market clearing price.
FORWARD SHIFT IN DEMAND INCREASES EQUIL PRICE
BACKWARD SHIFT IN DEMAND DECREASES EQUIL PRICE
FORWARD SHIFT IN SUPPLY DECREASES EQUIL PRICE
BACKWARD SHIFT IN SUPPLY INCREASES EQUIL PRICE
COMBINATION OF SHIFTS INCREASING EQUIL PRICE
COMBINATION OF SHIFTS DECREASING EQUIL PRICE
20
AND FINALLY
Complements such as CDs and CD players are said
to be in joint demand since one is no use without
the other.
Close substitutes such as butter and margerine
are said to be in competitive demand since they
both perform the same function and consumers will
choose between them.
Joint supply is where the production of one
product eg oil automatically leads to the
production of another eg petrol or paint or
plastics
Where the total supply of one commodity is fixed
because of limited resources, a reduction in the
supply of one necessitates the reduction of
another these are said to be in competitive
supply eg milk and cheese.
21
QUIZ
What factors changes equilibrium price?
Changes in any of the determinants of demand
and/or supply.
Give 2 examples of market intervention.
The minimum wage and price capping.
To encourage the consumption of some products and
discourage others.
Why might governments intervene in markets?
Tennis racquets and tennis balls.
Name 2 products in joint demand.
Name 2 products in joint supply.
Beef and leather
Give an example of products in competitive
demand.
Gas and electricity
Give an example of competitive supply.
Land for housing and land for recreation