Lesson-6

Supply and Demand-- Demand Analysis

Prices influence both buyers and sellers into making economic decisions. If the price for
computers goes down, it will stimulate more demand to purchase computers. If the price
of corn goes up, it will stimulate farmers into producing more corn. This is how the
marketplace works. This lesson will look at the market processes that influence the
demand side of the equation.

Introduction to Demand

A market exists when buyers and sellers interact to exchange products. Supply and
demand analysis describes what happens in only some of these interactions. To use
supply and demand analysis, we need markets in which there are many buyers and
sellers, each small relative to the overall market. Also, both buyers and sellers should be
well informed, and they must form distinct and separate groups. If buyers are a group
distinct from the sellers, we can analyze how they act separately from sellers. Only when
we have looked at these two groups separately, we will combine them and see how they
interact.

What determines the amount of a product that people are willing and ready to buy during
some period of time? For example, what determines the amount of hamburger purchased
in Chicago during a week? Economists answer such questions by examining the costs and
benefits of buying the product. When any of the costs or benefits changes, the amount of
the product that people will buy should also change.

The benefits a person gets from a product depend on his goals. These goals are referred to
in many ways in discussions of demand. The words "tastes," "wants," "needs,"
"preferences" and "usefulness" all refer to goals. When people's goals change, the amount
of benefit they get from the good changes, and this will cause them to change the amount
of the good they want to buy.

Goals (or preferences or tastes) depend on many factors, such as the age of people and
the amount of education they have. Social custom is an important determinant of
preferences and can account for many differences in demand among groups. One can
explain the large differences in squid sales in Japan and the United States, or the large
differences in consumption of horse meat in Europe and the United States, almost entirely
in terms of differences in preferences caused by differences in social customs.

The most obvious cost a person bears in buying a product is the price of the product.
Price reflects cost because people have a limited amount of funds that they can spend,
and if they spend their money on one thing, they cannot spend it on another. When the
price of a product goes up, the amount of other things that a person must give up in order
to buy the product rises. As a result, we expect people to buy more hamburger if the price
is $1.00 per pound than if it is $2.00 per pound.

The amount of income a person receives affects the cost of buying an item because it
determines which options a person should give up when buying a product. If a person
with a low income spends $5000 for a trip around the world, he will have to cut back on
food, clothing or shelter. The same trip will cause a person with a high income to cut
back on a very different set of options.

Increase in people's incomes raises consumption of most products. These products are
called normal goods. There are some products, however, that people use less of as their
income increases. These products are called inferior goods. In case of public
transportation, as people's incomes rise, they stop riding the bus and drive their own cars.
In the case of blue jeans, people with higher incomes bought them less frequently than
people with lower incomes. It was because they were a symbol of "working class"
clothes. They were adopted by the radical left in the 1960’s, and from there, they moved
into high fashion.

Prices of related goods also influence how much of a product people buy. Goods that are
substitutes satisfy the same set of goals or preferences. An example of a substitute for
hamburger is pork. If pork prices are high, people are tempted to shift away from pork to
hamburger. And if pork prices are low, people are tempted to shift from hamburger to
pork. The opposite of a substitute is a complement, a good that helps complete another in
some way. Catsup and hamburger buns are complements to hamburger, and if they are
priced low enough, consumption of hamburger may rise. Sometimes, goods are such
good complements that they are sold together and we think of them as a single item. Left
shoes and right shoes are an example.
There are other factors which influence the amount of a particular product that people are
willing to buy, such as the number of consumers in the market and their expectations
about future prices, incomes, and quality changes. To get a complete list for any product
might be time consuming and difficult. But it is not necessary because we want to focus
on the relationship between price and the quantity of a product that people are willing to
buy during some interval of time. To do this, we will assume that all other factors are
held constant.

Demand Schedule and Demand Curve

The relationship between price and the amount of a product people want to buy is what
economists call the demand curve. This relationship is inverse or indirect because as price
gets higher, people want less of a particular product. This inverse relationship is almost
always found in studies of particular products, and its very widespread occurrence has
given it a special name-- the law of demand. The word "law" in this case does not refer to
a bill that the government has passed but to an observed regularity.

There are various ways to express the relationship between price and quantity that people
will buy. Mathematically, one can say that quantity demanded is a function of price, with
other factors held constant, or:

Qd = f (Price, with other factors held constant)

A more elementary way to capture the relationship is in the form of a table. The numbers
in the Table A below are what one expects in a demand curve-- as price goes up, the
amount people are willing to buy decreases. This tabular representation is known as
“demand schedule” (A widget is an imaginary product that some economist invented
when he could not think of a real product to use in illustrating an idea).

A Demand Schedule
Price of
Widgets
Number of Widgets
people want to buy
$1.00 100
$2.00 90
$3.00 70
$4.00 40
Table A

The same information can also be plotted on a graph as shown below in Figure A.

This
graphical representation is known as “demand curve.”



Figure A

Law of Demand

The graph above also demonstrates the law of demand. The law of demand states that as
price decreases, quantity demanded increases. An inverse relationship exists. The law of
demand is dependent on ceteris paribus, all other factors remaining unchanged.

The following other factors are the assumptions of the law as well:

1. Price of related goods should remain unchanged.
2. Income of the consumer should not change.
3. Taste, preferences and fashion should not change.
4. All the units of product in question are homogeneous.

In economics, the term utility refers to the measure of satisfaction received from
consuming a good or service. The law of demand does not go on for infinity. There are
limits. The law of diminishing marginal utility describes how the last item consumed will
be less satisfying than the one before. This means, at some point, no matter how low the
price is, consumers will purchase less.

Change in Demand and Shift in Demand

A change in quantity demanded can be illustrated by a movement between points along a
stationary demand curve. Once again, demand is influenced by price. On the demand
curve above, this is seen in the movement from point A to point B.

A shift in demand can also occur. A shift in demand refers to an increase (rightward
change) or decrease (leftward change) in the quantity demanded at each possible price.
This shift is influenced by non-price determinants. An example of an increase and a
decrease in demand are shown below.

If one of the factors being held constant becomes unstuck, changes, and then is held
constant again, the relationship between price and quantity will change. For example,
suppose the price of getwids, a substitute for widgets, falls. Then, people who previously
were buying widgets will reconsider their choices, and some may decide to switch to
getwids. This would be true at all possible prices for widgets. These changes in the way
people will behave at each price will change the demand curve to look like in the table B
below.

A Demand Curve Can Shift
Price of
Widgets
Number of Widgets
People Want to Buy
$1.00 [100] becomes 80
$2.00 [90] becomes 70
$3.00 [70] becomes 50
$4.00 [40] becomes 10
Table B

These are the same changes as shown in the following graph in Figure B.


Figure B

For all the theoretical purposes, we will assume the demand curve to be a straight line.
Shift in demand can either be increase or decrease, as shown in graphs in figure C below:

Increase in Demand-- It results from the increase is the price of substitute, increase in
income, or change in taste and preferences etc.

Decrease in Demand-- It results from the decrease in the price of substitute, decrease in
income, or change in taste and preferences etc.



Figure C: Shift in Demand-- Increase or Decrease

The most important distinction to keep in mind is that a change in quantity demanded is a
movement along a single curve, while a shift in demand involves the creation of a second
curve.

Non-Price Determinants of Demand
There are other factors besides price that influence consumers to purchase products. A
brief description of each is provided below.

1. A Change in Income

If you receive a raise, you are likely to increase your demand for goods. If you get laid
off, your demand for goods is likely to decrease. When income increases, consumers buy
more. When income decreases, consumers buy less.

2. A Change in Taste

Fads, fashions and the advertising of new products influence consumer decisions. Think
of hula hoops and Pokeman cards craze.

3. A Change in the Price of a Substitute Good

A substitute good competes with another good for consumer purchases. Examples of
substitute goods include juice and soda, margarine and butter, and audio cassettes and
compact discs. If the price of soda increases too much, consumers may decide to drink
juice instead.

4. A Change in the Price of a Complementary Good

A complementary good is jointly consumed with another good. Examples include cars
and gasoline, tuition and textbooks, and milk and cereal. If the price of milk increases
dramatically, consumers will decide to purchase less milk, and consequently, less cereal.

5. A Change in Buyer Expectations
If consumers think the price of a good will increase in future, they may decide to buy
more of it now so that they pay less in future. Suppose that a storm damages a large part
of the orange crop. Consumers may run out and buy all the oranges they can find in
anticipation that the price of oranges will increase.

6. A Change in the Number of Buyers

Population growth will increase the demand for products because the pool of consumers
has grown. Population decline will have the opposite effect. Look at the baby boom
generation and how they have affected demand for goods over the course of their
lifetimes.

A good way to end is to summarize the lesson. Demand refers to the quantities of a
product that people are willing and able to purchase at a given price during some period
of time. The term quantity demanded refers to a point on the demand curve-- the quantity
demanded at a particular price. A demand curve can be used to illustrate the relationship
between quantity demanded and price.

Summary

When we speak of "demand," we usually mean the entire demand relationship, i.e. the
entire demand curve or table. By contrast, the "quantity demanded" is the particular point
on the demand curve, as shown in figure D below, or the quantity in a particular line of
the table.

Figure D: Demand Terminology




Lesson-7

Supply and Demand-- Supply Analysis

Why is it that farmers are more willing to grow certain crops one year and different crops
the next? The price they receive for the crop they grow determines what seeds the
farmers will sow. The information below will help you to understand the supply side of
the equation.

Supply

What determines the amount of a good or service that people are willing and ready to sell
during some period of time? People sell things because it is a way, indirect but effective,
of obtaining other things that they prefer. Sellers intend to make a profit from their sales,
and economists assume that they want their profits to be as large as possible. Because
profit is the difference between benefits in the form of revenues and costs, anything that
influences revenues or costs can influence the amounts sellers want to sell.

Supply focuses on the producer of goods and services. It refers to the quantities of a
product that producers are willing and able to offer at a given price during some period of
time. Like demand, there are price and non-price determinants for supply. Producers
make decisions on how much to supply based on profitability.

Revenue is calculated by multiplying the price of the product by the amount sold. A
change in price changes revenues, and hence profits. So, it is a major determinant of the
amount sellers will want to sell. Because a higher price leads to higher profit, and a
higher profit leads to a larger amount that sellers will want to sell, one expects that a
greater quantity should be supplied when the price is higher. Thus, the relationship
between quantity that sellers will sell and price should be direct or positive.

Though the positive relationship is almost always the case, there are a few exceptions. An
example is labor. As wages go up, people may decide to enjoy their higher wages and
work less. As a result, there is no law of supply that matches the law of demand.

The cost of something is what must be given up in order to get it. When costs are only
monetary, they are easy to see. If the price of an input increases, the cost of the output
will increase, and, other things held constant, profits will decrease. The seller will then
have to decide if shifting part of his resources and effort to other products will improve
his well-being.

Production costs are determined not only by the prices of inputs, but also by technology.
Technology represents the knowledge of how inputs (such as labor, raw materials, energy
and machinery) can be combined to produce the product. If this knowledge increases so
that people find cheaper ways to make the same output, then, other things held constant,
profit increases and we expect sellers to respond by producing more.

Costs may be non-monetary as well as monetary. For example, a farmer takes the
expected price of soybeans into account in deciding how much corn to plant. If soybeans
are expected to sell for a high price, then the farmer may find that shifting some of his
land from corn production to soybean production will increase profit. The decision to
plant corn means that the farmer gives up the opportunity to plant soybeans (as well as
giving up the money for seed, fuel, equipment and labor). Because we have defined cost
as what must be given up to get something, the prices of other goods that sellers could
otherwise produce and sell must be part of the calculation of the cost of production.

There are other factors that can influence the amount of a product that sellers will sell.
These include the number of sellers, expectations about the future, and whether or not
there are by-products in production that are valuable. An example of a valuable by-
product is cottonseed in the production of cotton. A farmer who produces cotton also gets
cottonseed, which yields cottonseed oil, a widely used vegetable oil. But, the emphasis of
supply is on the relationship between quantity and price. To focus on this relationship, all
other factors must be assumed to be constant.

The supply side of the equation also has a law. The law of supply states that sellers will
offer more of a good at a higher price and less at a lower price.

The Supply Schedule and Supply Curve

The relationship between the quantity sellers want to sell during some time period
(quantity supplied) and price is what economists call the supply curve. Though usually
the relationship is positive, so that when price increases so does quantity supplied, there
are exceptions. Hence, there is no law of supply that parallels the law of demand.

The supply curve can be expressed mathematically in functional form as below:

Qs = f (price, with other factors held constant)

It can also be illustrated in the form of a table or a graph. The tabular representation is
known as “supply schedule,” whereas graphical representation is called “supply curve.”

A Supply Schedule
Price of
Widgets
Number of Widgets
Sellers want to sell
$1.00 10
$2.00 40
$3.00 70
$4.00 140
Table A

The graph shown below in Figure A has a positive slope, which is the slope one normally
expects from a supply curve.

Figure A

For all practical purposes, we assume this curve to be a straight line. Examine the
following curve:

Figure B

A change in quantity supplied occurs when there is a movement between points along a
stationary supply curve. Once again, this movement is influenced by price. This change
can be seen in the graph above with the movement from point A to point B.

There can also be a shift in supply. A shift in supply refers to an increase (rightward
change) or a decrease (leftward change) in the quantity supplied at each possible price.
These shifts are influenced by non-price determinants.

Shift in Supply

If one of the factors that is held constant changes, the relationship between price and
quantity (supply) will change. If the price of an input falls, for example, the supply
relationship may change, as in the following table:

A Supply Curve Can Shift
Price of
Widgets
Number of Widgets
Sellers want to sell
$1.00 [10] becomes 20
$2.00 [40] becomes 60
$3.00 [70] becomes 100
$4.00 [140] becomes 180
Table B

The same changes can be shown with the help of a graph in the following figure:



Figure C

The theoretical purpose will assume the supply curve to be a straight line. This shift in
demand can either be increase or decrease, as shown in the graph in the figure below.

Increase in Demand-- It results from the increase in the price of substitute, increase in
income, or change in taste and preferences etc.

Decrease in Demand-- It results from the decrease in the price of substitute, decrease in
income, or change in taste and preferences etc.


Figure D

The most important distinction to keep in mind is that a change in quantity supplied is a
movement along a single curve, while a shift in supply involves the creation of a second
curve.

Non-Price Determinants of Supply

There are other factors besides price that influence producers to sell products. A brief
description of each is provided below.

1. Change in Technology

New, efficient technology makes it possible to offer more products at any possible selling
price. Technological devices such as computers and robots have made it possible to
reduce production costs and increase the supply of goods and services.

2. Change in Production Costs

A change in the cost of labor, taxes or a resource needed to produce a good impacts the
decisions of sellers on how much to produce.

3. Change in the Number of Sellers

An increase or decrease in the number of sellers can influence the production of goods
and services. If the United States removes a restriction on foreign imports, then there are
more sellers in the market.

4. Change in Supplier Expectations

Expectations of the future can influence the production of goods and services. If prices of
a good or service is expected to rise in the future, sellers may hold back production in the
present in the hope of making more profit by selling more in the future. For example, if
farmers think the future price of the corn will decline, they will increase the present
supply of corn in the hope of making more money now.

Supply Terminology

As with demand, economists separate changes in the amount that sellers will sell into two
categories. A change in supply refers to a change in behavior of sellers, caused because a
factor held constant has changed. As a result of a change in supply, there is a new
relationship between price and quantity. At each price, there will be a new quantity, and
at each quantity, there will be a new price. A change in quantity supplied refers to a
change in behavior of sellers, caused because price has changed. In this case, the
relationship between price and quantity remains unchanged, but a new pair in the list of
all possible pairs of price and quantity is realized.

Supply curves as well as demand curves appear much more concrete on an economist's
graph than they appear in the real markets. A supply curve is mostly potential-- what will
happen if certain prices are charged, most of which will never be charged. From the
buyer's perspective, the supply curve has more meaning as a boundary than as a
relationship. The supply curve says that only certain price-quantity pairs will be available
to buyers which are lying to the left of the supply curve.

The Long and Short Run

The supply relationship will depend on how long the suppliers have to adjust to a change
in the price.

With respect to supply, time plays a role which it does not (in most cases) play in the case
of demand. If there is plenty of time for the suppliers to adjust to a change in the price,
we have a “long run” analysis. This means that the sellers can invest and expand
productive capacity in response to a high price, or can gradually reduce the productive
capacity by under-replacing worn-out equipment in the case of a low price. However, if
the sellers are not sure that the high or low price will continue for a long time, a “short
run” analysis may be more appropriate. In a short run analysis, we treat the plant and
equipment of the industry as inflexibly given. In that case, output can be increased only
by using that fixed plant and equipment more intensively. Thus, we would expect the
adjustment of supply to a change in price to be more complete in the long run than in the
short run.

We do not ordinarily apply the long run versus short run distinction to demand, but there
are some special cases where it might be important. For example, for durable goods such
as cars, buyers might adjust less completely in the short run than in the long, since they
can postpone replacement of their durable goods until the price comes down. In the long
run, the goods wear out and so the consumers cannot postpone replacement for long
enough.

Summary

In the short run, the plant and equipment (productive capacity) of the industry are fixed.
While in the long run, sellers can change the productive capacity in response to the price.