2 - Demand and supply
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Introduction
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Economic systems exist to answer the economic problem, in other words to
facilitate the production, distribution and exchange of goods and services The
key functions of an economic system are the allocation of scarce resources to the
production of goods and services and the distribution of income. Economic systems
vary from ‘free market’ to ‘planned’, but regardless of the type they must all answer
the following fundamental questions:
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• what goods and services to produce (and how much)?
• what resources and methods of production will be used?
• who will consume the goods and services?
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Buyers and sellers might meet face-to-face, but could also exchange goods
and services by mail, telephone, or the internet. Buyers and sellers may also deal
with one another through an intermediary or middle-man, as happens in the
stock market, where transactions are usually handled by brokers on behalf of their
clients. Product markets deal with the buying and selling of goods and services.
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buyers (demand)
sellers (supply)
something to exchange (a good, service or resource)
voluntary exchange
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In this chapter, we outline how these questions are answered in a market economy.
Markets are one way to coordinate economic activity - they allocate resources in
order to resolve the economic problem. Markets help to ration scarce resources to
satisfy the wants of consumers. Markets coordinate economic activity and provide
incentives for both consumers and producers. A market is said to exist when buyers
and sellers exchange goods, services or resources. A market consists of four elements:
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In a product market, consumers represent the demand side of the market, while
firms represent the supply side. Firms produce goods and services and sell them to
households (consumers). Factor markets deal in the buying and selling of factors of
production or resources such as the labour market, the capital market and natural
resource markets. In a factor market, households sell their resources to firms. In
a factor market, households represent the supply side of the market, while firms
represent the demand side.
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Markets can also be classified according to the intensity of competition in the
market. A competitive market is characterised by:
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a large number of buyers and sellers.
very similar products (little product differentiation).
easy entry into the market (no barriers to entry or exit).
little or no variation in price.
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In a competitive market, price is determined by the interaction between buyers
and sellers. No individual buyer or seller can influence the market price - this
means that there is no market power. Firms are called price takers because they
must take the price that is established by the market. There are many examples of
competitive markets - agricultural markets, fruit and vegetables, cafes, newsagents
and dry-cleaners. The small business sector satisfies many of the assumptions of a
competitive market. Any market with a large number of relatively small firms selling
very similar goods and/or services and with easy entry conditions is a competitive
market. A market that is not competitive is called an imperfect or non-competitive
market. A monopoly market would be an extreme type of imperfect market with
just one dominant firm. Firms with market power can set their own price - they are
called price setters. An imperfect market is characterised by product differentiation
and barriers to entry which help to reduce competition in the market.
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The role of prices
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In the market system the four key economic questions are answered by the
price mechanism - the interaction of buyers and sellers in the market. In a market
economy, the consumer is king (consumer sovereignty), meaning that consumers
determine what will be produced, and how much will be produced. Consumers
signal their tastes and preferences to producers by casting their dollar votes when
they buy goods and services. Producers respond to the level of demand signalled by
consumers. For example, in the clothing market, striped shirts may become more
popular than plain shirts. If retailers find that the sales of striped shirts are high and
stocks are falling, they will increase the production of striped shirts. When petrol
prices increase, smaller cars become more popular and car producers will respond
by increasing the production of small cars relative to large cars.
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In the market economy, the how to produce question is answered by producers.
Like consumers, producers are guided by the principle of self interest. To operate
profitably, firms have to operate efficiently and minimise costs. Producers will
compare the prices of inputs when deciding what techniques of production to use.
The market system provides an incentive for the producer to become more efficient
and lower costs in order to increase profits.
2 - Demand and supply
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Price also determines the ‘for whom’ question. The rewards of production reflect
the price which the market is willing to pay for resources. Wages and salaries are
the reward for labour; owners of natural resources receive rent; the owners of
capital receive dividends (or interest in the case of money capital); and the owners
of entrepreneurial skills receive profits. The amount of income earned by resource
owners generally reflects the scarcity of the resource they have provided. Skilled
workers, for example, tend to be paid a higher wage than unskilled workers.
Doctors and engineers will receive a higher income than clerical staff or sales staff.
Elite sportsmen such as Rafael Nadal earn millions of dollars annually because of
their rare sporting skills.
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We will now turn our attention to how competitive markets determine prices. We
will focus on the most important model in microeconomics - the model of demand
and supply.
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Demand
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Demand refers to the buying intentions of consumers. The quantity demanded
of a good or service is the quantity that consumers are willing and able to purchase,
at a particular price and at a particular time. Demand is not the same thing as a
want. Many people may want a luxury yacht, but only a few are willing and able to
purchase the yacht. Demand refers to the actual buying intentions of consumers. I
might want a Rolls Royce car, but I actually purchase a Honda Civic because that is
what I can afford.
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An important law in economics is the law of demand. As the price of a good
rises, people buy less of it, ceteris paribus (holding other factors constant). The law
of demand describes a negative relationship between price and quantity demanded.
What is the explanation for the law of demand? There are two important reasons.
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The income effect - when the price of a good rises, consumers are not willing
to buy as much of the good because their real income or purchasing power has
decreased. If you have $100 in income and the price of pizza is $10 then your real
income is 10 pizzas. If the price of pizzas increases to $20, then your real income
halves to just 5 pizzas. When your real income falls you are poorer and therefore you
will purchase less. The income effect works in both directions - when the price of a
good falls, your real income rises and you will purchase more.
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The substitution effect - when the price of one good rises, other goods become
more attractive to buyers because they are relatively cheaper. An increase in price
will cause consumers to switch to relatively cheaper substitutes. For example, an
increase in the price of pizza will cause some consumers to switch to other types
of fast food. On the other hand, a decrease in the price of pizza, will now make
substitute goods relatively more expensive and consumers will purchase more pizza.
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Notice that both the substitution effect and the income effect work together to
reinforce the law of demand. Are there any exceptions to the law of demand? The
simple answer is No! The law of demand holds for all goods and services - as long
as the ceteris paribus condition holds. Don’t be fooled by people who claim that
there are exceptions to the law of demand. For example, it is often argued that if a
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consumer buys an expensive brand rather than a cheap brand, this violates the law
of demand. This is incorrect because we are dealing with two different goods. The
consumer may use price as a signal of quality and have a preference for the more
expensive brand. To break the law of demand, the consumer when given a choice
of buying the same good at two different prices chooses to pay the higher price.
For example if you decide to purchase an item for $50 but the sales person says
that it has a special 20% discount, reducing its price to just $40. Would you refuse
the discount? If you said to the sale person that you wanted to pay full price, then
you would be breaking the law of demand. In other words, you would be a ‘stupid
irrational person’!
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Of course, the law of demand varies in strength between different types of goods
depending on how strong the income and substitution effects are. For example, the
law of demand for petrol will be relatively weak. There are few close substitutes for
petrol. If the price of petrol increases, consumers will find it difficult to substitute
away from petrol. The law of demand for orange juice will be much stronger.
There are many close substitutes for orange juice such as apple, pineapple, guava
and grape juice. If the price of orange juice increases, then consumers can readily
substitute into another fruit juice.
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Figure 2.1 shows a demand schedule and a demand curve for pizza. A demand
schedule is simply a table showing the quantity demanded of a good consumers
are willing to purchase at various prices. Figure 2.1 shows the weekly quantity
of pizzas that consumers are willing to buy at various prices. It is called a market
demand schedule because it is the summation of all the individual consumers in
the market. As we would expect, rational consumers are willing to buy more pizzas
at lower prices than they are at higher prices. We can convert the data from the
schedule to a graph known as the market demand curve for pizza.
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The graph’s axes represent price on the Y axis, and quantity demanded on the
X axis. Note that the demand curve is negatively sloped (downward sloping to
the right) reflecting the law of demand. There are other factors apart from price,
however, which may affect the demand for a good or service. These are all the factors
that were held constant (ceteris paribus conditions) in deriving the demand curve.
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Price ($)
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Demand schedule
Price ($)
Quantity
demanded
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The demand curve
The demand schedule and graph
illustrate the Law of Demand - price
and quantity demanded are negatively
related, ceteris paribus. As price rises,
quantity demanded falls.
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Figure 2.1
2 - Demand and supply
Non-price factors affecting demand include the consumer’s disposable income, the
prices of related goods (e.g. substitutes and complements), the tastes and preferences
of consumers, consumer expectations and demographic (population) factors.
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Non-price factors affecting demand
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Price is an important but not the only determinant of demand. The demand
curve shows that quantity demanded is a negative function of price, but there are
non-price determinants such as
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Income of consumers
Prices of related goods
Preferences of consumers
Expectations of consumers
Demographic and other factors
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Levels of disposable income
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Consumers will normally purchase more of a good when their income increases.
Most goods in the economy are referred to as normal goods. A normal good is
defined as one where demand increases as income increases. An inferior good is a
good where demand decreases as income rises. An example of an inferior good is a
very low quality product such as a ‘plain wrap’ or ‘home’ brand product.
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The price of related goods
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On most occasions, consumers can choose between a number of goods and
services which satisfy the same wants. These are referred to as substitutes. For
example, there is a wide range of fast food products on the market other than pizza.
Consumers for example, can choose from chicken, hamburgers, kebabs, noodles,
or fish and chips - the list is very long and varied. If the price of pizza rises, the
quantity demanded of pizza will fall and consumers will increase their demand for
other types of fast food. There are many other examples of substitute goods such as
tea and coffee, butter and margarine, orange and apple juice.
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Many goods are also consumed with other goods - these goods are called
complements. For example, computers require software; filing cabinets require
document folders; cars require petrol; and the playing of tennis requires courts,
racquets and balls. You might like to consume pizza with garlic bread or with a bottle
of coke. If the price of pizza rises, the quantity demanded of pizza will fall, and the
the demand for complement goods, such as garlic bread will decrease. Similarly,
a rise in the price of computers will lead to a decrease in the demand for software
while a decrease in the price of cars will lead to an increase in the demand for petrol.
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The tastes and preferences of consumers are an important determinant of consumer
demand. The advertising industry attempts to affect consumers’ preferences through
persuasion and information. Consumers have quickly embraced products such as
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Tastes and preferences
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fast food, mobile phones, MP3 players and digital cameras. Plasmas and LCDs have
quickly replaced television sets. Cassettes replaced vinyl records and then were
superseded by compact discs (CDs). Sales of CDs have now declined dramatically
as consumer preferences shift towards MP3 players. Many consumers now indicate
a preference for environmentally friendly ‘green’ products.
Expectations of consumers
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If people expect conditions to change in the future, they may make decisions now
rather than postpone them. For example, if the price of cars is expected to rise next
year, perhaps because of rumours of a new tax, consumers may decide to purchase
now to beat the price rise. This is rational behaviour. Expectations of a future price
rise will increase the current demand for the product. If you expected the price of
petrol were to fall next week, then you would decrease your current demand for
petrol and wait for the price to fall.
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Demographic factors
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The size and age composition of the population can have an important bearing
on the pattern of demand. A growing population increases the market size for all
goods and services whereas a change in the age profile will affect specific goods and
services. For example, as the Australian population ages, the demand for child care
facilities will decrease relative to the demand for retirement facilities.
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Changes in demand
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We distinguish between two types of changes in demand:
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• a movement along the curve.
• a shift of the entire curve.
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These changes are shown in figure 2.2. A change in the price of the good itself will
lead to a movement along the demand curve. A change in price will cause a change
in quantity demanded. For example, an increase in the price of a good will cause
a decrease in quantity demanded whereas a fall in price will cause an increase in
quantity demanded. It is important to remember that when price changes, we move
along the curve. A change in price cannot shift the curve.
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Changes in any of the other non-price (ceteris paribus) factors affecting demand
will cause a shift in the entire demand curve. When non-price factors change, the
result is a new demand curve. There are two types of shifts - an increase in demand
occurs when the demand curve shifts to the right; a decrease in demand occurs
when the demand curve shifts to the left (refer to panel b in figure 2.2). An increase
in demand, for example, might result from any of the following events:
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an increase in consumer income (for a normal good).
a decrease in consumer income for an inferior good.
a fall in the price of a complementary good.
an increase in the price of a substitute good.
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2 - Demand and supply
Price
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Price
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Movements
Decrease in Qd
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Increase
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Increase
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A change in the price of a
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Quantity
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A change in a non-price
factor affecting demand will
bring about a change in
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Changes in demand
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Figure 2.2
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Supply
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• a change in tastes and preference in favour of the good.
• the expectation that price will rise in the future.
• an increase in the number of consumers in the market.
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Supply represents the sellers or producers side of the market. Supply is the amount
of a good or service that producers are willing and able to sell at a particular price
and at a particular point in time. The relationship between the quantity supplied and
the price of a good is a positive one. The law of supply states that as the price of a
good or service rises, the quantity supplied will also rise. Notice that this is opposite
to the law of demand. The law of supply also assumes that all non-price factors that
may affect supply are held constant - the ceteris paribus assumption.
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Figure 2.3 (see over) depicts the supply schedule and the supply curve for
pizzas. The supply curve is positively sloped, reflecting the law of supply. What
is the economic reason for the law of supply? Rational, self-interested producers
would prefer to sell their output at a high price than at a low price because of the
profit motive. If you are selling a good or service you would prefer to sell at the
highest price possible. When firms increase their output they may also find that their
production costs may increase which would require price to rise to maintain their
profit margin.
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What are the other key determinants of supply? The most important factors are
the prices of inputs; prices of other goods the firm can produce; technology; the
number of sellers; and expectations of producers.
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Non-price factors affecting supply
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Price
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Supply schedule
Price ($)
Quantity
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The supply schedule and graph
illustrate the Law of Supply price and quantity supplied are
positively related, other things
being equal. As price rises,
quantity supplied rises.
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Figure 2.3
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Quantity (’000)
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The supply curve
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Prices of inputs
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The price of resources such as labour, capital and raw materials determine the
firm’s costs of production. A supply curve can be thought of as a cost curve for the
firm. Usually, a firm’s largest costs are wages and salaries and the cost of purchasing
raw materials. An increase in production costs will mean that for a given price, the
firm will decrease its production.
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Prices of other goods
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Production is a process which involves combining productive resources to
produce a final good. In many cases the same resources could be used to produce
other goods. The producer will closely monitor movements in the prices of the goods
he is capable of supplying so that he can take advantage of profit opportunities.
In agriculture, for example a farmer may shift resources from wheat production to
wool if the price of wool rises relative to wheat. A car manufacturer will decrease
the supply of large cars if small cars become more popular.
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Technology
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Technology is knowledge about the techniques of production. If technology
improves, then more output can be produced from the same quantity of resources.
This means that the firm’s costs of production will fall. Other things being equal, an
improvement in technology will result in an increase in supply. The supply curve
will shift to the right. The cost of many products including computers, household
appliances and electronic devices has continuously fallen over time as a result of
improvements in technology.
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Suppliers expectations of future conditions may affect the quantity supplied. If a
higher price is expected in the future, then firms will decrease their current supply
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Expectations of producers
2 - Demand and supply
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in order to take advantage of future higher prices. Firms will make decisions about
investing in plant and machinery on expected future prices. Expected high prices for
oil for example, will encourage increased exploration. Similarly if a firm expected a
labour strike, it might increase current production so that future supply will not be
affected.
Changes in supply
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There are two types of changes in supply:
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• A movement along the supply curve
• A shift of the entire supply curve
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These changes are shown in figure 2.4. Changes in the price of the good itself will
lead to a movement along the supply curve. A change in price causes a change in
quantity supplied. An increase in the price of the good will cause an increase in the
quantity supplied while a fall in price leads to a decrease in the quantity supplied.
It is important to remember that when price changes, we move along the curve. A
change in price cannot shift the curve.
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Changes in any of the other non-price factors affecting supply will cause a shift in
the whole supply curve. These factors were all held constant when the initial supply
curve was drawn. Allowing these factors to change will result in a new supply curve.
There are two types of shift - an increase in supply occurs when the supply curve
shifts to the right; a decrease in supply occurs when the supply curve shifts to the
left. An increase in the supply of a good will result from any of the following events:
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• An improvement in technology
• A decrease in production costs (input prices)
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Figure 2.4
Changes in supply
Increase
in Qs
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20
30
40
A change in the price of a
good causes changes in
quantity supplied.
Increase
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Quantity
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A change in a non-price
factor affecting supply will
bring about a change in
supply.
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Quantity
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Shifts
Price
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Movements
Price
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• The expectation that prices will fall in the future
• An increase in the number of producers in the market
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A market consists of both buyers (demand) and sellers (supply). To determine
the market price and quantity we combine the demand and the supply curve on the
one graph.
Equilibrium price and quantity
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The price that clears the market is referred to as the equilibrium price. This is the
price that balances the buying intentions of consumers with the selling intentions
of producers. Figure 2.5 brings the two sides of the market (demand and supply)
together. The equilibrium price and quantity will be where quantity demanded
equals quantity supplied. This will be the price where the demand curve intersects
with the supply curve.
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It is important to understand how the market will automatically achieve the
equilibrium price and quantity. Suppose that the price of pizzas happened to be
$12. At this price, sellers are offering a quantity of 50,000 for sale, while buyers only
wish to purchase 10,000. There is an excess supply or surplus of 40,000 pizzas. The
price is too high to clear the market. Sellers will want to eliminate the surplus by
lowering prices. As prices fall, more consumers will want to purchase so that the
excess supply will be eliminated. As long as there is a surplus, the price will keep
falling until it reaches $8. If the price happened to be $4, then a market shortage of
40,000 pizzas would exist. At this price, quantity demanded would be 50,000 pizzas,
while quantity supplied would equal only 10,000 - a condition of excess demand.
Buyers would bid among themselves for the limited supply and price would rise to
eliminate the shortage. As the price rises, quantity demanded falls, while quantity
supplied rises until the price reaches $8.
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Only when the price of pizzas was $8 would quantity demanded exactly match
quantity supplied - 30,000 pizzas. At this price there is neither a surplus nor a
shortage. The market is said to be in equilibrium. The word equilibrium means a
state of balance or no tendency to change. Any other price/quantity combination
will automatically cause both the price and quantity to change in the direction of
equilibrium. Excess supply forces prices down while excess demand causes prices
to rise. These pressures for change are known in economics as the ‘invisible hand
of the market’ - a term coined by Adam Smith. A more modern term is the price
mechanism.
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Prices are always adjusting in competitive markets in response to changes in
demand and supply conditions. Changes to the market will create either temporary
shortages or surpluses which will then cause price to change to re-establish a new
equilibrium. The length of time required to eliminate shortages and surpluses
though will vary from one market to another. In the share market, prices change
very quickly to find a balance between buyers and sellers. The price of the Australian
dollar in the foreign exchange market changes by the minute to balance supply and
demand factors. In fruit and vegetable markets, prices adjust daily in response to
supply and demand conditions. These are both examples of competitive markets.
As long as a market is able to operate freely, prices will always adjust to balance
demand and supply.
2 - Demand and supply
Price
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12
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Surplus
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Equilibrium
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Shortage
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Price
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Price and quantity
Quantity
Quantity
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supplied
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schedules
Result
surplus
surplus
no change
shortage
shortage
Effect on
price
fall
fall
no effect
increase
increase
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Quantity (’000)
Figure 2.5
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Market equilibrium
Changes in demand and supply
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Why do prices in markets fluctuate? The reason is that either demand conditions
change which shifts the demand curve or supply conditions change which shifts the
supply curve. Remember, a given demand curve and supply curve will establish
a unique equilibrium price and quantity, but if the demand curve or the supply
curve shift, then a new equilibrium will be established. We can refer to four types
of changes to a market equilibrium, because both the demand curve and the supply
curve can increase (shift to the right) or decrease (shift to the left):
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an increase in demand.
a decrease in demand.
an increase in supply.
a decrease in supply.
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Increase in demand
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For each of these changes, we need to analyse the impact on equilibrium price
and quantity.
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Imagine a new medical report that announced that pizza consumption improved
your intelligence. This would lead to an increase in demand for pizzas - the demand
curve for pizzas will shift to the right, as consumers’ preferences change (see Figure
2.6, panel a). At the original equilibrium price of $8, quantity demanded will now
exceed quantity supplied. This excess demand for pizzas will cause the price to rise to
a higher equilibrium where the new demand curve intersects with the supply curve.
At the higher price, quantity supplied will increase. So an increase in demand will
result in an increase in the equilibrium price and equilibrium quantity. Whenever
you see rising prices and rising sales in a market, then you know that demand for
the good is increasing.
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Discovering Economics
Increase in demand
Decrease in demand
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Price
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12
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Price
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Quantity (’000)
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10
6
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40
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Quantity (’000)
10
20
30
40
50
Quantity (’000)
An decrease in supply will result in
an increase in price and a fall in equilibrium
quantity. Here, price rises to $9, and
quantity sold falls to 25,000.
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An increase in supply will cause an
increase in equilibrium quantity and
a decrease in price. Here, Q has
increased to 35,000 while P has fallen
to $7.
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Price
$
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Decrease in supply
S
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A decrease in demand causes
both price and quantity sold to fall.
Price has decreased to $7 and quantity
has fallen to 25,000 pizzas.
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Price
$
12
10
10
D
Changes in equilibrium
Increase in supply
0
D1
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40
50
Quantity (’000)
An increase in demand causes
both price and quantity sold to rise.
Price has increased to $9 and quantity
has risen to 35,000 pizzas.
Figure 2.6
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2 - Demand and supply
Decrease in demand
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Imagine if it was reported that pizza consumption was a cause of cancer. Now
consumers would change their preferences away from pizza. This would lead to
a decrease in the demand for pizza (see Figure 2.6, panel b). The demand curve
would shift to the left. The equilibrium price of pizza would fall and the equilibrium
quantity of pizza would also fall. Whenever you see prices and quantities falling in
a market, then you can safely assume that demand for the product is decreasing.
e
pl
Increase in supply
ig
yr
op
-c
A change in production costs or technology are important factors that can shift
the supply curve. Suppose that a new pizza oven is created which reduces the time
to cook pizza helping to lower production cost. This will cause the supply curve to
shift to the right - an increase in supply (see Figure 2.6, panel c). Pizza producers will
now be able to supply more pizzas for the same cost. The equilibrium price will fall,
while the equilibrium quantity will rise - the intersection of the new supply curve
will the demand curve. Price has fallen to $7 and quantity has increased to 35,000.
Decrease in supply
ht
tic
c
Ta
Suppose there was an increase in the price of mozzarella cheese - a key ingredient
in producing pizzas. This would increase the cost of making pizza and would cause
the supply curve to shift to the left - a decrease in supply (see Figure 2.6, panel d).
The new equilibrium will be where the new supply curve intersects with the original
demand curve - price will rise while quantity sold will fall. In our example, price has
increased to $9, while quantity has fallen to 25,000.
Pu
Simultaneous shifts in demand and supply
ns
io
at
ic
bl
When a single curve shifts, our model of demand and supply makes it relatively
easy to predict the movement in price and quantity. However, what will happen
to equilibrium price and quantity if both curves shift at the same time? While this
is more complex, our model can still be used to analyse the changes to price and
quantity. For example, if we combine an increase in demand with an increase in
supply (Figure 2.7, panel a), then the equilibrium quantity must increase, but the
equilibrium price may rise, fall or stay constant - it is indeterminate. This is because
an increase in demand pushes price up while an increase in supply pulls price down.
What happens to price will depend on the relative shift of each curve. If the demand
curve shifts more than the supply curve, then the equilibrium price will rise. If the
supply curve shifts by more, then the equilibrium price will fall. In our example,
both curves have shifted the same amount so that the equilibrium price has not
changed. An excellent example is the computer market. The demand for computers
has been increasing over time, while the cost of making computers has been falling.
The supply curve has been increasing faster than the demand curve so that prices of
computers have actually been falling despite the large increase in demand.
1
1
20
Let’s examine another case of a simultaneous shift. Panel b in Figure 2.7 shows
the impact of an increase in demand combined with a decrease in supply. In this case
35
Discovering Economics
Price
$
12
S
10
Sa
S1
Price
$
12
S2
S
10
8
8
m
6
pl
4
e
10
20
-c
0
30
D1
6
D
4
40
50
Quantity (’000)
Figure 2.7
D
0
10
20
30
40
50
Quantity (’000)
An increase in demand and a decrease
in supply will result in price rising but the
effect on quantity is indeterminate - in this
example, P has increased to $10 while Q has
remained at 30,000.
Simultaneous shifts in demand and supply
ht
ig
yr
op
An increase in demand and supply
will cause quantity sold to rise but the
effect on price is indeterminate - in this
example, Q has increased to 40,000
while P has remained at $8.
D2
tic
c
Ta
equilibrium price must increase, but equilibrium quantity is now indeterminate.
This is because an increase in demand increases quantity while a decrease in supply
decreases quantity. Quantity may increase, decrease or remain constant - it will
depend on the relative shifts of the curves. If the demand curve shifts more than
the supply curve, then the equilibrium quantity will rise. If the supply curve shifts
by more, then the equilibrium quantity will fall. In our example, both curves have
shifted the same amount so that the equilibrium quantity has not changed. During
2008, the world demand for oil was increasing while supply was decreasing - this
resulted in a substantial increase in the world price of oil.
Pu
ic
bl
Figure 2.8
Effect on Quantity
Increase in Demand and
Increase in Supply
Indeterminate
Increase
Increase in Demand and
Decrease in Supply
Increase
Indeterminate
Decrease in Demand and
Increase in Supply
Decrease
Indeterminate
Decrease in Demand and
Decrease in Supply
Indeterminate
Decrease
1
1
20
36
Effect on Price
ns
Type of Shift
io
at
Predicting price & quantity
2 - Demand and supply
m
Sa
Figure 2.8 summarises the effects on price and quantity of simultaneous shifts in
both demand and supply. Notice that when both curves shift, it is possible to only
predict what will happen to either price or quantity but not both. Only if we have
more information about the size of the relative shifts of each curve can we predict
the outcome on both price and quantity. For example, if there was an increase in
demand for pizza which was greater than a decrease in supply, then both price and
quantity would increase.
pl
Demand & supply - a case study
e
In 2006, Cyclone Larry devastated Australia’s banana industry. It destroyed over
$300 million of Queensland’s banana crop. Queensland accounts for around 95 per
cent of Australia’s banana production. What would we predict would happen to
banana prices and sales? Using our model of demand and supply we would show
the effect of Cyclone Larry as a large decrease in supply. The supply curve for
bananas would shift to the left resulting in a large increase in banana prices and a
significant decrease in banana sales. This is shown in figure 2.9.
yr
op
-c
ht
ig
The cyclone would be an example of a supply factor, not a demand factor. Is there
a shift in the demand curve? The answer is no! The supply curve shifts and we move
up along the demand curve. If a news report told you that a cyclone was approaching,
would you immediately have a craving for bananas? Would eating bananas protect
you from a cyclone? The answer is no - the demand curve for bananas does not shift!
Do not make the mistake of thinking that if banana prices increase this will cause
a decrease in the demand for bananas and shift the demand curve to the left. It is
important to remember that a change in price cannot shift the curve - only a change
in one of the ceteris paribus factors can shift the curve.
tic
c
Ta
Pu
Figure 2.9
The banana and apple markets
bl
The banana market
Price
$
S1
ns
io
S
P2
P2
P1
D2
D
Q2
Q1
Quantity
Cyclone Larry destroyed banana
plantations in Queensland. This caused
a large decrease in supply - increasing
prices and decreasing quantity sold.
0
Q1
Q2
Quantity
The rise in price of bananas causes
the demand for apples (a substitute
good)to increase - apple prices and sales
both rise.
1
0
D
1
20
P1
S
at
ic
Price
$
The apple market
37
Discovering Economics
m
Sa
What did banana consumers do in response to banana prices tripling? They
obviously stopped buying bananas, and looked for a substitute fruit. Is there a close
substitute for bananas? Yes, Australian consumers actually increased their purchases
of apples! Apples certainly don’t look or taste like bananas - they are generally red,
round and firm rather than yellow, long and squishy. But Australian consumers did
switch to apples as their replacement fruit. In the apple market, there was a large
increase in the demand for apples resulting in apple prices and sales both increasing.
This is exactly what our model would predict.
e
Exercises
pl
Worksheet
What are the key questions an economics system must answer?
Explain the four elements of a market.
Distinguish between a product market and a factor market.
What are the characteristics of a competitive market?
Explain the role of price in a market economy.
Define demand.
State the law of demand.
What is the income effect?
What is the substitution effect?
List the main non-price factors affecting demand.
Explain the difference between a normal good and an inferior good.
Explain the difference between a substitute good and a complement good.
How does a change in price affect demand?
How does a change in a non-price factor affect demand?
What effect would an increase in income have on demand?
Define supply.
State the law of supply.
What is the reason for the law of supply?
List the main non-price factors affecting supply.
How does a change in price affect supply?
How does a change in a non-price factor affect supply?
What effect would an increase in costs have on supply?
When is the market in equilibrium?
How does the market respond to a shortage?
How does the market respond to a surplus?
Explain what happens to equilibrium price and quantity for each of the
following:
a. An increase in demand
b. A decrease in supply
e. An increase in demand and a decrease in supply.
ht
ig
tic
c
Ta
Pu
ns
io
at
ic
bl
yr
op
-c
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
Data interpretation
1.
38
Quantity
demanded (Kg)
600
500
400
300
200
100
Quantity
supplied (Kg)
100
200
300
400
500
600
1
2.
Graph the demand and supply
curve and determine the
equilibrium price and quantity.
If the price was set at $2 per
kg would there be a shortage
or surplus of bananas? What
would happen to the market
price?
Price per
Kg $
1
2
3
4
5
6
1
20
The table refers to the banana
market.
2 - Demand and supply
3.
4.
Sa
5.
If the price was set at $5 per kg would there be a shortage or surplus of
bananas? What would happen to the market price?
If the price of a substitute fruit increased, what would happen in the
banana market? What curve would shift and what would happen to the
price and quantity sold of bananas?
If the government introduced a new banana tax, show the impact on the
banana market and explain the effect on price and quantity.
m
Demand and supply - the market for cars
The graph in the left panel shows the demand curve for cars. For each of
the cases below, indicate whether there will be a change in demand (shift
- increase or decrease) or a change in the quantity demanded (movement
- expansion or contraction)
e
pl
1. -c
$
$
$
S
S
ht
ig
yr
op
D
Qty
D
Qty
Qty
a. b. c. d. e. f. 2. The graph in the middle panel above shows the supply curve for cars.
For each of the cases below, indicate whether there will be a change in
supply (shift - increase or decrease) or a change in the quantity supplied
(movement - expansion or contraction)
a. The price of oil increases.
b. The price of steel decreases.
c. Robotics are introduced on car assembly lines.
d. The demand for cars increases.
e. The price of cars falls.
f. Tariffs (import taxes) on cars are reduced.
ns
io
1
The graph in the right panel shows the combined demand and supply
curves.
a. What factors could cause the market price of cars to increase?
b. Illustrate the impact of a recession on the car market. What would happen to the market price and quantity.
c. If both demand and supply both increased what would happen to price & quantity?
d. If demand increased and supply decreased, what would happen to price & quantity?
e. The real price of cars has fallen over time even though the demand for cars has increased? How can this be explained?
1
20
at
ic
bl
Pu
3.
tic
The price of petrol increases.
The price of public transport increases.
Real incomes increase.
The supply of cars increases.
The price of cars falls.
The price of cars is expected to rise in 6 months time.
c
Ta
39
Discovering Economics
Case study - unstable oil prices
Read the article below.
m
Sa
Oil prices have hit record highs in recent years reaching levels above $150 a barrel. Why
do oil prices fluctuate so much?
Economists will tell you that prices are set by supply and demand and, indeed, at the
heart of the rise in oil prices are what are known as the fundamentals.
Global demand for oil has been growing as Asia’s power-house economies such as China
and India fuel their rapid economic expansion. There are many factors that influence the
demand for oil. At the same time, there are all sorts of worries about the supply of oil. A lot
of the world’s oil comes from somewhat unstable countries, such as the middle East and
Africa, so every time oil workers are attacked in Nigeria or Iraqi oil facilities are damaged,
people get concerned about the supply of oil.
So fundamentally, people are worried that demand may be growing faster than supply,
and oil is such an important commodity that they are prepared to pay more and more for it
if they are worried.
e
pl
ig
yr
op
-c
Questions.
Use the models to
show how the world
oil price can increase.
Either the demand
curve must ________
or the supply curve
must ________. 2.
What factors could
increase the world
demand for oil?
Petrol Market
$
S
S
ht
1.
World Oil Market
$
tic
c
Ta
D
D
Pu
Qty
Qty
What factors could
decrease the world supply of oil?
4.
What effect does an increase in the price of oil have on the petrol market.
Show the impact using the demand/supply model in the second diagram.
Which curve shifts and in which direction? What happens to the price of
petrol?
5.
Explain the effect the rise in price of petrol will have on the following:
SUVs; scooters; hybrid vehicles; public transport
6.
How will an increase in oil prices affect the price of most goods and
services in the economy?
7.
In 2009, the global financial crisis resulted in a world recession. How
would this affect the price of oil. Use a diagram to explain your answer.
ns
io
at
ic
bl
3.
1
1
20
40
2 - Demand and supply
Case Study - Wine Market
m
Sa
e
pl
The wine industry took off in Australia in the 1990s as the demand for wine
increased. Wine is generally viewed as a luxury consumer good and as incomes
have risen, so too has the demand for wine, especially premium wine. But high
prices and profits led to a surge in new wineries being established. The wine
industry is a good example of a competitive market - a large number of producers,
similar products and relatively low entry barriers. With increased plantings of
grapes, wine prices fell due to a surplus of grapes on the market. Good news for
wine consumers but bad news for wine producers. Many small wine producers are
now finding it difficult to survive in the market.
-c
Questions
2.
ht
c
Ta
5.
S
ig
4.
Wine Market
$
yr
3.
Is wine likely to be a normal good or an inferior
good?
Why has the demand for wine increased? Use the
demand/supply model to show how this increases
price.
High profits have attracted more producers into
the wine market. Which curve will this shift demand or supply - and in which direction?
Show how a surplus in the market will cause price
to fall.
‘If the price of grapes falls, this will lead to an
increase in demand which will push prices back
up.’ What is wrong with this statement?
op
1.
D
Qty
Questions
tic
Fish becoming a luxury product?
Pu
Would declining fish stocks shift the demand curve or the supply curve for
fish? In which direction? Draw a diagram and show the impact on price
and quantity.
2.
What is happening to the cost
of supplying fish? How would
this affect the price of fish?
3.
Fish prices usually increase at
Christmas time. Explain why
using a demand/supply model.
4.
Why do the prices of other
foods such as chicken and
beef remain relatively stable
compared to fish?
bl
1.
ns
io
at
ic
Fish in Western Australia
may become too expensive for
the average family to afford. Fish
and chips was once viewed as
a relatively inexpensive family
takeaway meal. But this Aussie
favourite may soon be priced out
of the market. Fish stocks are
falling and the costs of obtaining
fish are increasing. Fish species
such as Dhufish and Pink Snapper
are being depleted rapidly which
is causing their price to escalate.
Sellers say that it is too expensive
to sell fish like Dhufish. Due to its
short supply it had become a real
luxury product that few customers
could afford.
1
1
20
41
Discovering Economics
Fresh food versus fast food
m
Sa
Consumers are moving from junk food to crunch food
with the biggest growth in sales of fruit and vegetables
in 20 years. Families are also turning their back on
fizzy drinks, sweets and fast-food, a Government study
shows. But while people’s health may be benefiting, their
bank balances may suffer. Vegetable and fruit prices are
subject to large weekly fluctuations in price, depending on
seasonal factors. For example, adverse weather conditions
such as frost, and/or heatwaves can cause steep
increases in price.
e
pl
op
-c
Questions
Explain why consumer preferences have shifted to eating more fresh fruit
and vegetables and less soft drink, fast food and sweets.
ig
yr
1.
Show the change in preferences on the two diagrams below. Explain the
impact on price and quantity.
3.
How does adverse seasonal weather affect fruit and vegetable prices?
Is this a supply or demand factor? Which curve will shift and in which
direction. Show the impact on the fruit/vegetable market.
4.
If demand for fresh fruit increases and at the same time supply
decreases, what will happen to price and quantity? If we know that
quantity sold has actually increased then this must mean that demand has
increased ______ than supply has decreased. Show this on your diagram.
ht
2.
tic
c
Ta
Fresh fruit and vegetables
$
Fast food
S
D
Multiple Choice
42
All of the following will cause a shift of the demand curve for a good
except
a. a change in income.
b. a change in the price of the good.
c. a change in the price of a closely related good.
d. a change in preferences.
1
1.
Qty
1
20
Qty
D
ns
io
at
ic
bl
S
Pu
$
2 - Demand and supply
2.
A demand curve is usually drawn on the assumption that
a. demand is not affected by the price of the good.
b. factors influencing demand other than price are held constant.
c. consumers buy whatever they want.
d. people buy more of a good when its price is raised.
Sa
If the
a. b. c. d. 4.
Mrs Smith recently announced that she was becoming a vegetarian and eliminated meat from her diet. Her behaviour represents
a. a change in her demand for meat.
b. a movement to the end of her demand curve for meat.
c. a reaction to higher meat prices.
d. a movement to the end of her demand curve for vegetables.
5.
A shift to the left of a demand curve could be due to a
a. rise in the price of a complement.
b. rise in the price of a substitute.
c. fall in the price of the good.
d. fall in the quantity supplied.
6.
If goods A and B are close substitutes, an increase in the price of good A would cause
a. the demand curve for good A to shift to the right.
b. the demand curve for good A to shift to the left.
c. the demand curve for good B to shift to the right.
d. the quantity demanded of good B to increase.
7.
The discovery of an improved production technique would result in
a. A movement upwards along the supply curve.
b. A movement downwards along the supply curve.
c. A shift to the left to a new supply curve.
d. A shift to the right to a new supply curve.
8.
Which of the following pairs could be considered complements?
a.
coffee and tea.
b.
oranges and apples.
c.
bread and butter.
d.
coke and pepsi.
9.
Which of the following is not a factor affecting demand?
a.Price.
b.
Consumer income.
c.
Consumer preferences.
d.
Number of sellers.
10.
“Market equilibrium” is achieved
a. only after government intervention.
b. at a price at which quantity demanded equals quantity supplied.
c. when there is an equal number of buyers and sellers in the market.
d. when there is no shortage of the commodity.
m
3.
e
pl
price for a product rises, then, ceteris paribus
supply will increase (supply curve will shift to the right).
the demand curve will shift to the left.
quantity supplied will rise.
quantity demanded will rise.
ht
ig
yr
op
-c
tic
c
Ta
Pu
ns
io
at
ic
bl
1
1
20
43
Discovering Economics
m
Sa
If quantity demanded exceeds quantity supplied then
a. price will fall.
b. price will rise.
c. price is at equilibrium.
d. the demand curve will shift to the right.
12.
An increase in quantity supplied would be shown graphically as a:
a. movement along a supply curve.
b. rightward shift of a supply curve.
c. leftward shift of a supply curve.
d. movement along a demand curve.
13.
Assume that apples and oranges are substitutes. If there is an increase in
the supply of oranges, this will a. shift the demand curve for apples to the right.
b. shift the demand curve for oranges to the right. c. increase the price of apples.
d. decrease the price of apples.
e
pl
11.
op
-c
If a surplus exists in the market for pizzas, an economist would predict
that
a.
the price of pizzas will rise.
b.
producers will increase the production of pizzas.
c.
the supply of pizzas will increase.
d.
the price of pizzas will fall.
1
1
20
44
Suppose that there is a decrease in the fees charged to play golf at all golf courses. What effect will this have on the market for golf balls?
a.
A decrease in supply.
b.
An increase in supply.
c.
A decrease in demand.
d.
An increase in demand.
ns
io
18.
at
ic
17.
Which of the following wold cause a decrease in the demand for tennis balls?
a.
A rise in the price of tennis rackets.
b.
A rise in the price of tennis balls.
c.
A rise in the price of golf clubs.
d.
A fall in the price of tennis shirts.
bl
Pu
16.
tic
15.
c
Ta
ht
ig
If buyers’ tastes changed in favour of pizza, and there was a simultaneous improvement in pizza cooking technology, we would expect
a. a shift to the right of both the demand and supply curves and an increase in both price and quantity.
b. a shift to the right of both the demand and supply curves and a decrease in both price and quantity.
c. a shift to the left of both the demand and supply curves with an increase in price and a decrease in quantity.
d. a shift to the right of both the demand and supply curves with an increase in quantity and either a rise or a fall in price.
A normal good is defined as a good for which demand increases as
a.
its price decreases.
b.
the price of a substitute increases.
c.
the income of consumers increases.
d.
the number of consumers of the good increases.
yr
14.
2 - Demand and supply
19.
Sa
m
20.
If both the demand and supply of a good increased, it could be predicted
that
a.
equilibrium price and equilibrium quantity will increase.
b.
equilibrium price and equilibrium quantity will decrease.
c.
equilibrium quantity will increase but equilibrium price may rise or fall.
d.
equilibrium price will increase but equilibrium quantity may rise or fall.
-c
e
pl
During 2007, the price of housing in Perth increased and the quantity sold also increased. This implies that
a.
the law of demand does not work.
b.
the supply of housing must have increased.
c.
the demand for housing must have increased.
d.
the demand for housing is upward sloping.
The market price of a good tends to rise when demand:
a. and supply both decrease.
b. decreases, while supply increases.
c. increases, while supply decreases.
d. and supply both increase.
22.
If jeans become less popular while cotton prices soared, we could expect:
a. higher prices for jeans.
b. lower prices for jeans.
c. lower quantities of jeans.
d. higher quantities of jeans.
23.
An increase in the demand for bananas combined with an increase in the
supply of bananas will cause the market:
a. quantity to decrease.
b. price to decrease.
c. quantity to increase.
d. price to increase.
tic
Pu
Vegemite sandwiches and tuna fish sandwiches are substitutes. Suppose
an international agreement reduced the worldwide catch of tuna by half.
The equilibrium price of vegemite would:
a. rise while the equilibrium quantity decreased.
b. fall while the equilibrium quantity increased.
c. fall and so would the equilibrium quantity.
d.
rise, and so would the equilibrium quantity.
io
at
ic
bl
If persistent shortages of petrol causes the price of petrol to rise by 10
percent each month, most economists would favor:
a. price controls on petrol to prevent inflation.
b. government subsidies for the petrol industry.
c. increasing the taxes on petrol.
d. allowing the price of petrol to continue to rise until the shortage was eliminated.
ns
1
1
20
c
Ta
25.
ht
ig
24.
yr
op
21.
45
Discovering Economics
Extended writing
Write extended answers (about two pages of writing) to the following questions.
m
Sa
1.
pl
2.
e
Outline the main factors affecting the demand and supply of passenger
motor vehicles in Australia.
a.
b.
Explain why consumers buy less of a good as its price rises. Explain how consumers react in markets when (i) their income increases; (ii) when the prices of related goods changes.
Explain each of the following using the model of demand and supply:
a. The demand for computers increases over time and yet computer prices continually fall.
b. The price of fruit and vegetables increases after a dry growing season.
c. Bicycle sales soar with rising petrol prices.
d. As incomes rise consumers spend less on instant coffee and more on espresso.
e. Australian wheat farmers earn more revenue due to a drought in Russia which cuts wheat production. [3 marks each].
1
1
20
46
ns
io
at
ic
7.
bl
What is the effect of each of the following on the equilibrium price and
quantity of hamburgers such as a ‘Big Mac’ or a ‘Whopper’? Use diagrams
to support your answers.
a. An increase in the price of chicken burgers.
b. An increase in the price of french fries.
c. The government requires that all ingredients of hamburgers be fresh - no frozen ingredients may be used.
d. An outbreak of ‘mad cow’ disease.
e. A new tax on all fast food.
f. New research discovers that eating hamburgers prevents hair loss.
Pu
Suppose that the price of new cars is higher this year than last year, but sales of new cars are also higher. Does this disprove the law of demand? [5 marks]
tic
6.
All markets are interrelated to varying degrees. Assume that the demand for wheat increases. Explain, using diagrams the effects on the wheat market; the wool market; the market for tractors and farm machinery; the car market. [5 marks]
c
Ta
a.
b.
ht
5
Explain the meaning of the term ‘market equilibrium’.
Explain why surpluses and shortages may exist, and why they are eliminated in competitive markets. Distinguish between an increase in demand, and an increase in quantity demanded.
ig
a.
b.
c.
yr
4.
op
-c
3.
a. Explain the meaning of the term ‘market’. [3 marks]
b. Outline the difference between product and factor markets.
[2 marks]
c. What are characteristics of a competitive markets? Provide examples.
[5 marks]