If at price p, demand for the good decreases from q to q2, the demand curve shifts left (D→D2).
The conditions of demand are ‘all other things’ that are assumed equal in the law of demand.
Conditions of demand include:
Normal good = a good whose demand increases when consumers have more income to spend (e.g. holidays, restaurant meals).
Inferior good = a good whose demand decreases when consumers have more income to spend (e.g. own brand products).
Substitute goods = goods that consumers see as alternatives to each other (e.g. margarine and butter, car and public transport).
Complement goods = goods that consumers demand jointly because they are used together (e.g. bread and butter, car and petrol).
Supply
Supply = a producer supplies a good if he is willing and able to offer the good for sale in the market at the price being charged.
Factors affecting the supply of a product
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The price of the good
Law of supply = ‘all other things being equal, if the price of the good increase, the quantity supplied rises, and if its price decreases, the quantity supplied falls.’
To produce more of a product, a firm will need to use more factor inputs, which will increase its costs. If the firm is being rational and aiming to maximise its profit, it will only produce and supply the extra products if the price rises to cover these extra costs.
A supply schedule = a table showing the quantity of a product supplied at different prices.
A supply curve = graph of the supply schedule
Points to remember:
- Always relate the quantity supplied to a suitable time period.
- Always put price on the vertical axis and quantity on the horizontal axis.
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Always use the correct terms – when price changes there is an increase or decrease in the quantity supplied.
If the price of pies rises from p1 to p2, the quantity supplied increases from q1 to q2 per day (extension of supply from A to B).
If the price of pies falls from p1 to p3, the quantity supplied decreases from q1 to q3 per day (contraction of supply from A to C).
The market supply curve for a product is obtained by adding together the supply curves for all the individual firms producing the product.
- The conditions of supply
Condition of supply = anything other than the price of the product that causes the quantity supplied to change.
When a condition of supply changes, the product’s supply curve will shift to a new position.
If at price p, supply of the good increases from q to q1, the supply curve shifts right (S→S1).
If at price p, supply of the good decreases from q to q2, the supply curve shifts left (S→S2).
The conditions of supply are ‘all other things’ that are assumed equal in the law of supply.
Conditions of supply include
The Determination of Price
Equilibrium point = the point at which quantity demanded is exactly equal to quantity supplied, and where the market price will be established.
Market equilibrium = Point where the D and S curves intersect = Point E.
Equilibrium price = Price at the market equilibrium = p.
Equilibrium sales = Sales level at the market equilibrium = q.
At price p, consumers buy q goods and maximise their utility, while producers sell q goods and maximise their profits.
Any attempt to charge a price other than p will lead to a disequilibrium situation and will activate market forces that will return the market to equilibrium.
At price p1, demand for goods will only be q1 while supply will be q2. Hence there is an excess supply of goods (also known as a ‘glut’) causing price to fall back to p (a buyers’ market).
At price p2, demand for goods will be q3 while supply will only be q4. Hence there is an excess demand for goods (also known as a ‘shortage’) causing price to rise back to p (a sellers’ market).
Causes of Price Changes
The only way that the price of a good can change, unless the government is price fixing, is for the market equilibrium to move to a new position. This will occur if conditions in the market alter, leading to a shift in either the demand or supply curve. There are four possibilities, two for a price rise and two for a price fall.
A price rise
(i) An increase in demand
- An increase in demand causes the demand curve to shift right.
- At the old equilibrium price p, there is now disequilibrium with a shortage of goods occurring.
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Shortage causes the price to increase to a new equilibrium point at a higher price of p1 with a higher level of sales q1.
Possible causes of an increase in demand include:
- Increase in consumer income for a normal good.
- Decrease in consumer income for an inferior good.
- Increase in the price of a substitute good.
- Decrease in the price of a complement good.
- Successful advertising of the good.
- Good publicity (e.g. a positive health report highlighting the benefits of consuming the good).
(ii) A decrease in supply
- A decrease in supply causes the supply curve to shift left.
- At the old equilibrium price p, there is now disequilibrium with a shortage of goods occurring.
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This causes the price to increase to a new equilibrium point at a higher price of p2 with a lower level of sales q2.
Possible causes of a decrease in supply include:
- An increase in the costs of production
- An increase in an indirect tax on the producers of the good.
- A decrease in the subsidy to the producers of the good.
- A strike by workers in the industry producing the good.
- A flood in the region producing the good.
- The closure of firms in the industry producing the good.
A price fall
(iii) A decrease in demand
- A decrease in demand causes the demand curve to shift left.
- At the old equilibrium price p, there is now disequilibrium with a glut of goods occurring.
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This causes the price to decrease to a new equilibrium point at a higher price of p3 with a lower level of sales q3.
Possible causes of a decrease in demand include:
- Decrease in consumer income for a normal good.
- Increase in consumer income for an inferior good.
- Decrease in the price of a substitute good.
- Increase in the price of a complement good.
- Bad publicity (e.g. a negative health report highlighting the dangers of consuming the good).
(iv) An increase in supply
- An increase in supply causes the supply curve to shift right.
- At the old equilibrium price p, there is now disequilibrium with a glut of goods occurring.
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This causes the price to decrease to a new equilibrium point at a lower price of p4 with a higher level of sales q4.
Possible causes of an increase in supply include:
- A decrease in the costs of production
- A decrease in an indirect tax on the producers of the good.
- An increase in the subsidy to the producers of the good.
- An increase in the productivity of labour working in the industry.
- Technical progress: an improvement in the technology used by producers of the good.
- The arrival of new firms into the industry producing the good.
Summary table on price changes
Elasticity
The laws of demand and supply explain how the quantity of a good demanded and supplied changes when its price changes. They reveal the direction of the changes (if price rises, quantity demanded decreases and quantity supplied increases), but they say nothing about the extent or size of the changes. This is considered by the concept of elasticity.
Price elasticity of demand
Price elasticity of demand = a measure of the sensitivity of the demand for a good to a change in its price.
It is calculated using the formula:
price elasticity of = % change in quantity demanded
demand (PED) % change in price
% change in quantity = new quantity – old quantity x 100
demanded old quantity
% change in price = new price – old price x 100
old price
Note: the value for PED should be negative, but the negative sign is usually ignored.
Elastic demand = quantity demanded of a good is sensitive to a change in its price.
PED > 1
Inelastic demand = quantity demanded of a good is insensitive to a change in its price.
PED < 1
Unit elastic demand = quantity demanded of a good changes by an equal percentage to the change in its price.
PED = 1
Examples
Remember that the negative signs are ignored in these calculations.
The demand curve can give an indication of a good’s price elasticity of demand.
The steeper the slope of the curve, the less elastic the demand for the good.
Good B has a less elastic demand (DB) than good A (DA) because if the price of both goods rises from p1 to p2, the quantity demanded of good B decreases less (q →qB) than the quantity demanded of good A (q →qA).
There are two extreme demand curves at opposite ends of the elasticity scale.
Determinants of a good’s price elasticity of demand
- The availability of substitutes – demand is more elastic for goods with more substitutes.
- Whether the good is a necessity or a luxury to the consumer – necessity goods have less elastic demand than luxury goods.
- The proportion of consumer income spent on the good – the higher the proportion of income spent on a good the more elastic the demand.
Total revenue and price elasticity of demand
There is a relationship between the price elasticity of demand for a good and the total revenue or expenditure on that good.
Total revenue = price of good x quantity demanded
The rules to remember are:
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If when price changes, total revenue changes in the same direction, demand is inelastic.
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If when price changes, total revenue changes in the opposite direction, demand is elastic.
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If when price changes, total revenue is unchanged, demand is unit elastic.
Examples
Price elasticity of supply
Price elasticity of supply = The responsiveness of the supply of a good to a given change in its price.
It is calculated using the formula:
price elasticity of = % change in quantity supplied
supply (PES) % change in price
Elastic supply = quantity supplied of a good is sensitive to a change in its price.
PES > 1
Inelastic supply = quantity supplied of a good is insensitive to a change in its price.
PES < 1
Unit elastic demand = quantity supplied of a good changes by an equal percentage to the change in its price.
PES = 1
The slope of the supply curve will reflect the good’s price elasticity of supply.
S1 = perfectly inelastic supply (PES = 0)
S2 = inelastic supply (PES < 1)
S3 = unit elastic supply (PES = 1)
S4 = elastic supply (PES > 1)
S5 = perfectly elastic supply (PES = ∞)
Factors determining a good’s price elasticity of supply
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Time – when the price of a good changes, its supplier has to adjust production, but this cannot be done quickly because the factors of production have to be hired or fired. Supply is less elastic in the short run than in the long run.
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The availability of excess capacity or stocks – if a supplier is not working at full capacity, there is slack in the production system, which will enable supply to react more quickly to a price change and hence be more elastic. The same is true if a producer is carrying stocks of unsold goods.
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The availability of factors of production – if the price of a good rises and the supplier wishes to extend output, more factors of production will be needed. If these are easy to obtain, supply will be more elastic. Factors of production will be available if there is a recession, with high unemployment and plenty of empty (closed down) shops on the high street.