ECN1014

Introductory Economics
LECTURE 2
THE PRICE SYSTEM: DEMAND, SUPPLY AND
MARKETS
READING:
SLOMAN AND GARRATT,
CHAPTER 2 AND 3

Learning Objectives
After this lecture, you should be able to:

Describe demand and its determinants

Describe supply and its determinants

Differences between a change in quantity demanded and a change

in demand
Differences between a change in quantity supplied and a change in
supply

Relate how demand and supply interact to determine market

equilibrium
Explain how changes in demand and supply affect equilibrium
prices and quantities
Assess the desirability of government controlling market prices

Demand
Reading:
Sloman and Garratt,
Chapter 2, pp.29-31

The Law of Demand: Price and Demand

The law of demand holds that there is a negative

relationship between price and quantity demanded.

Other things being equal, as price falls, the quantity demanded

rises (and vice versa).
Quantity demanded is the amount that consumers are willing
and able to purchase over a period of time.

The law of demand can be explained by:

Income effect
Substitution effect

Demand Curve: A Change in Quantity Demanded

The demand curve is a graphical representation of

the negative relationship between price and quantity

demanded.
Its downward slope reflects the law of demand (i.e.
the higher the price, the lower the quantity
demanded).
A change in the price of the goods will lead to a
change in quantity demanded.

Price

Demand Curve:
A Change in Quantity Demanded
(1) An increase in the price from P1 to P2...
(2) ...reduces the quantity demanded from Q1
to Q2...
(3) ...as reflected by a movement along the
same demand curve from point A to B.

P2

P1

D
O

Q2

Q1

Quantity

Demand Curve: A Change in Demand

Apart from the change in the price of the goods,

there are other factors which may influence the

quantity of goods consumers plan to purchase at
each price.
A change in any other factor apart from the price of
the goods will lead to a change in demand.

Other determinants of demand:

Tastes and preferences

Number of buyers
Income

Number and prices of related goods

Normal goods
Inferior goods
Substitutes
Complements

Consumer expectations of future prices

Government policies

Price

Demand Curve:
A Change in Demand
A change in any other factor apart from the
price of the goods would shift in demand
curve.

D0
O

Q0

Q1

D1
Quantity

Determinants of Demand: A Summary

Change in Quantity
Demanded

Change in Demand

(movement along)
Price of the goods only

(shift)
Tastes and preferences
Number of buyers
Income
Number and price of related goods
Consumer expectations
Government policies

Supply
Reading:
Sloman and Garratt,
Chapter 2, pp.34-36

The Law of Supply: Price and Supply

The law of supply holds that there is a positive

relationship between price and quantity supplied.

Other things being equal, as price rises, the quantity supplied

rises (and vice versa).
To a supplier, price represents revenue, which serves as an
incentive to produce and sell a product.
The higher the price, the higher the profit incentive and the
higher the quantity supplied.

Supply Curve: A Change in Quantity Supplied

The supply curve is a graphical representation of the

positive relationship between price and quantity

supplied.
Its upward slope reflects the law of supply (i.e. the
higher the price, the higher the quantity supplied).
A change in the price of the goods will lead to a
change in quantity supplied.

Price

Supply Curve:
A Change in Quantity Supplied
(1) An increase in the price from P1 to P2...
(2) ...raises the quantity supplied from Q1 to
Q2...

(3) ...as reflected by a movement along the

same supply curve from point A to B.

B
P2
A
P1

Q1

Q2

Quantity

Supply Curve: A Change in Supply

Apart from the change in the price of the goods,

there are other factors which may influence the

quantity of goods producers plan to supply at each
price.
A change in any other factor apart from the price of
the goods will lead to a change in supply.

Other determinants of supply:

Costs of production

Input prices
Technology
Organisational changes
Government policies

Profitability of other products

Profitability of goods in joint supply
Random shocks and unpredictable events
Producer expectations
Number of suppliers

Price

Supply Curve:
A Change in Supply
S0

S1

P
A change in any other
factor apart from the price
of the goods would shift in
supply curve.

Q0

Q1

Quantity

Determinants of Supply: A Summary

Change in Quantity
Supplied

(movement along)
Price of the goods only

Change in Supply

(shift)
Costs of production
Profitability of other
products
Profitability of goods in
joint supply
Random shocks
Producer expectations
Number of sellers

Demand, Supply and Market

Equilibrium:
Reading:
Sloman and Garratt,
Chapter 2, pp.37-38

The decisions of buyers and sellers will interact to

determine the equilibrium price and quantity.

At the equilibrium level,

Intentions of buyers exactly match the intentions of sellers.

Quantity demanded equals quantity supplied.
The market is cleared of any surplus or shortage.

Price

Market Equilibrium
S

C
Pe

At the market equilibrium at

point C, quantity demanded
equals quantity supplied.

D
O

Qe

Quantity

At times, shortages or surpluses will appear in a

market.
Under such conditions, prices will function as
allocative mechanisms.

Prices will fluctuate until shortages or surpluses are eliminated

and market equilibrium is again restored.

Price

Market Surplus and Adjustment to Market Equilibrium

S
Surplus
A

P1

When there is a surplus,

sellers reduce the price in
order to get rid of the excess
stock. Price keeps falling until
market equilibrium is again
established.

C
Pe

D
O

Qd

Qe

Qs

Quantity

When there is a surplus in the market, sellers reduce

the price so as to get rid of the excess stock.

A price reduction produces two simultaneous
results:

Buyers raise their purchase from Qd to Qe (movement along

the demand curve from point A to C)

Sellers reduce their production from Qs to Qe (movement along

the supply curve from point B to C)

These actions would continue until market

equilibrium is again established at point C.

Price

Market Shortage and Adjustment to Market Equilibrium

S

C
Pe

P1

When there is a shortage, there

is competition among buyers for
limited amount of goods. Sellers
take advantage of the situation
by raising the price. Price keeps
rising until market equilibrium is
again established.

B
Shortage
D

Qs

Qe

Qd

Quantity

When there is a shortage in the market, buyers

compete with one another for limited amount of

goods, thus driving up the price.
A price increase produces two simultaneous results:

Buyers reduce their purchase from Qd to Qe (movement along

the demand curve from point B to C)

Sellers raise their production from Qs to Qe (movement along

the supply curve from point A to C)

These actions would continue until market

equilibrium is again established at point C.

Rationing Function of Prices

Rationing function of prices refers to the ability of

competitive forces of demand and supply to establish

a price and quantity at which both buyers and sellers
mutually agree to undertake an economic
transaction.

Buyers purchase what they want at the agreed price and

quantity.
Producers sell what they want at the agreed price and quantity.

Changes in Supply, Demand

and Market Equilibrium
Reading:
Sloman and Garratt,
Chapter 2, pp.38-45

The Change in Market Equilibrium

The market equilibrium is subject to persistent

changes as a result of:

Changes in demand
Changes in supply
Changes in both demand and supply

The Three-Step Analysis

Step 1: Demand or supply?

Identifying whether an event is a demand-side factor or

supply-side factor
Identifying whether an event would raise or reduce market
demand or supply

Step 2: Shortage or surplus?

Explaining whether an event would create a shortage or

surplus

Stem 3: Adjustment process

Explain the role of prices as the rationing mechanism in

removing market excesses and restoring market equilibrium

A Change in Demand
Step 1: Demand or Supply?

Assuming there is an increase in demand, shifting the demand

curve rightward from D1 to D2.

Step 2: Shortage or Surplus?

At the existing price of P1, there is shortage of AB (quantity

demanded at Q2 > quantity supplied at Q1).

Step 3: Adjustment Process

As a result of shortage, consumers will compete with each

other for limited amount of goods, pushing up the price from
P1 to P2.
On the supply side, suppliers raise quantity supplied from Q1 to
Q3, in accordance to the law of supply (movement along the
supply curve, S, from point A to C).
On the demand side, buyers reduce quantity demanded from
Q2 to Q3, in accordance to the law of demand (movement along
the demand curve, D2, from point B to C).
The adjustment process continues until market equilibrium is
restored at point C.

Price

A Change in Demand
S

P2
P1

An increase in demand
with unchanged supply will
create a market shortage
of AB, pushing up the
price from P1 to P2.

New equilibrium point is

found at point C, with
equilibrium price at P2 and
quantity at Q3.

D2

Shortage
D1
O

Q1

Q3

Q2

Quantity

A Change in Supply
Step 1: Demand or Supply?

Assuming there is an increase in supply, shifting the supply

curve rightward from S1 to S2.

Step 2: Shortage or Surplus?

At the existing price of P1, there is surplus of AB (quantity

supplied at Q2 > quantity demanded at Q1).

Step 3: Adjustment Process

As a result of surplus, sellers will clear the excess stocks by

reducing the price from P1 to P2.
On the supply side, suppliers reduce quantity supplied from Q2
to Q3, in accordance to the law of supply (movement along the
supply curve, S, from point B to C).
On the demand side, buyers raise quantity demanded from Q1
to Q3, in accordance to the law of demand (movement along
the demand curve, D2, from point A to C).
The adjustment process continues until market equilibrium is
restored at point C.

Price

A Change in Supply

P1

S1

An increase in supply
with unchanged
demand will create a
market surplus of
AB, pushing down
the price from P1 to
P2.

Surplus
B
C

P2

S2

New equilibrium point

is found at point C,
with equilibrium price
at P2 and quantity at
Q3.

D
O

Q1

Q3 Q2

Quantity

A Change in Both Demand and Supply

Assuming there is a simultaneous increase in both

demand and supply, shifting both the demand and

supply curve rightward from D1 to D2 and S1 to S2,
respectively
When there is a simultaneous change in both
demand and supply, the impact on equilibrium price
and quantity is ambiguous, depending on the relative
magnitude of the change in demand and supply.

Overall impact on equilibrium price and quantity

An increase in demand will raise the price and quantity

An increase in supply will reduce the price but raise the
quantity
Since the increase in demand is larger than the increase in
supply, there is an overall increase in both price and quantity
Equilibrium point shifts from point A to B.

Price

Simultaneous Change in Demand and Supply

S1

B
P2
P1

A simultaneous
increase in both
S2 demand and supply
will shift the
equilibrium point to
B. Impact on
equilibrium price and
quantity is
ambiguous,
depending on the
relative magnitude
of the change in
demand and supply.

D2
D1
O

Q1

Q2

Quantity

Price Controls
Reading:
Sloman and Garratt,
Chapter 3, pp.68-71

Market Equilibrium Revisited

At market equilibrium, there will be no shortages or

surpluses, as prices would fluctuate so as to

eliminate any imbalances.
Sometimes the government may find it necessary to
fix the prices of certain commodities.

Setting a maximum price (or price ceiling)

Setting a minimum price (or price floor)

Setting a Maximum Price (or Price Ceiling)

Price ceiling is the maximum price legally enforced

by the government at which a commodity may be

purchased or sold for the following purposes:

Preventing the prices of certain commodities (especially basic

necessities) from rising above a certain level
Safeguarding the economic interests of consumers (especially
those who are less well-off materially)

Price

A Binding Price Ceiling

S
A price ceiling becomes
binding when the price is fixed
below the equilibrium price.

Pe
B

A permanent shortage will

ensue.

Pc

D
Shortage

Qs

Qe

Qd

Quantity

As price ceiling is fixed below the equilibrium level, a

permanent shortage becomes inevitable, which in

turn creates the following unintended complications:

Queueing and waiting

Discrimination by sellers
Rationing
Black or underground market
Worsening scarcity of commodities

Price

A Binding Price Ceiling

Pbm

S
Profit-seeking producers will
cut back production to Qs
while charging consumers at a
much higher price at Pbm.

M
A

Pe
B

Pc

D
Shortage

Qs

Qe

Qd

Quantity

Setting a Maximum Price (or Price Floor)

Price floor is the minimum price legally enforced by

the government at which a commodity may be

purchased or sold for the following purposes:

Preventing the prices of certain commodities (especially basic

necessities) from falling below a certain level
Safeguarding the economic interests or incomes of producers
Creating a surplus (for example, grains, corn or wheat) which
can be stored in preparation for possible future shortages

Price

A Binding Price Floor

Surplus
Pf

A permanent surplus will

ensue.

Pe

A price floor becomes binding

when the price is fixed above
the equilibrium price.

Qd

Qe

Qs

Quantity

As price floor is fixed above the equilibrium level, a

permanent surplus becomes inevitable, which in turn

creates the following unintended complications:

The government may need to buy and store the surplus,

destroy or sell it abroad in other markets.
The government may have to raise demand by advertising,
finding alternative uses, or reducing substitute goods.
Firms may have lower incentive to cut costs as they are
protected by high prices.
Artificially high prices may discourage firms from producing
other commodities for which there is demand.