A-Level Economics: Supply and Demand

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A note going into detail about Supply and Demand covered in the A-Level Economics course. Credit to: www.s-cool.co.uk/

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Page 1

Effective DemandBefore we look at the basic demand curve, it is important to understand that economists only recognise demand when it is effective demand. This means demand that is backed up with a willingness and ability to pay. I should think that many of you reading this page would demand a Ferrari, but let's face it, it's not really effective demand, is it!

The Theory of DemandNow we will look at the theory of demand. At higher prices, a lower quantity will be demanded than at lower prices, ceteris paribus. At lower prices, a higher quantity will be demanded than at higher prices, ceteris paribus. Basically, when the price is high demand is low and vice versa. Ceteris paribus means 'all other things being equal'. It is very important that you state this condition when using demand curves. I will explain why under "determinants of demand"

The determinants of demandIt is fairly obvious so far that the price of a good is a pretty strong determinant of its demand, but there are many other things that will affect demand too. Real income. If one's real income rose (real means 'allowing for inflation'), one should be able to afford more CDs. The price of other goods. If the price of CD players rose then one would expect demand for CD players to fall, and so would the demand for CDs. These goods are complements. If the prices of rock concerts rose then one would expect the demand for these concerts to fall. Perhaps those who decided against the concert might buy a CD instead. These goods are substitutes. Tastes and preferences. A slightly obscure but very important determinant. As you get older, you may lose interest in the repetitive music currently in the charts and try some original sounds from the 60s, 70s or 80s. Changing preferences will affect your demand for a product regardless of its price. Expectations of future prices. If you think that the price for CDs is likely to fall in the near future, perhaps because of reduced production costs or competition from the US, you may delay some purchases which will reduce demand in the current time period. Alternatively, you may feel that CD prices are likely to rise in the near future, perhaps due to the lack of competition in the retail market, so you may increase your demand in the current time period. Advertising. Although many of you probably doubt the effectiveness of some of the appalling adverts on the TV, one assumes that these companies would not spend fortunes on these adverts if they did not expect to see a significant rise in demand for the product in question (Virgin and Our Price are always trying to sell you CDs via the TV.) Population. Quite obviously, a significant rise in the number of people in a given area or country will affect the demand for a whole host of goods and services. Note that a change in the structure of the population (we have an ageing population) will increase the demand for some goods but reduce the demand for others. Interest rates and credit conditions. If interest rates are relatively low then it is cheaper to borrow money that can then be spent. This is not so applicable to CDs, but will certainly affect the demand for 'big ticket' items such as cars and major electrical goods. In boom time (like the late 80s) it is often easier to obtain credit regardless of the rate of interest. Now that you understand that there are many things that affect the demand for a good other than its price, I hope you can see the importance of the ceteris paribus assumption. The normal downward-sloping demand curve shows the relationship between the price of the good and its demand, all other things being equal. Those 'all other things' are the list above: incomes, prices of other goods, etc. If you do not make this assumption, then you could have a situation when the price of CDs falls, but at the same time one's income falls by such a large amount that one actually demands fewer CDs. In other words, one does not want to confuse shifts in the demand curve and movements along a demand curve.

Movements along a demand curveIt is very important that you understand the difference shifts of and movements along demand curves. Examiners often test your understanding of this point in multiple-choice questions.A movement along a demand curve only occurs when there is a change in the price of the good in question. Some textbooks call these movements extensions and contractions.

Shift of a demand curveA shift in the demand curve occurs if one of the 'other' (i.e. non-price) determinants of demand change. This means that for a given price level the quantity demanded will change.

The Theory of SupplyJust like with demand, where it only became effective if it was backed up with the ability to pay, supply is defined as the willingness and ability of producers to supply goods and services on to a market at a given price in a given period of time. With demand, the downward-sloping curve reflected an inverse relationship between price and quantity demanded. The opposite is true of supply. In theory, at higher prices a larger quantity will generally be supplied than at lower prices, ceteris paribus, and at lower prices a smaller quantity will generally be supplied than at higher prices, ceteris paribus. So this time we have higher supply at higher prices and vice versa. Again, in is important to assume that 'all other things remain constant'. Any change in one of the other determinants of supply will cause the curve to shift

The determinants of supplyAs with the demand curve, there are many things that affect supply as well as the price of the good in question. Notice how similar many of these factors are in comparison to the factors that affect demand. Notice also that nearly all of these factors affect the firms' costs. Given that the firms' supply curve is its marginal cost curve (see the 'costs and revenues' topic) then it is of no surprise that a cost changing measure will shift the supply curve. Prices of other factors of production. An increase in the price of, say, hops, will increase the costs of a brewing firm and so for any given price the firm will not be able to brew as much beer. Hence, the firm's supply curve will shift to the left. The same would be true for changes in wage costs or fuel costs. Technology. The supply curve drawn above assumes a 'constant' state of technology. But as we know, there can be improvements in technology that tend to reduce firms' unit costs. These reduced costs mean that more can be produced at a given price, so the supply curve would shift to the right. Indirect taxes and subsidies. When the chancellor announces an increase in petrol tax (again!), it is the firm who actually pays the tax. Granted, we end up paying the tax indirectly when the price of petrol goes up, but the actual tax bill goes to the firm. This again, therefore, represents an increase in the cost to the firm and the supply curve will shift to the left. The opposite is true for subsidies as they are handouts by the government to firms. Now the firm can make more units of output at any given price, so the supply curve shifts to the right. Labour productivity. This is defined as the output per worker (or per man-hour). If labour productivity rises, then output per worker rises. If you assume that the workers have not been given a pay rise then the firm's unit costs must have fallen. Again, this will lead to a shift to the right of the supply curve. Price expectations. Just as consumers delay purchases if they think the price will fall in the future, firms will delay supply in they think prices will rise in the future. It's the same point but the other way round. Entry and exit of firms to and from an industry. If new entrants are attracted into an industry, perhaps because of high profit levels (much more on this in the topic 'Market structure'), then the supply in that industry will rise at all price levels and the supply curve will shift to the right. If firms leave the industry then the supply curve will shift to the left. As with demand, we must now look at the difference between a movement along a supply curve and a shift of a supply curve. Those of you who have looked at the 'Demand curve' Learn It should know exactly what is coming next!

Movements along a supply curveIf you understand this topic when it is related to the demand curve then you will be fine here as well. The principles are exactly the same. A movement along a supply curve only occurs when the price changes, ceteris paribus. In other words, the price changes but the other non-price determinants remain constant.

As with shifts of demand curves, supply curves shift, at all prices, if there is a change in one or more of the determinants of supply. As stated above, nearly all the determinants of supply affect the costs of the firm and, therefore, its supply curve, which is its marginal cost curve. Put simply, if something happens that increases a firm's costs regardless of the price level (e.g. an increase in the wage rate, of an increase in government taxes), then the firm's supply curve will shift to the left. If something happens that decreases a firm's costs regardless of the price level (e.g. improved technology or a subsidy from the government), then the firm's supply curve shifts to the right.

Shifts of a supply curveAs with shifts of demand curves, supply curves shift, at all prices, if there is a change in one or more of the determinants of supply. As stated above, nearly all the determinants of supply affect the costs of the firm and, therefore, its supply curve, which is its marginal cost curve. Put simply, if something happens that increases a firm's costs regardless of the price level (e.g. an increase in the wage rate, of an increase in government taxes), then the firm's supply curve will shift to the left. If something happens that decreases a firm's costs regardless of the price level (e.g. improved technology or a subsidy from the government), then the firm's supply curve shifts to the right.

The price mechanismSome of the textbooks you have read may have referred to the price mechanism. This is the mechanism through which the price is determined in a market system. Basically, the price will adjust until supply equals demand, at which point we have the equilibrium price.The dictionary definition of 'equilibrium' is 'a state of physical balance', or put more simply, 'a state of rest'. 

Shifts in Supply and DemandEarlier, we called this process the 'price mechanism'. From the analysis above, we can see that the price itself has the most important role. The rising price has acted as a signal to possible new firms who might want to join this expanding industry. It acted as an incentive, encouraging existing firms to produce more (the movement along the supply curve). It also acted as a sort of rationing device in the sense that it put off some existing buyers and helped make sure that demand matched supply.

The Demand Curve

The Supply Curve