CIE IGCSE Economics 0455 Section 2 - Units 5 to 7

2.2 Demand and Supply Analysis Demand

Demand is the willingness and ability of consumers to buy a product at a given price over a given period of time.

Law of Demand The law of demand states that, all else equal, an increase in price results in a decrease in quantity demanded and vice versa. That means, there is an inverse relationship between price and quantity demanded. An example of a typical demand schedule is presented below:

Fig 1. Increase/Decrease in Quantity Demand

Fig 2. Shifts in Demand

Increase or Decrease in Quantity Demand is a movement up and down the curve

A decrease in price of the good will cause a rise in quantity demanded (move from Q to Q1) of that good; it is called an extension of the demand curve. Fig 1.

An increase in price of the good will cause a fall in quantity demanded (move from Q to Q2) of that good; it is called contraction of the demand curve. Fig 1.

Shifts in Demand Increase in demand (shift from D to D1) means a rise in demand due to a change in any one of the factor that affect demand other than price. It is a forward shift in demand curve.

Decrease in demand (shift from D to D2) means a fall in demand due to any one of the factor that affect demand other than price. It is a backward shift in demand curve. These changes have be shown in figure 2.

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Reasons for Increase/Decrease in Demand 1. Increase (Decrease) in taste or preference for a good will increase (decrease) the demand for that good.

2. Increase (Decrease) in population will increase (decrease) demand for goods and services.

3. Increase (Decrease) in income of the workforce will increase (decrease) demand for goods and services, given that it’s a normal good.

4. Decrease (Increase) in income of the workforce will increase (decrease) demand for goods and services, given that it’s an inferior good.

5. Increase (Decrease) in price of a substitute good will increase (decrease) demand for that good, e.g. coke and pepsi.

6. Decrease (Increase) in price of a complement good will increase (decrease) demand for that good, e.g. coffee and sugar 7. If consumers expect the price of the product to increase (decrease) in the future, consumers’ demand today will increase (decrease).

Supply Supply refers to the amount of a good or service firms (or producers) are willing to produce and sell at a given price at given time period.

Law of Supply The law of supply states that, (all else equal) an increase in price results in an increase in quantity supplied. That means, there is a direct relationship between price and quantity supplied. An example of a typical supply schedule is presented below:

S2

S

Decrease

Increase

Q2 Fig 3. Increase/Decrease in Quantity Supplied

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Q

Fig 4. Shifts in Supply

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Q1

S1

Increase or Decrease in Quantity Supplied is a movement up and down the curve

An increase in price of the good will cause a rise in quantity supplied (move from 12 to 16) of that good; it is called an extension of the demand curve. Fig 3.

A decrease in price of the good will cause a fall in quantity supplied (move from 12 to 8) of that good; it is called contraction of the demand curve. Fig 3.

Shifts in Supply Increase in supply (shift from S to S1) means a rise in supply due to a change in any one of the factor that affect supply except price. It is a forward shift in supply curve.

Decrease in supply (shift from S to S2) means a fall in supply due to any one of the factor that affect supply except price. It is a backward shift in supply curve. These changes have be shown in figure 4.

Reasons for Increase/Decrease in Supply 1. Increase (Decrease) in technology used to produce a good will cause an increase (decrease) in supply of that good.

2. Decrease (Increase) in cost of production of a good will increase (decrease) the supply of that good.

3. Government laws and policies will affect supply. As tax increases (decreases) supply will decrease (increase). Additionally, if Government provides subsidies to firms then supply of the good that the firm produces will increase.

4. Increase (Decrease) in number of firms selling a product will cause an increase (decrease) in supply of that product.

5. Expectation of an increase (decrease) in the price in future tends to decrease (increase) the supply. Moreover expectation about the tax changes will also affect supply in a similar manner.

6. A favorable or a good weather condition gives a good harvest, resulting in an increase in supply. On the contrary, a bad or unfavorable weather will spoil the crops, causing a decrease in supply.

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Equilibrium Equilibrium means a state of stability or balance. A market is in equilibrium when the demand and supply are equal. This means, at the equilibrium state, consumer and produces are both content to pay and receive the equilibrium price in order to consume and produce the equilibrium quantity, respectively. There will neither be any excess demand (shortage of supply) or excess supply (deficient demand) nor, any price rise or fall in price.

Equilibrium

Fig 5. Equilibrium Excess demand (shortage of supply) is situation where demand is more than supply. (DD > SS) Excess supply (deficient demand) is a situation where supply is more than demand. (SS > DD)

Changes in Equilibrium The equilibrium point will change as demand or supply or both changes. So any factor that affects demand or supply makes a change in equilibrium price and equilibrium quantity.

1. When demand increases due to any one of the factors, the demand curve shift right and new equilibrium will be achieved. The new price will be higher than the previous price as shown in figure 6. The reasons to increase in demand may be the following factors: i. ii. iii. iv. v. vi. vii.

An increase in income of the consumer.

More credit facilities.

A change in the taste of the consumer in favor of goods in consideration.

An increase in the population.

An increase in the price of substitutes A fall in the price of complementary goods A successful advertisement etc.

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E is the initial equilibrium where DD and SS intersect each other.

After an increase in demand (forward shift in demand curve) new equilibrium is E1, where D1D1 and SS meet each other. As a result, price increases to P1 and supply expands to Q1.

Fig 6. Impact of Increase in Demand on Equilibrium price and quantity

2. When supply increases due to any one of the factors (that affect supply), the supply cure shifts right and new equilibrium will be achieved. The new price will be lower than the previous price and there will be an expansion in demand as shown in figure 7. The reasons for an increase in supply may be the following factors. a. b. c. d.

A fall in cost of production A favorable climate (good harvest) Technical progress A change in the price of other goods etc.

E E1

E is the initial equilibrium where DD and SS intersect each other. After an increase in supply (forward shift in supply curve) new equilibrium is E1, where S1S1 and DD meet each other. As a result, price decreases to P1 and supply expands to Q1.

Fig 7. Impact of Increase in Supply on Equilibrium price and quantity

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