CHAPTER 5

Demand and supply in action

Dr Jacques de Jongh
[email protected]
(016) 910 3524
LEARNING OUTCOMES
Once you have studied this chapter you should be able to:

 Explain how changes in demand and/or supply will affects the equilibrium price and
quantities in the market and illustrate it graphically

 Predict the effects of simultaneous changes in demand and supply and illustrate it by
means of graphs

 Explain the interaction between related markets and illustrate it graphically

 Indicate what happens if the government intervenes in the market, for example by
setting minimum or maximum prices
INTRODUCTION
 In chapter 4 we mentioned a number of factors which can cause a change
in market demand as well as those which can cause a change in market
supply

 Remember a change in any of the determinants of demand or supply

except the price of the product will cause a change in demand or supply,
illustrated by a shift of the demand curve or supply curve

 In this chapter, we examine what happens to the equilibrium price and

quantity when an underlying force (i.e. a non-price determinant of
demand and supply) changes.
 5.1) CHANGES IN DEMAND
What would cause an increase in demand?
(determinants of demand)

 Increase in the price of the related goods

 Increase in consumers income
 Greater Tastes/preferences
 Increased Population
 Expected increase in the future prices of the goods
 EXCEPT THE PRICE OF THE PRODUCT
An increase in demand
(rightward shift)
• ↑ demand → ↑ price → ↑ quantity
exchanged

• This is represented by a rightward shift

from DD to D1

• The increase in demand is a result of an

increase in any of the determinants of
demand except the price.

• What happens to supply?

It remains unchanged but the Qs ↑ as the

price ↑ (shown by an upward movement
from E to E1)
 What would cause an decrease in demand?
(determinants of demand)

 Decrease in the price of the related goods

 Decrease in consumers income
 Reduced tastes/preferences
 Reduced Population
 Expected fall in the future prices of the goods
 EXCEPT THE PRICE OF THE PRODUCT
A decrease in demand
(leftward shift)

• ↓ demand → ↓ price → ↓ quantity

exchanged

• This is represented by a leftward shift from

DD to D2

• The decrease in demand is a result of a

decrease in any of the determinants of
demand except the price.

• What happens to supply?

It remains unchanged but the Qs ↓ as the price

↓ (shown by an movement from E to E2)
5.2) Changes in supply

What would cause an increase in supply?

(determinants of supply)

 A fall in the price of an alternative product /a rise in the price of

a joint product

 A reduction in the price of any of the factors of production or

other inputs

 An improvement in the productivity of the factors of production

An increase in supply
(rightward/downward) • ↑ supply → ↓ price → ↑ quantity
exchanged

• Such an increase in supply means more

goods are supplied

• Shift in supply could be the result of a

change in any of the determinants of
supply other than the price of the product

• What happens to demand?

It remains unchanged but the Qd ↑ as the

price ↓ (shown by a movement from E to E1)
 What would cause an decrease in supply?
(determinants of supply)

 An increase in the price of an alternative product /a fall in the price of a joint product

 An increase in the price of any of the factors of production or other inputs

 A deterioration in the productivity of the factors of production

A decrease in supply
(leftward/upward)

• ↓ supply → ↑ price → ↓ quantity

exchanged

• Such a decrease in supply means fewer

goods are supplied

• The shift could be the result in any of the

determinants of supply other than the
price of the product

• What happens to demand?

It remains unchanged but the Qd ↓ as the

price ↑ (shown by a movement from E to
E2 )
5.3) Simultaneous Changes in Demand and Supply

Table 5 – 1: Simultaneous changes in demand and supply

Changes in Changes in Changes in price Changes in

demand supply quantity

Increase Increase Uncertain Increase

Increase Decrease Increase Uncertain
Decrease Increase Decrease Uncertain
Decrease Decrease Uncertain Decrease

Textbook page 96[88]

Possibility 1

Increase in demand → increase in supply → change in price is uncertain →

quantity will increase
Possibility 2
 Increase in demand → Decrease in supply → price will increase → change in quantity is uncertain
 As indicated in by Figure 5-5, the equilibrium quantity could ↑, remain unchanged, or fall depending
on the relative magnitude of changes in demand and supply
Possibility 3
Decrease in demand → Increase in supply → price will decrease → change in quantity is
uncertain
Possibility 4

Decrease in demand → Decrease in supply → change in price is uncertain → quantity will

decrease
5.4) Interaction between related markets
 Substitutes – Taste and preference (Figure 5-6)
 Restriction on meat removed (Before, meat was banned and Catholics used to eat fish only)

 Impact of the decision on the prices and sales of meat & fish?

o Fish – Demand for fish will decrease during the week, causing the price and quantity to decrease.

o Meat – Demand will increase during the week, causing the price and the quantity to increase.
 Complements – cost price increase (Figure 5-7)
 Cost of producing cars increased (e.g. ↑ in costs of FOP)

 Impact of the decision on the prices and sales of cars and tyres?

o Moto cars – The supply for motor cars will ↓, causing an ↑ in price and a ↓ in the quantity
supplied
o Tyres – With fewer cars being produced, Demand will ↓, causing a ↓ in the price and quantity of
tyres
5.5) Government Intervention
 In previous sections – Market forces being demand and supply determined the price

 However, economic agents are not always satisfied with market outcomes

 Dissatisfaction often puts pressure on the government to intervene

 This intervention can take different forms:

• Price ceiling (maximum prices)

• Price floors (minimum prices)

• Subsidies

• Tax
 Maximum prices: price ceilings, price control
 Maximum price or price ceiling is set when the government sets a maximum legal limit of a price of a
particular good or service.

 For this to have an effect on market, the price ceiling must be set below the market clearing price.

 If a government decides that the market clearing price of a good or service is too high and needs to be
reduced, a price ceiling maybe imposed.

 Reasons for setting Maximum prices (price ceilings, price control)

• Help the poor by keeping the prices of basic foodstuff low
• Avoid consumer exploitation by producers (avoid unfair pricing)
• Combat inflation
• Limit the production of certain goods and services
Figure 5-8 Maximum prices (Textbook page 91 [144])

• If maximum price is set above the equilibrium

(P1), it will have no effect on the market

• However, when maximum price is set below the

equilibrium (Pm) – there will be significant
impact

• At lower price Pm consumers will demand Q2

while suppliers will only be willing to supply Q 1

• As a result, there is a market shortage or excess Shortage

demand which is equal to the difference

between Q1 and Q2

How do we solve the problem of excess demand?

 Fixing prices below the equilibrium price will:

• Creates shortages (excess demand)

• Prevents the market mechanism from allocating the available quantity among consumers

• Stimulates black market activity by providing an incentive for people to obtain the good and resell it at a
higher price to those consumers who are willing to pay higher prices to obtain it

 Dealing with excess demand (Solutions):

• Serve consumers on a first come first served basis

• Informal rationing system (e.g. limiting quantity sold to each customer)

• Government may introduce an official rationing system by issuing ration tickets or coupons that must be
submitted when purchasing
The welfare costs of maximum price fixing
(Figure 5-7 page 103)
• A maximum price Pm is set below the market
clearing price P1

• As a result, quantity exchanged falls from Q1 to Qm

• In the absence of minimum price, Producer surplus

is 0P1E and the Consumer surplus was P1DE

• At the new fixed price, the CS is now PmDRU and PS

is now 0PmU

• Consumers have lost the shaded triangle by A, since

only Qm is exchanged  But they have gained
rectangle B (which used to be part of PS), since
those who can obtain the product now pay less for it
than before.

• Shaded area A and C both disappear.

• The total deadweight loss to the society is equal to A

plus C
 Minimum Prices (Price Supports, Price Floors)
 Minimum price or price floor is set when the government sets a minimum legal limit of a price of a
particular good or service.

 For this to have an effect on market, the price must be set above the equilibrium price.

 Price floors are set by the government for certain commodities and services that it believes are being
sold in an unfair market with too low of a price and thus their producers deserve some assistance.

 Some situations in which price floors are imposed:

• To attempt to raise incomes for producers of goods and services which are essential. e.g.
agricultural products —serve as guaranteed prices to producers given the unstable and uncertain
nature of prices and income of farmers.

• To protect workers by setting minimum wage — ensuring workers earn enough to lead a
reasonable life.
 Figure 5-10: A minimum price (pg. 94 [149])

• If minimum price is set below the

equilibrium (i.e. at prices < R30), no effect
on market – still in disequilibrium

• However, if minimum price is set above

the equilibrium (i.e. at R40) – there will
be significant impact

• At R40, suppliers are supplying 9 mil. (i.e.

point b) while consumers are demanding
4 mil. (i.e. point a)

• The introduction of a price floor of R40

results in a market surplus or excess
supply of R5 million kg of beef
 Problems of price floors:

• All consumers have to pay artificially higher prices including the poor

• Bulk of the benefit accrues to large producers or big companies

• Inefficient producers are protected and manage to survive

• The disposal of the market surplus usually entails further cost to taxpayers and welfare losses to society

 Thus if the government wants to assist certain producers, the direct cash subsidies paid only to those producers is a
better alternative than fixing price floors

 Dealing with excess supply – Governments and/or producers can:

• Purchasing the surplus and export it

• Purchasing the surplus and storing it (provided its non-perishable)

• Purchasing the surplus and destroying it

• Government may even introduce production quotas to limit the quantity supplied to the quantity demanded
at the minimum price.
The welfare costs of minimum price fixing
• The equilibrium price and quantity are P 1 and Q1
respectively

• The government now fixes the minimum price

Pm above the equilibrium price

• If producers respond to actual demand, the

quantity supplied and exchanged will fall to Qm

• In the absence of price fixing, the CS was P1DE

and PS was 0P1E.

• After minimum price, the CS is PmDR, consumers

thus lose area A (to producers)

• Area B (which used to be part of CS) and C

(which used to be part of PS) both disappear

• Total deadweight loss to the society is equal to

B plus C

Figure 5-11 (page 95/150)

Conclusion
In this chapter, we have:

 explained how a change in demand affects the equilibrium price and quantity in the market

 explained how a change in supply affects the equilibrium price and quantity in the market

 predicted the effects of simultaneous changes in demand and supply

 analysed the interaction between related markets

 showed what happens if the government interferes in the market, for example by setting minimum
or maximum prices
 Thank you
See you in the next class!!

"Hard work spotlights

the character of people:
some turn up their
sleeves, some turn up
their noses, and some
don’t turn up at all.“ –
Sam Ewing