 # International Baccalaureate Economics SL : Microeconomic Study Resources ## SUPPLY AND DEMAND

### Demand

Law of Demand – when price goes up, ceteris paribus, quantity demanded goes down. Therefore, a negative relationship exists between price and quantity demanded.

This relationship makes sense because consumers will want to buy less of a good when its price has risen.

Ceteris paribus means ‘when all else remains equal’. In this case it means that the law of demand only holds when everything except price and quantity demanded remains the same.

In this formula:

the demand curve will shift to the left (if a decreases) or to the right (if a increases);

• b = slope; the higher the b, the higher the slope of the demand curve; in the case of the demand curve, b will be negative because of the negative relationship between price and quantity demanded.

The Demand Curve

A move along the demand curve occurs when the price of the product changes. If, for example, the price increases, a shift along the demand curve may occur from point B to point A.

A shift of the demand curve occurs in cases in which any other factor than price changes.

Below the most important of these factors are listed along with their effect on the demand curve:

The income of consumers In general when the income of consumers increases (decreases), consumers will have more (less) money to spend.

Their demand of the good of which the demand curve is drawn will increase (decrease). This will shift the demand curve to the right (left).

⇒ The shift above will only happen if the good in question is a normal good (i.e. any good for which demand increases when income increases).

Most goods on the market are normal goods.

⇒ In the case of inferior goods (i.e. goods for which demand decreases when income increases) the opposite will happen.

When income increases (decreases), the demand curve will shift to the left (right). An example of an inferior good is a hamburger from McDonald’s.

When the income of people increases, they will typically use the extra money to buy better, healthier and more expensive types of food so demand for hamburgers goes down.

Prices of complementary goods A complementary good is a good that is consumed along with another good.

Examples of complementary goods include cars with fuel, computers with computer software and christmas trees with christmas decorations. When the price of a complementary good increases (decreases), the demand for the original good will decrease (increase), shifting the demand curve for the original good to the left (right).

Prices of substitute goods A substitute good is a good that is consumed instead of another good.

Examples of substitute goods include iPhones vs. Samsung phones, Volkswagen vs. Opel cars and match sticks vs. lighters.

When the price of a substitute good increases (decreases), consumption of the original good increases (decreases) because it is now a relatively less expensive (more expensive) alternative. This will shift the demand curve for the original good to the right (left).

Population When the population increases (decreases) there will be more (less) people to demand the good.

This will increase (decrease) demand, shifting the demand curve to the right (left).

Taste when taste (e.g. in fashion) changes so will the demand for certain goods. This depends on the change. If wearing a certain type of shoe suddenly becomes a trend, the demand for this type of shoe will increase, shifting the demand curve to the right.

## Supply

Law of supply Higher prices will, ceteris paribus, increase quantity supplied. Therefore a positive relationship exists between price and quantity supplied.

This relationship makes sense, because producers will want to make and sell more products when the price on the market for these products has increased in order to make more profit.

Ceteris paribus means ‘when all else remains equal’.

In this case it means that the law of supply only holds when everything except price and quantity supplied remains the same.

The law of demand can also be written as a formula, the formula of the demand curve, which has the following general form: QS = c + dP

The Supply Curve

A move along the supply curve occurs when the price of the product changes. If, for example, the price increases, a shift along the supply curve may occur from point B to point A.

A shift of the supply curve occurs in cases in which any other factor than price changes.

Below the most important factors are listed along with their effect on the supply curve:

Cost of factors of production When the factors of production become more (less) expensive, the production cost for producers will increase (decrease). This means they will probably produce less (more) and the supply curve will shift to the left (right).

Level of technology When technology advances (deteriorates), producers can produce more (less) efficiently. This means they will probably produce more (less), shifting the supply curve to the right (left).

Prices of related competitive goods When the prices of competitive goods increase (decrease), producers will feel more (less) confident about ‘winning’ the competition.

They will increase (decrease) production, shifting the supply curve to the right (left). Prices of related joint goods When the prices of related goods increase (decrease), producers will feel less (more) confident about selling their goods along with the related good.

Therefore they will produce less (more) goods, shifting the demand curve to the left (right).

## Equilibrium

Supply and demand interact to produce market equilibrium. This market equilibrium will be at the intersection of the demand and the supply curve, where supply equals demand

At this equilibrium point, you can find the equilibrium quantity (Q∗ ) at the horizontal axis and the equilibrium price or market price (P∗ ) at the vertical axis.

But in some cases the price is different from P∗ :

• If the price lies above the market price, the quantity supplied will be higher than the quantity demanded (QS > QD). In this case there will be excess supply.

• If the price lies below the market price, the quantity demanded will be higher than the quantity supplied (QD > QS ). In this case there will be excess demand.

Equilibrium

Excess Supply

Excess Demand

In general, price can be said to have two functions on a market:

Signalling function: A high price is a signal to producers that consumers want to buy the good.

Incentive function: A higher price is an incentive for producers to produce more to increase profit.

### Market Efficiency

The efficiency that is achieved on a market can be measured by adding up the consumer and producer surplus. This gives you the total welfare.

Consumer surplus (CS) The extra satisfaction gained by consumers from paying a price that is lower than the price they were prepared to pay → total welfare gained from being able to consume.

Consumer surplus is measured by calculating the size of the area locked inside the demand curve; the horizontal line from P∗ and the vertical line from Q∗

Producer surplus is measured by calculating the size of the area locked inside the supply curve; the horizontal line from P∗ and the vertical line from Q∗ .

Consumer Surplus and Producer Surplus when market is in Equilibrium

Consumer Surplus and Producer Surplus when market is not in Equilibrium

Best allocation of resources is reached at the market equilibrium. At that point the community surplus (CS + PS) is maximised. (At that point marginal benefit = marginal cost, see section on market failure).

⇒ To see that this is true, let’s look at a situation where price is not equal to the market price (see Figure 1.7).

⇒ You can see that CS + PS is smaller than at the equilibrium, the loss in producer and consumer surplus is marked in the figure.