Microeconomics Chapter 2: Supply and Demand

Conditions of Supply

• The conditions of supply refer to factors that are held constant
• These factors include:
  • The price of factor inputs or factors of production
  • The price of other goods
  • Trade unions
  • Government taxes and subsidies on the firm
  • The state of technology
  • The expectations of future price changes
  • Weather or unforeseen circumstances
  • The number of firms in the industry

Supply Curve

• A supply curve shows the relationship between the price of a good and the quantity supplied
• The supply curve can shift due to changes in the conditions of supply
• A leftward shift in the supply curve indicates a decrease in supply, while a rightward shift indicates an increase in supply

Factors Affecting Supply

• A change in the cost of production will lead to a change in the supply curve
• A rise in costs will lead to a decrease in supply, while a fall in costs will lead to an increase in supply
• The price of other goods can also affect the supply curve
• A fall in the price of a good in competitive supply will lead to an increase in the supply of the other good
• Trade unions can also affect the supply curve
• A rise in wages will lead to a decrease in supply, while a fall in wages will lead to an increase in supply

Retail Price Index (RPI)

• The RPI is a measure of the average change in prices of a basket of goods and services
• The RPI is used to measure inflation
• The RPI is constructed by sampling the prices of a range of goods and services
• The RPI is used to calculate the rate of inflation

Inflation

• Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time
• Inflation can be caused by a variety of factors, including:
  • Monetarist theory: an increase in the money supply
  • Keynesian theory: an increase in aggregate demand
  • Cost-push or supply-side inflation: an increase in production costs
  • Imported inflation: an increase in the price of imported goods
• The effects of inflation can be negative, including:
  • A decrease in the purchasing power of money
  • A decrease in the value of savings
  • Uncertainty and inflationary expectations

Elasticity of Demand

• Elasticity of demand is a measure of how responsive the quantity demanded of a good is to a change in its price
• Elasticity of demand can be measured using the formula: elasticity of demand = percentage change in quantity demanded / percentage change in price
• Elasticity of demand can vary along the demand curve, with demand being more elastic at higher prices and less elastic at lower prices

Income Elasticity of Demand

• Income elasticity of demand is a measure of how responsive the quantity demanded of a good is to a change in income
• Income elasticity of demand can be measured using the formula: income elasticity of demand = percentage change in quantity demanded / percentage change in income
• Income elasticity of demand can vary depending on the type of good, with normal goods having a positive income elasticity of demand and inferior goods having a negative income elasticity of demand

Producers' Surplus

• Producers' surplus is the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received
• Producers' surplus is a measure of the profit made by producers

Taxation

• Taxation is a means of raising revenue for the government
• There are different types of taxes, including direct and indirect taxes
• Direct taxes are levied on income and wealth, while indirect taxes are levied on goods and services
• The government uses taxation to redistribute income and wealth, and to influence economic activity

Fiscal Policy

• Fiscal policy is the use of government spending and taxation to influence the overall level of economic activity
• Fiscal policy can be used to stabilize the economy, promote economic growth, and reduce unemployment
• The government uses fiscal policy to manage aggregate demand and prevent inflation

Monetary Policy

• Monetary policy is the use of the money supply and interest rates to influence the overall level of economic activity
• Monetary policy is used to promote economic growth, stability, and low inflation
• The central bank uses monetary policy to regulate the money supply and interest rates, and to maintain financial stability

Inflation Measurement

• Inflation is measured using the Retail Price Index (RPI)
• The RPI is a basket of goods and services that is representative of the average consumer's expenditure
• The RPI is used to calculate the rate of inflation, which is the percentage change in the price level over a period of time

Demand

• Demand is the amount of a good or service consumers are willing and financially able to buy at a given price during a period of time.
• Effective demand is when wants are backed up by the financial ability to buy.
• The law of demand states that if other things do not change, the quantity demanded of a commodity will be smaller at higher market prices and larger at lower market prices.
• Utility is the satisfaction people get from consuming or using a good or service.
• The law of diminishing marginal utility states that the extra units consumed of any good or service usually yield less and less additional utility.

Individual Demand Curve and Market Demand Curve

• An individual's demand is one buyer's demand for a good.
• Market demand is the total amount demanded by each consumer at that price.
• A market demand curve is the horizontal summation of all individual demand curves.
• It shows the amount of a good demanded at different prices during a specific period of time.

Movements along the Demand Curve and Shifts in the Demand Curve

• Movement along the demand curve occurs when the price changes and there is no change in other factors influencing demand (ceteris paribus).
• A change in the product's own price (caused by a change in supply) never shifts the demand curve for that good.
• If something other than price changes (so that the ceteris paribus condition is violated), then there is a change in demand and the demand curve shifts.

Factors Influencing Demand

• Real disposable income of consumers
• Price of substitutes or goods in competitive demand
• Price of complements or goods in joint demand
• Consumer tastes and fashion
• Advertising
• Expectations about the economy
• Population size and structure
• Religious beliefs

Exceptional Demand Curves

• Veblen goods: demand increases as price rises due to conspicuous consumption.
• Goods with uncertain product quality: demand increases as price rises due to consumer ignorance.
• Giffen goods: demand increases as price rises, often due to subsistence economies and basic necessities.

Consumer Surplus

• Consumer surplus is the difference between the maximum a consumer would pay for a good and the price actually paid.
• It is shown by the area above the price line and below the demand curve.

Supply

• Supply is the amount of a good that producers in an industry are both willing and able to sell at a given price during a period of time.

Individual Supply and Market Supply

• An individual supply curve shows the quantity that one firm is willing and able to sell at different prices.
• A market supply curve is the total amount that will be supplied by all firms in the industry at different prices during a period of time.

Movements along the Supply Curve and Shifts in the Supply Curve

• Movement along the supply curve occurs when the price changes and there is no change in other factors influencing supply (ceteris paribus).
• A change in the price of a good never shifts the supply curve for that good.
• If something other than price changes (so that the ceteris paribus condition is violated), then there is a change in supply and the supply curve shifts.

Factors Influencing Supply

• Price of factor inputs or factors of production
• Price of other goods (competitive supply or joint supply)
• Government taxes and subsidies on the firm
• State of technology
• Expectations of future price changes
• Weather or unforeseen circumstances
• Number of firms in the industry

Producers' Surplus

• Producers' surplus is the difference between the minimum price a producer would accept to supply a given quantity of a good and the price actually received.

Determination of Market Price

• In a free or uncontrolled market, prices are determined by the interaction of demand and supply.
• The market equilibrium price is the price at which there is no reason for anything to change unless disturbed by an outside shock.

Changes in Market Equilibrium Price

• Changes in market equilibrium price must be due to changes in demand or supply, or both.
• Changes in demand or supply can cause changes in the market equilibrium price.

Importance of Ceteris Paribus Condition

• The 'ceteris paribus' condition is a Latin term that means 'all other things remaining the same'.

• It is important to remember that the effect of a change in price depends on the cause.### Ceteris Paribus

• Ceteris paribus allows us to isolate the factor of interest and investigate its impact on another variable by holding all other relevant factors constant.

• It enables us to understand the effect of a change in one factor on the dependent variable, assuming all other factors remain constant.

Economic Theory and Experiments

• In laboratory sciences, experiments are conducted to hold all other relevant factors constant, except for the one under investigation.
• In economics, it's difficult to isolate the effect of a single factor as multiple factors vary simultaneously.

Conclusions

• Changes in demand or supply conditions push the system into disequilibrium, leading to changes in equilibrium prices.
• The market price is automatically moved towards equilibrium by forces at work.
• Products with unstable demand and supply conditions are subject to greater price fluctuations.
• The effect of a rise in price on equilibrium output depends on the cause.

The Price Mechanism

• The price mechanism responds to shortages and surpluses, causing prices to rise or fall.
• The price mechanism ensures convergence towards equilibrium.
• An efficient price mechanism fulfills three functions:

  Signalling Function

  • A rise in price signals suppliers to produce more of the product.

  Incentive Function

  • A price rise provides an incentive for firms to reallocate resources and increase production.

  Rationing Function

  • The price mechanism rations out the available supply as the price rises.

Society's Welfare

• At the market equilibrium price, society's welfare (the summation of consumers' and producers' surpluses) is at its greatest.
• Price control results in an unequal shift of surplus from one group to another, leading to a deadweight loss in society's welfare.