TOPIC 2 ► DEMAND AND SUPPLY

LEARNING OUTCOMES

By the end of this topic, you should be able to:

1. Explain the law of demand and supply;
2. Sketch the demand and supply curves;
3. Describe the demand and supply curves;
4. Apply four demand and supply determinants; and
5. Compare between the shifts of the demand and supply curves with the movement along a particular curve.

INTRODUCTION

In Topic 1, you have learnt about the free market economy. In a free market economy, there is no central body responsible for making decisions on production and utilisation. Instead, each individual has the freedom in making purchase decisions that can provide maximum satisfaction and producers have the freedom to sell based on the needs to maximise profit. A complex market system will regulate the decisions of both parties to determine market equilibrium.
The concept of demand and supply is a basic concept in market economy. The price system will determine how resources, products and services are distributed. Distribution is made based on wants and the ability to pay. Anyone who has wants and is willing to pay will obtain what is required.
In this topic, we will look at the operation of the market system through the concept of demand and supply. We will also try to understand the factors involved in moving the market.

2.1 DEMAND

In economic analysis, the concept of demand is used to describe, analyse and predict the behaviour of buyers in the market.

Demand can be defined as the total amount of goods required and able to be purchased by consumers at various price levels in a particular period of time.

Demand can be described by using tables or curves that relate the quantity of a product required and can be afforded by consumers in a particular period of time at various price levels, while other variables remain unchanged (you will find that some authors refer to other determinant variables as ceteris paribus).
Two important facts you have to understand about the definition above are the relationship between demand quantities with:

1. Price; and
2. Related variables (ceteris paribus). 

Demand does not solely mean quantity but also refers to the relationship between demand quantity and price. Therefore, demand can be described in the form of tables or curves that connects a set of variables with another variable, that is, quantity with price.
In measuring the changes in demand quantity, it is assumed that other variables affecting consumption do not change at the same time a good’s price changes. Other variables are those that can influence the demand of the particular goods, such as income, consumer preferences, price of other related goods and consumers’ predictions towards the future.

ACTIVITY 2.1

How is the price of a particular product or service determined in the market? Why do the same goods have different prices at different times? Discuss in your class.

2.1.1 Law of Demand

Figure 2.1: Demand curve

A demand curve with a negative gradient indicates an inverse relation between demand quantity and price level. When price increases, demand quantity decreases, and when price decreases, demand quantity increases. This inverse relationship is referred to as the Law of Demand. There are two explanations for this law of demand, which are:

1. Substitution Effect; and
2. Law of Diminishing Marginal Utility.

Substitution effect occurs when price change causes consumers to substitute the scarce goods with other goods with lower price but still able to give the same amount of satisfaction. Law of Diminishing Marginal Utility explains this negative relation by using the concept of utility or satisfaction.
Table 2.1 and Figure 2.1 illustrate the demand table and demand curve respectively, that is, the relationship between price level and quantity demanded.

Table 2.1: Demand Table

Price (RM)	Demanded Quantity (Unit)
1	60
2	50
3	40
4	30
5	20
6	10

How does the price level of a particular good affect the demand quantity?

2.1.2 Demand and Quantity Demanded

It is important for us to understand the difference between these terms: demand, demanded quantity, demand curve shiftsand movement along the demand curve.

1. Demand curve illustrates the relationship between price and quantity at a certain point of time only; with the assumption that other factors remain unchanged. However, it cannot show the relationship for a longer period of time due to the changes in other demand determinants.
2. Movement along the demand curve indicates the changes of demanded quantity caused by the goods’ own price change. This movement is related to the law of demand. When price changes, buyers will make changes to the quantity of the goods willing to be purchased.
3. Shifts in the demand curve caused by changes in other determinant variables (such as price of particular goods, consumer opinions and preference) are known as demand change. The right shift of demand curve indicates increase in demandwhile shift to the left indicates decrease in demand quantity.

Figure 2.2(a) shows the concept of changes in quantity demanded. The shift from point A to point B indicates increase in quantity demanded, while shift from point A to point C shows decrease in quantity demanded. Figure 2.2(b) shows demand change. Shift from point A to point B indicates increase in demand, while shift from point A to point C indicates decrease in demand.

Figure 2.2: Change of quantity demanded and change of demand

2.1.3 Demand Determinants

After knowing the difference between demand change and change of quantity demanded, we will now look at demand determinants in more detail.

1. Price of Related Goods The change in price of goods that are related to a commodity will cause shifts in the position of a demand curve. There are two types of goods related to a commodity, namely substitute goods in use and complementary goods in use (Figure 2.3).
   
   

   

   Figure 2.3: Two types of goods related to a commodity

   
   
   Substitute goods are goods that can be used as substitutes in the use of a commodity. Examples of substitute goods are: butter to margarine or meat to fish.
   Assume that product Y is the substitute for X, when price of Y increases, consumers will reduce the purchase of Y and substitute it by increasing the purchase of X. As a result, quantity demanded for Y decreases while demand for X increases. The opposite happens when the price of Y decreases. Figure 2.4 shows the specified position. In both diagrams, A is the original point and B is the point after the change of price.
   Price increase of margarine (Y), that is, from P1 to P2 will result in consumers reducing the use of margarine and substituting it with butter (X). With that, even though the price of butter remains unchanged, demand on butter had increased as a result of the increase in the price of margarine.
   

   

   Figure 2.4: Changes in the price of substitute goods

   
   
   Complementary goods are goods that can be consumed together to get satisfaction. Examples of complementary goods are: car with petrol and pen with ink.
   Now assume goods Z as the complement for goods X. The price increase of goods Z leads to a decreased quantity demanded for both, Z and X. The opposite happens if price Z decreases. Figure 2.5 illustrates the position.
   Let’s say the price of petrol (Z) increases from P1 to P2. This will cause the quantity demanded for petrol to decrease. As a result of the increase of petrol price, consumers will reduce demand for cars (X); even if the price of cars remains unchanged.
   

   

   Figure 2.5: Change in the price of complementary goods

   When the use of a particular good does not affect the use of another good, it is known as unrelated goods. For example, a change in the price of sugar, which has no relationship to cars, does not affect the demand for cars.
2. Income Normally, income is positively related to demand. When income increases, demand also increases and vice-versa.
   However, this relationship only applies to normal goods. Sometimes the increase in income will decrease demand for a particular product. This situation happens for inferior goods. Therefore, the relationship between demand and income will give indication on the type of goods (Figure 2.6). The types of goods are luxury goods, normal goods, common goods and inferior goods.
   

   

   Figure 2.6: The relationship between demand and income

   Even though classification of goods depends on the income level of the consumers, we can categorise goods generally, such as cracked rice which is considered as inferior goods by most consumers. Similarly, consumer goods bearing international brands are considered luxury goods, such as prestige cars, clothes with international designer brands and others. Common goods are goods that have no change in use with price change, such as salt and normal rice for most consumers in Malaysia.
3. Preferences Consumers have a variety of preferences that change from time to time. When consumers’ preference towards a commodity increases, consumers will tend to make more purchases at every price level. Hence, the demand curve for the particular commodity will shift to the right. For example, change in preferences can be seen in the fast food market such as fried chicken. People in the earlier days would have never imagined consuming chicken without having to incorporate them as a dish to go with their rice. However, due to change in time and advertisements through media, the preference towards such food has increased.
4. Predictions on Change of Price and Income in the Future Consumers may be able to predict future changes in price and income, for example during the festive seasons. If price is expected to increase in future, current demand will increase. On the other hand, current demand will decrease if price and income is expected to decrease in future.
   To explain further about the demand determinants we have discussed before, let us look at the example of demand for butter. We will look at what increases the demand for butter and shifts the demand curve for butter to the right.
   We know that butter is not a traditional food in our country. However, with the exposure of our people to foreign food, butter has been accepted by a large population of the society, especially to be served with bread or as an ingredient to prepare cakes. This change in preference shifts the demand curve for butter to the right.
   Margarine is the substitute for butter. Therefore, if the price of margarine increases, demand for butter will also increase. Bread is considered as the complement for butter, therefore, for those who increase their bread consumption due to price decrease or other reasons, will also increase the demand for butter. Likewise, if the income of consumers increases, there will be those who substitute margarine with butter because margarine is considered by some consumers as an inferior good. Figure 2.7 illustrates the shift of demand curve for butter which is caused by various factors.
   

   
   

   Figure 2.7: Shifts in demand curve of margarine

ACTIVITY 2.2

To enhance your understanding on demand, below are a list of factors. Discuss how these factors affect demand for coffee.

1. Preference;
2. Price of related goods (substitute goods and complementary goods);
3. Income; and
4. Prediction of price and income changes in future.

Present your answer in your tutorial.

2.1.4 Individual Demand and Market Demand

The market consists of many individuals. Therefore, a market demand table or curve is the total sum or aggregate of a demand table or curve of all individual buyers present in the market. We can obtain the market demand table or curve by summing up quantities demanded by all individual buyers at each price level.  The relationship between price and quantity in the market is influenced by the same determinant variables that influence individual demand.
Table 2.2 and Figure 2.8 illustrate how we can derive market from individual demand curve. Assume that there are only two consumers in the market. At the price of RM2 per unit, the quantity demanded by Consumer 1 is 25 units and 50 units for Consumer 2. Therefore, the market demanded quantity at the price of RM2 per unit is 75 units and so on for other price levels.

Table 2.2: Derivation of Market Demand

Price (RM)	Quantity Demanded (Unit)		Market Demand (unit)
	Consumer 1	Consumer 2
1	30	60	90
2	25	50	75
3	20	40	60
4	15	30	45
5	10	20	30
6	5	10	15

Figure 2.8: Derivation of market demand curve

2.2 SUPPLY

What is meant by supply?
According to the demand theory, we have seen the behaviour of consumers in the market. However, the market not only consists of buyers, but also sellers or producers. Therefore, we will now look at the behaviour of sellers in the market. In an economic analysis, the behaviour of sellers in a market is analysed and predicted using the concept of supply.

Hence, supply can be defined as a table or curve that relates various quantities of goods to be sold at a certain time at various price levels, while other variables remain unchanged.

In measuring the change in quantity supplied, other variables that can influence the amount of goods willing to be offered by sellers, are assumed to be unchanged. The other determinant variables referred to includes production input price, price of other goods, technology and predictions of suppliers about the future.

2.2.1 Law of Supply

If you are a seller or a producer of a commodity, you may earn a higher profit if the selling price increases and the opposite if the price decreases. Therefore, the quantity of goods you sell will increase with the increase in price and the contrary if the price decreases. The positive relationship between price and supply quantity is known as the Law of Supply.
Table 2.3 is a supply table, that is, a table that shows the quantity offered by sellers or producers at various price levels. Figure 2.9 is the supply curve derived and sketched based on Table 2.3. Figure 2.9 shows a supply curve with a positive gradient.

Table 2.3: Supply Table for Good X

Price (RM)	Quantity Supplied (Unit)
1	10
2	20
3	30
4	40
5	50
6	60

Figure 2.9: Supply curve for Good X

There are three reasons why supply has a positive relationship with price:

1. Increase in production may bring about the increase in cost due to the problem of decreasing returns. This concept will be discussed further in the production topic in Topic 5;
2. The increase in price may cause an increase in profit, therefore, the firm will be encouraged to increase production; and
3. If the price remains at a high level for a long period of time, new producers will be attracted to enter the market, giving rise to the total market supply. This theory will be discussed further in Topic 8.

2.2.2 Supply and Quantity Supplied

Like demand, the concept of supply and quantity supplied also differs. Change in quantity supplied occurs when there is a change in the price of the goods itself.
Price of goods positively influences quantity supplied. Increase in price will increase the quantity supplied, and vice-versa. Change in goods supplied triggered by change in price will show movement along the same supply curve.
Change in supply on the other hand, refers to shifts of the supply curve caused by changes in supply determinants. The determinants include production cost, predictions and price of other goods.

Change in goods supplied means movement along one supply curve, whereas change in supply is illustrated by the right or left shift of the curve.

Figure 2.10: Movement along the curve and shifts in supply

Figure 2.10(a) illustrates the change in quantity supplied caused by the price variation of the goods itself. An increase in price will cause an increase in quantity supplied from point A to point B, whereas decrease in the quantity supplied caused by price decrease of the product itself is shown by the movement from point A to point C. Look at how the movement takes place along the same curve. This is known as change in quantity supplied.
Figure 2.10(b) on the other hand, shows the change in supply due to factors of supply determinants such as price of other goods, production cost, price prediction and number of producers. For example, increase in production cost will bring about decrease in supply and further causes the supply curve to shift to the left from point A in curve S0 to point C in curve S2. On the other hand, decrease in production cost will increase supply in the market and will shift the supply curve to the right
(S0 → S1). Observe that price is not a factor that changes supply, but changes are caused by other factors of supply determinants. This is illustrated by shifts in the supply curve known as supply change.

2.2.3 Supply Determinants

Now we will discuss on supply determinants in more detail.

1. Price of Other Goods Correlation of goods in the production process influences the supply of a particular good when a price change for related good occurs. Correlation of goods in production process can be divided into two:
   1. Substitutes in supply; and
   2. Complements in supply.
   Substitutes in supply refer to goods that can be produced to substitute the production of other goods without having to make significant changes in the production process. For example, the production of rice flour and glutinous rice flour can be done using the same machine.
   
   If the profit or price of a substitute good in the production increases, producer will shift production to that particular good and decrease the production of other goods. For example, if the price of rice flour increases, the producer will suspend the production of glutinous rice flour to be substituted with the production of rice flour, in order to gain current profit.
   
   Complements in supply refer to goods jointly produced in a production process. For example, in the process of producing petrol from crude oil, a few other products such as gas and diesel will also be yielded. If the price of petrol increases, increase in supply of petrol also causes the increase in supply of other products, and vice-versa.
2. Change in Production Cost Production cost can change due to a few reasons including the change in price of production factors, change in technology, tax collection and subsidies provided by the government (Figure 2.11).
   
   

   

   Figure 2.11: Factors that cause change in production cost

   Producers use a combination of production factors in the production process. The price of production factors is determined in the factors market. Change in the price of factors will influence production cost. Therefore, if the price of factors decreases, production cost will also decrease. This situation provides incentive to producers to increase production, even if there is no price increase for that particular good in the market. Hence, a decrease in the price of factors will shift the supply curve to the right due to ann increase in supply. 
   Changes in the government policy related to tax and subsidies will also influence the supply curve. When producers have to pay tax, production cost will increase, resulting in the left shift of the curve. On the other hand, subsidies given to producers will reduce the production cost and hence, shift the curve to the right.
   The discovery of new technologies that can reduce production cost will also shift the supply curve to the right.
3. Prediction of Price If producers are able to predict an increase in price of the goods produced, production will be increased and the supply curve will shift to the right. If price is predicted to decrease, production will also be decreased and the supply curve will shift to the left.
4. Number of Producers Supply curve will shift to the right when there is an increase in the number of producers and vice-versa.

ACTIVITY 2.4

Rise in petrol price will not affect purchase of cars
KLANG: The interest of purchasing cars in Malaysia will not erode even with the rise in petrol and diesel price, says automotive expert, Tan Sri SM Nasimuddin SM Amin.
He says that the increase in price of fuel in Malaysia is not obvious compared to other countries in Europe, Japan and Korea, where the sales of automobiles continue to increase even when the price of fuel increase rapidly.
He also said that suggestions to reduce or even terminate road tax for vehicles will facilitate the selling of cars in this country, especially during this situation of fuel price increase.
“It is good as it will lessen the burden,” says the Naza Group Managing Director who supports the suggestion of terminating the road tax for all kinds of vehicles. The Naza Group, operating since 1975, has been involved in the business of importing and selling cars in need of APs.
Nasimuddin was interviewed after attending the opening ceremony of the Kia Motors showroom owned by Perstimas Sdn. Bhd. by Deputy Finance Minister, Datuk Dr. Ng Yen Yen here yesterday.

Source: Harian Metro Online (2005)

Based on the article from a local newspaper, give your opinion about the effect of petrol price increase on the supply of cars and other goods. In your opinion, what action should the government take to counter the continuous problem of petrol price increase?

2.2.4 Individual Supply and Market Supply

Like market demand, market supply will also be obtained by summing up the quantity supplied by all sellers at various price levels. Table 2.4 and Figure 2.12 illustrate how the market supply curve is derived.
Assuming there are only two sellers in the market, at the price of RM1 per unit, seller 1 is supplying 10 units and seller 2 is supplying 5 units. Hence, the market quantity supplied at RM1 per unit is 15 units and so on.

Table 2.4: Derivation of Market Supply

Price (RM)	Quantity Supplied (Unit)		Market Supply (Unit)
	Seller 1	Seller 2
1	10	5	15
2	20	10	30
3	30	15	45
4	40	20	60
5	50	25	75

Figure 2.12: Derivation of market supply curve

SUMMARY

Below is a mind map to help you visualise the content scope of this topic:

• Demand is the quantity wanted and can be afforded by consumers at various price levels. Demand is determined by the price of the good itself, price of related goods, income, preference and predictions.
• The negative relationship between quantity  demanded with the price of the good itself is called the Law of Demand.
• Change in quantity demanded due to the change in the price of the good itself causes movement along one demand curve. Demand change that is caused by changes in demand determinants other than the price of the good itself, will result in shifts of the demand curve.
• Increase in demand will shift the curve to the right, while decrease in demand will shift the curve to the left.
• Supply is the quantity that is willing to be sold by sellers at various price levels. Supply is determined by the price of the good itself, price of related goods, production cost and predictions.
• The positive relationship between quantity supplied and the price of the good itself is known as the Law of Supply.
• Change in quantity supplied caused by the price of the good itself is shown in the movement along one supply curve.
• Supply change due to change in supply determinants other than the price of the good itself will result in shifts of the supply curve.
• Increase in supply will shift the supply curve to the right while decrease in supply will shift the curve to the left. Market demand is the total sum of individual demands while market supply is the total sum of all individual supplies.