Supply and Demand Theory

We can show the law of demand, when we look at a market in operation.
If movie tickets cost $10 each, the average person will go to the movies twelve times per year. This is represented as the point E on the graph. The cinema owner will gain revenue equal to the price of a cinema ticket, multiplied by the number of cinema tickets sold in a specified period of time. At a price of $10 per ticket, the cinema owner will gain a revenue of $10 x 12 = $120
If the price of movie tickets rises, to $12 each, the average person will go to the movies less often; nine times per year. This is represented as the movement along the demand curve from E to E¹. At a price of $12 per cinema ticket, the cinema owner will gain a revenue of $108

If movie prices rise even further, to $14 per ticket, demand will contract even further to six visits per year. This is represented as the movement along the demand curve from E¹ to E². Economists use the term ceteris paribus as a ''short hand'' for all other variables remaining the same.

What are these other variables? Some of the factors that effect demand include consumers' incomes, their tastes and preferences, the season... there are many factors that effect demand. We will investigate some of these in more depth later.

Demand, in a market economy, means the behaviour of consumers who are able to buy the commodity. If you have no money, your tastes and preferences are simply ignored.
When we talk about demand, we are talking about effective demand.

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An ''Expansion'' of Demand

One reason consumers buy more of a commodity when its price is lower is because you can increase your total utility or the amount of ''satisfaction'' you can gain from your income. If you have a fixed income and you like tomatoes, if the price of tomatoes falls, then you can buy more of them. This is called an income effect. Lower prices mean you have more purchasing power; effectively, your real income has effectively risen, because your income can buy more tomatoes.
When tomatoes are $5 per kilogram, the average household buys one kilogram per month (see point E). When the price falls to $4 per kilogram, economists say there has been an expansion of demand (from point E to point E¹) and 2 kilograms are purchased per month.

A further fall in price to $3 per kilogram sees a further ''expansion of demand'' to the point from E¹ to E², at which point households consume three kilograms of tomatoes per month.

Another reason consumers buy more of a commodity when its price is lower is because the price of alternatives has become effectively more expensive. If the price of beef falls, and the price of lamb does not, then lamb has become effectively dearer. Consumers substitute beef for lamb for their Sunday dinner. This is called the substitution effect.

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Marginal Utility

Economists also use the concept of ''utility'' to explain the law of demand. The utility of a good or service is its ability to satisfy your want for it. Utility can change. On a hot day, an icecream has more utility than an icecream on a cold day.

''Marginal utility'' is the additional satisfaction one gets from consuming an additional unit of a commodity.

Because we have unlimited wants and limited incomes, we buy a wide range of goods and services, and we often buy more than one of an item in a given period of time. All of us budget, whether we think about it consciously or not. You may go to your local shop three or four times a week, and buy soft drinks, and snack food. If you want to go to the movies on the weekend, you will reduce your spending at the corner store during the week. You have changed your preferences. You have changed the valuation of the opportunity cost of an extra can of soft drink.

At the ''margin'', that is, at the ''edge'', you have decreased the utility of the, say, third can of soft drink, and substituted the greater satisfaction of going to the movies.

The marginal utility of any item depends on how much of it you already have. If you are thirsty, the first can of soft drink is the most satisfying. The second can may be enjoyable, but if you keep drinking, the fifth will probably make you feel sick! Each can of soft drink costs the same amount of money. After each drink, you will consciously or unconsciously make a judgement on whether to buy another drink, or to buy something else with the money, or maybe save the money for later. The marginal utility of each can of soft drink is reducing, as your want is being satisfied.

If the shop keeper said "You are such a good customer, this extra soft drink is now 50 cents less than the last one", you would probably buy it. However, since he or she does not reduce their sales price for each additional soft drink you buy, you will eventually stop consuming soft drinks.

In many countries, prices are not fixed, and people have to bargain. If you shopping for clothes in Bali, and you see a shirt you like, you will probably be willing to pay a high price for it. To induce you to buy another shirt, the shop keeper will have to reduce his or her price on this additional item. To get you to buy another shirt, the price on this shirt will have to be lower still. This the ''law of diminishing marginal utility''.

At some point in your consumption, additional units of consumption result in smaller increases in utility. The marginal utility of successive units of consumption will always fall.

As a result, the demand curve for a good or service is downward sloping. Since the marginal utility of each additional item is less, the seller will have to reduce their price to induce you to buy it.

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The Supply Curve

An ''Expansion'' of Supply

When tickets to the movies cost $10 each, a cinema theatre owner will supply six separate theatres in his or her ''megaplex'' (see point E). These will be large cinemas and will play popular movies to large audiences. If the movie company receives $7 of each $10 ticket, the cinema owner only receives a gross profit of $3 per ticket. The cinema owner will probably only supply ''mass appeal'' ''Hollywood'' movies, because the profit per ticket is low when tickets are only $10 each. If consumers of movies are willing to pay $12 per ticket, and the movie companies still only charge $7 for each customer, as the fee for providing the movie to the cinema, then the cinema will make higher gross profits per ticket. The cinema owner will supply nine screens in his or her ''megaplex''; see the movement from E to point E¹).

The cinema owner can vary the range of movies he or she supplies to include ''cult classics'' and others, even though these may not attract as many customers per movie screening. Because the cinema is making higher profits per ticket, not as many customers are needed per screening to make a profit. If customers are willing to pay $14 for a movie ticket, the cinema owner will expand the number of screens in his or her ''megaplex'' to twelve. (Let's continue to assume the movie companies still only charge $7 licencing fee per ticket.) The cinema owner can offer more, smaller screens, and more varied movies (foreign language etc), because not as many customers are needed to ''breakeven'' per movie screening. The expansion in supply, caused by the market price of a cinema ticket increasing from $12 to $14, is shown in the movement E¹ to E².

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Market Equilibrium

Consider the market for beef. If your local butcher thinks he will be able to sell beef at $10 per kilogram, he will prepare 150 kg for sale in a given week. Those who supply goods and services can never be sure of the level of demand. Suppliers take risks. Your butcher will carefully monitor the level of his stocks of unsold beef. By Wednesday, your butcher notices his stocks are much higher than usual. It looks like he will only sell 50 kg of beef (point K) by the end of the week, and not the 150 kg (point L) he had expected. What does your butcher do? He lowers his price for beef, in an attempt to get stock levels back to an acceptable level. If he does not lower his price, he risks making a loss on the unsold stock.

If, on the other hand, your butcher only expects to sell 50kg of beef, and that the best price he will get is $6 per kilogram, he will only supply 50 kg (point J) that week. He has misread the market however. By Wednesday, he has sold nearly all his beef. At $6 per kilogram, consumer want to buy (demand) 150 kg (point M). What does your butcher do? He increases the price on his remaining stocks.
The butcher gets deliveries every week. His supply of beef is fixed in the short term. In an attempt to improve his profits, he will increase the price on his remaining stocks. If consumers do not buy on Thursday at the higher price, he still has time to lower his price on Friday. If he does not increase his price, he will run out of beef anyway.

In most markets, the competing desires of consumers and suppliers help to establish an equilibrium price (Shown here as the point E.) Firms monitor their level of stocks, and adjust prices. What firms want is to sell all of their stocks just before the next delivery, or production run. Consumers are always looking for the lowest price, at a given level of quality.
We can summarise this dynamic (''moving'') process : if Supply is greater than Demand, a surplus (or ''excess supply'') develops and prices tend to fall.
If Demand is greater than Supply, a shortage develops and prices tend to rise.

Our butcher has discovered, by trial and error, that consumers will buy 100 kg of beef per week at a price of $8 per kilogram. If our butcher can supply beef at this price, and make a profit, he will remain in the market.

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Movements of the Demand Curve

The demand curve slopes downwards. This illustrates the assumption that consumers will try to maximise their satisfaction by making choices between the goods and services they buy. If the price of a good falls, then consumers will buy more of it. A change in price causes a contraction or expansion of demand. These, as you will recall, are movements along a given demand curve.

The demand curve can shift (a movement of the whole curve, to the right or left) for a variety of reasons.

Key Concept : The demand curve shifts to the left or the right if all households operating in the market are effected by the change in market conditions.

Demand can increase (a shift of the whole curve to the right) if households have more income to spend. Before the increase in income, households would buy Q_o of a good at price P_o.
With higher incomes, households will be willing to pay more (price P₁) for the same quantity of the good or service in question.

Demand can increase for a variety of reasons. Demand for good A can increase if the price of its substitute, B rises. If the price of beef rises, people will buy more lamb, or fish. Demand for a good will increase if the price of its complement falls. Let's say you are looking for a new bicycle, and you notice that one store has the one you want on ''special'' : $50 off the usual price. You will probably buy a better qualiy, (and more expensive) helmet, or repair kit, or some other item that is associated with cycling. After all, you had budgeted for the bicycle : you had a fixed amount of money you wanted to spend. A fall in the price of the bicycle left you with some spare cash.

Demand for many products is seasonal - what we wear and what we eat varies from winter to summer, for example.

Demand will increase or decrease if the size of the population, its composition or its age distribution changes. Australia in 1999 is vastly different from Australia in 1945. In 1945, Australia had a population of 7 million people - mostly of U.K. or Irish background. In 1999, Australia is a multicultural society of 18 million people. And this population is more in contact with global trends than any other generation before it. The growth of telecommunications and computer science will continue to change Australia, just as surely as migrants from Europe changed what we ate, a generation ago.

One major impact on demand is advertising, in all forms of the media. The world has experienced the growth of ''global'' brands since the 1970's. This has not lead to a growing uniformity of fashion and tastes. The ability of the media to inform people around the world of new fashions and new trends anywhere means demand can change rapidly.

One reason demand grew strongly in the period 1947/48 to 1971/72 (apart from the ''mini recession'' of 1961/62), was because Australia's population was rapidly growing. The ''baby boomer'' generation, created demand and employment. As this group grew into the decades of their 20's and 30's, however, the number of children per family began to fell. The ''baby boomers'' put a higher preference on ''lifestyle'' than children. This meant that the average age of the population began to rise. In the 1950's, the birth rate soared, and the average of the population fell. In the 1980's, 12% of the total population over 65 years. By 2020, the proportion of people in their ''third age'' are expected to be 20% of the total population. In the housing market today, the demand for ''medium density'' housing for people in their retirement years, is growing faster than the demand for standard homes. The rise in the number of people over 50 years has also seen greater demands on our health system. Funds for this are gained through taxation. Increasingly in the 1990's, what is made and what is bought is determined by the needs and spending of older people.

Economists make a distinction between normal goods and inferior goods. If income rises, the demand for most goods increases. These are normal goods. There are some goods, however, for which demand will decrease as incomes rises. These are called inferior goods. As our income rises, we consume less of these goods. For example, as our income rises we buy less mince, and more steak. As our incomes rise, we tend to buy better quality goods, and less ''budget'' brand goods.

Demand or spending can be financed either out of savings, or by borrowing. People will borrow more if they believe that economic conditions in the future will be better than they are today. A key factor in positive consumer expectations is employment. If people feel confident about future income, they borrow against it, and spend. This increases sales for firms, and increases profits. These firms hire more labour; and to a certain extent, you can ''guarantee'' your own employment if you can create demand (and production and employment) somewhere else. How much you borrow is highly influenced by the size of the repayments and the level of interest rates. If you borrow $10,000 for one year at 12% interest (annual), you will clearly pay more than you would if you borrowed $10,000 at 5% interest (annual). If you borrow at 12%, you will have to repay $1,200 in interest; at 5%, you will only have to pay back $500. In a sense, you have ''gained'' $700 in borrowing power. You can borrow more than $10,000, maybe $10,500. You can increase your consumption, and thus spending.

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Movements of the Supply Curve

The supply curve is an upward sloping curve. This illustrates the assumption that a firm will supply more of a good or service, if the price per unit rises. If price rises then profits can rise as well.

A change in price causes a contraction or expansion of supply. These, as you will recall, are movements along a given supply curve.

The supply curve can shift (a movement of the whole curve, to the right or left) for a variety of reasons.

Key Concept : The supply curve shifts to the left or the right if all firms operating in the market are effected by the change in market conditions.

Supply can increase (a shift of the whole curve to the right) if new technology is developed, that reduces the cost of production. Before the improvement in technology, this firm could supply Q_o of a good at price P_o.
Adapting the new technology has lowered production costs. Now the firm can supply Q₁ at price P_o, and still make a profit.

An increase in the number of firms operating in a market can also increase supply. Decreases in the cost of resources used in production (especially labour) can also shift the supply curve to the right. If all firms operating in the industry having have rising expectations of future profitability, all firms will increase production and increase supply. A lowering of business taxation, or an increase in subsidies given by Government can also increase supply.

Supply can decrease (a shift of the whole curve to the left) if the costs of production rise. Before the increase in costs, this firm could supply Q_o of a good at price P_o.
Now the firm can only supply Q_o at price P₁.

Pick any quantity you like : prior to the change in the conditions of supply, this quantity had a given price. After the change, the same quantity now costs more.

A decrease in supply can be caused by increased taxation, or by increases in the cost of inputs used in production. Increased wage costs are a major cause of rising production costs. For agricultural commodities, a decrease in supply can be caused by drought or unseasonal weather that can effect crop yields.

The Income Effect

Our analysis so far has assumed our income has remained the same. But what do we really mean by ''income''?

A given number of $20 notes has a given purchasing power. These notes can be exchanged for a given amount of goods or services. If the price of a good falls, then we can purchase it with less dollar notes. A fall in the price of a good is equivalent to us gaining an increase in our incomes. Our money income is the amount of dollar notes we receive; our real income is the purchasing power of these notes.

The Substitution Effect

An improvement in memory chip technology has allowed computer manufacturers to offer a new computer with a faster operating speed to the public. Because the chip is cheaper to produce as well, the manufacturer can retail the new computer at $2,800; down from the old model's $3,000 sales price. The improvement in technology has caused an increase in supply. The same quantity of computer now costs less. This is shown as a shift of the supply curve to the right.

The increase in supply will cause an expansion of demand for new computers. Sales will increase from ten to fifteen per week.

The improvement in the conditions of supply of new computers will impact on the price of old computers, as the two are close substitutes. Market demand for the old model computer will decrease. The demand curve for old computers will shift to the left. This change in the market is called a decrease in demand.
Not only will households demand fewer old computers (demand contracts from ten per week to seven), they will only buy them if the price falls to $2,700.

The substitution effect applies when supply decreases as well.

In the diagram to your left, the cost of locally made cars has increased from $18,000 to $20,000. This could have been caused by an increase in government taxes, or an increase in the cost of production (such as increases in wages paid to your production line staff).
In any case, the decrease in supply (shown as the movement from E to E¹ has caused a contraction in demand for domestically made cars (cars made in Australia). Now only ten cars are sold per week from the car yard we are studying.

The increase in price of locally made cars has caused some consumers to switch their preferences to imported cars, of a similar size and style. Car yards selling these imported cars notice an increase in demand for their product.
They decide to increase their sales price from $16,000 to $19,000. Despite the increase in price, the quantity sold per week increases from seven to ten.
Both cars are now more expensive than they were before; however, the imported car is now relatively cheaper than the locally made car, and as a result demand for the imported car expands.

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Complements

When people decide to consume, they will often buy several things, together. For example, many people, when they go to the movies, often buy popcorn or snack food. Goods or services that go together in satisfying the same want are called complements.
In the illustration to your left, the price of cinema tickets has increased, from $12 per session to $14. As a result, the number of people attending per movie screening has contracted from 550 to 500 people per session.

Popcorn is a complementary good, when we consume the service called ''entertainment'' at the movies. Demand for popcorn has contracted, as a result of the increase in the price of the cinema ticket.
Previously, when the price of a movie ticket was $12, two hundred patrons bought popcorn per session. Now, as a result of the increase in the price of a movie ticket, only 170 people are buying popcorn; and to sell this quantity of popcorn, the cinema owners have had to decrease the price of popcorn to $1.70 per cup.

Economists argue that this effect is logical; people budget and plan their expenditures. Consumers will put aside a certain amount of money for the entire act of consumption; that is the movie ticket and any other associated expenditure. If the price of one part of the total consumption rises, consumers will reduce their expenditure on other parts of the act of consumption, to stay within their total budget.

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Review : Factors Effecting Demand

If price only changes, the demand curve for a good or service will not shift. Instead, there will be a movement along the demand curve. If price rises, demand will contract; less will be purchased in a given period of time. If price falls, demand will expand, and more will be bought in a given period of time.

The demand curve will shift to the left or right, if other factors, other from price, change.

What are these other factors?

There are many, but some include

changes in income.
An increase in household income will see demand increasing (a shift of the curve to the right). Usually, this is associated with an increase in the price of the good or service being consumed.

changes in the prices of substitutes. If the price of a substitute falls, then demand for the good or service will also fall (or contract, to use the correct terminology).

changes in the prices of complements. If the price of a complement rises, then the demand for the good or service will fall (or ''contract'').

changes in the size and age distribution of the general population. As Australia's population is rapidly aging (as a result of smaller numbers of children per family), demand for many goods and services demanded by older people has risen. For example, in the building industry, there has been an increase in demand for retirement homes, and ''medium density'' housing.

changes in interest rates and the general availability of credit. Many households finance consumption through borrowing. If interest rates rise, demand contracts for many goods and services; particularly housing.

advertising and changes in fashion can have a market effect on demand. Indeed, producers of goods that are close substitutes generally spend large amounts on advertising, reminding consumers that their product is ''better'' than the opposition's product. (Whether or not this is reality true, of course is another matter).

seasonal changes. For example, demand for icecreams rises in warmer weather, and falls in the colder months of the year.

changes in technology. Firms are constantly attempting to gain greater sales through improvements in the quality and features of their product. This is seen clearly in the computer market. The introduction of a new personal computer with a bigger memory chip or a faster operating speed soon results in prices of older model computers rapidly falling.

consumer expectations also effect demand. People tend to maintain high levels of consumption when they feel confident about their continuing employment in the future. If people, for whatever reason, feel less confident about the future, they tend to decrease consumption and increase saving.
If households believe that inflation will rise in the future, or that government taxes will rise, they will increase their demand for many goods and services, to ''beat'' the price rise.

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Isn't Everyone After the Quickest Profit? - The Goals of Firms

What is produced is what people want. Firms will follow changes in household demand, changing production as demand is influenced by tastes and preferences, and by technology.

Firms in competitive markets usually attempt to find the least cost, greatest profit method of production.

Economists assume that firms, operating in competitive markets, always try to maximize their profits. This is done by increasing the quantity of goods or service you produce. As we know, revenue equals the price per unit multiplied by the quantity sold. In competitive markets, there is little likelihood of increasing your price without decreasing the quantity you sell.

Firms will produce one more unit of a good, as long as the additional revenue gained is greater than the additional cost of production. Economists say ''Production increases as long as marginal revenue is greater than marginal cost''.

In a market economy, firms invest in research and development, and in new technologies, in a continual attempt to lower their costs. Firms are always looking for the least cost method of production.

At the same time, some firms may be focussing on sales maximisation, in an attempt to gain a share in the market. A firm may sell at lower prices for a time, and reduce the profits paid to it's owners, as result. The shareholders in this firm may be focussing on the long term, 5 to 10 year period, rather than on the next two years. Proponents of this management objective focus on market share as the key to profitability.

Let's say your chain of retail stores sells one in every ten of video cassette recorders sold in Australia. In years of economic growth, your competitor's sales will rise; but so will your's. In bad years, their sales will fall as your's do. You have developed a solid customer base, and are likely to be in business for the long term.

Some firms look to increase their productive capacity and their capital assets rather than increase sales or profits. If you decide to follow this management objective, your shareholders may not be paid a dividend for a considerable time. However, your firm will be in position to become a large producer in the medium term, and make even larger profits.

Some firms may deliberately run at breakeven point (to make no profit), selling their production at low prices to stop a new entrant into the market from becoming established. Other firms may decide that you can deal with competitors well if you have a happy workforce, good relationships with unions and a good standing in the community. This means that profits may be less than what could be obtained with a different style of management; but, you as a shareholder or manager want a quiet life, not one full of confrontations with unions and other groups.

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Introduction	The Law of Demand
Contraction of Demand	Expansion of Demand
Marginal Utility	Expansion of Supply
Market Equilibrium	Increase in Demand
Increase in Supply	The Substitution Effect
Complements	The Goals of Firms
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