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DEMAND AND SUPPLY

CHAPTER MAP

1 INTRODUCTION

2 DEMAND

2.1 Relationship between Price and Quantity Demanded

2.2 Movements along versus Shifts in the Demand Curve

2.3 Non-price Determinants of Demand

3 SUPPLY 

3.1 Relationship between Price and Quantity Supplied

3.2 Movements along versus Shifts in the Supply Curve

3.3 Non-price Determinants of Supply

4 EQUILIBRIUM

4.1 Equilibrium Price and Equilibrium Quantity

4.2 Effects of a Change in Demand on Price and Quantity

4.3 Effects of a Change in Supply on Price and Quantity4.4 Effects of Simultaneous Changes in Demand and Supply on Price and Quantity

5 SURPLUS

5.1 Consumer Surplus

5.2 Producer Surplus

1 INTRODUCTION

In Chapter 1, we learnt that the allocation of resources in the market system is determined by the

market forces of demand and supply. Therefore, to have a good understanding of the allocationof resources in the market system, we need to understand the concepts of demand and supply.

Indeed, as demand and supply are two fundamental economic concepts which permeate the

study of economics, a good understanding of the concepts is essential for understanding

economics. To draw an analogy, the importance of demand and supply in economics is equivalent

to the importance of the four mathematical operations of addition, subtraction, multiplication

and division in mathematics. This chapter provides an exposition of the concepts of demand

and supply.

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2 DEMAND

2.1 Relationship between Price and Quantity Demanded

The demand for a good is the quantity of the good that consumers are able and willing to buy at

each price over a period of time, ceteris paribus.

The law of demand states that there is an inverse relationship between price and quantity

demanded. When the price of a good falls, the quantity demanded will rise. Conversely, when the

price of a good rises, the quantity demanded will fall.

The quantity of a good that consumers are able and willing to buy at each price can be shown

by the demand curve. The demand curve shows the quantity demanded at each price and is

downward sloping due to the law of demand.

Demand Curve

In the above diagram, when the price (P) is P0, the quantity demanded (Q) is Q0. A fall in the price

from P0 to P1 leads to an increase in the quantity demanded from Q0 to Q1.

The law of demand can be explained with the concept of diminishing marginal utility. Utility refers

to the satisfaction obtained by consumers from consuming a good. Marginal utility is the additional

satisfaction resulting from consuming one more unit of a good. The more a consumer has of a

good, the less they will value it at the margin and this is known as diminishing marginal utility.

Due to diminishing marginal utility, consumers will only increase the consumption of a good if the

price falls. The law of demand can also be explained with the concepts of substitution effect and

income effect. When the price of a good falls, the real income of consumers will rise as they will be

Price

Quantity Demanded

D

P0

Q0   Q1

P1

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able to buy a larger amount of goods and services with the same amount of nominal income. This

will induce them to buy more of the good. This effect is known as the income effect of a price fall.

Furthermore, when the price of a good falls, the good will become relatively cheaper than other

goods. This will induce consumers to substitute the good for other goods. This effect is known as

the substitution effect of a price fall.

NOTE: Ceteris paribus is Latin which means other things being equal.

The demand curve of a consumer is downward sloping due to the law of demand. The market

demand curve is the horizontal summation of the demand curves of all the consumers in

the market and hence is also downward sloping.

Students are not required to explain the inverse relationship between price and quantity

demanded in the examination unless the question specifically asks so.

2.2 Movements along versus Shifts in the Demand Curve

 A change in quantity demanded occurs when quantity demanded changes due to a change in

price. This is shown by a movement along the demand curve.

In the above diagram, the quantity demanded (Q) increases from Q 0 to Q1 due to a fall in the price

(P) from P0 to P1. This is called an increase in quantity demanded.

 A change in demand occurs when quantity demanded changes due to a change in a non-price

determinant of demand. In other words, quantity demanded changes at the same price. This is

shown by a shift in the demand curve.

Price

Quantity Demanded

D

P0

Q0   Q1

P1

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In the above diagram, the quantity demanded (Q) increases from Q0 to Q1 at the same price (P0 )

due to a change in a non-price determinant of demand. This is called an increase in demand.

NOTE: Students should not mix up a change in quantity demanded which is shown by amovement along the demand curve and a change in demand which is shown by a shift in

the demand curve as failure to do so will lead to a great loss of marks in the examination.

2.3 Non-price Determinants of Demand

Tastes and Preferences

 A change in tastes and preferences towards a good will lead to an increase in the demand for

the good. Tastes and preferences are affected by a number of factors such as technological

advancements and campaigning. For example, the inventions of smartphones and tablets have

led to a change in tastes and preferences from print publications to digital publications. Healthy

living campaigns have led to a change in tastes and preferences from non-diet soft drinks to dietsoft drinks. These have increased the demand for digital publications and diet soft drinks.

Prices of Substitutes and Complements

Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. A

rise in the prices of substitutes for a good will induce consumers to buy less of the substitutes

resulting in an increase in the demand for the good. For example, if the price of Pepsi rises,

consumers will buy less Pepsi and more Coke. Complements are goods which are consumed

in conjunction with one another such as car and petrol. A fall in the prices of complements for

Price

Quantity Demanded

D0   D1

P0

Q0   Q1

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a good will induce consumers to buy more of the complements resulting in an increase in the

demand for the good. For example, if the prices of cars fall, consumers will buy more cars and

more petrol. Substitutes and complements will be explained in greater detail in Chapter 3.

Number of Substitutes and Complements

 An increase in the number of substitutes for a good will lead to a decrease in the demand for the

good and vice versa. For example, if scientists found out that milk could be used as a substitute for

shampoo, the demand for shampoo would decrease. An increase in the number of complements

will lead to an increase in the demand for a good and vice versa. For example, if more models of

digital cameras are introduced onto the market, the demand for memory cards will increase.

Level of Income

When consumers’ income rises, the demand for most goods will increase. These goods are

called normal goods. However, the demand for some goods will decrease. These goods arecalled inferior goods and are typically low in quality. Normal goods and inferior goods will be

explained in greater detail in Chapter 3.

Distribution of Income

If income is redistributed from the rich to the poor, the demand for luxuries which are typically

consumed by the rich will fall as the rich will become less rich. The demand for inferior goods

which are typically consumed by the poor will also fall as the poor will become less poor. However,

the demand for necessities will increase as both the rich and the poor will buy more necessities.

Expectations of Price Changes

If consumers expect the price of a good to rise, they will bring forward the purchase to avoid paying

a higher price in the future. If the good can be resold such as residential properties, consumers will

also buy the good to sell it at a higher price later. When these happen, the demand for the good

will increase.

Size of the Population

 An increase in the size of the population will lead to an increase in the demand for certain goods

and services. With the exception of a few countries such as Japan, most countries have been

experiencing an increase in the size of the population.

Structure of the Population

If the population is greying, the demand for pharmaceutical products will increase. An example is

Singapore. If the birth rate rises, the demand for infant products will increase.

Government Policies

The government is the biggest spender in every economy. Therefore, if the government increases

expenditure, the demand for certain goods and services will increase. The government can also

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affect private expenditure by changing interest rates and tax rates. For example, if the government

cuts income taxes, consumers will experience a rise in their disposable incomes which will lead to

an increase in the demand for certain goods and services.

Weather Conditions

In winter, the demand for coats and sweaters will increase and the demand for ice creams will

decrease. The opposite is true in summer.

3 SUPPLY 

3.1 Relationship between Price and Quantity Supplied

The supply of a good is the quantity of the good that rms are able and willing to sell at each price

over a period of time, ceteris paribus.

The law of supply states that there is a direct relationship between price and quantity supplied.

When the price of a good falls, the quantity supplied will fall. Conversely, when the price of a good

rises, the quantity supplied will rise.

The quantity of a good that rms are able and willing to sell at each price can be shown by the

supply curve. The supply curve shows the quantity supplied at each price and is upward sloping

due to the law of supply.

Supply Curve

In the above diagram, when the price (P) is P0, the quantity supplied (Q) is Q0. A rise in the price

from P0 to P1 leads to an increase in the quantity supplied from Q0 to Q1.

Price

Quantity Supplied

S

P0

Q0   Q1

P1

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The law of supply can be explained with the concept of prot maximisation. A rise in the price of

a good will increase the protability of selling the good. Therefore, rms which are prot-oriented

will sell more of the good. The law of supply can also be explained with the concept of diminishing

marginal returns. Suppose that a rm employs two factor inputs: capital and labour. Although labour

is a variable factor input, capital is a xed factor input. As the quantity of capital is xed in the shortrun, the rm can increase production only by employing more labour. However, as each additional

unit of labour will have less capital to work with, it will add less to total output than the previous

additional unit and this is known as diminishing marginal returns. Due to diminishing marginal returns,

to produce each additional unit of output, more units of labour will be required which will lead to an

increase in marginal cost. Marginal cost is the additional cost resulting from producing one more unit

of output. Therefore, rms will increase the production of a good only if the price rises.

NOTE: The supply curve of a firm is upward sloping due to the law of supply. The marketsupply curve is the horizontal summation of the supply curves of all the firms in the market

and hence is also upward sloping.

Students are not required to explain the direct relationship between price and quantity

supplied in the examination unless the question specifically asks so.

3.2 Movements along versus Shifts in the Supply Curve.

 A change in quantity supplied occurs when quantity supplied changes due to a change in price.

This is shown by a movement along the supply curve.

In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 due to a rise in the price

(P) from P0 to P1. This is called an increase in quantity supplied.

Price

Quantity Supplied

S

P0

Q0   Q1

P1

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 A change in supply occurs when quantity supplied changes due to a change in a non-price

determinant of supply. In other words, quantity supplied changes at the same price. This is shown

by a shift in the supply curve.

In the above diagram, the quantity supplied (Q) increases from Q0 to Q1 at the same price (P0 ) due

to a change in a non-price determinant of supply. This is called an increase in supply.

NOTE:  Students should not mix up a change in quantity supplied which is shown by amovement along the supply curve and a change in supply which is shown by a shift in the

supply curve as failure to do so will lead to a great loss of marks in the examination.

3.3 Non-price Determinants of Supply 

Cost of Production

 A rise in the cost of production will lead to a decrease in supply and vice versa. When the costof production rises, rms will increase the price at each quantity to maintain protability. In other

words, they will reduce the quantity supplied at each price which will lead to a decrease in supply.

The converse is also true. There are several factors that can lead to a change in the cost of

production. For example, a fall in factor prices such as wages will lead to a fall in the cost of

production and vice versa. Subsidy will decrease the cost of production and tax will have the

opposite effect. Labour productivity refers to output per hour of labour. When labour productivity

rises, which may be due to an increase in the skills and knowledge of labour or the efciency

of capital, rms will need a smaller amount of labour to produce any given amount of output.

Therefore, the cost of production will fall.

Price

Quantity Supplied

S0   S1

P0

Q0   Q1

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Production Capacity

If the production capacity in the industry increases, which may occur due to an increase in the

number of rms in the industry or an expansion of the production capacities of the existing rms,

the supply of the good will increase. The converse is also true.

Expectations of Price Changes

If rms expect the price of a good to rise, they will hoard some of the output that they currently

produce to sell it at a higher price in the future. This will lead to a fall in the supply of the good. The

converse is also true.

Protability of Goods in Joint Supply

Goods in joint supply refer to goods that are produced in the same production process. An example

is petrol and diesel. In the process of rening crude oil to produce petrol, other grade fuels suchas diesel are also produced. Therefore, if the demand for petrol increases which will lead to an

increase in the protability, more petrol will be produced. When this happens, the supply of diesel

will also increase. The converse is also true.

Protability of Substitutes in Supply

Substitutes in supply refer to goods that are produced using the same factor inputs. An example

is potatoes and tomatoes. If the demand for tomatoes increases which will lead to an increase in

the protability, some farmers who are currently producing potatoes will switch to the production

of tomatoes which will lead to a decrease in the supply of potatoes. The converse is also true.

Disasters (Natural and Man-made)

Natural disasters such as oods and earthquakes, and man-made disasters such as wars which

may kill workers and destroy factories and machinery, may lead to a decrease in the supply of

certain goods including agricultural products.

Weather Conditions

When weather conditions become less favourable, the supply of agricultural products will fall as

harvests will decrease. The converse is also true. In the event of severe weather conditions, the

supply of air travel will fall as airlines will be forced to cancel ights.

4 EQUILIBRIUM

4.1 Equilibrium Price and Equilibrium Quantity 

 An equilibr ium is a state where there is no tendency to change. The equilibrium of a market is

determined by the market forces of demand and supply. If consumers demand more of a good than

what rms supply at a particular price, the quantity demanded will exceed the quantity supplied.

The resultant shortage will push up the price. This is because when rms do not produce enough

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to sell, they can raise the price without losing sales. Therefore, they will do so to increase their

prots. A rise in the price of the good will incentivise rms to increase the production due to the

higher protability and consumers to decrease the consumption due to the higher relative price

and the lower real income. Therefore, the quantity supplied will rise and the quantity demanded

will fall. The price will continue rising until the quantity demanded is equal to the quantity supplied,at which point the shortage is eliminated and an equilibrium is established.

In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the

equilibrium quantity are PE and QE. At a price below PE, such as P1, the quantity demanded (QD )

is greater than the quantity supplied (QS ) and this results in a shortage (QD  – QS ). As the price

rises, the quantity demanded falls and the quantity supplied rises and this process continues

until the price rises to PE where the quantity demanded and the quantity supplied are equal at QE.

Similarly, if rms supply more of a good than what consumers demand at a particular price, the

quantity supplied will exceed the quantity demanded. The resultant surplus will push down the

price. This is because when rms cannot sell all the output that they produce, their stocks will

build up. Therefore, they will lower the price to reduce their stocks. A fall in the price of the good

will incentivise rms to decrease the production due to the lower protability and consumers to

increase the consumption due to the lower relative price and the higher real income. Therefore, thequantity supplied will fall and the quantity demanded will rise. The price will continue falling until

the quantity demanded is equal to the quantity supplied, at which point the surplus is eliminated

and an equilibrium is established.

Price

Quantity

D

S

PE

P1

QS   QE   QD

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In the above diagram, given the demand (D) and the supply (S), the equilibrium price and the

equilibrium quantity are PE and QE. At a price above PE, such as P2, the quantity supplied (QS ) is

greater than the quantity demanded (QD ) and this results in a surplus (QS – QD ). As the price falls,

the quantity demanded rises and the quantity supplied falls and this process continues until the

price falls to PE where the quantity demanded and the quantity supplied are equal at QE. At PE, the

quantity demanded is equal to the quantity supplied. There is neither surplus nor shortage and

hence there is no incentive for rms to change the price.

4.2 Effects of a Change in Demand on Price and Quantity 

Increase in Demand

 An increase in demand will lead to a rise in price and quantity.

Price

Quantity

S

D

PE

QD   QE   QS

P2

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In the above diagram, an increase in the demand (D) from D 0 to D1 leads to a rise in the price (P)

from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0 ) and the supply

(S0 ), the price and the quantity are P0 and Q0. When the demand increases from D0 to D1, although

the quantity demanded rises at the same price (P0 ), the quantity supplied remains at Q0 and this

results in a shortage. When rms do not produce enough to sell, they can raise the price without

losing sales. Therefore, they will do so to increase their prots. As the price rises, the quantitydemanded falls and the quantity supplied rises and this process continues until the price rises to

P1 where the quantity demanded and the quantity supplied are equal at Q1.

Decrease in Demand

 A decrease in demand will lead to a fall in price and quantity.

Price

Quantity

S0

D0

D1

P0

Q0   Q1

P1

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In the above diagram, a decrease in the demand (D) from D0 to D1 leads to a fall in the price (P)

from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. Given the demand (D0 ) and the supply (S0 ),

the price and the quantity are P0 and Q0. When the demand decreases from D0 to D1, although the

quantity demanded falls at the same price (P0 ), the quantity supplied remains at Q0 and this results

in a surplus. When rms cannot sell all the output that they produce, their stocks will build up.

Therefore, they will lower the price to reduce their stocks. As the price falls, the quantity demandedrises and the quantity supplied falls and this process continues until the price falls to P1 where the

quantity demanded and the quantity supplied are equal at Q1.

NOTE: When demand changes, price and quantity will change in the same direction.

4.3 Effects of a Change in Supply on Price and Quantity 

Increase in Supply

 An increase in supply wil l lead to a fall in price and a rise in quantity.

Price

Quantity

S0

D1

D0

P1

Q1   Q0

P0

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In the above diagram, an increase in the supply (S) from S 0  to S1  leads to a fall in the price (P)

from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. Given the demand (D0 ) and the supply

(S0 ), the price and the quantity are P0 and Q0. When the supply increases from S 0 to S1, although

the quantity supplied rises at the same price (P0 ), the quantity demanded remains at Q 0 and this

results in a surplus. When rms cannot sell all the output that they produce, their stocks will

build up. Therefore, they will lower the price to reduce their stocks. As the price falls, the quantitydemanded rises and the quantity supplied falls and this process continues until the price falls to

P1 where the quantity demanded and the quantity supplied are equal at Q1.

Decrease in Supply

 A decrease in supply will lead to a r ise in price and a fall in quantity.

Price

Quantity

D0

Q0   Q1

S1

S0

P0

P1

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In the above diagram, a decrease in the supply (S) from S0 to S1 leads to a rise in the price (P) from

P0 to P1 and a fall in the quantity (Q) from Q 0  to Q1. Given the demand (D0 ) and the supply (S0 ),

the price and the quantity are P0 and Q0. When the supply decreases from S0 to S1, although the

quantity supplied falls at the same price (P0 ), the quantity demanded remains at Q0 and this results

in a shortage. When rms do not produce enough to sell, they can raise the price without losing

sales. Therefore, they will do so to increase their prots. As the price rises, the quantity demanded

falls and the quantity supplied rises and this process continues until the price rises to P1 where the

quantity demanded and the quantity supplied are equal at Q1.

NOTE: When supply changes, price and quantity will change in opposite directions.

4.4 Effects of Simultaneous Changes in Demand and Supply onPrice and Quantity 

Same Directional Changes in Demand and SupplySuppose that demand and supply rise simultaneously. An increase in demand will lead to a rise in

price and quantity. An increase in supply will lead to a fall in price and a rise in quantity. Therefore,

quantity will rise and price will be indeterminate. In this case, the effect on price will depend on

the relative changes in demand and supply. If the increase in demand is greater than the increase

in supply, price will rise.

Price

Quantity

D0

Q1   Q0

S0

S1

P1

P0

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In the above diagram, given the demand (D 0 ) and the supply (S0 ), the price (P) and the quantity

(Q) are P0 and Q0. A larger increase in the demand from D0  to D1 and a smaller increase in the

supply from S0 to S1 lead to a rise in the price from P0 to P1 and a rise in the quantity from Q0 to Q1.

However, if the increase in supply is greater than the increase in demand, price will fall.

In the above diagram, given the demand (D0 ) and the supply (S0 ), the price (P) and the quantity (Q)

are P0 and Q0. A larger increase in the supply from S0 to S1 and a smaller increase in the demand

from D0 to D

1 lead to a fall in the price from P

0 to P

1 and a rise in the quantity from Q

0 to Q

1.

Price

Quantity

S0

S1

D0

D1

P0

Q0   Q1

P1

Price

Quantity

S0

S1

D0

D1

P0

Q0   Q1

P1

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Similarly, when demand and supply fall simultaneously, quantity will fall and price will be

indeterminate. The effect on price will depend on the relative changes in demand and supply. If the

decrease in demand is greater than the decrease in supply, price will fall. However, if the decrease

in supply is greater than the decrease in demand, price will rise.

Different Directional Changes in Demand and Supply

The above analysis is based on the assumption that demand and supply change in the same

direction. However, if demand and supply change in opposite directions, the analysis will be a little

more complicated. As the analysis of such a case involves the concepts of price elasticity of demand

and price elasticity of supply which have not been covered, it will be explained in Chapter 3.

5 SURPLUS

5.1 Consumer Surplus

Consumer surplus is the difference between the maximum amount that consumers are able and

willing to pay for a good and the amount that they actually pay.

In the above diagram, consumers are able and willing to pay $10 for the rst unit of the good, $9

for the second unit, $8 for the third unit and $7 for the fourth unit. Suppose that consumers buy

4 units of the good. When the quantity demanded is 4 units, the price is $7. In this case, although

the maximum amount that consumers are able and willing to pay is $34 ($10 + $9 + $8 + $7 = area

of trapezium), the amount that they actually pay is $28 ($7 x 4 = area of rectangle). Therefore, the

consumer surplus is $6 ($34 − $28 = area of trapezium − area of rectangle) and is represented by

the area below the demand curve and above the price.

Price

D

$10

$9

$8

$7

1 2 3 4 Quantity Demanded

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      ►    D

   E   M   A   N   D   A   N   D   S   U

   P   P   L   Y

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5.2 Producer Surplus

Producer surplus is the difference between the minimum amount that rms are able and willing to

receive for a good and the amount that they actually receive.

In the above diagram, rms are able and willing to receive $4 for the rst unit of the good, $5 for the

second unit, $6 for the third unit and $7 for the fourth unit. Suppose that rms produce 4 units ofthe good. When the quantity supplied is 4 units, the price is $7. In this case, although the minimum

amount that rms are able and willing to receive is $22 ($4 + $5 + $6 + $7 = area of trapezium),

the amount that they actually receive is $28 ($7 x 4 = area of rectangle). Therefore, the producer

surplus is $6 ($28 − $22 = area of rectangle − area of trapezium) and is represented by the area

below the price and above the supply.

$7

$6

$5

$4

1 2 3 4

Price

Quantity Supplied

S