All Rights ReservedPRINCIPLES OF ECONOMICS Third Edition
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All Rights ReservedPRINCIPLES OF ECONOMICS Third Edition
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 2– 2
CHAPTER 2DEMAND AND SUPPLY
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DEFINITION OF DEMAND
Demand is defined as the ability and willingness
to buy specific quantities of goods
in a given period of time
at a particular price, ceteris paribus.
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CLASSIFICATION OF GOODS AND SERVICES
Free goods are goods that have no production cost.
Public goods are goods that are for common use and will benefit everyone.
Economic goods are goods of value that can be seen and touched. Economic services are intangible things (with value) that cannot be seen or touched.
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LAW OF DEMAND
Law of demand states that the higher the price
of a good, the lower is the quantity demanded
for that good and the lower the price, the higher is the quantity demanded, ceteris paribus.
P Qdd P Qdd
NEGATIVE RELATIONSHIP
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DEMAND SCHEDULE AND CURVE
Price Quantity
5 2
4 4
3 6
2 8
1 10
Demand Schedule Demand Curve
5
4
3
2
1
0
6
2 4 6 8 10
DD
Quantity (units)
Price (RM)
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INDIVIDUAL AND MARKET DEMAND
INDIVIDUAL DEMAND
The relationship between the quantity
of a good demanded by a single individual
and its price.
MARKET DEMAND
The relationship between the total quantity
of a good demanded by adding all the quantities demanded by all consumers in the market and its price.
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Level of taxationLevel of taxationFestive seasons and climate
Festive seasons and climate
Price of related goodsPrice of related goods
Consumers’ incomeConsumers’ income
Tastes and trendsTastes and trends
Population or number of buyers
Population or number of buyers
Supply of money in circulation
Supply of money in circulation
Expectation about future prices
Expectation about future prices
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CHANGES IN QUANTITY DEMANDED VS. CHANGES IN DEMAND
CHANGES IN QUANTITY DEMANDED CHANGES IN DEMAND Price
DDQuantity
Movement along DD curve Price changes and other factors are
constant Upward movement Decrease in
quantity demanded (Contraction) Downward movement Increase in
quantity demanded (Expansion)
Price
D1
D0
Quantity
Shift in the demand curve Occurs when there are changes in
other factors but price remains constant
Increase in Demand (D0 D1)
Decrease in Demand (D1 D0)
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EXCEPTIONAL DEMAND
Exceptional Demand is the opposite of the Law of Demand where as price increases, demand will also increase and vice versa.
STATUS SYMBOL GOODS
SPECULATION
EMERGENCIES
HIGHLY-PRICED GOODS
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INTER-RELATED DEMAND
The demand for a good is also affected by the price ofits substitute or complementary goods. Cross demand can be divided into two: Joint demand and competitive demand.
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CROSS DEMAND: JOINT DEMAND VS. COMPETITIVE DEMAND
Price of pizza
Q2 Q1
P2
P1
Negative relationship exists between complement goods
Quantity of soft drinks Q1 Q2 Quantity of spaghetti
P1
P2
DD
Positive relationship exists between substitute goods
Cross Demand
Price of pizza
a) Joint Demand b) Competitive Demand
DD
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Derived demand is the demand for a good which is derived from other goods.
INTER-RELATED DEMAND
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DERIVED DEMAND
Derived Demand
Price (RM)
Q0 Q1
P1
P0
D0
Quantity of houses Q0 Q1 Quantity of
workers
WR0
WR1
Wage rate (RM per hour)
Demand and supply for houses Demand and supply for carpenters
D1
S0
D0
D1
S0
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INTERRELATED DEMAND
Composite demand is demand for a good that has multiple uses
For example: oil can be used for petrol, kerosene and diesel
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COMPOSITE DEMAND
Price
Q0 Q1
P1
P0
D0
Quantity of petrol Q1 Q0 Quantity of diesel
P0
P1
Demand and supply for petrol Demand and supply for diesel
D1
S0
D0
S1Price
S0
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PRICE ELASTICITY OF DEMAND
DEFINITION:
Measures the sensitivity/responsiveness of the quantity demanded due to a change in its price.
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PRICE ELASTICITY OF DEMAND (cont.)
d = Q2 – Q1 x P1
Q1 P2 – P1
FORMULA:
d = % Quantity Demanded % Price
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Perfectly Inelastic DemandA condition in which the quantity demanded does not change as the price changes.
Inelastic DemandA large percentage of change in the price of a good will only affect a small percentage of change in the quantity demanded.
Elastic Demand A small percentage of change in the price of a good will lead to larger percentage of change in quantity demanded.
Unitary Elastic DemandA condition in which percentage changes in price equals to percentage changes in quantity demanded.
Perfectly Elastic DemandA condition in which a small percentage of change in price leads to an infinite percentage of change in the quantity demanded.
d > 1
d < 1
d =0
d =
d = 1
DEGREE OF ELASTICITY
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DEGREE OF ELASTICITY
Price (RM)
Quantity Demanded
d > 1
d < 1
d = 1
d =0
d =
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Existence of substitutesExistence of substitutes
Frequently purchased products
Frequently purchased products
Time dimension
Time dimensionComplementary
goodsComplementary
goods HabitsHabits
Proportion of the expenditure on a product
Proportion of the expenditure on a product
Nature of goods
Nature of goods
Income levelIncome level
Existence of substitutesExistence of substitutes
Proportion of the expenditure on a
product
Proportion of the expenditure on a
product
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RELATIONSHIP TO TOTAL REVENUE
Price
D
RM30
10
DEMAND IS ELASTIC
Total Revenue
RM20 x 10 = RM200
If seller increases price to RM30
New Total Revenue
= RM30 x 5 = RM150
TR = RM50
RM20
5 Quantity Demanded
The information on price elasticity of demand will be useful for the seller to adjust their selling price since it will affect the total revenue.
Total Revenue (TR) = Price (P) x Quantity (Q)
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RELATIONSHIP TO TOTAL REVENUE (cont.)
Price
D
RM2
15
DEMAND IS INELASTIC
Total Revenue
RM1 x 15 = RM15
If seller increases price to RM2
New Total Revenue
= RM2 x 10 = RM20
TR = RM5
RM1
10Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)
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RELATIONSHIP TO TOTAL REVENUE (cont.)
Price
D
RM2
20
DEMAND IS UNITARY ELASTIC
Total Revenue
RM1 x 20 = RM20
If seller increases price to RM2
New Total Revenue
= RM2 x 10 = RM20
TR = 0
RM1
10 Quantity Demanded
Total Revenue (TR) = Price (P) x Quantity (Q)
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INCOME ELASTICITY OF DEMAND
DEFINITION:
Measures the sensitivity/responsiveness of the quantity demanded due to a change in income.
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INCOME ELASTICITY OF DEMAND (cont.)
Y = Q2 – Q1 x Y1
Q1 Y2 – Y1
FORMULA:
Y = % Quantity Demanded
% Income
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RESPONSES OF INCOME ELASTICITY
Negative Income Elasticity-Type of good: Giffen/ Inferior goods such as
used car and low grade potatoes
Income
Quantity Demanded
y< 0y > 1
y =0Inelastic Income
-Type of good: Normal goods such as food and clothing
Elastic Income-Type of good: Luxury goods such as antique
furniture and diamonds
0 < y < 1 Zero Income Elasticity-Type of good: Necessity Goods such as rice
and vegetables
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CROSS ELASTICITY OF DEMAND
DEFINITION:
Measures the sensitivity/responsiveness of the quantity demanded of one product
due to a change in the price of a related product.
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CROSS ELASTICITY OF DEMAND
X = QX2 – QX1 x PY1
QX1 PY2 – PY1
FORMULA:
X = % Quantity Demanded of good X
% Price of good Y
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RESPONSES OF CROSS ELASTICITY
Price of Good X
Quantity Demanded of Good Y
x < 0x > 0
x =0
Zero Cross Elasticity-Good X and Y have no relationship
Positive Cross Elasticity-Good X and Y are substitute goods
Negative Cross Elasticity-Good X and Y are complementary goods
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DEFINITION OF SUPPLY
Supply is defined as the ability and willingness to sell or produce a particular product and services in a given period of time at a particular price, ceteris paribus.
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LAW OF SUPPLY
P Qss P Qss
POSITIVE RELATIONSHIP
Law of supply states that the higher the price of a good, the greater is the quantity supplied for that good and the lower the price of a good,
the lower is the quantity supplied, ceteris paribus.
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SUPPLY SCHEDULE AND CURVE
Price Quantity
5 10
4 8
3 6
2 4
1 2
Supply Schedule Supply Curve
10
8
6
4
2
0
12
1 2 3 4 5
Supply
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INDIVIDUAL AND MARKET SUPPLY
INDIVIDUAL SUPPLYThe relationship between the quantity of a product
supplied by a single seller and its price.
MARKET SUPPLYThe relationship between the total quantity
of a product supplied by adding all the quantities supplied by all sellers
in the market and its price.
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Price of related goods
Price of related goods
Number of sellers
Number of sellers
Improvement in infrastructure
Improvement in infrastructure
Government Policies
Government Policies
Proportion of the expenditure on a product
Proportion of the expenditure on a product
Expected future priceExpected
future price
Technological advancementTechnological advancement
Cost of productionCost of production
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CHANGE IN QUANTITY SUPPLIED VS. CHANGE IN SUPPLY
CHANGE IN QUANTITY SUPPLIED CHANGE IN SUPPLY
Price
SS
Quantity
Movement along supply curve Price changes and other factors are
constant Downward movement Decrease in
quantity supplied (Contraction) Upward movement Increase in
quantity supplied (Expansion)
Price
s0
s1
Quantity
Shift in the supply curve Occurs when there are changes in
other factors but the price remains constant
Increase in Supply (S0 S1)
Decrease in Supply (S1 S0)
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EXCEPTIONAL SUPPLY
Wage Rate
Labour
15
4 5
5
10
20
0 1 2 3
Income Effect
(Exceptional Supply Curve)
Substitution Effect
Exceptional Supply is the opposite of the Law of Supply where as price increases, the quantity supplied decreases and vice versa
6
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INTERRELATED SUPPLY
Increase in the supply of one good brings to an increase in the supply
of another related goods.
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PRICE ELASTICITY OF SUPPLY
DEFINITION:
Measures the sensitivity/responsiveness of the quantity supplied due to a change
in the price of a product or service.
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PRICE ELASTICITY OF SUPPLY (cont.)
SS = Q2 – Q1 x P1
Q1 P2 – P1
FORMULA:
ss = % Quantity Supplied % Price
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DEGREE OF ELASTICITY
Price (RM)
Quantity Supplied
Unitary Elastic SupplyPercentage change in price equals the percentage change in the quantity supplied.
Inelastic SupplyA large percentage of change in the price of a good will only affect a small percentage of change of the quantity supplied.
Elastic SupplyA small percentage of change in the price of a good will lead to larger percentage of change in the quantity supplied.
Perfectly Inelastic Supply A percentage of change in price has no effect on the percentage of change in the quantity supplied.
Perfectly Elastic SupplyAn almost zero percentage of change in price brings a very large percentage of change in the quantity supplied.
ss > 1
ss < 1
ss = 1ss =0
ss =
ss > 1
ss < 1
ss = 1
ss =0
ss =
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Technology improvements
Technology improvements
PerishabilityPerishabilityAvailability and mobility of
factors of productionAvailability and mobility of
factors of production
Nature of the market
Nature of the market
Time PeriodTime Period