RAFFLES INSTITUTION

YEAR 5 H2 ECONOMICS 2024

PRICE MECHANISM AND ITS APPLICATIONS

CONTENTS:
ECONOMICS

LECTURE NOTES
• PRICE MECHANISM AND ITS
APPLICATIONS (PART 1)
o Demand and Supply Model
o Price Mechanism in Resource
Allocation

• PRICE MECHANISM AND ITS

APPLICATIONS (PART 2)
o Elasticities and its Applications
o Impact of Government Intervention
o The Labour Market

TUTORIAL PACKAGE

• Section A: Short Structured Questions

• Section B: Case Study Questions
• Section C: Essay Questions
• Section D: Further Reading
This series of lectures provides an insight into the workings of the price mechanism
in a perfectly competitive market. It focuses on the use of the demand-supply
framework and elasticity concepts to analyse product and factor markets such
primary products, manufactured product, and the labour market. It also discusses
the role of the price mechanism in the efficient allocation of resources.
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PRICE MECHANISM AND ITS APPLICATIONS (PART 1)

Contents
1. MARKET ECONOMY................................................................................................. 3
1.1 The Market System .................................................................................................... 3
1.2 The Price Mechanism............................................................................................... 3
1.3 An Overview of Demand-Supply Model ................................................................. 4
2. DEMAND THEORY.................................................................................................... 5
2.1 Definition of Demand .................................................................................................. 5
2.2 The Law of Demand .................................................................................................. 5
3 SUPPLY THEORY ………………………………………………………………………….13
3.1 Definition of Supply ................................................................................................ 13
3.2 The Law of Supply ................................................................................................. 13
3.3 Factors influencing market supply ........................................................................... 15
4. DEMAND-SUPPLY MODEL..................................................................................... 19
4.1 Changes in Demand and Supply ......................................................................... 19
5. ECONOMIC WELFARE ........................................................................................... 22
5.1 Consumers’ Surplus ............................................................................................. 22
5.2 Producers’ Surplus............................................................................................ 22
5.3 Society’s welfare ............................................................................................... 23
6. ROLE OF THE PRICE MECHANISM IN EFFICIENT ALLOCATION OF
RESOURCES IN A FREE MARKET ............................................................................... 23
6.1 Functions of the Price Mechanism .................................................................... 23
6.2 How does the Price Mechanism achieve Economic Efficiency? ........................ 24
6.2.1 Allocative efficiency.................................................................................... 24
6.2.2 Productive efficiency .................................................................................. 25
6.3 How desirable is the free market equilibrium? ................................................... 25
Appendix A ……………. .................................................................................................. 27
Appendix B – Economic Systems.................................................................................... 29
References:

1. Sloman, John. (2013). ‘Chapter 2: Markets, demand and supply’ and ‘Chapter 3: Markets in
action’. In Essentials of Economics 6th Edition. Pearson Education.
2. Mankiw, Gregory N.; Quah, Euston & Wilson, Peter. (2013). Part 2: Supply and Demand 1:
How Markets Work. In Principles of Economics: An Asian Edition 2nd Edition. Cengage
Learning.
3. McEachern, William A. (2013). ‘Chapter 4: Demand, Supply, and Markets’ and ‘Chapter 5:
Elasticity of Demand and Supply’. In Microeconomics: A Contemporary Introduction 10th
Edition. Cengage Learning.
4. Krugman, Paul & Wells, Robin. (2012). ‘Part 2: Supply and Demand’ and ‘Part 3: Individuals
and Markets’. In Microeconomics 3rd Edition. Worth Publishers.
5. Gillespie, Andrew, Foundations of Economics, 2nd Edition, New York: Oxford University
Press

Lecture Objectives:

After this series of lectures and tutorials, students should be able to:

▪ Explain how the price mechanism allocates resources in a free market

▪ Identify the determinants of demand and supply, and explain how they influence demand
and supply
▪ Explain and analyse how prices are determined by free market forces of demand and supply
▪ Apply demand and supply analysis in various markets in various markets
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1 . MARKET ECONOMY

1.1 The Market System

In the free market system (free of government intervention), resources are allocated
according to the market forces of demand and supply. It is the level of demand and
supply of each factor of production or final good/service that determines their respective
prices and quantities traded.

Households are consumers of final goods/services, and their consumption decisions

give rise to the market forces of demand. Firms are producers of goods/services, and
their production decisions give rise to the market forces of supply. The coming together
of buyers and sellers to transact goods/services is known as a market. In a free market
system, resources are allocated according to the market forces of demand and supply.

The following characteristics are necessary for the market-based economy to allocate
resources efficiently:

▪ Perfect Competition

Perfect competition is an essential feature of the free market economy. In perfect Question:
competition for each type of good/service, there are many buyers and sellers, each Does this happen
having an insignificant share of the market. No single buyer or seller is strong enough commonly in the real
world? Which market
to control a market and exploit other sellers or buyers. most closely resembles
this?
▪ Rational Behaviour and the Pursuit of self-interest

Consumers and producers are assumed to behave rationally. Economic activity in the
free-market system is driven by self-interest. Producers or firms try to maximise profits,
while consumers try to maximise utility.

▪ Freedom of choice and enterprise

All decisions are made by households and firms. Consumers are free to decide what Note:
to buy with their incomes. This is known as consumer sovereignty. Firms are free to There is consumer
choose what to sell and what production methods to use. sovereignty when they
influence the production
decisions of the
▪ Private ownership of property economy.

Individuals have the right to own, control and dispose of land, capital and natural
resources. Owners of factors of production have the right to the income (in the form of
rent, interest and profits) earned from the use of these factors of production.
Recall from The
1.2 The Price Mechanism Central Problem of
Economics:
What are the 3 different
The price mechanism operates in market economies where changes in prices types of economic
(resulting from changes in demand or supply) will cause resources to move in or out of systems?
industries. According to Adam Smith (1776) The Wealth of Nations, the price
mechanism is the invisible hand that allocates resources, based on the self- interest
What are the 3
of consumers and producers, to result in the right mix of goods and services for society. fundamental questions
of resource allocation?
Guided by self-interest, households and firms interact in markets to eventually
determine what and how much to produce, how to produce and for whom to
produce.

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1.3 An Overview of Demand-Supply Model

Market Equilibrium

The meaning of “equilibrium”:

Market equilibrium refers to a situation in which buyers and sellers are on aggregate
satisfied with the current combination of price and quantity of a good bought or sold and
are under no incentive to change their present economic actions. Market equilibrium
refers to a position of balance - a position from which there is no inherent tendency
for change and is achieved at a price where quantity demanded equals to quantity
supplied.

Equilibrium Price and Output

▪ The equilibrium price is the price at which the quantity demanded is equal to the
quantity supplied, i.e., the price at which the equilibrium quantity is traded.
▪ Equilibrium price can therefore be referred to as the market clearing price.
▪ At any other price where quantity demanded and quantity supplied are not the
same, the market is said to be in disequilibrium. There will be shortages or
surpluses of the good in the market which will trigger the adjustment process to
cause price and quantity to change.

Price Quantity Quantity Surplus or Price will...

($) Demanded Supplied Shortage
1.25 8 28 Surplus fall
1.00 14 26 Surplus fall
0.75 20 20 None remain unchanged
0.50 24 16 Shortage rise
0.25 32 12 Shortage rise

Price
Excess SS
(surplus)
D S
1
Equilibrium price = $0.75

Equilibrium quantity traded

0.75 = 20 units

0.50
Figure 1
Excess DD
(shortage)
S D
0 Quantity of cars
14 16 20 24 26

Market Adjustment Process:

As seen in Figure 1, at prices above the equilibrium price of $0.75 (e.g., $1), there is a Refer to Section 2
surplus in the market since quantity supplied exceeds the quantity demanded resulting and 3 for demand
and supply theory.
in a downward pressure on the price. To sell their surplus, producers will begin to lower
prices. As price falls, consumers are willing and able to buy more causing quantity

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demanded to increase. As price falls, producers will also be less incentivised to produce
due to a fall in profitability, causing quantity supplied to decrease. This fall in price
continues until the equilibrium price ($0.75) is reached. At this equilibrium price, quantity
demanded is equal to quantity supplied at 20 units.

The opposite would happen if price was initially below the equilibrium price (e.g. $0.50).
There is a shortage in the market as quantity demanded exceeds quantity supplied and
consumers will be unable to purchase all they will like. This will put an upward pressure
on the price as consumers try to outbid one another for existing supplies. As price
increases, producers will be incentivised to produce more due to an increase in
profitability. Due to the increase in price, consumers will be less willing and able to buy,
thereby causing quantity demanded to fall. This increase in price continues until the
equilibrium price ($0.75) is reached. At this equilibrium price, quantity demanded is
equal to quantity supplied at 20 units.

Equilibrium price and quantity change in the real world due to changes in market
demand or supply which will trigger the market adjustment process. This causes price
to change to a new equilibrium where the new quantity demanded is equal to quantity
supplied.

Sectional Summary

▪ In the free market economy, price mechanism determines what and how much to
produce, how to produce and for whom to produce,
▪ Market equilibrium occurs when quantity demanded is equal to quantity supplied at
the same price. At the equilibrium price and quantity, there is no tendency to
change.
▪ Markets are in disequilibrium when there is a shortage or a surplus. A shortage
creates upward pressure on price, while a surplus creates downward pressure on
price.

2. DEMAND THEORY

2.1 Definition of Demand

The demand for a commodity refers to the amount that consumers are willing and able
to purchase at each given price over a given period of time. For demand to be effective
(thus also called ‘effective demand’), willingness to pay must be supported by the ability
to pay.

2.2 The Law of Demand

The Law of Demand states that the quantity demanded of a good/service is inversely
related to its price, ceteris paribus. The lower the price of a good, the greater its
quantity demanded and vice versa. Graphically, this is represented as a movement
along the downward-sloping demand curve.
Price Note:
S2 Movement along
C the demand curve
P2 is caused by shifts
S0 in supply curve.

A
P0
S1 Figure 2

B
P1
DD Curve
0 Q2 Q0 Q1 Quantity of cars

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Demand Curve

An individual demand curve is a graphical representation of the relationship between

the price of the good and its quantity demanded, ceteris paribus. It shows the amount
of a good that a consumer is able and willing to purchase at each given price over a
given period of time.

Price of good X ($)

Price ($) Quantity demanded
10 10 1
8 2
6 3
8

6
Figure 3

D
0 2 3 Quantity of good X

The marginal utility that a consumer derives from consuming an additional unit of a good
is important in determining how much he/she is willing to pay. Referring to the above
diagram:

▪ With reference to Figure 3, Consumer A derives $10 equivalent of utility from Recall:
consuming the 1st unit of good X, $8 equivalent of utility from consuming the 2nd LDMU states that
unit of good X, and $6 equivalent of utility from consuming the 3rd unit of good X. beyond a certain point of
consumption, each extra
▪ The marginal utility of consuming additional units of good X is decreasing due to the unit consumed gives less
Law of Diminishing Marginal Utility. additional utility than
previous units.
▪ Being a rational consumer seeking to maximise his/her utility given a budget
constraint, Consumer A will apply the Marginalist Principle in deciding how many
units of good X to purchase.
▪ According to the Marginalist Principle,
• Consumer A should purchase an additional unit of good X if its marginal utility is
equal to or more than its price. Doing so allows consumer A to become better-off,
as he/she is able to derive utility which exceeds the amount he has spent.
• Consumer A should not purchase an additional unit of good X if its marginal utility
is less than its price. Doing so makes consumer A worse- off, as the amount he has
spent exceeds the utility he is able to derive from consuming the good.

▪ Applying the Marginalist Principle to this example:

• If P=$10, Consumer A should purchase 1 unit of good X.

• If P=$8, Consumer A should purchase 2 units of good X.
• If P=$6, Consumer A should purchase 3 units of good X.
• The above constitutes the individual demand curve of good X.

In summary, a consumer experiences diminishing marginal utility in consuming

additional units of good X. In maximising utility with a given budget, the rational
consumer will increase the quantity demanded as price decreases, and vice versa. This

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gives rise to a downward sloping individual demand curve. The individual demand curve
of good X indicates the decreasing marginal utility that consumers derive from
consuming each additional unit of the good.

As shown in Figure 4, the market demand curve is the horizontal summation of all
individuals’ demand curves.

Figure 4

The market demand curve is downward sloping due to the Law of Demand. There are
two reasons for this law:

• Substitution effect

It is the effect of a change in the price of the good on its quantity demanded arising
from the consumer switching to, or from, alternative products, ceteris paribus. For
example, an increase in the price of strawberries leads to it being replaced by a
substitute, such as grapes. Hence, the substitution effect will cause consumers to buy
less of the strawberries when the price of strawberries increases.

• Income effect

The income effect occurs when a change in the price of the good affects consumers’
real income or purchasing power which in turn affects consumers’ ability to buy the
good. For example, the increase in the price of strawberries will lead to a fall in real
income, ceteris paribus. When consumers’ purchasing power falls, their ability and
willingness to buy strawberries will fall and hence, they can only buy less of that.

2.3 Factors influencing market demand

Non-price determinants of demand determine the position of the demand curve. A

change in the non-price determinants of demand changes the quantity that consumers
are willing and able to purchase at any given price. Graphically, this is represented by
a shift of the demand curve. Any change in non-price determinants of demand that
lowers the quantity that consumers are willing and able to purchase at any given price
is a fall in market demand. With reference to Figure 5, this is represented by a shift of
the demand curve to the left from D to D1. Similarly, any change in non- price
determinants of demand that increases the quantity demanded by consumers at every
given price is an increase in market demand. This is represented by a shift of the
demand curve to the right from D to D2.

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Price
Note:

S Shifts in the demand

curve results in the
movement along the
supply curve.
P
Increase in Figure 5
demand
Decrease in
demand
D2
D
D1
0
Q1 Q Q2 Quantity of cars

These non-price determinants of demand include:

a. Tastes and Preferences

Question:
Taste is significant in influencing consumers' desired purchases and hence their To what extent do you
willingness to purchase a good. think are consumers
today affected by
advertisements?
Factors affecting taste include the effects of advertisements, education, culture and age
group. A change in taste towards a particular good is likely to increase the demand for Do consumers really
make their own
that good and will cause the demand curve to shift to the right, vice versa. decisions, or are we
“controlled” by subliminal
For example, temporary increases in demand for merchandise can occur due to fads, messaging?
latest craze like K-pop and Korean dramas. Similarly, there have been permanent
decreases in demand for CD players as a result of new inventions, new improved
products like iPods and iPads.
Price
S Question:
To what extent do you
think are consumers
today affected by
P Figure 6 advertisements?
Do consumers really
make their own
decisions, or are we
“controlled” by subliminal
D2 messaging?
D1
0 Q1 Q2 Quantity of wine
As seen in Figure 6 above, suppose that the original demand curve for wine is given by
D1. If the given price is OP, then the demand curve D 1 indicates that quantity 0Q 1 will
be demanded.

Suppose there is a discovery by the British Medical Association that people who
regularly drink wine live longer, healthier lives. This discovery would then influence
consumers’ taste and preference and raise the demand for wine. Consumers are now
more willing to purchase a greater quantity of wine at every price. The demand curve
shifts rightwards from D1 to D2. At the same price OP, quantity demanded increases
from OQ1 to OQ2.

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b. Seasonal changes / Climatic changes (a sub-set of tastes & preferences)

For example, during the hot season, the demand for air conditioners and fans increases. Question:
The hot weather increases the consumers’ willingness to purchase more air What other examples
conditioners and fans in order to keep cool, causing the demand curve to shift to the can you think of?
right. On the other hand, during winter, the demand for winter clothes would increase.

Festivals can also play a part. For example, just before Chinese New Year and Hari
Raya, the demand for eggs, flour and new clothes increases. Similarly, Valentine’s Day
will see an increase in demand for flowers, chocolates, and restaurant meals.

c. Expectations of future prices

Another factor which influences the demand for goods is consumers’ expectations of
future prices of the goods. If consumers expect prices of the good (e.g. gold) to rise in
the future, ceteris paribus, they would demand for more gold now, leading to a rightward
shift of the demand curve. When consumers expect the price of gold to fall in the future,
they will postpone consumption of gold now, leading to decrease in demand for gold in
the current period.

d. Income

Changes in consumers’ incomes will affect the consumers’ ability to purchase goods
and services. An increase in income means that consumers have more to spend in total
and this increases their ability to purchase more goods and services. This will lead to
re-adjustments of consumers’ expenditure patterns, which increases demand for some
goods and decreases demand for other goods depending on whether the goods are
normal goods or inferior goods.

A good is a normal good when the demand for it increases in response to an increase
in consumer income and vice versa i.e. demand for the good varies directly with
income. Most goods are normal goods. An increase in income leads to a rise in demand
hence shifting the demand curve to the right.

An inferior good is one where the demand will fall as consumers’ incomes increase.
They are often regarded as cheap but inferior substitutes for other goods. Examples of
inferior goods are second-hand clothes, second-hand cars. As incomes increase,
consumers experiencing an increase in their ability to buy, tend to switch to more
expensive and better quality substitutes (new clothes, branded clothes, new cars). This
results in a decrease in the demand for inferior goods. There is a negative relationship
between income and demand for inferior goods.

Price
Market for new cars (normal goods)
S
An increase in income will increase the
consumers’ ability to buy new cars, thus
Figure 7 increasing the demand for new cars.
P
As shown in Figure 7, the demand curve
for new cars will shift to the right from D 0
to D1. At the same price OP, quantity
D1 demanded increases from OQ0 to OQ1.
D0
0 Q0 Q1 Quantity of
new cars

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Price
Market for second-hand cars (inferior goods)
S
As consumers’ ability to buy new cars increases
P with increases in their income, consumers will
tend to switch away from purchasing second-
Figure 8 hand cars causing a decrease in the demand
for second-hand cars.

With reference to Figure 8, the demand curve

D1 D0 will shift to the left from D0 to D1. At the same
price OP, quantity demanded decreases from
0 OQ0 to OQ1.
Q1 Q0 Quantity of
second-hand cars

e. Prices of Related Good

The demand for a good/service may change as a result of a change in the price of a
related good. Related goods can either be substitutes or complements.

(i) Substitutes

A substitute is a commodity that can be used in place of another. It satisfies the same
want. Substitute goods are thus in competitive demand, e.g. Coca-Cola & Pepsi, MRT
& taxi services, Cadbury and Nestle chocolates, milk and yoghurt.

An increase in the price of Coca-Cola results in a rise in the demand for its substitute,
Pepsi and vice versa. As the price of Coca-Cola rises, some consumers switch from
Coca-Cola to Pepsi. This leads to an increase in demand for Pepsi.

With reference to Figure 9, suppose the rise in price of Coca-Cola is due to a rise in the Refer to Section 3
cost of production, leading to a fall in the supply of Coca-Cola. The supply curve for on determinants of
supply.
Coca-Cola shifts left from S0 to S1 and the quantity traded falls from 0Q0 to 0Q1. Since
Coca-Cola is now relatively more expensive as compared to Pepsi, people will now shift
their consumption to Pepsi. Hence the demand for Pepsi increases and the demand
curve for Pepsi shifts right from D0 to D1. At the same price OP, quantity demanded
increases from OQ0 to OQ1.

Price Price
S1
S0 S0

P1
Figure 9
P0
P0

D1
D0 D0

0 Q1 Q 0 Quantity 0 Q0 Q1 Quantity

Market for Coca- Cola Market for Pepsi

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(ii) Complements

A complement is a good that is used in conjunction with another. They are jointly Question:
demanded to satisfy the same want. Complements are thus in joint demand, e.g. tea What other examples
and sugar, car and petrol, digital camera and memory card, blue ray DVDs and blue ray can you think of?
DVD players, computers and computer software, etc.

A fall in the price of cars leads to an increase in the demand for petrol. This is because
the fall in the price of cars results in a bigger quantity of cars being purchased. Since
cars require petrol to run, the higher quantity demanded of cars will increase the demand
for petrol.

With reference to Figure 10, suppose there is a reduction in the cost of producing cars
because of technological advancement, the price of cars will fall from 0P 0 to 0P1. As a
result, the supply of cars increases, and the supply curve shifts to the right from S0 to
S1. With the decrease in price from 0P0 to 0P1, the quantity traded for cars increases
from 0Q0 to 0Q1. As more cars are purchased and consumed, the demand for petrol
(the complementary good) will increase. The demand curve for petrol shifts right from
D0 to D1. At the same price OP, quantity demanded increases from OQ 0 to OQ1.

Price Price
S0
S1 S0

P0
Figure 10
P0
P1

D1
D0 D0

0 Q0 Q1 Quantity 0 Q0 Q1 Quantity

Market for Cars Market for Petrol

f. Derived Demand Important:

Students often
confuse complements
Derived demand refers to demand for one good or service that occurs as a result of the with factors of
demand for another intermediate/final good or service. Changes in the final product production.
market will cause the demand for factor resources to change because the demand for Go back to the
factors of production is derived from the demand for final goods and services. definitions of these
terms to clarify any
For example, the production of cars requires the use of steel. An increase in demand confusion which may
arise.
for cars will increase the revenue that firms can obtain from selling the cars produced
Complements are
by labour. Hence firms are more willing to buy more steel in order to increase their car goods that are used in
production. Demand for steel increases. The demand for steel is thus a derived demand. conjunction to fulfil a
From Figure 11, the demand for cars and steel both increase from D0 to D1. want, whereas factors
of production are
resources/intermediate
goods used to produce
a final good.

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Price Price

S0 S0
P1
P0 P0
Figure 11

D1 D1
D0 D0

0 0
Q0 Q1 Quantity Q0 Q1 Quantity

Market for Cars Market for Steel

Another common analysis will be the market for labour since workers are needed to
produce goods and services. Thus, the demand for labour is also a derived demand.

g. Government Policies

(i) Direct Tax Policy

Direct tax is a tax on people’s incomes. Changes in direct tax rates affect people’s Question:
disposable income (income available for spending after payment of income tax). An What is the income tax
increase in the income tax rate will reduce people’s disposable income. This in turn rate for different income
reduces their ability to pay, leading to a decrease in demand for normal goods and brackets in Singapore?
services, and vice versa.

(ii) Direct Subsidy Policy

Direct subsidies are payments made by the government to the consumers. For example, Question:
housing grants for married couples who stay near their parents, Edusave grants for What other examples
primary to junior college students. can you think of?

Such direct subsidies increase the consumers’ ability to pay and hence demand. For
instance, the housing grants encourage married couples to stay near their parents and
result in an increase in demand for housing in areas near to where their parents are
staying.

h. Population

This affects the number of potential consumers or the size of the market. Changes in
population can be due to an absolute increase or decrease in the total population or a
change in the composition/demographics of the population.

For example: a change in age distribution due to

Baby boom OR Ageing population

- - increase in demand - - increase in demand

for baby products (short-run effect) for healthcare services
- - increase in demand for schools, housing
- (Long-run effect)

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i. Interest Rates

The rate of interest is the price of borrowing money. Changes in the rate of interest Think:
affect the level of demand by consumers, especially those who rely on loans or hire Interest rates also affect
purchase. For example, an increase in the rate of interest will reduce the demand for savings. How would an
cars and housing as the cost of purchase (in terms of monthly payments) increases increase in interest affect
your savings?
even though the prices of cars and housing stay the same. The demand curve for these
goods shifts leftwards.

j. Exchange Rates

This refers to the rate at which a country’s currency (e.g. S$) exchanges for another
currency (e.g. US$). Changes in the rate of exchange will affect foreign demand for a
country’s goods and services.

If the S$ appreciates (strengthens) against the US$, ceteris paribus, Singapore goods
which are sold to the USA (known as Singapore’s exports) become more expensive in
US$. For instance, at an exchange rate of S$1 = US$0.70, a S$100 export from
Singapore will be sold in the US for US$70. If the S$ appreciates to S$1 = US$0.85, the
same good will be sold for US$85.

US consumers will turn away from Singapore exports and turn to relatively cheaper US
domestic substitutes. This decreases the demand for Singapore exports and increases
the demand for US goods.

Sectional Summary

▪ Demand for a good/service refers to the quantity of the good/service that

consumers are willing and able to purchase at every given price over a given
period of time.
▪ The demand curve is downward sloping as price and quantity demanded are
inversely related.
o The Law of Diminishing Marginal Utility influences the individual
demand curve.
o The Law of Demand influences the market demand curve.
▪ The list of non-price determinants of demand is not exhaustive and not all
determinants are applicable to every market. The more significant
determinants include tastes and preferences, income, and expectation of
future prices.

3 SUPPLY THEORY

3.1 Definition of Supply

The supply of a good or service refers to the quantity of a good or service that producers
are willing and able to offer for sale at each given price over a given period of time.

3.2 The Law of Supply

The quantity supplied is directly related to the price of a product. The higher the
price of a good, the greater the quantity supplied and vice versa, ceteris paribus.
Graphically, this is represented as a movement along the upward-sloping supply curve.

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Price

Note:
P2 B Movement along the
supply curve is
caused by shifts of
P A D2 Figure 12 the demand curve.

P1 D
C
D1
0 Q1 Q Q2 Quantity
0

Supply Curve

The firm’s supply curve is a graphical representation of the relationship between the
price of a good and the quantity supplied by a firm over a given period of time, ceteris
paribus. It shows the amount of a good that a producer is able and willing to make
available for sale at each given price over a given period of time.
sale at each given price over a given period of time.

Price ($)

S Price ($) Quantity

supplied
1.40
0.50 1
0.90 0.90 2
1.40 3
0.50
Figure 13

0 2 3 Quantity of cars

The marginal cost that a producer incurs from producing an additional unit of a good is
important in determining how much he is willing to accept for producing it. Referring to
the above diagram:

• From Figure 13, producer A incurs $0.50 from producing the 1st unit of good X, Recap:
$$0.90 from producing the 2nd unit of good X, and $1.40 from producing the
3rd unit of good X. LDMR states that
beyond a certain point
• The marginal cost of producing additional units of good X is increasing due to of production, adding
the Law of Diminishing Marginal Returns to output. A simple illustration will be an additional factor of
the scenario whereas more and more labour works on a unit of machine, production results in
eventually there will be over-utilisation of the machine and productivity is smaller increases in
output. This
affected. In this case, with less addition to output, the addition to cost increases.
essentially means an
This will be covered in detail in ‘Production and Cost’. increase in marginal
• Being a rational producer seeking to maximise its profits, Producer A will apply cost.
the Marginalist Principle in deciding how many units of good X to produce.

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According to the Marginalist Principle:

• Producer A should produce an additional unit of good X if its price is equal to or
more than its marginal cost of production. Doing so allows Producer A to
become better-off, as its profits increases.
• Producer A should not produce an additional unit of good X if its price is less
than its marginal cost of production. Doing so makes Producer A worse-off, as
its profits decreases.

• Applying the Marginalist Principle to this example:

• If P=$0.50, Producer A should produce 1 unit of good X.

• If P=$0.90, Producer A should produce 2 units of good X.
• If P=$1.40, Producer A should produce 3 units of good X.
• This constitutes the firm supply curve of good X.

In summary, a producer experiences diminishing marginal returns in producing

additional units of good X. In maximising profits, the rational producer will increase the
output as price increases, and vice versa. This gives rise to an upward sloping firm
supply curve. The firm’s supply curve of good X indicates the increasing marginal cost
that producers incur from producing each additional unit of the good.

• A higher price is required to incentivise firms to increase output and vice

versa. The firm’s supply curve is upward sloping.
• The supply curve of good X indicates the marginal costs incurred from the
production of each additional unit of the good.
• The upward sloping firm’s supply curve is explained by the Law of
Diminishing Marginal Returns.

The market supply is the horizontal summation of firms’ supply curves as seen in Figure
14.
Question:
Are firms able to
quantify their
supply? Why or
why not?

Figure 14
6

3.3 Factors influencing market supply

There are many non-price determinants of supply. A change in the non-price

determinants of supply changes the quantity that producers are willing and able to sell
at every given price. Graphically, this is represented by a shift in the supply curve. Any
change in non-price determinants of supply which lowers the quantity supplied by
producers at every given price is a fall in market supply. This is represented by a shift
of the supply curve to the left. Similarly, any change in non-price determinants of supply
that increases the quantity supplied by producers at every given price is an increase in
market supply. This is represented by a shift of the supply curve to the right.

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Price
S1
S0 Note:
S2
Shifts of supply
increase in curve causes
decrease in
supply movement along the
supply Figure 15 demand curve.
P0
D

0 Quantity
Q1 Q0 Q2

a. Costs of production / Prices of factors of production

Changes in the price of factor inputs such as raw materials, fuel and power, cost of
labour (wage rates) and the cost of capital will change the cost of production, causing
changes in the level of profits. This in turn affects the supply of the good.

For example, if the price of steel increases, the cost of producing cars will rise, causing
production to be less profitable. Firms will be only willing to supply fewer cars at each
and every price. The supply of cars will fall and the supply curve shifts leftwards from
S0 to S1 as shown in Figure 16. At the same price OP, quantity demanded decreases
from OQ0 to OQ1.

Price

S1
S0

Figure 16
P0

D0

0 Quantity of cars
Q1 Q0

b. Innovation / State of Technology

The state of technology represents the economy’s stock of knowledge about how Is technology
change and
resources can be combined most efficiently. Over time, technology changes as a result productivity change
of new discoveries and innovations. Supply of a good will change with technological more likely to
change. happen in the long
run or the short run?
Improvements in the techniques of production, resulting from new inventions or
technological advances within the industry, will increase the productivity of the Definition:
factors of production. Each unit of a factor will be able to produce more now. With the Productivity is
same factor price, cost per unit of output will be lower. measured by output
per unit of input.
Producers are willing and able to supply more of the good at each and every given price.
This will increase the supply of the good and cause the supply curve to shift to the right
from S0 to S2 in Figure 17.

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Price

S0
S2
P0
Figure 17

D0

0 Quantity of cars
Q0 Q1
c. Natural Factors

Favourable climatic conditions such as abundant and reliable rainfall as well as absence Think:
of pests increase the supply of agricultural products. This will shift the supply curve to How does this affect
markets in Singapore?
the right. Occurrence of natural disasters such as droughts, floods, earthquakes, severe
haze will reduce the supply of agricultural produce, leading to a leftward shift in the
supply curve.

d. Number of firms

The number of firms producing the goods can increase due to the entrance of new firms
in the industry. This increases supply and gives rise to a rightward shift in the market
supply curve and vice versa.

e. Government Policies

Government policies on indirect taxation and subsidies affect the cost of production and Think:
therefore the supply of a good. When there is an indirect tax levied, the cost of What other examples of
production increases, causing the supply to fall. When there is an indirect subsidy given, indirect taxes/subsidies
the cost of production decreases, causing the supply to increase. can you think of?

Indirect taxes are taxes imposed on expenditure of goods and services. An example
is the Goods & Services Tax (GST). Such a tax is levied on the firms and added on to
their cost of production. Since cost has increased because of the tax, firms will only be
willing to supply fewer goods at every price, leading to a fall in supply and a leftward
shift of the supply curve.

Indirect subsidy is a payment made by the government to firms to produce a particular

good. This will reduce the firms’ cost of production and increase the firms’ willingness
and ability to supply more goods at every price. Supply increases leading to a rightward
shift of the supply curve.

f. Prices of Related Goods

(i) Joint Supply

Think:
Joint supply of two or more products refers to the production of goods that are derived What other examples
from a single product. It is not possible to produce more of one without producing can you think of?
more of the other. This means that an increase in the price of one leads to an increase
in supply of the other joint product. For example, butter and skimmed milk are both
produced from whole milk, petrol and diesel are produced from crude oil, beef and
leather from cattle.

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With reference to Figure 18, an increase in the demand for beef (demand curve shifts
right from D0 to D1) will result in an increase in its price. Producers will be encouraged
to increase quantity supplied to 0Q1. The increase in quantity supplied of beef results in
more leather being offered for sale on the market. Hence the supply of leather increases
and the supply curve of leather shifts right from S0 to S1. At the same price OP, quantity
supplied increases from OQ0 to OQ1.

Price Price
Market for Beef Market for Leather

S0 S0
S1
P1

P0 P0

D1
D0 D0

0 0
Q0 Q1 Quantity Q0 Q1 Quantity
Figure 18

(ii) Competitive Supply

Competitive supply of two or more products refers to production of one OR the other
by a firm. The goods compete for the use of the same resources and producing more
of one means producing less of the other.

An example would be corn which can be used as food for consumption or for the Question:
production of biofuel. They are thus in competitive supply. As seen in Figure 19, an What other examples
increase in the demand for biofuel (demand curve shifts right from D 0 to D1) causes the can you think of? Do
price of biofuel to increase from 0P0 to 0P1, and farmers will choose to produce corn for you think this applies to
your 4 factors of
biofuel production as this is more profitable. As a result, the supply of corn for production such as
consumption will decrease and the supply curve of corn as food shifts to the left from S 0 land and labour?
to S1. At the same price OP, quantity supplied decreases from OQ 0 to OQ1.

Price Market for Biofuel Price Market for Corn as Food

S0 S1
S0
P1
P0
Figure 19
P0

D1
D0 D0

0 Q0 Q1 Quantity 0 Q1 Q0 Quantity

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g. Expectations of future price changes

If price is expected to rise, producers may temporarily reduce the amount they sell in
the market. They are likely to build up stocks and only release them to the market when
the price increases.

At current prices, producers are willing to supply less than they otherwise would. This
is represented by a leftward shift of the supply curve. The opposite would be true if
producers expect prices to fall.

Sectional Summary

▪ Supply of a good/service refers to the quantity of the good/service that

producers are willing and able to offer for sale at every given price over a given
period of time.
▪ The supply curve is upward sloping as price and quantity supplied is directly
related according to the Law of Supply.
▪ There are many non-price determinants of supply. The more significant non-
price determinants of supply include cost of production/prices of factors of
production, innovation/state of technology, and government policies.

4. DEMAND-SUPPLY MODEL

4.1 Changes in Demand and Supply

The equilibrium price and quantity is stable and does not change until demand and/or
supply conditions changes. When that happens, the market is said to be in market
disequilibrium, which is a situation of having shortages or surpluses since quantity
demanded does not equal to quantity supplied at a given price. The market adjustment
process occurs.

Effect of Demand Shifts on Equilibrium Price and Quantity

When demand increases, a shortage is created at the initial equilibrium price as the
current equilibrium quantity would be insufficient and price adjusts upwards in order to
reach a new equilibrium price and quantity. Conversely, if demand falls, a surplus is Strategy:
created such that price adjusts downwards to reach a new equilibrium price and Use the 3-step
quantity. analysis

Price of roses ($) 1.Decide whether

S demand or supply is
affected given the
scenario.

P1 2. Decide direction of
shift in demand or
Figure 20 supply curve and the
P demand / supply
initial factor
equilibrium causing the change.

D1 3. Explain how the

market adjust to new
D equilibrium price and
quantity given shifts
in demand and
supply curves.
0
Qs Q1 QD1 Quantity of roses

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