Concepts of Economics, Demand and Supply Analysis

Subject Wise Study Resources for Banking Diploma Examination - JAIBB

Paper 1: Principles of Economics and Bangladesh Economy

Module A: Concepts of Economics and Demand Supply Analysis

Q1.      Law of demand and supply definition, examples and graph.

The four basic laws of supply and demand are: 

• If demand increases (demand curve shifts to the right) and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price.
• If demand decreases (demand curve shifts to the left) supply remains unchanged, a surplus occurs, leading to a lower equilibrium price.
• If demand remains unchanged and supply increases (supply curve shifts to the right), a surplus occurs, leading to a lower equilibrium price.
• If demand remains unchanged and supply decreases (supply curve shifts to the left), a shortage occurs, leading to a higher equilibrium price. 

The Law of Demand: The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded.

Fig: The Law of Demand

In the diagram below, you see this relationship. At price P1, the quantity of that good demanded is Q1. If the price of this good were to be decreased to P2, the quantity of that good demanded would increase to Q2. The same is true for P3 and Q3. When prices move up or down (assuming all else is constant), the quantity demanded will move up or down the demand curve and define the new quantity demanded.

Figure: The Law of Supply

The Law of Supply: Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied.

In the diagram below, you can see that as the price shifts from P1 to P2, the quantity supplied of that good shifts from Q1 to Q2. The movement in price (up or down) causes movement along the supply curve and the quantity demanded will change accordingly.

Q2.      Market equilibrium definition, Market equilibrium in economics. 

Market equilibrium is a market state where the supply in the market is equal to the demand in the market. The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in the market. If a market is at equilibrium, the price will not change unless an external factor changes the supply or demand, which results in a disruption of the equilibrium.

Market equilibrium in this case refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes and the quantity is called "competitive quantity" or market clearing quantity.

Q3.      Definition of shortage and surplus in economics. Difference between shortage and surpluses:

The existence of surpluses or shortages in supply will result in disequilibrium, or a lack of balance between supply and demand levels.

Simply a surplus is when there is EXCESS, or too much of a resource/product/item. In economics a Market Surplus occurs when there is excess supply- that is quantity supplied is greater than quantity demanded.  In this situation, some producers won't be able to sell all their goods.  This will induce them to lower their price to make their product more appealing.  In order to stay competitive many firms will lower their prices thus lowering the market price for the product.  In response to the lower price, consumers will increase their quantity demanded, moving the market toward an equilibrium price and quantity.  In this situation, excess supply has exerted downward pressure on the price of the product.

Simply a shortage is when there is a LACK (not enough) of that particular resource/product/item. In economics a Market Shortage occurs when there is excess demand- that is quantity demanded is greater than quantity supplied.  In this situation, consumers won't be able to buy as much of a good as they would like.  In response to the demand of the consumers, producers will raise both the price of their product and the quantity they are willing to supply.  The increase in price will be too much for some consumers and they will no longer demand the product.  Meanwhile the increased quantity of available product will satisfy other consumers.  Eventually equilibrium will be reached.

Q4.      How is a price floor different from a price ceiling? Explain Price Ceiling and Floor.

Figure: Effect of Price ceiling

Price ceiling: A price ceiling is a government-imposed price control or limit on how high a price is charged for a product. Governments intend price ceilings to protect consumers from conditions that could make necessary commodities unattainable. However, a price ceiling can cause problems if imposed for a long period without controlled rationing.

If the price ceiling is above the market price, then there is no direct effect. If the price ceiling is set below the market price, then a "shortage" is created; the quantity demanded will exceed the quantity supplied.

Price floor: A price floor is the lowest legal price a commodity can be sold at. Price floors are used by the government to prevent prices from being too low. The most common price floor is the minimum wage--the minimum price that can be payed for labor. Price floors are also used often in agriculture to try to protect farmers.

When a "price floor" is set, a certain minimum amount must be paid for a good or service. If the price floor is below a market price, no direct effect occurs. If the market price is lower than the price floor, then a surplus will be generated.

Q5.      Price elasticity of demand.

Price elasticity of demand or PED or Ed is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price.

Price elasticity of demand measures the responsiveness of demand to changes in price for a particular good. If the price elasticity of demand is equal to 0, demand is perfectly inelastic (i.e., demand does not change when price changes). Values between zero and one indicate that demand is inelastic (this occurs when the percent change in demand is less than the percent change in price). When price elasticity of demand equals one, demand is unit elastic (the percent change in demand is equal to the percent change in price). Finally, if the value is greater than one, demand is perfectly elastic (demand is affected to a greater degree by changes in price).

For example, if the quantity demanded for a good increases 15% in response to a 10% decrease in price, the price elasticity of demand would be 15% / 10% = 1.5. The degree to which the quantity demanded for a good change in response to a change in price can be influenced by a number of factors. Factors include the number of close substitutes (demand is more elastic if there are close substitutes) and whether the good is a necessity or luxury (necessities tend to have inelastic demand while luxuries are more elastic).