TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1

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Topic 4: Interaction of Demand and Supply

Topic 4: Interaction of Demand and Supply


1 What is a market?


1.1 A market is formed when buyers and sellers of a good, service or resource come in contact with each other in order to agree a price and exchange.


1.2 The concept of a market in economics goes beyond the idea of a place where people meet to buy and sell goods. Any arrangement where buyers and sellers are in contact to exchange a product is a market. Markets may be worldwide, e.g. oil, wheat, cotton and copper when a single world price may be established, others may be more localised, e.g. the housing market when prices for a similar house will vary from area to area.


1.3 Markets exist for:


• goods, e.g. cars, houses

• services, e.g. bus travel, haircuts

• resources, e.g. labour, land, raw materials

• money, e.g. credit, foreign exchange.


Each of these markets has common features, i.e. something to be exchanged, buyers, sellers and a price. Price may be known by different names, e.g. bus fare, wage, rent, interest, exchange rate but all are determined in similar ways.


1.4 Suppliers are usually firms but may in some markets be individual citizens, e.g. car boot sales or local government departments, e.g. council housing or central government, e.g. prescribed medicines.


1.5 Buyers may be individual citizens or households in the case of consumer products, firms who buy raw materials, machinery or labour and government who buy the supplies needed to provide services.


2 Free market


A free market is one where:


• there are no barriers to firms competing with each other

• the price is set in the market by the total demand and supply; firms have to accept this, i.e. they are price takers not price makers

• there is no government intervention.


3 Equilibrium price


In a free market an equilibrium price will be established. At the equilibrium price:


• Quantity demanded by consumers is the same as quantity supplied by suppliers.

• The market is cleared, i.e. there will be no unsatisfied customers (shortages) and there will be no unsold supplies (surpluses). This is why the equilibrium price is also called the market clearing price.

• The price will not change unless there is a change in demand or supply conditions.

TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1


















(a) At a price of P1 this market is not in equilibrium. Suppliers are willing to supply B, and consumers are willing to demand A; therefore, there would be a surplus of AB. Suppliers will react to the unsold stocks by cutting production and reducing price.


(b) At a price of P2, suppliers are willing to supply C and consumers are willing to demand D; therefore there would be a shortage of CD. Consumers will compete with each other for the available

quantity by offering to pay a higher price and suppliers will supply more.


(c) At a price of P, there is no upward or downward pressure on price. The market is in equilibrium.


4 Changes in demand conditions

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• a rise in demand (D curve shifts to the right) leads to a rise in equilibrium price and in the quantity exchanged in the market.

• a fall in demand (D curve shifts to the left) leads to a fall in equilibrium price and in the quantity exchanged.


Note that the extent of change in price and quantity is affected by the elasticity of supply. The more supply is elastic then the less will be the change in price, but the more will be the change in quantity exchanged.


TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1

5 Changes in supply conditions

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(a) An increase in supply (S curve shifts to the right) leads to a fall in equilibrium price and a rise in the quantity exchanged.


(b) A fall in supply (S curve shifts to the left) leads to a rise in equilibrium price and a fall in the quantity exchanged.


Note that the extent of change depends on the price elasticity of demand. The more demand is elastic then the less the change in price but the more the change in the quantity exchanged.


6 Intervention in free markets


Governments may intervene in markets to alter the price or the quantity exchanged. (This topic is also dealt with in Unit 2, The UK Economy, Topic 4, under Market Failure and Government Policies.)


6.1 Governments may intervene in a market by:


• setting a minimum price

• setting a maximum price

• imposing tax

• giving a subsidy

• setting a quota.

6.2 Minimum price above equilibrium. Governments may do this because they feel that the equilibrium price is too low. However, it may create the problem of surpluses as is shown by AB in the following diagram.

TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1

















Two examples of this include:


• Setting of minimum prices for farm products by the EU. This was done to ensure that farmers got a decent income. However, it has created the problem of surpluses and what to do with them. A number of options is possible. The EU buys the surplus then stores it, or gives it away as aid to the third world. To prevent surpluses the EU has set production quotas for some products, i.e. limits to what farmers should produce.

• Setting a minimum wage for low-paid workers. Critics said that this would create unemployment, i.e. surpluses of workers, although in practice this has not happened, as the introduction of the minimum wage coincided with a rise in demand for labour.


6.3 Setting a maximum price below equilibrium, because they feel that the equilibrium price is too high. Governments have done this in order to help low-income consumers or as part of an anti-inflation strategy.


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Fixing prices below equilibrium may create black markets to which black marketeers will divert supplies at a price above the official price. In the diagram consumers demand B but can only get A. For quantity A, consumers are willing to pay Z. This sort of intervention and effect was common in planned economies such as the Soviet Union. This explains the scenes of long queues at shops for bread, etc. Governments may counteract a black market by rationing – by issuing coupons of entitlement to each family so that each family has a fair allocation. Rationing was used in the UK during and after the Second World War when supplies were restricted.


6.4 Imposing expenditure taxes. A tax on expenditure has the same effect as increasing the cost of production, since the suppliers have to pay it to the government. Producers will raise their selling price to recover this increased cost, although they may absorb part of the cost by taking a reduced profit.



TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1















• Tax of EG. Supply curve moves up vertically by EG. Of the tax, consumers pay EF, i.e. price goes up from P to P1 and the producer pays FG out of his profit.


• Share of the tax burden depends on the proportion which the supplier can pass on to the consumer, which in turn depends on how responsive the consumer is to an increase in price. If the supplier believes that consumers will not cut their demand significantly, i.e. if demand is price inelastic, then more can be passed on.



6.5 Subsidies have the opposite effect to taxes. Subsidies are given to encourage supply and keep prices low, e.g. rural bus services. Costs of production are reduced and the producer may pass this on to the consumer by lowering price. The extent to which it is passed on depends on the price elasticity of demand. The more demand is price inelastic, the more will be passed on. In the following diagram, XZ is the subsidy, the consumer benefits by XY and the supplier gains by YZ.






TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1














6.6 Quotas. Government may intervene to set a maximum quantity which can be supplied to a market. An example is the total allowable catch by UK fishermen of white fish (cod, haddock). This yearly quota has been fixed to try to conserve white fish stocks. Economic analysis would suggest that the price of white fish would rise. This has not happened to any great extent because some fishermen have been catching above the quota and selling on the black market to processors. (Hence the term black fish.) Supply has also been boosted by imports.




TOPIC 4 INTERACTION OF DEMAND AND SUPPLY 1




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