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 b e
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:
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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 al l 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:
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Unit 4 Summary (Interaction of Demand & Supply)
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• 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 suppli es (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.
(a)
At a price of P 1 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 P 2 , 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
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quantity by offering to pay a higher price and suppliers will supply
more.
(c)
4
At a price of P, there is no upward or downward pressure on price. The
market is in equilibrium.
Changes in demand conditions
• 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.
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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 c hange in price,
but the more will be the change in quantity exchanged.
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Changes in supply conditions
(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:
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setting a minimum price
setting a maximum price
imposing tax
giving a subsidy
setting a quota.
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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.
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.
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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.
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 b lack 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 re duced profit.
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• Tax of EG. Supply curve moves up vertically by EG. Of the tax, consumers
pay EF, i.e. price goes up from P to P 1 and the producer pays FG out of his
profit.
• Share of the tax burden depends on the proportion which the s upplier 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.
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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.
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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.
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