Coach Con s Government: Economics Resource

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8 How Demand and Supply Determine Market Price Introduction Price is arrived at by the interaction between demand and supply. Price is dependent upon the characteristics of both these fundamental components of a market. Demand and supply represent the willingness of consumers and producers to engage in buying and selling. An exchange of a product takes place when buyers and sellers can agree upon a price. This module will look at price in a competitive market. When imperfect competition exists such as a monopoly or single selling firm, price outcomes may not follow the same general rules. Equilibrium Price When a product exchange occurs, the agreed upon price is called an "equilibrium" price, or a "market clearing" price. Graphically, this price occurs at the intersection of demand and supply as presented in Figure 1. In Figure 1, both buyers and sellers are willing to exchange the quantity Q at the price P. At this point, supply and demand are in balance. Price determination depends equally on demand and supply. It is truly a balance of the two market components. To see why the balance must occur, examine what happens when there is no balance, for example when market price is below that is shown as P in Figure 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would be clamouring for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market. Page 8 of 24

9 The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily the market would be in surplus, too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases. Only when the price falls would balance be restored. A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller. Typically some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be selfinterested and, although they may not have perfect knowledge, at least they will try to look out for their own interests. Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business. Change in Equilibrium Price When either demand or supply shifts, the equilibrium price will change. Look at the modules on understanding supply for a discussion of why of that market component may move. Some examples are given below to show what happens to price when supply or demand shifts occur. Example 1: Unusually good weather increases output. When a bumper crop develops supply shifts outward and downward, shown as S2 in Figure 2; more product is available over the full range of prices. With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price. How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand. Page 9 of 24

10 In Figure 2, price falls from P 1 to P 2 if a bumper crop is produced. If the demand curve in this example were more vertical (more inelastic), the price-quality adjustments needed to bring about a new equilibrium between demand and the new supply would be different. To see how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve (or line) with a slope more vertical than that depicted in Figure 2. Then compare the size of price-quality changes in this with the first situation. With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic. The opposite is true for quantity. A larger change in quantity will occur when demand is elastic compared with the quantity change required when demand is inelastic. Example 2: Consumers lower their preference for beef A decline in the preference for beef is one of the factors that could shift the demand curve inward or to the left, as seen in Figure 3. With no immediate change in supply, the effect on price comes from a movement along the supply curve. An inward shift of demand causes price to fall and also the quantity exchanged to fall. The amount of change in price and quantity, from one equilibrium to another, is dependent upon the elasticity of supply. Imagine that supply is almost fixed over the time period being considered. That is, draw a more vertical supply curve for this shift in demand. When demand shifts from D 1 to D 2 on a move vertical supply curve (inelastic supply) almost all the adjustment to a new equilibrium takes place in the change in price. Page 10 of 24

11 Price Stability Note that two forces contribute to the size of a price change the amount of the shift and the elasticity of demand or supply. For example, a large shift of the supply curve can have a relatively small effect on price if the corresponding demand curve is elastic. That would show up in Example 1 if the demand curve is drawn flatter (more inelastic). In fact, the elasticity of demand and supply for many agricultural products are relatively small when compared with those of many industrial products. This inelasticity of demand has led to problems of price instability in agriculture when either supply or demand shifts in the short-run. Price Level The two examples focus on factors that shift supply or demand in the short-run. However, longer-run forces are also at work, which shift demand and supply over time. One particular supply shifter is technology. A major effect of technology in agriculture has been to shift the supply curve rapidly outward by reducing the costs of production per unit of output. Technology has had a depressing effect on agricultural prices in the long-run since producers are able to produce more at a lower cost. At the same time both population and income have been advancing, which both tend to shift demand to the right. The net effect is complex, but overall the rapidly shifting supply curve coupled with a slow moving demand has contributed to low prices in agriculture compared to prices for industrial products. At various levels of a market, from farm gate to retail, unique supply/demand relationships are likely to exist. However, prices at different market levels will bear some relationship to each other. For example, if hog prices decline it can be expected that retail pork prices will decline as well. This price adjustment is more likely to happen in the longer run once all participants have had time to adjust their behaviour. In the short-run price adjustments may not occur for a variety of reasons. For example, wholesales may have long-term contracts that specify the old hog price, or retailers may have advertised or planned a feature to attract customers. Page 11 of 24

12 Summary Market prices are dependent upon the interaction of demand and supply. An equilibrium price is a balance of demand and supply factors. There is a tendency for prices to return to this equilibrium unless some characteristics of demand or supply change. Changes in the equilibrium price occur when either demand or supply, or both, shift or move. Supply, Demand, and the Invisible Hand Equilibrium: Mr. Demand, Meet Mr. Supply Supply, Demand, and the Invisible Hand Equilibrium: Mr. Demand, Meet Mr. Supply It's Not Just a Good Idea, It's The Law The beauty of the market is that the competing motivations of consumers and producers interact to arrive at a price and quantity for a product that's determined by impersonal market forces. You've heard the expression market price (or seen it written on menus next to the word lobster ). The market price for a product is the price at which the quantity demanded is equal to the quantity supplied. Figure 4.5 shows how this occurs. The arrows along the supply and demand curves in this chart indicate the pressures at work in the market for beef (or any market for that matter). To understand how the price and quantity reach the equilibrium point, let's first examine the area above that point. Above the equilibrium point say, at the $4 price where I have drawn a line producers would be supplying more beef (90,000 pounds) than consumers would be demanding (40,000 pounds). That price results in a surplus of beef on the market supply would be greater than demand because consumers won't buy enough of it at the $4 price. If supply is greater than demand, then there are meat lockers full of unsold beef across a region. What are the suppliers of that beef going to do? They will cut the price until consumers start buying it. In this way, a surplus of a product puts downward pressure on its price. It also puts downward pressure on supply. If beef is not selling briskly if there's a Page 12 of 24

13 surplus of it on the market what are producers going to do? They are going to raise fewer cattle. They'll shift the resources to raising sheep or maybe hogs. Maybe some ranchers will get out of the business. Whatever it takes, that surplus quantity of beef will be taken off the market for the simple reason that consumers don't want to buy that quantity of beef at the price suppliers want for it. The excess supply will dwindle until the quantity supplied equals the quantity demanded at a price both consumers and producers can live with, in this case $3 a pound. So surplus quantity puts downward pressure on the prices and the supply of the product. That pressure is exerted by market forces until the quantity supplied equals the quantity demanded. Let's turn to the area below the equilibrium point. There we have a shortage of beef. The market is demanding more beef (80,000 pounds) than the quantity that producers are supplying (30,000 pounds). That results in a shortage, which puts upward pressure on prices. How? When sellers see that they are constantly running out of beef before the next delivery, they know they can raise the price of the stuff. Consumers, in effect, are bidding up the price. When the price starts increasing (from the $2 mark), producers start producing more beef. They send their cattle to market sooner, and they move resources away from raising sheep and into raising cattle. If it's a long-term trend, more people may take up cattle ranching. Again, whatever it takes, that shortage of beef will disappear as the price rises and the higher prices bring more beef to market. How much more beef will come to market? Enough to bring the quantity supplied equal to the quantity demanded in this case, 60,000 pounds again, at a price both consumers and producers can live with. Market Forces Are the Invisible Hand The market forces described here, working through the price mechanism, are the essence of Adam Smith's invisible hand (see Overview of Economics). The beauty of a market is that supply and demand come into balance without central planning, mandates, boycotts, raids, or wars, as each consumer and producer responds to the price of the product. The price sums up, contains, and channels the forces of the market the motives and desires of consumers and producers. This is not to say that markets do away with pain and loss for consumers and producers. Market forces generate tremendous amounts of pain and loss. People go without beef, suffer protein deficiencies, and even go hungry. They see people eating sirloin steak and prime rib and feel terrible that they can't afford it. Producers get stuck with beef they can't sell. Some meat may be sold at a loss or go to waste. Some ranchers and meat wholesalers go out of business and lose their livelihoods. Markets can be inefficient and even cruel. However, the pain and loss that occur in the market arise largely from decisions good and bad decisions made freely by consumers and producers. Therefore, most Americans prefer the inefficiencies and cruelties of the market to those of a command economy. Page 13 of 24

14 What About Shifts in Demand or Supply? Finally, let's return to those overall shifts in demand or supply. What effect do they have? Essentially, they shift the equilibrium point up or down. Two pictures will be worth 2,000 words. First, let's look at the effect of a shift in demand as illustrated in Figure 4.6. As the chart shows, an increase in demand raises the quantity demanded at a given price. This results in a new, higher market price, and producers will be more than happy to supply that higher quantity, which is 75,000 pounds, at that higher market price, which is $3.50. Thus, when demand shifts upward, the equilibrium point rises. To see the effect of a decrease in demand, simply reverse the situation and pretend that Page 14 of 24

15 the curves in the chart are reversed (that D is the new curve and D 1 is the original one). A shift to lower demand decreases the quantity demanded at a given price. Producers will (not quite so happily) meet that lower demand at a new, lower market price. This generates a new, lower equilibrium point. Turning to a shift in supply, as depicted in Figure 4.7, an increase in supply which shifts the curve to the right lowers the market price to $2.50 and raises quantity supplied from 60,000 to 70,000. That is why overcapacity or numerous competitors in an industry will cause the price to decrease. There's more supply than people demand. However, a decrease in supply which shifts the curve to the left has the opposite effect, as you can see by pretending that S 1 is the original curve and S is the new one. The decrease in supply increases the market price. That's because demand now exceeds the quantity supplied, and in that circumstance consumers bid up the price. Excerpted from The Complete Idiot's Guide to Economics 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc. Page 15 of 24

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