1 T h e D e m a n d & S u p p l y M o d e l. The Demand and Supply Model

Transcription

1 The Demand and Supply Model o o o o o The Demand Curve The Supply Curve Equilibrium Changes in Demand & Supply rice Mechanism 1 T h e D e m a n d & S u p p l y M o d e l

2 p 1 An Introduction to Demand Introduction Demand is the amount of a good or service that consumers are willing and able to buy at a given price. Demand for Hot Chocolate rice 5 uantity Demanded p 25p 2 T h e D e m a n d & S u p p l y M o d e l

3 uestions 1. If the price of the hot chocolate shown was 3, what would our class quantity demanded be? 2. What would happen to quantity demanded if: a) rice fell to 50p b) rice rose to 4 3. Suggest what would happen to demand if a) The income of the class increased by 100 b) Another similar hot chocolate was available at a price of 2 4. Can you suggest any other reasons why demand for hot chocolate may go up or down other than those suggested in questions 2 and 3? Extension: How do you think the changes in question 2 and question 3 would be illustrated on our demand curve diagram? 3 T h e D e m a n d & S u p p l y M o d e l

4 p 1 Demand & Supply: Demand Curve What is Demand? Demand The amount of a good or service that consumers are willing and able to buy at a given price It is important to remember that in economics we are concerned with effective demand. This is the quantity of a good or service that consumers would be willing and able to purchase at any given price. We are not interested in how much consumers would buy if they had unlimited resources (desire); of course we know that consumers do have limited resources, and so in economics, when we refer to demand we are always talking about effective demand, ie, wants/desires backed up by purchasing power. It is also worth noting that individual demand is the demand of one person whereas market demand is the demand that comes from everyone in a particular market. Demand for DVDs: an example of a demand curve A demand schedule below tells us how many DVDs would be demanded by consumers in the UK at each given price over the course of the year, The demand schedule for DVDs for 2012 rice of DVDs ( ) uantity demanded in 2008 (millions) T h e D e m a n d & S u p p l y M o d e l

5 Here is the demand curve for DVDs in 2012 oints to note: rice (p) is always on the vertical axis and uantity demanded (d) is always on the horizontal axis The demand curve always slopes downwards from left to right. This is because of the inverse (negative) relationship between quantity demanded and price, embodied in the law of demand: There is normally an inverse (negative) relationship between price and quantity demanded, all other things being equal. When isolating the relationship between 2 variables, here d and, we use the phrase all other things being equal to indicate that all other variables that may affect d are assumed to remain constant. Economists use the Latin phrase ceteribus paribus to say all other things being equal. The slope of the demand curve tells us how d for a product changes in response to a change in, and nothing else. Only a change in can cause a movement along the demand curve. Such movements along the demand curve are called a contraction or expansion in demand. Movements along the demand curve From the demand curve we drew you can see what happens to the demand for DVD as price changes. Assume the current (average) price of DVDs in 2012 is 14. What happens if price changes to Demand before Demand now Falls to million 120 million This is called an expansion in demand Rises to million 60 million This is called a contraction in demand 5 T h e D e m a n d & S u p p l y M o d e l

6 Illustrate these changes on the demand curve below: rice D1 Shifts in demand All other factors (other than price of DVDs) will cause the demand curve to shift its position i.e. these can lead to an increase or decrease in demand. In general factors that affect demand are: The (real) income of consumers & income tax changes: higher income allows consumers to buy more goods and services. This could occur if income tax fell or if wages & salaries rose. The demand for substitutes (e.g. epsi & Coke): consumers may demand less goods & services if they decide to buy a substitute good instead, possibly due to a cheaper price or increased quality. The demand for complements (e.g. dishwasher tablets and dishwashers): if consumers demand more dishwashers there will be more demand for complements like tablets. Fashion and changes in consumer tastes: consumers may start to prefer products if they become more fashionable or if consumer tastes move towards a certain product. Changes in legislation e.g. less demand for smoking after the smoking ban? Advertising: should increase the demand for products if it is effective Changes in population: should also increase demand as there are more people to buy goods and services e.g. rising populations in China and India. Shifts in demand for DVDs DVDs have become a popular form of home entertainment, almost exclusively replacing videos for watching films and superseding CD-ROMs as a means of storage. However, DVDs are now facing competition of their own from new high-definition DVDs (HD-DVD and Blu-ray). These new media have higher storage and better quality picture and sound; many experts expect these to replace DVDs in the next few years. They predict that many consumers will switch once either consumer s income rise or prices drop, making the new media more affordable. 6 T h e D e m a n d & S u p p l y M o d e l

7 Suggest what effect on DVD demand would the following have? Fall in price of HD-DVD and Bluray Fall in price of DVD players a Change in consumer tastes towards HD-DVD and Blu-ray Change in legislation declaring DVDs unsafe to use due to viruses contained on them Increased number of people owning TVs in China Increase in people s income in the UK Increased advertising for DVD Illustrate one of these changes on the demand curve below: rice D1 7 T h e D e m a n d & S u p p l y M o d e l

8 Joint Demand, Competitive Demand and Derived Demand Joint Demand When an increase in demand for good X, causes consumers to demand more of good Y. E.g. complements such as dishwasher tablets and dishwashers Competitive Demand When the demand for one good, reduced the demand for another E.g. substitutes such as Channel 4 and BBC Derived Demand When goods are demanded only because they are needed for the production of other goods E.g. Vaseline and crude oil, if there is consumer demand for Vaseline, then producers will demand crude oil? oint to onder What goods (if any) are related to DVDs in terms of: a) joint demand b) competitive demand c) derived demand 8 T h e D e m a n d & S u p p l y M o d e l

9 p 1 Demand uestions You need to be able to apply the basic theory of demand to a variety of markets. For each question explain how the change will affect demand and illustrate it on the diagram given. 1. Wheat Rising real incomes in India D 2. Diamonds Decreased price of diamonds D 3. Owner-occupied housing Credit Crunch D 9 T h e D e m a n d & S u p p l y M o d e l

10 4. Labour Market (Builders) Decreased Demand for Housing D 5. Cars Rising world population D 6. Coca-Cola Success of innocent smoothies fuelled by 5-a-day campaign D 10 T h e D e m a n d & S u p p l y M o d e l

11 7. Supermarket own brands UK recession D 8. Nintendo Wi Game Falling price of S3 Console D 9. Shares for Sainsbury s rofit warning issued by Sainsbury s D 11 T h e D e m a n d & S u p p l y M o d e l

12 10. Steel Increased demand for cars D 11. Child seats for cars Stricter car safety legislation D 12. Oil Speculators believe the price will rise D 12 T h e D e m a n d & S u p p l y M o d e l

13 p 1 An Introduction to Supply Would you sell your mobile phone? To understand the supply curve and the supply topic in general you need to think like a business, rather than as a consumer. One example of something you could supply to the market is your mobile phone. Complete the table below showing what price you would sell your mobile for (your individual supply), your prediction about the class (predicted class supply) and actual class supply (when we vote). 10 Individual Supply redicted Class Supply Class Supply What if? You are selling a different phone that cost you twice as much? The Government gave you 40 if you sold your phone (recycling subsidy)? The Government taxed you 5 if you sold your phone? 13 T h e D e m a n d & S u p p l y M o d e l

14 p 1 Demand & Supply: Supply Curve What is Supply? Supply How many goods firms are willing and able to put on the market (ie, supply) at any given price. Just as previously we constructed a demand curve which told us how much of a good consumers were willing and able to buy (ie, demand) at any given price, we can also construct a supply schedule. As with demand, there is a distinction between individual supply and market supply. The Supply Curve for Wheat SULY SCHEDULE FOR WHEAT rice of wheat/tonne ( ) s of wheat (tonne - millions) From this we can construct a supply curve: oints to Note: Again, price always goes on the vertical (Y) axis, quantity supplied on the horizontal (X) axis The slope of the supply curve tells us how s for a product changes in response to a change in, and nothing else. Whilst the demand curve sloped downwards from left to right (negatively sloped) the supply curve slopes upwards from left to right (positively sloped). 14 T h e D e m a n d & S u p p l y M o d e l

15 Why is supply upward sloping? Supply curves for most products slope upwards from left to right giving a positive relationship between the market price and quantity supplied. Two main reasons for this are as follows: 1. When the market price rises (for example following an increase in consumer demand), it becomes more profitable for businesses to increase their output. 2. Higher prices send signals to firms that they can increase their profits by satisfying demand in the market. When output rises, a firm's costs may rise, therefore a higher price is needed to justify the extra output and cover these extra costs of production Movements along the supply curve The only factor that causes a movement along the supply curve is price. Suppose the market price for wheat was 40 per tonne. What happens when price changes to Supply before Supply now Falls to 30 8 million 6 million This is called a contraction in supply Rises to 60 8 million 12 million This is called an expansion in supply Illustrate these movements along the supply curve on the axes below: rice S 15 T h e D e m a n d & S u p p l y M o d e l

16 Shifts in the supply curve In general the supply curve will shift due to the following factors: Costs of production: higher costs of production will decrease supply as there is less incentive to supply in that market due to lower profitability Indirect Taxes and Subsidies on a good: taxes will increase costs of production as they need to be paid to the Government but subsidies reduce costs of production. Therefore taxes will reduce supply and subsidies will increase supply. Technology & roductivity: better technology could improve productivity and reduce costs of production and therefore increase supply. Supply of alternative goods the producer could make with the same resources i.e. competitive supply. If producers can switch to producing a more profitable product they may reduce the supply of their current product. Supply of goods actually produced at the same time (i.e. joint supply): some goods will see a rise in supply if other goods are produced e.g. beef and leather The weather e.g. in agriculture the weather can determine the crop yield / the size of the harvest. Therefore good weather may increase supply. Entry/exit of new firms into/out of the market: if more firms enter a market then the market supply will increase and will decrease when firms leave the market. roducer cartels: this is when many firms/countries operate together and decide how much to supply onto the market and hence determine price. The main example is OEC for oil. They can restrict world supply of oil and therefore lower supply & raise the oil price. 16 T h e D e m a n d & S u p p l y M o d e l

17 Shifts in the supply curve for wheat Wheat is an agricultural product produced using mass production methods. It competes with other forms of basic foods such as maize, rice, corn etc. Suggest what the effect on the supply of wheat will be if A rise in the cost of fertilisers There was an improvement in farming technology (e.g. GM) There was a poor growing season due to climate change A producer cartel of wheat farmers limits wheat production A sharp fall in the price of wheat A tax imposed on wheat production 50 new farms set-up producing wheat Illustrating Shifts in Supply Using examples from the previous page, illustrate an increase and a decrease in supply: rice S1 17 T h e D e m a n d & S u p p l y M o d e l

18 p 1 Supply uestions You need to be able to apply the basic theory of supply to a variety of markets. SECTION A: Suggest what could have caused the changes in these markets. 1. Gold S2 S1 Decrease in supply 2. Computers S1 S2 Increase in supply 3. etrol S1 Expansion in supply T h e D e m a n d & S u p p l y M o d e l 1 2

19 SECTION B: Illustrate and explain the effect of the following changes on supply in these markets 4. Wheat oor Weather & Harvests of Wheat S1 5. Diamonds Decreased price of diamonds (due to lower demand) S1 6. Owner-occupied housing Major home building programme S1 19 T h e D e m a n d & S u p p l y M o d e l

20 7. Alcohol Increased tax on alcohol S1 8. Hydrogen Cars Entry of new firms in the market due to new Government subsidies S1 9. M3 players Better production technology S1 20 T h e D e m a n d & S u p p l y M o d e l

21 10. Leather Increased supply of cows S1 11. Oil Restrictions in supply by oil cartel S1 12. Shares for Sainsbury s Sainsbury s shareholders worry the share price will fall due to poor results S1 21 T h e D e m a n d & S u p p l y M o d e l

22 p 1 Demand & Supply: Equilibrium Market Equilibrium The price and quantity when demand equals supply Having looked at demand and supply we can now determine what the equilibrium quantity and price will be in a market. The equilibrium price is called the market clearing price: the price at which there is neither excess demand nor excess supply. This is simply where demand = supply, as illustrated below: NB. We are assuming we are in a free market As this is a free market it is producers and consumers who will determine the price and quantity. Indeed, in the example we are about to look at it will be market forces will ensure that the price tends towards the equilibrium, there is no need for Government intervention. Only if the market fails to do this would a Government intervene (e.g. for goods which no one would be willing to purchase like street lighting). 22 T h e D e m a n d & S u p p l y M o d e l

23 Why is this equilibrium? Market Stall Example DAY 1: Set price at 10p for apples for the day During this day the apples flew off the shelf, we were sold out before lunchtime and people were coming back later in the day having heard of the great offer! Illustrate the outcome on a demand and supply diagram: DAY 2: Set price at 1 for apples for the day Well the next day I thought I should increase my price as there was so much demand and I set the price at 1 an apple. Maybe I was a little greedy but I didn t expect to end up with a load of unsold fruit at the end of the day Illustrate the outcome on a demand and supply diagram: 23 T h e D e m a n d & S u p p l y M o d e l

24 DAY 3: Set price at 30p for apples for the day This was my best day of the three, 30p seemed an ideal price and I just sold my last apple at the end of the day. Illustrate the outcome on a demand and supply diagram: Activity: why is Demand = Supply equilibrium? a) Why would price fall if it were above equilibrium? b) Why would price rise if it were below equilibrium? Complete your answer below using the terms excess demand and excess supply 24 T h e D e m a n d & S u p p l y M o d e l

25 p 1 Changes in D & S Activity Illustrate the impact on the equilibrium price and quantity of apples of the following changes. a) A switch in consumer tastes for apples, as people try to become healthier & get 5-a-day b) A fall in price of other fruits 25 T h e D e m a n d & S u p p l y M o d e l

26 c) Entry of more apple producers into the market d) A fall in the crop yield of apples 26 T h e D e m a n d & S u p p l y M o d e l

27 A Final Example Slight increase in productivity in diamond extraction and a significant switch in tastes towards diamonds caused by advertising Illustrate this below: TI: A shift in either curve will always cause a movement along the other curve. Key oints Initial equilibrium will be where D = S Increase in supply caused by increased productivity. This causes a shift in the supply curve to the right and a movement along the demand curve (i.e. an expansion in demand) Increase in demand caused by advertising (not the price fall) will shift demand to the right and a movement along the supply curve (i.e. an expansion in supply). New equilibrium is where D1 = S1 Evaluation: what will happen to price and quantity? The impact on equilibrium price and quantity depends on the strength of each factor (i.e. how much each curve shifts), as well as the shape / elasticity of each curve. 27 T h e D e m a n d & S u p p l y M o d e l

28 p 1 Functions of the rice Mechanism The rice Mechanism Where the free markets allocate resources through the interaction of demand and supply 1. Signalling, Incentive and Rationing Functions The price mechanism operates in the free market and has several functions. rices in a free market can help solve the economic problem and allocate scarce resources by answering the questions: what, how and for whom. SIGNAL Change in what goods are preferred Demand & price changes Buyers & sellers observe this price INCENTIVE Change in price influences how much is produced RATIONING Who buys is determined by who wants it and if consumers can afford the price a) The Signalling Function Firstly, prices perform a signalling function. This means that market prices will adjust to demonstrate where resources are required, and where they are not i.e. helps society decide what should be produced and consumed. Signalling Consumer Demand: if market prices are rising because of high and rising demand from consumers, this is a signal to suppliers to expand their production to meet the higher demand. Through the signalling function, consumers are able through their expression of preferences to send important information to producers about the changing nature of our needs and wants. Signalling Availability to Consumers: signalling also occurs with the supply curve. For example, if market prices fall due to advances in technology and higher supply (such as for digital cameras) then this is signalled to consumers with lower prices and they will respond by expanding their demand. b) The Incentive Function roducers and consumers in the examples above have responded to the incentives provided by a change in price. Here the market is decided how much should be produced and consumed in the free market i.e. allocating resources. Incentives for producers: suppliers have the incentive to produce more when demand is high as they will make more profit. Incentives for consumers: consumers have more incentive to consume goods after supply increases (e.g. due to higher productivity) as the price will be lower. 28 T h e D e m a n d & S u p p l y M o d e l

29 c) The Rationing Function rices can ration resources as well. The market here answered the question for whom the goods should be provided. Rations Demand: when demand increases there will be a shortage of a good or service, only those who are able and willing to pay the higher price will be able to afford them. Rations Supply: prices can also help ration the supply of a good. For example, when a non-renewable resource is running out, the supply will fall and price will rise causing demand to contract. Again, only those with a high willingness and ability to pay can obtain the good. Example of the rice Mechanism: UK Broadband In a free market goods and services are allocated by demand (consumers) and supply (producers). In this example we see how resources are reallocated when consumers increase their demand for broadband. 1. If there is an increase in consumer demand for Broadband Internet, then this will signal to producers that Broadband is a profitable market. 2. There is therefore an expansion in supply to take advantage of this incentive 3. The new higher price rations who buys Broadband. These can be illustrated on the diagram below: 29 T h e D e m a n d & S u p p l y M o d e l

30 Example of the rice Mechanism: World Oil Supply This time we are going to see the functions of the price mechanism responding to a change in supply i.e. world oil supplies depleting. 1. If there is a decrease in the world oil supply then the oil price will rise. This higher price will signal to consumers that consuming oil is less desirable due to the high cost. 2. There is therefore a contraction in demand as there is an incentive for consumers to switch to renewable energy sources or reduce oil consumption (e.g. switching to public transport). 3. The amount of oil used has been rationed and will help to stop the decline in oil supplies. Only those with higher incomes will be able to continue purchasing oil on a large scale. These can be illustrated on the diagram below: 30 T h e D e m a n d & S u p p l y M o d e l

31 oint to onder: The ower of the rice Mechanism What if [all] markets were perfectly competitive? Every product would be linked to every other product through an ultra-complex network of prices, so when something changes somewhere in the economy (there s a frost in Brazil, or a craze for iods in the US) everything else would change maybe imperceptibly, maybe a lot to adjust. A frost in Brazil, for example, would damage the coffee crop and reduce the worldwide supply of coffee; this would increase the price coffee roasters have to pay to a level that discourages enough coffee drinking to offset the shortfall. Demand for alternative products, like tea, would rise a little, encouraging higher tea prices and extra supply of tea. Demand for complementary products like coffee creamer would fall a little. In Kenya, coffee farmers would enjoy bumper profits and would invest in improvements like aluminium roofing for their houses, the price of aluminium would rise and so some farmers would wait before buying. That means demand for bank accounts and safety deposit boxes would rise, although for unfortunate farmers in Brazil with their failed crops, the opposite may be happening. The free market supercomputer processes the truth about demands and about costs, and gives people the incentive to respond in astonishingly intricate ways. 2. Other Functions of the rice Mechanism Source: The Undercover Economist, Tim Harford There are two other functions of the price mechanism which we have already covered during this handout: a) Entry & Exit of Firms When we looked at the price mechanism we suggested that when demand increased for a product, existing producers would increase their production and supply would expand. This is true in the short-run, however in the long-run more producers would enter the market in search of increased profit (assuming a competitive market with low barriers to entry). Thus our Broadband example was not complete. Entry of Firms: if there is an increase in consumer demand for Broadband Internet, then this will signal to producers that Broadband is a profitable market. There is therefore an expansion in supply to take advantage of this incentive in the short-run. In the long-run more producers may enter the industry to take advantage of the extra profit. Exit of Firms: the opposite argument is also true, if there was a decrease in demand for broadband then in the long-run firms would exit and possibly enter new, more profitable markets. Again, this analysis assumes that there are free, competitive markets. We will consider imperfectly competitive markets in Unit T h e D e m a n d & S u p p l y M o d e l

32 b) Eliminating Surpluses and Shortages As we saw when we studied market equilibrium, the price mechanism will allow the price to rise for goods when there is a shortage (excess demand) and allow prices to fall when there is a surplus (excess supply). This means prices will eliminate surpluses and shortages in a functioning free market. Eliminating surpluses: if there is excess supply (i.e. supply is greater than demand) then the price will fall. This will lead to a contraction in supply (as it is less profitable) and an expansion in demand (as it is now cheaper to buy the goods). Both these forces will continue until demand equals supply and equilibrium is reached. Eliminating shortages: if there is excess demand (i.e. demand is greater than supply) then the price will rise. This will lead to a contraction in demand (as it is now more expensive) and an expansion in supply (as it is now more profitable to produce). Both these forces will continue until demand equals supply and equilibrium is reached. Both these can be shown diagrammatically, for example in the diagram below price will need to fall from 40p to 35p to eliminate excess supply or a surplus: 32 T h e D e m a n d & S u p p l y M o d e l

33 1. DATA RESONSE 33 T h e D e m a n d & S u p p l y M o d e l

34 2. This resource has been contributed by eter Davis, Head of Economics & Business Studies at Latymer School. 34 T h e D e m a n d & S u p p l y M o d e l