Supply and Demand in Action

Supply and Demand in Action

In the previous section we learnt that a change in any determinant of demand or supply exceptthe price of the product will cause a change in demand or supply, illustrated by a shift of the demand curve or the supply curve. We now examine the impact of changes in demand or supply on the equilibrium price and quantity of the product concerned. We first look at changes in demand.

Changes in demand

An increase in demand

An increase in demand (rightward shift of the demand curve) will result in an increase in the price of the product and an increase in the quantity exchanged, ceteris paribus.

This is illustrated in the diagram above where the demand curve shifts from DD to D1D1. The increase in demand can be the result of a change in any of the determinants of demand except the price of the product– a change in the price of the product will result in a change in the quantity demanded, illustrated by a movement along the demand curve.

The sources of an increase in demand include…

an increase in the price of a substitute product
a decrease in the price of a complementary product
an increase in consumers’ income
a greater consumer preference for the product
an expected increase in the price of the product

What happens to supply when demand increases?

Supply (represented by the supply curve) remains unchanged, but the quantity supplied increases as the price of the product increases.
There is an upward movement along the supply curve (E to E1) in the diagram above.
Equilibrium isre-established at E1, at a higher price (P1) and a higher quantity (Q1) than before.

A decrease in demand

A decrease in demand will result in a decrease in the price of the product and a decrease in the quantity exchanged, ceteris paribus.

This is illustrated in diagram above by a leftward shift of the demand curve from DD to D2D2.

The decrease in demand could be the result of a change in any of the determinants of demand except the price of the product.

The causes of a decrease in demand include…

a fall in the price of a substitute product
an increase in the price of a complementary product
a fall in consumers’ income
a reduced preference for the product
an expected fall in the price of the product

What happens to supply when demand decreases?

When demand decreases, the price of the product falls and this leads to a reduction in the quantity supplied.
The supply curve remains unchanged, but there is a downward movement along the supply curve (E to E2).
Equilibrium is re-established at E2, at a lower price (P2) and a lower quantity (Q2) than before.

Changes in supply

An increase in supply

This will result in a fall in the price of the product and an increase in the quantity exchanged, ceteris paribus.

This is illustrated in the diagram above, where the supply curve shifts to the right (or downwards) from SS to S1S1.Such an increase in supply means that more goods are supplied at each price than before.

The shift of the supply curve could be the result of a change in any of the determinants of supply other than the price of the product.

Causes of an outward shift in supply could be…

a fall in the price of an alternative product or a rise in the price of a joint product
a reduction in the price of any of the factors of production or other inputs (ie a decrease in the cost of production)
an improvement in the productivity of the factors of production (eg as a result of technological progress) – this also lowers the cost of production.

What happens to demand when supply increases?

Demand remains unchanged but the quantity demanded increases as the price of the product falls.
There is a downward movement along the demand curve (E to E1).
Equilibrium is re-establishedat E1, that is, at a lower price (P1) and a higher quantity (Q1) than before.

A decrease in supply

A decrease in supply will result in an increase in the price of the product anda decrease in the quantity exchanged, ceteris paribus.

This is illustrated the diagram above by a leftward (upward) shift of the supply curve from SS to S2S2. Such a decrease in supply means that fewer goods are supplied at each price than before.

The shift of the supply curve could be the result of a change in any of the determinants of supply other than the price of the product.

Possible causes of a decrease in supply are…

an increase in the price of an alternative product or a fall in the price of a joint product
an increase in the price of any of the factors of production or other inputs (ie an increase in the cost of production)
a deterioration in the productivity of the factors of production (which also raises the cost of production).

What happens to demand when supply decreases?

Demand remains unchangedbut there is an upward movement along the demand curve (E to E2)
Equilibrium is re-established at E2, that is, at a higherprice (P2) and lower quantity (Q2) than before.

Simultaneous changes in demand and supply

When more than one change is involved, it is not always possible to predict the outcome, since the changes may work in opposite directions.

We have seen that an increase in demand leads to an increase in the equilibrium price and that a decrease in supply also leads to an increase in the equilibrium price. It follows, therefore, that an increase in demand accompanied by a decrease in supply will raise the equilibrium price of the product concerned.

What we cannot predict, however, is what will happen to the equilibrium quantity exchanged in the market. An increase in demand raises the equilibrium quantity, ceteris paribus, while a decrease in supply lowers the equilibrium quantity, ceteris paribus. The two forces work in opposite directions as far as the equilibrium quantity is concerned and the outcome will depend on the relative magnitudes of the changes in demand and supply.

Similar problems occur in other cases as seen in the table below…

A simultaneous increase in demand and decrease in supply

In all three diagrams the original demand, supply, equilibrium price and equilibrium quantity are represented by DD, SS, P0 and Q0. A simultaneous increase in demand (rightward shift of the demand curve) and decrease in supply (leftward shift of the supply curve) raises the price of the product. The impact on the equilibrium quantity depends on the relative magnitude of the changes.

in (a) the quantity remains unchanged at Q0.
in (b) quantity falls to Q2 and
in (c) quantity increases to Q3.

Government intervention

The changes explained in the previous sections will occur only if the market forces of supply and demand are free to establish the equilibrium prices and quantities of goods and services. Often consumers, trade unions, farmers, business people and politicians are not satisfied with the prices and quantities determined by market demand and supply. Their dissatisfaction leads them to put pressure on government to intervene to influence prices and quantities in the market. This intervention can take different forms, including…

•setting maximum prices (price ceilings)

•setting minimum prices (price floors)

•subsidising certain products or activities

•taxing certain products or activities.

Maximum prices (price ceilings, price control)

Governments often set maximum prices for certain goods and services. Governments set maximum prices to…

•keep the prices of basic foodstuffs low, as part of a policy to assist the poor

•avoid the exploitation of consumers by producers

•combat inflation

•limit the production of certain goods and services (eg in wartime).

If a maximum price is set above the equilibrium (or market-clearing) price, it will have no effect on the market price or the quantity exchanged. Prices and quantities will still be determined by demand and supply.

However, when a maximum price is set below the equilibrium price (as is usually the case), it will have significant effects.

In the diagram on the right…

•The government sets a maximum price (Pm) below the equilibrium price (P0).

•At the lower price (Pm) consumers demand a quantity (Q2) higher than theequilibrium quantity (Q0).

•Suppliers will only be willing to supply Q1, which is lower than Q0.

•Leads to a market shortage (or excess demand) equal to the difference between Q2 and Q1 (or ab).

In the absence of price control, this excess demand will raise the price until equilibrium is re-established at P0 and Q0. But when price control is introduced,different ways of solving the problem of excess demand have to be found.

When market prices are not allowed to fulfil their rationing function, someone or something else must do the job. The basic problem is how to allocate the available quantity supplied (Q1) between consumers who demand a total of Q2 of the goodconcerned.

This can be done in various ways…

•Consumers may be served on a “first come first served” basis, resulting in queues or waiting lists.

•Suppliers may set up informal rationing systems (eg by limiting the quantity sold to each consumer or by selling to regular customers only).

•Government may introduce an official rationing system by issuing ration tickets or coupons which have to be submitted when purchasing the product.

A major consequence of maximum price fixing is the development of black markets. Black markets occur in any situation where the market forces of supply and demand cannot (or are not allowed to) eliminate excess demand.

Take for example the Mayweather – Pacquiao fight in Las Vegas. Anyone who succeeds in getting a ticket can sell this ticket to someone else at a much higher price. In the diagram on the previous pagewe see that some consumers are willing to pay a price of P1 for a quantity of Q1. Anyone who is able to purchase a ticket at a price of Pm (the official price) has the potential to make a profit equal to the difference between P1 and Pm by selling it to someone who was not fortunate enough to get hold of a ticket.

This alternative market in tickets is called a black market. Not all black markets are illegal, but in the case of maximum price fixing by government, black market activity is outlawed. A black market is therefore often defined as an illegal market in which goods are sold above the maximum price set by government.

Fixing prices below the equilibrium (or market-clearing) price thus…

•creates shortages (or excess demand)

•prevents the market mechanism from allocating the available quantity amongconsumers

•stimulates black market activity by providing an incentive for people to obtainthe good and resell it at a higher price to those consumers who are willing topay higher prices to obtain it.

The welfare costs of maximum price fixing

The concepts of consumer surplus and producer surplus can be used to illustrate the welfare loss associated with maximum price fixing.

In the diagram on the right…

•a maximum price Pm is set below the market-clearing price P1.

•Quantity falls from the equilibrium level Q1 to Qm.

•At P1, consumer surplus was P1DE.

•At Pm, consumer surplus is PmDRU.

•Consumers have lost the shadedtriangle indicated by A, since only Qm is exchanged; but they have gained rectangleB, since those who can obtain the product now pay less for it than before.

•Area Bused to be part of the producer surplus but now becomes part of the consumersurplus.

•In the absence of the maximum price, the producer surplus is indicated bythe triangle 0P1E.

•After the maximumprice is set, producer surplus is now the small triangle 0PmU.

•Rectangle B istransferred to the consumer surplus.

•Triangle C simply disappears, since only Qmis produced and exchanged.

•The total welfare loss to society is triangle A plus triangleC. This is usually referred to as deadweight loss.

•Too little is being produced,and in the end society (which consists of consumers and producers) isworse off as a result of the interference in the market system.

Minimum prices (price supports, price floors)

Markets for agricultural products are usually characterised by a relatively stable demand, but also by a supply which is subject to large fluctuations. Prices therefore tend to fluctuate and farmers’ income is unstable and uncertain. To stabilise income, governments often introduce minimum prices (or price floors) which serve as guaranteed prices to producers.

If the minimum price is below the ruling equilibrium price, the operation of market forces is not disturbed, but if the minimum price is above the ruling equilibrium price (as is often the case) there is a surplus (or excess supply).

This is illustrated the diagram on the right…

•Equilibrium price = R30,00 per kg & equilibrium quantity = 7 million kg.

•Government sets a minimum price ofR40,00 per kg.

•Qdnow = 4 million kg & Qs = 9 million kg.

•Excess supply (surplus) of 5 millionkg (ab).

When government fixes a minimum price above the equilibrium price, it creates a market surplus. This usually requires further government intervention. The options are essentially the following…

•Government purchases the surplus and exports it.

•Government purchases the surplus and stores it (provided the product is non-perishable).

•Government introduces production quotas to limit the quantity supplied to thequantity demanded at the minimum price.

•Government purchases and destroys the surplus.

•Producers destroy the surplus.

The artificially high price is usually justified by arguments that it is in consumers’ interests that producers receive a stable income (and keep producing the products) or that the surplus can be exported to earn foreign exchange.

Setting minimum prices above equilibrium prices is a highly inefficient way ofassisting small or poorer producers, since…

•all consumers, including poor households, have to pay artificially high prices

•the bulk of the benefit accrues to large producers or concerns owned by bigcompanies

•inefficient producers are protected and manage to survive

•the disposal of the market surpluses usually entails further cost to taxpayers and welfare losses to society.

If government wishes to assist certain producers, then direct cash subsidies paid only to those producers is a better alternative than fixing a minimum price. With direct subsidies there is no interference in the price mechanism.

The welfare costs of minimum price fixing

In the figure on the right…

•Equilibrium price quantity = P1 and Q1.

•Government fixes a minimumprice Pm above the equilibrium price.

•Qsfalls to Qm.

•Initially, consumer surplus = P1DE & producer surplus =0P1E.

•After minimum price fixing consumer surplus =PmDR.

•Consumers lose rectangle A (to producers) and triangle B (disappears).

•Producersurplus becomes 0PmRT.

•Producers gain rectangle A at the expense of consumersbut triangle C disappears.

•The total deadweight loss to society is thus triangleB plus triangle C.

•As in the case of maximum price fixing, too little isproduced and society is worse off as a result of the interference in the market system.