the interaction of and applications of demand and supply section 2: microeconomics

THE INTERACTION OF AND APPLICATIONS OF DEMAND AND SUPPLY Section 2: Microeconomics

EQUILIBRIUM (p38) Equilibrium may be defined as a state of rest, self-perpetuating in the absence of any outside disturbance. Economists spend a lot of time considering situations where equilibriums change and the reasons why the change has taken place. They use this information to begin to predict changes in equilibrium situations that may be caused by a certain action. They can then begin to formulate economic policy.

Graph Interpretation Both the demand and supply curves for coffee are in the same diagram. At the price Pe, the quantity Qe is both demanded and supplied. The market is in equilibrium at the price Pe, since the amount of coffee that people wish to buy at the price Qe is equal to the amount suppliers wish to sell at that price. The Price Pe, is sometimes known as the market clearing price, since everything produced in the market will be sold.

EQUILIBRIUM Equilibrium is self righting. If you try to move away from it, without an outside disturbance it will return to the original position.

Excess Supply The producer has tried to raise the price to P 1. However, at this price, the quantity demanded will fall to Q 1 and the quantity that producers supply rises to Q 2 We now have excess supply of Q1-Q2. In order to eliminate the surplus, producers will need to lower their prices.

Excess Demand The producers have to tried to lower the price to P 2. However, at this price the quantity demanded will rise to the Q 4 and the quantity the producers supply falls to Q 3. There is excess demand of Q 3 to Q 4. In order to eliminate the shortages, producers will need to raise their prices. As they do the quantity demanded will fall and the quantity supplied will increase, until equilibrium is reached.

EQUILIBRIUM The effect of changes in demand and supply upon the equilibrium Equilibrium may be moved by any outside disturbance. In the case of supply and demand this would be a change in one of the determinants of demand or supply, other than the price of the product, which would lead to shift of either of the curves.

D1D1 DAYS Increase in Incomes: Impact on Holidays There is an increase in income for consumers who normally take foreign holidays. This leads to an increase in demand for holidays and the demand curve will shift to the right. When the demand curve shifts from D to D 1, price initially remains at P e and so Q e continues to be supplied. However demand now increases to Q 2. There is now a situation of excessive demand. Its necessary for the price to rise. The Price will rise until it reaches a new equilibrium price at Q e1

Equilibrium Whenever there is a shift of the demand or supply curve, the market will, if left to act alone, adjust to a new equilibrium market- clearing price.

PRICE CONTROLS Although it may seem to be an optimum situation, the free market does not always lead to the best outcomes for products and consumers or society in general. Governments normally choose to intervene in the market in order to achieve a different outcome. There are number of situations where this occurs: maximum prices. minimum prices. price support/buffer stock schemes commodity agreements.

Maximum (Low) Price Controls This is a situation where the government sets a maximum price below the equilibrium price, which then prevents producers from raising the price above it. These are sometimes known as ceiling prices, since the price is not able to go above the the ceiling. Maximum prices are usually set to protect consumers and they are normally imposed in markets where the product in question is a necessity and/or a merit good (a good that would be underprovided if the market was allowed to operate freely.)

Maximum (Low) Price Controls Governments may set maximum prices in agricultural and food markets during times of food shortages to ensure low cost food for the poor, or they may set maximum prices on rented accommodation in an attempt to ensure affordable accommodation for those on low incomes.

MAXIMUM PRICE CONTROLS Without government interference, the equilibrium quantity demanded and supplied would Q e. at a price of P e. The government imposes a maximum price of P max. In order to help the consumers of bread. However a problem now arises. A the price P max Q 2 will be demanded, but only Q 1 will be supplied. There is a problem of excess demand. The consumption of bread actually falls from Q e to Q 1 even though it is at a lower price.

Problems with Maximum (Low) Price Controls The excess demand creates a problem. Excess demand results in shortages. Shortages may lead to the emergence of a black market (an illegal market) where the product is sold at a higher price, somewhere between the maximum price and the equilibrium price. There may also be queues developing in the shops and producers my start to decide who is going to be allowed to buy. Governments may be forced to reverse price controls or reduce price controls.

Government responses to Problems with Maximum Price Controls Two Options. Shift the Demand Curve to the Left It could attempt to shift the demand curve to the left, until equilibrium is reached the maximum price, but this would limit the consumption of the product. Shift the Supply Curve to the Right Shift the supply curve to the right until equilibrium is reached at the maximum price, with more being demand and supplied. This option is normally used and can be implemented in several ways.

Government responses to Problems with Maximum Price Controls How to shift the supply curve to the right 1.The government could offer subsidies to the firms in the industry to encourage them to produce more. 2.The government could start to produce the product themselves, thus increasing the supply. 3.If the government had previously stored some of the product (eg: buffer stocks) it could release some of the stocks onto the market. Not possible for perishable products like bread.

Action to Solve the Problem of Excess Demand If the government is able to shift the supply curve to the right by subsidies or direct provision, the equilibrium will be reached at P max with Q 2 loaves of bread being demanded and supplied. If the government occurs a cost in the terms of subsidy this will have an opportunity cost. Money supporting the bread industry may mean less for education or health care.

Minimum (high) price controls This is a situation where the government sets a minimum price, above the equilibrium price which then prevents producers from reducing the price below it. These are sometimes known as floor prices, since the price is not able to go below the floor.

Why do governments sets minimum prices? 1.To attempt to raise incomes for producers of goods and services that the government thinks are important, such as agricultural products. These industries may be helped because their prices are subject to large fluctuations or because there is a lot of foreign competition. 2.To protect workers by setting a minimum wage, to ensure that workers can earn enough to lead a reasonable existence.

Minimum Price Controls Without government interference, the equilibrium quantity demanded and supplied would be Q e and at a price of P e. The government imposes a minimum price of P min. in order to increase the revenue of producers of wheat. However, at P min only Q 1 will be demanded because the price has risen but Q 2 will now be supplied. There is a problem of excess supply. Consumption of wheat will fall to Q1, albeit at a higher price.

Government Response to excess supply problems (p43) The government would normally eliminate the excess supply by buying up the surplus products, at the minimum price, thus shifting the demand curve to the right, creating new equilibrium. The government could then store the surplus, destroy it or attempt to sell it abroad. Storage is expense and destroying it wasteful.

Government Response to excess supply problems Selling it abroad is an option, but is often causes angry reactions from foreign governments involved, who claim that products are being dumped on their markets and will harm their domestic industries. In some cases such as the European Union agricultural farmers are guaranteed a minimum price and are paid to set aside land that they would have used to produce the product in question. Farmers in the EU are then paid the price for an estimated harvest and nothing is actually grown. There is always an opportunity cost with such policies.

Government Action to solve problem of Excess Supply The government would normally eliminate the excess supply by buying up the surplus products, at the minimum price, thus shifting the demand curve to the right and creating a new equilibrium at P min with Q 2 being demanded and supplied. The new demand curve, would be D + government spending.

OTHER WAYS TO MAINTAIN THE MINIMUM PRICE QUOTAS Producers could be limited by quotas restricting supply so they it does not exceed Q 1. This would keep the price at P min but it would mean only a limited number of producers would receive it.

OTHER WAYS TO MAINTAIN THE MINIMUM (High) PRICE The government could also attempt to increase demand for the product by advertising or, if appropriate.... by restricting supplies of the product that are being imported, through protectionist policies, thus increasing demand for domestic products.

Problems with guaranteed minimum prices, paid by the government Firms may think that they do not have to be as cost-conscious as they should be and this may lead to inefficiency and as waste of resources. It may also lead to firms producing more of the protected product than they should and less of other products that they could produce more efficiently.

Price Support/Buffer Schemes AIM: PRICE STABILITY (p30) This is a situation where a government intervenes in a market to stabalise prices. This has been attempted in markets for commodities (raw materials) whose prices are often unstable. Producer of agricultural commodities such as wheat, coffee or coca are very much at the mercy of the weather and also dangers like insects, and crop diseases.

Price Issues for agricultural commodities If conditions are excellent (eg: perfect amount of sun/rain) there might be what is known as a bumper crop and abundant supply. This will drive the price of the product down and impact on the income of producers. If there is a poor weather, such that the supply of crops falls, this will drive the price up, but this will only be for the benefit of the farmers who have the crops. Producers face volatile prices.

Price Issues for Industrial or Mineral commodities Another category of raw materials is industrial or mineral commodities such as copper, rubber or tin. These produce face volatile prices mainly due to factors that cause big swings in demand. Changes in the world economy are likely to have a large impact on producers of such commodities. Periods of high economic growth = greater income for commodity producers. Periods of low economic growth = lower incomes for commodity producers.

Demand / Supply Factors Commodity Markets Both demand and supply-side factors create instability in commodity markets. Unstable incomes may result in lower standards of living with negative consequences for commodity producers and their communities. Governments may attempt to intervene to protect prices from extreme fluctuations by buffer stock scheme.

BUFFER STOCK To operate a buffer stock scheme, the buffer stock manager sets a price band with a highest possible price and the lowest possible price. It then intervenes in the market whenever free market forces push the price either above the top price or below the bottom price.

The Price Band Set in Buffer Stock Scheme

A Surplus in Buffer Stock Scheme An increase in supply from S 1 to S 2 would push the price below the acceptable bottom price of $2 per kilo. At the bottom price, there would be an excess of supply of Q 1 to Q 2. In order to maintain the price at $2, the buffer stock manager would have to buy this excess supply (surplus). The surplus would them have to be stored.

A Shortage in a Buffer Stock Scheme If there is poor weather or a problem with pests such that supply were to fall considerably from S 1 to S 2 then this would push the price above the acceptable top price of $4. At the top acceptable price, there would be excess demand (shortage) of Q 1 to Q 2. The buffer stock manager would have to intervene to prevent the price from going above the price band. The manager could do this by selling coffee from stored stocks.

Problems with Buffer Stock Schemes Most of the problems are similar to the problems outlined with minimum prices. Ideally works with non perishable goods. However, even non perishable goods can have high storage costs. Significant improvements in technologies, means that persistent surpluses have to be brought by government which is expensive. There may be few bad seasons to releases the stock. Choosing the appropriate price band can be problematic. Producers want the highest possible band, which results in surpluses.

Commodity Agreements When different countries work together to operate a buffer stock for a particular commodity, it is known as a commodity price agreement. They were pioneered in the 1960s through the United Nations Conference on Trade and Development (UNCTAD). They were designed to support commodity producers in developing countries.

Commodity Agreements There are many cases where developing countries are dependent on the export of a few commodities for their export revenues. Some countries have seen slow growth and little development as a result of low commodity prices.

EXAMINATION QUESTIONS Short Response Questions 1.Using demand and supply analysis, explain how resources are allocated through changes in price in a market economy. (10 marks) 2.Using an appropriate diagram, explain the likely consequences of an increase in the legislated minimum wage? (10 marks)

EXAMINATION QUESTIONS Essay Question 1a. Explain the role of prices in allocating resources in a market economy (10 marks) b. Evaluate the consequences of government intervention in the market place in setting maximum prices. (15 marks) 2a. Explain how a buffer stock scheme is expected to work. (10 marks) b. Evaluate the likely success of an international buffer stock scheme in the coffee industry. (15 marks)

the interaction of and applications of demand and supply section 2: microeconomics

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