THE INTERACTION OF AND APPLICATIONS OF DEMAND AND SUPPLY
Section 2: Microeconomics
Slide 2
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.
Slide 3
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.
Slide 4
EQUILIBRIUM Equilibrium is self righting. If you try to move
away from it, without an outside disturbance it will return to the
original position.
Slide 5
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.
Slide 6
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.
Slide 7
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.
Slide 8
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
Slide 9
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.
Slide 10
Slide 11
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.
Slide 12
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.)
Slide 13
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.
Slide 14
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.
Slide 15
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.
Slide 16
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.
Slide 17
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.
Slide 18
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.
Slide 19
Slide 20
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.
Slide 21
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.
Slide 22
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.
Slide 23
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.
Slide 24
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.
Slide 25
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.
Slide 26
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.
Slide 27
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.
Slide 28
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.
Slide 29
Slide 30
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.
Slide 31
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.
Slide 32
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.
Slide 33
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.
Slide 34
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.
Slide 35
The Price Band Set in Buffer Stock Scheme
Slide 36
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.
Slide 37
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.
Slide 38
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.
Slide 39
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.
Slide 40
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.
Slide 41
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)
Slide 42
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)