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UNIT 2 : Economics
Price determination
This unit should enable you to understand and explain
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The determinants of demand
The determinants of supply
How prices are formed in a free market
How prices change in response to changes in the market
In this unit we are going to see how prices are formed in free markets by the interaction of
supply and demand, the two elements that, collectively, we term ‘market forces’.
A lot of time and effort was spent in the last century and the early part of this century
trying to produce useful theories that could explain consumer buying behaviour. All
economics textbooks contain chapters entitled ‘consumer theory’ that would lead you
through the construction of these theories and their usefulness. Since this is only a ten
credit module such detail is unnecessary but you should be aware that there is some
theoretical foundation for the ideas that we will make use of in this part of the course.
The first task is to look at the factors affecting demand for goods and services to try to
understand what makes consumers ‘tick’. There are many ideas from the fields of
marketing and psychology that can help us understand consumer behaviour but in this
course we will concentrate on a traditional economic perspective.
FACTORS AFFECTING DEMAND
The price of the product
Consumer theory, and also common sense, tells us that for most products, more will be
sold if the price is lower. This can be restated as the first law of demand:
The first law of demand says that:
More will be demanded at a lower price
This is likely to be true for two reasons. Firstly, existing consumers will tend to buy more
if the product is cheaper. If a pair of trainers sells for £30 rather than £60 a customer may
buy two pairs each year rather than one. Secondly, new buyers will be attracted into the
market at the lower price ensuring that demand is greater at the lower price.
We can show this relationship between quantity demanded and price diagrammatically,
focusing this time on the market for audio tapes.
The Demand Curve
1 .8 0
e
Price (pounds per tape)
1 .5 0
d
1 .2 0
c
0 .9 0
b
0 .6 0
a
0 .3 0
0
0
De m a n d
fo r ta p e s
2
2
4
6
8
10
4
6
8
10
Q a n tity (m illio n s o f ta p e s pke r we e )
Quantity ( millions of tapes per week )
Fig 2.1
You will find that diagrams can be very useful in explaining economic concepts. A
picture may not always be worth a thousand words, but diagrams will usually shorten the
process of describing and analysing economic events. This will certainly be true in this
unit.
We will use diagrams to build-up a simple model of the way markets function which we
can then go on to use to help us deal with the complexities of the real world. If the model
is a good one it should be able to answer a range of ‘what-if’ questions and enable us to
reach logical and reasonable conclusions. It should help us to manipulate ideas quickly
and help us understand the way markets work. If the model does not do this we should
discard it and look for a better model.
Now we should return to the demand curve shown in fig 2.1
The demand curve for audio tapes tells us what consumers would like to do at all the
possible prices. It could have been derived from historical information, market research,
mathematical modelling, or it could be purely illustrative. It doesn’t matter. What does
matter is that we have an idea how consumers (collectively) will react to a change in price
of a product, in this case, to the price of audio tapes.
Activity:
Are there any exceptions to the first law of demand? If you can think of
any try to list them.
Now we will consider the other factors that influence demand apart from price.
NON-PRICE FACTORS
1.
Income
I’m sure it will come as no surprise to you when I say that our income plays a large part in
determining the kind of products we buy and the quantities we buy them in. If you were to
win the lottery, I think that your weekly shopping list would look quite different from the
way it looks now. At the moment our model, which consists of a single demand curve,
can only handle changes in price, it cannot handle a change in income. We will see how
non-price factors influence demand at the end of the section.
2.
The price of related products
In the fast-food business consumers choose between a hamburger from McDonalds and
one from Burger King, in the petrol business between say, BP and Shell and in the softdrinks business between Coke and Pepsi. Surely if the price of one of these rival brands
changes then it could affect the demand for the other one. It would seem reasonable to say
so. Similarly, as the price of PCs comes down we should surely see an increase in the
number of games and other software titles sold. Clearly, the price of substitutes and the
price of complementary products will influence demand. Unfortunately, for the time being
our simple model cannot handle the effects of such changes so we must wait patiently
until the end of this section.
Activity:
3.
From your own experience think of 4 pairs of substitutes that consumers
often choose between. Now think of 4 pairs of complements that are nearly
always purchased together.
Tastes and preferences
As rational consumers, we would only ever buy products that we like. If our preference
for a particular product should strengthen, this must affect our demand for it. If our
preferences are shifting away from certain products, demand must also change.
Advertisers are constantly trying to manipulate these tastes and preferences just to
influence demand. At this stage our simple model cannot accommodate changes in tastes,
all it can do is show us what happens when prices change but this will be rectified soon.
4.
Seasons
The demand for a whole range of products is affected by seasonal factors, Christmas
crackers and decorations, Valentines cards, Easter eggs, sun-tan lotion and swimwear,
football boots, salad items, the list could go on and on. As the season approaches you
would expect demand to increase and as the season passes so demand is likely to
decrease. Again, at the moment our model cannot deal with seasonal changes it can only
deal with a change in price.
5.
Cost of finance
For expensive consumer durables like cars, furniture, and particularly houses, finance
charges and interest rates must influence demand. When interest rates move upwards and
mortgage repayments rise, it is reasonable to expect the housing market to slow down.
Similarly, cheaper finance costs would surely encourage more demand for houses and any
other expensive consumer durables. We need to make sure our model can reflect this too.
6.
Population
A long-term influence on the demand for goods and services is the size and composition
of the population. More people in the economy means increased demand for most goods
and services. More old people in society will result in increased demand for everything
from private nursing to spectacle frames and hearing aids. A smaller number of young
people would reduce the demand for CDs and designer clothing.
Activity:
What other goods and services will decline in popularity in UK markets as
the population ages?
There are other influences on demand; for example, expectations, advertising and
government legislation to mention three. You might like to think how changes in these
factors could change the demand for a product or even think of some other factors that we
haven’t mentioned here.
Now we should make sure that our model can deal with all of the non-price factors that
might be at work in the market.
Supposing we had conducted market research concerning audio tapes and used the
information to construct a demand curve as in fig 2.1. How useful would this diagram be
if subsequently the Chancellor of the Exchequer reduced basic rate of income tax to 15p
in the pound? With such a substantial change to most peoples income, I would think the
diagram was out-of-date and useless. You would need to conduct the research again and
come-up with a new curve. The same thing would be true if there was a change in any of
the other non-price factors presented above.
A change in any non-price factor will result in a need for new data which will give rise to
a new demand curve .
A Change in Demand Versus a
Change in the Quantity Demanded
DDecrease
e c re a sin
e in
Price
qquantity
u a n tity
ddemanded
e m a nd e d
De c re a s e in
In c re a s e in
d e m a nd
d e m a nd
In c re a s e in
Increase in
q u a n tity
quantity
demanded
d e m a nd e d
D
D2
Do
D
DD1
1
0
Quantity
Fig 2.2
Q u a n tity
The diagram above illustrates the way we can treat a change in both price and also nonprice factors identified earlier.
An increase in price will lead to a decrease in the quantity demanded.
A decrease in price will lead to an increase in the quantity demanded
A change in a non-price factor will lead either to an increase in demand or a decrease in
demand.
It is vital that you stick with this terminology if you are to become confident in the use of
supply and demand analysis.
Activity:
Can you answer the following question, what factor can never cause an
increase in demand?
Well, that is half the story. We now need to look at the other side of the coin and turn our
attention away from consumers and demand, towards producers and supply.
FACTORS INFLUENCING SUPPLY
The price of the product
Would you rather sell a delivery of ladies shoes that has just arrived from Italy for £50 a
pair or £40 a pair? Of course, rational suppliers would always sell at the higher price
unless there was some devious strategy going on that shouldn’t concern us right now. If
you sell the shoes for £50 you will make more profit than if you sell them for £40. You
would try to sell them for £60 if you thought you could sell them all at that price …and so
would every other seller in the market. This is the first law of supply:
The first law of supply says that:
More will be supplied at the higher price
This will be true for two reasons.
Existing producers will try to supply more if the market price is rising because this will
increase their profits.
New firms are likely to enter the market since the prospect of making money are getting
better and better.
The same will be true in reverse. If market prices fall (as in the case of beef recently) then
farmers cut back on beef production and some leave the beef industry altogether thus
reducing supply.
This relationship can be shown in another diagram.
The Supply Curve
1.80
0
Sup p ly of ta p e s
Price (pounds per tape)
1.50
e
1.20
d
0.90
c
0.60
0.30
0
b
a
2
4
6
8
10
Quantity ( millions of tapes per week )
Fig 2.3
The supply curve for audio tapes tells us what sellers would like to do at all the possible
prices. Once more the information could be obtained from historical data, market
research, mathematical modelling or it could be just for the purpose of illustrating what
we believe to be true.
Activity:
We have just seen the supply curve for audio tapes which is typical of the
supply of most goods and services. Try to draw the supply curve for
Wimbledon Centre Court tickets on the day of the men’s final.
There must be more to supplier behaviour than price alone. There are several other
influences and we have to consider those factors now.
NON-PRICE FACTORS
1.
Costs of production
Sellers are very concerned about their costs. If they can find a way to get costs down then
profitability improves and they become more interested in supplying the market. If costs
start to rise they are less and less interested in supplying the market at current prices. Our
model needs to be able to deal with changes in costs of production.
2.
Technology
New machines and equipment, new techniques and methods, tend to lower costs of
production and this encourages firms to produce and sell more. However, if we wanted to
reduce the role of technology, for example in the production of chickens, we could
abandon ‘battery’ rearing methods in favour of ‘free-range’ methods but we shouldn’t
expect farmers to be able to produce so many birds. I think you know also that they
wouldn’t be very interested in selling them at today’s low prices either. Our model needs
to be able to accommodate changes in technology too.
3.
The number of suppliers in the market
It is pretty obvious that the number of businesses we have operating in a particular market
will affect the supply. If there are three hairdressers in a small town then the supply of
hairdressing services is likely to be greater than if there was only one. At the moment our
model can only cope with changes in price, it needs to be able to deal with this kind of
thing too.
4.
Seasons
Production of many goods and services is affected by seasons and by the weather.
Obviously a whole range of agricultural products fall into this category and many other
things too. The supply of new houses in the UK has a seasonal pattern since most
construction work is affected by winter weather. Up until now our model is unable to
handle a change in seasons.
5.
The attractiveness of other markets
In a healthy market economy, entrepreneurs are constantly searching for new
opportunities. If switching out of one line of business and into another will improve
profits then this is what entrepreneurs will tend to do. If a farmer could make more money
growing carrots rather than peas then this will affect both the supply of carrots and the
supply of peas. If the market for soft furnishings is more attractive than hardware, then
department stores will tend to use more floor space for soft furnishings and less for
hardware. If there is a change in the relative attractiveness of markets we need to be able
to show this within our model.
Now there are some other factors which influence supply. There may be changes in the
tastes and preferences of the suppliers themselves and there may be natural or man -made
disasters. However, it is now time to ensure that our model can deal with all of the nonprice factors on the supply side.
Supposing we had conducted research on supplier intentions in order to arrive at the
supply curve in fig 2.3. How useful would this diagram be if subsequently a new machine
is launched onto the market which can generate 20% cost savings for the producers of
audio tapes? The effect on the industry would be considerable and it would totally change
the way suppliers viewed the market. Our old diagram would be out-of-date and useless.
You would need to conduct the research again and the result would be a new curve. This
would be true for a change in any of the non-price factors reviewed above.
A change in any non-price factor will result in a new supply curve.
A Change in Supply Versus
a Change in the Quantity Supplied
S0
S1
PricePric
eece
Inc re a se in
q ua ntity
sup p lie d
De c re a se in
sup p ly
Inc re a se in
sup p ly
De c re a se in
q ua ntity
sup p lie d
0
Quantity
Fig 2.4
S2
The diagram above illustrates the way we can show the effect of changes in price and also
in non-price factors.
An increase in price will lead to an increase in the quantity supplied
A decrease in price will lead to a decrease in quantity supplied
A change in a non-price factor will lead either to an increase in supply or a decrease in
supply.
Once more the terminology must be accurate if our model is to be used correctly.
Activity:
Can you answer the following question, what factor can never cause a
decrease in supply?
We now have both parts of the picture. It is time to bring together the forces of demand
and supply in our competitive market environment in order to analyse the outcome.
Equilibrium
Price (pounds per tape)
1.8 0
Su rp lu s o f
2 m illio n ta p e s
a t £ 1 .2 0 a ta p e
Su p p ly o f ta p e s
1.5 0
1 .2 0
Equilibrium
Eq u ilib riu m
0 .9 0
0 .6 0
De m a n d fo r ta p e s
Sh o rta g e o f
3 m illio n ta p e s
a t 6 0 p a ta p e
0 .3 0
0
2
4
6
8
10
Q u a n tity( (millions
m illio n s oof
f tatapes
p e s p per
e r wweek
e e k) )
Quantity
Fig 2.5
This diagram shows how the forces of supply and demand interact in a competitive
market to create a price.
What our model is predicting is that, given the attitudes and decisions of consumers and
producers at this point in time, the likely market price here will be 90p per tape. This price
is not the result of one big firm fixing price at 90p, just as the exchange rate between the
pound and the US dollar is not determined by Barclays Bank. Our price is the result of the
decisions made by millions of buyers and sellers coming together in a free market. The
world market prices of commodities like sugar, soya beans and gold, money and foreign
currency are all determined in this way.
Many of our markets for goods and services are very competitive and prices are created
by the interaction of many buyers and sellers. However, I’m sure you have realised that
not all markets are like this. We know that Microsoft, for example, has a lot of power in
its markets. Consequently, prices in those markets are not the result of the wishes of
thousands of buyers interacting with the wishes of thousands of sellers. In fact they are
much more likely to be the result of Microsoft trying to impose its pricing decisions on
the market.
Activity:
Can you name three other large companies that have significant power in
their markets?
Our economic analysis will eventually extend to looking at a whole range of different
markets but for the rest of this unit we will concentrate on the highly competitive free
market that we have been working with so far.
EQUILIBRIUM
Let’s take another look at the previous diagram but now we can add a little more
information.
Equilibrium
Supply of tapes
Price (pounds per tape)
1.80
SSurplus
u rp lu s of
of
2
2 million
m illio n tapes
ta p e s
at £1.20 a tape
a t £ 1 .2 0 a ta p e
1.. 50
1 .2 0
Equilibrium
Eq u ilib riu m
0 .9 0
0 .6 0
Demand for tapes
Sh o rta g eofo f
Shortage
3 million
m illio n tapes
ta p e s
at
a t60p
6 0 pa tape
a ta p e
0 .3 0
0
2
4
6
8
10
Q u a n tity (m illio n s o f ta p e s p e r we e k)
Fig 2.6
The price of 90p will now be referred to as an equilibrium price, that is, a point of balance
between the forces of supply and demand.
This equilibrium price is likely to prevail in the market until something happens to either
demand or supply to change it.
Why is price likely to remain at 90p rather than some other price?
At a price above 90p, say £1.20, the wishes of consumers do not co-incide with the wishes
of producers. There will be a surplus on the market at a price above equilibrium. There
aren’t enough people prepared to pay a high enough price to prevent the surplus that we
see at £1.20. When a surplus occurs on a market at any particular price, the market is not
in a stable condition. Sellers will tend to mark prices down to clear their stock.
At a price below 90p, say 60p, the wishes of consumers again do not co-incide with the
wishes of producers. There will be a shortage on the market at a price below equilibrium.
There are just too many consumers wanting to buy the product at this price. There isn’t
enough to go round at this price. When a shortage occurs on a market sellers will tend to
raise their prices to cash-in on the situation. For proof of this we don’t have to look any
further than the market for ‘Tellytubbies’ toys in the Christmas of 1997.
When price is above equilibrium it will tend to fall and when it is below equilibrium it
will tend to rise. Logically, the only price that is stable is the equilibrium price therefore
prices in free markets will tend towards equilibrium and will stay at the equilibrium until
disturbed by some change in the underlying market forces.
Activity:
Write a list of the factors on both the supply side and the demand side that
could change the equilibrium in our diagram.
We now have a set of supply and demand ‘tools’ that will help us to understand how
markets work and how they are likely to be affected by events. Now is the time to put the
model to the test and see if it comes up with reasonable solutions to the questions we
pose.
To begin with we can introduce a change on the demand side.
Negative publicity about the effects of British beef on health, shifts consumer tastes away
from British beef.
The Effects of Change in Demand
Supply of
beef
S p p lyu
o f ta p e s
12
12
.2
8
Price (pounds per Kilo)
10
8
8
66
6
6
mDemand
a n d fo
for beef
04. 4
02. 3 0
De m a n dfor
fo beef
r ta p e s
Demand
after
(Wa lkBSE
m a n £12 5)
0
2
4
6
8
10
12
Q ua n tity (m illio n s o f ta p e s p e r we e k)
Quantity ( millions of kilos per week )
Fig 2.7
The diagram above shows that demand has decreased. The fact that consumers are not so
keen on British beef has resulted in a lower price. At lower prices, suppliers are less
interested and reduce the quantity they supply to the market. So as a result of the shift in
consumer preferences we end up with a new equilibrium price.
Demand decreased, which led to a fall in the quantity supplied.
At the end of the process we have less of the product being bought and sold and a lower
market price. This is just what we would intuitively expect and our model seems to be
able to cope with it.
Now for an event which initially affects the supply side. Let’s think about the world
market for oil and gas. How will the market be affected by the exploitation of massive oil
fields recently discovered in Kazakhstan?
The Effects of A Change in Supply
18
1.8
0
SuSupply
p p ly ooff taoil
pes
(o ld te c h n o lo g y)
15
1.50
112
.2 0
SuSupply
p p ly o of
f taoil
pes
(nafter
e w tediscovery
c h n o lo g y)
Price
09.9 0
06.6 0
03.3 0
D
e m a n dfor
fo roil
ta p e s
Demand
0
2
4
6
8
10
12
Q u a n tity (m illio n s o f ta p e s p e r we e k)
Quantity
Fig 2.8
The exploitation of new oil fields increases supply. The increase in supply has driven
price down. At lower prices consumers are more interested and increase the quantity
demanded. So as a result of the increase in supply we end up with a new equilibrium
price.
Supply increased, which led to an increase in the quantity demanded.
At the end of this adjustment process we have more oil being bought and sold worldwide, accompanied by lower market prices. This conclusion is very reasonable and once
more the model seems to be able to deliver a logical outcome to the problem we set it.
Activity:
Try to sketch diagrams showing each of the following events:
i) In the market for coffee.
Bad weather destroys a large part of this years’ coffee crop.
ii) In the market for garden furniture.
Summer comes to an end.
We can use the tools of supply and demand analysis to establish what is going on in any
market and to make predictions about what will happen in that market if it is subject to
change in some way. This will be true of the markets for goods, services, resources and
money, which is why supply and demand analysis is so important to a study of
economics.
CONCLUSION
In this unit we have seen the powerful forces of demand and supply. We looked at the
determinants of each of these market forces and saw how they interacted in a free market
to produce market prices. Equilibrium prices are established by market forces and will
only change if there is a change in one or more of the underlying determinants of supply
or demand. We went on to consider how changes in supply or demand would affect
equilibrium and how this should be dealt with diagrammatically.
An understanding of this material is essential for anyone operating in a market economy.
Everyone in business needs to consider the factors at work in their market in order to
develop strategies and policies that will lead to success. Failure to understand the market
will almost certainly lead to business failure.
We will go on to look at some other applications of supply and demand analysis in unit 4.
REFERENCES FOR UNIT 2
Begg, D et al, Economics, McGraw-Hill, 1997, 5th edition Ch 3
Cook, M and Farquharson, C, 'How do businesses price their products?', Business Studies,
Dec 1995
Ingham, Alex, 'Markets - exchange or extortion?', The Economic Review, Feb 1996
Lipsey, R and Chrystal, K, Introduction to Positive Economics, OUP, 1995, 8th edition,
Ch 4
Parkin, M et al, Economics, Addison Wesley Longman, 1997, 3rd edition, Ch 4 and Ch 6
Sloman, John, Economics, Prentice Hall, 1997, 3rd edition, Ch 2
Smith, Peter, 'Flexible and Stable Prices', The Economic Review, Sept 1997