Download tma03 - john p birchall

j.p.birchall P0194869/A/94
TMA 03 10/5/94
(A)
Prices are of vital interest as they effect daily choices and standard of living. The theory of supply and demand
which attempts to explain the level and changes of prices and is, therefore, fundamentally important. The model is precise
and logical but it can be misinterpreted. The common error is to believe that changes in prices and quantities are movements
along the demand curve rather than shifts in the curve itself, or vice versa. Such errors can then lead to the wrong decisions
being taken.
The model postulates a demand curve for a particular good or service, comprising the quantities which households
plan to purchase per period at various unit prices. A similar supply curve represents the quantities which firms will plan to
supply per period at the unit prices.
Fig 1 shows the demand curve, DD, typically sloping down to the right as higher quantities are demanded as the
unit price decreases, and the supply curve, SS, moving in the opposite way as firms will plan to supply more if the unit price
is higher.
In fig. 2 movement along the demand curve indicates the change in quantity demanded (an increase) as unit price
decreases. When conditions change the demand curve can be shifted, a shift to the right, from DD to D D in fig.2, indicating
demand has increased, a shift to the left would indicate demand has decreased.
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The quantities demanded by households will depend on several factors.
First as the price of a good or service changes the quantity demanded will change as represented by the movement
along the curve. This is defined as own price demand.
If the price of a substitute or complement changes the demand curve will shift. For example, the demand curve for
butter will shift to the right indicating a higher demand if the price of substitute margarine rises. However, if the price of a
complement, say bread, rises the quantity of both butter and bread wanted will fall and the curve shift to the left. This is
defined as cross price demand.
Changes in household income will also cause a shift in the demand curve. For normal goods higher incomes will
shift the curve to the right as more is demanded. For some goods, inferior goods, the quanties may actually fall as income
rises. For example, the demand for holidays in Blackpool may decline as incomes rise and foreign travel becomes affordable.
Availability of credit can also shift the curve. As interest rates decline and credit is cheaper demand can be
expected to rise and the demand curve shift.
Changes in population size and tastes will also shift the demand curve. Demand predictably increasing as
population rises; and demand can be expected to follow fashion as tastes change.
Expectations, particularly expectations concerning income or tax levels, can shift the demand curve as people
anticipate better or worse times in the future.
The complex decisions of everyday life can be precarious if a decrease in price is assumed to result in more
demand, the reality could be that the price change is the result of a shift in the curve and less demand.
(B)
The extent of changes in price/quantity relationships will depend on the shapes and slopes of the curves. fig. 3
shows typical supply and demand curves again.
The key to the diagram and the theory lies in the equilibrium point X where both supply and demand are consistent
and mesh. The intersection point defines the price, p and quantity, q , which will be traded in the market if the plans of
households and firms materialise.
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To understand the significance of equilibrium we should consider what would happen if the purchase and supply
plans did not correspond. If the price of the good depicted in fig. 3 was p instead of p the quantity demanded would be q .
However, at this price the quantity firms would be willing to supply would be limited to q . Obviously at p there would be
shortages and disappointed customers. The theory assumes that in this situation suppliers will realise that customers are
willing to pay more and that they can profitably increase their prices. The tendency would be for the market price to move to
equilibrium at X, indicated by the direction of the arrows, where both customers and suppliers are happy to trade the same
quantity at the same price.
A shift in the demand curve from D to D illustrated in fig. 4 will result in a new equilibrium point. This new
equilibrium point will depend on the characteristics of the supply curve. A steeply sloping curve S , will result in equilibrium
point Y and a shallow sloping curve S , will result in Y .
Thus the supply curve S will result in equilibrium price p and quantity q and S will result in p and q . These
differences are characterised by elasticity which is a measure of the sensitivity of the quantity supplied to changes in the
price of the good. Elasticity is measured as the proportional change in the quantity supplied divided by the proportional
change in the price which caused the change.
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This definition can be elaborated, the supply curve would be vertical if supply is not effected by price at all. For
example, the supply of Cup Final tickets. The proportional change quotient in this case is 0 and the supply is said to be
perfectly inelastic. A perfectly elastic supply curve would be horizontal if the supply responds to demand with no price
influence. Perfectly elastic supply may apply when markets are competitive and identical substitutes available. The
proportional ratio in this case is infinity.
Most real situations are in between these extremes and inelastic supply is defined as a ratio of proportional change
anywhere from 0 to 1, and elastic supply as a ratio greater than 1. S in fig. 4 could be inelastic and S elastic.
In general supply tends to be inelastic, particularly in the short term as increases in production often require
extending the acreage under cultivation or further investment in plant and equipment which takes time to organise. Short and
long term elasticities can therefore be different.
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(C)
Elasticities have a major impact on the decisions and plans of firms supplying goods for the market place. For any
firm with a degree of market power product pricing policy has to be carefully considered because of the effect of price level
on total revenue and therefore profit.
Fig. 5 shows the relationship between price and total revenue for an inelastic demand curve D . A firm currently
suppling quantity q at price p may try to improve its profitability by increasing prices to p . The resulting
quantity sold would be q . The supply plans shifting from S to S . The effect of this manouver on total revenue can be seen
from the diagram. The revenue accrued is the quantity sold times the price per unit, initially this was p * q , and after the
price change p * q . It can be seen that in the case of inelastic supply the price increase has resulted in an increase in total
revenue the shaded area A being larger than the area B.
The reason firms have to be careful is illustrated in fig. 6. This time the demand is elastic and the curve D much
shallower. In this case a similar price increase will result in a much larger quantity reduction to q . The effect on total
revenue can again be seen, the revenue lost, the shaded area C, is much greater than the revenue gained, D.
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(D)
The level of demand for a product will depend on a variety of factors as has been outlined in section (A) but the
elasticity of that demand depends mainly on the availability of substitutes and the time frame required to adjust purchasing
behaviour when prices change.
Inelastic demand will result if there are no readily available substitute goods being offered at a similar price and
quality. Firms lucky enough to have a patented high tech product which cannot easily be copied will find that the abscence
of alternatives will make demand inelastic and insensitive to price, and within reason they have an opportunity to move price
higher. On the other hand common commodities with close substitutes will be confronted with elastic demand. Vegetables
are an example where an increase in price will result in a large decrease in sales because people can switch their puchases to
alternatives; peas or cabbage being perfectly acceptable substitutes if the price of carrots rises.
A change in demand for vegetables can be very rapid but for other purchases the response time maybe much
slower and result in relatively inelastic demand. When the price of oil was increased in 1972 by the OPEC cartel the market
reponse was relatively slow and demand appeared inelastic. The development of the smaller 'compact' car and energy saving
investments took several years before they impacted on the demand curve.
Eventually the adjustment to the price rise worked through and the current surplus of oil and/or it's relatively low
price could be predicted and explained by the supply and demand model emphasising its value as a fundamental economic
theory.