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Overview
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Adam Gore
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Demand and Supply in a Market Economy
Curriculum:
Economics
Date:
Tue, Sep 2 12:54:15 GM
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Tue, Sep 2 12:54:15 GM
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Overview
Market Economy
INTRODUCTION
In a market economy, markets are controlled through competition. Competition in general
means a rivalry. The rivalry could be between individuals, groups of people, firms, or nations.
It could be over almost anything -- goods, resources, prizes, or prestige. When economists
use the term, however, they are trying to describe a complex relationship between producers
and consumers.
Consumers have the freedom to decide what to purchase and they compete with each other
to buy products. Consumers are willing to purchase different quantities of the product,
depending on the price that they have to pay for it. Similarly, producers can decide what they
want to produce and they compete with each other to supply products to the market. They are
willing to supply different quantities of their product, depending on the price that they will
receive for it. They also compete with each other to purchase the capital goods and services
they need to produce their good or service. The quantity demanded and the quantity supplied
are determined by interactions between consumers and producers. Thus, the two major parts
of a market economy are consumers and producers -- what economists call demand and
supply.
DEMAND
The term "demand" means the general willingness of consumers to buy a specific quantity
of a product at different prices. One prediction that economists can make based on rational
self-interest is that consumers will buy more if the price is reduced. Predictions like this result
in the law of demand. It states that consumers will buy more of a good or service if the price is
reduced; also, that they will buy less if the price is increased. Why do consumers do this?
They are motivated to maximize the benefits they receive because of their self-interest.
Benefit (Utility) Maximization
Consumers buy for their own benefit and most rational people make economic choices
based upon what they think will be in their own best interest. Market economies are based
upon a very simple idea: everyone seeks to maximize the benefits received. Thus, benefit
maximization means that a consumer seeks to maximize the benefit gained from a good or
service and wishes to pay the least opportunity cost possible.
Since economists frequently use the term "utility" to mean benefit, economists use the
terms benefit maximization and utility maximization interchangeably.
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Declining Marginal Benefit (Utility)
Marginal benefit is "the benefit gained from one more of something." Marginal benefit
declines as we consume additional units. We get more benefit from the first of any product
we consume. We get less and less benefit from each additional (marginal) unit we consume.
One candy bar may be very satisfying. A second may be just good, but the third may not
give any real pleasure. The very thought of consuming a fourth one may actually be
discomforting. We will gladly pay the full price for that first candy bar, but we may decide
not to consume the fourth one even if it were free. This is the normal reaction to consuming
almost everything. Economists call this the law of declining (or diminishing) marginal benefit
(utility).
Limitations on the Law of Demand
Despite the fact that economists can make predictions based on benefit maximization that
result in the law of demand, there are limitations we must understand. A basic principle of
all statistics is "What is true of the individual is not necessarily true of the group, and what is
true of the group is not necessarily true of the individual." Different people gain pleasure
and happiness in different ways. Thus, different people will have different goals when it
comes to benefit maximization.
The law of demand basically says that if the price of something is reduced, sales will
increase. However, every single consumer will not necessarily buy more, but enough of
them will such that the sales will increase. Because individuals are different, social
scientists cannot make predictions as well as physical scientists. Economists can make
predictions about what people in general will do, but not what each individual will do.
Market Demand
In economics, thus, we distinguish between individual demand and market demand.
Individual demand is the demand of an individual person or household to consume a good
or service. Market demand is the total demand for a type of good or service within a
particular geographic area. For instance, when economists refer to the "national housing
market demand ," they mean all of the houses (new and old) being sought for purchase
anywhere within the nation. Similarly, the term "the U.S. labor market demand" means the
demand for all workers in the United States. In general, economists only concern
themselves with market demand.
Illustrating Demand
Demand can be illustrated as both a demand schedule and a demand curve.
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Overview
Demand Schedule
A demand schedule is a list of all the possible prices and the quantity that consumers
would be willing to buy at those prices. Let us suppose there are just four possible prices
at which sneakers can be priced: $30, $45, $75, and $90. The following demand
schedule lists how many pairs of sneakers consumers are willing to purchase at various
prices:
Price
Quantity Demanded
$30
$45
$75
$90
9,000
6,000
4,000
1,000
See the "Supply and Demand Schedules" tutorial for a more detailed explanation and
examples.
Demand Curve
This demand schedule can also be graphed with quantity demanded on the x-axis and
price on the y-axis. The line drawn connecting the points is called the demand curve.
Because of the law of demand, the demand curve is always high on the left with a fall
to the right. This is because purchases are higher at the lower prices, but lower at the
higher prices, reflecting the decreasing willingness of consumers to buy as the price rises.
See the "Supply and Demand Curves" tutorial for a more detailed explanation and
examples.
Demand versus Quantity Demanded
As mentioned previously, demand is the willingness of consumers to purchase a specific
amount of a product at different prices. The quantity demanded by consumers at a
particular price is called "quantity demanded." This is determined after the consumer knows
the price. The amount of a good or service consumed can change depending on its price
because a change in price is a signal to consumers . Lower prices are a signal to increase
purchases in order to maximize benefit without suffering greater opportunity cost. Higher
prices, of course, are a signal to decrease purchases because they will suffer greater
opportunity cost for each unit they buy.
If a demand curve is used to illustrate demand, individual points along the demand curve
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identify the quantity demanded at particular prices. Thus, a change in price means a
movement ALONG the demand curve, not that the demand curve itself changes or shifts.
Thus, changes in the price of a good or service motivate consumers to purchase different
amounts and affect the quantity demanded, but not the demand. The demand for a good or
service only changes when people are willing to purchase a DIFFERENT amount than
before at the same price. An increase in demand means that consumers are willing to
purchase more at all price levels, while a decrease in demand means that consumers are
less willing to purchase at all price levels.
Changes in Demand
Demand can be changed by any factor that makes consumers more or less willing to
purchase a product at the same price. Five major factors that can change demand are: (1)
a change in consumer preferences; (2) a change in the number of people in the market; (3)
a change in people's income level; (4) a change in the price of other goods; and (5) a change
in consumer expectations. See the tutorial "Supply and Demand Curves" for an illustration
of the effects of a change in demand.
A Change in Consumer Preferences
The demand for aspirin immediately increased when the results of a study were
published that concluded that a daily dosage of low-dose aspirin reduced the risk of a
heart attack. At any given price, people were willing to buy more aspirin than before. In
particular, at the current price, more aspirin could be sold. If people had bought more
aspirin because the price had gone down, that would be a change in quantity demanded
because it was a response to a price signal, not a change in demand.
A Change in the Number of People in the Market
As mentioned, market demand is the total demand for a type of good or service within
a particular geographic area. Thus, one factor that can influence demand is if the number
of people in the market increases or decreases significantly. This could be either the total
population of the area changing or it could be a change in the composition of the
population. For example, as the post-World War II "Baby Boom" population has matured
over the years, it has altered the demand for certain products. In future years, as it ages
further, it will affect the demand for products used primarily or often by the elderly,
including health care.
A Change in People's Income Level
People may change the goods and services they purchase based on their income
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level. If their income increases, they may purchase a more expensive car. Similarly, if
their income decreases, they may purchase a less expensive car. Economists use the
terms "superior" and "inferior" to distinguish between these two types of goods and
services. Superior goods (also called "normal" ones) are those whose quantity
demanded INCREASES as income increases. Inferior goods are those whose quantity
DECREASES as income increases. As used by economists, these two terms have little
or no real relationship to the actual quality or usefulness of the products. These
economic terms solely reflect how the quantity demanded for these products is affected by
changes in income.
The fact that people at different income levels purchase different goods and services
can have an effect on the demand for superior and inferior goods. For example, when the
economy is doing well, the income of many consumers will increase. These consumers
will be willing and able to buy more superior goods at each price, while their willingness to
purchase inferior goods will decrease at each price. If the income of enough consumers
increases, this will affect demand. It also works in reverse. If the economy is stagnant or
declining, the income of many consumers will decrease . These consumers will be less
willing to purchase superior goods at each price, while their willingness to purchase
inferior goods will increase at each price. Again, if the income of enough consumers
decreases, this will affect demand for these products.
Examples of superior goods are steak, fine restaurants, and designer-brand clothing.
Cheaper meats like hamburger, fast foods, and budget clothes are inferior goods.
A Change in the Price of Other Goods
The demand for some goods and services is directly affected by changes in the prices
of other goods and services -- in particular, for instance, if the goods or services are
complementary or are alternatives (substitutes).
Some products are consumed with other products -- that is, they are complementary.
An increase in the quantity demanded for one product will produce an increase in the
quantity demanded for the other. For example, many Americans put ketchup on their
French fries. Thus, if the sales of French fries go up, so will ketchup sales. Increased car
sales will result in an increase in the sale of gasoline. These are all examples of
complementary goods -- that is, goods that are demanded together.
Some products are consumed in place of other products -- that is, they are alternatives
or substitutes for each other. They may be from different markets but they are in such
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direct competition that the increased consumption of one will probably result in a decrease
in demand for the other. Similarly, an increase in the price of one will actually cause an
increase in demand for the other. For example, if the prices of private single-family homes
are high, then more people will be discouraged from purchasing them and the quantity
demanded of rental apartments will increase. Other examples are: auto sales and public
transportation usage, private education and public education, and chicken and beef.
A Change in Consumer Expectations
A change in consumer expectations is similar to a change in people's income level, just
that consumers may increase or decrease their demand even before the actual change in
their income level based on their expectations. It could also be based on their
expectations of price changes for a good or its substitutes.
For example, a student may be hired for a job a month before graduation. In
anticipation of having the money, the student may make some purchases. In a booming
economy , many people make purchase decisions based on their expectations of
increased income in good economic times. This can influence demand.
Another example is anticipating price changes. In a time when home prices are
increasing steadily, a person may choose to purchase one with the belief that the price
would only be higher if the purchase were delayed. Since many people tend to be
influenced to make purchases of this nature under similar conditions, this can influence
the demand for homes to purchase.
Elasticity of Demand
If the price of a good or service changes, we know that the quantity demanded will also
change -- but by how much? Exactly how much the quantity demanded for a particular good
or service will change if its price changes is determined by how sensitive consumers are to
a price change for that product. The quantity demanded for some goods and services is
more sensitive than that for other goods and services. The term economists use to describe
this price sensitivity is called "elasticity." Basically what they mean is "responsiveness" -how responsive the quantity demanded of that good or service is to a price change.
If a product's quantity demanded is very sensitive to price changes, then economists will
call its demand "elastic." If it is not, then economists will call its demand "inelastic." The
demand for most products is considered to be elastic. For example, the demand for
expensive steak cuts is fairly price sensitive -- when prices go up, the quantity demanded
goes down. The demand for other products, however, is considered to be inelastic. For
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example, if the price of table salt decreased, most people would not change how much they
bought. They would continue to consume the same amount.
SUPPLY
The term "supply" means the general willingness of firms to make and sell a specific
quantity of a product at various prices. The law of supply states that firms will produce and sell
more of a good or service if the price is increased; also, that they will produce and sell less if
the price is decreased. Why do firms do this? The law of supply is another prediction that
economists can make based on the assumption of rational self-interest. Firms are motivated
to maximize the benefits they receive because of their rational self-interest. For firms, the
benefits they receive are called profits.
Role of Profit
When a firm (business) sells goods or services to a consumer (purchaser), the money
spent by the consumer is his or her cost. To the firm, that same money is revenue (income)
or the money received by a firm for selling its product. The consumer's cost is the revenue
of the producer or firm.
Firms, too, have costs (expenses) . They have to purchase the resources that they need
to produce their goods and services in order to have these goods and services to sell.
These production costs include the wages paid to employees, the rent on the factory or
store, taxes, and the cost of materials and technology (machinery and tools) used in
production.
In a market economy, all firms seek profits. Profits are the amount by which revenues
(income) exceed production costs (expenses). To compute profits, we merely subtract the
total cost of production from the total revenue obtained by selling the product:
Profit = Revenue (Income) - Production Costs (Expenses)
Just as consumers decide to consume more if their marginal benefit exceeds their
marginal cost, a firm decides to increase production only if marginal revenues exceed
marginal costs. (See "Marginal Analysis" in the "Economics: The Science of Scarcity"
chapter.) That is, the revenue (income) gained from making more units of their product or
service is greater than the cost of making those units. A price reduction may attract more
buyers, but a firm will not reduce its price if it will cause marginal revenue to drop below
marginal costs.
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Profit Maximization Is the Goal of All Firms
If asked, people would say that the goal of firms is to make a profit. That is not entirely
correct. Actually, their goal is to make as much profit as possible -- "profit maximization."
This means they are always trying to cut expenses (costs) and to increase income
(revenues). In this way they are much like consumers seeking benefit maximization. To
the firms, benefit maximization is profit maximization -- they get their greatest benefit from
profits. Just as consumers always want more goods and services, firms always want
more profits.
Limitations of the Law of Supply
Despite the fact that economists can make predictions based on profit maximization that
result in the law of supply, there are limitations on the law of supply just like those for the
law of demand -- and for similar reasons. Like the different goals of consumers when it
comes to benefit maximization, different firms may also have some different goals.
For example, some firms have strong local ties. This may make them reluctant to expand
if their own region cannot support it. Other firms have strong social goals -- for example,
Ben & Jerry's (the ice cream company) has a strong commitment to environmental and
social causes. This commitment is strong enough that the company sacrifices a certain level
of profits in order to meet its commitment. Thus, although recycled paper is more expensive
than normal paper, Ben & Jerry's require that a specified minimum quantity of recycled paper
be used in order to help the environment.
Although firms are more inclined to be predictable than consumers, economists can make
predictions about what firms in general will do, but not what each individual firm will do.
Market Supply
In economics, thus, we distinguish between individual supply and market supply.
Individual supply is the supply of an individual firm. Market supply is the total supply for a
type of good or service within a particular geographic area. For instance, when economists
refer to the "national housing market supply ," they mean all of the houses (new and old)
available for sale anywhere within the nation. Similarly, the term "the U.S. labor supply"
means the available supply of all workers in the United States.
Illustrating Supply
Supply can be illustrated as both a supply schedule and a supply curve.
Supply Schedule
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A supply schedule is a list of all of the possible prices and the quantity that firms would
be willing to supply at those prices. Again, let us suppose there are just four possible
prices at which sneakers can be priced: $30, $45, $75, and $90. The following is the
supply schedule -- a list of how many pairs of sneakers firms are willing to produce at
these prices:
Price
Quantity Supplied
$30
$45
$75
$90
2,000
6,000
10,000
15,000
See the "Supply and Demand Schedules" tutorial for a more detailed explanation and
examples.
Supply Curve
The supply schedule can also be graphed with quantity supplied on the x-axis and
price on the y-axis. The line drawn connecting the points is called the supply curve.
Because of the law of supply, the supply curve is always low on the left with a rise to
the right. This is because production is lower at the lower prices, but higher at the higher
prices, reflecting the increasing willingness of firms to produce and sell as the price rises.
See the "Supply and Demand Curves" tutorial for a more detailed explanation and
examples.
Supply versus Quantity Supplied
As mentioned previously, supply is the willingness of firms to produce and sell a specific
amount of a product at different prices. The quantity supplied by firms at a particular price is
called "quantity supplied." This is determined after the firm knows the price it can obtain for
the product. The amount of a good or service supplied can change depending on its price
because a change in price is a signal to firms. Lower prices are a signal to decrease
production and sales in order to maximize profit without suffering greater opportunity cost.
Higher prices, of course are a signal to increase production and sales because they will
suffer greater opportunity cost for each unit they do not produce.
If a supply curve is used to illustrate supply, individual points along the supply curve
identify the quantity supplied at particular prices. Thus, a change in price means a
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movement ALONG the supply curve, not that the supply curve itself changes or shifts.
Thus, price changes in the market only affect the quantity supplied of a good or service
by motivating firms to produce and sell more or less, not the supply. The supply for a good
or service only changes when firms are willing to supply a DIFFERENT amount of the
product than before at the same price. An increase in supply means that firms are more
willing to produce and sell at all price levels, while a decrease in supply means that firms are
less willing to produce and sell at all price levels.
Changes in Supply
Supply can be changed by any factor that makes firms more or less willing to supply a
product at the same price. Five major factors that can change supply are: (1) a change in
the cost of resources needed to produce the good or service; (2) a change in technology
that allows the good or service to be produced more efficiently; (3) a change in the price of
other goods or services that may make their production more profitable; (4) a change in
producer expectations; and (5) a change in the number of suppliers. See the tutorial "Supply
and Demand Curves" for an illustration of the effects of a change in supply.
A Change in the Cost of Resources
The supply for some goods and services is directly affected by changes in the price of
other goods and services used in their production. For instance, the supply for consumer
goods and services is directly related to that for capital goods and services.
Assume an increase in the price of steel. As a result, there will be an increase in the
cost of producing automobiles and other products that are made with steel. This means
that the cost of making these goods increases at every level of quantity supplied. This will
reduce supply because producers will offer less for sale at each price.
Included in this category would be any changes in taxes or subsidies because they
would affect the supplier's costs to produce the product.
A Change in Technology
Technology has a very direct effect on goods, services, and their costs. New
developments in biology, chemistry, electronics, and many other fields can alter supply by
providing new products, improving existing ones, or lowering the costs of production on
existing products. In early American history, the type of cotton grown in the South was
easier to grow than some other varieties; however, it was harder to clean because it was
more difficult to remove its seeds. Eli Whitney developed the cotton gin in 1793, which
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made the process of removing cotton seeds from cotton easier. This lowered the cost of
producing this type of cotton -- thus increasing the willingness of producers to grow it.
Ultimately, there was both an increased supply and an increased demand for Southern
cotton.
A Change in the Prices of Other Goods or Services
Producers are influenced by a change in the price of other goods or services that may
make their production more profitable. If a producer sees prices increasing for a product
(perhaps from increased demand), it may increase production of that product in order to
maximize profits. In order to increase production of that product, it may have to decrease
production of another product due to limited resources. For example, farmers adjust their
production on the basis of the prices they receive for their products. As the demand for
ethanol has increased and prices for the corn used to make it have increased, farmers will
shift their production away from other crops in order to produce more corn.
A Change in Producer Expectations
A change in supply due to producer expectations is similar to a change in demand due
to consumer expectations. Like consumers, producers may alter their supply based on
their expectations on resource prices, product prices, or potential profits even before the
actual changes take place. Since many producers tend to be influenced under the same
conditions, this can influence supply, just as consumer expectations can influence
demand. For example, anticipating price increases in a production resource, a producer
may purchase additional units of the resource and store them for the future.
A Change in the Number of Suppliers
A change in supply due to the number of suppliers is similar to a change in demand
due to the number of consumers . As mentioned, market supply is the total supply for a
type of good or service within a particular geographic area. Supply is influenced if the
number of producers in the market increases or decreases significantly. For example, the
U.S. government regulated airlines very strictly until the 1980s, including fare prices and
the ability of new firms to enter the market. After many of these regulations were
eliminated or relaxed, the number of new airlines increased, which increased the supply.
Elasticity of Supply
If the price of a good or service changes, we know that the quantity supplied will also
change -- but by how much? Exactly how much the quantity supplied for a particular good or
service will change if its price changes is determined by how sensitive firms are to a price
change for that product. The quantity supplied for some goods and services is more
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sensitive than that for other goods and services. Like with demand, the term economists use
to describe this price sensitivity is called "elasticity." Basically what they mean is
"responsiveness" -- how responsive the quantity supplied of that good or service is to a price
change.
If a product's quantity supplied is very sensitive to price changes, then economists will
call its supply "elastic." If it is not, then economists will call its supply "inelastic." Whether or
not the supply for a product is elastic depends on the type of product and the timeframe
needed for the firm to respond. For most consumer manufactured goods, it is comparatively
easy to adjust production by adding (or subtracting) work shifts or contracting out some
production (or ending a contract). Thus, their supply is probably elastic.
For some other products, however, such as petroleum, it is very difficult to increase
production. There is a very large amount of finance capital that would need to be invested
and physical effort involved before production could be increased substantially. Thus, their
supply is likely to be inelastic at first. Over a long period of time, their supply gets more
elastic because firms have the time to make the investment in money and effort. Thus, the
elasticity of supply depends very much on how expensive it is to alter production and the
length of time needed to do so.
MARKET EQUILIBRIUM OF DEMAND AND SUPPLY
The Market Price Is the Equilibrium Price
How is the market price of goods and services determined? Because of the laws of
supply and demand, as prices change, so do the quantities demanded and supplied. For
example, if the price goes up, the amount demanded goes down and the amount supplied
increases. Thus, there will always be a price -- called the "market price" or "equilibrium
price" -- where the quantity demanded equals the quantity supplied. ("Equilibrium" means
that a state of balance exists between two things.)
How do we know if consumers and producers have reached a market price? We know
because all of the available products will be sold and, at the same time, there are no
consumers searching for the product offering to pay extra money to buy it. This means that
consumers have purchased all they want at that price and suppliers have sold all they chose
to produce at that price. This is called "market clearing." The market has been "cleared" of
excess products and excess consumers when a fair market price has been reached. Since
the market is cleared, the market price is sometimes also called the market-clearing price.
Changes in demand and supply usually lead to changes in the market price.
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Illustrating Market Equilibrium
Consider our sneaker example. If we put the demand and supply together into a single
schedule, we get:
Price
$30
$45
$75
$90
Quantity Demanded
Quantity Supplied
9,000
2,000
6,000
4,000
1,000
6,000
10,000
15,000
The equilibrium price is $45. At this market price, the quantity demanded (6,000) will
exactly equal the quantity supplied (6,000).
When supply and demand are graphed together on the same graph, the supply curve
intersects with the demand curve. The point at which they intersect is where the quantity
supplied equals the quantity demanded and determines the market price. In our sneaker
example, the two lines drawn will intersect at a quantity of 6,000 and a price of $45.
To see demand and supply graphed together, along with the effects of changes in
demand and supply, see the "Supply and Demand Curves" tutorial.
Adam Smith's Invisible Hand at Work
As mentioned at the beginning of this chapter, markets are controlled through competition
in a market economy. Consumers compete with each other to buy products, while producers
compete with each other to supply products to the market. Each is willing to alter the
quantities involved based on the product's price. The price (market price) is determined by
the quantity demanded by consumers and the quantity supplied by firms based on their
interactions in the market. This is what Adam Smith meant when he referred to "the
invisible hand" of competition regulating the economy. "The invisible hand" of competition is
the interaction between the competing self-interest of suppliers and that of consumers . He
understood that when both suppliers and consumers were satisfied with a price, the market
would be cleared.
Benefits of Markets
Competition in Markets Is More Efficient
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Because suppliers are motivated by their self-interest to maximize profits in a market
economy , they are motivated to use the resources of production as efficiently as possible
in order to reduce their opportunity cost. Efficiency occurs when they produce at the
lowest possible cost per unit. Competition encourages this because suppliers know that if
they do not, others will.
Suppliers in a market economy are also motivated by profit maximization to produce
what consumers want. Suppliers compete with each other in order to sell their products
and thus to make a profit. If they cannot sell their product because consumers do not
want it, they will eventually go out of business. Thus, competition in market economies
also motivates suppliers to produce the products consumers want, at the quality level
consumers want, and at the price that consumers are willing to pay.
Markets Reduce Transaction Costs
A transaction occurs when a good or service is sold by a producer to a consumer.
When consumers buy goods and services they actually pay two costs: the cost of the
product itself (the market price) and the cost of the transaction. There is usually little or
no transaction cost when we buy something at a local store. However, buying a house
usually involves many legal fees and special taxes. By raising the total price, transaction
costs force consumers to pay more without increasing the revenue of the seller.
Transaction costs can discourage trade, but markets help to reduce transaction costs
by facilitating the selling process. They reduce transaction costs primarily by providing a
central place for buyers and sellers to interact. This enables the transaction to happen
faster than without a market -- buyers and sellers can find one another easily. It also
reduces or eliminates transportation costs on the part of the seller since many sellers plan
their physical locations based on the physical locations of markets. Lastly, information on
pricing or products is readily available to everyone.
Shortages and Surpluses
What happens if firms do not produce enough of something? What if there is a shortage?
Shortages will leave some consumers without the goods or services they want. This will
motivate them to offer to buy the good or service at a higher price. As we have seen, that
higher price will signal firms that they can earn increased revenues and profits by increasing
production. That increase in the number (amount) produced results in an increase in
quantity supplied.
If firms produced too much of a product (a surplus), the opposite would be true. Some of
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the product would go unsold and firms would have to reduce prices to sell the surplus.
These lower prices would reduce revenue and firms would respond by producing less. This
decrease in the number (amount) produced, as a response to the lower price, results in a
decrease in the quantity supplied.
Effects of Shortages and Surpluses
If there is a shortage (too few supplied) or a surplus (too many supplied), the market
will not be cleared. It will not be cleared until the shortage or surplus forces a change in
the market price and the firms respond by changing the quantity supplied (either more or
less). Thus, in both cases, the markets will clear only after a new market price results in a
new quantity supplied.
Shortages always cause the market price to rise. Because consumers cannot obtain
enough of the good or service that they want, they will be motivated to offer to buy the
good or service at a higher price. The rise in price motivates increased production.
Eventually, when the market again clears, consumers and suppliers will have established
a new, but higher, market price and a new quantity supplied that satisfies both firms and
consumers.
Surpluses always cause the market price to fall. When firms cannot sell a product or
service that they have produced, they are motivated to cut production and reduce the
price so that all available units will be sold. Eventually, a new, but lower, market price and
quantity supplied will be established where the market will clear.
How Price Ceilings and Floors Affect Supply and Demand
Sometimes , governments interfere in markets in an effort to protect either consumers or
producers by setting price ceilings or floors. Unfortunately, these efforts usually cause more
problems than they solve.
Protect Consumers with Price Ceilings
A price ceiling is an upper limit on the price of a good or service that is set by law. The
purpose of price ceilings is to protect consumers from high prices on goods or services
thought to be essential. Price ceilings are usually meant to be a temporary measure while
a shortage exists. For instance, if there should be a drought and supplies of wheat are
very low, a government might put a price ceiling on bread so that people can still afford it.
The biggest problem with price ceilings is that they destroy the incentive for firms to
respond to the shortage. For instance, in the case of our wheat shortage, firms could
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Overview
import wheat from other countries or make bread from other grains. Unless there is a
decrease in the quantity demanded, the price ceiling causes the shortage to continue.
Protect Sellers with Price Floors
A price floor (or support) is a lower limit on the price of a good or service that is set by
law. The purpose of price floors is to encourage producers to keep production high on
goods or services thought to be essential by virtually guaranteeing a certain profit. Price
floors are usually meant to be long term to insure that there is never even a temporary
shortage. For instance, the American government supports milk and cotton prices and
some other farm products.
The problem that often results from price floors is that the excess profits guaranteed by
the price floor encourage firms to overproduce. In addition, the price support causes the
consumer to pay more than without the support. For instance, milk costs the American
consumer more than it would without the price floor.
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