Download 1. understanding the market system: supply and demand

1. UNDERSTANDING THE MARKET SYSTEM: SUPPLY AND DEMAND
The concept of demand and supply can be used to understand the nature of markets and
how prices and output are determined and specific economic issues. Therefore, it is
necessary to have a good understanding of the demand and supply principles.
Markets defined
A market is an institution or mechanism that brings together the buyers ("demanders") and
the sellers ("suppliers") of particular goods and services. Markets assume a wide variety of
forms. Common forms of agriculture, livestock and forest product markets include: the
various vegetable, fruit and staple food bazaars where people buy raw food and take it to
their homes for preparation; raw meat stalls and shops; the farmer's roadside stand; the
door-to-door seller; the firewood merchant; the furniture seller; the farm produce and
timber auctions. All situations that link potential buyers and sellers constitute markets. We
shall concentrate on product markets, but keep in mind that many of the principles
discussed have specific applications to resource markets.
Demand
In economics the term demand specifically refers to a schedule of combinations of the
various amounts or quantities of a product that consumers are willing and able to
purchase at a given price. This demand function is defined during a particular time by
holding all other things and allowing only the quantity and the price to vary. The terms
"willing and able" indicates that we are referring only to effective demand; we say
"willing and able" because willingness alone is not effective in the market. For example, a
family may need more protein food such as meat and cheese, than they are not able to
purchase because of low income. Thus their effective demand remains low, while their real
needs may be very high.
Table 3.1 is a hypothetical demand schedule for an individual buying rice. Note that in
order to be meaningful the quantities demanded must relate to a specific time period, in this
case a week. Also, note that the demand schedule, in and of itself, does not tell which of the
five possible prices actually exists in the market; this depends on both demand and supply.
The demand schedule is simply a statement of a buyer's intentions. The actual
determination of market price is explained in the Section on Market Equilibrium below.
Table 3.1 An Individual Buyer's Demand for Rice (Hypothetical Data)
Price of 1 kg of rice
Nu 10
8
6
4
2
Quantity demanded per week
Kg 1.0
2.0
3.5
5.5
8.0
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The Law of Demand
The law of demands states that all other things being equal, as price falls the
corresponding quantity that is demanded rises, and vice versa. This law is based on the
following foundations:
i.
Common sense and the simple observation that people buy more of a given
product at a low price than they do at a high price.
ii.
The law of diminishing marginal utility: since successive units of a good
yield less and less satisfaction, consumers will only buy additional units if
the price is reduced.
iii.
The fact that if price is reduced, all other things being constant, the
consumer effectively has more purchasing power, and can buy more of the
good in question as well as other goods.
Demand Curve
The inverse relationship between product price and the quantity demanded can be
presented on a simple two dimensional graph, measuring quantity demanded on the
horizontal axis and the price on the vertical axis. The resulting curve is called the demand
curve. (See Figure 3.1, depicting the graph from the numbers in Table 3.1.) The demand
curve (D1D1 in Figure 3.1) slopes downward and to the right, because as the price falls
from OP to OP1 demand increases to OM2 from OM0, while on the other hand when price
increase to OP2 from OP, the quantity demanded decreases to OM1 fro OM.
Figure 3.1 The Demand Curve for Rice
Y
Price
O
Qty demanded
X
Other Factors That Affect Demand
Besides price, the demand for any good is affected by a number of other factors. When
these non-price determinants of demand change, the location of the demand curve will shift
to a new position to the left or to the right of D1D1, depending on the change in the
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individual factor. For this reason, the non-price determinants of demand are called "demand
shifters". Let us now have a look at each of these factors in turn.
Tastes and Preferences
Every person has his/her own tastes and preferences, and these influence whether they
consume a good at all or whether they will consume more or less of good. Tastes and
preferences are influenced by age, sex, religion, socio-cultural background, and so forth.
A favourable change in consumer taste and preference for the good will mean that more of
the good is desired at each price. The demand curve will thus shift to the right; see D”D”
(Figure 3.2).
An unfavourable change in consumer taste and preference will mean that less of the good is
desired at each price. The demand curve will thus shift to the left, to; see D’D’ (Figure 3.2).
Number of Buyers
Clearly, an increase in the number of buyers, which may be brought about by improved
transportation and access or population growth will increase the amount demanded of a
commodity at any given price. Fewer consumers will result in a decline in demand.
Income
The effect of a change in income on demand is slightly more complex. For most goods, a
rise in income will cause an increase in demand, and thus a shift of the demand curve to the
right. Conversely a decrease in income would lead to a decline in the demand for most
goods. Commodities whose demand varies directly with income are called superior or
normal goods.
Although most goods are normal goods, there are some exceptions. For example, as
incomes increase beyond some point, the amount of certain starchy foods (like kharang,
and cassava) may decline at each price, because the higher income allows consumers to
buy more protein-rich foods such as dairy products and meat. Similarly, as income rises,
the amount of domestic firewood consumed at any price may decline as people switch to
electric and gas cookers and heaters.
Goods whose demand varies inversely with a change in money income are called inferior
goods. The term 'inferior' is used here only an economic sense, and is not meant to convey
any judgments regarding the nutritive, taste, cultural, or any other values of such goods.
Prices of Other Related Commodities. The prices of other commodities in the market will
affect how much of a given commodity will be bought. Whether the change in the price of
a related good will increase or decrease the demand for a given product will depend on
whether the related good is a substitute for or a complement to the good in question.
Substitute Goods. These are two products that have the same use, or can fulfil the same
need. Groundnut oil and mustard are examples of two such goods. When the price of
groundnut oil, consumers will purchase a smaller amount of it, and increase their demand
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for mustard oil. To generalise: when two products are substitutes, the price of one good and
the demand for the other are directly related.
Complementary Goods. These are products that are used together, or are "jointly
demanded". To some extent, ema (Bhutanese chillis) and datshi (Bhutanese cheese) may be
an example of complementary goods. When the price of ema goes up, less of it is expected
to be consumed. As a result, less datshi is is expected to be consumed too. To generalise:
when two goods are complements, the price of one good and the demand for the other are
inversely related.
Independent Goods. Many pairs of goods are of course not related. These are referred to as
independent goods. For such pairs of goods, for example, datshi and ink, the price of one
would have little or no impact on the other.
Expectations. Consumer's expectations about such things as future prices of products,
product availability, and their own future incomes can shift the demand curve. For
example, consumer expectation that the road between Phuntsholing and Thimphu will be
closed during the monsoon may induce them to buy now in order to "beat" anticipated
shortages and higher price.
Change in Demand Versus Change in the Quantity Demanded
A change in demand refers to a shift in the entire demand curve. This can be depicted in
two ways: (Figure 3.2)
Entire demand curve shifts to the right: this is an increase in demand; i.e. from DD to
D2D2 and the demand in the market increases from OM to OM2 at the same OP price due
to a positive change in other factors.
While on the other hand the entire demand curve shifts to the left: this is a decrease in
demand. i.e. from DD to D1D1 and the demand in the market decreases from OM to OM1
at the same OP price due to a negative change in other factors.
Figure 3.2 Shift in the Demand Curve
Y
D
D”
O
Qty. demanded
X
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A change in demand is caused by a change in one or more of the determinants of demand,
other than own-price. Table 3.2 summarises the general effects of changes each of these
factors on the position of the demand curve.
In contrast a change in the quantity demanded designates the movement from one point
on the demand curve to another point (Fig. 3.3). The cause of a change in the quantity
demanded is a change in the price of the concerned product. The increase in price from OP
to OP2 the quantity demanded decreases from OM to OM1 and when price decreases from
OP to OP1, the quantity demanded increases to OM2 all due to change in the price.
Figure 3.3 Change in quantity demanded
Y
D
P
Price
D
O
Qty. Dd.
X
Table 3.2 Determinants of Demand: Factors that Shift the Demand Curve
EXAMPLE
FACTOR AFFECTING
DEMAND
GENERAL NATURE OF
CHANGE
1. Consumer Tastes &
Preference
Favourable change in consumer
tastes shifts demand curve to the
right.
Unfavourable change in consumer
tastes shifts demand curve to the
left.
Kuensel publishes a medical
study that shows chillis to be
harmful to the stomach and
thus to general health. If a
significant number of
Bhutanese were to accept the
results of the study, this
would lead to a decline in
their taste and preference for
chillis. The demand curve for
chillis would then shift to the
left.
2. Number of Buyers
An increase in the number of
buyers shifts the demand curve to
n An agreement between the
Bhutanese and Bangladeshi
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the right.
A decrease in the number of buyers
shifts the demand curve to the left.
Governments removes
restrictions in the sale of
Bhutanese agriculture and
forest products in
Bangladesh. This greatly
expands the market for
Bhutanese products and
causes their demand curves
to shift to the right.
3. Change in income
An increase in income shifts the
demand curve of normal goods to
the right. That of inferior goods
shifts to the left.
A decrease in income shifts the
demand curve of normal to the left.
That of inferior goods shifts to the
right.
n The Government increases
all public sector salaries by
15%. There will be an
increase in the demand for
normal goods like rice, meat
and milk. There will be an
decrease in the demand for
inferior goods like kharang,
re-soled tires and used
clothing.
4. Changes in the price of
related goods.
An increase in the price of a
substitute good causes the demand
curve of the original good to shift
to the right, and vise versa.
An increase in the price of a
complementary good causes the
demand curve of the original good
to shift to the left, and vise versa.
An increase in the price of
corrugated iron sheet causes
the demand for roofing
shingles to increase.
An increase in the price of
erma causes the demand for
datshi to decrease.
5. Expectations
Favourable expectations cause the
demand curve to shift to the right,
while unfavourable expectations
cause it to shift to the left.
Heavy monsoon rains cause
the expectation of shortages
of essential commodities in
Thimphu, and therefore
increases in their prices. The
current demand for goods
like rice thus increases.
Supply
In economics, the term supply specifically refers to a schedule of combinations of the
various amounts a product that a producer is willing and able to produce and make available
to buyers at each specific price. This is defined for a particular time, while holding all other
things constant. Thus the supply schedule shows a series of alternative possible
combinations such as those shown in Table 3.3.
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Table 3.3 Individual Producer and Total Market Supply of Rice (Hypothetical)
(1)
(2)
(3)
(4)
Price of 1 kg.
Quantity supplied per week by
Number of sellers
Total market quantity supplied per
of rice
one producer
week (2x3)
Nu. 10
Kg. 120
200
Kg. 24,000
8
100
200
20,000
6
70
200
14,000
4
40
200
8,000
2
10
200
2,000
Note:
Total supply at the market level (Column 4) is just the aggregation of all individual supply (Column 3). For simplicity, this case
has 200 producers selling the same amount each at every price.
The Law of Supply
As Table 3.3 shows, there is a positive or direct relationship between price and the quantity
supplied. This particular relationship is called the law of supply: as price increases the
quantity supplied increases; and as price decreases, the quantity supplied decreases.
As in the case of demand, this is largely a common sense matter. Price, you will recall is a
deterrent to the consumer, the higher the price the less is consumed. On the other hand, to
the supplier, price represents revenue per unit. It is, therefore, an inducement or incentive to
produce and sell in the market. The higher the price, the higher is the incentive.
The Supply Curve
As in the case of demand it is convenient to graphically present the concept of supply. The
graphing procedure is the same as that outline in Annex 1.B. The market supply data from
Table 3.3 is graphed in Figure 3.4. The graph shows that quantity supplied is directly related
to price. When the price increases from OP to OP2 the quantity supplied increases to OM2
while on the other hand when the price decreases to OP1 from OP the quantity supplied also
decreases to OM1.
Figure 3.4 Market Supply Curve for Rice
S
Y
Price
O
Qty. supplied
X
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Other Factors That Affect Supply
As with the demand curve, the position of the supply curve is given, "other things being
equal". That is, the supply curve is drawn on the supposition that certain other non-price
factors that determine the amount supplied are given and do not change. We shall now look
into each of these determinants of supply in turn.
Resource Prices or Prices of Factors of Production
A business's supply is closely linked to the cost of the resource that it employs in
production. A decrease in the price of resources will lower the cost of production and
increase supply, that is, shift the supply curve to the right. Conversely, an increase in the
price of resources will increase the cost of production, and shift the supply curve to the left.
Technology. A technological innovation involves the discovery and adoption of new
knowledge that allows us to produce a unit of output more efficiently, that is, with fewer
resources. Such an innovation will lower the cost of production and shift the supply curve
to the right.
Taxes and Subsidies. Businesses treat most taxes as costs. Therefore, an increase in taxes on
resources or produce will increase costs of production and reduce supply. Conversely,
subsidies are treated as "reverse taxes". If Government subsidises the production of some
good, the effect is to lower the cost of production and to increase supply.
Prices of Other Goods
Substitutes in production. These are goods that are competitive in production. An increase,
say, in the price of tomatoes would cause the farmer to divert resources away from cabbage
and into tomatoes. This would cause the supply of cabbage to decline.
Complements in production. These are goods whose production goes hand in hand. An
increase in the supply of one automatically increases the supply of the other. For example,
an increase in the supply of mustard oil will automatically lead to an increase in the supply
of mustard cake.
Expectations. Expectations concerning the future price of a product may also affect the
producer's current willingness to supply that product. However, it is difficult to generalise
about how expectation will affect the present market supply curve. If farmers anticipate a
higher price of rice in the future, they may withhold some of the current harvest from the
market, and try to sell it when the price rises.
Number of Sellers. In general, the greater the number of sellers in the market, the greater
will be the market supply. Conversely, the smaller the number of sellers, the smaller is the
market supply. For example, as the number of apple producers in Bhutan has increased, the
supply of apples has also increased, i.e. the supply curve of apples has shifted to the right.
The Aims of the Business Owner. Production is not always undertaken in order to obtain
maximum profits. Certain outputs from a farm or any other business may be produced for
prestige, psychological, or spiritual-religious satisfaction. The advantages of production may
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be non-monetary (or non-pecuniary). If these aims change, production and, therefore supply,
will change accordingly.
Change in Supply Versus Change in Quantity Supplied
The distinction between a "change in supply" and a "change in quantity supplied" parallels
that between a change in demand and a change in quantity demanded. A change in supply
involves a shift of the entire supply curve: an increase in supply shifts the entire supply
curve to the right (S’S’); a decrease in demand shifts the entire supply curve to the left
(S”S”) (Figure 3.5). A change in supply is due to change in one or more of the non-price
determinants of supply.
While on the other hand a change in the quantity supplied refers to a movement along the
supply curve due to a change in the price. (Figure 3.5.) The quantity supplied increases with
increase in price and decreases with decrease in price. In the Figure 3.5 when the price
increases to OP2 from OP and the quantity supplied increases to OM2, while with the
decrease in price to OP1 from OP, the quantity supplied also decreases to OM1 from OM.
Figure 3.5 Change in quantity supplied
Y
S
Price
O
Qty. supp.
X
Due to a change in other factors the entire supply curve in the market shifts either towards
right or left (Figure 3.6). A positive change from a factor other than price will shift the entire
supply curve towards right i.e. from SS to S”S” and the quantity supplied increases to OM@
from OM, while on the other hand the supply a negative impact will shift the entire supply
curve towards left from SS to S’S” and the quantity supplied also decreases to OM1 from
OM at the same market price.
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Figure 3.6 Shift in the Supply Curve
S’
Y
S
S”
Price
O
Qty supplied
X
Relationship between supply and demand: market equilibrium
We may now bring the two concepts of supply and demand together to see how the
interaction of the buying and selling decisions will determine the market price of a product,
and the quantity that is actually bought and sold in the market.
The economic principles governing the market price of any product in a free market is
illustrated in Table 3.4. Column 1 shows a common set of prices. Columns 2 and 3,
respectively, reproduce the market supply schedule and the market demand schedule. Now,
the question to be faced is this: Of the five possible prices at which rice might be sold, which
one will actually prevail as the market price?
Table 3.4 Supply and Demand Schedule for Rice
(1)
Price of 1
kg.of rice
Nu. 10
8
6
4
2
(2)
Total quantity
supplied per week
(3)
Total quantity
demanded per week
(4)
Excess supply per
week (3-2)
Kg. 24,000
20,000
14,000
8,000
2,000
Kg. 4,000
8,000
14,000
22,000
32,000
Kg. 20,000 ¯
12,000 ¯
0 ®¬
-14,000 -30,000 -
Let us find the answer through trial and error. Could Nu. 10 be the prevailing market price
for rice? The answer is no: at Nu. 10 producers are willing to supply 24,000 kg of rice; but
buyers are willing to take only 4,000 kg. The result is a 20,000-kg surplus or excess supply
of rice in the market (Column 4). The very large surplus of rice would prompt sellers to
accept lower prices from buyers in order to get rid of this surplus. Thus whenever supply
exceeds demand it leads to a downward pressure on price.
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Supposing the price goes down to Nu. 8? At this price, there is still an excess supply of
12,000 kg. The downward pressure on price continues!!
Now suppose the price goes further down to Nu. 6? At this price there is no surplus. In fact
at this price, supply equals demand. This is the market equilibrium price with 14,000 kg of
rice being sold, and 14,000 kg of rice being bought.
But are we sure that this is the equilibrium price? To answer this question, let us see what
happens when the price is allowed to fall still further to Nu. 4. At Nu. 4, we find that
demand exceeds supply: producers are willing to sell only 8,000 kg of rice, while consumers
are willing to buy 22,000 kg. Decreasing the price further to Nu. 2, would make the excess
demand even greater: supplier will reduce the amount they are willing to sell to only 2,000
kg, while consumers will are willing to buy 32,000 kg. Then only way to achieve
equilibrium again would be increase prices up to Nu. 6. In fact we can generally say that
whenever demand exceeds supply, there is an upward pressure on price.
A graphic analysis of supply and demand should yield the same conclusions. Figure 3.57
indicates that any price above the equilibrium price of Nu.6 will lead to a excess supply.
This surplus will cause competitive bidding down of the price. Equilibrium will be attained
when the price reaches Nu. 6. That is where the demand curve intersects the supply curve.
Any attempt to sell or buy at a price lower than Nu.6 will lead to a shortage of supply over
demand (or excess of demand over supply). This will cause competitive bidding up of the
price, until the equilibrium is established again at Nu. 6.
Figure 3.5 The Equilibrium Price and Quantity for Rice as Determined by Market
Supply and Demand
Y
D
S
11
O
Qty. Suppd. & Dd.
X
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