The Market System - Part 3

Demand and Supply

Putting Demand and Supply Together: The Market Mechanism.

Information on how to use this resource can be found in Part 1.

So far we have been looking at the impact on the demand curve and the supply curve as a result of changes in various factors. A market consists of buyers (consumers) and sellers (producers). In order to analyse what happens in markets we generally use a tool called 'comparative static analysis'. We know that in reality demand and supply are constantly changing but in order to try to assess the impact of such changes on markets we adopt a principle called ceteris paribus which means 'other things remaining equal'. In effect we are starting off with one scenario (an equilibrium position) imposing some change - usually just the one change - and then explaining what happens to the market. It is 'comparative static' because we are comparing one static position at the beginning with another at the end! In reality of course, the situation is rarely, if ever, static but without this technique it would be virtually impossible to make any predictions about what might happen to markets when factors influencing demand and supply change.

Let us look at an example:

Get Interactive:

Assume the diagram above represents the market for video cassettes. The price of video cassettes is currently 5 and the amount bought and sold 50. What would we expect to happen to the market for video cassettes if the price of recordable DVDs fell? DVDs and videos are substitutes for each other. If prices of recordable DVDs are cheaper we would expect people to buy more of them and consequently less video cassettes. The demand curve would shift to the left. Move the slider to the left and watch what happens.

Surpluses and Shortages

The important thing to remember about markets is that there is almost always some form of time lag between the changes in either demand and supply and the ability of consumers or producers to react to the changes. In this case, the fall in demand leads to a surplus of video cassettes being available. Producers will have been happily churning out cassettes and will take time to recognise the change in the patterns of demand and adjust their production levels accordingly. The changing market situation will lead to sales of cassettes being less than the amount supplied - a surplus. When surplus stocks exist there is a tendency or pressure on prices to fall to try to offload the surplus. As prices fall, some consumers may be tempted back into the market whilst producers start to adjust supply and cut back given that they now recognise cassettes are not in such strong demand. The process continues - market forces will act on price - until a new equilibrium is reached. At this new equilibrium, the demand curve is now situated to the left of the original one signifying that these goods are not as popular as they once were; prices will be lower and the amount bought and sold lower. The precise effect depends on just how strong the fall in demand has been, if demand fell by a great deal price and quantity would be lower than if demand had only fallen by a small amount.

Get Interactive:

Test out the theory above. Note the effect in each case on the price and the quantity. Press the reset button after each question.

• What happens to price and quantity if demand falls by 10 units?
• What happens to price and quantity if demand falls by 15 units?
• What happens to price and quantity if demand falls by 20 units?
• What happens to price and quantity if demand falls by 30 units?
• What happens to price and quantity if demand falls by 40 units?

Now investigate what happens if some factor changes that causes demand to increase.

Assume that the diagram represents the market for 1 bedroom bungalows. What would you predict would happen to this market given the fact that we have an aging population?

We have analysed the effect on the market when the demand curve shifts, now let us look at the effect when the supply curve shifts. The diagram below allows you to look at the impact of changes in supply on the market. The effects will be similar to that of demand in that surpluses and shortages will be created as supply increases or decreases. The exact impact on the market will depend on how far the supply changes and this is related to the price elasticity of supply for the goods concerned. In some cases it will be easy to increase the supply of a product in others, it will be almost impossible, at least in the short run and so the effect on the market is going to vary also.

Get Interactive:

• What happens to the price and the quantity if supply increases by 10 units?
• What happens to the price and the quantity if supply increases by 20 units?
• What happens to the price and the quantity if supply increases by 30 units?
• What happens to the price and the quantity if supply increases by 35 units?
• What happens to the price and the quantity if supply increases by 50 units?

Now investigate what happens if some factor causes supply to fall.

Assume that the diagram represents the market for white wine. The growing season has been very good with ideal amounts of sun and rain. What would you predict will happen to the market for white wine? (Think as well about how much the supply will change not that it is merely going to change!)

Calculate the impact of the changes you make on the total revenue of wine producers.

Let us now try to put all our knowledge together and review what we have learned.

Answer the following questions as a way of reviewing your own learning on key points:

1. What is the difference between a movement along a curve and a shift in a curve?
2. Why is the price elasticity an important concept in analysing what happens to markets when factors cause the demand and or supply to change?
3. Why is the ceteris paribus principle important in analysing markets?
4. Scan through a newspaper or the 'In the News' section of the Biz/ed Web site. Choose 5 cases where markets are changing - use your knowledge of supply and demand analysis to explain what has happened in the market and why? You should consider what has happened to either demand or supply, why the changes have occurred, what the impact on the price and the quantity has been and the extent of the change and what could have influenced this - i.e. was there a massive change in demand or supply or only a small change?

Suggested answers:

1. There are a number of factors that affect the demand and supply of a product. The level of demand is determined by factors other than price, for example the level of incomes, tastes and advertising levels. A shift in the curve occurs when a factor other than price changes causing a change in the level of supply or demand AT EVERY PRICE. So no matter what the price is, there is either more or less demanded or supplied. For example, if incomes increased we would expect the demand for most goods to increase at all prices. A movement along the curve shows the response of consumers and producers to changes in price alone. Movements along the curve will occur because there has been a shift in either the demand or supply curve causing a surplus or shortage in the market, as market forces cause price to either rise or fall, consumers or producers will respond to the changing price altering the quantity they wish to buy or sell.
2. Price elasticity is an important concept because it tells us how responsive the demand or supply will be to changes in price. If prices rise by 10% will the demand or supply fall or rise by less than 10% or more than 10% and if so by how much? It is important to businesses because it influences their behaviour in terms of pricing strategies and the degree of market power they exercise. Some businesses are able to charge different prices for the same product at different times because the degree of elasticity is different - for example electricity prices, train fares or pub 'happy hours'. Elasticity has an important influence on the total revenue earned by the firm following changes in price and is therefore very important in analysing the extent of the impact on a market as a result of a change in demand and supply conditions. We can see this clearly in the case of the increase in petrol duty - there are very few substitutes for petrol and as a result in the short term motorists and haulage contractors have very little choice but to pay the higher price - the influence on the level of demand therefore is going to be negligible. Knowledge of such concepts allows us to be able to offer an insight into government policy on this issue. If the government claim to be increasing petrol duty to influence behaviour - i.e. get people out of their cars and onto alternative forms of transport, without at the same time investing heavily in those alternatives we might question their true motives!
3. The ceteris paribus principle is important because it allows us to identify the impact of a change in the market on that market. In reality, changes in demand and supply are occurring all the time, it would be extremely difficult to be able to make any sense of what is happening and why without using this principle. The ceteris paribus principle allows us to model behaviour and predicted outcomes at a simple level and then build on that model making it ever more sophisticated in order to try to understand the impact of changing circumstances on markets.