Economic Analysis for Business

1. Economic Analysis for Business Chapter 7 Supply and Demand beyond Equilibrium

2. Supply and demand beyond equilibrium The entire notion of equilibrium is something like a diversion to take your eye from what is really important in markets, and that is change and how people deal with such change. It is important as a tool for understanding theory, not for understanding reality

3. Change as typically presented • changes is typically presented as a shift in supply or demand for some existing product or service • much change, however, is due to innovation where new and unexpected products are released on the market and completely disturb the pre-existing equilibrium • the following discussion is based on the traditional analysis and its static nature should be appreciated

4. Price S P D Quantity Q Equilibrium where everything starts Change in some existing market only comes from a change in underlying factors that cause a shift in the level of supply or demand

5. Change in demand Start with an increase in the incomes received by buyers of this good If it is a normal good, higher incomes will lead buyers to buy more Here the assumption is that higher incomes have led to an increase in demand

6. How does a business know if demand has increased? The question is, how would anyone in business know: • firstly, that there has been an increase in the incomes of the industry’s customers, • secondly, that this increase in income has been followed by a desire to buy more of the industry’s output? The one action no one in business can take is to look at what is happening to the demand curve, either for the business or for the industry.

7. Price S P E D2 D Quantity Q Qa A business experiences an increase in demand A firm first finds out because it is selling more than it did

8. Final result of an increase in demand More are being sold than in previous occasions There is pressure on businesses to increase production levels and possibly raise price If this shortage persists, the response may well be to increase production levels and push prices up Eventually the price will lift, the amount demand will be cut back to some extent but usually not to the full extent of the previous increase in sales A new equilibrium is established at a higher price and a higher volume in which the level of sales is matched by the level of demand

9. Price S E2 P2 P D2 D Quantity Q Q2 Qa How equilibrium is drawn The textbook story

10. Price P Quantity Q What a business is likely to know The market price is generally known and how much they are selling themselves – beyond that it’s all guesswork

11. Demand and business decision We state that demand has shifted. This is a short form statement about there being new facts on the ground that those who run businesses must take into account. Cannot leave out the need for business decisions to be made by actual human beings.

12. Buyer decisions must also be made Also cannot leave out the decisions that face the buyers of the product. Relative to the original equilibrium, they are buying more in aggregate. Relative to the intermediate position, when demand had risen but price had not, now that the price has gone up, some are buying less. When everything has worked its way through, the total quantity demanded is the same as the total quantity supplied.

13. Price S2 P2 P S Quantity q Shift in supply Changes that affect the willingness to supply particular amounts at each price

14. Cost factors shift supply Originally the willingness to supply is shown by the firm’s supply curve S. This is the kind of information that a firm might have readily available. Higher prices would lead to more production and lower prices to less. Into this setting, there is an increase in costs.

15. Business decisions and change in supply The higher price leads to a lower level of sales Behind the scenes is the unknown and invisible demand curve which, if the information could be known, would tell the producer what the new price ought to be In reality, there is a process which businesses go through in finding their way to the new equilibrium

16. Price S2 Pc Pe2 Pe1 S D Quantity Qe2 Qe1 Market equilibrium with a fall in supply Sellers are only willing to sell a smaller amount at each price

17. Horizontal supply It is possible that the supply curve may be horizontal over the relevant range or with economies of scale perhaps even downward sloping. Both of these are genuine market possibilities. With a horizontal supply curve over the relevant range, changes in demand lead to changes in production levels but no change in price.

18. Price P S D2 D Quantity Q Q2 Effect on P and Q with horizontal supply curve Changes in demand lead to changes in production levels but no change in price.

19. The shape of the curves Market demand curves are invariably downward sloping which is why the relevant principle is called the law of demand. Supply curves can go in any direction, particular over what might be described as “the relevant range” which is the output level in proximity to the current level of production. Sometimes the existence of other buyers in a market causes the price to go up and sometimes it causes the price to go down

20. Economies of scale and downward sloping supply There is no particular reason that the supply curve might not be downward sloping in some industries. In industries where there are large economies of scale that can be captured, so that as output goes up average production costs go down, it is possible that higher volumes will bring prices down.

21. Price P P3 S D3 D Quantity Q Q3 Economies of scale and increased demand Higher volumes lower average costs

22. Supply curves and time dimension The shape of these curves is to some extent determined by the time period being examined. In the short term, extending no farther than the immediate future, supply might be near vertical since there is only so much and no more. As the time frame is extended, the supply curve may begin to bend forward until in the longest of runs, the supply curve may actually be downward sloping as the most efficient approaches to production are introduced.

23. Elasticity Amongst economists, there are actual specific terms used to describe the tilt of supply and demand curves. Rather than describing these curves as “horizontal” or “vertical”, the words used are “elastic” and “inelastic”. The economic point about elasticity is to gauge the responsiveness of changes in quantity to changes in price. Demand, for example, is said to be elastic if there is a large change in the quantity demanded following a relatively small change in price.

24. Measurement of elasticity  = Percentage Change in Quantity Percentage Change in Price

25. Elastic demand Where quantity demand is generally responsive to change in price, demand is said to be elastic. For an elastic demand curve, as the price goes down, total revenue goes up.

26. Inelastic demand Where quantity demand is generally unresponsive to change in price, demand is said to be inelastic. For an inelastic demand curve, as the price goes down, total revenue goes down.

27. Elasticity can change along a demand curve The very same demand curve will typically shift from being elastic at higher prices to becoming inelastic at lower prices. As price comes down, at first total revenue will go up and then, having reached a maximum, total revenue will come down.

28. Demand and total revenue

29. Switch from elastic in inelastic This process also works in reverse. In the inelastic range, a rise in price will lead to a rise in revenue. From the moment that the demand curve moves from the inelastic portion to the elastic section, the rise in price is associated with a fall in revenue.

30. Price Total Revenue Elastic Inelastic Quantity Quantity Total revenue and demand Elasticity is related to total revenue as prices change

31. Using supply and demand Both supply and demand are a relationship between price and quantity all other things being equal A market price does not change unless there is a change in the conditions affecting either demand or supply or both together If a market price or market volume have changed, one or the other of those two underlying forces must have changed first Within economics, there is no other valid explanation for a change in prices charged or output produced in any market

32. Explaining price or quantity movements If there has been a change in a market price or in the level of sales, an explanation must be given in terms of supply and demand • If a price has gone up, either demand has increased or supply has gone down • If a price has gone down, either demand has fallen or supply has gone up • If the level of sales has gone up, either supply or demand have increased • If sales levels have gone down, either supply or demand have fallen

33. Example with electricity prices The price of electricity has gone up. Why might it be? That is where the ceteris paribus issues come in to play

34. Supply side factors On the supply side, the following may have led to a rise in prices: • the cost of inputs including the cost of labour might have increased in price • the capital stock available has diminished because there has not been sufficient maintenance of generating capacity • there are expectations that demand is going to increase and more capital will be needed • taxes on the industry have increased

35. Demand side factors On the demand side, the following may have led to a rise in prices: • incomes have risen and more energy is demanded • the population has gone up • there has been an increase in the use of products that use electricity • the prices of other sources of energy have risen • governments have decided to discourage the use of electricity and have increased taxes on energy use

36. Inflationary periods and price movements During an inflationary period: • incomes paid out are rapidly rising faster than technological change can produce productivity increases so the supply curve of many products is moving to the left • at the same time, because incomes in nominal terms are rapidly rising, the demand curves for many products are moving to the right The effect on prices is certain to be positive but the effect on the level of sales could be either positive or negative

37. Price S2 S P2 P D2 D Quantity Q Inflationary effects on individual prices Prices certainly higher but quantity change unknown

38. Common sense applied to supply and demand The formal use of supply and demand clouds some people’s minds so that what they once understood intuitively they lose their grip on by seeing it in this way

39. Just remember this If producers become more willing to produce, the supply curve will move to the right – producers will supply more at every price If producers become less willing to produce, the supply curve will move to the left – producers will supply less at every price If buyers become more willing to buy, the demand curve moves to the right – buyers will buy more at every price If buyers become less willing to buy, the demand curve will move to the left – buyers will buy less at every price

40. Price ceilings and price floors Governments frequently attempt to influence the prices of various goods and services by imposing prices on the market.

41. Price ceilings A price ceiling is a maximum price imposed by governments below the equilibrium point Done always for political reasons – there is no good economic argument A very popular use of the price ceiling was once the use to control rents

42. Price S Pe Pc D Quantity Qs Qe Qd Introduction of a price ceiling The ceiling price is lower than the equilibrium price

43. Effect of price ceiling According to the diagram, three things are sure to happen. • After the price ceiling is imposed, prices are lower. • With lower prices, more people try to buy, with the quantity demanded moving up from Qe to Qd. • With lower prices, meanwhile, fewer sellers are willing to take on the expense and hassles of selling, and the quantity supplied falls from Qe to Qs.

44. Price ceilings cause shortages In these circumstances, the price may be lower but there is not enough output to satisfy all those who would like to buy Some who had been buying before may no longer buy the product since the price has risen and others are buying the higher volumes instead What’s worse, the increase in demand means that there is even more competition for the available supply

45. Markets operate according to supply and demand To push the price of anything below its equilibrium price will create shortages. The evidence from history is overwhelming. Although supply and demand curves are totally invisible, the world operates in just the way it would if these curves could actually be seen.

46. Price floor The opposite of a price ceiling is a price floor Always done for political reasons A floor price is the lowest price allowed by law or the price at which the government will buy everything not bought by the market

47. Price S Pf Pe D Quantity Qd Qe Qs Price kept above equilibrium Floor price is higher than the equilibrium price

48. Effect of a floor price Here again there are three certain results. (1) After the price floor is imposed, prices are higher. (2) With higher prices, there is less bought than had been bought before. (3) With higher prices, however, producers produce more even though less is being bought in the market.