Application of The Theory of Demand and Supply

Economics, R.A. Arnold, 9th ed. (Ch. 3 & 4)

From One Equilibrium to Another

In Ch. 3 we saw a market may experience a shortage or surplus, but then it moves towards equilibrium. A market should remain in equilibrium unless the demand or supply curve shifts. If the demand or supply curve shifts then the market may move to a new equilibrium.

This is illustrated in the next slide. In diagram (a) the market is initially in equilibrium (point 1). Then the number of buyers increase and the demand curve shifts right (to D2). The market moves to a new equilibrium point (2). This gives us the new equilibrium price (P2) and Q, which is greater than the previous equilibrium price (P1) and Q. So if the demand increases, the market price and Q is likely to increase (a prediction of the model).

Continued

In the figure (b), second diagram of last slide,

we are analyzing the demand of coffee. Assume, a new report finds coffee consumption leads to high blood pressure. Hence, buyers will prefer less coffee. Demand curve of coffee shifts left and a new equilibrium is established at (2). As a result, the price of coffee and quantity of coffee in the market decreases. You can analyze the other diagrams yourself.

Equilibrium and Predictions: An Application of The Theory of Supply and Demand

Further examples (Remember: shortage in market causes price to rise and surplus causes price to fall):

Education market: Current situation indicates a shortage in this market. Many students can’t get admitted due to limited seats. In the future tuition fees of private universities may increase.

**Remember: a good theory should be able to accurately predict what happens in the real world (Ch. 1)**

The Economy (Society) and its Markets

An economy or society that allocates its resources through the price changes in the market is called a market economy. Most economies in the world are market economies.

E.g. Bangladesh (BD) has a limited amount of land and labor (resources) and it can use (allocate) them to produce rice or clothes. How will BD decide how much resource to use in rice production and how much in clothes production?

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The market of rice and clothes can help in making the decision (allocation).

If the price of rice increases in the market of rice, then QS of rice will increase (law of supply), and more labor, land will be used (allocated) to produce rice. Hence, the market helps in the allocation of resources of the economy.

Market Interventions

In a market economy, usually, the government does not interfere (intervene) with the market. But sometimes, the government might feel the equilibrium price of a product is too low (e.g. in case of cigarettes: 15 taka). In this case, the government might intervene and impose a price floor (a minimum price for the product: 20 taka). That is cigarettes cannot be sold at less than 20 taka. This will lead to lower consumption of cigarettes (high price; less quantity demanded). But it will also lead to a surplus in the market. Next slide

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Similarly, the government (gov) might feel the equilibrium price of a product is too high (e.g. price of eggs: 12 taka per piece). So, the govimposes a price ceiling (the maximum price at which a product can be sold: 8 taka per egg). The gov might think more people will be able to buy eggs now. But remember at a low price sellers will not want to sell too many eggs. So gov’s plan may not work. Next slide.

Taxes and Subsidies

The Government can affect the market using taxes and subsidies as well.

For example, to reduce the consumption and production of cigarettes, the government can impose a tax on cigarettes. Because of the tax, the price of cigarettes increase and people consume less cigarettes.

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To increase the production and consumption of a product, the government can provide subsidies (money, resources) to the sellers for producing the product.

For example, the government can provide subsidy to the farmers to increase the production of fruits and vegetables. If the supply of fruits increase, then the price decreases, and more fruits are consumed by the society.