Essay/Term paper: Demand and supply

Essay, term paper, research paper:  Essays

Every organisation which provides goods or

services to fee paying customers must, by its very

nature, charge price for that good or service, to

pay for its costs, have retained profits for

investments and to keep its shareholders happy. In

theory, the market price of any good or service is

determined by the interaction of forces of demand

and supply. There is an old saying, that "if you can

teach a parrot to say "demand" and "supply" you

have created a trained economist."1 There is some

truth to this saying as most problems in the

economics can be examined by applying the rules

of demand and supply. Therefore, the concepts of

demand and supply can be claimed to be among

the most important in economics. In order to

understand either of them it is necessary to

examine the factors that determine them. Although,

a good"s price relative to other goods is probably

the most important factor influencing demand for

most goods most of the time, there are other

factors as well. These are disposable income, the

price of complimentary goods and substitutes,

tastes and preferences, expectations, size of

population, advertising. Suppliers on the other

hand are interested in making profits, and thus

anything that affects profitability affects the supply.

These include the price of other products, costs,

technology and goals of firms. a) The price of any

product is determined by the interaction of the

forces of demand and supply. The market price is

set at the point, where demand equals supply,

equilibrium. This can be seen from figure 1. For

the purpose of this essay we will look at the prices

of beer. We can see that, the price is set at 1.65,

where D intersects S. Fig. 1 The Penguin

dictionary of economics defines demand as "the

desire for a particular good or service supported

by the possession of the necessary means of

exchange to effect ownership", while supply is

defined as:" the quantity of a good or service

available for sale at any given price"2. When an

economist refers to the demand for a product he

means effective demand, which may be defined as

"the quantity of the commodity, which will be

demanded at any given price over some given

period of time."3 However, the price of the good

or service varies according to the changes in either

demand or supply. In order to show that it is

necessary to look at determinants of demand and

supply separately. One of the factors that might

affect the demand for beer is a disposable income,

income less taxes. For most of the products, when

disposable income goes up the demand goes up as

well, and vice versa, thus affecting the price of the

product. A rise in income leads consumers to buy

more of a product, as they have more money to

spend. This can be seen from figure 2. Fig.2 Thus,

we can see that, when income rises, demand shifts

to D1, and since S curve remains the same, the

price of beer goes up to 2.00. The other factor

that influences demand for beer, could be the

change in consumer tastes and preferences. Some

industries like clothing and furniture are more

affected by it than the others. However, in beer

market it also has a great effect. It can go out of

fashion if consumers believe that, it is more

fashionable to drinks spirits or not to drink at all,

and vice versa consumers might decide that beer is

more fashionable than spirits. The effect of fashion

and tastes on the prices can be seen from figure 2.

If beer becomes less popular D shifts to D2 and

the price becomes 1.45, while if it is more

fashionable D shifts to D1 giving the new

equilibrium price of 2.00. Another factor, which

influence demand, is the price of other products,

substitutes or complementary goods.

Complementary goods are purchased together to

satisfy one want, and these goods are in joint

demand. For beer, the best example could be

pubs and night clubs. If the prices of admission to

night clubs goes up, the demand for beer is likely

to go down and thus the price will go down, so in

figure 2 the D curve will shift to D2 thus giving the

new equilibrium price of 1.45. On the other hand,

if night clubs were to make the admission free

more people would go and they would have more

money to spend, thus shifting D curve for beer

would shift to D1 giving the new price of 2.00. In

modern world the advertising can also cause

changes to the demand. A successful advertising

campaign can increase the demand, and thus

price, by shifting the demand curve to the right and

at the same time move the demand curves of the

competitors to the left. Change in legislation can

also affect the demand for beer. If the government

decided to decrease the age of those allowed to

buy beer to 17 or 16 the demand for beer would

have shifted to the right to D1 giving a new

equilibrium price. Price changes can also be

caused by change in one or more of the

determinants of supply, like costs or technology. "

Supply curve is drawn on the assumption that the

general costs of production remain constant"4

Therefore, if any of the costs change, it will result

in the changes in supply and thus prices. In the

beer industry there are many costs to consider,

there are production costs, transaction costs and

the costs of the raw materials. The government

can also force the companies into higher costs, like

the introduction of the minimal wage, which will

increase the company"s costs. If the costs increase

at any given level of output the producers will

attempt to pass on these increases on to

consumers in the form of higher prices. If they are

unable to pass on to consumers they would face

lower profits, thus giving less dividends to the

shareholders, which even might result in company

going out of business. The company would start to

produce less of the product, as it is less profitable,

thus shifting supply curve to the left. On the figure3

the supply will shift to S1 thus giving a new

equilibrium price of 2.00. Fig. 3 On the other

hand, technological advances would increase the

supply. If new technology is introduced to the

production process it should lead to the fall in the

costs of production. This greater productive

efficiency will encourage firms to produce more at

the same price or produce the same amount at the

lower price or some combination of both. The

supply curve will shift downwards and to the right

to S2 giving the new equilibrium price of 1.45. It

would be unusual for firms to replace more

efficient technology with less efficient. The other

factor that might affect the supply of the beer is the

future expectation. If firms expect future beer

prices to be much higher, they may restrict

supplies and stockpile beer. If they expect the

prices of raw materials like hops to be higher they

might decide to buy it in advance at the lower

prices so that to keep costs stable. The amount of

changes in price and quantity depends on the price

elasticity of demand and supply, as they affect the

slope of the curves. Price elasticity of demand is

the responsiveness of changes in quantity

demanded to changes in price. The more inelastic

the demand for a product is the greater the change

in price is, and vice versa the more elastic the

demand curve is the lesser the price change is.

This can be seen from the figure 4., D1 is the

perfectly inelastic demand curve while D2 is the

perfectly elastic. Fig. 4 The price elasticity of

supply is the responsiveness of quantity supplied

to a change in price. It is measured by dividing the

percentage change in quantity supplied by the

percentage change in price. For both PED and

PES the factors affecting them are substitutes and

time. b) It is useful to look at demand and supply

analysing when dealing with prices, and many

authors regard it as rather useful. "Demand and

supply diagrams provide a powerful and simple

tool for analysing the effects of demand and supply

on equilibrium price and quantity."5 However

economic analysis of demand and supply has

many limitations and assumptions. As J.

Beardshaw states:" It is only possible to reach any

conclusions so long as we keep the rule of only

considering one change at a time."6 Economists

when dealing with any kind of microeconomic

problem always preface any statement with the

phrase "all other things remaining constant" or

"ceteris paribus". Therefore it can be seen that in

real life when dealing with the real business and its

pricing policy it would be difficult to place such a

problem solely on the economic analysis.

Businesses have to deal with more than just one

change at a time. Economic analysis also shows as

a "perfect" world or business environment. It does

not take any account of factors like corruption for

example. In some developing countries it is

possible to be more cost efficient than its rival and

charge lower prices, but not be able to compete

as its rivals have good connections with the

government. The example of this could be my

home town Kiev, small breweries which charge

lower prices are unable to compete with the

"Obolon" brewery, as the latter has a tender with

the mayor for providing beer to all public and

sport events. Microeconomic analysis assumes

that the more efficient the company is in cutting its

costs, for example, the lower the prices its going

to charge. In reality however, it is difficult to think

of a company, which would do that, if it can

increase its profit margins and keep the stable

demand for its product, especially, if its rivals

charge the same amount and not lowering their

prices. The other assumption of this analysis is that

the equilibrium price is the current market price or

the price toward which the market moves. In

reality the market price could be at any level.

There could be excess demand or excess supply

at any point in time. This can be seen from the

examples of CAP (the Common Agricultural

Policy) and OPEC (the Organisation of Petroleum

Exporting Countries). The other basic assumption

is that any change in either demand or supply

affects the price. However, in beer industry there

are increases and decreases in supply due to the

holidays for example, and the prices tend to

remain the same. During Christmas for example,

there is an increase in demand for beer and other

drinks, people celebrate, go to restaurants and

pubs, thus according to the demand and supply

theory the prices would have to go up. (see Fig. 2)

In reality however, the prices tend to stay the

same or in some cases, like supermarkets, even

drop. This phenomenon can be explained by the

oligopolistic competition and the games-theory.

The demand and supply analysis assumes free

(competitive) markets. However, if we have

market occupied by just a few firms, like British

brewing industry, which is dominated by

Scottish-Courage, Bass, Whitbread and Allied

Donecq7, "the analysis may be rather different"8.

Firms in such markets make decisions on price

and output taking into account the expected

decisions or reactions of the other rival firms. This

sort of market is known as an oligopoly.

"Oligopoly theory is concerned with market

structures in which the actions of individual firms

affect and are affected by the actions of other

firms."9 As far as business planning is concerned,

it is impossible for a business to solely use demand

and supply analysing when making plans for a

future. This is mainly because it is only a theory,

and when faced with actual quantities it is difficult

to estimate an actual increase or decrease in the

price of a particular product. The businesses most

probably would make such decisions based on the

feelings of their shareholders, due to the fear of

"going under", if their shareholders are not satisfied

they will sell shares and the company will be

vulnerable to take-over bids. In conclusion, it can

be seen that the principles of demand and supply

have a theoretical influence on price determination.

The theory provides a useful and simple tool in

determining the price of a product by the means of

demand and supply, an equilibrium price.

However, the theoretic approach, uses many

assumptions, which limit the application of theory

to the real business environment. It is useful for

academic purposes, while it is difficult to imagine

that actual businesses will follow it in the business

planning process. It is also difficult to use it as the

theory assumes the perfect market, which does

not exist, with few exceptions, newsagents being

one of these. In other forms of competition firms

would base pricing decisions on expected

decisions of their rivals (oligopoly), or would

decide by themselves taking into account only their

needs (monopoly). Thus, it can be concluded that

companies would adopt their pricing policy on the

environment they operate in, probably without

even using the theory of demand and supply.