5
Simultaneous changes in supply & demand
Difficult to predict outcome when ˃1 change is involved due to forces working in opposite
directions
Depends on magnitudes of changes in demand & supply
Change in demand Change in supply Change in price Change in quantity
Increase Increase Uncertain Increase
Increase Decrease Increase Uncertain
Decrease Increase Decrease Uncertain
Decrease Decrease Uncertain Decrease
↑ demand ˂ ↓ supply Same magnitudes ↑ demand ˃ ↓ supply
Interaction between related markets
Affected by • 2 graphs always affected
❖ Social norms
❖ Price of substitutes (in production & consumption) & complements
❖ Supply of joint products
Gvrn intervention
Max price controls (price ceilings)
❖ Set to:
⬧ Keep prices of basic foodstuffs low to assist poor
⬧ Avoid exploitation of consumers through “unfair” prices by products
⬧ Combat inflation
⬧ Limit production of g+s
❖ Available QS allocated in various ways:
⬧ First come first served – queues / waiting lists (additional costs to consumers)
⬧ Suppliers set up informal rationing systems (additional costs to supplier)
⬧ Gvrn introduces official rationing system (additional costs to gvrn)
❖ Black markets:
⬧ Illegal markets where g+s sold above max price set by gvrn
⬧ When market forces can’t eliminate excess demand
❖ Result of max price controls:
⬧ Shortages
⬧ Prevents market mechanism from allocating available quantity among consumers
⬧ Stimulates black market activity
❖ Max price (P1) set below equilibrium price (P)
❖ At lower price, consumers demand quantity (Q2) more than equilibrium quantity (Q)
❖ Suppliers supply lower quantity (Q1) than Q
❖ Market shortage / excess demand = Q2 - Q1
❖ Welfare costs of max prices:
⬧ At market price (P), consumer surplus
was PDE
⬧ At new price fixed price (P1), consumer
surplus is P1DRU
⬧ Consumers have lost A but gained B
(pay less for product)
⬧ At market price (P), producer surplus
was 0PE
⬧ At new price fixed price (P1), producer
surplus is 0P1U
⬧ Total welfare loss (deadweight loss) to
society = A + C
- Too little produced
- Society is worse off than before
Min price controls (price floors)
❖ Agricultural products
❖ Negative effects:
⬧ Causes surplus (excess supply)
⬧ All consumers pay artificially high prices
⬧ Bulk of benefit to large producers
⬧ Inefficient producers protected & manage to survive
❖ Requires further gvrn intervention:
⬧ Gvrn purchases surplus & exports it
- Usually at loss & expense of domestic consumers
- Only benefits large producers
⬧ Gvrn purchases surplus & stores it (non-perishable product)
⬧ Gvrn purchases surplus & destroys it
- Additional cost & welfare loss
⬧ Producers destroy surplus
- Additional cost & welfare loss
⬧ Gvrn introduces production quotas = limit QS to QD at min price
❖ Max price (P1) set above equilibrium price (P)
❖ At higher price, consumers demand quantity (Q1) less than equilibrium quantity (Q)
❖ Suppliers supply higher quantity (Q2) than Q
❖ Market surplus / excess supply = Q2 - Q1
❖ Welfare costs of min prices:
⬧ Qs falls to Q1
⬧ Without price fixing = consumer surplus
was PDE & producer surplus was 0PE
⬧ With price fixing = consumer surplus is
P1DR
- Consumers lose A to producers & B
disappears
⬧ With price fixing = producer surplus is
0P1RT
- Producers gain A at expense of
consumers, but C disappears
⬧ Total welfare loss (deadweight loss) to
society = B + C
- Too little produced
- Society is worse off than before
Subsidising certain products / activities
❖ Gvrn want to ↓ price to consumers & ↑ production by subsidising producers
❖ At Q1 producers receive price (P2) equal
to what producers pay (P1) + subsidy per
unit (P2 - P1)
Taxing certain products / activities
❖ VAT:
⬧ Levied as % of price of g+s
❖ Specific excise tax:
⬧ Specific amount per unit of product
⬧ Cigarettes, alcohol, fuel
❖ Effective incidence of tax ≠ statutory
incidence of tax
❖ Burden of excise tax shared by:
⬧ Consumers
- Pay more
⬧ Suppliers receive less per unit sold
- ↓ profits of owners / shareholders
⬧ Employees of suppliers
- ↓ production & ↓ jobs available in industry & wage cuts
❖ Welfare costs of excise tax:
⬧ Before tax = consumer surplus DEP
& producer surplus SEP
⬧ Tax introduced = gvrn receives A from
consumers & B from producers in tax
revenue
⬧ Tax ↓ level of output = X (from
consumers) & Y (from producers)
disappear
⬧ Deadweight loss to society = X + Y
Quotas
❖ Limits production of certain goods to prevent overexploitation
❖ Quota above equilibrium quantity has no effect
❖ Quota introduced (Q1) below equilibrium quantity (Q)
❖ Supply curve is now Q1
⬧ Lower production level
❖ Price to consumer ↑ to P1
❖ Cost to producers ↓ to P2
❖ Welfare costs is same as min prices
Import tariffs
❖ International trade = countries with relative / comparative advantage in production export
at price ↓ than world price (Pw)
❖ International supply = PWSW
⬧ QD ↑ to Q5
⬧ New equilibrium point EW
⬧ Domestic production falls from Q3 to Q1
⬧ Imports = Q5 - Q1
❖ Tariffs = Pt – Pw
⬧ Pt = domestic price after tariff
⬧ Equilibrium price = Et
⬧ ↑ Price = ↓ QD from Q5 to Q4
⬧ Quantity produced ↑ to Q2
⬧ Imports = Q4 - Q2
❖ Consequences of tariffs:
⬧ ↑ domestic production & employment
⬧ ↓ imports
⬧ ↑ revenue for gvrn
⬧ ↑ price of product
❖ Welfare costs of tariffs:
⬧ Consumers spend more by PTABPW
⬧ Transfer from consumers to gvrn as
revenue from tariff is FABG
⬧ Domestic producers receive more
due to ↑ selling & receiving ↑ price
- 0PTFQ2
⬧ X = additional consumer payments to
support inefficient firms
⬧ Y = consumers lose due to ↓ quantity
purchasable
⬧ Deadweight loss & pure waste = X+Y
Agricultural prices
❖ Supply of agricultural products varies from season to seasons
❖ Affected by weather, disease, perishability
❖ Fallacy of composition
⬧ Individual farmer improves his position by producing more but if all farmers improve
= worse off than before due to ↓ prices & profits
❖ Total income = 0PEQ
❖ Higher prices expected = ↑ supply to S1
❖ Demand stays same = quantity sold ↑ to Q2 but price falls to P2
❖ Farmers’ income lower than before at 0P1E1Q1
Speculative behaviour
Behaviour of looking into future & making buying & selling decisions based on expectations
When all participants in market expect price to move in certain direction & incorporate this
into their decision-making = expected movement realised immediately (if supply is elastic)
Markets in which this occurs
❖ International commodity markets
❖ Capital markets
❖ Foreign exchange markets
❖ General expectation of ↑ price incorporated into participants’ decisions = ↑ demand to
D1 & ↓ supply to S1
❖ Result = immediate ↑ price
❖ Same vice versa effect if price expected to fall
