AN INTERPRETATIVE ANALYSIS OF DEMAND, SUPPLY AND MARKET EQUILIBRIUM PRICE

2.3 AN INTERPRETATIVE ANALYSIS OF DEMAND, SUPPLY AND MARKET EQUILIBRIUM PRICE

For a given product (goods and services), the market demand depicts the price buyers are willing to pay in aggregate for a specified quantity provided in the market at a point in time, holding all other factors affecting demand constant. For example, as shown in Figure 2.1 , if the quantity of a given product available

in the market is Q 0 , other things being equal, P 0 is the maximum price consumers would be willing to pay. On the other hand, if what is available in the market is Q 1 , it follows that consumers would be willing to pay P 1 . In general, the price-quantity relationship shows that, other things being equal, quantity demanded is inversely related to price. In other words, the market demand for a product is negatively sloped. What is the significance of the “other things being equal” assumption? Why is the demand curve for a product negatively sloped?

In the normal construction of the market demand for any product, certain variables are held constant. Some of the key variables include income, prices of related goods, the preference of consumers for the product under consideration, and the number of relevant consumers. A change in any one of these variables will be manifested by a shift in the entire demand curve. For example, normally, as shown in Figure 2.2 , an

SCARCITY, EFFICIENCY AND MARKETS 17

Figure 2.1 A market demand curve

Figure 2.2 A shift in market demand curve

increase in the average income of consumers will shift the demand curve outward from D 0 to D 1 . This implies that with a rise in average income, for any given level of the product offered in the market consumers will be willing to pay a higher price. Hence, if what is offered in the market is Q 0 , with an increase in average income the price consumers are willing to pay increases from P 0 to P 1 . The important lesson here is the recognition that market demand is a measure of consumers’ willingness to pay, which depends on some key variables such as income, prices of related goods and consumer preference. The next question that we need to address is why it is that the consumers’ willingness to pay declines when the quantity of a product available in the market increases.

18 MARKETS, EFFICIENCY, TECHNOLOGY

Figure 2.3 A market supply curve

The answer to this question requires delving into an aspect of human consumption psychology. The conventional wisdom here is that people engage in the act of consumption because, in the process of doing so, they derive satisfaction (utility). Further, if the consumption of all other products is held constant, the general tendency is for the marginal utility, the utility obtained from each additional units of a product, to decline—the law of diminishing marginal utility. Hence prices need to be lowered in order to entice consumers into consuming more of a given product. Thus, declining willingness to pay (price) as we move down along

a given demand curve is consistent with the postulate of diminishing marginal utility. In determining the value of any scarce resource, market demand constitutes only half of the story. The

other half is market supply. Market supply shows, other things being equal, the minimum price that producers in aggregate are willing to accept in order to provide a given quantity of a product in the market at

a given point in time. Accordingly, as shown in Figure 2.3 , in order to provide level Q 0 of a product, producers will require, at the minimum, a price P 0 . Similarly, to provide a larger quantity, Q 1 , the producers’ required minimum price would have to increase to P 1 . The implication is that the market supply curve for a product is positively sloped. What possible explanation can we provide for this phenomenon? Before answering this question, it will be helpful to first identify the “other things being equal” assumptions regarding market supply.

In depicting the relationship between price and quantity, the supply curve assumes that certain variables are held constant. Some of the key variables held constant in the normal consideration of a supply curve include prices of factors of production (labor, capital and other basic resources), productivity of factors of production, and technology. Any change in these variables will cause the supply curve to shift. For example, if other factors are held constant, an increase in the price of labor (wages) will shift the supply

curve to the left. That is, as shown in Figure 2.4 , to provide a given level of output in the market, Q 0 , after the wage increase, producers require a higher minimum price, P 1 instead of P 0 . This is easy to understand, given that the ultimate effect of a wage increase, in this respect, is to increase the cost of production. The effect of a change in productivity and/or technological change on a supply curve can be demonstrated in a similar manner.

SCARCITY, EFFICIENCY AND MARKETS 19

Figure 2.4 A shift in market supply curve

Let us now turn to the issue of why the normal shape of a supply curve for a product is positively sloped. First, it should be noted that the supply curve for a product is intimately related to the cost of production. If other factors affecting supply are held constant, to produce more output requires the use of more inputs (labor, capital and natural resources). Thus, a higher level of output is associated with a higher level of total production cost. This higher cost of production alone, however, would not have necessitated (justified) producers to increase prices, as implied by the supply curve. For example, in the case where the increase in the cost is directly proportional to the increase in output, the unit (average) cost of production would have remained constant. In other words, if the increase in cost is proportional to the increase in output, the average and marginal costs of production would be constant.

This can be illustrated using a simple numerical example. Suppose the total cost of production was $1, 000 when the rate of output production was 20 units. In this case the cost per unit of output would be $50 ($1,000/20). Suppose now that the production of output is expanded to 60 units and, as a result of this, the total cost is increased to $3,000. What is observed here is that a tripling of the output rate causes a tripling of the total cost. As a result, it is evident that the cost per unit of output remains unchanged at $50 ($3,000/ 60). In this case the marginal cost, which is the addition to total cost resulting from producing one more unit of output (it is equal to the change in total cost divided by the change in output), is also $50 ($2,000/40).

Thus, in a situation where the increase in cost is proportional to the increase in output, the supply curve will

be a horizontal rather than an upward-sloping curve in the price-quantity space. The implication here is that for a supply curve to be upward sloped as output increases, the increase in total cost of production must be proportionately higher than the increase in output. For this to happen, the productivity of the variable inputs must be declining as the production of output increases. What could cause this to happen?

The answer to that question depends on whether the issue under consideration is a short- or long-run supply curve. In the short run (a time period too short to allow all inputs to vary), the phenomenon of declining productivity is explained by the famous law of diminishing marginal product. This law simply states that, in

a production process with at least one fixed input, variable inputs eventually encounter diminishing returns —declining marginal productivity. This is because the fixed input(s) acts as a limiting factor in the

20 MARKETS, EFFICIENCY, TECHNOLOGY

production process. To observe this, imagine a farm often acres producing wheat. In this simple case, it is not hard to see that after a certain point, increasing the labor of the farm owner and the application of fertilizers will not increase output (wheat) substantially because there is a limit to how much wheat ten acres of land can produce. In this case, land is the limiting factor. Hence, fundamentally, the positive slope of the short-run supply curve is explained by the law of diminishing marginal product.

In the long run, however, all inputs with the exception of technology are assumed to be variable. Thus, since there are no fixed inputs, the law of diminishing marginal product cannot be used to explain why the long-run supply curve of a product may be positively sloped. In this situation, two explanations may be given, as follows.

First, some resources may be available only in limited quantities. An example is highly skilled workers. Other things being equal, the prices for these kinds of factors of production may rise as, profit seeking, competitive firms attempt to expand their production in response to increased demand. The increase in the prices for factors of production may mean that firms are encountering rising production costs as they attempt to increase the quantity supplied of their product. The result is a long-run market supply curve that is upward sloping. It is important to note that the primary cause of the increasing unit production costs (as firms attempt to expand their output) is increase in the prices for factors of production, not declining productivity.

Second, in the long run, one way to increase the quantity supplied of a product may be by encouraging new entrants. However, not only do firms have different costs, but the expectation is that in any given industry, new entrants have higher costs than those firms already in the market. Because these new entrants have higher costs, the price must rise to make entry profitable for them. This suggests that the long-run market supply curve for a competitive industry will be positively sloping.

Now that we have discussed market demand and supply, it is time to formally demonstrate how a price is formed in the market. From the previous section, we know that market demand and supply for a product are nothing more than expressions of consumer and producer behaviors, respectively. For example, in

Figure 2.5 , if P 0 is the prevailing market price, consumers will purchase only amount Q d . On the other hand, for the same price, producers will be willing to sell amount Q s of output. This would not be a stable situation, since at P 0 , producers would end up with an excess supply (unsold product), to the amount of Q s – Q d . In this situation it would be in the interest of producers to decrease price so that they could reduce their excess inventory. It would be also in the self-interest of consumers to buy more of the product, as it is offered at a lower price. These mutually reinforcing, voluntary expressions of consumers and producers will continue until a market price is reached where excess supply is eliminated. In Figure 2.5 , this will be the

case at the market price P e . At this price, quantity demanded is exactly equal to quantity supplied, i.e. Q e =Q d =Q s . Thus, a market equilibrium price is that price which tends to equate quantity demanded with quantity supplied of a product at a point in time. Several implications can be drawn from the above market outcome. First, the very fact that the market equilibrium price is positive entails that the product under consideration is scarce. In other words, with a positive price, acquiring this product carries with it an opportunity cost. In economic literature, this particular notion of scarcity is known as absolute scarcity. It is absolute in the sense that it does not go beyond simply telling us that the particular product under consideration is scarce. Second, in a situation where market prices for more than one product are available at the same point in time, market prices can be used as a measure of relative scarcity. For example, if the current market prices per pound of oranges and apples in Kalamazoo are $1 and $0.75 respectively, then we can conclude that oranges are scarcer than apples. This is because, on the basis of the given price information alone, in the marketplace 1.0 orange is worth as much as 1.33 units of apples. As we shall see, the notion of relative scarcity is at the heart of most

SCARCITY, EFFICIENCY AND MARKETS 21

Figure 2.5 How the market gravitates toward equilibrium

economic decision-making processes. Third, the market price of a product is subject to change over time. The change could come as a result of factors affecting demand (such as income, preference, prices of related goods, etc.) and/or changes in the factors affecting supply (input prices, productivity, technology, etc.).

From the above discussion, it is evident that market prices can be used as measures of either absolute or relative scarcity of products at a point in time. At this point we need to ask: how well does a market price perform those functions? That is, is market price a true measure of resource scarcity? What exactly do we mean by true scarcity? To answer these questions adequately, we need to probe further into the operation of the market economy.