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Price					Price	Original	New
	a*	a			(£000)	quantity	quantity
24						millions/year	millions/year
18	b*		b		6	30	12
					12	15	6
		c*
12				c	18	9	3
					24	7	2
			d*
6					d
					D1
					D2
0	6		12		Quantity
					30

F I G U R E 2 . 2 A M O V E M E N T O F T H E D E M A N D C U R V E ( A N D N E W D E M A N D S C H E D U L E )

in demand for cars at each possible price caused by consumers’ plans to substitute away from cars towards SUVs.

Alternatively, if D2 were the original demand function, a fall in preferences for SUVs would lead to a rise in demand for cars over the entire price range, to D1 for example.

2 . 4 S U P P LY

Consumers’ buying plans can only be satisfied if there are goods and services supplied to them.

The economic concept of supply relates to the activities of firms that organize the factors of production to produce output and make it available to buyers.

Producers have an incentive to engage in supplying output to markets if they see that a profit can be made, where profit is the difference between the costs of production and the revenue received from buyers. From an accounting perspective the nature of profit is evident from a company’s accounts but the economic concept of profit is not equivalent.

An economic profit is made if a producer earns enough from supplying their product (or service) to the market to cover all their costs and pay themselves for the cost of the time and effort put into the business.

This economic definition of profit takes the opportunity cost of the suppliers’ efforts in their business into account and from an economic perspective a supplier

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should only stay in business if all the costs of supply including the opportunity cost of the owner of the business’s efforts are covered. Each business person has their own subjective view of how much they need to earn to cover their opportunity costs; it is impossible to say objectively what amount of income must be earned for a business person to remain in business rather than sell up and do something else.

Factors apart from a desire to make an economic profit also affect supply. Suppliers must be able to supply output, which implies having the required resources, factors of production and technology to produce. Over a specific time period, suppliers will take all information available to them regarding their available resources, the type and costs of the factors of production needed for production and assess if it is worthwhile to produce.

Similarly to their use of the law of demand, economists use the law of supply, which states that at higher prices the quantity supplied of a good is expected to be higher than at lower prices. Figure 2.3 presents the relationship between the price of cars in Europe and the quantity supplied for the year 2000. The logic of the law of supply is that firms are willing to supply greater quantities only if they receive higher prices because of the increasing marginal costs encountered in increasing output (see Figure 1.5).

In terms of the supply curve, a firm is only willing to supply more output if it receives a higher price for a higher output since its marginal cost increases with production. This implies that the marginal cost of producing the 1000th car is higher than for the 999th car so suppliers require a higher price to cover their higher marginal costs. The logic of this assumption relates to the need to attract more resources into car production from other uses if suppliers want to increase output. There is an opportunity cost of using resources in car production rather

	Price
	24	Price	Quantity
	18	(£000)	(millions/year)
		6	7
	12	12	15
		18	18
	6	24	20

0	7				Quantity
		15 18 20

F I G U R E 2 . 3 T H E S U P P L Y C U R V E A N D S U P P L Y S C H E D U L E

48	T H E E C O N O M I C S Y S T E M

than other alternatives, and hence the increasing marginal cost of production in a specific market is conceptually similar to the argument used earlier that there are increasing opportunity costs of production underlying a production possibility frontier. (When we consider differences in the supply decision in the short run and long run later, we will see that there are additional reasons why short-run supply curves are upward sloping.) Hence, we observe a positive relationship between price and quantity supplied and this is reflected in the upward slope of the supply curve.

The supply curve indicates the amounts all car firms plan to sell at different prices (not how much they actually sell). The table presented in Figure 2.3 is a supply schedule showing the quantity of cars supplied for a range of prices: at a price of £6000, 7 million cars would be supplied; at a higher price of £12 000, quantity supplied would be 15 million and, at higher prices, quantity supplied increases to 18 million at a price of £18 000 and to 20 million at £24 000.

For a change in price, suppliers react by changing the quantity of goods supplied to a market. A supply curve is drawn ceteris paribus, as if factors apart from price affecting supply are unchanging. These other factors include:

•prices of the factors of production (and technology);

•expected future prices;

•government regulations.

•prices of related goods;

•the number of suppliers;

If any one of these factors changes, it causes a movement/shift of the supply curve.

Prices of the factors of production (and technology)

The price that a firm earns for its output provides the firm’s revenue. This can be calculated as the price of output times the quantity of output (e.g. if the price of a car was £12 000 and a firm supplied 20 000 cars its revenue would be £240 million). Using its revenues the firm hopes to cover its costs and make at least a normal (economic) profit.

Normal (economic) profit: the minimum profit a firm is willing to make rather than go out of business. Any level of profit beyond this is called supernormal profit.

In producing its output the firm uses factors of production and if the costs of the factors increase, this reduces the firm’s profits. Possible sources of increased costs would be higher wages, raw materials prices, rent, or interest rates on loans.

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Costs might also be changed considerably by the introduction of new technology. When economists refer to technology we mean not just machinery, equipment or robots but also the level of knowledge or know-how that exists about production at a specific point in time.

The car industry’s extensive use of robotics (for the welding of seats onto chassis, for example) represented a significant investment by the firms in the industry but allowed considerable cost savings once the robots were functional on assembly lines since they could perform a number of tasks (placing and fitting of components) more efficiently, removing the necessity for thousands of manual workers. Many of the activities performed by robots were those in the harshest of working conditions, which were uncomfortable and even risky for workers and since a robot has an advantage of being able to perform repetitive tasks without feeling the boredom often associated with such activities, the accuracy and speed of output also improved.

Restructuring of organizations also allows for cost savings. The concepts of downsizing and rationalizations (used extensively in the 1990s) refer to the process of laying off considerable numbers of employees by firms that substantially reorganized their production. Quite often this occurred in conjunction with outsourcing which involved firms contracting out work to others that was previously performed by the firms themselves. The logic for such restructuring allows a firm to focus on its most important activities, what it does best, and buy in any other non-essential activities that could be more efficiently supplied by other firms. There is a substantial debate on the downsizing that occurred over the 1990s and whether it made sense economically and socially. (Refer to www.geocities.com/WallStreet/Exchange/4280/ for an interesting discussion on the phenomenon.)

Costs for firms can also be affected by government policies. If subsidies are provided, firms’ costs fall, such as happened in the UK in 1999 when the government provided more than £150 million to BMW to maintain production of Rover models at the Longbridge plant in Birmingham. BMW had threatened to move production to Hungary, where a free site was available and production costs were considerably lower.

Since BMW was making substantial losses on the cars, the subsidies received served to cut their losses rather than increase profits. A further example of

50	T H E E C O N O M I C S Y S T E M

the effects of government policy on costs is the EU directive on End of Life Vehicles which attempts to make car makers responsible for dealing with the waste caused by cars that end their useful lives (approximately 12 million in the EU annually). If car manufacturers have to bear such costs (estimated at £50bn) then this will affect car supply.

The effect of higher costs on the supply curve for any product can be considered at any price on the supply curve. A supply curve is drawn for a given set of costs (ceteris paribus strikes again!). If costs change, this causes a movement of the supply curve. For example, any supplier willing to supply at a price of £12 000 incurs higher costs if labour costs rise. Given higher costs and the total cost outlay suppliers are willing to incur to earn revenues of £12 000 per car, suppliers are willing to supply a lower quantity of output at point x in Figure 2.4 than at point x (with lower costs).

More generally, depending on their line of business, it is possible that some suppliers might wish to switch production to other products for which costs have not increased. With sufficient advance information of cost changes, suppliers will take any new information into account and may change their supply decisions. In Figure 2.4 there is a reduction of supply from 15 million cars to 8 million cars caused by an increase in production costs. At every price on the original supply curve, once production costs increase, producers cut back their production and this leads to a leftward shift in the supply curve from S1 to S2 .

Beginning with S2 a cost reduction would have the opposite effect; some producers are enticed to supply greater quantities resulting in a shift of the supply curve to S1 for example.

Price	S2				Price	Quantity
				S1
24					(£000)	(millions/year)
					6	0
18					12	8
					18	11
	x*
12			x		24	14
6
0	8	15	18	20	Quantity

F I G U R E 2 . 4 A M O V E M E N T O F T H E S U P P L Y C U R V E ( A N D N E W S U P P L Y S C H E D U L E )

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Prices of related goods

Supply is influenced by the prices of related goods, substitutes and complements. In car production, different types of vehicles can be produced from a given factory – saloons or sports utility vehicles (SUVs) – with minor alterations to the production line, which means they are substitutes in production. The quantity of saloons supplied is affected by the price of SUVs because if the price that can be earned from supplying SUVs increases, suppliers of saloons have the incentive to switch towards producing SUVs (so the supply curve for saloons moves leftwards).

Complements in production also exist where at least two goods are produced jointly from the same resources, e.g. beef and leather. If the price of leather increases, leather suppliers have the incentive to supply more, which would lead to the joint additional supply of beef (the supply curve for beef would move rightwards).

Expected future prices

Suppliers who can store their output over time would have the incentive to do so if prices in the future were expected to be higher than the current price they could earn on their supply, hence a lower current supply would be offered on the market than if no change in the future price was expected. The alternative is also true. In the car market when new editions appear, previous models become more difficult to sell – in buying a new car, many customers prefer to buy the most up-to-date model rather than earlier editions. If suppliers have stocks of the older models available and know that future models are about to be launched they often offer good deals on the old models to try to sell them before new models reduce the demand for the old. Expectations about the future prices that can be earned on the old models create incentives for suppliers to sell in the present rather than stock up their supply for the future.

The number of suppliers

The supply of cars or any product is the sum total of each car firm’s supply in that market. The entry of a new firm into the market adds extra supply moving the supply curve rightwards.

This effect could be short term if the new firm supplies more attractive cars or better value cars than other firms. Reaction by competing firms may follow. Some firms might be forced out of the market if they can no longer compete with the new firm and the end result might be a replacement of a supplier with no significant impact on the overall supply.

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Government regulations

The regulation function of governments permeates many different activities in an economy. It can affect supply through various channels, such as through the policy regarding End of Life Vehicles explained above, and various other environmental and safety regulations that limit the activities of suppliers across a range of industries. Various policies apply to the chemicals industry, for example, from food labelling requirements and the classification of dangerous substances to general health safety and environmental regulations. To the extent that new regulations force firms to deal with additional costs (e.g. to pay for anti-pollution systems, to employ people with regulatory expertise) the supply curve may move leftwards.

This may not necessarily be all bad news for a firm, though. Some buyers might be attracted to products when they know the suppliers apply stringent standards. Some firms go beyond government regulations to make their products even safer or more environmentally friendly because the additional cost is more than covered by the extra demand generated by the product.

Although costly to manufacture, cars that are capable of withstanding a 64 kmph (40 mph) head-on smash and a 48 kmph (30 mph) side-on collision are currently being engineered and developed to deal with European New Car Assessment Programme tests reported regularly on new cars – for more on this see www.euroncap.com. Manufacturers realize that safety is an important selling feature for cars and invest substantial funds into safety improvements that increase their performance.

2 . 5 M A R K E T I N T E R A C T I O N : D E M A N D A N D S U P P LY

Each market consists of buyers and sellers, demand and supply. Bringing both together allows for analysis of how market prices are arrived at, showing how both sides of the market combine to give rise to the outcome in terms of the price and quantity of goods bought and sold. Using the example of the car market, the market demand and supply curves can be shown together as in Figure 2.5.

There is only one price at which the quantity buyers are willing to buy coincides with the quantity sellers are willing to sell. This price is £12 000 and is called the market clearing price because if all good supplied at this price are sold, all buyers

			M A R K E T A N A L Y S I S : D E M A N D A N D S U P P L Y					53
Price
(£000)	D				S
24		a
18			b
12				c
6						d
0	7		9	15	19 21	30	Quantity
							(millions/year)
F I G U R E 2 . 5 D E M A N D A N D S U P P L Y : T H E C A R
M A R K E T

wishing to buy at this price can do so. At this price firms do not build up stocks of unsold cars and no consumer demand is left unsatisfied. A market does not clear if demand cannot be met (shortage) or if suppliers provide more than is demanded in the market (surplus).

This price is also called the equilibrium price. The term equilibrium is used widely in economics and it refers to a situation from which there is no tendency to change – unless something to cause a change occurs. An equilibrium quantity corresponds to the equilibrium price. In Figure 2.5 this quantity is 15 million cars, the amount of goods that are bought and sold when the market is in equilibrium.

The market for cars will tend towards the market-clearing equilibrium price and quantity. This happens if you consider the forces at work at any other price. If the price were £24 000, demand would be 7 million cars while corresponding supply would be 21 million. Such a high price means few buyers are willing and able to buy cars while quite a number of suppliers are willing to supply at such a high price.

At a price of £24 000 the market does not clear because the quantity demanded does not correspond to the quantity supplied:

QD < QS

Quantity demanded is less than quantity supplied. The discrepancy between these quantities is 14 million cars which suppliers are willing to supply, for which no demand exists; hence, a surplus exists in the market. The expected reaction to this non-equilibrium situation is for firms to try to do something to sell their unsold

54	T H E E C O N O M I C S Y S T E M

stocks. One rational response might be to cut their price. If price declines to £18 000, quantity demanded increases to 9 million while quantity supplied falls to 21 million. This reduces the surplus or excess production to 12 million cars but does not eliminate it. Reducing the price further will further reduce the surplus. Only if the price falls to £12 000 will the surplus production be eradicated. If firms wish to sell all their output, the price needs to fall to this level, otherwise they are left with unsold stocks of cars.

If the price were below the equilibrium level, that too would create problems and represent a disequilibrium situation in the market. Take the case where the price of cars was £6000. The quantity demanded at this price would be 30 million cars (high demand at such a relatively low price) but suppliers are willing to supply only 7 million cars. A shortage would exist in the market; 23 million more cars would be in excess demand compared to the available supply.

QD > QS .

Customers lucky enough to get their hands on cars at £6000 are surely very satisfied but a large number of potential customers willing and able to pay this amount just cannot buy cars as supply does not meet demand at this price.

The method by which cars are allocated to customers could be extremely problematic – first come first served might be a possibility but someone who really wanted the product might not be happy to settle for a straightforward queuing system. Attempts at bribery might occur, preferential treatment might be given to some customers, and corruption is a real possibility. Any supplier happy to supply at this price can sell their output but because the price is relatively low, the supply of cars is also low. If this situation existed in a market, suppliers would be aware of the excess demand and might try to react to it. Sellers might decide to increase the price a little which would have the effect of encouraging greater production of cars while reducing the quantity demanded. At any price greater than £6000 but less than £12 000 suppliers will have the incentive to charge a higher price which means that the quantity supplied will rise. As price rises, quantity demanded is reduced but since supply does not match demand, a portion of it is unsatisfied at prices below £12 000.

Hence, in a free market – where price and quantity are set by market demand and supply – a tendency for the price and quantity to change exists if the market is not in equilibrium. In equilibrium, the market price is the equilibrium price and neither excess demand nor supply is observed as the market clears.