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2.5.1CHANGES IN EQUILIBRIUM

Market analysis based on demand and supply can be used to consider the effects of changing circumstances on equilibrium.

Staying with the car market, city councils in both London and Paris were considering banning SUVs due to their environmental impacts; they are big, relatively more dangerous to pedestrians and other motorists in crashes, and they generally have higher emissions than cars.

Figure 2.6A shows a possible scenario for the international car market, should a ban be imposed. D1 indicates initial demand for cars before the outlawing of SUVs, when P1 was the equilibrium price and Q1 represents equilibrium quantity. D2 shows the increase in demand for cars indicating that changes in regulation affecting the use of goods change demand. With no change to supply, the effect of the rightward shift of the demand curve is a new equilibrium at P2 and Q2. Increased demand leads to both a higher price and quantity in equilibrium.

If such bans become commonplace internationally, many SUV producers might switch their production to more standard cars as their equipment and factories could be adapted without too much difficulty. Should this lead to substantial new entrants into the market, Figure 2.6B indicates a possible outcome. Supply expands from S1 to S2 giving rise to another new equilibrium position. Focusing on D2 and S2 as the relevant demand and supply curves, P3 and Q3 represent the equilibrium position where price falls relative to P2 and where quantity expands to Q3.

A			B
Price	D2	S	Price	D1	D2
D1						S1
							S2
P2			P2
P1			P3
	Q1 Q2		Quantity		Q2	Q3	Quantity
F I G U R E 2 . 6 P O S S I B L E S C E N A R I O S F O R T H E C A R M A R K E T

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2 . 6 G O V E R N M E N T A F F E C T I N G P R I C E S

Attempts are sometimes made by government to influence the price in a particular market. Examples are price ceilings and price floors, which are cases when the actual market price is not the same as the equilibrium price.

2.6.1PRICE CEILING

A price ceiling or price cap is a price that puts an upper limit on the price that suppliers can charge.

The purpose of a price ceiling is to allow consumers to buy products at relatively low prices.

In January 2002 the Filipino government implemented a price ceiling on utility vehicles in an attempt to reform taxes in that industry. The price ceiling applied to basic models only and meant they were tax exempt.

The general effects of a price ceiling are shown in Figure 2.7 for the case of a price ceiling on cars of £6000. The result is excess demand of 23 million cars (30 – 7), but prices cannot adjust upwards to clear the market since it is illegal to charge more.

Economists generally do not favour price ceilings because of the costs they generate. There is a cost to consumers who wish to buy the product at £6000 but who cannot because of the limited supply. Suppliers have an incentive to maintain supply at a relatively low level because of the low price and so industry

Price	D
(£000)			S
24
18
12
6			excess demand
0	7	9	15	30	Quantity
					(millions/year)

F I G U R E 2 . 7 P R I C E C E I L I N G I N T H E C A R M A R K E T

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output, employment and taxes paid to government may all be lower as a result. Furthermore, potential problems exist regarding how the 7 million cars will be allocated among the people demanding 30 million cars.

2.6.2PRICE FLOOR

A price floor is a price that suppliers can be sure to receive for their output.

A price floor is a minimum price with the purpose of helping the producer/supplier attain a price higher than the equilibrium price. It is common in the agriculture sector, as with Europe’s Common Agricultural Policy. The general effects of a price floor are shown in Figure 2.8.

The price floor is set at £24 000. Suppliers are willing to supply 19 million cars, 4 million more than if the equilibrium price could be earned. The result is excess supply in this market since quantity demanded is 12 million cars less than quantity supplied of 19 million. The surplus output may be taken up by a government agency or perhaps exported. Prices cannot adjust freely downwards to clear the market and bring demand and supply to equilibrium.

2.6.3PROBLEMS OF PRICE CEILINGS AND FLOORS

Economists generally do not support the use of price ceilings and floors as they interfere with the free working of the market system and mean that markets do not clear. Problems are created which are worse than those the policies are aimed at solving. Instead of allowing the accumulated choices taken by people on both demand and supply sides of markets to feed into the market price and quantity of goods bought and sold, individuals with decision-making power judge what the

Price
(£000)	D				S
24	<excess supply>
18
12
6
0	7	9	15	19	30	Quantity
						(millions/year)

F I G U R E 2 . 8 P R I C E F L O O R I N T H E C A R M A R K E T

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‘correct’ market price should be. This removes the contributions of some individuals to the market process meaning less collective information feeds into the market outcome. This means that some information of relevance to the market is not used, or is purposefully ignored, and hence, the economic outcome is not as efficient as it could otherwise be.

2 . 7 I N F O R M A T I O N A N D K N O W L E D G E I N T H E M A R K E T S Y S T E M

You will appreciate already that demand and supply curves are not simple features of an economy but relate to a complex range of factors that together reflect the behaviour of individual buyers and sellers in markets. The behaviour results from all of the information used by buyers and sellers when making their economic decisions and is, therefore, the result of numerous independent decisions made by unrelated and non-directly communicating individuals seeking to satisfy their personal economic goals – maximizing their utility. Information available to each individual informs their decision-making so all relevant information distributed across a range of individuals is reflected in supply and demand.

The market system is built on individuals’ use of information and their incentives about how best it should be used. Some of this information is generally available. Take the case of a firm trying to decide if it should hire an additional worker. It will know how much the employee will cost, based on the going or market wage rate, and it will have to make a guess about how much additional revenue the worker will be able to generate for the firm, maybe using information they already have about other workers. Using this information, the economic decision to hire or not is taken.

General information or knowledge that we all possess provides no economic advantage to us relative to others in the economic system although it is useful for some decision-making. Specific knowledge is also used in the economic system. Specific knowledge differs from general knowledge because it is not generally known or available and can be difficult and/or costly to share with others. It includes:

•Scientific knowledge – e.g. the laws of quantum physics or astrophysics that are not easily shared with non-specialists.

•Assembled knowledge – e.g. an administrator who has worked dealing with students in a university department has assembled knowledge about courses offered, timetables, the marks and standards of the courses, details of assignments,

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deadlines and so forth; e.g. the knowledge of how a machine works and how it can be fixed if it breaks down. Such assembled information would take time to be learned by new staff.

•Idiosyncratic knowledge of particular circumstances which if not acted upon swiftly leads to missed opportunities and, hence, wasted resources – e.g. if more output is required in a factory then information on whether a specific machine is operating to capacity will be known to individuals working closely with that machine; if more products must be distributed, information about which containers/lorries are not fully loaded is known to employees on the spot.

Some knowledge may be easily redistributed if it can be expressed in facts, phrases or drawings. Depending on the time it takes to distribute the knowledge, however, it may still be costly to transfer to other people. Other types of knowledge are of a tacit nature, made up of perceptions, beliefs, experience and other types of specific knowledge and can be impossible to explicitly transfer.

The role of knowledge within firms and its central role within the economic system is discussed by Stewart (1997).

Knowledge is more valuable and more powerful than natural resources, big factories, or fat bankrolls. In industry after industry, success comes to the companies that have the best information or wield it most effectively – not necessarily the companies with the most muscle. WalMart, Microsoft, and Toyota didn’t become great companies because they were richer than Sears, IBM, and General Motors – on the contrary. But they had something far more valuable than physical or financial assets. They had intellectual capital . . .

Intellectual capital is the sum of everything everybody in a company knows that gives it a competitive edge. Unlike the assets with which business people and accountants are familiar – land, factories, equipment, cash – intellectual capital is intangible. It is the knowledge of a workforce: the training and intuition of a team of chemists who discover a billion-dollar new drug or the know-how of workmen who come up with a thousand different ways to improve the efficiency of a factory. It is the electronic network that transports information at warp speed through a company, so that it can react to the market faster than its rivals. It is the collaboration – the shared learning – between a company and its customers, which forges a bond between them that brings the customer back again and again.

In a sentence: intellectual capital is intellectual material – knowledge, information, intellectual property, experience – that can be put to use to create wealth. It is collective brainpower. It’s hard to identify and harder still to

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deploy effectively. But once you find it and exploit it, you win. (Stewart, 1997. Reproduced by permission of Currency Publishers.)

From the perspective of encouraging an economy to be efficient it is a challenge to ensure that all resources, including knowledge, are used in the best way possible. As outlined in Chapter 1, economists generally believe that the free-market system provides the most appropriate form of economic organization to encourage efficient resource use. Each person or organization has the incentive to use their knowledge to maximize their utility.

Adam Smith discussed the concept of the ‘invisible hand’ when he referred to how the economic system performed as though it were guided towards getting the most out of its resources in spite of the fact that individuals in the economic system do not make their economic decisions with such a goal in mind. Within the free-market system any ‘guiding’ activity is the result of how people and firms react to the prices and the market opportunities they observe. Prices are the signals that feed into economic decisions about what to buy and what to sell, how to use resources, or whether to supply labour or not.

Hayek (1945) described how the price system operates in by allowing all relevant information and knowledge to be incorporated into the functioning of markets without the participants necessarily being fully aware of why changes occur, but by reacting to them and taking any new information into account in their decision making.

It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes

. . . [S]omewhere in the world a new opportunity for the use of some raw material, say, tin has arisen . . . All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin . . . If only some of them know directly of the new demand and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the entire economic system. This influences not only all of the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all things made of tin, and their substitutes and so on. All this takes place without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes. The whole acts as one market, not because any of its members surveys the whole field, but because their limited individual fields

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of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity – or rather that local prices are connected in a manner determined by the cost of transport, etc. – brings about the solution which (if conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process. (Hayek, 1945. Reproduced by permission of the American Economic Association.)

Economic decision-making in free markets is decentralized across all the individuals dispersed in each market and is synchronized or coordinated by the price system.

Decisions in command economies are not made on the basis of price signals because the central planners decide what should be produced and in what quantities, without reference to supply and demand. Central planners attempt to assemble as much information as possible in making their decisions but given the dispersion of knowledge throughout an economy; it would be impossible for central planners to gather all relevant information for each economic decision that must be made. In the case of specific knowledge, even when it is possible to transfer knowledge it is often costly. Centralized decision-making creates problems for the effective use of information and knowledge within an economy and so leads to a less efficient use of resources than a free-market system.

Another principle that differentiates free markets from centrally planned economic systems is the right to own private property. Private property rights are often taken for granted by those of us in free markets. Since we have the rights to personally own and use property – as opposed to a system of centrally owned and operated property within a centrally planned economy – both individuals and firms have the incentive to use their specific knowledge to maximize their utility. Economists argue that, in general, when decision-makers do not own resources that they may have control over, their incentive to make optimal use of the resources is reduced. Bring this close to home by focusing on the incentive to take care of a TV (or room) you rent rather than one you own!

2.7.1DECENTRALIZED DECISION-MAKING – THE OPTIMAL FORM OF ORGANIZATION?

Allowing economic decisions to be the outcome of market decisions rather than central planning appears to be Hayek’s conclusion. Even the expressions ‘free-market

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system’ or ‘market economy’ indicate the central role of markets in how many economies are organized. However, it would be incorrect to argue that decentralized decision-making is always the most efficient form of economic organization. Look at how firms function by making many of their decisions centrally – by the chief executive officer (CEO) or board of directors – with staff ‘lower down’ in the hierarchy making few, if any, decisions.

Economic activity within the market system relies largely on firms for the markets to function. In principle, it would be possible for economic decisions to be made without the existence of firms – if I want a new wooden table I could contact a timber supplier and organize a carpenter to assemble it. In practice, however, most tables are manufactured by firms and sold on to consumers because some transactions are more efficiently conducted by firms rather than in markets. Consumers save time, effort and, therefore, money in buying from a firm rather than having to deal with what may be a multitude of different suppliers of individual parts and assemblers.

Searching out suppliers is more time-consuming the more complex the product and such search costs represent just one element of what are called transactions costs.

Transactions costs are the complete price plus non-price costs of a transaction, including search, information, bargaining and policing costs.

Consumers incur information costs when they must find out about suppliers or about the quality of different parts; they incur bargaining and decision costs when they must haggle to negotiate the final price with the supplier and decide between alternatives; policing and enforcement costs when the consumer must ensure that the other party to the transaction is honouring the agreed terms of the transaction.

The most efficient way of organizing a transaction minimizes transactions costs. Firms will make and supply goods and services and consumers will buy from them when the transactions cost to the consumer is lower than using markets. Firms too incur transactions costs in organizing their economic activities but exist when these costs are lower than the costs of organizing in markets. Usually transactions costs in firms increase as the firms grow and it becomes more difficult for the management to keep track of all relevant knowledge for their decision-making. Hence, there is a limit to the size of firms that is related to the cost of their transactions and this is one explanation as to why firms do not grow indefinitely.

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2 . 8 M O R E O N E Q U I L I B R I U M I N T H E D E M A N D A N D S U P P LY M O D E L

The demand and supply model and the role of equilibrium within it outlined in this chapter is the foundation of the economics discipline, allowing analyses of different markets and assessment of the implications of changes across a range of factors on market outcomes. The demand and supply model, however, does not provide any answers. Rather, it provides a framework for economists who use the model as best they can for making sense of what they observe. Despite its place at the centre of the economist’s toolbox there is disagreement among economists as to the purpose of equilibrium analysis, which is viewed alternatively by some as a description of reality or by others as a theoretical construct.

•Equilibrium as a description of reality: According to this view, real markets come sufficiently close to being approximated by the supply and demand model – tending towards equilibrium – and in cases where an individual market does not, the supply and demand model allows us to make better explanations and predictions of that market than any alternative model available.

•Equilibrium as a theoretical construct: Holders of this view consider that the supply and demand model can help us to understand things that might occur in reality but it is through our observations of the economy that we figure out what is going on in any particular market and why. Allowance is made for a market that is in disequilibrium and this helps us to understand how markets change over time as individuals (on demand or supply sides of the economy) learn from available information and incorporate it into their economic decisions.

The definition of equilibrium as a state from which there is no tendency to change does not describe markets all of the time as the quantities of goods bought and sold change over time as does their price. Hence we need to understand what equilibrium means, how it comes about, its implications for sellers and buyers and causes and consequences of changes in factors that feed into economic decision-making. Irrespective of your preference for one description or other, the supply and demand model allows us to address these issues.