Unit 1. The effects of demand and supply on business

1.1. Markets

Key words: resources, opportunity cost, market, market conditions, demand, effective demand, market demand curve, normal good, inferior goods, disposable income, complementary goods, substitutes, profit, profit margin, supply, market supply curve, market price, excess demand, excess supply, price mechanism, price elasticity of demand, price elasticity, price inelasticity, unitary elasticity

Business involves the organization and management of productive resources to produce goods and services to satisfy consumers’ wants and needs. Productive resources are: human (labour), natural, and man-made. When goods and services are produced, resources are used up. The resources used for productive activity are scarce compared to limitless human needs and wants. Business organizations must, therefore, decide what goods and services to produce with their limited resources.

Opportunity cost

Every society, no matter what its size, faces a choice, because resources are scarce compared to wants and needs. The real cost of choosing one thing and not another is known as opportunity cost. This is the benefit foregone from not choosing the next best alternative. For example, if you choose to buy a compact disc, you are making a choice to go without other items you could have bought. Similarly, in business, if an organization chooses to use its resources to produce electric kettles, it must go without the profits it might have earned from producing electric toasters instead.

Individuals, business organizations, even whole nations are continually faced with choice. The real cost of a government decision to build more schools will be the alternatives, such as hospitals or reduced taxes, foregone. The business that decides to use resources to make clothes reduces the total amount of resources available to make other items.

Market

The goods and services produced by business organizations are sold in markets. A market is defined as consisting of all those consumers willing and able to buy goods and services and all those producers willing and able to supply them. For example, the market for TV sets will consist of the producers of televisions and the people who buy them. Similarly, there will be a market for cars, hairdressing, video recorders, window cleaning, and all other goods and services. These are called consumer goods markets.

Business organizations will also operate in many other markets, for example:

• Capital goods markets – where items such as machinery and vehicles are bought and sold by business organizations

• Commodity markets – where raw materials such as oil, copper and wheat are bought and sold

• The labour market – where people are hired for their services

• The money market – where people and financial institutions borrow and lend money

• The foreign exchange market – where people and firms buy and sell foreign currencies if they need to trade overseas

• The property market – where people and firms buy and sell houses, offices and factories

A market for a good or service can be of any size and cover any area. It can involve any number of consumers and producers anywhere in the world willing to exchange a good or service. The interaction of consumer demand and producer supply in a market will determine the price at which a product is sold and the quantity sold. Changes in market conditions – that is, changes in the level and strength of consumer demand and/or producer supply – can, therefore, influence how individual businesses use their resources.

Market demand

Demand refers to the want or willingness of consumers to buy the goods and services produced by business organizations. In order to be an effective demand, their wants must be backed by an ability to pay for goods and services. A business enterprise must attempt to estimate the potential effective demand for its product in order to plan production. To do this, firms can use market research.

Firms can measure the quantity demanded for a good or service at a number of possible prices that may be charged for the product, and over a certain period of time. This information can be plotted on a graph to derive a market demand curve.

In general, all firms observe the following relationship between the price they charge for a good or service and consumer demand:

• As product price falls, the quantity demanded of that product expands

• As product price rises, the quantity demanded of that product contracts

A change in product price causes quantity demanded to expand or contract along a given demand curve. However, over time, consumer demand for a product will be influenced by a number of factors other than price. These will cause the demand curve to shift. An increase in demand for a good or service can be represented by a rightward shift in its market demand curve. This shows that consumers are now willing to buy more of that product than they did before, regardless of the price. A fall in demand for a good or service can be represented by an inward shift of the market demand curve. It shows consumers as only willing and able to buy less than they did before, regardless of the price.

Factors in market demand

The following factors are likely to cause a shift in the market demand curve for a good or service:

• Changes in income. In general, if the demand for a product tends to rise as incomes rise, the product is said to be a normal good. If the demand falls as incomes rise, the product is said to be an inferior good. On the other hand, a rise in income is unlikely to make most consumers want to buy more salt or matches than they actually need.

• The prices and availability of other goods and services. Some of the goods and services need other things to go with them. These complementary goods are said to be in joint demand. On the other hand, some goods and services are substitutes, i.e. similar and competing for consumer demand. A business organization will find it useful to gather information on changes in the prices and quality of competing and complementary products from rival producers because any changes in competitors’ products can affect demand and, therefore, sales revenues and profits for its own products.

• Changes in tastes, habits and fashion.

• Population change.

• Other factors.

Market supply

Supply refers to the willingness and ability of producers to make goods and services to satisfy consumer wants and needs. The market supply of a given product represents the sum of individual supplies of all the producers competing to supply that product to consumers. We can plot information on the amount of a product firms wish to supply to a market on a market supply curve.

In general, we can observe the following relationship between the quantity supplied of a product and product price:

• As product price rises, the quantity supplied of that product expands

• As product price falls, the quantity supplied of that product contracts

Falling prices will generally be expected to reduce firms’ sales revenues and consequently reduce their profit margins over and above production costs.

A change in the price of a product will normally cause the quantity supplied to expand or contract along a given supply curve. However, changes in factors other than the price of the product can cause the whole supply curve to move. An increase in supply of a good or service can be represented by a rightward shift in the market supply curve. It shows producers as willing and able to supply more of the product, regardless of the price. A fall in supply can be represented by an inward shift in the market supply curve. It shows producers as less willing and able to supply the product, whatever the price.

Factors in market supply

The following factors are likely to cause shifts in the market supply curves of goods and services:

• Changes in the price of other goods. Price changes act as the signals to private-sector firms to move their resources to and from the production of different goods and services.

• Business optimism and expectations. Fears of an economic downturn may cause some firms to move resources into the production of goods and services they feel will be less affected by falling consumer incomes and demand. Conversely, expectations of an economic recovery may result in a re-allocation of scarce resources into new markets.

• Technological advance. Technical progress can mean improvements in the performance of machines, employees, production methods, management control, product quality, etc. This allows more to be produced, often at a lower cost, regardless of the price at which the product is sold.

• Global factors. The supply of goods and services can be affected by a variety of factors that cannot be controlled by producers, for example, sudden climatic change, trade sanctions, wars, natural disasters, and political factors.

• Business objectives. A firm might seek to increase market share by forcing competitors out of business. This may lead to a fall in market supply.

• The costs of production. By far the largest determinant of supply is the cost of production, i.e. payments made for raw materials, power supplies, labour, buildings, and machinery.

Market prices

Product prices are affected by changes in their market demand and supply. Rising prices are likely to be the result of either a rise in market demand or a fall in the market supply of a product. Falling prices, on the other hand, are likely the result of either a fall in consumer demand for a product or an increase in supply. The interaction of consumer demand and producer supply will ultimately determine the price at which a good or service is traded.

The market price of a product can be found at the point at which the market demand and supply curves intersect. At this price, the amount consumers are willing and able to buy is exactly equal to the amount producers are willing and able to supply.

If firms set their prices above the market price, there will be an excess supply. Firms will be producing more of the product than consumers are willing and able to buy. If consumers are to be persuaded to buy up the excess supply, the price will have to fall.

If firms set their prices below the market price, there will be an excess demand. There will be pressure on the price to rise to ‘clear the market’. As the price rises, firms are willing to expand output, while at the same time the rising price causes demand to contract.

The same reasoning applies to any good or service. Only at the market price will consumers' decisions to buy a product match producers' decisions to supply it. There will be no need for price to change unless there is a change in market conditions, i.e. a shift in the market demand or supply curves.

Changes in market price

Four basic movements in the market price for a given product are conceivable if we consider all possible changes in demand and supply:

1. An increase in demand results in more being traded at a higher market price as the quantity supplied expands

2. A fall in demand results in less being traded at a lower market price as the quantity supplied contracts

3. An increase in supply results in more being traded at a lower market price as quantity demanded expands

4. A fall in supply results in less being traded at a higher market price as quantity demanded contracts

The price mechanism

Changes in demand and supply cause changes in the prices and quantity traded of different products. In most economies, changing prices are a signal to producers to increase or decrease the production of different products. For example, a rise in consumer demand for pork will push up the market price and increase the potential for producers to earn higher profits from the sale of the meat. As a result, a number of food producers may be tempted to use more land, labour and capital to breed and keep more pigs. This leaves fewer resources to be used to make products whose prices are lower or falling. The same is true of most products. In this way, consumers get what they want. This is known as the price mechanism.

Price elasticity of demand

Producers need to know by how much demand for their products will change, given a change in market price. The measure of responsiveness of quantity demanded to a change in the price of a good or service is referred to as price elasticity of demand.

The price elasticity of demand for a good or service can be measured in two ways:

1. By comparing the percentage change in quantity demanded to the percentage change in price that caused it

2. By observing what happens to sales revenues following a change in price

Demand for a product is price elastic if:

• The market demand curve is relatively flat

• The % change in demand is more than the % change in price

• A rise in price reduces revenues

• A reduction in price increases revenues

Demand for a product is price inelastic if:

The market demand curve is relatively steep

• The % change in demand is less than the % change in price

• A rise in price raises revenues

• A reduction in price reduces revenues

Demand for a product is of unitary elasticity if:

• The % change in demand is exactly equal to the % change in price

• Revenue remains the same whether the price has been reduced or increased

Factors which affect price elasticity of demand:

• If the product is a necessity. Basic food staffs are necessary for human survival. The demand for such products as bread and flour tends to be relatively price inelastic.

• How many substitutes a product has. When consumers are able to choose between a large number of substitutes for a particular product, demand for any of them is likely to be price elastic. Demand will tend to be price inelastic where there are few substitutes. Much advertising is aimed at promoting a brand image that suggests the advertised product has few close substitutes.

• How long a consumer takes to search for alternative products. Demand for any product is likely to become more elastic in the long run.

• The proportion of income spent on a product. Goods and services tend to be price inelastic if they are relatively inexpensive and account for only a small proportion of the average consumer's budget. On the other hand, demand for high-cost, luxury items tends to be price elastic. If the percentage change in demand exceeds the percentage change in consumer income that caused it, demand for that product is said to be income elastic. If the percentage change in demand is less than the percentage change in income, demand is said to be income inelastic.

Price elasticity of supply

Price elasticity of supply measures the responsiveness of supply to a change in price. Supply is said to be elastic if a change in price causes a larger proportionate change in quantity supplied of a given product.

At any given moment in time, the market supply of a product will be fixed. No more can be supplied whatever the product price. If there is a sudden increase in demand, producers will only be able to supply more in the long run, not in the short run, because of limited stocks and resources. That is why supply is said to be fixed regardless of price at any moment in time; it is said to be price inelastic in the short run; and it is said to be price elastic in the long run.