Demand is the total quantity of a good or service wanted at a given price over a period of time (lecture note). From the demand curve we can see that there is an inverse relationship between the price of a product and the amount of demand for this product. The higher the price, the lower the demand and the lower the price, the higher the demand while others things unchanging. This is called “the general role of demand”, which can be explained further by the income effect and the substitution effect (lecture note). The income effect refers to that the lower the price of a product, the more a consumer can afford, and this becomes especially true with products that take up a significant percentage of a consumer’s budget. The substitution effect refers to that the lower the price of a product, the better value that product becomes compared to any possible alternative products. Take a simple example, if the price of gas falls, it becomes a better value way of cooking compared with electricity.
Price is not the only thing determining the demand, there are many other factors that can affect the demand such as consumer preferences, the number and prices of substitute goods and complementary goods, the level and distribution of incomes, expectation of future prices and the number of consumers (lecture note). But also these factors can affect the change of demand, which can only be found out through the change of prices.
Just take another example, suppose that, there are less wood used in producing papers, then there will be less papers produced. What will the consumers find is that the prices of books, newspapers and other things made of papers rise. That is because the supply of papers is in shortage, so people have to pay more to get papers. On the other hand, if there are more papers produced, the prices will surely go down.
Supply is the total amount of a good or service offered by the producers at a given price over a period of time (lecture note). As the supply curve shows, there is a positive relationship between the supply of a product and its price, while other things do not change, if its price rises, the supply will increase. That is because the only objective of producers is to make profits. The rise of the price means a greater possibility of making greater profit, so the existing producers will produce more and news firms will be interested in joining this market where there is an increased profit opportunity. Of course, there are some other determinants of supply such as profitability of alternative products, profitability of goods in joint supply, natural factors, aims of producers and expectations of future prices (lecture note). As the same as demand, the information about the change of supply can only be transmitted through the change of prices.
But prices are not determined simply by only demand and supply. From 1st, November 2002, the cost of make a call to China from U.K. would increase by about 7 times more than the previous cost. That is not because people want to make more calls to China or the amount of the calls would be controlled to fall for some other reason. The only reason is that China Telecom, who provides the only network foreign calls can use, decided to raise the price. So we can see that prices can change because of monopoly. What is more, sometimes the government will force the prices to change for some reason and the erratic inflation will also make the prices to rise.
Prices can transmit information, but this is only one of its three functions, another one of its functions is to provide an incentive to adopt those methods of production that are least costly and thereby use available resources for the most highly valued purposes (see “The role of prices”). In economics, we recognize the vital role that prices play in allocating scarce resources. Depending on the prices of products, we do or do not demand them. This dictates the amount of resources that are then used to produce each product (Colin G.Bamford & Stephen Munday (2002)). The central economic problem is the problem of scarcity. It is worth noting an important result due to John Sloman (2001). What he shows is the reason for scarcity: human wants are virtually unlimited, whereas the resources available to satisfy these wants are limited, so scarcity can be defined as ‘the excess of human wants over what can actually be produced’. There are three kinds of resources. The first are land, the natural resources such as soil or woods. The second are labor referring to the human resources used in productions. The third are capital, which means the resources that are the result of human action investment.
Then, why is the information important to the efficient allocation of scarce resources? In his book called “An inquiry into the Nature and Causes of Wealth of Nations”, Adam Smith shows that though a person intends always only his own gain, and he is in this, as in many other cases, led by an “invisible hand”(prices) to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of society more efficiently than when he really intends to promote it.
Suppose that, the amount of copper left in the mines is very little, what will the producers who produce things made of copper do? Of course the cost of the production will rise, so they have to use less copper in the production. One way is to reduce the output, but that will also reduce their profit, so a rational way they will choose is to reduce the waste of copper in production. What is more, they will try to find new technologies that can help reducing the amount of copper used in each production or other materials to take the place of copper in production.
Just take the first example given above one step further. If the demand of that particular clothes increases, and the demand of Western-style clothes decreases, then the producers will employ more workers to produce this first kind of clothes, and where are these workers from? They are probably from the department producing Western-style clothes. This is called “shift of labor”. And the producers will also increase the input in producing the clothes of Tang Dynasty to buy more machines, train new workers and any other things that can be called “capital” in all. On the other hand, they will spend less in other productions.
As a conclusion, what I want to say is prices is the only way to transmit the information in market. It is not perfect as the market is not perfect, but it is the best way through which people get information and allocate the scarce resources efficiently. What people should do is try to make prices expressing freely the condition of demand and supply.
●References:
Friedman,M. & Friedman,R. (1980) Free to Choose. Pelican Books, Harmondsworth, Middlesex, England
Pascal Petit.ed.(2001) Economics and Information. Kluwer Academic Publishers. Dordrecht, Netherlands
John Sloman (2001) Essentials of Economics. 2ed ed. Person Educational Limited. Essex, England
Colin G.Bamford & Stephen Munday. (2002) Markets. Heinemann Educational Publishers. Oxford, England