Explain what supply and demand curves indicate. Show how they can be used to reveal how a market clears.

P= Price of the good

Ps/c= Price of substitute or complimentary goods

C= Cost of factor inputs

T= Technology

E= Business Expectations

N= Number of suppliers

There is always a positive relationship between the price and quantity supplied illustrating how they are directly related. The chart which follows using a chocolate bar as a physical example shows how quantity supplied increases when the price per bar increases. This is because firms are eager to sell at higher prices and generate extra revenue, thus increase their supply of products to the market.

The reason for the interaction of quantity supplied and price in this instance lies in the chocolate bar suppliers desire to maximise profits. When the price rises the supplier has an incentive to increase production because they can justify higher costs to produce the product, increasing the potential to earn larger profits. It is essential to distinguish between a movement along a supply curve and a shift in the supply curve. A change in price results in a movement along a fixed supply curve, which is also referred to as a change in quantity supplied. For example, if the price of the chocolate bar rises from £0.30 to £0.40, then the quantity supplied rises from 80 to 120 units. A change in any other variable that influences quantity supplied produces a shift in the supply curve or a change in supply.

Demand curves show the relationship between price and quantity demanded holding 'other things' constant. The law of demand states that, if all 'other factors' remain equal, the higher the price, the less people will demand a good and vice versa. Consumers will buy less at the higher price because as the price of a good goes up, so does the opportunity cost of buying that good. People will naturally be hesitant towards buying a product that will force them to forgo the consumption of something else they value more. The chart on the following page again using chocolate as an example shows the negative relationship between price of chocolate bar and the quantity demanded, larger quantities are demanded at lower prices.

The slope of a demand curve is always negative depicting the relationship between price and quantity demanded. Again it is essential to distinguish between a movement along a demand curve and a shift in the demand curve. A change in price results in a movement along a fixed demand curve. This is also referred to as a change in quantity demanded. For example, an increase in the price of the chocolate bar from £0.30 to £0.40 will reduce quantity demanded from 80 to 40 bars. A change in any other variable that influences quantity demanded produces a shift in the demand curve or a change in demand.

Market equilibrium is illustrated by the intersection of the supply and demand curve; it is at that point that the market clears. In the chocolate bar example is at a price of £0.30 at which 80 bars are transacted. At any other price the quantity traded is the smaller of the quantity demanded and the quantity supplied. The chart below illustrates the equilibrium point at which supply meets demand.

.

At the equilibrium point, every consumer who wishes to purchase the product at the market price is able to do so, and the supplier is not left with any unwanted stock. More often than not, markets are not in equilibrium. Shortages and surpluses of products are very common in today's economy, it is up to the business owner's judgements or trial and error to eventually settle on a price that equates the forces of supply and demand. Excess supply and shortage of supply are illustrated by the graphs below.

When incomes rise the demand for most goods increases. Typically, consumers will buy more of everything. However there are exceptions. For a normal good, demand increases when incomes rise, for an inferior income elastic good demand falls when income rises. Because a consumer's demand for goods and services is hampered by income, higher income levels allow the consumer to purchase more products shifting the curve to the right. Correspondingly, a decrease in income shifts the demand curve to the left. As their name suggests most goods are normal goods.

Income elasticity of demand measures the relationship between a change in quantity demanded and a change in income. The basic formula for calculating the coefficient of income elasticity is:

Percentage change in quantity demanded

The percentage change in real consumers' income

Normal goods have an income elasticity of greater than 1 (positive) so as income rises more is demand at each price. If consumers' income increases then firms in which sell income inelastic goods may try and exploit this fact and raise prices, with the aim of generating extra revenue, but this depends on the degree to which they are income inelastic. The graph which follows illustrates clearly the shift in the demand curve as a result of an increase in income.

As can be seen above each time income increases so does quantity demanded. This creates a new equilibrium price level as the supply curve does not shift. In this case the price has risen from £9 to £10 then £10 to £11. Quantity supplied has risen from 7 000 to 8 000 then 8 000 to 9 000.

A technological advance is any idea that allows more output from the same inputs as before. A technological advance shifts the production possibility frontier outwards and will shift the supply curve to the right since producers will supply a larger quantity than previously at each price, the graph below illustrates this. With reference again to my chocolate example an improvement in cocoa refining makes it possible to produce more chocolate for any given total cost. Faster shipping and better refrigeration may lead to less wastage in cocoa beans. A technical improvement that affects all firms will shift the industry supply curve down and to the right. This lowers equilibrium price and raises output. The increase in supply could bring about lower prices which is good news in the eyes of the consumer. As can be seen in the graph below every time the supply curve shifts to the right due to technical progress, a new equilibrium price level occurs. Demand stays the same which could lead to 'price wars' between firms, which is good news for the consumer as they are likely to get the same product if not a 'technically improved one' for a cheaper price.

The graph above illustrates both the shift in supply due to technical progress and shift in demand due to increases in income. Notice that the technical progress line is straight, this is due to the presumption that the advance is not a 'one off' and that it will continue to progress over time.

We now have the information necessary to answer some of the questions presented at the beginning of this document. Why does a doctor earn £40 000 per year when some professional footballers earn £10 million per year? Isn't health more important than sport?

The number of doctors in the U.K. is fairly high. Thousands of students go on to be doctors after completing the relevant degree. In contrast, star footballers such as Beckham and Ronaldo are extremely rare and only come along every so often. This noticeably small supply of such superstars, coupled with a high demand for their services, allows them to command enormous salaries. Is it fair that doctors are paid such small salaries incomparison to the footballers? Many doctors may not think so, but again, life is not always fair.

498 Words

30 Paragraphs

References

Cook and Faquuharson- Business Economics, 4th edition, Pitman Publishing, 1998.

John Sloman- Economics, 5th Edition, PEARSON Education Ltd, 2003

Steven E. Landsburg- The Armchair Economist: Economics & Everyday Life, New York: Free Press, 1993

www.bized.ac.uk- Accessed on 12th March 2004

www.onlinetexts.com- Accessed on 12th March 2004