The external influences on the firm: - Here we are referring to the various factors that affect the firm that are largely outside its direct control. Examples are the competition it faces, the prices it pays for raw materials, the state of economy (e.g. whether growing or in recession) and the level of interest rates. Businesses will need to obtain a clear outstanding of their environment before they can set about making the right decisions.
The price mechanism: -
In a free market individuals are free to make their own economic decisions. Consumers are free to decide what to buy with their incomes: free to make demand decisions. Firms are free to choose what to sell and what production methods to use: free to make supply decisions. The resulting demand and supply decisions of consumers and firms are transmitted to watch other through their effect on prices: through the price mechanism.
The price mechanism works as follows. Prices respond to shortages and surpluses. Shortages cause prices to rise. Surpluses cause prices to fall. If consumers decide they want more of good (or if producers decide to cut back supply), demand will exceed supply. The resulting shortages will cause the price of the good to rise. This will act as an incentive to producers to supply more since production will now be more profitable. At the same time, it will discourage consumers from buying so much. The price will continue rising until the shortage has thereby been eliminated.
If on other hand consumers decide they want less of a good (or if) if producers decide to produce more, supply will exceed demand. The resulting surplus will cause the price of the good to fall. This will act as a disincentive to producers, who will supply less, since production will now be less profitable. It will encourage consumers to buy more. The price will continue falling until the surplus has thereby been eliminated.
The price, where demand equals supply is called the equilibrium price. By equilibrium we mean a point of balance or a point of rest: in other words a point towards which there is a tendency to move. The same analysis can be applied to labour (and other factor) markets, except that here the demand and supply roles are reversed. Firms are the demanders of labour. Households are the suppliers. If the demand for a particular type off labour exceeded its supply, the resulting shortage would drive up the wage rate. (i.e. the price of labour), thus reducing firms, demand for that type of labour and encouraging more workers to take up that type of job. Wages would continue rising until demand equalled supply: until the shortage was eliminated.
Likewise if there were a surplus of a particular type of labour, the wage would fall until demand equal supply. As with price, the wage rate where the demand for labour equals the supply is known as the equilibrium wage rate. The response to demand and supply to changes in price illustrates a very important feature of how economics works.
The effect of changes in demand and supply: -
How will the price mechanism respond to changes in consumer demand or producer supply? After all the pattern of consumer demand changes over time. For example people may decide they want to downloadable tracks and fewer CDs. Likewise the pattern of supply also changes. For example changes in technology may allow the mass production of microchips at lower costs, while the production of hand-built furniture becomes relatively expensive.
In all cases of changes in demand and supply, the resulting changes in price act as both signals and incentives.
A change in demand: -
A rise in demand is signalled by rise in price. This then acts as an incentive for firms to produce more of the good: the quantity supplied rises. Firms divert resources from goods with lower prices relative to costs (and hence lower profits) to those goods that are more profitable.
A fall in demand is signalled by fall in price. This then acts as a incentive for firms to produce less: such goods are now less profitable to produce.
A change in supply: -
A rise in supply is signalled by a fall in price. This then acts as an incentive for consumer to buy more: the quantity demanded rises. A fall in supply is signalled by a rise in price. This then acts as an incentive for consumers to buy less: the quantity demand falls.
Conclusion: -
If the demand for a good exceeds the supply, there will be a shortage. This will lead to a rise in the price of the good. If the supply of a good exceeds the demand, there will be a surplus. This will lead to fall in the price. Price will settle at the equilibrium. The price equilibrium price is the one that clears the market: the price where demand equals supply. This is shown in a demand and supply diagram by the point where the two curves intersect. If the demand or supply curves shift, this will lead either to a shortage or to a surplus. Price will therefore either rise or fall until a new equilibrium is reached at the position where the supply is reached at the position where the supply and demand curves now intersect.
