Market equilibrium Essay

1. Demand

Demand for a particular commodity refers to the amounts of it that consumers are prepared to purchase within a specific time period given its price and a set of other economic conditions. These conditions are primarily the relative prices and extent of availability of related products, incomes of the consumers, tastes and preferences and expectations regarding these conditions of the consumers. Demand for a good can stem from two purposes – direct consumption or usage as input.

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1.1  Direct Demand:

The demand that is generated out of purpose of direct consumption is known as direct demand. If Consumers gain utility from direct consumption of a good it will be demanded for direct consumption. The amount of satisfaction that the good in question generates, or in other words, the utility that the consumers derive from consuming the good, determines the amount of direct demand for it.

 

1.2  Derived Demand

The demand for goods and services that are used as inputs in the production of any commodity is critically dependent upon the demand of the commodity itself and is hence referred to as derived demand. The Derived demand for a good comes not from direct consumption purposes but rather due to its use as means to obtain other goods and services. Accordingly, the magnitude of derived demand for a good depends upon the demand of the good from which its demand is derived. Derived demand for an input is crucially dependent upon its relative cost benefit features for the producing house. If the marginal benefit of using a particular input is higher than its marginal cost, demand for that input shall rise.

 

 

1.3 Market Demand Function and the Determinants of market demand

The market demand function is the function that depicts the relation ship between the total quantity demanded of a good in a market and the factors affecting this demand.

This kind of function looks like:

 

Qy = f (Py, Px, I, …)

Where, Qy stands for total Quantity demanded of product Y; stands for the price of Y, Stands for price of any related good X, I represents the total income of the consumers. There can be a multitude of other factors that influence the market demand of good Y, such as, tastes and preferences of the consumer, expectations, advertisement etc.

For instance, suppose the market demand function for domestically manufactured Computers takes the following form:

 

Q = – 10P – 4 Px +5 Py  + 9I + 2A

 

This implies the total market demand Q linearly depends upon own price, prices of related goods, disposable income of households and advertising. It falls by 10 units for a unit increase in own price, falls by 8 units due to a unit rise in price (Px) of a very closely related complement (A UPS for instance), rises by 5 units for unit rises in price of imported computers (Y)., rises by 9 units for unit rises in disposable income of households (I) and rises by 2 units for unit increases in effective advertising (A). The coefficients of the variables are the parameters of the demand function and these quantitatively capture the extent to which demand is influenced by the corresponding variable.

 

1.4 Firm Vs Industry Demand

Market demand functions differ for individual firms and industries. The main cause behind this is the simple fact that for individual firms, other firms belonging to the same industry are rivals. So, advertising that positively impacts demand for a rival’s product while negatively influences the market demand for an individual firm, from the perspective of the industry demand such advertising has positive impacts provided it contributes in increasing in over all demand for the industry. Industry market demand therefore is concerned with overall demand, i.e, the sum of individual firms’ demands. Although the same factors influence both industry as well as firm demand, the impacts are different. As a result, although the same variables are likely to be included in the firm as well as industry demand, the values of the parameters shall differ.

1.5 Demand Curve

The demand curve is essentially a diagrammatic exposition of the demand function. However, here the effects of all other variables apart from the own price are held constant so that the demand curve depicts the relationship between the quantity demanded and price of a product. Consider once more the demand function for domestically produced computers. To derive the demand curve from it, all variables apart from P have to be held constant. For simplicity if we assume all the other variables to be unity, then the function becomes

Q = – 10P – 4 + 5   + 9 + 2 => Q = 10 – 10P

This relation ship can be alternatively expressed as: P = 1 – 0. 1Q

This is known as the inverse demand function and it expresses the price of the product as a function of its quantity demanded. It is common practice to use this form to draw the demand curve.

Putting Q = 1, 2, 3, 4 respectively we get P = 0.9, 0.8, 0.7, 0.6

Joining these points we get the demand curve.

Essentially, the linear demand curve takes the form of Q = A – B.P, where A, B are parameters of the relation. A represents the intercept while the negative of B represents the slope.

 

1.6 The Demand Curve and the Demand function

The demand function and the demand curve are interestingly related. For changes in values of P, quantity demanded changes and as a result, we move along the demand curve. For changes in the other demand determining factors that were held constant, however, quantity demanded changes at each price and thus there is a change in demand. Diagrammatically this implies a shift in the demand curve. For instance, if there is a rise in disposable income, at the same prices households are likely to demand more of the product in question. So, there shall be an outward shift in the demand curve.

2. Supply

Supply refers to the amount of a particular commodity the producers are willing and able to sell at a given price and a set of conditions in a particular period of time. Apart from the price of the good itself, this set of conditions is comprised mainly of factors such as the state of technology, input prices, weather conditions etc. The total market supply is made up of individual firms’ supplies. The amount supplied by individual firms essentially depends upon the profit maximization principle. The firms go on increasing their outputs as long as the marginal benefit of producing more is greater than the marginal cost of producing more.

2.1 Output price and supply

Price of a product and its supply in general are directly related. An increase in price causes a rise in the amount supplied. The rise in price, given everything else remains unchanged implies an increase in the marginal benefit of producing more and thus an increase in output results. Similarly, a reduction in prices, given all other things remaining the same implies a reduction in revenues and thus profitability. This can be alternatively interpreted as a decline in marginal benefits relative to the marginal costs. Accordingly there is a decline in output producers are willing to sell.

2.2 Other factors influencing supply

Among other factors, state of technology plays a key role in determining the amount supplied. Technology essentially determines the amount of output that is producible from a given amount of inputs. So, for advancement in technology the amount of output producible at the same costs increase as a result of which producers can supply more units at the same prices.

An important determinant of market supply is the price of inputs. These determine the cost of production and thus for a rise in input prices marginal costs of raising output increases and thus there is a decline in the supply. For a reduction in input prices the opposite happens.

Weather conditions play a crucial role in determining the supply of agricultural products or products that intensively use agricultural raw materials.

 

 

 

2.3 Market supply function

The market supply is essentially the sum total of all the individual firms’ supplies. The market supply function is a function that depicts the relationship between the total output that is supplied and the factors that determine the supply.  We can get general forms as well as assume hypothetical linear forms for the supply function as was done in case of the demand function. However it has to be remembered that the variables shall have opposite effects on supply. For example the price the product itself shall have a positive coefficient implying the direct relationship between quantity supplied and the price. Again, input prices shall negatively affect the supply of a good and thus variables like wages and prices of other raw materials shall have negative coefficients.

2.4 Firm Vs Industry Supply

As in case of market demand, although firm and industry supply functions include the same set of variables, the relative impacts of these variables, as captured in the values of the coefficients shall be different. Moreover since industry supply is the aggregate of the individual firm level supplies, the industry supply shall be higher than firm supply, provided there is more than one firm in the industry. However, in the extreme case of having a number of firms that are identical to one another from all perspectives including choices of technology, hired workers in identical patterns, and actually in short faced the same profit maximizing problem so that optimal output choices for each would be identical, the firms and industry would have supply curves with same coefficients and the industry supply would be a simple multiple of an individual firm’s supply.

 

 

2.5 The Supply curve

The supply curve is a graphical representation of the relationship between the quantity supplied and the price of the product, and to arrive at this relationship, as in the case of demand, all other independent variables in the supply function apart from own price are held constant. The relationship then assumes the form

Q = C + DP with C and D being the parameters. Here D represents the slope while C represents the intercept. Observe, that quantity supplied is positively affected by prices is captured in the positive sign of the coefficient D.

 

 

 

2.6 Supply curve and Supply function

The relationship between supply curve and supply function is also similar to the previously depicted relationship of the demand curve and demand function. For price changes, other things remaining the same the quantity supplied changes and we move along the supply curve. However for changes in other supply determining factors like technology or input prices, as already mentioned, at the same prices a different amount of the product is offered by sellers and as a result, the supply changes, i.e, the supply curve shifts.

3. Market equilibrium

Market equilibrium is attained at that price for which the market demand and the market supply are equal. Point e1 represents market equilibrium with Qe being the amount supplied as well as demanded by the market at a unit price of Pe. If price is higher than the equilibrium price, at P2 say, the amount supplied shall exceed the amount demanded. Here we have a surplus. Due to this excess supply, the price will fall to the equilibrium level and the quantity demanded shall equal the quantity supplied. Similarly, for a lower price, say P1, the amount supplied shall fall short of the amount demanded and we shall have a deficit. Due to the pressure of excess demand, price will rise up and go on rising until the amount of demand equals amount of supply.

Now, for changes in price, we move along the demand and supply curve. But for changes in the other determinants of demand or supply, the corresponding curve shifts. For example, suppose there is an increase in the disposable income of households. So, the demand curve will shift outwards to D2 and the new equilibrium shall be point e3. Again suppose instead of an increase in income, there is an improvement in technology. The impact shall be of more goods being available at the same prices reflected in a right ward shift of the supply curve to S2. Then the new equilibrium point shall be e2. However if both these changes occur simultaneously, then both the demand as well as supply curves shall shift and the new equilibrium point will shift to e4, the corresponding price and output being the equilibrium output and price.

 

Reference:

Hirschey, Mark (2005) Managerial Economics, South-Western Pub

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