A2: Unit 3 - The demand for labour and the elasticity of labour

Demand for labour:

•     Derived demand: Demand for labour. Not wanted as an end product but rather for the process. Rise in demand lead to increase of workers.
•           Aggregate demand for labour: Demand for labour depends on level of economic activity. If economy is growing and firms +confident for continuous growth > employment levels increase. If economy is declining; firms –confident therefore fall in employment levels.
•        Individual firm’s demand for labour: No. of workers that firm employs also depends on:
• Price of Labour: Rise in wage rates > rise in labour productivity = raise unit labour costs; contraction in demand for labour.
•    Productivity: Output per worker per hour increase, more attractive labour becomes.
•    Price of other factors of production: If capital becomes cheaper, e.g. firms may substitute some workers with machines.
• Supplementary labour costs: E.g. increasing employers National Insurance contributions will lead to a fall in demand for labour.

*Change in last 3 factors will lead to a change in the quantity of labour demanded at given wage rate.

•           Marginal productivity theory of labour: Demand for workers depend on Marginal revenue product; cost of taking on additional unit of labour = MRP; establishes equilibrium quantity of labour employed. Whereas Marginal product of labour is number of extra units of output a firm gains from employing an additional worker.  
• Short run; firm takes +1 workers > out rises at first (because increasing returns due to benefit of division of labour)
•    After x amount of employment reached, marginal product tends to fall because of onset of diminishing returns.
• MRP is the addition to firm’s revenue from employing additional worker. Calculated by multiplying workers marginal product (MP) by marginal revenue (MR): MRP = MP * MR

•        *With perfect competition in product market; firms become price taker. Price of output does not change if it sells more > marginal revenue = price. Firms can sell all its output at the ruling market price. Assuming perfect competition in labour market; firms can recruit workers at constant wage rate.
• The marginal revenue product of labour curve. Shows marginal revenue product and equilibrium quantity of labour employed; or basically the quantity of labour demanded at each wage rate.

• Shifts in demand curve for labour: Demand curve for labour will shift right if MRP of labour increases due to increase of marginal product of labour and/or marginal revenue.
 
•   E.g. Demand for car assembly workers increase if productivity of car assembly workers rises > perhaps from +training and/or price of their output rises due to rise in demand for cars.
•       Measuring MRP: In reality is difficult because hard to isolate the contribution to output made by individual worker (work tends to be done in teams).

 

The elasticity of demand for labour:

•           Elasticity of demand for labour:  measure responsiveness of quantity demanded of labour to changes in the wage rate; formula:


•   Elasticity of demand for labour = % change in Q of labour demanded / % change in wage rate
• E.g. elasticity of demand for labour = 5, wage rate +10%; demand for labour would fall by 50%
• E.g.2 If demand for labour -10%, wage rates +100%, elasticity of demand = 0.1 (inelastic.)
•          Factors determining elasticity for labour:
• Time: Long run easy to substitute labour for other factors of production vice-versa. Short run; firms may not have time to re-organise operations therefore employ same no. of workers even if wage rates increase. Elasticity of demand for labour will be higher in long run.
•    Elasticity of demand for the product: Labour is derived demand > collapse in demand for e.g. tin > collapse in demand for tin miners. If elasticity of demand for product is low, reduction in demand for it will have little effect on employment in industry.
• Availability of substitutes: Easier to substitute other factors of production of labour; more rise in real wage rates will lead to a firm replacing labour with machines. E.g. relatively easy to replace production line workers with automated capital equipment. If a lot of good substitutes then elasticity of labour will tend to be high.
•   Proportion of labour costs to total cost: Larger proportion of labour cost to total cost; higher elasticity of demand for labour. Because +wage bill > +impact on total costs.
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AS: Unit 1 - Maximum and Minimum pricing, Zero Pricing

In this post we will learn:

1.  Maximum pricing / Price ceilings
2.  Minimum pricing / Price floors
3. Zero pricing

 

Maximum prices

 

Maximum prices may be defined as a price ceiling whereby price of a good or service is not allowed to exceed. It usually below the free market equilibrium price (Pe).

Suppliers therefore are no longer allowed to charge the market price and is forced to meet the maximum price ceiling set by the government.

However this contributes to excess demand (Q2 to Q1) as suggested by the Law of Demand, the lower the price, the higher the demand HOWEVER at 'Pmax' suppliers are not willing to supply what is demanded at 'Q1' and is only willing to supply at 'Q2' thus there is excess demand.

 

Maximum prices may be imposed by the government in an attempt to prevent the market price from rising above and beyond a given amount; for example to prevent the monopolistic exploitation of consumers.

 

Impact (evaluation)

• Can result in a underground market whereby maximum prices is evaded targeting those who are prepared to paid more (to satisfy excess demand) promoting illegal criminal activity. Higher prices therefore act as a device for rationing.
• May lead to corruption and bribery in regulation
• Maximum price above the equilibrium will contribute no effect thus may be considered as Government failure (as government administration costs will exceed the 'benefits')

Minimum pricing

 

Minimum prices may be defined as a price floor whereby price of a good or service is not allowed to go below. It usually above the free market equilibrium price (Pe).

Suppliers therefore are no longer allowed to charge the market price and is forced to meet the minimum price floor set by the government.

 However this contributes to excess supply (Q3 to Q1) as suggested by the Law of Supply, the higher the price, the higher the supply HOWEVER at 'Pmin' consumers are not willing to pay what is supplied at 'Q1' and is only willing to pay at 'Q3' thus there is excess supply.

 

Minimum prices may be imposed by the government I an attempt to prevent the market price from falling beyond a given amount; for example to prevent over consuming of  a demerit good. 

 

Impact (evaluation)

• Prevents the market from working efficiently therefore may lead to further misallocation of resources.
• Minimum price below the equilibrium will contribute no effect thus may be considered as Government failure (as government administration costs will exceed the 'benefits')

Zero Pricing

This illustrates the effect of the market when a  good is produce free at the point of use. This suggests a market price of 0. For example the NHS health care (though we 'pay' for it through taxation it is free at point of use). However demand for this service will most likely lead to excess demand (Q2 - Q1) thus disequilibrium resulting in waiting lists.

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A2: ESSAY Unit 3 - ECON 3 Distribution of income made more equal solely through progressive taxation and transfers? (25 marks)

Here I have attached my essay answer for this question; it is graded an A. Remember a good essay needs a balance of knowledge, application, analysis, and evaluation. My essay isn't perfect but I hope you can benefit from it nevertheless. This is a distribution of wealth and income question where you argue government policies for a more equal distribution. Questions like these are excellent opportunities for you to include real life application! *please do not repost without credit, thanks!

Do you agree that the distribution of income should be made more equal solely through the use of progressive taxation and transfers? Justify your answer. (25 marks)

Progressive taxation is when the proportion of income tax increases as income increases thus the marginal rate of tax is greater than the average rate; this enables a more equal distribution of income. However criticism could be made for the progressive taxation policy and there are other policies which may aid in a more equal distribution of income such as the national minimum wage and government supply-side schemes to improve education and training

Firstly progressive taxation closes the wealth gap as when income increases so does the tax rate. For example in the UK the lowest band with earnings up to £32,000 are taxed at 20% whereas the highest income band earning over £150,000 are taxed at 45%. Consequently this redistributes income with more equality and gives the government higher tax revenues, some transferring in the forms of welfare spending therefore closing the income and wealth gap. However, it can be argued that it is unfair for the higher income earners to be taxed harshly only for their income to be distributed to lower income earners as welfare benefits. This may create disincentives for people to aim for high income jobs or become entrepreneurs, typically requiring greater skill and qualifications, as a large quantity of the income will be taxed away; by extension this will decrease the UK’s competitiveness and wealth compared with other countries in the long run. Thus it can be considered that progressive taxation and transfers should not be the sole instrument for a fairer distribution of income. A system of regressive taxation maybe considered for example VAT where the tax added on items is fixed (currently at 20%) for all income earners, though this may be considered unfair to the low income earners. Progressive and regressive taxation discourages the equity concept whereby distribution is fair and just as it can be argued that for example a window cleaner should not be earning as much as a surgeon thus progressive taxation can be considered as not a fair system. However equity carries a value judgement as there may be conflicting opinions on what ‘fair’ is.

 

The National Minimum Wage must also be considered; in the UK the NMW is currently at £6.31 per hour for those who are aged 21 or over. Higher income will suggest higher tax revenues and national insurance contributions for the government. This policy suggests that all workers must be paid a bare minimum of £6.31 (a substantial increase since the introduction of the national minimum wage at £3.60 per hour in 1999) and therefore closes the income gap. Additionally the national minimum wage will further encourage more unemployed workers to work at the increased going wage rate thus will reduce workers falling into the unemployment trap (whereby benefits outweighs thus erode any motivation to go to work). As illustrated in the diagram above, the national minimum wage will increase wages from ‘W’ to ‘NMW’ however this illustrates there is trade-off between higher wages and employment, as firms are unwilling to hire more than ‘Q1’ at the ‘NMW’ wage rate and as more workers are willing to work at the ‘NMW’ rate results in excess supply as illustrated. Therefore higher wages can only be achieved at the cost of unemployment (Q2 to Q1).  However this will also give firms incentives to raise the productivity of employees if they must pay the minimum wage. A high minimum wage can also cause price inflation as it increases the costs to firms who then may pass on the higher cost in wages to higher prices for consumers thus results in cost-push inflation.

Government supply-side schemes promoting education and training may also be considered. For example, the government may implement training schemes to improve teaching which will lead to better education and in the long run a more educated population with greater skills and qualification which will reduce likeliness of different wages arising from very skilled and unskilled workers thus resulting in a more equal distribution of income. Other government schemes may also be considered, such as awareness campaigns illustrating the positive spill overs of merit goods such as education which will encourage people to work harder, for example in the long run better education will suggests a more prestigious high status job in the future which will also benefit the economy and contribute to economic growth.

Overall progressive taxation can be considered strong instrument in the fairer distribution of income and wealth. However this policy does not follow the concept of equity and therefore can be considered unfair. Furthermore it may cause disincentives for people to work harder for higher income jobs as a larger percentage will be taxed away thus will decrease the rate of growth of the economy and therefore weakening the international competitiveness in the long run. Thus cannot be considered the sole policy to distribute income more fairly. Other policies such as the national minimum wage can be considered as it immediately minimises the income gap in the short run. Furthermore it will encourage unemployed workers to find work however as the supply of labour increases with the higher wage rate, the demand of labour from firms will be reduced due to higher costs thus promotes unemployment. Cost push inflation may also occur if the pressure for higher wages gets passed onto to the customers by higher prices. Education and training supply-side reforms may perhaps be the best way to distribute income more fairly as it gives the opportunity of ‘unskilled workers’ to be trained thus allows more job opportunities which may enable access to better paid jobs in the long run resulting in a more equal distribution of income, though it must be considered that supply-side polices are a long run phenomenon. Overall, the best solution to a more equal distribution of income may be the combination of several policies simultaneously.

A2: ESSAY Unit 3 - ECON 3: Do you agree that large firms are always better than small firms? (25 marks)

Here I have attached my essay answer for this question; it is graded an A. Remember a good essay needs a balance of knowledge, application, analysis, and evaluation. My essay isn't perfect but I hope you can benefit from it nevertheless. This is essentially a Monopoly vs. Perfect competition essay and there is a lot to talk about. Please note I did not do this in timed conditions. *please do not repost without credit, thanks!

Do you agree that large firms are always better than small firms? Justify your answer. (25 marks)

 

Large firms can experience certain advantages that small firms cannot achieve thus can be argued to be better; however this may not always be true as they may also face disadvantages for example from diseconomies of scale. Furthermore the market is fundamental to determine if large firms are better than small firms, as perfectly competitive and monopoly markets varies the advantages and disadvantages of being a small or large firm.

Large firms tend to benefit more due to several factors from economies of scale; this means that the firm can benefit from falling average costs in the long run – however small firms cannot achieve such benefits. For example purchasing benefits whereby large firms are able to bulk buy raw materials as they are producing on a larger scale thus are able to receive discounts and therefore reducing production costs. Or they may experience technical economies whereby investment in more advanced machinery or larger premises will allow firms to experience increasing returns to scale where output is greater than input thus improving productive efficiency through division of labour and specialisation resulting again in lower costs. Economies of scale can be illustrated in diagram 1, whereby when output increases (Q to Q1), cost decreases (C to C1). Minimum efficient scale is illustrated at the constant part of the LRAC labeled QA firms are operating at the optimum point experiencing constant long run average costs where economies of scales are exhausted; the firm therefore is operating at long-run productive efficiency. This is the reason why large firms are considered to be better than small firms. However as the LRAC curve rises; large firms will experience diseconomies of scale. For example as a firm grows control becomes more difficult, monitoring productivity of each worker in a large firm will become more challenging thus may result in a loss of productive efficiency and therefore rising average costs. Additionally coupled with poor communication and co-ordination due to increasing size of firms increasing average costs are accelerated. Furthermore as large firms are often public limited companies ownership and control is often divided among a group of shareholders thus control over the firm is not subject to one person and instead are run by several directors who carry the interest of the shareholders. This makes management over large firms more difficult as negotiations and meetings are needed to carry out various operations thus reducing the efficiency of the firm whereas small firms are usually owned by one person thus management and decisions are able to be made swiftly. Also communication and co-ordination in small firms are much easier to manage and is less costly due to smaller amount of factors of production. In this sense, small firms can be argued to work more efficiently than large firms.

 

 

 Some large firms strive for monopoly market power therefore enjoying greater market power and influence thus larger profits which may be used to finance and promote innovation can result in dynamic efficiency and therefore economic growth. Additionally it enables them to obtain supernormal profits however this is impossible for small firms to achieve. This is illustrated in diagram 2 where profit maximisation occurs at MC=MR output ‘Q’, ATC is ‘Pn’ however monopolists will charge ‘Ps’ exploiting consumers at the point of demand thus will make supernormal profits illustrated in the shaded region of the diagram.  Monopolies are also able to protect their market position through the use of entry barriers. However monopolies are very rare thus such a market is not very likely to occur in the real world. Furthermore at the point of supernormal profits monopolists are not productively efficient as they are not operating at the optimum point of the ATC curve, this is because as a monopoly they face no threats to compete with others firms therefore can be considered X-inefficient as they are ‘slacking’ in efficiency if they were to be in a more competitive market. Also monopolies may not use their profits to invest to innovate thus may prevent growth. Therefore it can be argued that small firms are better as their objectives do not include exploiting consumers with high prices for supernormal profits thus may operate where they are productively efficient. Additionally since small firms cannot operate as a monopoly, there will be no abuse of monopoly power therefore small firms can be argued to be better.

 

However a perfectly competitive market is made up of a large number of small firms; the industry equilibrium of supply and demand which establishes the price – firms who try sell above this amount, consumers will not buy the product, similarly if the firm sells below this price consumers will purchase their goods however they will not be maximising returns. And thus the individual firms have no choice but to accept the price given by the industry and therefore act like price takers in a perfectly competitive market. However they can benefit from allocative efficiency; this is where the optimum allocation of scarce resources that best accords with the consumers’ pattern of demand. As shown in diagram 3 price is equal to marginal cost (P=MC) thus allocative efficiency is achieved in both the short and long run, as at the ruling price ‘P’ firms are producing the exact quantity consumer’s demand and thus there are no wasted resource thus total economic welfare is maximised.

Furthermore small firms in a perfectly competitive market often also benefit from productive efficiency as well as dynamic efficiency thus will lower costs. However the conditions for a completely competitive market are based on several assumptions such as perfect information – consumers will have all available information about price and products from competing suppliers and can access freely, many sellers and buyers, no externalities etc. however this is impossible to have in reality thus such market does not exist.

 

Overall large firms are better in terms of the benefit of economies of scale however there are pull backs if the firm becomes too large and diseconomies sets in. Additionally if a large firm becomes a monopoly; they can achieve high profits but only at the expense of exploiting consumers and they may not use profits to invest further thus abusing monopoly power this therefore suggests that large firms may not be better than small firms in all cases. In perfectly competitive market small firms has the advantage of great economic efficiency and are able to minimise costs unlike monopoly firms. However it must be emphasized that such markets are impossible in reality. Therefore overall both large firms and small firms are only better in than each another in certain cases.

A2: ESSAY Unit 3 - ECON 3 JAN 10 [06] DATA RESPONSE 2 (25 marks): Oligopoly colluding

Here I have attached my essay answer for this question; it is graded an A. Remember a good essay needs a balance of knowledge, application, analysis, and evaluation. My essay isn't perfect but I hope you can benefit from it nevertheless. After the introduction, I have included a paragraph explaining why oligopolies can mistaken for colluding due to nature price rigidity in oligopolistic markets  *please do not repost without credit, thanks!

 

‘When oligopolists collude, the results can be anti-competitive and against the consumer interest’ (Extract E, lines 27-28) Evaluate policies that could be used to deal with this problem (25 marks)

Oligopoly is where a market is dominated by a few firms holding majority of the market share thus a high level of market concentration. However behaviour such as use of product branding, barriers to entry, interdependency etc. promotes anti-competitiveness which is most significant in identifying oligopolists. There are several policies that can be used to tackle problems of collusion (which can act against consumer’s interests) such as interventions from the government for example; subsidising new competitors and taxation.

As illustrated in diagram 1, price rigidity is a common characteristic of oligopolies. Firms will not charge above ‘P’ due to elastic demand thus a rise in price will lead to a more than proportionate decrease in demand, furthermore firms will not charge below ‘P’ due inelastic demand thus a decrease in price will lead to a less that proportionate increase in demand hence prices being very stable. Additionally the discontinued or vertical section of the MR curve highlights that if costs increase (MC1 to MC2), marginal cost will still equal to marginal revenue thus price and quantity will remain unchanged and vice-versa thus price rigidity. However this raises concern for the government as behaviour of collusion such as price-fixing is illegal within the UK and EU; thus government may be concerned by oligopoly behaviours [Extract E, lines 3-5] highlights that anti-competitive behaviour will be put down. Thus if collusion practices among oligopolies were proven deliberate, the government will have to take action.

 
 

Firstly government may subsidies new competing firms’ thus promoting competition and diluting market power of original oligopolists. Assuming the oligopolies are operating at the minimum efficient scale (MES) therefore at productive capacity as illustrated in diagram 2, new firms entering the market (at ‘Pn’ / ‘Qn’) will have difficulty competing with existing oligopolies that benefit from low costs due to economies of scale. The government can therefore subsidies cost for the new competitors (‘Pn’ to ‘Psubsidy’) thus allowing new firms a more stable position to of compete against the existing oligopolies and therefore deals with anti-competitiveness of an oligopoly market. In addition subsidising new competitors will reduce unemployment and will therefore promote growth. However there are several problems with this policy.

 

A fundamental part of oligopolies is that they rely non-price competition; for example brand loyalty. New firms are unable to compete with large brand names for example in the motor vehicle industry; Volkswagen, Fiat, BMW etc. therefore it is still difficult for new firms to compete despite subsidies from the government. Furthermore oligopolists depend on huge research economies of scale for product differentiation thus efficiency is a major component; even with subsidies new firms are only operating at ‘Psubsidy’ whereas existing oligopolies are operating at ‘Po’  (productive efficiency). Moreover this suggests that existing oligopolies can exercise predatory with their low costs and price thus forcing new competitors into bankruptcy.  Therefore new competitors are still unable to overcome several barriers to entry despite government subsidies thus intervention maybe considered unnecessary and a waste of government spending and therefore can be considered as government failure. In addition [Extract E, lines 30-31] states that ‘the industry will find it difficult to support many firms’ thus subsidising new competitors into the market may also damage the motor vehicle industry greatly.

 

 

However it is assumed that the existing oligopoly is operating at the lowest point of the average cost curve therefore experiencing MES. [Extract E, table] suggests for the motor vehicle industry to reach MES, firms require 20% of the market; however as illustrated in [extract D] the closest to 20% is Volkswagen with 18.3% of the market share thus no firm is operating at MES. Therefore in reality government subsidies may allow new competitors a strong position in the market.

 

 

Another policy the government can execute is by imposing taxes on the industry’s raw material suppliers e.g. steel industry as the demand for steel is a derived demand from the motor vehicles; thus indirectly forcing the motor vehicle manufacturers to pay more for the materials and with their rigid pricing may therefore weaken their barriers to entry. For example taxation will decrease oligopolists’ profits which may reduce their advertising budget and thus promotes competition as it enables other competing firms more of a chance to compete with a reduction in advertising. Additionally it will also reduce the use of limit pricing of oligopolists if their costs increase as they are no longer able to exploit low prices from lower costs. Furthermore fewer profits will mean oligopolists will have less to spend on research and development therefore reduces the chances of product differentiation thus products will become more homogenous which will promote more competition in the industry.  However such policy will also act against the interest on consumers. For example is research and development expenditure decreases firms may not be able to experience dynamic efficiency and will lose out on international competition (highlighted in [extract D] Japanese companies already own 13.8% of the EU market share of the motor vehicle industry) and thus consumers will have to pay higher prices compared to that outside the UK and EU, furthermore there will be a reduction of consumer choice. Additionally taxing their raw material suppliers will be unfair for them as they have to suffer higher prices and to accommodate this, for example the steel industry may need to decrease their costs by laying off workers thus promoting unemployment. Thus such policy may not be the most effective to deal with the problem of collusion and non-competitive behaviour. 

 

 

Overall in conclusion there are several policies that can deal with oligopolies colluding, by subsidising new competitors thus promoting more competition into the market however this does not handle with many high barriers to entry set by oligopolies thus it may be still very difficult for new firms to compete with existing oligopolies thus intervention of subsidies may be considered government failure. Another policy is taxation to reduce oligopolists profits and therefore reduce the power of their barriers to entry. However this will result in several problems for the oligopolist such as lack of profits to spend on research and development thus increasing costs which will be passed on to consumers and lack international competitive strength. Therefore it may be a combination of policies is required to tackle the problem of collusion and anti-competitiveness such as use of legislation as well as taxes and subsidies etc. However it could be argued that market mechanism is self-sufficient and operates best alone thus no intervention is needed; additionally there may be no collusion between oligpolists and it is just oligopolistic nature to have stable prices which may seem to look like price-fixing thus no intervention or policies may be required at all.

 

AS: Unit 1 - Shifts in demand and supply

In this post we will learn:

1. How and why there are shifts in demand
2. How and why there are shifts in supply

Shifts in the demand curve

Analysing the diagram:

Given that the original equilibrium demand curve is 'D' at price 'P' and quantity 'Q'

• Reduction in demand
• The demand curve will shift left (D to D1)
• Price will reduce from 'P' to 'P1'
• Quantity demanded will reduce from 'Q' to 'Q1'
• Increase in demand
• The demand curve will shift right (D to D2)
• Price will increase from 'P' to 'P2'
• Quantity demanded will increase from 'Q' to 'Q2'

Causes:

• Change in prices or related goods
• Substitutes
• If price of a substitute increase then demand for this good will increase
• If price of a substitute decrease then demand for this good will decrease
• E.g. If the good is butter and the price of margarine increases, then the demand for butter will increase. Similarly if price of margarine decreases, then the demand for butter will decrease.
• Complements
• If price of complementary good increase then demand for this good will decrease
• If price of complementary good decrease then demand for this good will increase
• E.g. If this good is DVD players and the price of DVDs increases, the demand for DVD players will decrease. Similarly if price of DVDs decreases, the demand for DVD players will increase as they are consumed together.
• Change in income
• Normal goods
• If income increases then demand for normal goods will increase
• If income decreases then demand for normal goods will decrease
• Inferior goods
• If income increases then demand for inferior good will decrease
• If income decreases then demand for inferior good will increase
• E.g. Transportation, if income increases you are more likely to drive your car. If income decreases you are more likely to take the train. In this case car is the normal good and public transport is the inferior good.
• Change in taste
• Change in expectation

Shifts in the Supply curve 

 

 

Analysing the diagram:

Given that the original equilibrium demand curve is 'S' at price 'P' and quantity 'Q'

• Reduction in supply
• The supply curve will shift left (S to S2)
• Price will increase from 'P' to 'P2' 
• Quantity demanded will reduce from 'Q' to 'Q2'
• Increase in supply
• The supply curve will shift right (S to S1)
• Price will decrease from 'P' to 'P1'
• Quantity demanded will increase from 'Q' to 'Q1'

Causes:

•  Change in technology
• Better technology will increase efficiency / productivity
• E.g. new machine which can produce 5 times more goods will lead decrease average costs
•  Change in supplies
• Cheaper supplies
• E.g. cheaper source of oil will decrease average costs (therefore shift S to S1). Conversely natural disaster may increase price of oil thus increase average costs (therefore shift S to S2)

 

AS: Unit 1 - Demand and Supply curves in a market and the equilibrium

In this post we will learn:

1. The basics of the demand and supply curve
2. How the price mechanism establishes an equilibrium in a market

So this post will mainly be about the very basic demand and supply diagram.

*ASSUMING CETERUS PARABUS*

Firstly the Demand curve (on the right) is downwards sloping. Why?

This because of the Law of Demand which suggests there is an inverse relationship between the price and demand of a good (hence the axes on the diagram)! This basically means as prices fall (P1 to P2) there will be a increase in quantity demanded (Q1 to Q2), similarly as prices rises (P2 to P1) there will be a decrease in quantity demanded (Q2 to Q1).

 

Secondly the Supply curve (on the left) is upwards sloping. Why?

Well surprise; this is because of the Law of Supply! Similarly to the relationship of the demand curve, as prices increase (P1 to P2) there will be an increase in the quantity supplied (Q1 to Q2) and as prices decrease (P2 to P1) there will be a decrease in the quantity supplied (Q2 to Q1).

 

It is actually quite logical, if you think about it. If the price of  a good decreases of course you're more likely to buy it! Similarly if you sold a good and the price of the good increased of course you'd supply more!  

 

The Equilibrium

 

When demand meets supply the equilibrium is established and there is no tendency for change. Price is at 'P1' and quantity is at 'Q1'.

 

 

However when we're not at equilibrium we are at market disequilibrium and supply does not equal demand.

• If price is at 'Ps'
• Suppliers are willing to supply quantity 'Qy'
• However demand is only at 'Qx'
• Thus there is excess supply (more supply than demand) from points 'A' to 'B' (Qx to Qy)
• If price is at 'Pd'
• Suppliers are only willing to supply at 'Qx'
• However demand is at 'Qy'
• Thus there is excess demand (more demand than supply) from points 'C' to 'D' (Qy to Qx)
• If price is at 'P1'
• There is market equilibrium

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Please leave feedback and any questions. Thank you! xx