Accounting Articles for Students

The theory of supply and demand

by Bob Souster | Published on 5/15/2003

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"Teach a parrot to say supply and demand and you have an economist. Discuss"
(Question in a higher education final degree examination.)

The concepts of supply and demand are central to the study of economics. The body of theory is substantial " standard undergraduate text books such as Lipsey"s An Introduction to Positive Economics deal with the subject over several hundred pages.

Paper 4 requires the candidate to have an elementary understanding of supply and demand theory. It is important to understand basic concepts and then apply them to real-life situations. In doing so, some of the "nuts and bolts" of the theories may quite properly be overlooked. For example, the candidate may have to demonstrate an ability to analyse a situation using supply and demand curves without ever knowing - or needing to know - how the curves are actually derived from first principles.

Background

Some regard Adam Smith as the founding father of economics. His famous book "The Wealth of Nations" (1776) touched upon his perceptions of markets and how they operate. Writing of the price system, which is built on the theories of supply and demand, Smith stated that it was the "invisible hand which guides the actions of consumers and producers".

Over a century later, Alfred Marshall proposed a more complex theory, focusing on micro-economic analysis. It was Marshall who first formally identified the determinants of supply and demand and then developed his concepts in diagrammatic form. The supply and demand curves used in micro-economics today depend directly on Marshall"s work.

In the inter-war years, John Maynard Keynes drew inspiration from the work of Marshall in formulating his "General Theory of Employment, Interest and Money". His theory of effective demand (now more commonly referred to as aggregate demand) is a direct extension of micro-economic analysis to macro-economic theory.

Supply

Supply is the flow of goods and services brought to the market place by producers in a given time period.

Generally, the higher the price which can be obtained, the higher the quantity supplied. Economists represent the supply curve by measuring price on the vertical axis and quantity supplied on the horizontal axis, with the curve sloping upwards from left to right (Figure 1).

Determinants of supply

The supply to a market will not be constant. The flow is influenced by several factors, all of which may change over time.

Price:
As mentioned above, a higher price will prompt producers to supply more.

Prices of other goods and services:
Some goods and services display inter-dependency of supply. If the price of good A increases this may render the supply of a good whose price remains unchanged less attractive. An example of inter-dependency is gas bottles and gas heaters.

Costs of factors of production:
The factors of production (or productive resources) are the inputs to the production process. They therefore, directly influence the capability of producers to bring products to the market. These costs are those relating to land, labour, capital and the entrepreneur. If the cost of land increases, producers may shift production towards goods which rely less on land and more on other factors of production.

Technological innovation:
Advances in technology reduce the unit costs of production through economies of scale. This can increase supply capability at each price level.

Producers" objectives:
Micro-economic theory relies on an assumption of profit maximisation. In practice, producers can have many different objectives which distort our perception of how supply behaves. In addition, market supply can depend on a wider range of factors, including climate, action by the labour force and so on.

Demand

Demand is the flow of goods and services required by consumers over a given period of time. Generally, the higher the level of price, the lower the level of demand. The demand curve is therefore, usually represented as sloping downwards from left to right (Figure 2). There are exceptions to this. Some goods and services attract lower demand when the price falls, including many products where the price is a "badge" of exclusivity. These products are said to display a "downward-sloping demand curve".

Determinants of demand

The determinants of demand are:

Price:
As mentioned above, the higher the price, the lower the level of quantity demanded.

Prices of other goods and services:
Some goods are substitutes for one another. If the price of one falls, the demand for the other should also fall as it becomes less attractive to the consumer. Holidays in Greece and Florida are good examples of this.

Some goods are complementary " the demand for them moves in tandem. If the price of one of them falls, the quantity demanded of the other will rise. Examples of complementary goods are portable CD players and batteries.

Income:
This is the most important determinant of demand. Generally, as income increases, the quantity demanded should also increase. Again, there are exceptions to this. In poorer countries, there is evidence that some staple goods, such as rice, will become less popular even if their prices fall as incomes increase.

Tastes and preferences:
Consumer preferences have a major impact on the level of demand. These may be influenced by a wide range of factors, all difficult or impossible to quantify precisely.

Changes in tastes and preferences can be permanent or temporary. Consider products such as ten-pin bowling (hugely successful in the 1960s), cinema, fashion and childrens" toys (witnessed by the resurgence of the yo-yo in 1998).
 

Table 1: Determinants of supply and demand
Determinants of supply Price Prices of other goods and services Costs of factors of production Technological innovation Producers objectives	Determinants of demand Price Prices of other goods and services Income Tastes and preferences

The determinants of supply and demand are summarised in Table 1 above.

Price equilibrium

Conventional micro-economic analysis states that the price of a good or service and the output level will be determined at the intersection of the supply and demand curves (Figure 3). This is called the equilibrium price.

Any price above the equilibrium will result in a situation where the quantity supplied exceeds the quantity demanded. As they are unable to "clear" the market, producers may reduce prices. Any price below the equilibrium will see the quantity demanded exceed the quantity supplied, bidding the price upwards.

Prices should always tend to settle at equilibrium unless artificial constraints are imposed by government, other outside agencies or by collusion between producers (cartels).

Using supply and demand curves

Your analysis of a situation posed by the examiner can be illustrated quite well by using supply and demand curves. Some are more comfortable with these than others. In many instances, a description in words is an adequate substitute.

Care must be taken to distinguish between a movement of the whole supply/demand curve and a movement along a supply/demand curve. Remember the simple rule:

• if price changes, a movement will occur along the curve;
• if a determinant of supply or demand other than price changes, the whole curve will move.

Limitations

In practice, of course, producers and consumers do not actually draw up or consult supply and demand curves. Nor could they.

The theory is based on important assumptions, not least that in examining the relationship between price and quantity demanded, all other factors are assumed to remain constant (ceteris paribus).

The micro-economic model is simply a useful starting point for examining economic behaviour from a theoretical viewpoint.

Intervention

Sometimes a maximum price is imposed for a good or service. The motive for this is usually to protect the consumer.

During the Second World War, maximum prices were declared by the government for essential foodstuffs and some other goods. The economic consequence is demonstrated in Figure 4. As quantity demanded outstrips quantity supplied, several problems can emerge. These were tackled during the war by a rationing system. Alternatives can be:

• first come, first served;
• the strongest consumers gain and the weakest consumers lose;
• emergence of a black market alongside the "official" one.

One does not have to rely upon the wartime example to illustrate the impact of a maximum price. Exactly the same analysis can be applied to the ticket situation for the football World Cup in France 1998.

Conversely, a minimum price may be imposed to protect producers. If this price exceeds equilibrium, the situation demonstrated in Figure 5 emerges.

Under the minimum price regime, there is a situation of over-supply. Producers cannot sell all they produce. This is vividly illustrated by the real-life problems which have intermittently afflicted the Common Agricultural Policy of the European Union.

Elasticity

The concept of elasticity is important in both micro-economics and macro-economics. Elasticity of supply is the responsiveness of quantity supplied to a change in price. It can be calculated by:

Elasticity of supply
=   Change in quantity supplied / Change in price

Elasticity of demand is the responsiveness of quantity demanded to a change in price and can be calculated by:

Elasticity of demand
=   Change in quantity demanded / Change in price

If a small change in supply (or demand) brings about a larger than proportionate change in quantity supplied (demanded), the supply (or demand) is said to be elastic.

The importance of elasticity is best demonstrated by practical examples:

Price discrimination:
Consider the example of two petrol filling stations, directly opposite one another on a restricted access motorway junction. Petrol station A is on the slip road to the motorway from which the motorist cannot turn off. Petrol station B is on the exit side which leads to a town served by many similar businesses.

The demand for petrol will be more elastic at petrol station B than petrol station A. Station B is competing with many others: station A on the other hand is the last chance for motorists to fill up before entering the motorway. As long as the two enterprises are physically separable, the responsiveness of quantity demanded to changes in price will be radically different.

The Budget:
Each year, the Chancellor of the Exchequer delivers his Budget to Parliament. This sets out, amongst other things, the planned income, expenditure and borrowing plans for at least the coming year.

One recurrent feature of the Budget is the review of rates of indirect taxes such as VAT. Indirect taxes are those which are imposed on expenditure. The "old favourites" for changes in VAT are alcohol and tobacco. The reason for this is that the demand for these products has always tended to be inelastic. A price increase through increased tax should therefore, yield more revenue to the Exchequer. The change in price brings about a relatively small change in quantity demanded.

The government cannot assume that such trends will continue unabated. For example, the long-term trend against smoking (the proportion of the population smoking has reduced by 50% in 30 years) and the cross-Channel traffic in "cheap booze" are both factors which will have increased the elasticity of demand over time, with consequences for projected revenues from VAT.

Other concepts of elasticity:
It is also worth having an understanding of two further measures of elasticity:

• cross-elasticity of demand is the responsiveness of quantity demanded of good A to a change in price of good B;
• income elasticity of demand is the responsiveness of quantity demanded to a change in income.

Application of supply and demand concepts in the examination

Paper 4 can pose questions which test either straight text book theoretical knowledge or your ability to apply these concepts to given scenarios.

In the past there have been questions on the nature of supply and demand, their determinants, movements of or along the curves, elasticity and so on. More practical questions have been set in relation to price intervention (agriculture, OPEC, etc.), practical applications of elasticity, as well as some of these concepts as they relate to the theory of the firm (perfect competition, oligopoly, etc.,).

Article courtesy of ACCA Accountant

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