The Allocation of Resources - Price Changes

Objective: How price changes are caused by changes in demand and supply

This section explores the fundamental relationship between price, demand, and supply. Understanding how these forces interact is crucial for analyzing resource allocation in a market economy.

Understanding Demand

Demand refers to the quantity of a good or service that consumers are willing and able to purchase at various prices during a specific period. The law of demand states that generally, as the price of a good increases, the quantity demanded decreases, and vice versa. This inverse relationship is typically represented by a downward-sloping demand curve.

• Factors influencing demand (other than price):
• Consumer income: An increase in income usually leads to an increase in the demand for normal goods.
• Consumer tastes and preferences: Changes in fashion, advertising, or health trends can affect demand.
• Prices of related goods:
• Substitute goods: If the price of a substitute good increases, the demand for the original good will increase.
• Complementary goods: If the price of a complementary good increases, the demand for the original good will decrease.
• Expectations about future prices: If consumers expect prices to rise in the future, they may increase their current demand.
• Population changes: A larger population generally leads to higher demand.

Understanding Supply

Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at various prices during a specific period. The law of supply states that generally, as the price of a good increases, the quantity supplied increases, and vice versa. This direct relationship is typically represented by an upward-sloping supply curve.

• Factors influencing supply (other than price):
• Cost of production: An increase in the cost of inputs (e.g., wages, raw materials) will decrease supply.
• Technology: Improvements in technology usually lead to an increase in supply.
• Expectations about future prices: If producers expect prices to rise in the future, they may decrease current supply to sell later at a higher price.
• Number of sellers: More sellers in the market generally lead to an increase in supply.
• Government policies: Taxes and subsidies can affect the cost of production and therefore supply.
• Weather conditions (for agricultural products): Favorable weather conditions usually lead to an increase in supply.

The Interaction of Demand and Supply

The interaction of demand and supply determines the market price and quantity. The point where the demand and supply curves intersect is known as the equilibrium point. At this point, the quantity demanded equals the quantity supplied, and there is no surplus or shortage.

Price Changes due to Shifts in Demand and Supply

Changes in either demand or supply will lead to a new equilibrium price and quantity.

Changes in Demand

A change in demand (other than a change in price) will cause the demand curve to shift.

• Increase in Demand: A shift to the right of the demand curve. This leads to a higher equilibrium price and a higher equilibrium quantity.
• Decrease in Demand: A shift to the left of the demand curve. This leads to a lower equilibrium price and a lower equilibrium quantity.

Changes in Supply

A change in supply (other than a change in price) will cause the supply curve to shift.

• Increase in Supply: A shift to the right of the supply curve. This leads to a lower equilibrium price and a higher equilibrium quantity.
• Decrease in Supply: A shift to the left of the supply curve. This leads to a higher equilibrium price and a lower equilibrium quantity.

Changes in Both Demand and Supply

When both demand and supply shift simultaneously, the effect on the equilibrium price and quantity depends on the magnitude of the shifts.

Demand Shift	Supply Shift	Effect on Equilibrium Price	Effect on Equilibrium Quantity
Increase	Increase	Increase	Increase
Increase	Decrease	Increase	Decrease
Decrease	Increase	Decrease	Increase
Decrease	Decrease	Decrease	Decrease

Figure: Suggested diagram: A graph showing shifts in the demand and supply curves and their impact on the equilibrium price and quantity. The diagram should clearly label the axes (Price and Quantity), the demand and supply curves, and the equilibrium point. Arrows should indicate the direction of the shifts in the curves.

Price Elasticity of Demand and Supply

The responsiveness of quantity demanded or supplied to a change in price is known as price elasticity. This is a more advanced topic but is important for understanding the magnitude of price changes caused by shifts in demand and supply.

This section provides a foundational understanding of how price changes arise from shifts in demand and supply. Further study will delve into the concept of price elasticity and its implications.