The Price Mechanism in Ac/on Shi2s in Market Demand and Supply Changes in Equilibrium Prices – Increasing Supply Price An outward shi< of market supply (ceteris paribus) will lead to a fall in equilibrium price and an expansion of market demand/ This will lead to an increase in equilibrium quan+ty. Market Supply (1) Pe Market Supply (2) P2 Market Demand (1) 0 Qe Q2 Quan+ty Changes in Equilibrium Prices – Decreasing Demand Price An inward shi< of market demand (ceteris paribus) leads to a fall in equilibrium price and a contrac+on of market supply Market Supply (1) Pe P2 Market Demand (1) Market Demand (2) 0 Q2 Qe Quan+ty Changes in Equilibrium Prices – Decreasing Supply Price An inward shi< of market supply (ceteris paribus) leads to a rise in equilibrium price and a contrac+on of market demand Market Supply (2) Market Supply (1) P2 Pe Market Demand (1) 0 Q2 Qe Quan+ty Moving from one Market Equilibrium to another Price An increase in demand in the immediate period leads to the price rising to P2, before an expansion of supply takes effect B P2 C Supply (1) P3 P1 A Demand (2) Demand (1) 0 Q1 Q2 Quan+ty Shi2s in both Market Supply and Market Demand Price In this example the size of the outward shi< of supply exceeds the increase in demand. Both factors cause quan+ty bought and sold to rise; but the equilibrium market price will fall. S1 B P2 P1 P3 S2 C A D2 D1 0 Q1 Q2 Q3 Quan+ty Explaining Possible Changes in Beef Prices Price of Beef Average retail price of beef in the UK £ per kg
S2 P2 S1 P1 2010
2011
2012
2013
What demand & supply factors might explain the rising price of beef? Demand Factors D1 D2 0 Quan+ty of beef 6.16
6.42
6.99
7.47
Supply Factors Rise in price of beef Increase in price of subs+tutes animal foodstuffs Rising real incomes Higher rents paid if YED > 0 by beef farmers Change in tastes and preferences Rise in wages of farm labourers Summary of Changes in Equilibrium Prices Equilibrium prices change when condi+ons of demand/supply alter Shi2 Equilibrium Price Equilibrium Quan/ty Demand increases Higher Higher Demand decreases Lower Lower Supply increases Lower Higher Supply decreases Higher Lower In analysing price changes, iden+fy the relevant supply/demand factors men+oned in the data response s+mulus extracts Key Func/ons of the Price Mechanism The Main Func/ons of the Price Mechanism In an mixed economy like the UK, many decisions on how to resolve the issues of opportunity cost and trade-­‐offs are resolved by prices. 1.  Alloca/on – alloca+ng scarce resources among compe+ng uses 2.  Ra/oning – prices serve to ra+on scarce resources when market demand outstrips supply 3.  Signalling – market prices adjust to demonstrate where resources are required, and where they are not 4.  Incen/ves – e.g. when the price of a product rises, quan+ty supplied increases as businesses respond! Prices send important signals Prices change incen/ves for consumers and suppliers The Ra/oning Func/on The ra/oning func/on -­‐ when there is a shortage of a product, price will rise and deter some consumers from buying the product Price P2 P1 S2 Higher food prices Rising cost of ren+ng Online auc+ons Tickets for major event S1 In recent years the steep rise in food prices plus declining real incomes has highlighted the ra+oning func+on of the price mechanism D1 Quan+ty The Signalling Func/on The signalling func/on -­‐ changes in price provides informa/on to both producers and consumers about changes in market condi+ons Coffee farmers Share prices send signals Shale oil and gas Interest rates on loans Consider the price signals in this example “CoRon farmers hit hard as prices drop to lowest since 2009” (December 2014) Plen/ful global supplies of coRon thanks to favourable weather have caused coRon prices to fall to a 5 year low. China’s farmers benefited from a $5bn scheme which ran from 2011-­‐14 where the government purchased coRon at a minimum price, building up a huge stockpile — China’s reserves have risen six-­‐fold since 2010 and it holds 60% of the world’s comon inventories. The slump in world prices is being badly felt by growers in the southern African country Zambia whose comon industry employs a fi<h of the popula+on. Rising Prices for Olive Oil Extract The price of premium virgin olive oil has risen to $4,282 a tonne in November 2014, the highest since 2008. A severe drought in Spain and a fruit fly infesta+on in Italy have caused a surge in the price of olive oil. The two countries normally account for just under 70 per cent of output. If prices remain high, consumers may con+nue to switch towards cheaper subs+tutes such as soya, palm and rapeseed oil. Source: Newspaper reports Q: Explain why the price of olive oil has risen A: An inward shi< of market supply causes increased scarcity -­‐ drives prices higher. PED is likely to be low which amplifies price rises Q: To what extent might the rise in the price of olive oil lead to a rise in the price of olive oil in UK supermarkets? A: There are few processing costs so a rise in olive oil prices should feed through quickly But………… •  Other costs may be falling e.g. bomling, wages, distribu+on etc. •  Supermarkets may maintain prices and be prepared to sacrifice some profits. •  A rise in the £/Euro exchange rate may prevent a price rise as imports are cheaper Falling Market Demand for Film Video Rentals The volume of films rented from UK retail stores has fallen sharply Film rental market volume in the UK 2001-­‐2013
Falling cost of fast broadband • Increase speed of downloads • Shi< in consumer preferences Annual rentals (millions)
Recovery in live cinema visits 2001
198
2004
159
• Investment in digital projec+on • Greater use of dynamic pricing 2007
92
Film rentals seen as inferior good 2010
84
2013
53
• Preference to download or buy • Real incomes rising, demand for rentals falls (nega+ve income elas+city) Key Takeaway points •  Revise thoroughly the key condi+ons of supply & demand •  Show and explain causes of market prices and the effect on equilibrium quan+ty •  Understand and apply the func+ons of the price mechanism in alloca+ng scarce resources •  Think about inter-­‐related markets e.g. for subs+tutes and complements •  Revise this topic first before moving onto market failure and government interven+on The Price Mechanism in Ac/on