Demand And Supply Theory The Prices example essay topic

Every organisation which provides goods or services to fee paying customers must, by its very nature, charge price for that good or service, to pay for its costs, have retained profits for investments and to keep its shareholders happy. In theory, the market price of any good or service is determined by the interaction of forces of demand and supply. There is an old saying, that "if you can teach a parrot to say 'demand' and 'supply' you have created a trained economist". 1 There is some truth to this saying as most problems in the economics can be examined by applying the rules of demand and supply. Therefore, the concepts of demand and supply can be claimed to be among the most important in economics. In order to understand either of them it is necessary to examine the factors that determine them.

Although, a good's price relative to other goods is probably the most important factor influencing demand for most goods most of the time, there are other factors as well. These are disposable income, the price of complimentary goods and substitutes, tastes and preferences, expectations, size of population, advertising. Suppliers on the other hand are interested in making profits, and thus anything that affects profitability affects the supply. These include the price of other products, costs, technology and goals of firms. a) The price of any product is determined by the interaction of the forces of demand and supply.

The market price is set at the point, where demand equals supply, equilibrium. This can be seen from figure 1. Forthe purpose of this essay we will look at the prices of beer. We can see that, the price is set at 1.65, where D intersects S. Fig. 1 The Penguin dictionary of economics defines demand as "the desire for a particular good or service supported by the possession of the necessary means of exchange to effect ownership", while supply is defined as:" the quantity of a good or service available for sale at any given price"2. When an economist refers to the demand for a product he means effective demand, which may be defined as " the quantity of the commodity, which will be demanded at any given price over some given period of time". 3 However, the price of the good or service varies according to the changes in either demand or supply.

In order to show that it is necessary to look at determinants of demand and supply separately. One of the factors that might affect the demand for beer is a disposable income, income less taxes. For most of the products, when disposable income goes up the demand goes up a swell, and vice versa, thus affecting the price of the product. A rise in income leads consumers to buy more of a product, as they have more money to spend.

This can be seen from figure 2. Fig. 2 Thus, we can see that, when income rises, demand shifts to D 1, and since S curve remains the same, the price of beer goes up to 2.00. The other factor that influences demand for beer, could be the change in consumer tastes and preferences. Some industries like clothing and furniture are more affected by it than the others. However, in beer market it also has a great effect. It can go out of fashion if consumers believe that, it is more fashionable to drinks spirits or not to drink at all, and vice versa consumers might decide that beer is more fashionable than spirits.

The effect of fashion and tastes on the prices can be seen from figure 2. If beer becomes less popular D shifts to D 2 and the price becomes 1.45, while if it is more fashionable D shifts to D 1 giving the new equilibrium price of 2.00. Another factor, which influence demand, is the price of other products, substitutes or complementary goods. Complementary goods are purchased together to satisfy one want, and these goods are in joint demand. For beer, the best example could be pubs and night clubs.

If the prices of admission tonight clubs goes up, the demand for beer is likely to go down and thus the price will go down, so in figure 2 the D curve will shift to D 2 thus giving the new equilibrium price of 1.45. On the other hand, if night clubs were to make the admission free more people would go and they would have more money to spend, thus shifting D curve for beer would shift to D 1 giving the new price of 2.00. In modern world the advertising can also cause changes to the demand. A successful advertising campaign can increase the demand, and thus price, by shifting the demand curve to the right and at the same time move the demand curves of the competitors to the left.

Change in legislation can also affect the demand for beer. If the government decided to decrease the age of those allowed to buy beer to 17 or 16 the demand for beer would have shifted to the right to D 1 giving a new equilibrium price. Price changes can also because by change in one or more of the determinants of supply, like costs or technology. "Supply curve is drawn on the assumption that the general costs of production remain constant"4 Therefore, if any of the costs change, it will result in the changes in supply and thus prices.

In the beer industry there are many costs to consider, there are production costs, transaction costs and the costs of the raw materials. The government can also force the companies into higher costs, like the introduction of the minimal wage, which will increase the company's costs. If the costs increase at any given level of output the producers will attempt to pass on these increases on to consumers in the form of higher prices. If they are unable to pass on to consumers they would face lower profits, thus giving less dividends to the shareholders, which even might result in company going out of business. The company would start to produce less of the product, as it is less profitable, thus shifting supply curve to the left.

On the figure 3 the supply will shift to S 1 thus giving a new equilibrium price of 2.00. Fig. 3 On the other hand, technological advances would increase the supply. If new technology is introduced to the production process it should lead to the fall in the costs of production. This greater productive efficiency will encourage firms to produce more at the same price or produce the same amount at the lower price or some combination of both.

The supply curve will shift downwards and to the right to S 2 giving the new equilibrium price of 1.45. It would be unusual for firms to replace more efficient technology with less efficient. The other factor that might affect the supply of the beer is the future expectation. If firms expect future beer prices to be much higher, they may restrict supplies and stockpile beer.

If they expect the prices of raw materials like hops to be higher they might decide to buy it in advance at the lower prices so that to keep costs stable. The amount of changes in price and quantity depends on the price elasticity of demand and supply, as they affect the slope of the curves. Price elasticity of demand is the responsiveness of changes in quantity demanded to changes in price. The more inelastic the demand for a product is the greater the change in price is, and vice versa the more elastic the demand curve is the lesser the price change is.

This can be seen from the figure 4., D 1 is the perfectly inelastic demand curve while D 2 is the perfectly elastic. Fig. 4 The price elasticity of supply is the responsiveness of quantity supplied to a change in price. It is measured by dividing the percentage change in quantity supplied by the percentage change in price. For both PED and PES the factors affecting them are substitutes and time. b) It is useful to look at demand and when dealing with prices, and many authors regard it as rather useful. "Demand and supply diagrams provide a powerful and simple tool for analyzing the effects of demand and supply on equilibrium price and quantity". 5 However economic analysis of demand and supply has many limitations and assumptions.

As J. Beard shaw states:" It is only possible to reach any conclusions so long as we keep the rule of only considering one change at a time". 6 Economists when dealing with any kind of microeconomic problem always preface any statement with the phrase "all other things remaining constant" or " ceteris paribus". Therefore it can be seen that in real life when dealing with the real business and its pricing policy it would be difficult to place such a problem solely on the economic analysis. Businesses have to deal with more than just on echange at a time. Economic analysis also shows asa 'perfect' world or business environment. It does not take any account of factors like corruption for example.

In some developing countries it is possible to be more cost efficient than its rival and charge lower prices, but not be able to compete as its rivals have good connections with the government. The example of this could be my home town Kiev, small breweries which charge lower prices are unable to compete with the " Obolon' brewery, as the latter has a tender with the mayor for providing beer to all public and sport events. Microeconomic analysis assumes that the more efficient the company is in cutting its costs, for example, the lower the prices its going to charge. In reality however, it is difficult to think of a company, which would do that, if it can increase its profit margins and keep the stable demand for its product, especially, if its rivals charge the same amount and not lowering their prices. The other assumption of this analysis is that the equilibrium price is the current market price or the price toward which the market moves. In reality the market price could be at any level.

There could be excess demand or excess supply at any point in time. This can be seen from the examples of CAP (the Common Agricultural Policy) and OPEC (the Organisation of Petroleum Exporting Countries). The other basic assumption is that any change in either demand or supply affects the price. However, in beer industry there are increases and decreases in supply due to the holidays for example, and the prices tend to remain the same.

During Christmas for example, there is an increase in demand for beer and other drinks, people celebrate, go to restaurants and pubs, thus according to the demand and supply theory the prices would have to go up. (see Fig. 2) In reality however, the prices tend to stay the same or in some cases, like supermarkets, even drop. This phenomenon can be explained by the oligopolistic competition and the games-theory. The demand and supply analysis assumes free (competitive) markets. However, if we have market occupied by just a few firms, like British brewing industry, which is dominated by Scottish-Courage, Bass, Whitbread and AlliedDonecq 7, "the analysis may be rather different"8.

Firms in such markets make decisions on price and output taking into account the expected decisions or reactions of the other rival firms. This sort of market is known as an oligopoly". Oligopoly theory is concerned with market structures in which the actions of individual firms affect and are affected by the actions of other firms". 9 As far as business planning is concerned, it is impossible for a business to solely use demand and supply analyzing when making plans for a future. This is mainly because it is only a theory, and when faced with actual quantities it is difficult to estimate an actual increase or decrease in the price of a particular product. The businesses most probably would make such decisions based on the feelings of their shareholders, due to the fear of " going under', if their shareholders are not satisfied they will sell shares and the company will be vulnerable to take-over bids.

In conclusion, it can be seen that the principles of demand and supply have a theoretical influence on price determination. The theory provides a useful and simple tool in determining the price of a product by the means of demand and supply, an equilibrium price. However, the theoretic approach, uses many assumptions, which limit the application of theory to the real business environment. It is useful for academic purposes, while it is difficult to imagine that actual businesses will follow it in the business planning process. It is also difficult to use it as the theory assumes the perfect market, which does not exist, with few exceptions, newsagents being one of these.

In other forms of competition firms would base pricing decisions on expected decisions of their rivals (oligopoly), or would decide by themselves taking into account only their needs (monopoly). Thus, it can be concluded that companies would adopt their pricing policy on the environment they operate in, probably without even using the theory of demand and supply.