Market Equilibrium

Market Equilibrium:

Equilibrium occurs in a market when the price has no tendency to change. This occurs at the price at which the quantity demanded equals the quantity supplied. Only at the market equilibrium price do buyers buy the quantity they want and sellers get to sell the quantity they want. No one wants to buy or sell anymore.

Market equilibrium achieves when the supply and demand curves cross marks. When the market price is above the market equilibrium price where quantity supplied is more than quantity demanded, excess surplus occurs causing a fall in the market price. While when the market price is below the market equilibrium price, quantity demanded exceeds quantity supplied, shortage occurs causing a hike in the market price.

Agricultural products such as fruits, soybeans, wheat and so on are basically about the equilibrium prices. Due to the unpredictable market conditions, the prices of wheat may be changing very often. The following could be explained with a table below.

             The market equilibrium price is 80 cents. The quantity demanded and quantity supplied is the same, which is 85, at the price of 80 cents.

At any price higher than the equilibrium price, there will be a surplus where the producers are willing to produce and also to supply more wheat than consumers want to buy. At the price of 90 cents, the surplus is 70 units. The market is not in equilibrium because the producers has an excessive surplus of 115 units as they are not able to sell their products out therefore lowering the prices of wheat to the buyers may be the last option for the farmers while for the consumers’ demand only stands for 45 units.

At the price of 80 cents, the market achieves market equilibrium, where quantity demanded and quantity supplied stands at 85 units. At this period of time, buyers are acquiring the most wheat when they intend to at the price of 80 cents while the producers are selling the most wheat at 80 cents therefore no one has the intention to neither buy nor sell the wheat.

Prices that is lower than the equilibrium price causes a shortage. According to the table, the quantity demanded of wheat by the buyers is at 125 units and it will be stronger than the quantity supplied, which is only at 55 units causing to a shortage of 70 units at the price of 70 cents. This indicates that the market is not equilibrium, buyers insist on the suppliers to increase the supply. The explanation mentioned above could be explained with a graph shown below.

Changes In Equilibrium:

Market forces adjust the price and quantity of a good or service until they correspond to where the demand curve crosses the supply curve. After the price and quantity reach that point- the market equilibrium, it remains unchanged as long as the demand and supply curve is left unchanged. Prices and quantities do adjust when there is a change in the demand and supply curve.

Supply Increase ; Demand Increase. 

When there’s a hike in demand and decrease in supply, it leads to a higher equilibrium price and higher quantity exchanged. Between the beginning of 2006 and the middle of 2007, the price of corn doubled while the demand for other food products were relatively stable. While the main cause driven the price of corn to increase was not due to the decrease of supply of corn but it was the increased demand of ethanol, an alcohol-like substance that is blended with conventional gasoline. Producers in the United States refine ethanol mainly from corn. The market achieved new equilibrium when there is an increase in demand; it shifts the demand curve to the right from D0 to D1. The increase in demand of corns upped the equilibrium price of corn from P0 to P1, leading the quantity exchange of corns shifting to Q0 to Q1. The following is shown by the graph above.

Supply Decrease ; Demand Decrease.

Next, when there is a low supply, it pushes up the equilibrium prices as well as the quantity exchanged. Due to the unfavorable weather condition, every now and then we hear news that the reduction of crops such as lettuce, apples and so on. For example, the severe freeze destroys most portions of lettuce crop. This would lead to a decrease in supply, supply curves shift to the left from S to S1. The freeze does not affect the demand for the lettuce as at each price level consumers still desire as much lettuce as before therefore D0 does not shift. The leftward shift of the supply curve from S0 to S1 causes the push in equilibrium price from P0 to P1, due to the increase in price, the quantity demanded for lettuce reduced from Q0 to Q1. The decrease of supply of lettuce is shown in the graph above.

Supply Increase ; Demand Decrease.

Several decades ago, people who caught pink salmon earned as much as $1 for each pound of pink salmon. As time passed by, supply and demand changed in the market for pink salmon. High profits made by producers attracted many new fishers to enter the market leading to a huge increase in supply of pink salmon. However, over the years, the change in consumers’ income and reduction of price of substitution products caused the drop in demand for pink salmon. Because of the improvement in living environment, consumers tend to move to a higher quality fresh or frozen fish, such as the Coho salmon. Other than that, the improvement in technology created more efficient fishing boats greatly increased the catch and also reduced the cost of it. Therefore, there are changes in supply from S1 to S2 while the demand of pink salmon also decreased from D1 to D2 whereas equilibrium price reduced from P1 to P2 as the increase in supply exceeded the decrease in demand. The following could be seen in the graph shown above.

                              

Supply Decrease ; Demand Increase.

For the past few years, the price of gasoline has increased rapidly. For example, the average price of a gallon of gasoline rose around $2 in 2004 to about $4 in 2007. With the figure shown below, the price of a gallon of gasoline at P0, represents the $2 price. Supply uncertainties relating to Middle East politics and warfare and rapid growth of demand of oil for fast-growing countries such as China leads to the hike of price per barrel of oil from $37 in 2004 to $80 in 2007 as oil is the main input producing gasoline. With the increase in cost, it decreases the supply of gasoline causing a leftward shift from S0 to S1 in the figure shown below. While the supply of gasoline reduced, the demand for gasoline increased, leading to a rightward shift of the demand curve from D0 to D1. Due to the reduced supply of gasoline and increased demand for gasoline, it pushes the price of gasoline from P1 to P2 in the figure shown below. As the demand increase outweighed the supply decrease, the equilibrium quantity increased from Q0 to Q1.

                                                                                                   

In short, the table shown below will be a short summary of effect of changes in both supply and demand.

Aggregate Demand

Aggregate Demand :

           

            Aggregate demand is a schedule or curve that shows the amount of real output (real GDP) that buyers collectively desire to purchase at each possible price level. The relationship between the price level (as measured by the GDP price index) and the amount of real GDP demanded is inverse or negative. Which means, when price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases.

As for the reason why the demand curve is download sloping; it is due to several reasons explained below:

1. Real wealth effect

A decrease in price level would increase the consumers’ spending on goods and services. Therefore, the real value of money, measured by the quantity of goods and services each dollar buys, rises. 

           

            ↓P  → ↑purchasing power → ↑W/P  →  ↑C  →  ↑AE ( increase in real GDP. )

2. Interest-rate effect/money demand effect

A reduction in the price level will reduce the need of consumers to borrow money in order to purchase goods and services. A reduction in demand for borrowings would reduce the level of interest rate, hence reducing the cost of borrowing. This will lead to a rising investment as it will increase the AE. 

 ↓P  →  ↑purchasing power  →  ↓demand for credit  →  ↓i  →  ↑investment (I)   →  ↑AE ( rise in real GDP. )

3. Foreign purchase effect

            A reduction in the price level would mean that our goods and services are relatively cheaper than the imported items, which would eventually reduce the value of imports.  A reduction in the price level would also mean that foreigners are attracted to our goods, increasing the level of our exports.  Consequently, the net export will rise, bringing rise to the level of AE.   

            ↓P  →  ↓M (our goods cheaper than abroad) + ↑X (foreigners buy our goods) →  ↑AE ( rise in real GDP. )

Next, there are four determinants of aggregate demand. The changes in aggregate demand involve two components. First, a change in one of the determinants of aggregate demand that directly, changes the amount of real GDP demanded. While for the other one, a multiplier effect that produces a huge change in aggregate demand.

Four determinants that changes the aggregate demand:

•         Consumer Spending/Expenditure (C)

•         Investment Expenditure (I)

•         Government purchases (G) and

•         Net exports

Now let’s have a look at the first determinant which is the consumer spending/expenditure. Under the consumer spending/ expenditure determinant, there are several factors that cause the shift in aggregate demand curve. Those factors are consumer wealth, consumer expectations, household debt, and taxes.

·         Consumer wealth – Consumer wealth is the total dollar value of all assets owned by consumers in the economy less the dollar value of their liabilities, known as debts.

·         Consumer expectation – Changes in consumer expectation about the future may change the pattern of consumer spending.

·         Household debt – Consumers can increase their consumption spending by borrowing, it would shift the aggregate demand to the right.

·         Taxes – Reduction in personal taxes would lead to less spending by consumers.

Next, under the investment-spending determinant, there are several factors that cause the shift in aggregate demand curve. Those factors include real interest rate and expected returns.

·         Real interest rate - Interest rates affect the firm because they represent a cost of business projects.

·         Expected returns - Expectation about future sales.  If firms expect sales to increase in the future, they will invest to meet this expected increase in demand. 

Under unexpected returns, it is influenced by several factors:

·         Future business condition – Optimistic future of business conditions, firms are likely to forecast a higher return on current investment or may make more investment.

·         Technology – New and improved technologies enhance the rate of returns on investment as well.

·         Degree in excess capacity – Increase in excess capacity, known as unused capital would reduce rate of returns.

·         Business taxes – An increase in business taxes will reduce profit after tax there leading to a lower rate of returns.

Lastly, under the government spending determinant, there are several factors that cause the shift in aggregate demand curve. Those factors include net export spending.

Under net export spending, it is influenced by two possibilities to change the net export spending.

·         National Income Abroad – The increasing national income abroad encourages foreigners to buy more products from our home country.

·         Exchange rates - Exchange rate is the price of one currency expressed in another currency.  An appreciation of RM means that RM has increased in price, making foreign goods cheaper. 

Increases in AD: Above-Full Employment and Demand-Pull Inflation.

            One type of inflation would be the demand-pull inflation. Due to the rising demand for Malaysia goods and services by households and firms, there will be a shortage of goods and services in the short run. Therefore, firms will be able to push the prices of goods and services up. Moreover, due to the high demand, firms will now produce more goods and services and since consumers are willing to pay high price, firms will raise the prices of goods and services.

            The factors which cause total aggregate demand to increase would be an increase in consumer spending, government spending, investment spending as well as export earnings. An increase in income level or consumer confidence will lead to an increase in consumption spending, thus, increasing the aggregate demand. For example, a rise in disposable income in Malaysia will result in Malaysian consumers being able to buy more goods and services than previously. This will cause the demand for goods and services to increase, indicating a rise in consumption spending as well as in the prices of goods and services.

            The following diagram shows the rise in the price level from P1 to P2, the increase in aggregate demand ; AD1 to AD2 beyond the full-employment level of output causes inflation. The increase in demand expands real output from the full-employment level Qf to Q1. The distance between Q1 and Qf is a positive, or ‘ inflationary ‘, GDP gap.

Demand and Supply - Not that hard after all

The picture on the left explains it all! When people talk about economics, most them say it is one of the toughest subjects and it is hard to understand. Truth be told, there is a secret to learn economics. How? It is by understanding demand and supply thoroughly.

What is demand and supply? According to Moffat (n.d.), demand in economics is the want or desire to possess a good or service provided they have sufficient financial instruments or services to own the goods itself. Supply, however, is the relationship between the quantity of a good or service consumers will offer for sale at a specific price.

Now, lets look at an example on how to read a simple demand-supply graph. 

Let's imagine that the graph on the right is the demand-supply graph for palm oil in the year 2012. The Y-axis represents the price and the X-axis represents the quantity.The curve that is downward slopping is the demand curve while the curve that is upward slopping is the supply curve. The point of intersection of the demand and supply curve is known as the equilibrium point. At this point, both quantity demanded and quantity supplied for palm oil is equal. In addition, the equilibrium point will determine the price of the product or services provided.

Ceteris Paribus
When ceteris paribus is applied, it means that all other factors, besides price, that might affect the supply or demand curve are kept constant. This means that if there is a change in demand or supply when ceteris paribus is applied, it is caused by the change of price of the good or services provided itself. Note that the curve will NOT shift.

The demand and supply curve do shift. They shift due to other determinants, which of course is not the price.

Determinants for demand:

• Festive seasons
• Income of individuals
• Brand
• Availability of substitutes
• Weather
• Complements
• Tastes/Preferences
• Etc

Determinants for supply:

• Technology
• Tax Rates
• Subsidies
• Price of other goods
• Etc

Whether the curve shifts left or right depends on the type of determinants that affect the curve.

Demand-supply curve for Starbucks' coffee
Shift of demand curve to the right

Referring to the graph above where the supply is constant, lets take income of individuals as an example of a determinant for the demand for Starbucks' coffee. Lets assume that your pocket money for a week is RM50. Definitely, your demand for Starbucks' coffee is not high, correct? However, if you are given RM200 a week, you wouldn't mind spending money on coffee from Starbucks despite the price would you? This shows that your demand for Starbucks has increased by a significant amount. Thus, it causes the demand curve to shift towards the right (from Demand to New Demand), increasing the demand for Starbucks (from Q1 to Q2) as well as readjusting the equilibrium price to a higher value (from P1 to P2).

Shift of demand for Starbucks' coffee to the left

On the other hand, referring to the graph above, if your pocket money was RM200 for a week at first and it was then reduced to RM50, you tend to spend less. This means that you are not willing to pay for a cup of coffee from Starbucks. The reduction in income causes the demand curve for Starbucks to shift left since the demand for Starbucks has decreased (from D to D1). The price will eventually fall as well (from P to P1). The shift of the demand to the left or right is easier to be seen when you put yourself in the shoes of the consumers.

Demand-supply curve for the supply of rice

The graph above shows the demand-supply curve for the supply of rice. Lets assume that tax rates is now the determinant for the supply of rice. Take note that the supplier's view is different from the consumer's. As a supplier, you would want to maximise profit while a consumer would want to maximize satisfaction. Assume that the tax rate has increased from 10% to 20% for example. What will you, as a consumer, do? Definitely, you will produce less because the cost of production is now high due to the high tax rate imposed. Therefore, the supply curve shifts to the left (from S0 to St). This causes the price to increase (from P0 to Pt) for a shortage in supply occurs. The effect is reversed if the tax rate is reduced.

The shift of the demand and supply curve can be easily seen when you put yourself in the position of the consumer or the supplier. The effect can also be easily seen. If the demand curve shifts right, the price increases; vice versa.

Perfect Competition

To claim that something is "perfect" is to say that it cannot be done better. Perfect competition’s theory is a well worked out theory that has been around the world for over a century. Unfortunately, the theory of perfect competition is nonsensical when applied to an economy of a country. Let me explain why this theory is nonsensical. First of all, let me define the meaning of perfect competition. Perfectly competitive markets are defined by two main characteristics: the first characteristic is the goods being offered for sale are all the same which is also known as homogenous product and as a result buyers have no preference between one sale and another; and the other characteristic is the buyers and sellers are so numerous that no single buyer or seller can influence the market price.  Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. Besides that, in perfectly competitive market, there are no barriers to entry. There must be free entry to and exit from the market. If the industry is making profits, then new firms will enter the market. Otherwise, some firms will leave the market. No restriction is imposed in perfectly competitive market.

But the fact is in real world situation, there are no examples for a real perfect competition or for anything close to that, because no producer wants to position themselves in perfectly competitive market. Producers cannot expect to make any profit in this market. Perfect competition is achieved when a particular industry have exactly the same cost structures and there are a sufficiently large number of these identical firms so that the output decision of any one firm has no impact on the price at which its product is sold. Firms maximize its profit by giving big discount to attract consumer to buy their products, claiming that their product is better than the other and etc. According to perfect competition theory, sellers and buyers cannot determine the market price themselves. This is the characteristic that do not like by all the producers. This can be said that the main reason why perfectly competitive market is nonsensical in real world.

For example, agricultural markets particularly up through the beginning of the 20th century, were viewed as being close to a real-world version of a perfectly competitive market. But as the technology is keep on growing now, farmers can grow their crops much faster and much better and the quantity and the cost used to produce the crop differs for each farmers. In this situation, agriculture cannot become a perfect competition anymore.

In conclusion, we can know that there are no perfectly competitive markets in the real world.  However, in our fast changing world, the choices of products and services available to consumers, the technologies for producing those products and services, and the costs involved in production are rapidly changing. Before market forces can begin to gel to create price competition and firms can modify their operations to copy the most successful sellers, changes in circumstances may stir enough such that the market formation process starts newly again and make no way for perfectly competitive market.

"TNB" a monopoly in Malaysia!

 As we all know who is Tenaga Nasional Berhad (TNB). TNB was formed in 1990 by the National Electric Board (NEB). They are the one and only electricity utility company and their the largest in Malaysia and their also the largest power supplier company in South-east Asia with MYR 69.8 billion worth of assets. So the electric supply in Malaysia is a virtual-monopoly own by them.

What is a monopoly? A monopoly is a market with only one seller and the nation or the consumers do not have another alternative to purchase the product or the service. A monopoly normally arise due to the barrier of entry which restrain other companies from entering the market and the exerting pressure from the monopolist. A monopolist is also a price maker which means they can set the price to earn supernormal profits. There are multiple forms of barrier to entry. 

In Malaysia, one of the reason why there is no alternative to TNB is because the government itself don't allow or approve the license for another company to enter the market. Another reason is because of the existence of economies of scale. TNB produces large output of electricity in Malaysia which can also lower down their average cost of production. For a new company which newly entered the market, they have to start from scratch with a low output. That means their average cost of production will be too high and that will make the new company to leave the market. It is not cheap to produce electricity and most of the electricity in Malaysia are all run by hydroelectric dams. Building a new dam can cost up to billions of Ringgit which even banks will not give out such a big loan. So the initial investment or the modal to start up a new company will be to expensive which discourages new firms from entering the market.

There are several advantages and disadvantages for a monopoly market (TNB):

• A monopolist can facilitate the supply and demand every second as it make decisions to produce or not to produce electricity.
• A monopoly can also lead to lower prices with a greater supply.
• A good stock to buy with the return of great dividends.

But on the other hand there are also disadvantages:

• A monopolist can simply control the price of their product (Electricity).
• With the existence of "tariff" TNB losses money from every household or firms.
• Since TNB is a monopoly, if a consumer uses low electricity the "tariff" would be lower but when a consumer uses higher electricity, the higher the "tariff" would be.

Source: TNB