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CHAPTER

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5.1 Market Equilibrium and Determination of Price and Quantity 5.2 Demand and Supply Shifts 5.3 Sources of Demand Shifts 5.4 Sources of Supply Shifts 5.5 Anatomy of Famines 5.6 Efficiency of the Price Mechanism and Competitive Markets 5.7 Economic Policy by the Government and Market Equilibrium

The foundations underlying the demand and supply curves were laid in Chapters 2 and 4 respectively. These curves respectively tell us how much consumers demand and how much producers supply at different prices. But they do not tell us what the actual price of the product will be (in principle) or, in other words, what points on the demand or the supply curve will be actually chosen in the market place. This issue is addressed in this chapter by pooling together what we have learnt about the demand and supply. It forms the core of how the market system works in particular how an economys central problem of what is solved through the price mechanism. You will see that there are not many new concepts or definitions to be learnt. The emphasis is on applications. A number of examples will be provided as we proceed. 5.1 MARKET EQUILIBRIUM AND DETERMINATION OF PRICE AND QUANTITY

Consider fig. 5.1. It depicts the market demand and supply curves of a particular product, denoted respectively by DD and SS. The question is: which price will prevail in the market? Suppose that, initially, the price

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in the market for that good is P1. At this price, the consumers demand the quantity D1 and the producers supply the quantity Q1. Obviously, there is a mismatch. Consumers want more than what the producers are willing to supply. There is excess demand, equal to AB or Q1D1.1 Will then the price stay at P1? No, excess demand will create competition among the buyers and push the price up. It will increase, say, to P2. Excess demand is present at this price also. Thus price will increase further. Indeed, the price will keep increasing as long as there is an excess demand. This is indicated by the upward-looking arrow. Finally it will converge to PO, at which there is no excess demand. Just the opposite happens if initially the price is P3. The quantity demanded (D3) is less than the quantity supplied (Q3). There is excess supply, equal to D3 Q3 which will create competition among the sellers and lower the price. The price will keep falling as long as there is an excess supply. It is indicated by the arrow, pointing downwards. Where will the price finally settle? The answer is again P0, at which there is no excess supply. The situation of zero excess demand and zer o excess supply defines market equilibrium. Alternatively, it is defined by the equality between quantity demanded and quantity supplied. In fig. 5.1, it is shown at the point E0. The price P0 is
1

called the equilibrium price. Recall that equilibrium means a position of rest. Here, the market rests at price P0 in the sense that there is no pressure on price to either increase or decrease. The equilibrium quantity exchanged (between consumers and producers) is equal to Q0. This is how price and quantity are determined in the market.

Fig. 5.1 Market Equilibrium

As a numerical example, consider Table 5.1, which gives the demand and supply schedules of bananas (in a given geographical location and within a given time period). The equilibrium price is Rs. 21, since at this price quantity demanded matches with quantity supplied. The equilibrium quantity sold/purchased is 6,000 dozens. The corresponding demand and supply curves and market equilibrium are shown in fig. 5.2.

The term excess demand here refers to a particular commodity or service. This is different from what is meant by excess demand in macroeconomics.

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Table 5.1

An Example of Demand, Supply and Equilibrium Quantity Demanded (in dozen) 10,000 8,000 7,000 6,000 5,000 4,500 Quantity Supplied (in dozen) 1,000 2,000 4,000 6,000 7,500 8,500

Price of Bananas per dozen (in Rs.) 18 19 20 21 22 23

Fig. 5.2 Market Equilibrium Corresponding to Table 5.1

which any positive amount can be supplied is higher than what the consumers are willing to pay. Put differently, costs are too high for any positive output to be produced. In India and many other countries, commercial aircraft is such an example, i.e., it is not produced at all. Of course, an industry, which is not viable in one country, can be viable in some other. For example, commercial aircrafts are produced in America, Russia, Britain and France.2

It is, however, quite possible that a situation such as in fig. 5.3 occurs: the demand curve and the supply curve do not intersect with each other at any positive quantity. What does this mean? This means that the product in question will not be produced in the economy. The industry is not economically viable. The price at
2

Fig. 5.3

A Non-Viable Industry

Computer memory chips, mother boards and copying machines are other examples. These are totally imported, not produced at all in India.

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Figs. 5.1 and 5.3 illustrate how the what problem of an economy is solved by market mechanism. Goods and services for which fig. 5.3 applies are not produced. Those for which fig. 5.1 applies are. Given that a good is produced, from fig. 5.1 we also know the quantity that will be produced and the price that will be charged in equilibrium. 5.2 DEMAND AND SUPPLY SHIFTS For any given product in the real world, price and quantity exchanged change from time to time. Some of you must have shopped for fruits and vegetables for your family or for yourself. The same cauliflower, for example, costs less in the winter than in the summer. Apples sell for less in some seasons than in others. A computer for a given configuration sells in your town for, say, Rs. 30,000. The same computer will sell for much less, six months after. The analysis of demand and supply curves and the market equilibrium provides the framework to explain such changes. How? Through shifts in the demand curve, the supply curve or both. We already know in Chapters 2 and 4 how various factors cause shifts in these curves. Changes in those factors explain price and quantity changes. Without going into what causes a shift, we first discuss how a demand or a supply shift will affect price and quantity. 5.2.2 Demand Shifts
(a)

(b) Fig. 5.4 Demand Shifts

Turn to fig. 5.4(a). Let the initial demand and supply curves be DD0 and

SS0 respectively. Accordingly, the initial price and quantity are respectively P0 and Q0. Now let the demand curve shift to the right, as shown by DD1. We see immediately that the equilibrium point shifts from E0 to E1. The new price and quantities are P1 and Q1 respectively. Thus both price and quantity increase. It is important to understand the economic process that leads to these changes. Starting from the initial situation of no excess demand or supply [at E0 in fig. 5.4(a)], a rightward shift of the demand curve moves the consumption point from E0 along DD0 to A along DD1.

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This creates an excess demand, equal to Q0Q'. In turn, it causes price to increase, and, hence the new price settles at a higher level. While there is a change in demand, producers however operate on the same supply curve. Hence, there is a change in the quantity supplied, not a change in supply. At a higher price they supply more quantity. This explains why the new quantity exchanged is greater. Likewise, a leftward shift of the demand curve will lower the equilibrium price and quantity, as shown in fig 5.4(b).

and supply curves are denoted again as DD 0 and SS 0; E 0 is the original equilibrium point. Suppose the supply curve shifts to the right to SS1. The new equilibrium point is E1. The new price and quantity are P1 and Q1. We see that the price decreases and the quantity increases. Why? At the original price P0, an increase in supply causes an excess supply in the market. This causes the price to fall and the new price settles at a level that is less than the original price. Since the demand curve remains the same, the decrease in price leads to a downward movement along the demand curve. More quantity is demanded and in equilibrium more is produced. The effects of a leftward shift of the supply curve cause rise in price and fall in quality as shown in Fig. 5.5 (b) 5.2.4 Simultaneous Demand and Supply Shifts

(a)

Fig. 5.5

(b) Supply Shifts

5.2.3

Supply Shifts

Now consider supply shifts, shown in fig. 5.5. In panel (a) the original demand

It is possible that both demand and supply shifts occur simultaneously. Their net impact on price and quantity will be a combination of 1 and 2 in Table 5.2. For example, the demand and supply curves both shift to the right. Then the market price may increase or decrease, but the quantity exchanged will increase unambiguously. The opposite happens if both curves shift to the left. Similarly, if the demand curve shifts to the right and the supply curve to the left, the market price will unambiguously increase, while the

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Table 5.2

Summary of Demand and Supply Shift Effects

1. A rightward (leftward) shift of the demand curve leads to an increase (a decrease) in market price and an increase (a decrease) in the quantity exchanged. 2. A rightward (leftward) shift of the supply curve leads to a decrease (an increase) in market price and an increase (a decrease) in the quantity exchanged. quantity exchanged may increase or decrease. The opposite happens if the demand curve shifts to the left and the supply curve to the right. We return now to demand and supply shifts one at a time, examine their causes, and, by using Table 5.2, their effects of price and quantity. 5.3 SOURCES OF DEMAND SHIFTS Recall from Chapter 2 that the market demand curve can shift because of changes in income, prices of related goods, tastes or size of the market. We analyse each of these in turn. 5.3.1 A Change in Income If it is an inferior good, we know that an increase in income shifts the demand curve to the left. Fig. 5.4(b) then applies: both price and quantity fall.
Example 5.1 Market for Real Estate in Kerala.

Suppose that there is an increase in aggregate income in an economy. We know from Chapter 2 that, as long as a product is normal, the demand curve for it shifts to the right. Fig. 5.4(a) applies. Both price and quantity increase. For a decrease in income fig. 5.4(b) applies. Both market price and quantity fall. Therefore, for a normal good, an increase (a decrease) in income leads to increases (decreases) in the price and quantity exchanged.
3

Think of the market for land, flats etc. The 1990s saw a large increase in urban land price and a vast increase in the number of single-houses and apartment buildings in Kerala, especially in towns like Cochin, T richur, Kottayam, Chalakudi and Chavakkad. It was not because there was a massive industrialisation or an unusual population explosion in these areas. Instead, the reason was that a lot of Keralites from these areas moved to the Middle East countries to work and earned substantial income there.3 They used that income to buy more and better housing at home. This shifted out the market demand curve for housing in urban Kerala. In some places the land price almost trippled in two years.4 Example 5.2 Japan in late 1980s and early 1990s. In this period, as the Japanese economy was growing strongly, various name

Air India even operated special flights from Trivandrum to the Middle East to accommodate the increased traffic. An estimated 16 lakh Keralites were working in the Middle Eastern countries and they brought, annually, foreign exchange worth of 700 to 1,000 crores of rupees. This is based on Sonali Mujumdar, Highrise Hungama, Touchdown India, undated.

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brand products became the outlet for rising income. For example, there was an increase in demand for Levis jeans and Nike shoes. As a result, the prices and quantities sold of these items in Japan soared.5

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as its quantity will fall. Hence, as the price of a complementary good increases, the price of a given product and its quantity exchanged both decrease.
Example 5.3 Prices of Coffee and Tea in the World Market in the Late 1990s. Brazil is a major producer in the world coffee market. In 1994, it was hit by two severe frosts, which damaged more than half of its coffee trees. As a result, the price of Brazilian coffee in the world market shot up and it remained high in the next few years. With a lag of two years, the price of tea in the world market also jumped up (while the production of tea was still growing). This can be interpreted as a delayed effect of an increase in the price of coffee on demand for tea.6

5.3.2 A Change in the Price of a Related Good in Consumption Take for instance, the market for tea. Suppose the price of coffee rises for some reason. From our analysis of demand shifts in Chapter 2, we know that, tea being a substitute of coffee, the demand curve for tea will shift to the right. Fig. 5.4(a) applies then. The price of tea rises and so does the quantity of tea exchanged. Thus, as the price of a substitute good in consumption rises, the price of a given product rises and its quantity exchanged increases. Unlike coffee and tea, sugar consumption is complementary to tea. Suppose the price of tea goes up. How does it affect the sugar market? From Chapter 2 again, the demand curve for it shifts to the left. Applying fig. 5.4(b), we find that the price of sugar as well
5

5.3.3 A Change in Tastes Think about the market for bitter gourd.7 Surely it is not a very popular vegetable in your age group. But imagine that medical research shows that eating 100 grams of bitter gourd per day prevents pimples on the face. This will definitely generate a

See William Baumol and Alan Blinder, Economics: Principles and Policy, 8th Edition, Harcourt College Publishers, 2000, page 80. Also see JETRO (Japan External Trade Organization), The Japanese Consumer: From Boom to Reality, 1994, http://www.jetro.go.jp/it/e/pub. In the New York wholesale market, Brazilian coffee sold for $1.43/pound in 1994, compared to 66.58 cents in 1993, i.e. it more than doubled. It remained high for the next four years ($1.46, $1.20, $1.67 and $1.22 in 1995, 1996, 1997 and 1998 respectively). During the same time period, the wholesale tea prices, as quoted in the London auction market, were 84.20 cents, 83.15 cents, 74.46 cents, 80.36 cents, $1.08 and $1.08 per pound for the years 1993, 1994, 1995, 1996, 1997 and 1998. Observe that the tea price went up particularly in 1997 and 1998. However, the world production of tea in 1997 was 2% higher than that in 1996, and, in 1998, it was 11% higher than it was in 1997. The Data sources are the following. For coffee and tea prices, it is International Monetary Fund, International Financial Statistics Yearbook 2000. For tea production, it is the web site of UK Tea Council, namely, http://www.teacouncil.co.uk. This is called karela in Hindi, kalara in Oriya and Pavakkai in Tamil.

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Example 5.4 Market for Air Travel.

Consider air travel. After the terrorist attacks in America on September 11, 2001, many people became afraid of flying. This can be thought of as an adverse change in tastes due to fear of flying, which would shift the demand curve for air travel to the left. The price of air tickets would fall and less number of people would travel. These things did happen. Shortly after that day, there was a major decline in the ticket price of air travel within America and a large decrease in the number of passengers. Many airlines had to reduce their scales of operation drastically.

Example 5.6 House Price Rise in Vancouver, Canada, during 1990-1995.

5.3.4 A Change in Market Size By now you should know immediately how this affects price and quantity. An increase in population would shift the market demand curve to the right and result in a higher price and a higher
8 9 10

During this period the price of houses in this city in Canada increased substantially from nearly 2.2 lakh Canadian dollars, on the average, in 1990 to nearly 3.08 lakh Canadian dollars, on the average, in 1995. This was primarily due to the huge migration of people from Asian countries, especially from Hong Kong. Uncertainty over the future of Hong Kong after the scheduled hand-over of the city from Britain to China in 1997 forced many residents of Hong Kong to leave for United States and Canada. They were, by and large, wealthy. Most of those who came to Canada settled in Vancouver.9 Their demand for housing was the main factor behind the house price surge there during the period 1990-1995.10

Recall that a change in taste does not only include a change in taste in ones mouth; it means a change in demand due to reasons other than price or income changes. Overall, migration from overseas contributed 79% to the net population growth of Vancouver. The source of this material is David Ley and Judith Tutchener, Immigration and Metropolitan House Prices in Canada, Research on Immigration and Integration in the Metropolis Working Paper Series, Vancouver Centre of Excellence, March 1999.

change in your food habits.8 Many of you will start to eat more bitter gourd than before. The market demand curve will shift out. We can use fig. 5.4(a), and deduce that price of bitter gourd as well as the total quantity produced and consumed of it will increase. Likewise, a decline in liking for a product will cause opposite changes. Thus, a favourable (an unfavourable) change in taste will cause product price and quantity exchanged to increase (decrease).

quantity, whereas a decrease in the population will do the opposite.

Example 5.5 Land Price Increase in Delhi in 1980s. Compared to 1970s, there was a substantial increase in land price in Delhi. It was because of large scale migration of people from Punjab to Delhi following disturbances in Punjab in the mid 1980s. This can be interpreted as an increase in market size for land in Delhi, which pushed up the land price in Delhi.

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5.4 SOURCES OF SUPPLY SHIFTS In Chapter 4 we learnt that technological progress, changes in input prices, changes in excise taxes or changes in the prices of related goods in production cause shifts in a firms supply curve and hence shifts in the market supply curve. Moreover, a change in the number of firms shifts the market supply curve without affecting the individual supply curves. 5.4.1 Technological Progress It shifts the supply curve to the right. Fig. 5.5(a) applies. Thus, technological progress leads to a fall in price and an increase in quantity exchanged.
Example 5.7 Micro-computer CPUs.

5.4.2 Change in Input Prices From Chapter 4 we know that the supply curve shifts to the right or left, as an input price decreases or increases. Therefore, in view of figs. 5.5(a) and (b), the product price decreases and the quantity rises or the price increases and the quantity falls according as an input price decreases or increases.
Example 5.8 Personal Computers.

This is a prime example of technological progress. As you might know, the brain of any micro-computer is its CPU, the Central Processing Unit. About 1.5 square inches in size only, the CPU is placed inside a computer. Its speed (similar to the speed of brain) is given in a MHz rating.11 Over the last few decades, the production of CPU has seen phenomenal technological progress. As a result, we see the price of a CPU of a given speed going down rapidly over time. Indeed, the technological progress is so rapid that, after being introduced in the market, a CPU of a given speed becomes almost obsolete in a matter of 6 to 7 years, sometimes less. For instance, in 2000, a 550 MHz CPU cost around Rs. 14,000. A year later in 2001, it was selling at around Rs. 9,000.

It is a common observation now a days that the price of a PC system (the computer, the monitor and the printer) of given configurations goes down rapidly over time. It is because the components (i.e. inputs) that go into making a PC are becoming increasingly cheaper. The case of CPU was discussed in Example 5.7. Other components of a computer system are becoming cheaper also. A 15" colour monitor used to cost around Rs. 8,400 in 2000. In 2001, it came down to about Rs. 7,000.

Note carefully that Example 5.7 was about a decrease in input price due to technological progress, whereas in Example 5.8 the product price decreases because of decrease in input prices.
Example 5.9 Internet Caf Rates in India.

These cafes have sprawled in many cities, big and small, all over India. In the year 2000, in Delhi an hourly

11

For example, at the time of writing this book, my desk-top computer had a 550 MHz CPU in it.

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rate for internet surfing was no less than Rs. 50. In 2002, it came down to an average Rs. 15 in many such cafes. 12 This is because of reduction in input prices. First, the price of computers came down. Second, the internet access charges to these cafes by ISPs (Internet Service Providers) such as VSNL (Videsh Sanchar Nigam Limited), Satyam etc. went down. Third, in connecting to the ISPs, instead of phone lines, cable lines could be used, which are cheaper and through which the connection can be kept uninterrupted for 24 hours a day.

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5.4.4 Increase in the Price of Substitute Goods in Production It was also discussed in Chapter 4 that an increase in the price of a substitute good in production shifts the supply curve of a given product to the left. Applying fig. 5.5 we can then say that an increase (a decrease) in the price of a substitute good in production leads to an increase (a decrease) in price and a decrease (an increase) in quantity. 5.4.5 Number of Firms Even when the individual supply curve does not shift, the market supply curve can if the number of suppliers in the market changes. We already know that an increase in the number of firms (which can be interpreted as greater competition) shifts the market supply curve to the right. A decrease in the number of firms, i.e., less competition does the opposite. Thus, from figs. 5.5(a) and (b), price falls and quantity rises or price rises and quantity falls, as there is more or less competition in terms of the number of firms.
Example 5.11 Mobile Phone Rates.

5.4.3 Change in Excise In Chapter 4, we saw that an increase (decrease) in the excise duty rates shifts the supply curve to the left (right). From fig. 5.5 then, it follows that the price of the product will increase (decrease) and quantity transacted will decrease (increase), as the excise duty rate increases (decreases).
Example 5.10 Cosmetics Toiletories in 2002. and

In the union budget of 2002-2003, the special excise duty on cosmetics and toiletories, 16% earlier, was completely removed. As soon as it happened, major companies like Hindustan Livers Ltd. (HLL), Godrej and Proctor and Gamble (P & G) reduced prices in this category of products. For example, HLL reduced prices across a variety of brands including Clinic and Sunsilk shampoos, Ponds skin creams, Ponds talc and Lakme make-up products.

12

This rates were found from the authors own survey.

Mobile phones came to the four major cities of India in the mid 1990s. In Delhi, there were initially two companies: AirTel and Essar. The charges for outgoing and incoming calls were quite high, no less than Rs. 15 per minute. By the end of 2002, there

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were four companies : Bharati's AirTel, Hutchison's Hutch (which acquired Essar), MTNL's Dolphin and Tata-Birla -AT & T's Idea. The mobile phone rates have come down drastically. Incoming calls in some schemes are even free.

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5.5 ANATOMY OF FAMINES: AN APPLICATION OF THE DEMANDSUPPLY ANALYSIS The reach of demand-supply analysis is quite far and deep. Not only it explains what happens in the market for products like coffee, tea or computers, it can shed light on very complex socio-economic issues. In this section, we apply it to understand how famines occur. A famine is characterised by widespread death due to starvation and epidemics.13 Epidemics typically result from large scale starvation. Hence, famine can be seen as a massive incidence of starvation. In turn, starvation is reflected mostly in the staple food of the region. Therefore, analytically, the question is how a large section of a regions population cannot afford to buy the minimum amount of the staple food for survival. The standard view is that it is primarily a production or total availability problem. We can define total availability of a product as the amount produced plus the amount stored in government and private warehouses. For reasons like natural calamities and unfavourable weather over critical months, the total production of the staple food is severely affected, which drastically limits the total availability. As a result, a large portion of a regions population

Although the mobile phone market has only a few number of firms, not many as in a perfectly competitive market, it is the entry of new firms, which is a contributing factor in the decline of mobile phone charges. 5.4.6 Other Factors Factors like weather, natural disasters such as cyclone, flood etc., which are results of Natures play, can also affect the supply of a product. For instance, variation in agricultural output in India from one year to the next is dependent partly on how good the monsoons are. A specific example of this and its effect on price is given below.
Example 5.12 (In)Famous Onion Price Increase in 1998.

13

In the Bengal Famine of 1943 for example, one of the worst famines of the 20th century, an estimated 16 lakh people died.

In October -November of 1998, the onion price in India increased 6 to 10 times from its usual price. Onion being a very common vegetable, consumed by most households, it became a very politically sensitive issue. The reason behind this unprecedented onion price rise was heavy rains and flooding in the onion growing areas in India, which caused a drastic decrease in supply of onions to the market in that year.

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does not get the minimum amount for survival and there is a large-scale starvation. Professor Amartya Sen of India, the only Nobel laureate in economics in Asia thus far, calls this the FAD theory, with FAD standing for food availability decline. In what follows, the FAD theory is illustrated in terms of the demandsupply analysis. Professor Sens own theory of famines is different. For those who are interested, Appendix 3 illustrates his theory in terms of the demand-supply analysis.14 See Clip 5-1 for a short bio-sketch of Amartya Sen. 15 5.5.1 The FAD Theory Let the staple food be called rice. Turn to fig. 5.6, which depicts the individual and market demand curves for rice as well as the market supply curve of rice. Let us say that there are three families, A, B and C, in the market. The panels (a), (b) and (c) graph their demand curves respectively. The B-type familys demand curve lies to right of that of the A-type and the C-type familys demand curve lies to right of that of the B-type. We can interpret the A-type as the poorest, the B-type as the next poorest and the C-type, the richest.
14

Note that when the price of rice is p1, the A-type family cannot afford to buy any rice at all, but the B-type or the C-type family can. As shown, this price is above the point at which the DDA, curve intersects the price axis. Hence, the A-type familys quantity demanded is zero. This is not true for the B-type or the C-type family. The former demands the amount B1, and the latter the amount C1. If the market price is p2 the A- and B-type families cannot buy rice but the C-type can; its quantity 16 demanded is C2. Panel (d) depicts the market demand curve, DD M as the horizontal summation of the three individual demand curves. This graph assumes that there is one family of each type. But it is not a major assumption at all. If there are two or more families of any given type, the market demand curve is obtained by horizontally summing the demand curves of all families. The resulting curve will look similar to DDM. From the supply side, let the total available amount initially be M0. It is drawn vertical to represent that, after the harvest, this is the total, potential amount available for consumption.17 The equilibrium price is then p0. At this price, all families are able to buy rice. The types A, B and C respectively buy

15 16 17

The material on FAD theory and Sens own theory is based on Sen, A.K., Poverty and Famines: An Essay on Entitlement and Deprivation, Oxford University Press, 1981. The demand-supply version of these theories is the authors own copyrighted work, based on Theories of Famine: An Exposition, mimeo, Indian Statistical Institute, April 2002. It is hoped that some of you will be inspired, decide to study economics further in college and eventually bag Nobel prizes for India. If the price of rice is p3 or higher no one can buy rice; but such a price cannot prevail in equilibrium and hence is irrelevant. We can instead draw a standard upward sloping supply curve. But this will not change the analysis.

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CLIP 5-1
By now Professor Amartya Sen is a household name in India. He was born in Santiniketan in 1933. He studied in Calcutta University and later got his Ph.D. from Cambridge University in 1959. Since then he has held faculty positions in various prestigious institutions at home and abroad such as Delhi School of Economics, Oxford University, London School of Economics and Harvard University. Currently, at this time of writing, he is the Master of Trinity College at Cambridge University. He has received more than forty honorary doctorates from major universities around the world, and the Bharat Ratna award, which is the highest civilian award in India. He has published numerous books and articles, and, his research has ranged over many areas of economics, particularly welfare economics, and philosophy. In awarding him the Nobel prize in 1998, the Royal Swedish Academy of Sciences said that he had made several key Amartya Sen contributions to the research on fundamental problems in welfare economics. His contributions range from axiomatic theory of social choice, over definitions of welfare and poverty indices, to empirical studies of famine.

A0, B0, and C0. This situation can be interpreted as normal, one in which there is no starvation or famine. Now suppose that, for some reason, say, because of a bad monsoon, there is less amount available, equal to M1. The equilibrium price is higher, equal to p1. Notice that at this price, the poorest cannot afford to buy any rice, but the other types can. We can think of this situation as starvation:

some people in the lower end of income cannot just afford to buy enough food for survival. If, instead, the total available amount were much less compared to the initial situation, e.g, equal to M2, the price would have risen to p2 and observe that at this price both A-type and B-type families would be out of the market. We can interpret this as a situation of famine or massive starvation. Whether exactly two types

Fig. 5.6

FAD Theory of Famines

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of families are deprived of the staple food or not is immaterial. This situation generally represents that a large number of people are under starvation. This is the FAD theory. In summary, it says that a drastic fall in the total availability of food causes massive starvation and famine. The causal link is that a large scale decline in food supply pushes the market price up to such a level that many poor people can no longer afford to buy the minimum amount for survival. 5.6 EFFICIENCY OF THE PRICE MECHANISM AND COMPETITIVE MARKETS

Many examples of demand and supply shifts have been analysed. You should not think, however, that such shifts are confined mostly to these examples. The chosen examples are the very obvious ones. In a market economy, these shifts occur almost always and in case of all goods and services, but they occur gradually over time. At this point, it will be better if you pause for a moment here and reflect how the forces of demand and supply and the price mechanism solve the what problem in a market-oriented economy. Suppose for some reason, demand for a product rises. This shifts out the market demand curve (which is not an observable physical object). It tends to raise the market price that is observed. The price change acts as a signal to producers. They increase their quantity supplied. The new equilibrium price is higher. The consumers are able to buy

as much as they wish to, and, the producers are able to sell as much as they wish to at that price. The adjustment is complete. You can interpret the equality between quantity demanded and quantity supplied as coordination between demanders and suppliers through the price mechanism. Unlike in a centrally planned economy, there is no need for a central authority to directly coordinate between the wants of millions of consumers out there and the production capabilities of the economy. Things happen in a systematic way by an invisible hand so-to-speak. This is the beauty of the price mechanism. In fact, it is said that price mechanism is one of the fundamental discoveries of the modern society. Like all great discoveries, however, the price mechanism has its own drawbacks. As argued by Sen and illustrated in Appendix 3, widespread starvation can occur even when there is no decline in the total availability of foodgrains. This is potentially a serious problem in a free market economy. There are also other issues relating to equity, preservation of our environment etc. that a free market system cannot handle in efficient ways. It does not however imply that a severely restricted market system is the right answer. What are the drawbacks of the free market system and what are their corrective solutions? These are very important questions. But we do not examine them here. It is a subject matter of higher courses in economics.

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5.7 ECONOMIC POLICY BY THE GOVERNMENT AND MARKET EQUILIBRIUM Not only is market equilibrium affected by the sources of demand and supply shifts considered earlier, it is influenced by various government policies as well. There are some policies, e.g., different kinds of taxes and subsidies, that change the market price indirectly via shifting the demand and supply curves. Sales taxes and excise taxes are common examples.18 These are called indirect interventions. There are other policies by which prices are fixed directly by the government; these are direct interventions. In what follows, we study direct interventions only. Price Control It is thought that if necessary items like sugar, rice, wheat etc. were left to the play of free market entirely, poor people

would not be able to afford them at the market-clearing price.19 Hence, for a long time, the government has adopted a system of price control through ration shops for such commodities. In terms of demand and supply curves, price control means fixing price below the equilibrium price (as the equilibrium price is presumed to be too high). This is shown in fig. 5.7(a) and denoted as P1. It is called the control price. Since it is below the equilibrium price (P0) the quantity demanded,P1D1, exceeds the quantity supplied, P1S1, This means that everyones demand, at the given price, cannot be satisfied. It implies the following: 1. There has to be some rationing an upper limit on the amount that can be purchased within a given time period. This explains why one cannot buy a large quantity at a time from a fair -price or ration shop.

(a) Fig. 5.7

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(b) Price Control and Price Support

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For example, in Delhi, the sales tax on pastries in the financial year 2001-2002 was 8% and that on bicycles was 5%. In general sales taxes vary across states and range typically from 5 to 15%. Some commodities are totally exempt from sales taxes. This is similar to the famine theory discussed earlier.

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2. Since there is a shortage at the control price, there will always be some buyers who are willing to pay a higher price than the control price and obtain the quantity that they desire. This gives rise to the existence of black markets. Support Price It is interesting that for the growers of the same essential products, e.g., for farmers who raise sugarcane, wheat etc., there have been support price or price support programmes, meaning price being fixed above the equilibrium price. These programmes are meant to insulate farmers from income fluctuations resulting from price variations in the free market. Support price is illustrated in fig. 5.7(b) and is denoted by P2. Since this price is above

the equilibrium price (P0), opposite to the price control case, the quantity supplied (P2S2) exceeds the quantity demanded (P2D2). There is always some surplus. Who buys the amount of surplus or excess supply, P2S2? It is the government by committing to buy the surplus at the pre-announced support price. It is noteworthy that while price control programmes are commonly observed in developing countries rather than in developed countries, agricultural price support programmes have been common in both groups of countries. However, many price support programmes are being phased out now in both developed and developing countries, because of their commitments made to World Trade Organisation as members.20

SUMMARY
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Excess demand pushes up the market price by causing competition among the buyers. Excess supply pushes down the market price by causing competition among the sellers. At the market equilibrium, there is no excess demand or excess supply and demand and supply curves intersect. A non-viable industry is one, in which the demand and supply curves do not intersect at any positive level of output. The supply curve lies above the demand curve and thus nothing is produced. A rightward (leftward) shift of the demand curve leads to an increase (a decrease) in price and quantity transacted.

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While the intentions behind price control and price support programmes are well-meant, there is considerable debate in economics literature about their efficiency in achieving the objectives, in comparison to other policies that can achieve the same objectives. This is something that will be studied in specialised courses in economics. World Trade Organisation is an international body like United Nations, having more than 120 member countries, whose objective is to promote free and fair international trade and commerce in the world economy. It came to existence in 1995 and is headquartered in Geneva, Switzerland. India is a founding member of WTO. China joined WTO in 2001.

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A rightward (leftward) shift of the supply curve leads to a decrease (an increase) in price and an increase (a decrease) in the quantity transacted. If both the demand and supply curves shift to the right (left), the effect on price is ambiguous but the equilibrium quantity exchanged increases (decreases). If the demand curve shifts to the right and the supply curve to the left, the price rises but the effect on quantity exchanged is unclear. An increase in the price of a substitute (complementary) good in consumption leads an increase (a decrease) in price and quantity transacted of a good in question. An increase in income results in a higher (a lower) price and quantity transacted according as the good is normal (inferior). A favourable (an unfavourable) taste shift leads to a higher (a lower) price and quantity transacted. A cost reducing technological progress leads to a lower price and more quantity being sold. An increase in an input price leads to a higher price and less quantity being sold. An increase in the rate of excise duty leads to a higher price and less quantity being exchanged of a particular product. An increase in the price of a substitute good in production will lead to a higher price and less amount exchanged of a particular product. More competition in an industry leads to a lower price and a higher quantity exchanged. According to the FAD theory of famines, as the available quantity of foodgrains falls, the price of foodgrains increases, such that families in the lower end of wealth and income can no longer afford to buy it. This causes starvation. The demand-supply equilibrium in a free market can be seen as co-ordination between consumers and producers. A price control system includes a rationing scheme since the quantity demanded at the control price exceeds the quantity supplied of it. It also leads to black marketing. A price support system leads to a surplus of output, which is purchased by the government.

EXERCISES

Section I
5.1 5.2 5.3 5.4 Give the meaning of excess demand for a product. Give the meaning of excess supply of a product. Define market equilibrium. Give the meaning of equilibrium price.

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5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14 5.15

For a non-viable industry, where does the supply curve lie relative to the demand curve? How does an increase in the price of a substitute good in consumption affect the equilibrium price? How does an increase in input price affect the equilibrium quantity exchanged in the product market? How does a favourable change in taste affect the market price and the quantity exchanged? How does a cost-saving technological progress affect the market price and the quantity exchanged? How does an increase in excise tax rate affect the market price and the quantity exchanged? When will an increase in demand imply an increase in price but no change in quantity supplied? What does the FAD theory of famines say? What is the relationship between the control price and the equilibrium price? What is the relationship between the support price and the equilibrium price? Why does a surplus emerge in case of a support price?

Section II
5.16 5.17 5.18 Show the determination of market equilibrium with the help of demand and supply schedules and a diagram. What is meant by economic viability of an industry? What will be impact on market price and the quantity exchanged when (a) there is a rightward shift in the demand curve ? (b) the demand curve perfectly elastic and the supply curve shifts out ? (c) both the demand and supply curves decrease in the same proportion ? How does an increase in the income affect the equilibrium price of a product? A severe drought results in a drastic fall in the output of wheat. Analyse how will it affect the market price of wheat. Suppose the demand for jeans increases. At the same time, because of an increase in the price of cotton, the supply of jeans decreases. How will it affect the price and quantity sold of jeans? Equilibrium price may or may not change with shifts in both demand and supply curves. Comment.

5.19 5.20 5.21

5.22

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5.23 5.24 5.25 5.26 5.27 5.28

5.29

5.30

5.31

How are decisions taken by consumers and producers in a market co-ordinated? Trace the effect of demand shifts on equilibrium price and quantity. Given one example each of direct intervention and indirect intervention in the market mechanism. What do you understand by (a) control price and (b) support price ? Show with the help of a diagram how rationing and black marketing can emerge in a price-control system. Answer all questions in terms of shifts in or movements along the demand and supply curves. (a) In 2001, the Supreme Court of India banned smoking in public places. How is this likely to affect the average price of cigarettes and the quantity sold? (b) New discoveries of oil reduce the price of petrol and diesel. Consider their effects on the market for new cars. (c) New environmental regulations require that the drug industry use a more environment-friendly technology whose running costs are higher but which discharges less toxic chemicals than before. How would it affect the price of drugs? China is a big manufacturer of telephone instruments. It has recently become a member of WTO, which means that it can sell its product in other member countries like India. Suppose that it does export a large number of telephone instruments to India. (a) How will it affect the price and quantity sold of telephone instruments in India? (b) Suppose that the demand for telephone instruments is relatively elastic. How will it affect Indias total expenditure on telephone instruments? In the union budget for year 2002-2003, the excise duty on tea was reduced from Rs. 2 per kg. to Rs. 1 per kg (this is a fact). All other things remaining unchanged, how will it affect the market price of tea? Suppose the price controls on sugar are lifted. How, ceteris paribus, will it affect the price and quantity consumed of sugar?

Section III
5.32 5.33 Mrs. Ramgopal says that economists say inconsistent things: as price falls, demand rises, but as demand rises, price rises. Defend or refute. Describe the FAD theory of famines.