50 THE ECONOMIC SYSTEM

the effects of government policy on costs is the EU directive on End of Life

Vehicles which attempts to make car makers responsible for dealing with the
waste caused by cars that end their useful lives (approximately 12 million in
the EU annually). If car manufacturers have to bear such costs (estimated at
£50bn) then this will affect car supply.

The effect of higher costs on the supply curve for any product can be considered at
any price on the supply curve. A supply curve is drawn for a given set of costs (ceteris
paribus strikes again!). If costs change, this causes a movement of the supply curve.
For example, any supplier willing to supply at a price of £12 000 incurs higher costs
if labour costs rise. Given higher costs and the total cost outlay suppliers are willing
to incur to earn revenues of £12 000 per car, suppliers are willing to supply a lower
quantity of output at point x ∗ in Figure 2.4 than at point x (with lower costs).
More generally, depending on their line of business, it is possible that some
suppliers might wish to switch production to other products for which costs have
not increased. With sufficient advance information of cost changes, suppliers will
take any new information into account and may change their supply decisions.
In Figure 2.4 there is a reduction of supply from 15 million cars to 8 million cars
caused by an increase in production costs. At every price on the original supply
curve, once production costs increase, producers cut back their production and
this leads to a leftward shift in the supply curve from S1 to S2 .
Beginning with S2 a cost reduction would have the opposite effect; some producers
are enticed to supply greater quantities resulting in a shift of the supply curve to S1
for example.

Price
S2 Price Quantity
S1 (£000) (millions/year)
24
6 0
18 12 8
18 11
x* 24 14
12 x

Quantity
0 8 15 18 20

F I G U R E 2 . 4 A M O V E M E N T O F T H E S U P P LY C U R V E ( A N D
N E W S U P P LY S C H E D U L E )
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 51

Prices of related goods

Supply is influenced by the prices of related goods, substitutes and complements.
In car production, different types of vehicles can be produced from a given
factory – saloons or sports utility vehicles (SUVs) – with minor alterations to the
production line, which means they are substitutes in production. The quantity of
saloons supplied is affected by the price of SUVs because if the price that can be
earned from supplying SUVs increases, suppliers of saloons have the incentive to
switch towards producing SUVs (so the supply curve for saloons moves leftwards).
Complements in production also exist where at least two goods are produced
jointly from the same resources, e.g. beef and leather. If the price of leather
increases, leather suppliers have the incentive to supply more, which would
lead to the joint additional supply of beef (the supply curve for beef would
move rightwards).

Expected future prices

Suppliers who can store their output over time would have the incentive to do so if
prices in the future were expected to be higher than the current price they could
earn on their supply, hence a lower current supply would be offered on the market
than if no change in the future price was expected. The alternative is also true. In
the car market when new editions appear, previous models become more difficult
to sell – in buying a new car, many customers prefer to buy the most up-to-date
model rather than earlier editions. If suppliers have stocks of the older models
available and know that future models are about to be launched they often offer
good deals on the old models to try to sell them before new models reduce the
demand for the old. Expectations about the future prices that can be earned on the
old models create incentives for suppliers to sell in the present rather than stock up
their supply for the future.

The number of suppliers

The supply of cars or any product is the sum total of each car firm’s supply in that
market. The entry of a new firm into the market adds extra supply moving the
supply curve rightwards.
This effect could be short term if the new firm supplies more attractive cars or
better value cars than other firms. Reaction by competing firms may follow. Some
firms might be forced out of the market if they can no longer compete with the new
firm and the end result might be a replacement of a supplier with no significant
impact on the overall supply.
52 THE ECONOMIC SYSTEM

Government regulations
The regulation function of governments permeates many different activities in an
economy. It can affect supply through various channels, such as through the policy
regarding End of Life Vehicles explained above, and various other environmental and
safety regulations that limit the activities of suppliers across a range of industries.
Various policies apply to the chemicals industry, for example, from food labelling
requirements and the classification of dangerous substances to general health safety
and environmental regulations. To the extent that new regulations force firms to
deal with additional costs (e.g. to pay for anti-pollution systems, to employ people
with regulatory expertise) the supply curve may move leftwards.
This may not necessarily be all bad news for a firm, though. Some buyers might
be attracted to products when they know the suppliers apply stringent standards.
Some firms go beyond government regulations to make their products even safer
or more environmentally friendly because the additional cost is more than covered
by the extra demand generated by the product.

Although costly to manufacture, cars that are capable of withstanding a

64 kmph (40 mph) head-on smash and a 48 kmph (30 mph) side-on collision
are currently being engineered and developed to deal with European New
Car Assessment Programme tests reported regularly on new cars – for more on
this see www.euroncap.com. Manufacturers realize that safety is an important
selling feature for cars and invest substantial funds into safety improvements
that increase their performance.

2.5 MARKET INTERACTION: DEMAND

A N D S U P P LY
Each market consists of buyers and sellers, demand and supply. Bringing both
together allows for analysis of how market prices are arrived at, showing how both
sides of the market combine to give rise to the outcome in terms of the price and
quantity of goods bought and sold. Using the example of the car market, the market
demand and supply curves can be shown together as in Figure 2.5.
There is only one price at which the quantity buyers are willing to buy coincides
with the quantity sellers are willing to sell. This price is £12 000 and is called the
market clearing price because if all good supplied at this price are sold, all buyers
 M A R K E T A N A LY S I S : D E M A N D A N D S U P P LY 53

Price
(£000)
D a S
24

b
18
c
12
d
6

Quantity
0 7 9 15 19 21 30 (millions/year)

FIGURE 2.5 D E M A N D A N D S U P P LY : T H E C A R
MARKET

wishing to buy at this price can do so. At this price firms do not build up stocks of
unsold cars and no consumer demand is left unsatisfied. A market does not clear if
demand cannot be met (shortage) or if suppliers provide more than is demanded
in the market (surplus).
This price is also called the equilibrium price. The term equilibrium is used
widely in economics and it refers to a situation from which there is no tendency
to change – unless something to cause a change occurs. An equilibrium quantity
corresponds to the equilibrium price. In Figure 2.5 this quantity is 15 million
cars, the amount of goods that are bought and sold when the market is in
equilibrium.
The market for cars will tend towards the market-clearing equilibrium price and
quantity. This happens if you consider the forces at work at any other price. If the
price were £24 000, demand would be 7 million cars while corresponding supply
would be 21 million. Such a high price means few buyers are willing and able to buy
cars while quite a number of suppliers are willing to supply at such a high price.
At a price of £24 000 the market does not clear because the quantity demanded
does not correspond to the quantity supplied:

QD < QS

Quantity demanded is less than quantity supplied. The discrepancy between these
quantities is 14 million cars which suppliers are willing to supply, for which no
demand exists; hence, a surplus exists in the market. The expected reaction to this
non-equilibrium situation is for firms to try to do something to sell their unsold
54 THE ECONOMIC SYSTEM

stocks. One rational response might be to cut their price. If price declines to
£18 000, quantity demanded increases to 9 million while quantity supplied falls to
21 million. This reduces the surplus or excess production to 12 million cars but
does not eliminate it. Reducing the price further will further reduce the surplus.
Only if the price falls to £12 000 will the surplus production be eradicated. If firms
wish to sell all their output, the price needs to fall to this level, otherwise they are
left with unsold stocks of cars.
If the price were below the equilibrium level, that too would create problems and
represent a disequilibrium situation in the market. Take the case where the price
of cars was £6000. The quantity demanded at this price would be 30 million cars
(high demand at such a relatively low price) but suppliers are willing to supply only
7 million cars. A shortage would exist in the market; 23 million more cars would be
in excess demand compared to the available supply.

QD > QS .

Customers lucky enough to get their hands on cars at £6000 are surely very satisfied
but a large number of potential customers willing and able to pay this amount just
cannot buy cars as supply does not meet demand at this price.
The method by which cars are allocated to customers could be extremely
problematic – first come first served might be a possibility but someone who really
wanted the product might not be happy to settle for a straightforward queuing
system. Attempts at bribery might occur, preferential treatment might be given to
some customers, and corruption is a real possibility. Any supplier happy to supply
at this price can sell their output but because the price is relatively low, the supply
of cars is also low. If this situation existed in a market, suppliers would be aware of
the excess demand and might try to react to it. Sellers might decide to increase the
price a little which would have the effect of encouraging greater production of cars
while reducing the quantity demanded. At any price greater than £6000 but less
than £12 000 suppliers will have the incentive to charge a higher price which means
that the quantity supplied will rise. As price rises, quantity demanded is reduced but
since supply does not match demand, a portion of it is unsatisfied at prices below
£12 000.
Hence, in a free market – where price and quantity are set by market demand
and supply – a tendency for the price and quantity to change exists if the market is
not in equilibrium. In equilibrium, the market price is the equilibrium price and
neither excess demand nor supply is observed as the market clears.