Introduction to economics: scarcity, choice, and opportunity cost
1.0 Introduction
A lot of statements have been said about economics as a subject. The following are some of the statements. a.‘Economics is the painful elaboration of the obvious.’
b. ‘Economics is everything we know in a language we don’t understand’
c. A Swedish contribution: "Economics is like red whine - you shouldn't smell it but drink it, but if you drink too much on one occasion, there is a risk for disystems "
This introductory chapter will define economics and discuss the central economic problem which is a problem of scarcity.
1.1 Defining economics
It is quite difficult to define economics as such. According to one standard definition, economics is concerned with the way in which resources are allocated among alternative uses to satisfy human wants. Economics therefore can be defined as a social science that studies how society allocates its scarce resources amongst competing alternatives.
From the above definition, economics is described as a 'social science'. 'Social' in that the subject matter is the human being. 'Science' because the approach used has much in common with that of the natural sciences because economicsuse scientific methodologies in its formulation of policies.
1.2 Microeconomics and macroeconomics
It is customary to divide economics into two parts: microeconomics, and macroeconomics. Microeconomics deals with the economic behaviour of individual units such as consumers, firms and households; while macroeconomics deals with the behaviour of economic aggregates such as national income and the level of employment. In simple words, it is like in microeconomics, we examine the trees not the forest while in macroeconomics we examine the forest and not the trees.
1.3 Positive and normative economics
Positive economics refers to that part of economic analysis based on established facts. Positive economics states ‘what is in existence’ and hence it is descriptive. It seeks to explain real economic events. For example, it explains that if the price of a normal good increase, the quantity demanded for that good decrease.
Normative economics refers to that part of economic analysis which deals with opinions or value judgments about what economic events should be like. Normative economics goes beyond the descriptions of particular economic situations and pass judgment.
As a result, normative economics is prescriptive. An example of normative economics is welfare economics.
1.4 The basic economic problem
The science of economics centersupon two basic facts: first, human material wants are virtually unlimited, second, economic resources are scarce. As a result, the economic problem is a problem of scarcity and can be described in terms of scarce resources in relation to unlimited wants.
1.4.1 Scarce resources
Resources are the things or services used to produce goods or services which can be used to satisfy wants. Economic resources may be classified as property resources - land and capital - or as human resources - labour and entrepreneurial ability. These resources are limited in supply and yet society desires more of them than is available. Thus it can be said that resources are scarce because they are limited in supply.However scarcity is a relative concept. It relates to the extent of the people's wants to their ability to satisfy those wants.
Table 1.1 Different types of resources
Type
|
Description
|
Reward
|
Land
|
All gifts of nature
The physical and mental effort of people
All goods used to produce other goods
|
Rent
|
Labour
|
Wages
| |
Capital
|
Interest
| |
Enterprise
|
All managers and organisers
|
Profit
|
These resources are scarce because they are limited in supply and yet society desires more of them than is available.
1.4.2 Unlimited wants
Material wants refer to the desires of consumers to obtain and use various goods and services which provide satisfaction. Desire for material wants is insatiable. The ends of human beings are without end. The fulfillment of some of the wants on the list seems to do little more than raise people's expectations of something even better.
There are three reasons why wants are virtually unlimited:
• Goods eventually wear out and need to be replaced.
• People get fed up with what they already own.
• New or improved products become available.
.
The economic problem of scarcity applies to every society whether rich or poor. Mckenna P.J (1958:2) writes in his book Intermediate Economic Theory, "whatever the cause, we find ourselves in a situation of scarcity where we can not have all the things we want, because the resources we have at any time are limited in supply while our wants appear to be unlimited.” As a result, societies have to make choices. Economics can also be defined as the study of the ways in which choices are made.
1.5 Economic choices - The requirement of making a choice is a consequence of the problem of scarcity. Resources are limited in
supply relative to demand for goods and services produced from the available resources. As a resultsociety and individuals
should make choices. This can be referred to as ‘economising’ – making the little available best be used to satisfy our wants and needs.
1.5.1 The basic economic problem of choice
The basic economic problem is universal. Any society (rich or poor) faces the problem of scarcity since resources are limited in supply. No society can produce all the goods wanted by its people. Society has to decide which commodities to make. For example, should we produce sugar cane or maize? We have to decide how to make these commodities. Do we employ more capital or labour? Who is going to use the goods that are eventually made?
Societies must make difficult choices of: -
What to produce and in what quantities?
How to produce?
For whom to produce?
The way in which different societies answer these questions give rise to different economic systems. These fundamental economic questions can best be examined using a production possibilities curve.
1.6 The production possibilities curve (PPC)
A production possibilities curve or frontier shows what the society could produce with its existing resources at any moment in time. That is, the PPC shows the maximum output that a society can produce given its existing supplies of land, labour, capital and technical knowledge. The PPC works on the society's technical knowledge because another society with greater technical knowledge may be able to produce more given the same quantities of resources.
1.6.1 An example
Let’s assume the following sample conditions for our illustration: -
a) The society can only produce two types of goods, sayconsumer goods which are those goods which directly satisfy our wants and capital goods which are those goods which satisfy out wants indirectly by permitting further production of consumer goods.
b) The available supply of resources is fixed both in quality and quantity.
c) The level of technology is fixed, that is, technology does not change during the course of our analysis.
d) The economy is operating at full employment and is achieving full production.
e) It’s a closed economy, that is, there is no international trade.
With its limited supplies of resources, our society could produce varying combination of consumer and capital goods. The extreme possibilities are that either all resources are devoted towards producing consumer goods or the resources are devoted to the production of capital goods. These are unrealistic possibilities since the society can notsurvive on consumer nor capital goods alone and so, some combination is essential.
Table 1.2 The production possibilities table
Type of Product
|
Production alternatives
| ||||
A
|
B
|
C
|
D
|
E
| |
Consumer Goods
|
0
|
4
|
7
|
9
|
10
|
Capital Goods
|
4
|
3
|
2
|
1
|
0
|
From the production possibilities table it can be concluded that economic resources are scarce hence the production of one type of
0 2 4 6 8 1012 CONSUMER GOODS
All points on the frontier (e.g. point C) show the maximum possible combined outputs of the two commodities. The society then must choose the product-mix it desires: more consumer goods mean less capital goods, and vice versa.
It is possible to produce a combination inside the curve (e.g. point R) but this would mean that resources are underutilized, that is, not fully employed. In such a case, it is possible to produce more of both goods by moving to a point on the boundary.
However, the limited supplies of resources make any combination of consumer and capital goods, lying outside the production possibilities curve, such as point S, unattainable. Hence product-mix represented by point S will only be possible when the productive capacity increase. Thus, the curve moves outwards.
1.6.2 Application: The PPC and the economic concepts of scarcity, choice and opportunity cost
A production possibility curve shows that maximum output that a society can produce with its existing resources at any moment in time. It is often referred to as the 'transformation curve' because in moving from one alternative or product-mix to another, say, from point B to point C, we are in effect transforming capital goods into consumer goods, by shifting resources from the production of the latter. Assuming that the society is producing only two goods, consumer and capital goods using its available resources and level of technical knowledge, its production possibilities can be represented by the following boundary.
.A
CONSUMER GOODS
Points on the curve represent points at which the economy is operating at full productive capacity, that is, full employment of all available resources. Points lying outside the production possibilities curve, such as point D, would be superior to any point in the curve, but such points are unattainable given the current supplies of resources and level of technology. Conversely, points inside the curve, say, point A are attainable but imply under utilization of resources, that is, point A mean that some resources are idle or not fully employed.
The production possibilities curve can be used to explain three economic concepts, namely choice, scarcity and opportunity cost. Choice is explained by the attainable combinations on the boundary, for example points B or C. the society has to choose its desired product mix from amongst the attainable points on the curve. For instance it can choose optimal mix B and have more capital goods than consumer goods or optimal mix C where consumer goods are preferred to capital goods. The economic problem of scarcity is implied by the unattainable combinations beyond the boundary. Such combinations are superior to those on the curve. However, because resources available are limited in supply or scarce, the society can not produce the combination represented by point D.
On the other hand, the scarcity of resources implies that we can only have more of consumer goods by having less of capital goods. This described an element of sacrifice in making choices. The next most desired alternative sacrifice is referred to as the opportunity cost. Thus the concept of opportunity cost can be illustrated by the negative slope of the boundary from the diagram of the production possibilities curve. Assume a society currently producing OR units of capital goods and OT units of consumer goods. Now if OU units of consumer goods are required, the maximum amount of capital goods that can be produced is OS Thus, additional units of consumer goods (TU) can be produced only at the expense of RS units of capital goods. Therefore RS units of capital goods are the opportunity cost of TU units of consumer goods.
In conclusion, the analysis of the production possibility curve is very important because it illustrates the concepts of choice, scarcity and opportunity cost. On the other hand the PPC helps to show how economies provide answers to the basic economic questions of what, how and for whom to produce.
1.6.3 Application: The PPC and the law of increasing opportunity cost -What is the rationale for a production possibility curve that is concave or bowed out from the origin? The answer to this question is rather complex. But, simply stated, it amounts to this: Economic resources are not completely adaptable to alternative uses. Thus, say, we attempt to increase the production of consumer goods, resources which are less suitable to the production of consumer goods must be induced or 'pushed' into that line of production. It will obviously take more and more of such resources - and an increasing great sacrifice of capital goods - to achieve a given increase of one unit in the production of consumer goods. Thus, a concave production possibility curve represents increasing opportunity cost.Therefore under the unrealistic assumption of perfect adaptability of resources the production, possibility curve would be a straight line, implying constant opportunity cost.
1.6.4 Application: The PPC and economic efficiency
Points on the production possibility curve represent points at which the society is operating at full employment and full productive capacity. By full employment we mean that all the available resources are employed. On the other hand, full production means that the employed resources are used to make their most valued contributions to output. This involves two kinds of efficiency - productive and allocative efficiency.
Productive efficiency or X-efficiency refers to a situation in which the existing resources are used in the best way in the production process. It implies that goods should be produced at the least cost. By definition, points on boundary of the production possibility curve are productive efficient while points inside are inefficient.
Allocative efficiency implies that resources are devoted to the production of products most wanted by society (consumers). It refers to the actual position on the production possibility curve, and depends on the society preferences. Of importance is to note that any point that lies on the boundary is productive efficient while not all points on the boundary are allocative efficient. An example is when people desire more health services than defence services but yet more of the country's resources are devoted to producing defence services, such as combination though productive efficient is not allocative efficient.
Dynamic efficiency or economic growth which is the ability to produce a larger total output - is reflected in a rightward shift of the production possibilities curve, as indicated by movement from boundary AB to CD on the following diagram.
CONSUMER GOODS
An expanding resource supplies: labour force, stock of capital goods, and/or an increase in technical knowledge which characterize a growing economy will move the production possibilities curve outward and to the right. This permits more of both consumer and capital goods to be produced. Thus the economy will consume an increased quantity of the goods produced over time and hence standards of living will improve. Precisely, economic growth or dynamic efficiency makes the problem of scarcity less acute.
1.7 Opportunity cost - Making of choices imply foregoing other alternatives. That is, sacrificing the other alternative uses for resources. Opportunity cost refers to the next best alternative foregone when a choice is made. The opportunity cost principle states the cost of making a choice in terms of the next best alternative foregone. Therefore, it’s the real cost and not monetary cost. For example, if a gardener decides to grow carrots on his allotment, the opportunity cost of his carrot harvest is the alternative crop that might have been grown instead (e.g. potatoes).
Economic systems
2.0 Introduction
While the nature of choices facing all societies are the same, societies sometimes adopt different methods of dealing with them One method of answering these questions is through a market economy where choices are resolved by the free play of market forces of demand and supply. That is, resources are allocated through the price mechanism, which simply mean that individuals as consumers freely choose what they want to purchase and producers freely decide on what they want to provide. Because of this free play purchase and production, market economies are often referred to as free enterprise or laissez faire ("leave-well-alone") economies. An alternative method of allocating resources is through the centrally planned economy in which the government issues directives of instructions indicating "what?", "how?", and "for whom?" to produce.
2.1 The market economy
The framework of market economies embodies the following institutions and assumptions:
a) Private ownership of property,
b) Freedom of enterprise and choice,
c) Self-interest as the dominant motive,
d) Competition,
e) Reliance upon the price system, and
f) A limited role for the government.
Laissez failure mean "leave-well alone' hence market economies are characterized by an almost total lack of government intervention.
2.1.1 Advantages
a) There is consumer sovereignty, that is, a market economy allocates scarce resources according to consumers' wants. "The consumer is king". P Samuelson
b) Producers have an incentive through profit to respond quickly to changes in consumer demand
c) Competition forces producers to produce high quality products at low cost.
d) Resources are allocated to their most efficient use through the price mechanism.
2.1.2 Disadvantages
a) There is elimination of the poor from consumption. That is, people with no money to pay for certain goods will be eliminated from the consumption of those goods and even basic goods.
b) Self interest may lead to great inequalities in the distribution of income and wealth.
c) There is likely to be exploitation of consumers through overcharging, short weighing and misleading advertising.
d) Production is for profit, therefore there will be non-production of public goods and under-production of merit goods.
2.2 The centrally planned economy - Centrally planned economies are characterised by
a) Government ownership of the means of production.
b) Government provision of goods and services.
c) Production is for use rather than for profits.
d) Non-price rationing mechanisms, that is, goods are distributed according to need and not ability to pay.
e) Government control and planning is through a central planning board credited to control coordinate and plan all economic activities.
2.2.1 Advantages
a) It is sometimes suggested that centrally planned economies are likely to have greater equality in the distribution of income and wealth.
b) There is provision of public and merit goods.
c) It is claimed that centrally planned economies are likely to be far more stable than market economies
d) The production and consumption of demerit goods which impose relatively large social costs on society can be eliminated or prevented.
2.2.2 Disadvantages
a) There is nobody who has power over the government such that even if it fails, it is answerable to nobody.
b) Where there are no incentives, people are not motivated to work.
c) Without competition producers will be inefficient and produce poor quality goods. As result, resources will be utilized inefficiently.
d) Complications in planning for the whole economy arise, that is, planning is a difficult task and there are too many stages of decision making - bureaucracy or red tape.
2.3 The mixed economy
Neither pure market economy nor pure centrally planned economy exists in the real world. This is because political authorities in most countries exercise economic functions e.g. controlling prices. However, it is useful to study the economic systems in their extremes such that by making them as models we can approach the realistic situations step by step.
When we use the term mixed economy, it is usually applied to economies where there is a significant component of both market and central planning features of production. The economy allows private ownership of property by allowing a private sector to exist and provide private goods and services for profit. The public sector provides public and merit goods.
2.3.1 Reasons for government intervention in a market economy
The government should intervene in the market economy and play the following roles:
a) Distributive role, that is, to ensure a fair or equitable distribution of income between the poor and the rich.
b) Allocative role, that is, to allocate some of the economy’s resources to the production of public and merit goods otherwise not provided in a market economy.
c) Stabilisation role, that is, to control fluctuations in economic activity such as stabilising prices and reducing unemployment.
d) Regulatory role, that is, to maintain law and order which create an environment conducive for business.
The above reasons of government intervention are rooted in the concept of market failure. Market failure refers to those situations in which the conditions necessary to achieve efficiency in the allocation of resources in the market economy fail to exist. It is believed that the market left to itself is very unlikely to operate efficiently. There is a tendency to over produce some goods and under produce others. Factors that bring about the failure of markets include: -
a) The existence of public goods and externalities.
b) Imperfect competition e.g. monopolies.
c) Imperfect information and uncersupply .
Price ($)
P2
P
So
Demand and supply [2
3.0 Introduction
According to Carlyle T "it is easy to train an economist; teach a parrot to say, demand and supply". This could be an understatement of an economics education. However, there is something to be learnt from Thomas Carlyle's statement on the central role played by demand and supply in economics.
3.1. Theory of demand
Demand is not the same as desire, willingness or want. Economists are interested in effective demand which can be described in terms of willingness or desire coupled by the ability to purchase a product or service. Demand is the amount of a good that consumers are willing and able to buy at a given price. Effective demand = Willingness + Ability. Willingness only = Latent demand. Ability only = Potential demand.
3.1.1 The law of demand
It states that, “other things being equal, more will be demanded at a lower price than at a higher price”. This describes a negative or inverse relationship between price and quantity demanded. As price falls, the quantity demanded rises. Conversely, as price increases the corresponding quantity demanded falls. In other words, the demand curve is downward sloping from left to right indicating that as price falls, more will be demanded.
Price ($)
$10
$5
0 10 20
Quantity Demanded (Units).
The downward sloping demand curve implies that a fall in price from $10 to $5 will lead to an increase in the number of units demanded from 10 units to 20 units.
3.1.2 Why the demand curve is downward sloping
More is demanded at a lower price than a higher price because: -
a) Common sense and ordinary observations tells us that consumers prefer cheaper products to dearer one. This is because price is
often an obstacle which deters people from buying hence the higher the obstacle, the less will be bought.
b) At a lower price, a given amount of money will buy more goods than at a higher price. For instance, $100 can buy 10 mangoes at $10 each while the same $100 can buy 20 mangoes at a reduced price of $5. Thus the purchasing power of money (buying power) increases as price decreases. This increased purchasing power can be equated to an increase in real income and hence is seen as the 'income effect of a price fall".
c) Consumers tend to substitute cheap products for dear products. For example, a fall in the price of butter will provide consumers
an incentive to substitute butter formargarine which is now relatively expensive. Purchases of butter will increase as a result and this is referred to as the 'substitution effect of a price fall".
d) Utility is the satisfaction derived from the consumption or use of a product as a consumer consumes successive units of a
product, the additional satisfaction derived from that consumption declines. Thus consumption is subject to diminishing marginal utility hence consumers will only buy additional units of price is reduced.
3.1.3 Exceptional demand curves
Exceptional demand curve do not confirm with the law of demand. They have a positive slope, that is, the curve slopes upwards from left to right as follows:
Fig 3.2 Exceptional demand curve
Quantity Demanded
The demand curve slopes upward indicating that as the price rises, quantity demanded will also increase. Examples include: - i) Ostentatious Goods of Goods with a "Snob - appeal"
Some people buy expensive goods simply because they are expensive. The ownership of such goods put them in a rather exclusive class. Where goods are bought for snobbish reasons, a fall in price might cause them to lose their appeal and hence demand decreases with decreasing price and increases with increasing price.
ii) Speculation or expectations.
If a price increases in the short term while they are expected to further increase in the near future, consumers may demand more at the current increased price in order to beat future price increases. Such is the behaviour of buyers in the stock exchange market where falling share prices will lead to a decline in demand because people expect the trend to continue that is, they expect to buy at even lower prices. An increasing share prices will lead to an increase in demand with people expecting the bull-run to continue, that is, they expect to sell at a much higher price.
3.1.4 The determinants of demand
The amount of a good demanded depend on:
• The price of the good (PX) – the higher the price the lower the quantity demanded and vice-versa.
• The price of other goods (substitutes and complements) (Py). Substitute goods serve the same purpose and are competitive in demand e.g. tea and coffee, while complementary goods are jointly demanded e.g. camera and film. An increase in the price of tea will increase demand for coffee while an increase in the price of cameras will lead to a reduced demand for films. Thus, the price of one affects the demand for the other.
• The income of consumers (Y) – a rise in income increases demand for superior or normal goods while demand for inferior goods will decrease.
• Consumer tastes and preferences (T) – changes in fashion may reduce demand.
• Advertising (A) – its purpose is to increase sales by increasing demand
• Availability of hire purchase finances (H) – e.g. 0% deposit scheme increases demand for durable goods such as TV sets.
• Population size and composition (N).
• Expectations on future price increases or shortages (E) raise current demand, as people want to beat the expected shortage or price increase.
****All this can be summarised in the demand function:
Qd = f (Px, Py, Y, T, A, H, N, E)
3.1.5 Changes in the quantity demanded
For any product a change in quantity demanded is always caused by a change in its price. A change in quantity demanded therefore refers to a movement along an existing demand curve. That is it refers to the nature of the demand curve's slope. For example movement from point A to B along the same demand curve is described as a change in quantity demanded.
A change in price never shifts the demand curve for that good. It results in a movement up or down the demand curve and is referred to as a change in quantity demanded.
Quantity Demanded
Price reinforces the law of demand. A movement down the demand curve is an increase in quantity demanded, while a movement up the demand curve is a decrease in quantity demanded
3.1.6 Changes in demanded
This does not refer to the nature of the demand curve's slope but to the movement of the curve either to the right - meaning an increase in demand or to the left - implying a decrease in demand. An increase in demand means that more is now demanded at each and every price than before while a fall in demand means that less is demanded at each and every price than before.
A demand curve shifts only if there is a change in factors influencing demand other than the price of the commodity. For example, changes in consumer income, consumer tastes and preferences, prices other goods, advertising etc. A shift to the right implies an increase in demand while a shift to the left is a decrease in demand.
Fig 3.4 Changes in demand
O Q2 Q0 Q1
Quantity demanded
A change in demand is always caused by a change in at least one of the conditions of demand, which are: -
i) Changes in household disposable income (Y)
The level of income determines the demand for most commodities. If income rises, demand for normal goods will increase while demand for inferior goods will decrease. However, disposable income is what is important. It refers to the actual amount that a household has to spend on purchasing goods. Changes in government policy on taxation can cause changes in demand since it influences disposable income.
ii) Changes in prices of other goods
Goods are related as substitutes or complements. Substitute goods are competitively demanded that is they serve the same purpose and therefore can be used interchangeably for example beef and chicken. Complementary goods are those goods used or consumed jointly such as cameras and films. When two products are substitutes, the price of one product and the demand for the other are directly related. For example, an increase in the price of beef will force consumers to buy less beef and this will increase the demand for chicken.
When two products are complements, the price of one product and the demand for the other are inversely related. Forexample if the price of cameras falls, demand for cameras will increase and as a result demand for films will also increase with people wanting to use their cameras.
iii) Advertising
A successful advertising campaign will move the demand curve to the right because advertising aims at increasing consumption by the regular customers as well as to more in more new customers.
iv) Changes in tastes and fashion
For certain goods such as clothing, changes in fashion can bring about marked demand changes. The more fashionable a good becomes the more demand for it will increase and vice versa.
v) The availability of hire purchase finance
The demand for most durable commodities such as television sets depend very much on the availability of hire purchase facilities. Any changes in the terms in which this type of finance is obtained will have a marked effect on demand for such goods as TV sets.
vi) Changes in population
This has a long term effect and changes in the size and age distribution will affect both the total demand of goods and the composition of demand. For example if the proportion of children increase in a society, more education will be demanded.
3.2 Theory of supply
We now look at what quantity is going to be supplied at any given price during a period of time. The producer is out interest. It does not mean that one offers all that has been produced for sale. Supply is the amount of a product a producer is willing and able to produce and make available for sale at a given price during a specified period.
3.2.1 The law of supply
It states that, "Other things being equal, more is supplied at a higher price than at a lower price". This implies a positive or direct relationship between price and quantity supplied. As a result the supply curve is upward sloping from left to right.
Fig 3.7 Supply curve
Quantity Supplied (Units)
A price increase from $10 to $15 will lead to an increase in quantity supplied from 30 units to 40 units.
3.3.1. Why the supply curve is upward sloping
a) It is assumed that firms produce for profit and other things being equal, at higher prices it becomes more profitable to expand and supply more.
b) At higher prices, it becomes profitable for marginal firms, that is, firms which can notcover their costs at lower prices, to undertake production.Therefore as price rises more firms will enter the industry and market supply will increase.
3.3.1. Determinants of supply -Supply if influenced by (a) price of the commodity and (b) conditions of supply. Price determines the shape of the curve that is, its upward slope from left to right. Conditions of supply determine the position of the curve within the axes.
(a) Price of the commodity.
This factor reinforces the law of supply normally more of a commodity is supplied the higher its price. A change in a commodity's price will lead to a contradiction or extension of supply that is a movement along the existing supply curve.
Therefore price is a determinant of quantity supplied.
P2
Quantity Supplied
If the price increases from P1 to P2, quantity supplied will increase from Q1 to Q2. This is termed an extension of quantity supplied.
Conversely, a change in quantity supplied from Q2 to Q1 is a contraction in quantity supplied.
(b) Conditions of supply
When conditions of supply change, then supply will either increase or decrease. An increase in supply means that more is supplied at each and every price than before while a decrease in supply would mean that less is supplied ateach every price.
P
Note that in the case of a change in supply, price does not change but it is the supply curve which either shifts to the left or to the right. A leftward shift from S0 to S1 is a decrease in supply while a rightward shift from S0 to S1 represents an increase in supply. Changes which bring about changes in supply include: -
(i) Change in the level of technology
Improvements in the level of technology reduces the cost of production and increases productivity hence more will be produced so that more is likely to be supplied at any price.
(ii) Change in the price of factors of production (cost of production)
Other things being equal, a change in costs will change the level of profit available from producing any particular commodity specifically a rise in costs will reduce profits and cause some firms to cut back on output while other firms will stop producing altogether. Thus, a rise in the price of factors of production will lead to a decrease in supply. (a shift to the left ). Conversely a fall in costs will lead to higher profits at any given price leading to an increase in supply (a shift to the right).
(iii) Entry by new firms into the industry
As new firms start producing a particular product, market supply will increase. If firms leave the industry, e.g. during a recession when some firms may close down, the supply curve will shift to the left.
(iv) Government policy
Taxation can be regarded as an increase in the cost of production and hence shifts the supply curve to the left. On the other hand, subsidies are seen as a reduction of the cost of production thereby they shift the supply curve to the right.
(v) Weather and other changes resulting from nature
Agricultural commodities are subject to the weather prevailing during production. Production will fluctuate because of drought years and good year and supply will change following these fluctuations. Thus changes from nature such as floods, droughts etc. cause the shifting of the supply curve of agriculture produce to the left. Human conditions such as war, fire and political unsuitability also affect supply.
(vi) Prices of other goods
When the price of a commodity does not change while that of another commodity increases, it means that its now profitable to produce the commodity whose price has gone up. Resources will be shifted from the production of the commodity whose price remains unchanged to the production of the more profitable commodity. This shifts the supply curve of the static-price commodity to the left.
3.3 Determination of equilibrium price and quantity
Price is not the same as value because value is relative from one individual to another. In economics the price of a commodity or service is measured in terms of what is offered in exchange for it (price = value in exchange). Economists view the value of exchange as the price.
Within markets, prices serve the important functions of: -
• Signalling the information that allows all the traders in the market to plan and co-ordinate their economic activities.
• Creating incentives for buyers and sellers to behave in a manner which allows the market to operate in an orderly and efficient manner and;
• Rationing and allocating scarce resources between competing uses.
3.3.1. Market equilibrium price and quantity
The price where the amount consumers want to buy equals the amount producers are prepared to sell, or where quantity demanded equals quantity supplied (Qd = Qs) is the market price. Graphically the intersection of the demand curve and the supply curve for a product will indicate the equilibrium price and quantity.
Fig 3.10 Market equilibrium
Qe Quantity
At prices above the equilibrium (Pe) there is excess supply while at prices below the equilibrium (Pe) there is excess demand. The effect of excess supply is to force the price down, while excess demand creates shortages and forces the price up. The equilibrium price (Pe) is unique in that it is the only price that can be maintained for long.
3.3.2. Changes in market equilibrium conditions - The market equilibrium condition can only be disturbed if there are changes in either the conditions of demand or the conditions of supply. In which case the demand curve or supply curve will shift to the left or to the right, changing the equilibrium price and quantity in the process.
a) Changes in Demand Conditions
If the demand curve shifts to the right, for example, due to a rise in consumer income, the equilibrium price and quantity will increase while a shift of the demand curve to the left will result in a decrease in equilibrium price and quantity.
b) Changes in Supply Conditions
A shift of the supply curve to the right, for example, as a result of an improvement in the level of technology will reduce equilibrium price and increase the quantity while a shift to the left increases the price and reduces the equilibrium quantity
Fig 3.12Effect of changes in supply conditions on market equilibrium Price
So
O Q2 Q1 Q0 Quantity
The government can offset movements towards the market equilibrium price by imposing price controls or regulations.
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