The Dynamic Effects of Aggregate Demand and Supply Disturbances - Essay Example

PRINCIPLES OF MICROECONOMICS TABLE OF CONTENTS TABLE OF CONTENTS 2 Question 3 Question 2 7 Question 3: 14 Reference List 20 Bibliography 22 Question 1: In modern competitive economy, price plays three major roles, namely, the signalling function, transmission of preference and rationing functions. Brief descriptions of each of the function are discussed in below: The signalling function – In the present competitive market scenario, prices perform a signalling function. In other word, it helps to demonstrate where resources are required and where is not. In market, if price for any product rise or fall, it reflects level of scarcities and surpluses of the product (Griffiths and Wall, 2011). In general, prices are rises for any product, it indicates rising demand from the consumer’s segments. This is a signal to the supplier to expand their production in order to meet higher demand. Further, in case of excess supply, price factor also plays an important role to eliminate the excess supply. The signalling function of price can be discussed more briefly by using the following diagram. Figure 1: Higher demand signals to producer to increase their production (Source: Guide Jr, et al.2003, p. 76) Figure 2: An increase in supply leads to lower market price (Source: Guide Jr, et al.2003, p. 77) It can be seen from the Figure-1, as demand for good-Q increases, supplier of the goods can earn higher revenue and profit by selling it at higher price per unit. Thus, increase in market demand leads to expansion of market supply. Further, Figure-2 shows an increase in market supply causes fall in the relative price of good-Q and expansion of the market output along with the market demand curve. Transmission of preference – By utilising the signalling function of price, consumers are able to transmit expression of the preference or important information about changing needs and wants, to its customers. When market demand is high, price acts as the motivational factor to increase production, as supplier can earn higher profit by increasing their production. Similarly, when demand is low, it signals suppliers to contract their production. In market mechanism, suppliers actually control their production on the basis of price fluctuation (Mas-Colell et al. 2004). Rationing functions – Price also plays an important role to ration the scarce resources. It helps to allocate the scarce resources in an effective way, when demand in the market over strips the supply. When there is shortage of product in market, the price rises. Thus, only those people, whose willingness to pay is effectively high, purchases the product. It helps to eliminate consumers having low willingness to pay. In this context, it can be cited that, auction plays a crucial part to allocate resources in an appropriate manner and clears the market. Question 2 (a) “An increase or decrease in the demand or supply of a product or service” – Explanation Increase in demand – In economics, the term demand increase reflects increase in the ability and willingness on the buyers to buy a good or services at pre-existing prices. Demand can increase due to several factors, namely, increase in income, changes in buyer’s expectation, increase in price of substitute products or due to change in fashion, attitude and tastes of the consumers. When demand increases due to any of these reasons, it moves up price as well as quantity of the good. This is shown in Figure-3. It shows that, as the demand increases, the demand curve moves up, the equilibrium price also goes up to P2 and quantity increases to Q2. In this situation, to buy a new product, buyers must pay higher price. Figure 3: Increase in Demand (Source: Raybromley, 2014) Decrease in demand – Conversely, decrease in demand refers reduction in ability and willingness of the buyers to buy a good or service at some pre-existing price. A decrease in demand leads to decrease in both, equilibrium price and quantity. In market, demand for any product can decrease due to various factors, such as, expectation of lower future price, decrease in demand of buyers, decrease in number of consumer in market, less availability of complementary products and so on. Figure 4 shows this impact graphically. Figure 4: Decrease in Demand (Source: Raybromley, 2014) Increase in supply – Increase in supply refers to an increase in the ability and willingness of the supplier to sell a good or services at the existing price level. An increase in supply is generally caused by lower resources price, existence of large number of seller, favourable environment for producing or selling, lower resources price etc. Increase in supply causes rightward shift of the supply curve. Figure 4 represents the impact of increase in supply on equilibrium price and quantity. Figure 5: Increase in Supply (Source: Raybromley, 2014) Decrease in supply – Decrease in supply leads to leftward shifts of the market supply curve. It means that, sellers are willing to supply lower quantity of goods and services for every price level. Various factors are responsible for reduction in supply of goods and services in an economy including, higher resource price, unfavourable environment for producing or selling the product, high tax rate, smaller number of seller in the market and low diminishing return. The effects of decrease in supply are illustrated in Figure 6. Figure 6: Decrease in Supply (Source: Raybromley, 2014) (b) “An extension or contraction in the demand or supply of a product or service” – Explanation Extension and Contraction in demand – In economics, contraction and extraction of demand refers change in the quantity demanded as result of rise or fall in the price level. In this case, movements takes place along a given demand curve (Hubbard and OBrien, 2006). If quantity demanded rises as a result of fall in price level, this is called extension of demand. On the other hand, if quantity demanded falls due to rise in price level, it is termed as the contraction in demand. The concept of extension and contraction in demand can be explained in far detail way by using the following diagram. For instance, suppose the market price of good-Y is P and at this price, consumer buys Q amount. Now, if price of the product fall down to P2 and other things such as income of the consumer, price of the other good remain the same, then an extension in demand is said to have occurred and equilibrium point will shift to E2. Conversely, if price of the product rises to P1, then consumer will decrease their demand and the contraction in demand is said to have occurred. Figure 7: Extension and contraction in Demand (Source: BOUNDLESS, 2014) Extension and Contraction in supply Just like demand, supply side of a product also varies with the change in price level, ceteris paribus. If supply of a commodity increases due to rise in price level, it is called extension of supply, and if supply of a commodity decreases due to fall in price level, it is termed as contraction in supply. However, in both cases, movement occurs along with the supply curve. Figure 8: Extension and contraction in Supply (Source: BOUNDLESS, 2014) Question 3: (a) “A rise in the wages paid to all workers employed in the production of Television Sets” – Explanation Figure 9: A decrease in Supply (Source: AmosWeb, 2014) As the wages in the labour market has increased, the producers of Television Sets s have to pay higher price to its labours. It causes increase in cost of labour or resource price and thereby, cost of production. Thus, the manufacturer company will contract quantity supply of their Television Sets for each price level. This will result not only an increase in market price but also decrease in the quantity of their Television Sets. (b) “A continued major rise in the sales of iPads, other Tablets and Smartphones as devices providing televised content” – Explanation Figure 10: A decrease in demand (Source: Blanchard and Quah, 1990, pp-642) Tablets, iPads and other Smartphone are substitutes for Television Sets. A major rise in the sale of these products indicates that people are becoming more interested towards them. As the sale of the substitute product rises, the sale or market demand for the television is reducing. In addition, the remote nature of the above mentioned substitute products are attracting the consumers, while the television market suffers. Therefore, the market demand curve for Television Sets will shift inward. (c) “The introduction of new technology in the production processes involved in manufacturing Television Sets” – Explanation Figure 11: An Increase in supply (Source: (Source: Blanchard and Quah, 1990, p.645) Application of new technology in production process results an increase in productivity. Thus, for each unit of cost level, now the manufacturer company can produce large number of Television Sets in comparison to previous. Thus, advent of new technology leads to an increase in the supply of Television Sets. The market supply curve of Television Sets will shift to the rightward, which in turn, leads to greater quantity of Television Sets at lower equilibrium market price. In short, the introduction of new technology in the manufacturing process of Television Sets leads to change in equilibrium price and quantity in opposite direction. (d) “An increase in the number of households in the United Kingdom” – Explanation Figure 12: An Increase in demand (Source: Raybromley, 2014) Market demand for any good is determined by adding up individual demands and perspectives of the customers. Greater number of customers for a particular good indicates greater market demand for it. Thus, if the number of households in the United Kingdom increases, the number of consumer for Television Sets will also increase. In this situation, the market demand curve of Television Sets will shift to the right. (e) “A rise in the preferences amongst consumers for going out to the cinema and other entertainment venues in their social life” – Explanation Figure 13: A decrease in demand (Source: Raybromley, 2014) Preference of the consumers is one of the prime determinants of market demand for any goods and services. If the consumers in the United Kingdom are inclined more towards cinemas and entertainment venues in their social life, it results in decrease in demand for television. (f) “An increase in the number of companies entering the market for the production of Television Sets” – Explanation Figure 15: An Increase in supply (Source: Raybromley, 2014) The market supply curve is measured by horizontal summation of the individual supply curve. If more television-producing firms enter in the market, the number of suppliers increases. Thus, the market supply curve of Television Sets will shift outwards and drive the market price of Television Sets down. Reference List AmosWeb 2014. CONSTANT-COST INDUSTRY cost Industry, [online] Available at: [Accessed: 31 October 2014] Blanchard, O. and Quah, D. 1990. The dynamic effects of aggregate demand and supply disturbances.National Bureau of Economic Research Cambridge, Mass., USA. 21(3). pp. 65-78 BOUNDLESS 2014. Determinant of Supply, [online]Available at: [Accessed: 31 October 2014] Griffiths, M. and Wall, D., 2011. Economics for Business and Management, 3rd ed. Harlow: FT/Prentice Hall. Guide Jr, V., Teunter, R. and Van Wassenhove, L., 2003. Matching demand and supply to maximize profits from remanufacturing. Manufacturing \& Service Operations Management, 5(4), pp.303-316. Hubbard, R. and OBrien, A. 2006. Microeconomics. 1st ed. Upper Saddle River, N.J.: Pearson Prentice Hall. Mas-Colell, A., Whinston, M. D. and Green, J., 2004. Microeconomic, Oxford University Press. Raybromley 2014. pcecon.com Class Notes by Ray Bromley, Available at:< http://www.raybromley.com/notes/equilchange.html,> [Accessed: 31 October 2014] Bibliography Allen, W.B., Doherty, K, W. and E. Mansfield 2013. Managerial Economics: Theory, applications and cases, 8th Edition. New York: Norton. Pindyck, R. S. and Rubinfeld, D. L. 2005. Microeconomics. Upper Saddle River, N.J.: Pearson Prentice Hall. Read More