Quiz 4: Supply and Demand: Applications and Extensions
Introduction: Before judging the impact, it is necessary to understand relation between product market and factor market. Housing facility belongs to product market, while carpenters, plumbers and electricians will come under factors market. Market mechanism: Concept of Market is very important in economics. It is a medium which connects buyers and sellers. Buyers are the economic units who create demand for the product. Sellers are the manufacturer. They supply the product. Thus the two forces in the market are demand and supply. Both are linked with the price of the subject matter. Demand is inversely related with price. If price is set low more buyers will come to buy the product. So, total market demand will go up. Supply on the other hand, is directly related with the price. If price is high, profit of suppliers will be high. So they will be ready to supply more units for increasing profit. Market mechanism helps in fixing the equilibrium price. It is the price where quantity demanded and quantity supplied is equal. If the subject matter is transacted at this equilibrium price, then there will not be any shortage or surplus. Market will remain stable. Market classification: Market can be of different types. They are interlinked. Two markets are- 1. Product market and 2. Factors market. Product market: Market of consumable goods and services is known as commodity or product market. Here manufacture of commodity is their suppliers. They belong to Business sector. Household sector on the other hand, consists of those economic units who create demand for such products. They buy the product, uses them to satisfy their needs. They are commonly known as consumers. Factors market: In order to manufacture a commodity business sector requires different factors of production. Factors are the inputs needed to manufacture a commodity. Household sector owns such factors. Business sector purchases them from household and converts them into commodities. Such converted output is sold to household sector again for ultimate consumption. Thus markets of factors are also available in economy. Here factors will include land, labor, capital and organization. Land will include all god gifted items used in production. Agricultural product, minerals, fisheries, animals, air, water etc everything that is scarce and required in manufacturing commodities will be considered in land. Labor will mean manual and mental exhaustion of mankind used in production. Capital is manmade item used in manufacturing some other commodities. Machine is manufactured by man. It is used to manufacture some other items. So machine is a capital in economics. Organization is special skill of human being to collect scarce factors from different areas, organize manufacturing activities and undertake the risk of marketing produced items. Separate market exists for each factor. Producer of commodity (i.e. business sector) creates demand of factors of production. Owner of factors (i.e. household sector) supplies them. Business sector pays price for getting them. Rent is paid to landowner, wages to laborer, and interest to capital owner and normal profit to organizer. Total of such factors payment constitutes cost of the commodity. Impact of increase in product demand on factor market: In the problem, housing is coming under product market. Residential houses are built by business sector. House hold sector buys them or may hire on rent. In order to construct the house, business sector has to hire carpenter, plumbers and electricians. They will render their specialized services. They are coming under factors market of labor. These two markets are closely related. Change in demand or supply of one market will not only disturb equilibrium price of the market but also will affect the equilibrium price of other market. Here demand of housing is going up. It will induce business sector to build up more housing complex or increase the residential capacity of existing complex. It will require more and more services of carpenters, plumbers and electricians. The demand of these factors in the labor market will go up, indicating the willingness on the part of supplier to pay high wage rate, hence results in upward push in the wage rate. Diagrammatic explanation: The impact can be elaborately explained with the help of understated diagram: In the diagram above figure 1 is showing market of housing. It is a product market. D 0 is original demand curve of housing. It is downward sloping. So, demand of housing will go up if price is reduced. Initial supply curve is S 0. It is upward rising. Supply of housing will go up if price is raised. At e 0 , point, two curves have intersected. Therefore demand and supply are equal. Initially Q ₀ housing was demanded and supplied at P 0 price. Now consider increase in housing demand. It has shifted demand curve to D 1. As a result new equilibrium price is P 1 and quantity of housing is Q ₁. Thus equilibrium price of housing is going up by P 0 P 1 and equilibrium quantity of housing is also going up by Q ₀ Q ₁ units. Now consider figure 2. It indicates market of carpenters, plumbers and electricians. It is factors market. Initially demand of factor was demand curve D 0 and supply was S 0. Therefore L 1 factors demanded at wage rate W 0. After increase in demand of housing, demand of carpenters, plumbers and electricians have increased. So demand curve has shifted to D 1. Now L 1 units of labor is demanded at wages W 1 Conclusion: Thus increased in demand for housing raised both the wage rate (by W 0 W 1 dollar) and also employment of carpenter, plumbers and electricians (by Q ₀ Q ₁ numbers).
Market mechanism: Usually in a competitive environment price is determined through market mechanism. Market has two counterbalancing forces. They are demand and supply. Demand comes from consumers or buyers while commodities are supplied by manufacturer or seller. These two variables are related with price. Demand is inversely related with price. If price rises demand decreases. Supply on the other hand is directly related. High price implies higher profit, so producers supply greater units of goods and services for every unit increase in price. Market is finally stabilizes at a price where demand and supply are equal. It occurs where demand curve intersects supply curve. It is known as market equilibrium price. Price control concept: Sometimes buyer or seller encounters difficulties when external forces distort the price. From buyers point of view price is high and beyond their capacity. From sellers point of view difficulties arises when price is too low for their survival. In such circumstances, government come into force and mitigates the problem by regulating the price. Restriction may be of two types. 1. Ceiling: When government fixes a price beyond which product cannot be sold, then it known as price ceiling. It is enacted to protect consumers. It happens when market equilibrium price is very high and beyond the buying capacity of most of the consumers. 2. Floor: It is just opposite. Here price is very low. So government has fixed a minimum price below which selling price should not be allowed to fall. It is meant for protecting sellers. Problem of college students: In the problem, college students think that existing rent of housing is too high and beyond their capacity. So they want a restriction on the upper limit on rental. They want a price ceiling of $400 per month. This upper ceiling will keep the rental of housing within their capacity. So they will be able to take house on rent and will be able to stay there. But it will have many adverse impacts on different areas. They will crop up due to decrease in supply of rental housing and scarcity in the market. Diagrammatic explanation: Following diagram is considered to explain the impact of imposing ceiling on rental. Diagram drawn above is based on the following assumptions- 1. Both demand curve and supply curve is assumed as linear in shape. 2. Market determined rental of residential housing is assumed as $600 per month. In the above diagram rental of housing is measured on the vertical axis and demand and supply of housing on the horizontal axis. Demand of housing to college student is shown by the red line. It is downward sloping. If rent is lowered then more students will demand it. Supply of housing is shown by the upward rising blue line. More housing will be made available to students if rent is high. Demand and supply curve has intersected at point e 0. Therefore market determined rent is $600 and equilibrium quantity of rental housing is Q e. This rental is beyond the capacity of most of the students. So government has imposed ceiling of $400 rental per month. At this rental total housing demand is Q D and supply is Q S. Thus demand is in excess by Q S Q D. Impact of rental ceiling: Consider the impact of rental ceiling on housing as described below- (a) Quality of rental housing: Since maximum rental cannot increase beyond $400, owner of housing will reduce the quality of the housing to maintain their profit. Some facilities may be curtailed. Less money will be spent on maintenance and repair. (b) Amount of rental housing available: As the ceiling rent is less than equilibrium rent, quantity of house available for rental to student will decrease. After price ceiling profit has reduced. Now giving house on rent to college student is less attractive. They may prefer to use the housing in alternative ways where earnings will be more. The diagram clearly shows that total quantity of housing available at equilibrium rent was Qe. After ceiling it has reduced to Q D. (c) Incentive of landlord to maintain their property: Due to upper ceiling on rent, landlord is not earning profit of market equilibrium rent; he will not be able to spend enough money for maintaining his property properly. He will curtail the maintenance cost. Result will be quick depreciation in the value of property and less qualitative service provided to occupier of the house. (d) Discrimination in the local rental housing market: Due to imposition of ceiling total quantity of housing available for rent is less in number. Now demand is more than supply and there is crisis in the market. It will encourage owners to practice discrimination. They will be selective in giving their housing on rent. They may practice racial discrimination, gender discrimination or in any other form. They may give house on rent to their friends or known persons instead of giving to anyone ready to pay proper rental. (e) Ease with which student will find housing: There will be acute crisis of housing. Students coming initially will get the house. But students coming late will have to encounter enough difficulties in getting a vacant house. Further discrimination by race, cast, gender etc, will make it difficult for a class of students to get the house on rent. Also many rich and corrupted students will adopt unfair means by paying extra money from backdoor. It will be difficult for poor and ordinary students to counterbalance them. (f) Black market: Since the demand for housing exceeds the available capacity, there will be acute crisis in the market. It will encourage black market. Many wealthy and corrupt persons will offer extra money illegally to landlord. Landlord will bargain and ultimately give on rent to a student who has offered highest illegal payment over and above the normal rent.
Possibility of adopting unfair means will be very high. Some customers may pay extra money illegally and create a black market for the commodity. Ordinary and poor customers will suffer. 7. Waiting: Since product available is fewer, customers have to wait for a very long period to get their product. 8. Diversion of resources: Now producers have less incentive to expand their business. So they will try to divert the resources in some other products which are more profitable at this moment. Thus in the long run supply will decrease further. Impact on quality: After imposition of ceiling, profitability of the product has declined. Seller will try to make up a part of this decline by adopting different non price means. One such way is to reduce the quality. Product may be produced with less qualitative materials, finishing may not be very accurate, even packaging may be less effective. In some cases after sale service facilities may be curtailed. Maintenance may not be as effective as it was earlier. Thus customers will be compelled to consume less qualitative product after imposition of price ceiling. Impact on future availability: Also there will be adverse effect on the availability of product in the future. Resources used in manufacturing the product are scarce. Its owner will always try to utilize them in manufacturing that product which will produce highest profit to them. Now due to the imposition of ceiling product is less attractive. So producer will gradually shift their resources to more profitable areas. Thus in future there is every possibility of decrease in the supply of product in near future.