Market Equilibrium Adjustment Process

An increase in petrol prices arising from global supply shortage of petrol has a direct impact on petrol demand.  When price increases, then quantity demand for petrol reduces (Frank 2014). As a result, they chose to buy cars that are fuel-efficient that requires less amount of petrol. The effect on the market for high fuel-efficient cars is shown below.

Figure 1: Market for high fuel-efficient cars

(Source: as created by Author)

SS and D₀D₀ describes the initial supply and demand situation in the fuel-efficient car market. E is point of equilibrium yielding an equilibrium price of P* and Q* number of cars. When petrol price increase then more fuel-efficient cars will be demanded. The demand expansion is shown by the outward shift of the demand curve to D₁D_1.  At the new demand, there will be a shortage of fuel-efficient cars. The new equilibrium is at the intersection point of new demand curve D₁D₁ and old supply curve SS. E₁ is the new equilibrium point where price has increased to P₁ and number of cars increased to Q_1.

The effect of petrol price increase in the market for petro-substitutes products such as liquefied petroleum gas is same as that in the high fuel-efficient car market.

Figure 2: Market for cars using liquefied petroleum gas

(Source: as created by Author)

As people, substitute their old cars with new cars using liquefied gas, the demand for such cars increases (Fine 2016). The demand curve will shift rightward from D₁D₁ to D₂D_2.  Corresponding to new demand, there will be supply shortage in the car market using petroleum substitute product. With an increase in demand, new equilibrium is at E_1, obtained from the intersection of D₂D₂ and existing supply curve SS.  Consequently, in the new equilibrium there is a rise in price from P₀ to P₁ with an increase in number of cars sold from M₀ to M₁.

Figure 3: Impact of a rise in average income in the beef market

(Source: as created by Author)

Demand of a good depends on several factors. Average income of people determines the purchasing power of people and hence demand. For a normal good, when income increases then demand increases as well. The change in demand for a change factors other than price is indicated by a shift in the demand curve as explained above. When average income increases the beef demand curve shifts from DD to D₁D₁. Consequently, both the price and quantity in the new equilibrium increases.

Effect of Events on Beef Market

Figure 4: Impact of high quality cattle food in beef

(Source: as created by Author)

The high quality cattle food reduces the time taken for preparing cattle ready for the market. This implies there will be now more cattle available within the same time increasing the supply of beef. The increase in supply lead to a rightward shift in the supply curve from SS to S₁S₁ (Moulin 2014)_.  With increases in supply given demand, there is an excess supply of beef. The excess supply will bring down equilibrium price and will increase equilibrium quantity. Corresponding to the new supply curve, E₁ is the new equilibrium point, occurred where S₁S₁ and DD intersects. The rise in the beef supply pushes the equilibrium price down from P* to P₂ and increases the quantity of beef sold from B* to B₂

When government ordered the mass slaughter of cows because of the spread of mad cow disease then supply of beef reduces. At the same time, the warning given to consumers for beef consumption then demand will also reduce. Both decrease in supply and a consequent decline in demand causes a decline in the equilibrium quantity of beef sold. The effect on price in ambiguous. The decrease in supply pushes the prices up while a decline in demand tries to bring down price. The ultimate effect on price depends on the magnitude of demand and supply change (McKenzie and Lee 2016). There are three possible case.

Case I

Figure 5: Change in supply exceeds change in demand

(Source: as created by author)

When change in supply exceeds the change in demand, then in the new equilibrium price of beef increase while equilibrium quantity sold decreases as expected.

Case II

Figure 6: Change in demand exceeds change in supply

(Source: as created by author)

When magnitude of demand reduction is greater than decline in supply the in the beef market both price and quantity decreases.

Case III

Figure 7: Change in supply equals change in demand

(Source: as created by author)

This is a hypothetical situation. When demand and supply changes exactly in same magnitude then price remain same while quantity declines.

The increases in new commercial apartment combines with a decrease in availability of such apartment. This means in the housing market, there occur a change in both supply and demand. An increase supply causes a decrease in price. The reduced demand also has the same impact on price (Elsner, Heinrich and Schwardt 2014). However, the effect of equilibrium number of houses is ambiguous. The supply forces tend to increase number of such apartments while demand forces causes a decline equilibrium number of apartments. The final impact on the number of apartments is subject to magnitude of changes in demand and supply.

Profit Maximizing Quantity for a Firm

Case I

Figure 8: Change in supply exceeds change in demand

(Source: as created by author)

Consider first the case where increase in the supply of new apartment exceeds the decrease demand of such apartments. This causes a decline in price of apartments along with an increase in equilibrium number of apartments.

Case II

Figure 9: Change in demand exceeds change in supply

(Source: as created by author)

In situation where decline in apartments demand exceeds increased supply of new apartments then equilibrium price declines as usual with a decline in number of apartments from H to H₂

Case III

Figure 10: Change in supply equals change in demand

(Source: as created by author)

When supply of apartments changes by exactly same magnitude as the reduction in demand the Ceteris paribus number of houses, remain same while price declines.

The price elasticity of demand in this price range in -2.59.

It is very important for business to understand the elastic value its product. Revenue of firms is the unit price time the quantity sold. In case of elastic demand, demand changes at a higher proportion than price (Nicholson and Snyder 2014). Therefore, a price reduction is a profitable strategy for firms. With inelastic demand, it is difficult for people to adjust their demand much in response to a corresponding change in demand. An increase in price is beneficial here as it leads to an increase in revenue earned by the firm.  The elasticity value is computed as -2.59. As the elasticity value is greater than 1, this means the demand is relatively elastic in nature. Therefore, by charging a low price the business owner can enjoy a gain in revenue and hence profit.

Objective of a firm is to maximize profit. Profit is obtained as a difference between total revenue and total cost.

Profit = Total Revenue (TR) – Total Cost (TC)

There are two approaches towards profit maximizing decision. One is Total revenue-total cost method and other is marginal revenue-marginal cost method.

Total Revenue –total cost method

Under total revenue- total cost method profit is calculated from taking difference between total revenue and total cost for each level of output. Firms experience profit when total revenue is greater than total cost. For every unit of output firms know how much revenue it is going to be earned and how much is its product cost (Cowen, T. and Tabarrok, A., 2015). Graphically, profit is indicated by the vertical distance between total revenue and total cost curve. This is shown in the following figure.

Figure 10: Profit maximization with TR-TC approach

The vertical distance between total revenue and total cost is maximized at point A. Point A corresponds to maximum total revenue and minimum total cost. Thereby, giving profit maximizing output as Q_MAX. The CEO can choose Q_MAX for maximizing profit.

Marginal Revenue- Marginal Cost method

Marginal revenue is the change in total revenue due to unit change in output. It is the slope of total revenue curve. Marginal cost is the change in total cost for unit change in quantity. Profit is maximized where marginal revenue equals to marginal cost. Two condition of profit maximization under MR-MC approaches are

1. a) MR = MC
2. b) Slope of MC > Slope of MR at profit maximizing level

Figure 11: Profit maximization under MR-MC approaches

(Source: as created by Author)

The condition for profit maximization requires marginal revenue should be equal to marginal cost (Arrow 2015). This occurs at point E. The profit-maximizing price is P_F and the profit maximizing quantity is Q_F.

References 

Arrow, K., 2015. Microeconomics and operations research: Their interactions and differences. Information Systems Frontiers, 17(1), pp.3-9.

Cowen, T. and Tabarrok, A., 2015. Modern Principles of Microeconomics. Palgrave Macmillan.

Elsner, W., Heinrich, T. and Schwardt, H., 2014. The microeconomics of complex economies: Evolutionary, institutional, neoclassical, and complexity perspectives. Academic Press.

Fine, B., 2016. Microeconomics. University of Chicago Press Economics Books.

Frank, R., 2014. Microeconomics and behavior. McGraw-Hill Higher Education.

McKenzie, R.B. and Lee, D.R., 2016. Microeconomics for MBAs: The economic way of thinking for managers. Cambridge University Press.

Moulin, H., 2014. Cooperative microeconomics: a game-theoretic introduction. Princeton University Press.

Nicholson, W. and Snyder, C.M., 2014. Intermediate microeconomics and its application. Cengage Learning.