Explain what is meant by the term an economic model and outline a model of price and output determination in a free market. Examine the effect of a change in real disposable income on equilibrium price and output.
An economic model or theory is a simplified explanation and analysis of economic behaviour. It allows us to predict, and therefore intervene, if we do not like the outcome of a possible chain of events.
Theories and models are mainly derived from past responses to similar stimuli or from statistical surveys, and this information may not always be accurate as it assumes ceteris paribus, or all other things remaining equal. For example, figures may show that the number of people smoking doubled when the price of cigarettes halved in the 1960s. This does not mean to say that following a similar price reduction today, the response would be the same, as advertising has increased the awareness of the dangers of smoking. Such a difference in behaviour patterns can be explained when we consider that economics is a social science, concerned with people, who have a free will and cannot be made subject to laws. This also explains why many models are generalised, dealing with trends in economic behaviour rather than the choice of the individual, as this varies and is difficult to surmise and predict.
A market is a place where buyers and sellers communicate for the purpose of the exchange of a good. In free market, the price of a good can fluctuate, determined by supply and demand.
When economists discuss demand, they mean effective demand, or how much people will want, and can afford to buy at any given price of a product. This means that demand is dependent on price. The graph above is a demand curve that illustrates that as price rises, demand falls. This enables movement along the curve, which we term an expansion or contraction of demand, depending on the direction of this movement. Like most economic models, it is simplified and assumes ceteris paribus that price and demand have an inversely proportional relationship. This theory does not account for goods which are nesscessities or that have few close substitutes, for whom demand may remain constant with price changes.
Similarly, there is a supply curve that shows the relationship between price and supply. The economic theory here is that the higher price a good commands, the higher your profit margin will be (assuming costs of production remain constant). This results in new firms being attracted to the market, so supply will increase. We describe this as a directly proportional relationship.
As price is determined by supply and demand, output is determined by the factors of supply and demand. There are a number of factors that influence supply and demand, price being the main variable. However, demand is also affected by income, where a rise in income will result in a rise in demand as people have more spending power. The exceptions to this statement are inferior goods, for example, Spam as people choose a better substitute like Salmon. Prices of other goods may affect demand. These may be complements,- as technology has improved, video recorders have become cheaper, increasing demand for video cassettes, or substitutes, in the case of two similar chocolate bars, if one is cheaper that the other, demand for that one might increase. Demand for some products may change simply because of tastes and preferences or because of expectations of future price changes. Cost and availability of credit tend to reduce demand for some goods as you have to pay more to pay off a good brought on credit when interest rates are high.
The size and structure of the population can affect demand. The demographic time bomb occurring presently may mean that future production is geared towards goods that old people have more use of. How income and wealth is distributed in society can affect demand, poor people have a need for different goods than those of the wealthy.
The factors influencing supply are less obvious, as we are mainly consumers. Costs of production are influent, for example, if they rise due to interest rates the profit margin is reduced and some firms may have to leave the market, decreasing supply. There is an inverse relationship between costs of production and supply. Another important factor is the profitability of other goods. If a competing product is making consumers spend more, then businesses may diversify to produce the most profitable good. Fires or floods changes resulting from nature and abnormal circumstances- can limit supply of agricultural goods. Improvements in technology can increase supply. In recent years, the development of high yield varieties of wheat has increased the output of wheat per acre. Indirect taxes, particularly to small businesses, increase costs of production, therefore limiting supply in order to remain profitable. Subsidies however, decrease costs, so that firms can increase supply.
Any change in demand or supply due to factors other than price, we term an increase or decrease of demand. The curves on the graphical representations of demand and supply shift, as shown below.
Economic theories such as those involved in demand and supply do not have to be shown graphically, they can also be expressed in the form of an equation.
Where Qd is quantity demanded, it is a function of the price of the good(Pn), income(Y), the price of all other goods(P1,Pn-1), and all other factors(T). This is expressed,
Qd = f(Pn,Y, Pn,Pn-1,T)
Similarly, where P is price, N is nature and abnormal circumstances, C is costs of production and T all other factors, quantity supplied is,
Qs = f(P,N,C,T)
If we merge the demand and supply curves, we end up with a graph that looks like this,
This is a model of price and output determination in free market.
Point E is the equilibrium price. This is the only price where demand equals supply. It is not necessarily the price at which there is greatest economic efficiency. Any point right of point E means that the market is either in excess demand or supply- this may lead to a shift in the respective curve and a new equilibrium price. For example, how does a change in real disposable income affect equilibrium price and output?
Disposable income is income minus tax and National Insurance contributions. Your real disposable income is the purchasing power of your disposable income, i.e.; what one pound will buy you. A change in income will only affect the consumer, so the factor that changes is quantity demanded. Non-specifically, an increase in real disposable income, ceteris paribus, tends to increase the quantity demanded at any given price. The demand curve shifts outwards and there is movement along the supply curve, indicating an expansion in quantity supplied. The point at which the curves cross changes and a new equilibrium price is set. More is supplied and demanded at the higher equilibrium price. Output increases at any given price.
A reduction in real disposable income tends to reduce the quantity demanded at any given price. The demand curve shifts inwards and there is negative movement along the supply curve, indicating a contraction in quantity supplied. The point at which the curves cross changes and a new equilibrium price is set. Less is supplied and demanded at the lower equilibrium price. Output decreases at any given price.
These explanations assume ceteris paribus, that the relationship between real disposable income and quantity demanded/supplied is directly proportional. The models are also generalised and do not account for inferior goods for which demand is inelastic.