In a previous article supply, demand and market equilibrium we discussed the relationship between supply, demand and prices.
We can use graphs to predict the effects of changes in price and quantity demanded/ supplied to some extend (if all else stays equal).
Supply and Demand Curves
- If the price for a product change, the quantity of the product demanded or supplied change – movement occurs along the relevant curve.
- If other aspects of demand change (for example changes in income, preferences and prices of substitutes) there is a shift in the demand curve (rather than movement along the curve)
- Likewise, if other aspects of supply change (for example changes in cost, input prices, technology and prices of related goods and services) there is a shift in the supply curve (rather than movement along the curve)
Allocation of resources
Prices determine the allocation of resources and therefor the combination of products and services produced.
When prices increase, households are likely to demand less and suppliers are likely to supply more. Price changes lead to changes in profits. Profits attract capital investment and losses lead to disinvestment. Higher wages attract labor and encourage workers to acquire certain skills.
Changes in income or preferences or the availability of substitutes will affect quantity demanded for a specific product at a given price. The shift in the demand curve will affect the supply side. A new equilibrium will be reached.
If cost of production or input prices change, it affects the profitability of a product at a given price. This could result in a shift in the supply curve because of investment/disinvestment and ultimately affect the quantity supplied. New technology can also affect the quantity supplied at a given price. This shift in the supply curve will eventually affect prices and as a result the quantity demanded. So a new equilibrium will be reached.
Example: The war on drugs
If you have a budget to reduce the use of drugs… where should you focus your attention? Demand side or supply side?
If you focus your efforts on supply side, you will stop drugs from entering the country, destroy drugs where they are grown and stop domestic distribution. If supply side strategies are successful, it will increase the price of drugs on the street. Higher prices should result in a decrease in quantity demanded. The problem is that higher prices makes it more profitable. So when production from one source is reduced, it just come from somewhere else.
If you focus your efforts on demand side, you will spend your budget on treatment and prevention strategies. If demand side strategies are effective, less will be demanded which will lead to a lower price. The lower price will reduce the profitability and eventually the quantity supplied should come down.
Legalization of drugs
There is also the more radical view that drugs must be legalized. Legalization will lower the cost of production (lower the risk of prosecution and costs associated with smuggling). Higher quantities will be produced which will drive the price down. They claim it is the high price that forces people into criminal activity to support their habits.
The counter argument is that the lower price will increase the quantity demanded which means more addiction
Karl E. Case, Ray C.Fair, Principles of economics. Seventh Edition, Pearson Prentice Hall, 2004, Chapter 4