A free market economy is an idealized form of a market economy in which buyers and sellers are permitted to carry out transactions based solely on mutual agreement without interventionism in the form of taxes, subsidies, regulation of government provision of goods and services. In this type of economy, all decisions are made by individuals and firms.
The economy is in equilibrium when income equals output equals expenditure or simply, Injections equal Leakages. On a chart this is represented when the supply and demand curves intersect at the point where supply and demand are equal. The price at which the number of products that businesses are willing to supply equals the amount of products that consumers are willing to buy at a specific point in time.
Basic Supply/Demand Graph
If either of the curves shifts, a new equilibrium will be formed. If one of the determinant of demand changes, the whole demand curve will shift. This will lead to a movement along the supply curve to a new intersection point. Likewise, if one of the determinants of supply changes, the whole supply curve will shift. An increase in supply will lead to a shift to the right whereas a decrease in supply will lead to a shift to the left of the original supply curve. This will lead to a movement along the demand curve to the new intersection point.
When more people want something, the quantity demanded at all prices will tend to increase. This can be referred to as an increase in demand. The increase in demand could also come from changing tastes, where the same consumers desire more of the same good than they previously did. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded. An example of this would be more people suddenly wanting more coffee. This will cause the demand curve to shift from the initial curve D0 to the new curve D1. This raises the equilibrium price from P0 to the higher P1. This raises the equilibrium quantity from Q0 to the higher Q1. In this situation, we say that there has been an increase in demand which has caused an extension in supply.
Conversely, if the demand decreases, the opposite happens. If the demand starts at D1, and then decreases to D0, the price will decrease and the quantity supplied will decrease – a contraction in supply. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift. The reason that the equilibrium quantity and price are different is the demand is different.
When the suppliers’ costs change the supply curve will shift. For example, assume that someone invents a better way of growing wheat so that the amount of wheat that can be grown for a given cost will increase. Producers will be willing to supply more wheat at every price and this shifts the supply curve S0 to the right, to S1 – an increase in supply which has caused an extension in demand. This causes the equilibrium price to decrease from P0 to P1. The equilibrium quantity increases from Q0 to Q1 as the quantity demanded increases at the new lower prices. Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions.
Conversely, if the quantity supplied decreases, the opposite happens. If the supply curve starts at S1, and then shifts to S0, the equilibrium price will increase and the quantity will decrease which will lead to a contraction in demand. The quantity demanded at each price is the same as before the supply shift. The reason that the equilibrium quantity and price are different is the supply is different. The decrease in supply could have been caused by a number of possible events including; an increase in the cost of a factor of production and a fall in the number of suppliers.
Another way to view this is that the supply curve moves up and down as opposed to left and right. If the ability to produce increases as compared to a steady price, the supply shifts up. If the ability to produce decreases, the supply curve shifts down.
Many facotrs influence the position and shape of the demand curve; such as the price of the product and tastes and preferences. The influences of the factors affecting demand on market demand are two types; influences causing a movemnt along the demand curve and that of a shift in the position of the demand curve. Increases in supply may be caused by events such as reductions in the cost of production, the fall of the price of factors of production and government subsidies.