Tuesday, 25 September 2012

School day off and Marshallian curves

Yesterday, on the Monday of September 24th, around 9:30 CET, construction workers outside our secondary school have cut a water pipe. As a result, the owner of the school buffer has raised the price of bottled water from 260 HUF to 600 HUF (although only temporarily, and as a joke). And while most of us very just happy that school came to a quick end due to the risk of infestation, the story has some important economic consequences as well. Wondering how? Read below.


Source: Peak Oil Technology


A quick guide to supply and demand


The story's summary about a water pipe gone wrong, a subsequent water shortage and then a price rise in water is a miraculous real life example of the model of supply and demand. But what is that?
Firstly mentioned by Adam Smith in1776, the role of supply and demand states that in a competitive market, the price of a given product will settle where the quantity demanded by customers backs up the quantity supplied by producers, resulting in an equilibrium.
The relationship between the quantity sold/bought at any given price and the actual price is demonstrated by the so-called Marshallian curve, which is a graph with price on it's vertical and quantity on it's horizontal axis.


Basic moves of the Marshall curve


Students of mathematics and physics might be utterly confused. Why on earth would someone put the dependent value on the horizontal axis? I have now answer – but out of tradition, and respect to the genius of Alfred Marshall, the curve stayed this way. This means that the correlation is still that quantity changes according to price – just the depiction is different.
Expanding on the rule of supply and demand, there are four basic moves of the Marshall curve, corresponding to four basic changes; two in supply and two in demand, respectively. These are:

1. If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity – the demand curve goes right.
2. If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity – the demand cuve goes left.
3. If demand remains unchanged and supply increases, then it leads to lower equilibrium price and higher quantity – the supply curve goes down.
4.If demand remains unchanged and supply decreases, then it leads to higher equilibrium price and lower quantity – the supply curve goes up.

That is all nice and easy – but how does that translate to school buffet terms and a water shortage?


Water pipes and Marshallian curves


When the pipes bringing water into the school ceased, the overall water supply – consisting so far of the water from sinks, and in smaller amount, of the water sold in the buffet. While the sink water was technically free, it was also of very bad quality even on better days, forcing many to buy bottled water instead. Now what happened when the pipes stopped functioning, and hence the water supply decreased?
Water became a lot more scarce, which made the school buffet owner, a rational economic actor wishing to maximize their own profit, raise prices. Even though the demand for water stayed the same – people didn't become more thirsty due to the fact that the sinks were not functioning, or only slightly, due to a psychological effect -, the equilibrium price hence increased and consumed/bought quantities decreased.

Conclusion


If this was the case, then why didn't the buffet owner maintain the higher prices? The answers are two-fold. Firstly, the model of supply and demand requires a competitive market – and a market consisting of only two actors barely falls into that category. Secondly, the sudden fallout of sink water made the buffet owner a sole distributor – a situation where he had monopoly. The market regulators – in this case, the owner's conscience and were it came to that, the headmaster - however responded to this by setting a price limit on water sales, hence preventing the abuses which can be caused by a monopol situation.

Did you like the post? Tell us your opinion in comments and get ready for Economist of The Week tomorrow.

Sources: Wikipedia

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