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Distinguish between an extension and a contraction and an increase and a decrease in supply and demand. What factors may cause such changes?

  • July 22, 2005
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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.

Demand Curves

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...