Cost systems in an economy can be free (capitalist), fixed (socialist) or mixed. In fixed cost systems, the costs are controlled by the government. In a free economy, demand and supply establishes the costs and there is no control whatsoever from the government. In this economy, the question of what to produce and how much to produce, is determined by the cost mechanism. Sellers produce the goods that are demanded by the consumers and the amount of goods that meet their cost of production. Goods that are preferred by the consumer have a high demand and attract a higher cost. Lower costs of goods are an indication of the consumer’s lack of preference for those goods. Under the cost-mechanism system, social goods such as education are ignored as producers spend most of their resources producing goods that are more profitable. However, the free and fixed economies are extreme cases and most economies have a mixed cost system.

In competitive markets, no one influences the costs of goods and services. Everyone involved in the market determines the costs and the costs determine the produce. When the cost of a certain product is high, there will be more production of that product because the producers will want to gain the profits. However, fewer consumers will buy that product. Low costs encourage consumption but they discourage production. The forces of demand and supply determine the costs in a competitive market.

Demand refers to the amount of a product that a buyer is willing and able to buy at a given cost during a given period. There is a difference between demand and amount demanded. Amount demanded refers to a specific amount that the buyer desires and can afford to buy at one cost. There is a negative relationship between demand of a product and cost of that product. According to the law, other factors held constant, the higher the value of a good, the less the demand and the lower the cost, the higher the demand. The demand curve shows the negative relationship between the cost of a good and the amount demanded. Other factors can determine the goods demanded.

When the amount demanded increases, the demand curve shifts to the right and it shifts to the left when the amount demanded decreases. Decrease in demand is a situation in which at each cost, consumers plan to buy fewer goods. It is the reduction in the value of an additional unit of the good. Normal goods show that as the level of income increases, the demand increases and in this case, the demand curve shifts to the right. Normal goods refer to goods that consumers buy more of when their income increases. An inferior good shows that as income increases, demand decreases and in this case, the demand curve will shift to the left. An inferior good is a good that consumers buy less of when their income increases. Factors that can shift the demand curve include consumer income, cost of complements, cost of substitutes, population, preferences and future cost expectations. Changes in the cost of goods and services do not shift the demand or supply curve.

Supply refers to the amount of goods producers desire to produce and are able to sell at a certain cost. The law of supply shows a positive relationship between the amount supplied and the cost. According to the law of supply, the higher the cost of a good, the more that good will be supplied. If the cost is low, there will be less production of the good. Producers are willing to supply more goods when the cost is high because they will recover their costs and gain profits. Other than cost, other factors such as number of sellers, input costs, future cost expectations, cost of substitutes, cost of joint products and technology affect supply. Substitutes are goods used in place of another such as tea and coffee or butter and margarine. Joint products are products, which are used together such as cars and gas. The supply curve shifts to the right when there is an increase in supply and it shifts to the left when there is a decrease in supply.

The law of demand and supply asserts there is an adjustment in the cost of commodities so that the amount supplied of that good and the amount demanded are in balance. The economy is at equilibrium when demand and supply are equal. At this point, the amount demanded is equal to the amount supplied. In a competitive market, there is hardly a time when the market is at equilibrium. The costs of goods and services are constantly changing and this leads to disequilibrium. At this state, the market can have either excess supply or excess demand and it is determined by the competition from the sellers and buyers.

When the costs are too high, there will be excess supply (surplus) because of lower consumption. After some time, the suppliers find that they cannot continue selling the goods at the given cost. They in turn lower the costs of the goods so that they can sell the surplus. The decrease in costs attracts more buyers and this decreases the amount supplied. The costs continue to fall until they reach a state of equilibrium. When the costs are set below the equilibrium, there is a higher demand because of the cheaper costs. Many consumers are willing to buy more when the costs are low and this creates a shortage of the goods produced. Because of the shortage, sellers increase the costs of goods and as the cost increases, the demand falls and the supply increases. As this is happening, the market moves to a state of equilibrium.

Governments sometimes set cost floors to deal with the falling costs. They do this to help the sellers so that they do not incur huge losses. Cost floors restrict the costs from falling below a certain level. If the cost floor is above the market cost, it causes a surplus. The government can also impose cost ceilings, where it prohibits a cost from going above a certain level. They do this to help the buyers from being exploited by the sellers. If the cost ceiling is below the equilibrium cost, there will be a shortage. Cost floors and ceilings lead to non-cost rationing, changes in quality and black markets

The cost elasticity of demand shows the percentage change in the amount demanded because of changes in commodity costs. Elasticity of demand measures the sensitivity of the amount demanded of a good to changes in its cost, cost of other related goods and income. Cost elasticity of demand measures the change in amount demanded when its cost changes. If the amount of a good responds substantially to the change in cost, demand is said to be elastic and the elasticity is greater than one. Demand is inelastic if the amount demanded reacts slightly to cost changes. In this case, the elasticity is less than one. Inelastic demand is not sensitive to costs. Goods and services that have no close substitutes, necessities and inexpensive goods have an inelastic demand.

If the elasticity is one, demand is said to be unit elastic. It means that the amount moves the same amount proportionately as the cost. Cost elasticity of demand is determined by accessibility of close substitutes, time, markets and the types of goods. Close substitutes have a more elastic demand because consumers can switch from one good to another. A small increase in the cost of one good causes a large change in the amount demanded of that good. Goods have a more elastic demand over longer time horizons. Markets that are narrowly defined have more elastic demand than markets that are broadly defined because narrowly defined markets have more substitutes than broadly defined markets. Necessities, such as healthcare, are inelastic whereas luxuries are elastic. Cross-cost elasticity of demand shows the responsiveness of demand for one product to changes in the cost of another product. Cost elasticity of demand helps business people to decide whether to change products so that they can increase the sales revenues.

The cost elasticity of supply determines  the extent amount supplied responds to changes in cost of that commodity. When supply is elastic, it means that the amount supplied is controlled variably by the changes in cost. When the supply is inelastic, it means that the amount supplied responds slightly to changes in cost. Producers determine the cost elasticity of supply. Another important determinant of cost elasticity of supply is time. Supply is usually inelastic in the short run because producers cannot easily change their produce and therefore the amount supplied is not very responsive to cost. It is inelastic over long periods because producers have more time to determine their produce and the amount supplied responds largely to cost changes. When the supply is perfectly inelastic, the cost does not determine the amount supplied and it shows zero elasticity in a supply curve. When the supply is perfectly elastic, small changes in the cost leads to huge changes in the amount supplied.

Costs in a competitive market are determined by the forces of demand and supply. Consumers are willing to spend more when the costs are low and this creates a high demand. High demand leads to a shortage of commodities and the costs increase. Producers are willing to produce more when the costs are high and this creates a high supply. When there is a high supply of goods, the costs tend to come down as sellers look for ways of selling their products. The changes in the cost of commodities lead to a state of equilibrium where the amount produced and sold is the amount demanded. To protect the consumers from high costs, governments impose cost ceilings whereby consumers cannot sell above the set costs. To protect sellers from incurring huge losses in case of abundant supply, governments impose cost floors whereby sellers cannot sell below the set cost.

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