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5. Changes in Supply and Demand
Essay:
1. Describe the process by which a change in supply or demand leads to a change in the equilibrium price and quantity. Illustrate with a diagram.
2. Describe the effects on the equilibrium price and quantity of a change in supply and demand. Given a specific scenario, describe what change is certain and what change is ambiguous. Explain why.
Changes in Equilibrium Price and Quantity
Relative prices are constantly changing because of changes in supply and demand. There are four basic possibilities.
Increase in Demand
An increase in demand implies that buyers want to buy more of the good at the initial price. (This is illustrated by shifting the demand curve to the right.) The immediate result is a shortage. Sellers raise their prices. The higher price leads to an increase in the quantity supplied and a decrease in the quantity demanded. At the new equilibrium price, quantity supplied and quantity demanded are again equal. But the new equilibrium price and the new equilibrium quantity are higher.
P- Price Q-Quantity
Decrease in Demand
A decrease in demand has the opposite effect of an increase. Buyers want to buy less of the good at the initial price. (This is illustrated by shifting the demand curve to the left.) The immediate result is a surplus. Sellers shave their prices to raise sales. The lower price leads to an increase in the quantity demanded and a decrease in the quanitity supplied. At the new equilibrium price, quantity supplied and quantity demanded are again equal. But the new equilibrium price and the new equilibrium quantity are lower.
P- Price Q-Quantity
Increase in Supply
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An increase in supply implies that sellers want to sell more at the initial price. (This is illustrated by shifting the supply curve to the right.) The immediate result is a surplus. Sellers lower their prices to sell the extra product. The lower price leads to a decrease in the quantity supplied and an increase in the quantity demanded. At the new equilibrium price, quantity supplied and quantity demanded are again equal. But the new equilibrium price is lower and the new equilibrium quantity is higher.
P- Price Q-Quantity
Decrease in Supply
A decrease in supply has the opposite effect of an increase. Sellers want to sell less at the initial price. (This is illustrated by shifting the supply curve to the left.) The immediate result is a shortage. Sellers raise their prices to make more money. The higher price leads to an increase in the quantity supplied and a decrease in the quantity demanded. At the new equilibrium price, quantity supplied and quantity demanded are again equal. But the new equilibrium price is higher and the new equilibrium quantity is lower.
P- Price Q-Quantity
Changes in Supply and Demand
When both supply and demand change at the same time, the effects on either price or quantity can be discovered, but not both. The effects on one or the other is ambiguous.
For example, if both demand and supply increase, the equilibrium quantity clearly increases because both an increase in demand and an increase in supply cause quantity to rise. On the other hand, the effect on the equilibrium price is ambiguous. That means it could either increase or decrease depending on whether the increase in supply or the increase in demand is greater. If demand rises more than supply, then price will rise. If supply rises more than demand, then price will fall. If supply and demand increased the exact same amount, then price remains the same.
In the diagram above, the quantity increases and the effects on the price is ambiguous. This particular diagram shows demand increasing more than supply, so the price increases.
If supply decreases and demand decreases, then the result is the opposite. The quantity decreases and impact on the price is ambiguous.
On the other hand, what if supply decreases and demand increases. In that situation, the equilibrium price increases, but the effects on the quantity is ambiguous. That’s because both an increase in demand and a decrease in supply raise the equilibrium price. But since an increase in demand increases quantity and a decrease in supply decreases quantity, the two tend to counteract one another. That leaves the net effect ambiguous. If the decrease in supply is greater than the increase in demand, then quantity decreases. If the increase in demand is greater than the decrease in supply, then quantity increases. And if the change in supply and demand are exactly the same, quantity isn’t effected.
The diagram above shows an increase in demand and a decrease in supply. The price clearly increases, but the quantity is ambiguous. In this example, the quantity increases because demand increased more than supply decreased.
Discussion: When people decide they really like a product, they demand more of it. That causes an increase in price. A higher price goes with higher demand, so the law of demand is false. Comment.