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CHAPTER 5: EQUILIBRIUM
Supply and Demand Together
Supply represents the selling strategy of the firms while demand represents the buying strategy of the consumers. Since both sides of the market are sliding up and down their individual curves in reaction to price, there is only one outcome that is consistent with both strategies.
The intersection of the supply and demand curves is the only price where firms want to sell exactly what consumers want to buy.
It is the only quantity where firms will accept a minimum price that is equal to the maximum price that consumers are willing to pay.
At this point quantity supplied equals quantity demanded and the market “clears”. This point is called equilibrium. The market forces of supply – firms competing for buyers, and demand – consumers competing for the goods - will push us to this equilibrium.
Suppose this product had been put on the market at a price of $1.00. Firms only want to supply a quantity of 2.4 million bushels while buyers want to buy 2.8 million bushels. Since quantity demanded is larger than quantity supplied we have a shortage – in this case of .4 million bushels. Firms will see consumers want this good a lot more than they originally thought and they will raise the price accordingly. As price increases, the firms will produce more and the consumers will buy less until the shortage disappears.
Suppose this product had been put on the market at a price of $2.50. Firms want to supply a quantity of 2.7 million bushels while buyers only want to buy 2.5 million bushels. Since quantity demanded is smaller than quantity supplied we have a surplus – in this case of .2 million bushels. Firms will have unsold wheat piling up and will have to drop the price accordingly. As price decreases, the firms will produce less and the consumers will buy more until the surplus disappears.
Sometimes either the buyer or the seller is successful in preventing the equilibrium from occurring. Either side might appeal to the government that the equilibrium price is unfair and should be outlawed. Such government intervention is known as a price control and it will affect what happens in the market.
Price Controls
The consumers may argue that the equilibrium price is too high and constitutes an unfair burden to customers. They may claim that firms are not competitive and are artificially keeping price high. Very often, the effect on the poor is part of this appeal, as low-income households may not be able to afford this product. In such a case, the consumers ask the government to set a maximum price allowed in the market – a price ceiling.
In this market, we are not allowing price to rise above $25. At $25 consumers want 400 units while firms are only producing 200. There is a shortage of 200 units that will not disappear since price can’t rise to equilibrium. The ceiling is said to be binding because it prevents the equilibrium.
A black market for the good may develop as buyers and sellers try to find away around the ceiling. Government may choose to ration the good to try to achieve an equitable distribution. Some states have placed price ceilings on credit card rates and some cities have placed price ceilings on rental housing.
The sellers may argue that the equilibrium price is too low and constitutes an unfair burden to producers. They may claim that they cannot pay their workers a fair wage and make a normal rate of return. Very often, the effect on small, family owned businesses or individual sellers is part of this appeal, as they may not be able to afford to keep selling at current prices. In such a case, the consumers ask the government to set a minimum allowed in the market – a price floor or price support.
In this market, we are not allowing price to fall below $32.50. At that price consumers only want to buy 250 units while firms are producing 350 units. There is a surplus of 100 units that will not disappear because price can’t fall to equilibrium. The floor is said to be binding because it prevents the equilibrium.
In the US, we have sometimes placed price floors on agricultural products, and on labor - the minimum wage is a price floor. Generally, the sellers of the good also lobby for the government to buy the surplus or to somehow financially support those who are no longer able to sell. In the case of agriculture, the US has bought surplus grain as well as other agricultural goods and donated them to the UN food bank or given them to very poor people in the US. In the case of labor, the unsold labor adds to unemployment – the government has programs like unemployment benefits and food stamps to aid households that are not able to find jobs. As we will discuss in the labor chapter, the effect of the minimum wage on employment and unemployment is highly debated.
Changes in Equilibrium
Equilibrium will change as supply or demand shifts. Suppose that a determinant of demand changes and consumers then change their entire spending strategy. For example, they now want more of a good than they did before because their incomes have risen or there are more consumers than before. The demand curve will shift to the right and the old equilibrium point is no longer valid.
The old equilibrium in this market was at a price of $2.00 and a quantity of 2.6 billion. Now buyers want more than before, shifting the demand curve to the right. At the old $2.00 price consumers want more units than firms want to sell and this pushes the price up. The new equilibrium is at a price of $2.50 and a quantity of 2.7 billion. Notice that when demand shifts, price and sales move in the same direction.
A fall in consumer demand would have the opposite effect. Firms would no longer be able to charge the old price because consumers won’t buy all they have made. They will be forced to lower price and the new equilibrium will show falling price and sales. Again, price and sales move in the same direction as demand. A change in demand, all other things equal, slides us along the supply curve – a change in quantity supplied. When you move along the supply curve price and sales move together.
Suppose that a determinant of supply changes and firms then change their entire production strategy. For example, they now want to sell more of a good than they did before because their production costs have fallen or there are more firms than before. The supply curve will shift to the right and the old equilibrium point is no longer valid. In this case price and sales will not move in the same direction. A change in supply, all other things equal, slides us along the demand curve – a change in quantity demanded. When you move along the demand curve price and sales move in the opposite direction.
The old equilibrium in this market was at a price of $3.00 and a quantity of 2.6 billion. Now firms want to sell more than before, shifting the supply curve to the right. Firms have to lower price to get consumers to buy the extra output. Equilibrium is now at a price of $2.50 and a quantity of 2.7 billion. Notice that when supply shifts price and sales move in the opposite direction.
A fall in supply would have the opposite effect. Buyers would compete with each other for the now scarcer good driving price up. The new equilibrium will show falling sales and rising price. Again, price and sales move in the opposite direction. It is important to be able to identify when it is which curve and to remember that an increase in activity moves the curve to the right while a decrease moves it to the left.
Simultaneous Shifts in Supply and Demand
Sometimes, determinants of both supply and demand change at the same time causing both curves to shift. Whenever this happens, the effect on one equilibrium variable can be predicted but not the other. In other words, you will be able to state what will happen to price but not quantity or quantity but not price.
Note: In this class, I will always tell you when it is a two curve shift problem. Unless told otherwise only shift one curve in any one graph, even if you can see a reason why the other curve might shift.
For example, during the last 15 years or so, both the demand and supply of computers have risen. By itself, a rise in demand increases both the price and sales of computers. By itself, a rise in supply increases the sales of computers but lowers the price of computers. Notice that both curves are pushing sales up, but they are inconsistent on price. We can, therefore, predict that computer sales will rise in such an environment but the effect on price is unknown.
One possibility is that the increase in demand is very large compared to the increase in supply. In this case the demand dominates price, pushing price up. Another possibility is that the increase in demand and supply are approximately equal and price remains stable. The last possibility (and the one that reflects the computer market in the last 15 years) is that the increase in supply is very large compared to the increase in demand. In this case the supply dominates price, pushing price down. We have a consistent pattern of prices falling in the computer industry; new and better computers are introduced, fall in price and are finally replaced by even newer and better models.
Cross Markets
The supply and demand conditions of one market can crossover and affect another market for a different good or service. Buyers and sellers do not make decisions in isolation – they take circumstances into consideration about related markets. The following represent the main ways that markets are related:
Substitutes: goods buyers use instead of one another. AOTE, if a substitute becomes more attractive, it hurts the demand for the original good.
Complements: goods buyers use together. AOTE, if a complement becomes more attractive, it helps the demand for the original good.
Inputs: materials used by firms to produce other goods. AOTE, if an input becomes more attractive (cheaper or more productive), it helps the supply of the finished good.
Alternative outputs: goods firms make instead of one another. AOTE, if an alternative output becomes more attractive (profitable), it can hurt the supply of the original good.
By-products: goods firms produce together. AOTE, if a by-product becomes more attractive (profitable), it increases the supply of the original good.
In the early 1970s there was a disruption in the supply of cane sugar imported into the US. This reduced the supply of foreign cane sugar in the US market and drove the price of foreign cane sugar up, while reducing the sales of foreign cane sugar.
American cane sugar is an excellent substitute for foreign cane sugar, but was typically more expensive to produce. When the price of
foreign cane sugar rose, it increased the demand and price of US cane sugar. We expanded the production in Hawaii and Florida. It also increased the demand for US corn syrup which is another substitute for sugar.
Sugar is an input in the production of soft drinks and candy. When sugar becomes more expensive, some users switch to corn syrup which boosts the price there too. Now, whichever is used, it is more expensive to make soft drinks and candy which lowers the supply in those markets.
After foreign cane sugar became more plentiful again, US sugar growers and US corn farmers successfully lobbied to have a tariff (tax on an import) levied against foreign cane sugar. The soft drink, baking and candy industries have lobbied ever since to have it removed. Given the number of states that have a significant percent of their economy tied to the cultivation of corn these industries have not been successful.
Journal Topics: Complete the following assignment:
Find one example in the recent news of a change in demand, and one example of a change in supply. Describe each, with a general graph.
Over the last twenty years the demand for coffee has grown greatly in the world both with population growth and as a number of societies that used to drink tea are now drinking more coffee. About 12 years ago there was a drop in the supply of coffee due to poor weather in Latin American which killed a number of coffee plants. Describe what happens to equilibrium price and quantity when demand rises and supply falls. Draw the three possible outcomes .
A poultry disease kills many of the turkeys and chickens in the US. Graph what would happen in the poultry market, the market for hamburger, the market for stuffing mixes and the market for hamburger buns.
CHAPTER 6 ELASTICITY
Elasticity of Demand
When there is a change in supply, the market moves along the demand curve, shifting price and sales in the opposite direction. There can be very different reactions in the magnitude of the price and sales change. If supply rises, how much does price have to fall to get consumers to buy the extra output? A lot? A little? If new production costs require an increase in the price of a good, how much less will consumers buy? A lot? A little? Knowing the degree of change to price and sales from a supply shift is important for the firm’s business planning and success. We need to measure the responsiveness that consumers have to a price change – a concept known as elasticity of demand.
Put simply, there are three categories of responsiveness to a price change demonstrated by consumers. Total revenue provides a way of measuring this responsiveness since total revenue is the product of price and quantity. Since these move in the opposite direction, total revenue will move with the one that changes more – this is known as the total revenue test. We really want to know how flexible quantity demanded is. Does it change a lot, a little or somewhere in-between? Accordingly, demand can be elastic, inelastic or unit elastic.