In previous articles, we have discussed how both supply and demand can increase or decrease based on various factors. To recap, the shifters of demand can be remembered by the acronym M.E.R.I.T (Market size, Expectations, Related prices, Income, Taste) and the shifters of supply can be remembered by the acronym T.R.I.C.E (Technology, Related prices, Input prices, Competition, Expectations). A change in demand and/or supply can affect the equilibrium point, changing the market price of a good. Let’s look at some examples.
Suppose the demand for a good in the competitive market rises due to an increase of consumers’ income. Let’s look at how our equilibrium point changes and affects the market price of a good and the market quantity that good:
From this graph we see our initial supply and demand curve labeled S0 and D0 respectively and our initial equilibrium price and quantity labeled P0 and Q0 respectively. Due to the rise in consumers’ income, demand increases. This increase is modeled by the rightward shift of the demand curve moving the demand curve from D0 to D1. Now, the market’s current demand is represented by the shifted demand curve labeled D1. Due to the increase in demand, to find the market’s equilibrium point, we must locate where the current supply curve S0 intersects the new current demand curve D1. This intersection occurs at quantity Q1 and price P1, making this point the new equilibrium. Let’s observe how the equilibrium quantity and equilibrium price changed as this market achieved its new equilibrium. Recall that the initial equilibrium was at quantity Q0 and price P0. Moving from our initial equilibrium to our new equilibrium we see that the equilibrium quantity changes from Q0 to Q1. Q1 is greater than Q0 and therefore we can conclude that the new equilibrium quantity increases relative to the old equilibrium quantity. In other words, we can conclude that due to a rise in consumer’s income, the quantity of the good demanded and the quantity of the good supplied, in the market represented by the graph, has now increased but are still equal. Similarly, moving from our initial equilibrium to our new equilibrium we see that the equilibrium price changes from P0 to P1. P1 is a greater price than P0 and therefore we can conclude that the new equilibrium price has increased relative to the old equilibrium price. In other words, we can conclude that due to a rise in consumer’s income, the price of the good being sold in the market represented in the graph has now increased. To summarize how an increase in consumers’ income affected this market, the demand increased causing a rise in the market price and the market quantity of the good being sold.
Let’s look at another example. Suppose input prices for a good increase causing supply to decrease. Let’s observe how the equilibrium point changes:
From this graph we see our initial supply and demand curve labeled S0 and D0 respectively and our initial equilibrium price and quantity labeled P0 and Q0 respectively. Due to the rise of input prices, the supply for this market decreased. This decrease in supply is modeled by a leftward shift of the supply curve moving the supply curve from S0 to S1. Now S1 models the current market’s supply. Due to the shift in supply, the market has achieved a new equilibrium marked at the point where the market’s current (new) supply curve S1 and the current demand curve D0 intersect. We can see that D0 and S1 intersect and mark the market’s new equilibrium at a quantity of Q1 and a price of P1. Let’s observe how this new equilibrium point changed relative to the initial equilibrium in terms of the market price and the market quantity. At the new equilibrium, we notice that the price changed from P0 to P1. Since P1 is greater than P0, we can conclude that our market price has increased. We also notice that the market quantity shifted from Q0 to Q1. Q1 is less than Q0 and therefore we can conclude that our market quantity has decreased. Let’s summarize how an increase in input prices of this good affected the market. We saw that the supply curve shifted left to represent a decrease in supply causing a new equilibrium to form ultimately increasing the market price and decreasing the market quantity.
Let’s look at one more example where both the supply and demand curve shift. Suppose there is some technological advancement allowing for greater production levels for a certain good causing supply to increase. Simultaneously, suppose the price of a substitute good decreases causing demand to also decrease.
We can see that the market’s initial demand and supply curve are labeled D0 and S0 respectively and the initial equilibrium price and equilibrium quantity is labeled P0 and Q0 respectively. Recall that due to an increase in production levels and a decrease in the price of a substitute good, the market had an increase in supply and a decrease in demand. The increase in supply is modeled by the rightwards shift of the initial supply curve moving the market’s supply curve from S0 to S1. The decrease in demand is modeled by the leftwards shift of the initial demand curve moving the demand curve from D0 to D1. Note that now the current market’s demand and supply curves are D1 and S1 respectively. Therefore, the new equilibrium for this market would be marked at the point of intersection of the two curves D1 and S1. This new equilibrium sets the market price to P1 and sets the new market quantity to Q1. We can see that the new market price P1 is less than the initial market price P0 therefore indicating a decrease in the market price. We can also see that the new market quantity Q1 is greater than the initial market quantity Q0. It could be mistakenly assumed that since Q1 is greater than Q0, the market quantity has also increased. However, this is not the case. The reason for this is because we know that the demand is decreasing and the supply is increasing, however we do not know the magnitude of these changes for the two curves. Based on the magnitude of change for the two curves drawn in the graph above, the market quantity is increasing. However, if we change the magnitude of the shift for one of the curves, for example the supply curve, we can see that the new market quantity would appear to now decrease as shown below.
As seen below, the supply curve still has increased as modeled by the rightwards shift. However, this graph assumes a smaller increase in the supply as opposed to the previous graph. In this graph, we can see that the new market quantity, marked by the new equilibrium, is Q1 which is actually less than the initial quantity of Q0. As we can see, we just know that the demand will decrease and the supply will increase but we are unaware of how great or how small the change in demand and the change in supply will be. Therefore, since the market quantity could either increase or decrease, depending on the magnitude of the changes in supply and demand, we say that the new market quantity is indeterminate since it is unable to be determined based on the given information. On the other hand, regardless of the magnitude of change of the supply and the demand in the market, we can see that the new market price will always decrease relative to the initial market price and therefore we can conclude that the new market price has decreased. To summarize all the changes which occurred from a decrease in the price of a substitute good and a technological advancement, the supply increased while the demand decreased causing the market price to decrease and the market quantity to be indeterminate.
In the next article we will look into two possible ways governments might intervene in the competitive market and how these interventions affect the state of the market.
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