3 Supply and Demand

We can split supply curves into two categories: individual supply and market supply. Individual supply shows some firm’s preferences about the quantity they are willing to produce at different prices. For example, if there are four different firms producing the same product, then there are four individual supply curves. On the other hand, market supply is the aggregation (sum) of all individual supply curves. We generally use market supply (unless otherwise specified.) The table below shows the individual supply for three firms for hamburgers sold per week in addition to the market supply (comprised of the three individuals) for hamburgers sold per week.

Table 3.5 Market Supply versus Individual Supply

Price	QS1	QS2	QS3	=	Market QS
$1.00	75	125	60	=	260
$1.50	90	140	80	=	310
$2.00	110	170	100	=	380
$2.50	130	190	120	=	440
$3.00	140	205	130	=	475
$3.50	145	210	135	=	490

Shifts in Supply

The previous module explored how price affects the quantity supplied. The result was the supply curve. Price, however, is not the only factor that influences supply. For example, how is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence supply?

These factors matter for both individual and market supply as a whole. Exactly how do these various factors affect supply, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.

A supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given supply curve is based on the ceteris paribus assumption that all else is held equal. A supply curve is a relationship between two, and only two, variables when all other variables are kept constant.

We will discuss a total of six factors which cause the supply curve to shift. Again, notice INEPTT. These include:

• Input prices (cost of production)
• Number of suppliers
• Expectations
• Price of alternative goods
• Technology
• Taxes

Each will be discussed in more depth shortly. Before we do that, let us explore what a change in supply actually is. Recall, when the price of a good changes, we move along the supply curve. That is, when the price changes, the quantity supplied changes, but the supply stays the same (meaning we stay on the same demand curve.) On the other hand, when one of the shifters above changes, the entire supply curve moves. An increase in supply is shown by an outward shift while a decrease in supply is shown by an inward shift. Be sure to think about shifts as inward or outward. If you think about the shift as moving the curve up or down, you will likely make mistakes with the supply curve. This is shown graphically below.

Numerically, what a shift means is that the quantity supplied will be different at each price level. The table below shows a both an increase and decrease in supply using the supply schedule presented earlier in the chapter.

Table 3.6 A Change in Supply

Price (per gallon)	Decrease in Supply	Original Supply	Increase in Supply
$0.50	20	40	70
$1.00	65	90	130
$1.50	110	140	190
$2.00	150	170	240
$2.50	175	200	280
$3.00	190	220	310
$3.50	200	240	340
$4.00	205	250	360

Now that we have explored what supply shifts look like, let us examine what can cause these changes. Remember, if the price of the good changes, we move along the supply curve (meaning the supply curve does not move.) It is only if one of the following factors change that the entire supply curve will move.

Input Costs

A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as we described a shift in demand as a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.

In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. We can show this by the supply curve shifting to the right.

Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area and increase its supply.

Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.

Imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply.

Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right.

Number of Suppliers

This shifter is a bit more straightforward. This shifter is typically thought of as the number of firms. Put simply, as more firms enter the market, the supply will increase and vice versa.

Expectations

Just as was the case with demand, firms will make decisions not only using current conditions but will also use expected changes to make decisions as well. For instance, if a firm expects the value of its product to increase in six months, they may temporarily decrease the amount of product they make available in order to make more of it available when the price goes up sometime in the future. For example, toy companies produce a significant amount of inventory throughout the year but do not make it available for sale until the holiday season. In addition, if a firm expects the cost of its inputs to rise, they may increase production today to avoid the higher cost of production that may occur later.

Price of Alternative Goods

Here we consider a single firm that produces more than one good. We know from the previous chapter that firms face a production possibilities frontier meaning that they can only produce so much given their factors of production. Therefore, the profitability of one good may impact the supply of another.

For example, consider a firm that produces widgets and gizmos. Now, suppose that the price of a widget increases. Since the price of the widget went up, the quantity supplied of widgets will increase. But, in order to produce more widgets, the firm must shift some resources away from gizmo production. Therefore, the supply of gizmos decreases.

Be careful with terminology here. In the previous example, when the price of the widget changed, the quantity supplied of widgets changed, but the supply of gizmos changed. This is because the price of gizmos did not impact gizmo; instead, if was an external factor (in this case, the price of widgets) that affected production.

In summary, when the price of an alternative good (produced by the same firm) increases, the supply of the other good decreases and vice versa.

Technology

When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right so that a greater quantity will be produced at any given price.

Taxes

Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs.

A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right.

3.3 putting supply and demand together

Equilibrium

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.

Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross in the figure below is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.

Table 3.7 A Market in Equilibrium

Price (per gallon)	Quantity Demanded (millions of gallons)	Quantity Supplied (millions of gallons)
$0.50	700	40
$1.00	550	90
$1.50	400	140
$2.00	300	170
$2.50	200	200
$3.00	130	220
$3.50	60	240
$4.00	20	250

In the figure above, the equilibrium price is $2.50 per gallon of gasoline and the equilibrium quantity is 200 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.

Market Failures

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $2.50 per gallon, the price is $3.00 per gallon. The horizontal line at the price of $3.00 in the figure below illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 200 to 130. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $3.00, the quantity of gasoline supplied rises from the 200 to 220, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 130 gallons, while quantity supplied has risen to 220 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus. In this example, the surplus is 220-130=90 million gallons.

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions, in turn, will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create downward price pressure.

Now suppose that the price is below its equilibrium level at $2.00 per gallon, as the horizontal line at this price in Figure 3.7 shows. At this lower price, the quantity demanded increases from 200 to 300 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 200 to 170.

When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In our example, the shortage is 300-170=130 millions of gallons. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level.

3.4 Modeling market disequilibrium

Single Shifts

Let’s begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.

Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.

Step 2. Decide whether the economic change you are analyzing affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors? Which specific factor is it affecting? Then, decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?

Step 3. It is important to remember that in step 2, the only thing to change was the supply or demand. Therefore, coming into step 3, the price is still equal to the initial equilibrium price. Since either supply or demand changed, the market is in a state of disequilibrium. Thus, there is either a surplus or shortage. Determine which one exists. Next, determine what prices must do to reequilibrate the market. Remember, if there is a shortage, there will be upward price pressure and if there is a surplus, then there is downward price pressure. Prices continue to adjust until the market achieves a new equilibrium.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

Example 1 (Supply)

Scenario: The market for fast food in a certain town is initially in equilibrium. Several new fast-food restaurants open in the town. Show the impact of the new fast-food restaurants on the equilibrium price and quantity of fast food in this town.

Step 1. We begin by creating a supply and demand graph that is initially in equilibrium.

Step 2. This change affects the supply of fast food. Specifically, the number of suppliers has increased. Therefore, the supply of fast food has increased. This causes an outward shift of the supply curve.

Step 3. At the original price level, the quantity demanded is less than the quantity supplied. Therefore, the market currently has a surplus. In order to alleviate the surplus, the price of fast food must begin to fall (downward price pressure.) This continues until the market achieves its new equilibrium.

Step 4. We now compare the initial equilibrium to the new equilibrium. We can see that the price of fast food has fallen but the quantity of fast food has increased.

Example 2 (Demand)

Scenario: The market for pickup trucks is initially in equilibrium. A new marketing campaign is successful and creates a new desire to own pickup trucks. Show the impact of the advertising campaign on the equilibrium price and quantity of pickup trucks.

Step 1. We begin by creating a supply and demand graph that is initially in equilibrium.

Step 2. This change affects the demand for pickup trucks. Specifically, the tastes of consumers have changed. Therefore, the demand for pickup trucks has increased. This causes an outward shift of the demand curve.

Step 3. At the original price level, the quantity supplied is less than the quantity demanded. Therefore, the market currently has a shortage. In order to alleviate the shortage, the price of pickup trucks will begin to increase (upward price pressure.) This continues until the market achieves its new equilibrium.

Step 4. We now compare the initial equilibrium to the new equilibrium. We can see that the price of pickup trucks has increased and the quantity of pickup trucks has increased.

Summary of Shifts

Regardless of the cause of the shift, there are only a total of four possible cases. We can have an increase or decrease in supply or demand. Each scenario has its own unique template. The results are summarized below.

Table 3.8 A Summary of Shifts

Curve Shift / Change	Increase	Decrease
Demand	P↑ Q↑	P↓ Q↓
Supply	P↓ Q↑	P↑ Q↓