3 Supply and Demand

3.1 Demand

From: https://openstax.org/details/books/principles-microeconomics-2e (Chapter 3)

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won’t buy it. While a consumer may be able to differentiate between a need and a want, but from an economist’s perspective, they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter.

What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.

We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as Table 3.1 below, a demand schedule. In this case, we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like the graph below, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)

 

Table 3.1 A Demand Schedule
Price (per gallon) Quantity Demanded (millions of gallons)
$0.50 700
$1.00 550
$1.50 400
$2.00 300
$2.50 200
$3.00 130
$3.50 60
$4.00 20
The chart shows the demand for gasoline. The vertical axis is the price of gasoline and the horizontal axis is the quantity demanded of gasoline. The curve is downward-sloping showing the inverse relationship between price and quantity demanded.
Figure 3.1 A Demand Curve

The Law of Demand

Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.

Demand versus Quantity Demanded

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.

Individual and Market Demand

We can split demand curves into two categories: individual demand and market demand. Individual demand shows some individual’s preferences about what they are willing and able to pay for some good. For example, if there are 10 individuals, there are 10 different individual demand curves. On the other hand, market demand is the aggregation (sum) of all individual demand curves. We generally use market demand (unless otherwise specified.) The table below shows the individual demand for three individuals for cans of Pepsi-Cola per week in addition to the market demand (comprised of the three individuals) for cans of Pepsi-Cola per week.
Table 3.2 Market Demand versus Individual Demand
Price QD1 QD2 QD3 = Market QD
$0.25 25 6 18 = 49
$0.50 21 5 15 = 41
$0.75 18 4 14 = 36
$1.00 12 3 12 = 27
$1.25 7 2 10 = 19
$1.50 4 1 8 = 13

Shifts in Demand

The previous module explored how price affects the quantity demanded. The result was the demand curve. Price, however, is not the only factor that influences demand. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? What are the major factors, in addition to the price, that influence demand?

We defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors in addition to price that affects demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.

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

A demand 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 demand 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 demand curve is based on the ceteris paribus assumption that all else is held equal. A demand 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 demand curve to shift. You can use the mnemonic device INEPTT (which will be the same when we learn the supply shifters). These include:

  • Income levels
  • Number of consumers
  • Expectations
  • Price of related goods
  • Tastes
  • Taxes

Each will be discussed in more depth shortly. Before we do that, let us explore what a change in demand actually is. Recall, when the price of a good changes, we move along the demand curve. That is, when the price changes, the quantity demanded changes, but the demand stays the same (meaning we stay on the same demand curve.) On the other hand, when one of the shifters above changes, the entire demand curve moves. An increase in demand is shown by an outward shift while a decrease in demand is shown by an inward shift. This is shown graphically below.

The following graph shows three demand curves. The first demand curve is a regular downward-sloping demand curve. The second is shifted further outward (to the right) indicating a larger demand. The third is shifted inside of the original demand curve indicating a smaller demand.
Figure 3.2 Shifts in Demand

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

Table 3.3 A Change in Demand
Price (per gallon) Decrease in Demand Original Demand Increase in Demand
$0.50 600 700 850
$1.00 480 550 700
$1.50 360 400 550
$2.00 260 300 450
$2.50 180 200 320
$3.00 110 130 200
$3.50 50 60 100
$4.00 10 20 50

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

Changes in Income Levels

Consider the market for cars. Suppose that the market price of a car is $20,000. The original demand curve D, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand?

The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve, indicating an increase in demand. This would occur at every price, not just the original one.

Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve would shift left. The shift represents a decrease in demand: At any given price level, the quantity demanded is now lower.

When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.

The type of good just discussed is a normal good. That is, a good where if incomes rise the demand increases as well (and vice versa.) This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced (we will discuss this in a later chapter).

A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left and vice versa.

Number of Consumers

This shifter is a bit more straightforward. This shifter is typically thought of as the population. Put simply, as the population of an area increases, the demand will increase and vice versa. This does not necessarily refer to the number of people interested in the product (this will be discussed later) but simply as the number of potential customers.

Expectations

While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price.

Prices of Related Goods

Changes in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.

Other goods are complements for each other, meaning we often use the goods together because consumption of one good tends to enhance the consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.

Tastes

This category contains several different components.

The first is changes in what consumers want. For instance, from 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef. Similarly, fad items often see a rapid increase in demand when the item becomes popular and then a rapid shift inward when the item inevitably loses its popularity.

The second change is the demographics of an area. For example, the proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000 and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and daycare facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.

Taxes

Taxes have the ability to impact a consumer’s ability to afford a good, but the type of tax impacts the change in demand.

Income taxes will affect demand in the same way as changes in income did because they are essentially the same thing. For instance, an increase in income tax means that people now have less disposable income. Therefore, an increase in income taxes will cause a decrease in the demand for normal goods and an increase in the demand for inferior goods.

A sales tax applied to each good equally will function the same way as the income tax. If you have to pay the same tax (as a percent of its price), your purchasing power is affected in the same way that an income tax affects your purchasing power.

On the other hand, an excise tax, which is a tax on a specific good, then there is movement along the demand curve for that good and not a shift in the entire curve. For instance, a pack of cigarettes may cost $5 but then a $3 tax is applied. The quantity demanded for a $5 pack of cigarettes is greater than the quantity demanded for an $8 pack of cigarettes.

3.2 Supply

The good news is that much of this section is similar, but in many cases opposite, to what we just learned.

When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply are held constant.

The figure and table below both display the law of supply. Again, a supply schedule shows the different combinations of price and quantity supplied while the supply curve is a graphical representation of the same thing.

Table 3.4 A Supply Schedule
Price (per gallon) Quantity Supplied (millions of gallons)
$0.50 40
$1.00 90
$1.50 140
$2.00 170
$2.50 200
$3.00 220
$3.50 240
$4.00 250
The graph has price on the vertical axis and quantity supplied on the horizontal axis. The supply curve on the graph is upward-sloping and shows different combinations of price and quantity supplied.
Figure 3.3 A Supply Curve

The Law of Supply

Supply curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all supply curves share the fundamental similarity that they slope up from left to right. Supply curves embody the law of supply: As the price increases, the quantity supplied increases, and conversely, as the price decreases, the quantity supplied decreases.

Supply versus Quantity Supplied

In economic terminology, supply is not the same as quantity supplied. When economists talk about supply, they mean the relationship between a range of prices and the quantities supplied at those prices, as illustrated by a supply curve or a supply schedule. When economists talk about quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.

Individual and market supply

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.

The graph has price on the vertical axis and quantity on the horizontal axis. It shows that a decrease in supply is shown as an inward shift of the supply curve while an increase in supply is shown as an outward shift of the supply curve.
Figure 3.4 Shifts in Supply

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.

This graph has both a demand and supply curve. The point of intersection occurs when the price is $2.50 and the quantity is 200.
Figure 3.5 A Market in Equilibrium
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.

The graph has a supply and demand curve but the market price is set above the equilibrium price. This causes the quantity demanded to be less than the quantity supplied creating a surplus.
Figure 3.6 Surplus

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.

The graph has a supply and demand curve but the market price is set below the equilibrium price. This causes the quantity demanded to be greater than the quantity supplied creating a shortage.
Figure 3.7 Shortage

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.

Algebraic Equilibrium

Instead of using schedules or graphs to examine the supply and demand within a market, we can also express both as equations. This allows us to compact all of the information into a single mathematical expression. For instance, consider the demand equation below:

[latex]Q_{D}=30-5P.[/latex]

We can plug any price in and get the quantity demanded. For example, when the price is set at $3, the quantity demanded is

[latex]Q_{D}=30-5(3)=30-15=15.[/latex]

The same applies to the supply equation as well.

A market is in equilibrium when quantity demanded is equal to quantity supplied. Algebraically, this is accomplished by setting the demand equation equal to the supply equation. Then, you can solve for price. After you solve for price, you need to determine the equilibrium quantity. To accomplish this, plug the equilibrium price into either the demand or supply equation. To check your work, you can plug the equilibrium price into the other equation (depending on which equation you used first.) The quantities should be equal as this is the equilibrium condition (the quantity demanded must equal the quantity supplied.)

For example, let us find the equilibrium in the following market:

[latex]Q_{D}=30-5P[/latex]

[latex]Q_{S}=14+3P[/latex]

First, we set the equations equal:

[latex]Q_{D}=Q_{S}\Rightarrow 30-5P=14+3P[/latex]

Next, we solve for P:

[latex]30-5P+(-14+5P)=14+3P+(-14+5P) \Rightarrow 8P=16 \Rightarrow P=\frac{16}{8}[/latex]

Now, we plug the equilibrium price into the demand (or supply) equation:

[latex]Q_{D}=30-5(2)=30-10=20 \Rightarrow Q*=20.[/latex]

Finally, we can check our work by plugging the equilibrium price into the other equation. Since we used demand already, we will plug it into supply.

[latex]Q_{S}=14+3(2)=14+6=20 \Rightarrow Q*20.[/latex]

Therefore, the equilibrium price is $2 and the equilibrium quantity is 20 units.

Try the following problem: Find the equilibrium price and quantity in the following market:

[latex]Q_{D}=600-10P[/latex]

[latex]Q_{S}=200+15P[/latex]

[latex]Q_{D}=Q_{S}=600-10P=200+15P.[/latex]

Solving for P:

[latex]600-10P+(10P-200)=200+15P+(10P-200)\Rightarrow 25P=400[/latex]

[latex]\Rightarrow P=\frac{400}{25} \Rightarrow P^{*}=16.[/latex]

Plugging the equilibrium price into the demand equation:

[latex]Q_{D}=600-10(16)=440 \Rightarrow Q^{*}=440.[/latex]

Next, to check our work, we plug the equilibrium price in to the supply equation. We should get the same quantity.

[latex]Q_{S}=200+15(16)=440.[/latex]

Therefore, the equilibrium price is $16 and the equilibrium quantity is 440 units.

 We can also explore market failures algebraically as well. For example, consider the first example. What if the price in the market were set at $1.50. We can plug $1.50 into both the demand and supply equations:

[latex]Q_{D}=30-5(1.50)=22.5[/latex]

[latex]Q_{S}=14+3(1.50)=18.5[/latex]

Therefore, we face a shortage (since quantity supplied is less than quantity demanded) of 22.5-18.5=4 units.

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.

In the first step of this problem, we draw a supply and demand set of graphs that begins in equilibrium.
Figure 3.8 Market Disequilibrium, Step 1

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.

Following from the previous set of graphs, the supply curve shifts outward.
Figure 3.9 Market Disequilibrium, Step 2

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.

In the third step of the problem, we begin by determining that at the initial price there was a surplus. Therefore there is downward price pressure. The price continues to fall until the market achieves a new equilibrium.
Figure 3.10 Market Disequilibrium, Step 3

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.

In the final step, the market is now in a new equilibrium. The new price is lower than the original price and the new quantity is greater than the original equilibrium quantity.
Figure 3.11 Market Disequilibrium, Step 4

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.

In the first step of this problem, we draw a supply and demand set of graphs that begins in equilibrium.
Figure 3.12 Market Disequilibrium, Step 1

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.

Following from the previous set of graphs, the demand curve shifts outward.
Figure 3.13 Market Disequilibrium, Step 2

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.

In the third step of the problem, we begin by determining that at the initial price there was a shortage. Therefore there is upward price pressure. The price continues to rise until the market achieves a new equilibrium.
Figure 3.14 Market Disequilibrium, Step 3

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.

In the final step, the market is now in a new equilibrium. The new price is higher than the original price and the new quantity is greater than the original equilibrium quantity.
Figure 3.15 Market Disequilibrium, Step 4

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↓

Double Shifts

In the previous examples, we examined the impact of a single change on the market. We saw that either supply or demand shifted (not both) and the curve only shifted once. But in reality, it is possible for several factors to change at the same time. Let us explore how we can model several changes within one graph.

Example

The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service?

Instead of following the four-step procedure, let us think about the impact of each event separately. Then, we will put it on the same graph.

First, let us tackle increasing compensation. This can be considered as an input cost as labor is a required component of mail delivery. Recall that an increase in input costs will lead to a decrease in the supply. Thus, the supply curve will shift inward.

Next, let us tackle the change in the way people communicate. As people begin to use “snail-mail” less than ever, we can model the change as a decrease in the demand for mail service.

Let us put both of those shifts on the graph and determine what happens to the equilibrium price and quantity.

In this graph, the market begins in equilibrium. First, the demand curve shifts inward. Then, the supply curve also shifts inward. The equilibrium quantity falls while the change in the equilibrium price is ambiguous.
Figure 3.16 Double Shift

The inward shift of demand causes a decrease in both the equilibrium price and quantity. On the other hand, the decrease in supply causes an increase in the equilibrium price while it causes a decrease in the equilibrium quantity. Now, let us reconcile the two changes. The two changes caused both an increase and decrease in price. Therefore, there is no way for us to know the final impact on prices. The net effect is determined by which effect is larger (the demand shift versus the supply shift.) On the other hand, both shifts caused decreases in quantity. Therefore, we know there is a decrease in quantity. Thus, the net effect of the two shifts is an ambiguous change in price and a decrease in the equilibrium quantity.

3.5 Price controls

To this point in the chapter, we have been assuming that markets are free, that is, they operate with no government intervention. In this section, we will explore the outcomes, both anticipated and otherwise, when government does intervene in a market either to prevent the price of some good or service from rising “too high” or to prevent the price of some good or service from falling “too low”.

Economists believe there are a small number of fundamental principles that explain how economic agents respond in different situations. Two of these principles, which we have already introduced, are the laws of demand and supply.

Governments can pass laws affecting market outcomes, but no law can negate these economic principles. Rather, the principles will become apparent in sometimes unexpected ways, which may undermine the intent of the government policy. This is one of the major conclusions of this section.
Controversy sometimes surrounds the prices and quantities established by demand and supply, especially for products that are considered necessities. In some cases, discontent over prices turns into public pressure on politicians, who may then pass legislation to prevent a certain price from climbing “too high” or falling “too low.”

The demand and supply model shows how people and firms will react to the incentives that these laws provide to control prices, in ways that will often lead to undesirable consequences. Alternative policy tools can often achieve the desired goals of price control laws while avoiding at least some of their costs and tradeoffs.

Price Ceilings

Laws that government enact to regulate prices are called price controls. Price controls come in two flavors. A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor keeps a price from falling below a given level (the “floor”). This section uses the demand and supply framework to analyze price ceilings. The next section discusses price floors.

A price ceiling is a legal maximum price that one pays for some good or service. A government imposes price ceilings in order to keep the price of some necessary good or service affordable. For example, in 2005 during Hurricane Katrina, the price of bottled water increased above $5 per gallon. As a result, many people called for price controls on bottled water to prevent the price from rising so high. In this particular case, the government did not impose a price ceiling, but there are other examples of where price ceilings did occur.

In many markets for goods and services, demanders outnumber suppliers. Consumers, who are also potential voters, sometimes unite behind a political proposal to hold down a certain price. In some cities, such as Albany, renters have pressed political leaders to pass rent control laws, a price ceiling that usually works by stating that landlords can raise rents by only a certain maximum percentage each year. Some of the best examples of rent control occur in urban areas such as New York, Washington D.C., or San Francisco.

Suppose that a city government passes a rent control law to keep the price at the original equilibrium of $500 for a typical apartment. In Figure 3.16, the horizontal line at the price of $500 shows the legally fixed maximum price set by the rent control law. The quantity demanded at $500 is 19,000 units while the quantity supplied is 15,000. Therefore, there is a shortage of 4,000 units when rent control is enforced. One of the ironies of price ceilings is that while the price ceiling was intended to help renters, there are actually fewer apartments rented out under the price ceiling (15,000 rental units) than would be the case at the market rent of $600 (17,000 rental units).

The figure shows a market where the rental price is set below the equilibrium price which causes a shortage.
Figure 3.17 Rent Control

Price ceilings do not simply benefit renters at the expense of landlords. Rather, some renters (or potential renters) lose their housing as landlords convert apartments to co-ops and condos. Even when the housing remains in the rental market, landlords tend to spend less on maintenance and on essentials like heating, cooling, hot water, and lighting. The first rule of economics is you do not get something for nothing—everything has an opportunity cost. Thus, if renters obtain “cheaper” housing than the market requires, they tend to also end up with lower quality housing.

Price ceilings are enacted in an attempt to keep prices low for those who need the product. However, when the market price is not allowed to rise to the equilibrium level, quantity demanded exceeds quantity supplied, and thus a shortage occurs. Those who manage to purchase the product at the lower price given by the price ceiling will benefit, but sellers of the product will suffer, along with those who are not able to purchase the product at all. Quality is also likely to deteriorate.

Price ceilings can either be binding or non-binding. What has just be discussed is called a binding price ceiling since it prevents the market from achieving equilibrium. On the other hand, re-consider the last example. What if the price ceiling were set at $700? Some students believe that would cause the price to be set at $700 but this is incorrect. Remember, a price ceiling is just a legal maximum price. Therefore, a price ceiling of $700 only means that you cannot charge more than $700. So, even in the presence of the price ceiling, the market is able to achieve equilibrium. An important thing to keep in mind: if a market can achieve equilibrium, it will. The only time a price ceiling will have an impact on the market (that is, act as a binding price ceiling) is when the law makes the equilibrium price illegal.

Price Floor

A price floor is the lowest price that one can legally pay for some good or service. Perhaps the best-known example of a price floor is the minimum wage, which is based on the view that someone working full time should be able to afford a basic standard of living. The federal minimum wage in 2016 was $7.25 per hour, although some states and localities have a higher minimum wage. The federal minimum wage yields an annual income for a single person of$15,080, which is slightly higher than the federal poverty line of $11,880. As the cost of living rises over time, Congress periodically raises the federal minimum wage.

Price floors are sometimes called “price supports,” because they support a price by preventing it from falling below a certain level. Around the world, many countries have passed laws to create agricultural price supports. Farm prices and thus farm incomes fluctuate, sometimes widely. Even if, on average, farm incomes are adequate, some years they can be quite low. The purpose of price supports is to prevent these swings.

The most common way price supports work is that the government enters the market and buys up the product, adding to demand to keep prices higher than they otherwise would be. According to the Common Agricultural Policy reform passed in 2013, the European Union (EU) will spend about 60 billion euros per year, or 67 billion dollars per year (with the November 2016 exchange rate), or roughly 38% of the EU budget, on price supports for Europe’s farmers from 2014 to 2020.

Figure 3.17 illustrates the effects of a government program that assures a price above the equilibrium by focusing on the market for wheat in Europe. In the absence of government intervention, the price would adjust so that the quantity supplied would equal the quantity demanded at the equilibrium price. For this example, let us say that the free-market equilibrium price is $3.00 per bushel. However, policies to keep prices high for farmers keeps the price above what would have been the market equilibrium level—the price floor is shown by the dashed horizontal line in the diagram. For this example, let us say that is $4.00 per bushel. The result is a quantity supplied in excess of the quantity demanded (Qd). When quantity supplied exceeds quantity demanded, a surplus exists.

The figure shows a market where the price of wheat is set above the equilibrium price which causes a surplus.
Figure 3.18 Price floor

Economists estimate that the high-income areas of the world, including the United States, Europe, and Japan, spend roughly $1 billion per day in supporting their farmers. If the government is willing to purchase the excess supply (or to provide payments for others to purchase it)(also, there are times where the excess supply is simply destroyed), then farmers will benefit from the price floor, but taxpayers and consumers of food will pay the costs. Agricultural economists and policymakers have offered numerous proposals for reducing farm subsidies. In many countries, however, political support for subsidies for farmers remains strong. This is either because the population views this as supporting the traditional rural way of life or because of industry’s lobbying power of the agro-business.

 

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Introduction to Microeconomics by J. Zachary Klingensmith is licensed under a Creative Commons Attribution-ShareAlike 4.0 International License, except where otherwise noted.

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