Chapter 4: Market Equilibrium
Demand & Supply Together
Bringing Supply and Demand
Together
• How is the price of a good determined?
– The market forces of supply AND demand
work simultaneously to determine the price.
• The law of supply and demand
– The price of any good will adjust to bring the
quantity supplied and quantity demanded into
balance.
Supply and Demand
• Equilibrium point
– Graphically, the intersection of supply and demand
• Equilibrium price
– The price that causes quantity supplied to equal
quantity demanded.
– The price that “clears the market”
• Equilibrium quantity
– The numerical quantity (supplied and demanded) at
the equilibrium price
Shortages and Surpluses
• Shortage
– QD > QS
– Occurs at any price below equilibrium
– Price will rise over time toward equilibrium
• Why does price rise over time with a shortage?
– Consumers who value the product will “outbid” other
consumers or otherwise show a higher willingness to
pay.
– Suppliers will see that the price can be raised without
a decrease in sales.
Shortages and Surpluses
• Surplus
– QS > QD
– Occurs at any price above equilibrium
– Price will fall over time toward equilibrium.
• Why does price fall over time with a surplus?
– Firms will have to eventually get rid of mounting
inventories of goods.
– To do this, they must lower their prices.
Supply and Demand
Supply and Demand Together
• Equilibrium - a situation
– Market price has reached the level :
• Quantity supplied = quantity demanded
• Equilibrium price - the price:
– Balances quantity supplied and quantity
demanded
• Equilibrium quantity
– Quantity supplied and the quantity demanded at
the equilibrium price
7
8
The equilibrium of supply and demand
Price of
Ice-Cream
Cones
$3.00
2.50
2.00
Supply
Equilibrium
price
Equilibrium
1.50
1.00
0.50
0
Equilibrium
quantity
Demand
1 2 3 4 5 6 7 8 9 10 11 12
Quantity of Ice-Cream Cones
The equilibrium is found where the supply and demand curves intersect. At the
equilibrium price, the quantity supplied equals the quantity demanded. Here the
equilibrium price is $2.00: At this price, 7 ice-cream cones are supplied, and 7 ice-cream
cones are demanded.
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Supply and Demand Together
• Surplus
– Quantity supplied > quantity demanded
– Excess supply
– Downward pressure on price
• Shortage
– Quantity demanded > quantity supplied
– Excess demand
– Upward pressure on price
9
9
Markets not in equilibrium
(a) Excess Supply
Price of
Ice
Cream
Cones
Surplus
(b) Excess demand
Supply
Price of
Ice
Cream
Cones
Supply
$2.50
2.00
$2.00
Demand
Quantity
demanded
Quantity
supplied
1.50
Demand
Quantity
supplied
Shortage
Quantity
demanded
4
10
7
4
7
10
0
Quantity of Ice-Cream Cones
Quantity of Ice-Cream Cones
In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium price, the quantity
supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers try to increase sales by cutting the
price of a cone, and this moves the price toward its equilibrium level. In panel (b), there is a shortage.
Because the market price of $1.50 is below the equilibrium price, the quantity demanded (10 cones) exceeds
the quantity supplied (4 cones). With too many buyers chasing too few goods, suppliers can take advantage
of the shortage by raising the price. Hence, in both cases, the price adjustment moves the market toward
10
the equilibrium of supply and demand
0
Supply and Demand Together
• Law of supply and demand
– The price of any good adjusts
• Bring the quantity supplied and the quantity demanded
into balance
– In most markets
• Surpluses and shortages are temporary
11
Supply and Demand Together
• Three steps to analyzing changes in
equilibrium
1. Decide: the event shifts the supply curve, the
demand curve, or both curves
2. Decide: curve shifts to right or to left
3. Use supply-and-demand diagram
•
•
12
Compare initial and new equilibrium
How the shift affects equilibrium price and quantity
3
Three steps for analyzing changes in equilibrium
1. Decide whether the event shifts the supply or demand curve (or
perhaps both).
2. Decide in which direction the curve shifts.
3. Use the supply-and demand diagram to see how the shift changes
the equilibrium price and quantity.
13
10
How an increase in demand affects the equilibrium
Price of
Ice-Cream
Cones
Supply
2. …resulting in
a higher price . . .
1. Hot weather
increases the demand
for ice cream . . .
$2.50
New equilibrium
2.00
Initial equilibrium
D1
D2
3. …and a higher quantity sold.
0
7
10
Quantity of Ice-Cream Cones
An event that raises quantity demanded at any given price shifts the demand curve to the right. The
equilibrium price and the equilibrium quantity both rise. Here an abnormally hot summer causes
buyers to demand more ice cream. The demand curve shifts from D1 to D2, which causes the
equilibrium price to rise from $2.00 to $2.50 and the equilibrium quantity to rise from 7 to 10 cones
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Supply and Demand Together
• Shifts in curves versus movements along
curves
– Shift in the supply curve
• Change in supply
– Movement along a fixed supply curve
• Change in the quantity supplied
– Shift in the demand curve
• Change in demand
– Movement along a fixed demand curve
• Change in the quantity demanded
15
Supply and Demand Together
• Example: A change in market equilibrium due
to a shift in supply
– One summer - a hurricane destroys part of the
sugarcane crop
• Price of sugar - increases
– Effect on the market for ice cream?
1. Change in price of sugar - supply curve
2. Supply curve - shifts to the left
3. Higher equilibrium price; lower equilibrium
quantity
16
11
How a decrease in supply affects the equilibrium
Price of
Ice-Cream
Cones
1. An increase in the
price of sugar reduces
the supply of ice cream . . .
S2
2. …resulting in
a higher price . . .
S1
$2.50
New equilibrium
2.00
Initial equilibrium
Demand
3. …and a smaller quantity sold.
0
4
7
Quantity of Ice-Cream Cones
An event that reduces quantity supplied at any given price shifts the supply curve to the left. The
equilibrium price rises, and the equilibrium quantity falls. Here an increase in the price of sugar (an
input) causes sellers to supply less ice cream. The supply curve shifts from S1 to S2, which causes the
equilibrium price of ice cream to rise from $2.00 to $2.50 and the equilibrium quantity to fall from 7
to 4 cones
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Supply and Demand Together
• Example: shifts in both supply and demand
– One summer: hurricane and heat wave
1. Heat wave – shift demand curve; hurricane – shift
supply curve
2. Demand curve shifts to the right; Supply curve shifts
to the left
3. Equilibrium price raises
– If demand increases substantially while supply falls just a
little: equilibrium quantity –rises
– If supply falls substantially while demand rises just a little:
equilibrium quantity falls
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12
A shift in both supply and demand
Price of
(a) Price Rises, Quantity Rises
Ice
Cream
New
S2 S
equilibrium
Cones Large
increase
in demand
Price of (b) Price Rises, Quantity Falls
Ice
S2
Cream Small
Cones increase
in demand
1
P2
New
equilibrium
P2
Small
decrease
in supply
P1
D2
Large
decrease
in supply
P1
D2
Initial
equilibrium
Initial
equilibrium
D1
0
Q1
Q2
Quantity of Ice-Cream Cones
S1
0
D1
Q2 Q 1
Quantity of Ice-Cream Cones
Here we observe a simultaneous increase in demand and decrease in supply. Two outcomes are possible. In
panel (a), the equilibrium price rises from P1 to P2, and the equilibrium quantity rises from Q1 to Q2. In panel
(b), the equilibrium price again rises from P1 to P2, but the equilibrium quantity falls from Q1 to Q2.
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4
What happens to price and quantity when supply or demand
shifts?
No change
In Supply
An increase
In Supply
A decrease
In supply
No change
In demand
P same
Q same
P down
Q up
P up
Q down
An increase
In demand
P up
Q up
P ambiguous
Q up
P up
Q ambiguous
A decrease
In demand
P down
Q down
P Down
Q ambiguous
P ambiguous
Q down
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Graphs of Shifts
Change
Illustration
Impact on Price and
Quantity
Demand increases
The demand curve shifts
to the right. As a result,
the equilibrium price and
equilibrium quantity
increase.
Supply increases
The supply curve shifts to
the right. As a result, the
equilibrium price declines
and the equilibrium
quantity increases.
Graphs of Shifts
Change
Illustration
Impact on Price and
Quantity
Demand decreases
The demand curve shifts
to the left. As a result, the
equilibrium price and
equilibrium quantity
decrease.
Supply decreases
The supply curve shifts to
the left. As a result, the
equilibrium price increases
and the equilibrium
quantity decreases.
Conclusion
• If you take away just one thing from this course,
it will probably be “supply and demand.”
• In competitive markets, supply and demand
allow prices to adjust toward equilibrium.
• In equilibrium, the markets clears. This means
there are no surpluses or shortages.
Summary
• Supply and demand play a key role in
determining prices in the market economy.
Prices established through this process help
allocate resources.
• A market consists of a group of buyers and
sellers for a particular product or service.
• The demand curve is downward-sloping.
• The supply curve is upward-sloping.
Summary
• A change in the price of a good will cause
– A movement along the demand curve
– A movement along the supply curve
• Changes other than price
– Cause a shift in demand
– Cause a shift in supply
• Supply and demand interact through the process of
market coordination.
• The equilibrium is the balancing point between the two
opposing forces. The market clearing price and output are
determined at the equilibrium point.
• Shortages and surpluses are resolved in competitive
markets.