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Where Prices Come From: The Interaction of Demand and Supply

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3.3  Market Equilibrium: Putting Demand and Supply 	Together 3.4   The Effect of Demand and Supply Shifts on Equilibrium

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Recap: What Determines the Price of a Smartphone?

Demand  for smartphones How many smartphones do  consumers  want to buy? Affected by  price of the smartphones Affected by  other factors , including prices of other goods Supply  of smartphones How many smartphones are  producers  willing to sell? Affected by  price of the smartphones Affected by  other factors , including prices of other goods

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A change in something other than price that affects demand causes the entire demand curve to shift. A shift to the right ( D 1  to  D 2 ) is an  increase in demand . A shift to the left ( D 1  to  D 3 ) is a  decrease in demand .

Recap : Increase and Decrease in       Demand

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Recap: What Factors Influence Market          Demand ?

Income  of  consumers Prices of related goods 	 Tastes Population  and  demographics -   Expected  future  prices

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A change in something other than price that affects  supply causes  the entire  supply curve  to shift. A shift to the right  ( S 1   to  S 3 )  is an  increase in s upply . A shift to the left  ( S 1   to  S 2 )  is a  decrease in  supply .

Recap : Increase and Decrease in       Supply

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-   Prices  of inputs -   Technological  change -   Prices  of substitutes in production -   Number  of firms in the market -   Expected  future  prices

Recap : What Factors Influence Market         Supply?

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3.3 Market Equilibrium: Putting Demand and Supply Together

Market equilibrium  is a situation in which quantity demanded equals quantity supplied. Recall that markets with many buyers and sellers are perfectly competitive markets; a market equilibrium in one of these markets is called a  competitive market equilibrium . There are ~25 firms selling  smartwatches ; we will assume this is enough to generate competitive behavior in the market for  smartwatches .

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At  a price  of  $350 , consumers want to  buy 5  million  smartwatches ,  and  producers want to sell  5  million  smartwatches . We say the  equilibrium price  in this market is $350, and the  equilibrium quantity   is 5 million  smarwatches  per week. Since buyers and sellers want to trade the same quantity at the price of  $350 , we do not expect the price to change .

The graph shows demand and supply in the market for smartwatches. 
The vertical axis measures price in dollars per smartwatch, and the horizontal axis measures quantity in millions of smartwatches per week. The graph shows a downward-sloping, linear curve, labeled Demand, and an upward-sloping, linear curve, labeled Supply. Demand intersects Supply at a point corresponding to a quantity of 5 and a price of $350. This intersection point is labeled Market equilibrium. The price of $350 is labeled Equilibrium price and the quantity of 5 is labeled Equilibrium quantity.

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A   Market Surplus  occurs when there is excess  supply -  that is quantity supplied is greater than quantity demanded.  In  this situation, some producers won't be able to sell all their goods.  This  will induce them to lower their price to make their product more appealing.  In  order to stay competitive many firms will lower their prices thus lowering the market price for the product.  In  response to the lower price, consumers will increase their quantity demanded, moving the market toward an equilibrium price and quantity.  In  this situation, excess supply has exerted downward  pressure  on the price of the product.

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A   Market Shortage  occurs when there is excess  demand -  that is quantity demanded is greater than quantity supplied .    In  this situation, consumers won't be able to buy as much of a good as they would like .    In  response to the demand of the consumers, producers will raise both the price of their product and the quantity they are willing to supply . The  increase in price will be too much for some consumers and they will no longer demand the product.   Meanwhile  the increased quantity of available product will satisfy  other consumers. Eventually  equilibrium will be reached.

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Figure 3.8  The effect of  surpluses on  the market price

What if the price were $400 instead? At  a price of  $400 , consumers want to buy  4  million smartwatches ,  while  producers want to sell  6  million. This  gives a  surplus  of 2 million  smartwatches :  a situation in which quantity supplied is greater than quantity demanded. Prediction : sellers will compete amongst themselves, driving the price down .

The figure shows the effect of surpluses and shortages on the market for smartwatches. The horizontal axis measures quantity in millions of smartwatches per week, from 0 to 7, truncated from 0 to 3 and increasing by 1 thereon. The vertical axis measures price in dollars per smartwatch, from $0 to $400, truncated from $0 to $250 and increasing by $50 thereon. The graph shows a downward-sloping, linear curve, labeled Demand, and an upward-sloping, linear curve, labeled Supply. Demand intersects Supply at a point corresponding to a quantity of 5 and a price of $350. 
The price line drawn at $400 on the graph intersects demand at a quantity of 4 and supply at a quantity of 6. The horizontal distance between these two points at the price of $350 is labeled Surplus of 2 million smartwatches resulting from price above equilibrium. 
The price line drawn at $250 intersects supply at a quantity of 3, and demand at a quantity of 7. The horizontal distance between these two pints at the price of $250 is labeled Shortage of 4 million smartwatches resulting from price below equilibrium.

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Figure 3.8  The effect of shortages on the market price

Now what if the price were $250? At  a price of  $250 , consumers want to buy  7  million smartwatches ,  while  producers want to sell  3  million. This  gives a  shortage   of 4  million  smartwatches :  a situation in which quantity  demanded is  greater than quantity  supplied. Prediction : sellers will realize they can increase the price and still sell as many smartphones, so the price will rise ..

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Price  is determined by the  interaction  of buyers and sellers . Neither  group can dictate price in a competitive market (i.e. one with many buyers and sellers ). However  changes in supply and/or demand  will affect the price and quantity traded .

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3.4 The Effect of Demand and Supply Shifts on Equilibrium

Predictions  about price and quantity in model require us to know supply and demand curves . Typically , we know price and quantity, but  do not know  the curves that generate them . The  power of the demand and supply model is in its ability to predict  directional   changes  in price and quantity traded.

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Figure 3.9  The effect of an increase in supply on equilibrium

The graph shows the market for  smartwatches  before Apple enters the market. When Apple enters, more  smartphones are supplied at any given price—an increase in supply from  S 1  to  S 2 . Equilibrium price falls from  P 1  to  P 2 . Equilibrium quantity rises from  Q 1  to  Q 2 .

The graph shows the effect of an increase in supply on the equilibrium price and output in the market for smartwatches. The vertical axis measures price in dollars per smartwatch and the horizontal axis measures quantity in millions of smartwatches per week. The graph shows a downward-sloping, linear curve, labeled Demand, and two parallel, upward-sloping, linear curves, labeled S1 and S2. S2 lies to the right of S1. The intersection point between Demand and S1 corresponds to a price of P1 and a quantity of Q1. The intersection point between Demand and S2 corresponds to a price of P2 and a quantity Q2. P2 lies below P1, and Q2 lies to the right of Q1. A rightward arrow from S1 to S2 is labelled 1. As Apple enters the market for smartwatches, the supply curve shifts to the right… . A downward arrow from P1 to P2 is labelled 2. …decreasing the equilibrium price… . A rightward arrow from Q1 to Q2 is labelled 3. … and increasing the equilibrium quantity.

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By how much will price fall? By how much will quantity rise ? We cannot say, without knowing more information . For now, we can only predict that price will fall and quantity traded will rise .

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Figure 3.10  The effect of an increase in demand on equilibrium

Suppose incomes increase. What happens to the equilibrium in the  smartwatch   market ? Smartwatches   are a  normal good , so as income rises, demand shifts to the right ( D 1  to  D 2 ). Equilibrium price rises ( P 1  to  P 2 ). Equilibrium quantity rises ( Q 1  to  Q 2 ).

The graph shows the effect of an increase in demand on the equilibrium price and output in the market for smartwatches. The vertical axis measures price in dollars per smartwatch, and the horizontal axis measures quantity in millions of smartwatches per week. The graph shows an upward-sloping, linear curve, labeled Supply, and two parallel, downward-sloping, linear curves, labeled D1 and D2. D2 lies to the right of D1.  The intersection point between Supply and D1 corresponds to a price of P1 and a quantity of Q1. The intersection point between Supply and D2 corresponds to a price of P2 and a quantity of Q2. P2 lies above P1, and Q2 lies to the right of Q1. A rightward arrow from D1 to D2 is labelled 1. As income increases, demand shifts to the right… . An upward arrow from P1 to P2 is labelled 2. … increasing the equilibrium price….  A rightward arrow from Q1 to Q2 is labelled 3. …  and also increasing the equilibrium quantity.

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Table 3.3  How shifts in demand and supply affect equilibrium price ( P ) and quantity ( Q )

The table summarizes what happens when the demand curve shifts  or  the supply curve shifts, with the other curve remaining unchanged.

Demand Curve
Unchanged
Demand Curve
Shifts to the Right
Demand Curve
Shifts to the Left
Supply Curve
Unchanged
Q unchanged
P unchanged
Q increases
P increases
Q decreases
P decreases
Supply Curve Shifts to
the Right
Q increases
P decreases
Supply Curve Shifts
to the Left
Q decreases
P increases

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Making the Connection: The falling price of Blu-ray players

From  2006 to 2013, the price of Blu-ray players fell from about $800 to about $95, while the number of Blu-ray players traded increased dramatically . What  best explains this change? Increase in demand Decrease in demand Increase in supply Decrease in  supply Can  you show this change on a supply-and-demand diagram ?

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Supply increased as additional firms started manufacturing Blu-ray players and input costs fell.

A graph shows a large increase in the supply of Blu-ray players

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Figure 3.11  Shifts in demand and supply over time

Over time, it is likely that  both  demand and supply will change . For example, as new firms enter the market for  smartwatches   and  incomes increase, we  expect: The supply of  smartwatches  will  shift to the right,  and The demand for  smartwatches   will shift to the right .

The figure has two graphs. For each of the two graphs, the vertical axis measures price in dollars per smartwatch and the horizontal axis measures quantity in millions of smartwatches per week.  Panel (a) shows changes in equilibrium price and quantity when both demand and supply increase, and it is labelled Demand shifting more than supply. The graph shows two parallel, downward-sloping, linear curves, labeled D1 and D2, and two parallel, upward-sloping, linear curves, labeled S1 and S2. D2 lies to the right of D1, and S2 lies to the right of S1. The horizontal distance between D1 and D2 is greater than the one between S1 and S2. The intersection point between D1 and S1 corresponds to a price of P1 and a quantity of Q1. The intersection point between D2 and S2 corresponds to a price of P2 and a quantity of Q2. P2 lies above P1, and Q2 lies to the right of Q1. The rightward arrow from D1 to D2 and the rightward arrow from S1 to S2 are labelled 1. Demand has shifted to the right more than the supply… . An upward arrow from P1 to P2 is labelled 2. …so the equilibrium price has increased. A rightward arrow from Q1 to Q2 is also on the graph.
Panel (b) shows changes in equilibrium price and quantity when both demand and supply increase, and it is labelled Supply shifting more than demand. The graph shows two parallel, downward-sloping, linear curves, labeled D1 and D2, and two parallel, upward-sloping, linear curves, labeled S1 and S2. D2 lies to the right of D1, and S2 lies to the right of S1. The horizontal distance between D1 and D2 is smaller than the one between S1 and S2. The intersection point between D1 and S1 corresponds to a price of P1 and a quantity of Q1. The intersection point between D2 and S2 corresponds to a price of P2 and a quantity of Q2. P2 lies below P1, and Q2 lies to the right of Q1. The rightward arrow from D1 to D2 and the rightward arrow from S1 to S2 are labelled 1. Supply has shifted to the right more than the demand… . A downward arrow from P1 to P2 is labelled 2. …so the equilibrium price has decreased. A rightward arrow from Q1 to Q2 is also on the graph.

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What does our model predict ? S↑       ( P↓ and Q ↑ ) D↑      ( P↑ and Q ↑ ) So we can be sure equilibrium quantity will rise; but the effect on equilibrium price is not clear . This panel shows demand shifting more than supply: equilibrium price and quantity both rise.

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This panel shows supply shifting more than demand: quantity rises, but equilibrium price falls . Without knowing the relative size of the changes, the effect on equilibrium price is ambiguous . It is possible, but unlikely, that the equilibrium price will remain unchanged .

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We can now fill in the rest of Table 3.3. The cell in red is the example that we just did.

Demand Curve
Unchanged
Demand Curve
Shifts to the Right
Demand Curve
Shifts to the Left
Supply Curve
Unchanged
Q unchanged
P unchanged
Q increases
P increases
Q decreases
P decreases
Supply Curve Shifts to
the Right
Q increases
p decreases
Q increases
P increases, decreases,
or is unchanged
Q increases, decreases,
or is unchanged
P decreases
Supply Curve Shifts
to the Left
Q decreases
p increases
Q increases, decreases,
or is unchanged
P increases
Q decreases
P increases, decreases,
or is unchanged

Economics

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