Chapter 4: The Market Forces of Supply and Demand

Equilibrium

• Equilibrium: A state where the quantity of a good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell.
• Equilibrium price: The price that balances the quantity supplied and the quantity demanded.
• Equilibrium quantity: The quantity supplied and quantity demanded at the equilibrium price.

The Equilibrium of Supply and Demand

• The market's equilibrium is found where the supply and demand curves intersect.
• At the equilibrium price, the quantity supplied equals the quantity demanded.
• Example: If the equilibrium price is 4, 7 ice-cream cones are supplied and 7 are demanded.

Surplus

• Surplus: A situation in which the quantity supplied is greater than the quantity demanded.
• Sellers respond to a surplus by cutting prices.
• This price cut increases the quantity demanded and decreases the quantity supplied.
• These changes represent movements along the supply and demand curves.
• Prices continue to fall until the market reaches the equilibrium.

Shortage

• Shortage: A situation in which the quantity demanded is greater than the quantity supplied.
• Sellers can raise prices without losing sales in a shortage.
• This price increase decreases the quantity demanded and increases the quantity supplied.
• These changes represent movements along the supply and demand curves.
• Prices continue to rise until the market reaches the equilibrium.

Law of Supply and Demand

• Law of supply and demand: The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded of that good into balance.
• In well-functioning markets, surpluses and shortages are only temporary because prices quickly move toward their equilibrium levels.

Markets Not in Equilibrium

• Surplus: When the market price is above the equilibrium price, there is a surplus.
  • Example: At a price of 5, the quantity supplied is 10 cones, while the quantity demanded is 4 cones. Producers cut prices to increase sales, moving towards equilibrium.
• Shortage: When the market price is below the equilibrium price, there is a shortage.
  • Example: At a price of 3, the quantity demanded is 10 cones, while the quantity supplied is 4 cones. Producers raise prices due to high demand, moving towards equilibrium.
• Price adjustments move the market toward the equilibrium of supply and demand.

Analyzing Changes in Equilibrium: Three-Step Method

1. Decide whether the event shifts the supply or demand curve (or both).
2. Decide in which direction the curve shifts.
3. Use a supply-and-demand diagram to see how the shift changes the equilibrium price and quantity.

Shifts in Curves versus Movements along Them

• Change in supply: A shift in the supply curve.
• Change in demand: A shift in the demand curve.
• Change in the quantity supplied: A movement along a fixed supply curve.
• Change in the quantity demanded: A movement along a fixed demand curve.

Effects of Changes in Demand and Supply

• Increase in Demand:
  • The demand curve shifts to the right.
  • Both the equilibrium price and quantity rise.
  • Example: A hot summer increases the demand for ice cream, shifting the demand curve from D1 to D2, increasing the equilibrium price from 4 to 5 and the equilibrium quantity from 7 to 10 cones.
• Decrease in Supply:
  • The supply curve shifts to the left.
  • The equilibrium price rises, and the equilibrium quantity falls.
  • Example: An increase in the price of sugar decreases the supply of ice cream, shifting the supply curve from S1 to S2, increasing the equilibrium price from 4 to 5 and decreasing the equilibrium quantity from 7 to 4 cones.

Simultaneous Shifts in Supply and Demand

• A simultaneous increase in demand and decrease in supply leads to two possible outcomes:
  • The equilibrium price rises, and the equilibrium quantity may rise or fall.

Active Learning: Shifts in Supply and Demand for Orange Juice

• Scenario 1: Fall in the price of apple juice
  • Both curves shift.
  • Demand (D) shifts left, Supply (S) shifts right.
  • Price (P) falls, the effect on Quantity (Q) is ambiguous.
• Scenario 2: Decline in the price of oranges
  • Both curves shift.
  • Demand (D) shifts left, Supply (S) shifts right.
  • Price (P) falls, the effect on Quantity (Q) is ambiguous.
• Scenario 3: Both events occur simultaneously
  • Both curves shift.
  • Demand (D) shifts left, Supply (S) shifts right.
  • Price (P) falls, the effect on Quantity (Q) is ambiguous.

Effects of Supply and Demand Shifts on Price and Quantity

Conclusion: How Prices Allocate Resources

• In market economies, prices are the signals that guide decisions and allocate scarce resources.
• For every good in the economy, the price ensures that supply and demand are in balance.
• The equilibrium price determines how much buyers choose to consume and how much sellers choose to produce.