The Allocation of Resources - Price Changes

Objective: Use of demand and supply diagrams to illustrate the impact of changes in market conditions

This section focuses on how changes in market conditions affect the equilibrium price and quantity of a good or service. We will use demand and supply diagrams to analyze these changes.

Understanding Demand and Supply

Before we analyze price changes, let's briefly review the basic concepts of demand and supply:

• Demand: The quantity of a good or service that consumers are willing and able to purchase at different prices. The law of demand states that as price increases, quantity demanded decreases (inverse relationship).
• Supply: The quantity of a good or service that producers are willing and able to offer for sale at different prices. The law of supply states that as price increases, quantity supplied increases (direct relationship).
• Equilibrium: The point where the quantity demanded equals the quantity supplied. This determines the equilibrium price and quantity.

Shifts in Demand

A shift in demand occurs when something other than the price of the good changes. These shifts are represented by a movement of the entire demand curve to the left or right.

• Factors that can shift the demand curve:
• Consumer income:
  • Normal goods: An increase in income leads to an increase in demand.
  • Inferior goods: An increase in income leads to a decrease in demand.
• Consumer tastes and preferences: Changes in fashion, advertising, or health concerns can affect demand.
• Prices of related goods:
  • Substitutes: An increase in the price of a substitute good leads to an increase in demand for the original good.
  • Complements: An increase in the price of a complementary good leads to a decrease in demand for the original good.
• Consumer expectations: Expectations about future price changes or income can influence current demand.
• Population changes: An increase in population generally leads to an increase in demand.

Shifts in Supply

A shift in supply occurs when something other than the price of the good changes. These shifts are represented by a movement of the entire supply curve to the left or right.

• Factors that can shift the supply curve:
• Cost of production:
  • Changes in the price of factors of production (e.g., wages, raw materials, energy) affect supply. An increase in costs leads to a decrease in supply.
• Technology: Improvements in technology usually lead to an increase in supply.
• Government policies:
  • Taxes: Taxes increase the cost of production, leading to a decrease in supply.
  • Subsidies: Subsidies reduce the cost of production, leading to an increase in supply.
• Expectations about future prices: Expectations of higher future prices can incentivize producers to supply more today.
• Number of sellers: An increase in the number of sellers leads to an increase in supply.

Impact of Shifts in Demand and Supply on Equilibrium

Changes in demand and supply lead to new equilibrium prices and quantities. Here's how to analyze these changes using demand and supply diagrams:

Increase in Demand

An increase in demand shifts the demand curve to the right. This leads to a higher equilibrium price and a higher equilibrium quantity.

Diagram	Equilibrium Price	Equilibrium Quantity
Demand shifts right	Increases	Increases

Decrease in Demand

A decrease in demand shifts the demand curve to the left. This leads to a lower equilibrium price and a lower equilibrium quantity.

Diagram	Equilibrium Price	Equilibrium Quantity
Demand shifts left	Decreases	Decreases

Increase in Supply

An increase in supply shifts the supply curve to the right. This leads to a lower equilibrium price and a higher equilibrium quantity.

Diagram	Equilibrium Price	Equilibrium Quantity
Supply shifts right	Decreases	Increases

Decrease in Supply

A decrease in supply shifts the supply curve to the left. This leads to a higher equilibrium price and a lower equilibrium quantity.

Diagram	Equilibrium Price	Equilibrium Quantity
Supply shifts left	Increases	Decreases

Changes in Demand and Supply Simultaneously

When both demand and supply shift simultaneously, the impact on the equilibrium price and quantity depends on the magnitude of the shifts.

• Demand increases and supply increases: Equilibrium quantity will definitely increase, but the impact on equilibrium price is ambiguous (it could increase, decrease, or stay the same).
• Demand increases and supply decreases: Equilibrium quantity will increase, and equilibrium price will definitely increase.
• Demand decreases and supply increases: Equilibrium quantity will decrease, and equilibrium price will definitely decrease.
• Demand decreases and supply decreases: Equilibrium quantity will decrease, and equilibrium price is ambiguous (it could increase, decrease, or stay the same).

Conclusion

Understanding how changes in demand and supply affect market equilibrium is crucial for analyzing resource allocation. By using demand and supply diagrams, we can effectively illustrate the impact of various market conditions on prices and quantities.