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Equilibrium & Changes in
Supply and Demand
Chapter 3-3 & 3-4
The Interaction of Supply and
Demand
• The English historian Thomas Carlyle
once said:
“Teach any parrot the words supply
and demand and you’ve got an
economist.”
Equilibrium
• Equilibrium is a concept in which
opposing dynamic forces cancel
each other out.
Equilibrium
• In a free market, the forces of supply
and demand interact to determine
equilibrium quantity and equilibrium
price.
Equilibrium
• Equilibrium price – the price toward
which the invisible hand drives the
market.
• Equilibrium quantity – the amount
bought and sold at the equilibrium
price.
Market clearing price
• The textbook also uses the term
Market Clearing price for
equilibrium price
What Equilibrium Isn’t
• Equilibrium isn’t a state of the world,
it is a characteristic of a model.
• Equilibrium isn’t inherently good or
bad, it is simply a state in which
dynamic pressures offset each other.
The law of one price
• Why do all sales and purchases in
the market take place at the same
price?
the market price
Suppose that a seller offered a potential buyer
a price noticeably above what she knew other
people to be paying.
The buyer would clearly be better off walking
away from this particular seller and trying
someone else—unless the seller was prepared
to offer a better deal.
Conversely, a seller would not be willing to sell
for significantly less than the amount he
knew most buyers were paying; he would be
better off waiting to get a more reasonable
customer.
Thus in any well-established, ongoing market,
all sellers receive and all buyers pay
approximately the same price.
Excess Supply (surplus)
• Excess supply – a surplus, the
quantity supplied is greater than
quantity demanded
• Prices tend to fall.
• Why?
Excess Demand (shortage)
• Excess demand – a shortage, the
quantity demanded is greater than
quantity supplied
• Prices tend to rise.
• Why?
Price Adjusts
• The greater the difference between
quantity supplied and quantity
demanded, the more pressure there
is for prices to rise or fall.
Price Adjusts
• When quantity demanded equals
quantity supplied, prices have no
tendency to change.
The Graphical Interaction of
Supply and Demand
Price (per
DVD)
Quantity
Supplied
Quantity
Demanded
Surplus (+)
Shortage (-)
$3.50
7
3
+4
$2.50
5
5
0
$1.50
3
7
-4
The Graphical Interaction of
Supply and Demand
$5.00
S
Excess supply
Price per DVD
4.00
3.50
A
3.00
E
2.50
C
2.00
1.50
Excess demand
1.00
1
D
2 3 4 5 6 7 8 9 10 11 12
Quantity of DVDs supplied and demanded
The Graphical Interaction of
Supply and Demand
• When price is $3.50 each, quantity
supplied equals 7 and quantity
demanded equals 3.
• The excess supply of 4 pushes price
down.
The Graphical Interaction of
Supply and Demand
• When price is $1.50 each, quantity
supplied equals 3 and quantity
demanded equals 7.
• The excess demand of 4 pushes price
up.
The Graphical Interaction of
Supply and Demand
• When price is $2.50 each, quantity
supplied equals 5 and quantity
demanded equals 5.
• There is no excess supply or excess
demand, so price will not rise or fall.
Shifts in Supply and Demand
• Shifts in either supply or demand
change equilibrium price and
quantity.
Increase in Demand
• An increase in demand creates
excess demand at the original
equilibrium price.
• The excess demand pushes price
upward until a new higher price and
quantity are reached.
Increase in Demand
S0
B
$2.50
Excess demand
A
2.25
D0
0
D1
8
9
10
Quantity of DVDs (per week)
Decrease in Supply
• A decrease in supply creates excess
demand at the original equilibrium
price.
• The excess demand pushes price
upward until a new higher price and
lower quantity are reached.
Decrease in Supply
S1
S0
C
$2.50
2.25
B
Excess demand
A
D0
0
8
9
10
Quantity of DVDs (per week)
Florida Freeze
• The crop-damaging
freeze shifted the supply
curve to the left.
• At P0 quantity demanded
> quantity supplied.
P1
• Price rose to P1 until the
quantity demanded
P0
equaled the quantity
supplied.
S1
S0
Excess
Demand
D
Q1 Q0
Coffee Beans
• The supply of coffee
increased as new
growers entered the
market, technology
improved, and
weather was
P0
favorable. Price
decreased to P1.
P1
• Coffee growers
attempted to
increase demand
and raise price to P0
with a marketing
campaign.
S0
S1
D1
D0
Q0
Q1
Burkhas in Afghanistan
S
P0
P1
D0
Excess
Supply
D1
Q1
Q0
• Once the Taliban was
ousted, demand for
burkhas fell as many
women quit wearing them.
• At P0 quantity supplied >
quantity demanded.
• Price fell to P1 until
quantity demanded =
quantity supplied.
PITFALLS
• Which curve is it anyway?
• Which curve is shifting?
• Look at the movement in Price and
Quantity.
• Are they moving in the same or the
opposite directions?
Review of Changes in
Supply and Demand
No change in Supply shifts
supply
out
No change No change.
in demand
Demand
shifts out
Demand
shifts in
Supply shifts
in
Price falls;
Price rises;
Quantity rises. Quantity falls.
Price rises; Quantity rises; Price rises;
Quantity could
Quantityrises. Price could be
high or lower. rise or fall.
Price falls;
Quantity falls;
Price falls;
Quantity falls Quantity could Price could
rise or fall.
rise or fall.
Simultaneous Shifts in Supply and Demand
We can make the following predictions about the
outcome when the supply and demand curves shift
simultaneously:
Supply
Increases
Supply
Decreases
Demand
Increases
Price: ?
Quantity:
up
Price: up
Quantity: ?
Demand
Decreases
Price:
Price: ?
down
Quantity:
Quantity: ? down
The Limitations Of Supply And
Demand Analysis
• Sometimes supply and demand are
interconnected.
• Other things don't remain constant.
The Limitations Of Supply And
Demand Analysis
• All actions have a multitude of ripple
and possible feedback effects.
• The ripple effect is smaller when the
goods are a small percentage of the
entire economy.
The Limitations Of Supply And
Demand Analysis
• The other-things-constant
assumption is likely not to hold when
the goods represent a large
percentage of the entire economy.
The Fallacy of Composition
• The fallacy of composition is the
false assumption that what is true for
a part will also be true for the whole.
– Chapter 6 will discuss this in more detail
The Fallacy of Composition
• The fallacy of composition is of
central relevance to
macroeconomics.
– In macroeconomics, the other-thingsconstant assumption, central to
microeconomic supply/demand
analysis, cannot hold.
This is why some of you have a hard time
accepting this model