Market Equilibrium and Welfare Analysis for AP Economics (page 2)

By — McGraw-Hill Professional
Updated on Mar 2, 2011

Changes in Demand

While our discussion of market equilibrium implies a certain kind of stability in both the price and quantity of a good, changing market forces disrupt equilibrium, either by shifting demand, shifting supply, or shifting both demand and supply.

Increase in Demand

About once a winter a freak blizzard hits southern states like Georgia and the Carolinas. You can bet that the national media shows video of panicked southerners scrambling for bags of rock salt and bottled water. Inevitably a bemused reporter tells us that the price of rock salt has "skyrocketed" to $17 per bag. What is happening here? In Figure 6.8, the market for rock salt is initially in equilibrium at a price of $2.79 per bag. With a forecast of a blizzard, consumers expect a lack of future availability for this good. This expectation results in a feverish increase in the demand for rock salt and, at the original price of $2.79, there is a shortage and the market's cure for a shortage is a higher equilibrium price. (Note: The equilibrium quantity of rock salt might not increase much since blizzards are short-lived and the supply curve might be nearly vertical.)

Market Equilibrium

Decrease in Demand

The most recent recession was damaging to the automobile industry. When average household incomes fell in the United States, the demand for cars, a normal good, decreased. Manufacturers began offering deeply discounted sticker prices, zero-interest financing, and other incentives to reluctant consumers so that they might purchase a new car. In Figure 6.9 you can see that the original price of a new car was $18,000. Once the demand for new cars fell, there was a surplus of cars on dealer lots at the original price. The market cure for a surplus is a lower equilibrium price, therefore fewer new cars were bought and sold.

Market Equilibrium

  • When demand increases, equilibrium price and quantity both increase.
  • When demand decreases, equilibrium price and quantity both decrease.

Changes in Supply

Increase in Supply

Advancements in computer technology and production methods have been felt in many markets. Figure 6.10 illustrates how, because of better technology, the supply of laptop computers has increased. At the original equilibrium price of $4000, there is now a surplus of laptops. To eliminate the surplus the market price must fall to P2 and the equilibrium quantity must rise to Q2.

Market Equilibrium

Decrease in Supply

Geopolitical conflict in the Middle East usually slows the production of crude oil. This decrease in the global supply of oil can be seen in Figure 6.11. At the original equilibrium price of $20 per barrel, there is now a shortage of crude oil on the global market. The market eliminates this shortage through higher prices and, at least temporarily, the equilibrium quantity of crude oil falls.

Market Equilibrium

  • When supply increases, equilibrium price decreases and quantity increases.
  • When supply decreases, equilibrium price increases and quantity decreases.

Simultaneous Changes in Demand and Supply

When both demand and supply change at the same time, predicting changes in price and quantity becomes a little more complicated. An example should illustrate how you need to be careful.

An extremely cold winter results in a higher demand for energy such as natural gas. At the same time, environmental safeguards and restrictions on drilling in protected wilderness areas have limited the supply of natural gas. An increase in demand, by itself, creates an increase in both price and quantity. However, a decrease in supply, by itself, creates an increase in price and a decrease in quantity. When these forces are combined, we see a double-whammy on higher prices. But when trying to predict the change in equilibrium quantity, the outcome is uncertain and depends upon which of the two effects is larger.

One possible outcome is shown in Figure 6.12 where the initial equilibrium outcome is labeled E1. A relatively large increase in demand with a fairly small decrease in supply results in more natural gas being consumed. The new equilibrium outcome is labeled E2.

The other possibility is that the increase in demand is relatively smaller than the decrease in supply. This is seen in Figure 6.13 and, while the price is going to increase again, the equilibrium quantity is lower than before.

Market Equilibrium

"If you don't know the answer, it is probably where the sticks cross."

    —Chuck, AP Student

Market Equilibrium

  • When both demand and supply are changing, one of the equilibrium outcomes (price or quantity) is predictable and one is ambiguous.
  • Before combining the two shifting curves, predict changes in price and quantity for each shift, by itself.
  • The variable that is rising in one case and falling in the other case is your ambiguous prediction.
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