Back To CourseEconomics 102: Macroeconomics
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Jon has taught Economics and Finance and has an MBA in Finance
When a market is in equilibrium, the price of a good or service tends to stay the same. Equilibrium is the price at which the quantity demanded by consumers is equal to the quantity that's supplied by suppliers. When either demand or supply changes, however, the equilibrium price and quantity will also change. That's what we're talking about in this lesson - changes in the market equilibrium.
Let's look at some examples of changes in demand and supply, including an illustration of what happens when both demand and supply increase or decrease simultaneously. Before we begin, here's a helpful list of all the possible changes to equilibrium that you'll encounter in macroeconomics:
|Shifts in the Demand Curve
(when supply is unchanged)
|to the right||means an increase in demand||causes equilibrium to increase|
|to the left||means a decrease in demand||causes equilibrium to decrease|
|Shifts in the Supply Curve
(when demand is unchanged)
|to the right||means an increase in supply||causes equilibrium to decrease|
|to the left||means a decrease in supply||causes equilibrium to increase|
As you can see, an increase in demand causes the equilibrium price to rise. On the other hand, a decrease in demand causes the equilibrium price to fall. An increase in supply causes the equilibrium price to fall, while a decrease in supply causes the equilibrium price to rise.
Well, as it turns out, I'm thinking about chocolate chip cookies right now. For some reason, talking about macroeconomics really increases my demand for cookies. Ever since they removed the Cookie Monster from public television's 'Sesame Street,' I've noticed a remarkable decrease in the supply of cookies in my house; however, my demand for cookies has only gone up and up and up! So, let's look at an example of equilibrium in the cookie market and see what happens when things change.
Let's say the equilibrium price for a chocolate chip cookie is $3. Here's an example of the supply and demand curves, with an equilibrium price of $3, which is at the intersection of the supply and demand curves. At a price of $3, consumers will demand and suppliers will supply 5,000 cookies per year. Wow, that sounds great, doesn't it? What happens when something causes a shift in demand? Well, I'm glad you asked!
When household incomes increase by 30% this year (hey, this could happen!), that means that the demand for cookies goes up. If the demand for cookies increases, then this causes a shift of the demand curve to the right. As you can see, a new equilibrium is created after the shift. The new equilibrium price is higher than the old one because demand increased. At the new equilibrium, the price for a cookie is now $5, and the quantity demanded, which is the same as the quantity supplied, is 7,500 cookies at this higher level of price.
Okay, so now, let's say that instead of increasing, household incomes decrease this year by 30%. When they do, the demand for cookies is definitely going to go down. A decrease in the demand for cookies will cause the demand curve to shift to the left, and, assuming no change in anything else, the equilibrium price will go down. The new equilibrium price is going to be $2. At this price, only 2,500 cookies will get sold in this market instead of 5,000.
So far, we've talked about what happens to the demand for cookies. Let's look at the supply side now.
There are various things that could lead to a shift in supply, but let's say that a weird blue tornado flies through the city of Chiphaven, in West Cookieland. (It's a beautiful place. I've been there - you should go there. It's a great place for vacation - the kids would love it.) Unfortunately, half of all the cookie factories are located here in Chiphaven, and the tornado picks up all the cookie factories in the air (in addition to tens of thousands of cookies, if you can imagine that) and destroys them. Thankfully, Studio 65, the nearby disco, is perfectly intact!
So, what's the effect of this event? This natural disaster is going to lead to a decrease in the supply of cookies. A decrease in the supply of cookies causes the equilibrium price to rise. The new equilibrium price is $5 a cookie, and the associated quantity has gone down to 2,500 cookies.
Let's look at this example from the opposite point of view.
When a gigantic new cookie factory is built in Chiphaven, suddenly the nearby disco is flush with tons of cookies for sale. In this example, the increase in supply causes the equilibrium price to fall to $2, and consumers are willing and able to buy a lot more cookies (7,500) at this price.
Now let's talk about what happens when both curves shift simultaneously.
What would happen if both the demand and the supply curves increased? Well, that would lead to a rightward shift in the demand for cookies in our previous example. Let's say that the quantity demanded rises from 5,000 cookies to 7,500 cookies, but we can't determine the new equilibrium price because we don't know how much each of the curves has shifted relative to each other. So, in this example, quantity goes up, but price is what we call ambiguous - we're not able to determine it.
The opposite is true as well. When both the demand and supply curves shift simultaneously to the left (which means that demand and supply decreased), then we know that the quantity of cookies is going to go down. Let's say in this example that the quantity of cookies goes down from 5,000 to 2,500, but we don't know how much the equilibrium price is going to change because we can't tell, again, how much each of the curves shifted relative to each other. So in this case, quantity goes down, but price is ambiguous.
To summarize what we've talked about in this lesson, an increase in demand is illustrated by a rightward shift of the demand curve, which, all other things equal, causes the equilibrium price to rise. A decrease in demand is illustrated by a leftward shift of the demand curve, which, all other things remaining constant or equal, causes the equilibrium price to fall.
An increase in supply is illustrated by a rightward shift of the supply curve, and, all other things equal, this will cause the equilibrium price to fall. A decrease in supply is illustrated by a leftward shift of the supply curve - this will cause the equilibrium price to rise.
When both the demand and supply curves decrease at the same time, both curves are going to shift to the left, the quantity demanded goes down, and the new equilibrium price is going to either increase, decrease, or stay the same, depending on how much the curve shifted. But if the demand and supply curves both decreased by the same amount, then the new equilibrium price is going to be exactly the same - it's going to be horizontally to the left. When both the demand and the supply curves increase, both curves will shift to the right, and quantity increases, but price is ambiguous.
After this lesson you'll understand how shifts in supply and demand curves can affect market equilibrium and explain how these changes are reflected visually.
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Back To CourseEconomics 102: Macroeconomics
15 chapters | 123 lessons