Comparative Statics

We are now ready to move into the forecasting / explaining mode.   Once we have mastered the basics of supply and demand we are able to use the framework to explain movements in price. In this section we will examine the impact on price and consumption (quantity) of any changes in either supply or demand.  In the next section we will examine the impact of simultaneous shifts in supply and demand.  

Shifts in Supply or Demand

I. Demand Shifts

Increase in Demand: we represent an increase in demand by an outward shift in the curve (from D1 to D2) which will move the equilibrium point (intersection of the existing supply and the new demand curve) up and out. If you compare the two points you will see both the equilibrium price and quantity have risen.

Decrease in Demand: we represent a decrease in demand by an inward shift in the curve (from D1 to D2) which will move the equilibrium point (intersection of the existing supply and the new demand curve) down and in. If you compare the two points you will see both the equilibrium price and quantity have fallen.

II. Supply Shifts

Increase in Supply: we represent an increase in supply by an outward shift in the supply curve (from S1 to S2) which will move the equilibrium point (intersection of the new supply and the existing demand curve) down and out. If you compare the two points you will see the equilibrium price falls and the quantity increases.

Decrease in Supply: we represent a decrease in supply by an inward shift in the supply curve (from S1 to S2) which will move the equilibrium point (intersection of the new supply and the existing demand curve) up and in. If you compare the two points you will see the equilibrium price rises and the quantity falls.


Shifts in Supply and Demand

Increase in Supply and Demand: we represent an increase in supply and demand by an outward shift in both curves which will move the equilibrium point (intersection of the new supply and demand curve (red curves). Below you will see two diagrams describing the potential impact of the supply and demand increases.

When you compare the two equilibrium points you see there is a significant difference between the results when the demand shift is larger and when the supply shift is larger.  The left-side diagram depicts the situation where the shift in demand is greater than the shift in supply, while in the right-side diagram depicts a situation where the shift in supply is greater. What we see is that in both cases there is an increase in consumption (Q1 > Q*).  The difference is in the price effect since we cannot be certain about the projected change in price. When the demand shift is larger [left-side diagram], it will be the upward pressure on price that dominates and price will rise [ P1 > P*]. When the supply shift is larger [right-side diagram], it will be the downward pressure on price that dominates and price will fall [ P1 < P*]. RESULT: When supply and demand move in the same direction we can forecast the change in consumption (quantity), but we cannot forecast price changes since sometimes it will rise and sometimes it will fall.  When supply and demand increase we can forecast an increase in consumption while a simultaneous decrease in supply and demand will produce a decrease in consumption.

Decrease in Demand and Increase in Supply: We can follow the same procedure when supply and demand move in opposite directions. In this case we would represent an increase in supply and decrease in demand by an outward shift in the supply curve and an inward shift in the demand curve.   Below are two diagrams describing the impact of the shifts. In the left-side diagram the shift in supply is greater than the shift in demand, while in the right-side diagram the shift in demand is greater.

When you compare the two equilibrium points you see there is a significant difference between the results. In the first diagram the shift in supply is greater than the shift in demand, while in the second diagram the shift in demand is greater. In both cases there is a decrease in price ( P1 < P*).  What we cannot be certain about is the projected change in quantity. When the inward demand shift is larger than the outward supply shift, it will be the downward pressure on quantity that dominates and consumption will fall (Q1 < Q*).  When the supply shift is larger, it will be the upward pressure on quantity that dominates and consumption will increase (Q1 > Q*). RESULT: When supply and demand move in opposite directions we can forecast the change in price, but we cannot forecast quantity changes.

Conclusion: In situations where both the supply and demand curves shift, we cannot tell the direction of change in both price or quantity unless we know more about the relative size of the shifts. For example, if we thought both Supply and Demand increased, then the increase in demand would put upward pressure on price while the increase in supply would put downward pressure on price.  We would not be able to specify the direction of the price change until we knew something about the magnitudes of the shifts. We can, however, forecast an increase in quantity since both the supply and demand increases tend to increase output.  

Real World Examples: 

Now its time for a little practice with the type of work that you will be doing in the exams.  In the overview we looked at a few examples of translating a headline or story into a supply - demand graph.  Here you can look at the examples one more time after having worked through the unit.  We start with the brief article on world food production published by the foreign agricultural service.   In this unit of the course you will be repeatedly asked to look at real world headlines or stories and translate them into simple supply-demand graphs, and this production report offers an opportunity to see how this works. The second article on wheat production in Canada points out that "favorable summer weather aided crop development"  so total output was up from last year.  This is a story about supply and the story is one of an increase in supply.  We would demonstrate this with the outward shift in the supply curve in the diagram below which provides us with the basis for our forecast of the market - prices will fall and output will rise. 

The outward shift in the supply curve would also be the appropriate graph to demonstrate the situation in Argentina where additional land is brought under cultivation increasing the supply of wheat as well as the situation in Mexico where favorable weather increased corn output.  The situation in Europe, however, was quite different as wheat production fell sharply due to bad weather.  This would be reflected in a shift inward in the supply curve - what you see in the diagram below.

Before we leave, you should look at one additional article - a forecast of the future aircraft market by Airbus, one of the BIG players in the commercial airline business.  In the forecast summary section in the article  you will read that "tremendous potential still exists for an increase in demand for air travel as the world's economy continues to grow and the most populous, but less developed, nations climb up the economic development curve."  This demand growth would be represented in the supply-demand model with the diagram below.  The increase in demand translates into an outward shift in the curve.

As you work through the supply-demand section you might want to look at a few more of the articles and see if you can make the translation to supply-demand graphs.