Supply and Demand:
A Cookbook Model of Prices

In this unit we will look at the following topics that are important parts of the cookbook approach.  To introduce the concepts we will use a simple example based on the market for "seats" at RIU - a northeastern public university. 

• The Players: Determinants of behavior (why do they do what they do)
• The Picture: Represent the market graphically?
• The Details: Examine characteristics of the graphs
• The Government: Intervention in the market
• The Results: Impact of "events" on price and output

The Players: Demanders 

What influences the amount demanded?  To make life easy we will restrict our discussion to the situation in the output market where individuals like yourself are the demanders.  This should be easy for you since you are likely to be a demander - in fact I am willing to bet you have been in the position of being a demander today.  The demand for a good or service depends upon a number of factors that effect either the number of buyers or the behavior of the buyers. To convince yourself, think about what factors influence your decision to have pizza for dinner, the choice of gasoline for your car, or the number of automobiles sold in RI in the month of January.  One answer is supplied by Shlomo Maital in his book Executive Economics: Ten Essential Tools for Managers where thirteen "forces that shape what people buy" are discussed.   The thirteen forces, for which Maital provides numerous examples, arranged alphabetically, are: aptness, bandwagons and bubbles, price, demographics, sensitivity to price (elasticity), fashion and fads, greed, habit, income, jazz, knowledge, loyalty, minds and money.  At this time we will not discuss all of these factors, but rather focus our attention on a few of the key factors.

An entrepreneur would tend to focus attention on aptness - the ability to identify a need and deliver an apt way of satisfying that need.  The growth of Sears from a remote North Redwood, MN railroad station agency run by Richard Sears to the Sears Watch Co. in 1886 and then to the national catalogue business offers a good example of aptness in identifying customer needs.  And as so often happens, chance plays a significant role. Demand for Sears' watches in the west 'exploded' when the railroads in 1906 divided up the US into time zones in an effort to run an efficient train schedule.  All of a sudden 7AM took on more meaning than sunrise and those living in rural America needed watches.  Once Sears realized the magnitude of rural demand for 'things', he established a catalogue business to supply these things and Sears was off and running.  In 1999 we could see another example in Amazon.com, a company that realized the www was a good place to sell books - and once they succeeded there, Amazon expanded to other products including CDs.

Marketers, meanwhile, would tend to focus attention on factors such as fashion, fad and demographics.  Products tend to have a life-cycle similar to that of people. There are the early years where you see substantial growth followed by a maturity phase with slow growth which often turns into a period of decline.  An example would be the consumer electronics industry where we saw the passage of 'in-industries' from black and white TVs to color TVs to VCRs...  Maybe next it will be flat panel TVs, high definition TV, or internet TV.  The same would be true if you looked at automobiles as we passed through the mini-van era to the sports utility vehicle, or women's fashion as we move from short to long to mid length skirts and then back again.  

When we talk about demographics we are talking about people - how many and who they are - what ages, ethnicity, gender, family status, income...  You will undoubtedly hear much talk about certain classifications - baby boomers, Generation X, Yuppies (young, upwardly mobile, professional adults), DINC (double income no children households), Yiffies (young individualistic freedom-minded few born between Kennedy's death and Watergate), Hispanics, elderly  - what their needs are and what impact they will have on markets.  For example, two economists, Mankiw and Neil, created quite a furor when they suggested that the housing market was driven by demographics and the aging of the baby boomers would result in a long-term decline for housing.  In 1998 the excitement surrounding the stock market after the Asian crises pummeled Asian stock markets produced a number of articles citing the impact of the baby boomer generation on the stock market - how it propped up stock prices in the late 1990s and how stock prices will fall once the boomers begin retiring and selling off their stock shares to support themselves in retirement.  In general, if there was an increase in the number of demanders as a result of an increase in population, then we would expect to see an increase in demand as these new buyers arrived in the market. 

Financial advisors who guide people's decisions regarding how to allocate their wealth and real estate investors should be well aware of bandwagons and bubbles - an effect similar to fads.  For reasons we will discuss later [investing for the 21st century], prices in asset markets tend to be very volatile - moving up and down with wide swings.  At the heart of the discussion is the bandwagon effect.  Individuals buy an asset because others are buying it, which leads to more people buying it ... As more people rush in to buy the asset, the price rises which brings more people into the market.  Once the price begins to fall, however, the process reverses itself and prices fall rather sharply.  In the diagram below, the red line would be what you would expect in a market where there was a bandwagon effect creating the price bubbles - steep increase in price followed by a rapid decreases in price. 

History is full of examples of speculative bubbles.  In New England and Japan there were bubbles in the real estate market in the 1980s that burst in 1988 in New England and in the early 1990s in Japan.  There was also the US stock market 'crashes' in October of 1929 and 1987 and the Asian stock market crashes in in 1997-98.  In early 1999 there was much talk about a speculative bubble in the market for internet stocks as share prices of companies with some tie to the  internet rose dramatically.  According to The Economist (1/30/1999), this is just the most recent example of a speculative bubble associated with the stocks of companies in emerging technologies - railroads in the 19th century, radio in the 1920s, and biotechnology in the 1990s.

The most obvious factor affecting demand would be price. As the price of a product changes you would expect this would have an impact on demand.  Because we would expect an increase in price to cause a decrease in demand we expect there to be a negative relationship between price and quantity demanded. 

There is also the question of how much demand responds to price - a topic in the discussion of elasticity.  An example would be Apple computers that were historically much easier to use than PCs.  The result was Apple could charge higher prices than the PCs and demand would not decrease much as a result of the higher prices.  As the PCs became easier to use, however, demand for Apple computers responded more to price which caused Apple to change its pricing strategy.  You would also put loyalty into the discussion of responsiveness.  Companies work very hard to convince people their product is special so they will not lose customers as they raise price above that charged by competitors.  If sellers cannot differentiate their product, then they are likely to be drawn into 'ugly' price wars which will benefit buyers by driving down prices.   This is what happened to Apple when they lost their 'specialness' - they lost the loyalty of their customers.

The Apple computer can also be used as an example of the impact of habit.  If you own an Apple computer you are likely to buy another one if yours suddenly is stolen or breaks since you are in the habit of doing your computing with a Mac.  If, however, you have more time to adjust - the summer between semesters at school - then you are likely to be able to adjust your buying more. A more updated spin on this effect would be switching costs- it costs a user to switch computer systems and this should reduce the tendency to switch brands. 

Income and wealth should also influence demand. When we are discussing demand we are talking about how much people are willing and able to buy so ability to pay affects demand.  If income falls, a buyer will be likely to cut back on his/her purchases and thus income and demand move in the same direction.  The same would be true if someone felt a little less wealthy.  An example of the income effect, one that causes many environmentalists to lose sleep over, would be China's demand for automobiles or electricity.  As China's economy grows and its people see their incomes rise, they can be expected to trade their bicycles in for autos.  The resulting increase in demand for autos is seen as raising substantially the amount of air pollution.  They will also want electricity to power the lights, televisions, refrigerators, and air conditioners that they will buy with their higher incomes. An example of the wealth effect would be the US economy in the late 1990s.  As the stock market boomed you could see the effect in rising housing prices and booms in spending on automobiles, vacations and just about everything else.

You would also expect demand to depend upon other prices - the price of substitutes and the price of complements.  If the price of Hondas increased, then you would expect to see an increase in demand for Toyotas or Fords - substitutes for the Hondas.  If the price of computers (hardware) decreased, then you would expect an increase in demand for software which is a complement to the machines. There is a negative relationship between demand and the price of a complement while there is a positive relationship between demand and the price of a substitute.

Finally, you would also expect expectations to matter - if you expect things to improve then you are likely to increase your demand. An example of this would be the home heating oil "crisis" in early 2000 in Rhode Island. The price of heating oil began to rise creating the expectation of further price increases.  These expected price increases prompted consumers to increase their purchases of oil before the price rose any further.  A second example would be the situation in Japan in the late 1990s.  Concerns over the future state of the economy, the Japanese people's expectations about their economic future, prompted many individuals to cut back on their spending. 

Note: Be sure you make the distinction between a change in quantity demanded caused by a change in the price and a change in demand caused by a change in any other factor. The difference shows up in the demand curves where a change in quantity demanded is a movement on a curve while a change in demand is a shift of the entire curve. 

• Price of the good
• Price of other goods
  • Complements
  • Substitutes
• Income and wealth
• Population
  • Size
  • Composition
• Tastes / Preferences
  • Fashion & Fad
  • Aptness
  • Habits
• Confidence
• Expectation / Bubbles

The Players: Suppliers 

In every market there are buyers and sellers.  In the labor market individuals are the sellers who are offering their services, and firms looking for workers for their offices and factories are the buyers.  In the capital market people who save some of their income and put it in a savings account or a mutual fund are suppliers, and people who borrow funds to buy a car or a home are demanders. 

At this time, in an effort to make life easy, we are going to restrict our discussion to the output market where individuals are the demanders and firms are the suppliers.  If we are to understand supply, then we must 'get inside the heads' of those running the firms.  We must try to answer the question: what influences choices concerning the amount to supply?  The firm's choice regarding the amount of a good or service to supply depends upon a number of factors that affect either the number of sellers or the behavior of the sellers. A partial list of some of the important factors, including the nature of the relationship between each factor and supply, is provided below. 

For example, what will happen to supply if the price of inputs falls?  If we are Apple computer, what will happen to supply if the price of the computer chips fall.  If you are GM, what will happen to the supply of autos if workers receive a wage increase?   A supplier should be able to sell the same output at a lower price if the supplier's costs are down, while GM would be in a position to charge a higher price to cover additional costs associated with the wage increase.  In the first case we would be talking about an increase in supply, while in the second we would be talking about a decrease in supply.   In this situation we would characterize Apple's situation as an increase in supply since the decrease in the price of the input resulted in an increase in supply. 

The same would be true if there were an increase in productivity that allowed a firm to produce the same output with fewer inputs.  In this situation the firm's cost of production would decrease because fewer inputs were used.  The firm (supplier) would thus be able to sell more output at the same price - once again an increase in supply.  

When we are talking about the number of sellers we are talking about market structure - the main topic of the second part of the microeconomics course where we will talk about monopoly, oligopoly, and perfect competition.  At this time we can make the simplifying assumption that the number of sellers will also affect supply - an increase in the number of sellers will increase the supply as the new firms' output arrived in the market.  Other factors which we will not delve into now would be the motivation of the seller and the impact market structure has on the control individual firms would have over price. 

The final factor is price.  The supply of automobiles would be dependent upon the price of autos; the supply of rental units dependent upon the level of rents; the supply of oil dependent upon the price of oil.  We can expect an increase in price will prompt sellers to bring more to the market.  If you are a farmer deciding what crops to grow, when the price of wheat increases you can be expected to increase the land you devote to growing wheat.  As interest in American wine has grown and driven up the price, more land has been devoted to the cultivation of grapes.  This increased the supply of American wine.  If the price of mini vans falls as people shift from mini vans to sport utility vehicles (SUV), you could expect car companies to increase their supply of sport utility vehicles and decrease the supply of mini vans.  You could certainly see this in the late 1990s as a number of new SUV's came into the market (ex. Lexus and Mercedes). 

As you go through the analysis of supply - demand, you need to be sure you can differentiate between the change in quantity supplied caused by a change in price (movement on the curve) from the change in  supply caused by a change in any of the other factors (movement of the curve).

• Price of the Good
• Availability of Factors /Inputs
• Price of Factors /Inputs
• Productivity of Inputs
• Motivation of Supplier
  • (maximization of profit, growth, market share...)
• Market Structure number of buyers and sellers (+)
  • (monopoly, perfect competition, oligopoly...)

The Pictures: Supply and Demand Graphs

Demand:  Below you will find a table containing the results of the survey which you took part in. As you would expect, there seems to be a pronounced negative relationship between the prices (tuition) and the number of applicants. Everyone in the survey had a price past which they would not pay. When we added all of the surveys together, we arrived at the following table. At a price of $9,000, there were 16,600 people willing to pay the tuition, but by the time we got to a price of $12,000, there were only 15,900 willing to pay. In that $3,000 range we lost 700 applicants. In technical terms, the increase in the price of school (tuition) by $3,000 caused a decrease in the quantity demanded by 700.

Original Survey Results

We are now ready to take a somewhat different look at this information. It is now time to look at a graphical representation of the data.  If we return to the first survey results and graph the relationship between the price (tuition) and quantity (number of applications), we obtain the following graph. At a price of $15,000, there are 15,200 applicants to the university.  The picture of this is called the Demand Curve.

Before we move on, please take a moment to make a short list of the factors that influenced your decision in the survey. Would your answers have been different if URI's reputation were different?  Would you have been willing to pay more if a strong economy had allowed your parents to provide more support for you, or you had been able to earn more to defray the cost of college?  What if the costs of all other universities were higher?

Now let's consider how the survey result would have been different if URI's basketball team made it to the NCAA finals which gave the school's programs some national exposure. We should not be surprised that at each price there would be more applicants.  In fact there are 2,000 more applicants at each price. In more technical terms, we would say that in response to the good PR, the university had experienced an increase in demand.

Supplementary Survey Results

How do we represent the increase in demand? As you can see from the graph below, an increase in demand shows up as an outward shift in the demand curve. Now at a price of $15,000 there are 17,200 applicants.

Supply: Below you will find a table containing the results of an interview with the president and VP for finance. At the interview they were given the same survey, but they were asked how many applicants they would accept at each tuition rate. During the interview they indicated that they would accept more applications as tuition went up because they could open up some unused space on campus and pay more to bring on additional faculty and staff.  At a price of $12,000, the president indicated he could make space for 17,800 applicants, but if the price (tuition) were to be $6,000, he would only have openings for 16,600.  As the price increased $6,000 we lost 1,200 applicants. In technical terms, the increase in the price of school (tuition) by $6,000 caused an increase in the quantity supplied by 1,200.

Original Supply Survey Results

We are now ready to take a somewhat different look at this information.  It is now time to look at a graphical representation of the data.   If we return to the survey results and graph the relationship between the price (tuition) and quantity (number of students), we obtain the following graph.  At a price of $15,000, the university will supply seats for 18,400 students at the university.   This is called the supply curve.

Before we move on, please take a moment to make a short list of the factors that you would expect to have influenced the administrators' decision. Would their answers have been different if faculty had asked for, and received, a salary increase?  What if energy costs were higher?  What if some new technology greatly reduced the cost of administrative work?  If costs of running the university were lowered, we would expect that for each tuition rate, the president would make space for more applicants.  In fact there are spaces for 1,000 more applicants being made available at each price.  In more technical terms, we would say that in response to the decreased costs, the university had experienced an increase in supply.

Supply Survey Results with Lower Costs

How do we represent the increase in supply? As you can see from the graph below, an increase in supply shows up as an outward shift in the supply curve.

The Market: We have examined separately the results of our analyses of booth buyers and sellers, but now it is now time to bring the two pieces together. A place to start would be the table and graphs below containing the results of the initial surveys. The first three columns you have seen before while the fourth is simply the difference between what is demanded and what is supplied at every price (excess demand).

If we look at the situation if the tuition were $6,000, we find that there would be 17,300 people looking for slots at the university while the university would make 16,600 slots. At this price there would be a shortage as a result of excess demand for the slots.

Similarly, at a price of $24,000, the university is willing to make 20,200 slots available while only 13,100 slots are being sought. Here we would say we were experiencing a surplus of 7,100 slots as a result of excess supply.

Survey Results

At neither of these prices are we likely to find an equilibrium, a price at which the number of individuals seeking acceptance would just equal the number of slots being made available. There would be neither a shortage nor surplus. From the table we can see that somewhere between $6,000 and $9,000 we will find the equilibrium.

But what does this look like graphically? We find the same information, it just looks a bit different. At a price of $15,000, we find that there is a surplus. The equilibrium exists where the two curves intersect. At this point we just check out the values for price and applications.

You are now ready to move onward. We now have a model that explains prices, so let us use it to explain past and/or forecast future price changes. If you are interested, let's.

Comparative Statics:  We have now examined the results of our combined analyses of both buyers and sellers and introduced the concept of equilibrium. Now it is time to put the analysis to work. Let's see how we could use the analysis to forecast the impact of a few external shocks. More specifically, let's look at what happens when:

• energy costs increase
• the university receives some good national press
• the number of high school graduates in RI increases

For questions like this I suggest the cookbook approach.

Step1. In this problem where we know the market participants, so we need to begin by noting what participants are most directly affected by each external shock. In this example, if energy costs increase, this will most directly affect the supply.  If you are not convinced, ask yourself the last time you had your decision affected by energy cost changes. I suspect that you do not even know when energy costs are changed.

Step2. What will be the effect of the shock on supply? Will it increase supply (shift out) or decrease supply (shift in). In this case where we have higher production costs, the impact would be an inward shift in the curve.

Step3. It is now time to see what this external shock will do to the 'market?' As you can see from the graph, at the existing price we have a shortage which will put upward pressure until we have once again achieved an equilibrium (intersection). The new intersection is above and to the left of the original equilibrium which means that the decrease in supply will produce a higher equilibrium price and lower equilibrium quantity.

What about the second shock-the university gets some good national press? Once again we follow the cookbook approach.

Step1. The PR will have a direct impact on demanders, on the individuals looking for spaces at the university.

Step2. We would expect to see the increase PR have a positive effect on demand. The result will be an outward shift in the demand curve.

Step3. It is now time to see what this external shock will do to the 'market?' As you can see from the graph, at the existing price we have a shortage which will put upward pressure until we have once again achieved an equilibrium (intersection). The new intersection is above and to the right of the original equilibrium which means that the increase in demand will produce a higher equilibrium price and higher equilibrium quantity.

You are now on your own to try the third external shock. You should be able to convince yourself that it the result of more high school grads will be an increase in demand. 

 The Details

 Slope of the curves: The slope of a curve is the feature of a graph that conveys to the reader information on responsiveness to price changes.  Below you will see two demand curves.  The first demand curve is quite flat while the second is rather steep.   When we draw a flat curve we are telling the reader we believe demand is quite responsive to price - price has a substantial effect on the quantity demanded.  In this example, a relatively small change in price (P0 to P1) will generate a substantial change in quantity demanded (Q0 to Q1).  This is likely to be the situation facing a Mobil gas station at a busy intersection where there are four gas stations (Mobil, Shell, Exxon, and Citgo).  If the Mobil station raised its price, customers would pump gas at the other stations so we would expect a price rise to  substantially lower demand.

Responsive Demand

In the second diagram we have drawn a relatively steep demand curve.  When we draw a steep demand curve we are telling the viewer demand is not very responsive to price changes. In this example, a relatively large change in price (P0 to P1) will generate a small change in quantity demanded (Q0 to Q1).  This is likely to be the situation facing the gas industry.  If the industry raised its price, customers would still need to pump gas so we would expect a price rise to have a minimal impact on demand.

Unresponsive Demand

Two extreme cases would be when the curves are horizontal and vertical. A vertical demand curve would be called a perfectly inelastic demand and it tells us demand is completely independent of price.  Demand is what it is and a change in the price will not change demand.  A horizontal demand curve would be called a perfectly elastic demand and it tells us demand is completely dependent on price.  In this situation we are describing a situation where the buyers will buy any amount at a specified price, but at any higher price they will buy nothing.

The same interpretation can be applied to supply - a steep curve indicating that supply will not respond significantly to price changes while a flat curve indicates that a price change will substantially alter supply.  I will leave the detailed analysis to you. 

 Shifts of the curves: Supply and demand curves are meant to be visual representations of the behavior of buyers and sellers and therefore we should expect anything affecting behavior will be reflected in the supply and demand curves.  A shift in one of the curves will take place whenever there is an event which alters one or more of the determinants of behavior. 

Note: a shift in the supply or demand curves would not be the result of a change in the price since the slope captures the impact of price on supply and demand and we will discuss this relationship in the section on slope.  You should be careful here because experience clearly shows students often mess things up by shifting the wrong curve or two curves when only one shift is called for. The only time a curve shifts is when a change in some factor OTHER THAN PRICE affects the behavior of either buyers or sellers. For example, when there is a freeze in Florida this will directly influence suppliers.  They are the ones who lose their product so we should expect to see a decrease in supply that shifts the supply curve inward. You, as a buyer of orange juice, do not lose any sleep over the freeze and  your interest in orange juice does not change.  In fact I doubt you even know about the freeze.  What this means is the freeze does not change your behavior and the demand curve does not shift.   You will be affected by the freeze because the new intersection of the S & D curves is higher indicating you will pay more, but this is already shown on the existing demand curve. 

Returning to our RIU example, we would expect the demand for seats at RIU to be affected by a substantial decrease in the tuition rates at another school, while we would expect the number of seats supplied would be affected if there was a substantial decrease in state support for the school.  We will now examine how we would represent graphically these shifts in supply and demand. 

I. Demand Shifts

Increase in Demand: we represent an increase in demand by an outward shift in the curve (from D1 to D2). In the graph below at the price p1, demand has increased from Q1 to Q2. At every price there will be a greater demand than there was before the 'shock' of increased demand. We could expect this to describe the effect of an increase in income or an increase in the size of potential demanders.  In the case of RIU, we would expect to see the demand shift out if the tuition rate at another college were raised substantially, if the economy was expanding rapidly and families had more income to spend on education, or if high school grads were having real problems finding jobs.

Decrease in Demand: we represent a decrease in demand by an inward shift in the curve (from D1 to D2). In the graph below at p1, demand has decreased from Q1 to Q2. At every price there will be a less demand than there was before the 'shock' of decreased demand. We could expect this to describe the effect of a decrease in the price of a substitute good. In the case of RIU, we would expect to see the demand curve shift inward if tuition rates at another college were lowered substantially, if the economy was falling into a recession and families had less income to spend on education, or if high school grads were finding jobs quite easily.

II. Supply Shifts

Increase in Supply: we represent an increase in supply by an outward shift in the curve (from S1 to S2). In the graph below at P1, the amount sellers are willing to supply has increased from Q1 to Q2. At every price there will be a greater supply than there was before the 'shock' of increased supply. We could expect this to describe the effect of an increase in the productivity of the production process. In the case of RIU, we would expect to see the supply shift out if the costs of running the university fell substantially or the average class size rose.

Decrease in Supply: we represent a decrease in supply by an inward shift in the curve (from S1 to S2). In the graph below we see at p1, the amount sellers are willing to supply has decreased from Q2 to Q1. At every price there will be a less supply than there was before the 'shock' of decreased supply. We could expect this to describe the effect of an increase in the price of a resource used in production. In the case of RIU, we would expect to see the supply shift in if the costs of running the university rose substantially or average class size fell.

Government Intervention

What happens when the market is 'forced' away from its natural equilibrium? There are times when the government decides natural market prices are unacceptable. Two examples would be the government's establishment of a price floor ( minimum wage ) and a price ceiling ( rent control ).

Minimum wage legislation sets a lower limit to wages above the natural / equilibrium price. When this happens we end up with a surplus (excess supply of labor) which we would call unemployment.

Price Floors (minimum wage)

Under rent control, the government specifies the maximum rent (price) which is below the natural / equilibrium price.  Because the rent is below the equilibrium rent, there will be a shortage (excess demand). The result would be that we would see long waiting lists for apartments.

Price Ceilings (rent control)

To test your command of the material, you should compare the results in the diagrams below with what you would find if you changed the slope of one of the curves.  If the slope of the supply curve were flatter, would the surplus caused by the minimum wage be larger or smaller?  Would the shortage in the rental market be larger or smaller?  It is also important to realize each of these policy decisions is far more complex than these simple graphs suggest, but a more thorough discussion is beyond the scope of our analysis here. 

The Results

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. 

The Results: A Summary

It is now time to review the findings from our comparative static experiments.  The results appear in the two tables below.  The first table summarizes the situation where there is only one shock which affects only one curve.   In this situation you are able to predict what will happen to the price and quantity.  If there is an increase in demand, this can be expected to push prices and output higher.  Similarly, if there is a decrease in supply, this will put downward pressure on output and upward pressure on price.

Shifts in Supply or Demand

But what about the situation where there is a simultaneous shift in both curves?  In these situations you will not be able to predict both the quantity and price effect.  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. In this situation 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.  In the table below you will see the  ? in these situations where we  can not tell the direction of change in price or quantity unless we know more about the relative size of the shifts.

Shifts in both Supply and Demand