Shifts in Supply and Demand

Supply and demand curves tell us how much competitive producers and consumers are willing to sell and buy as functions of the price they receive and pay. But supply and demand are also determined by other variables besides price. For example, the quantity that producers are willing to sell depends not only on the price they receive, but also on their production costs, including wages, interest charges, and costs of raw materials. And in addition to price, quantity demanded depends on the total disposable income available to consumers, and perhaps on other variables as well. Later we will want to determine how changes in economic conditions or tax or regulatory policy affect marketprices and quantities. To do this, we must understand how supply and demand curves shift in response to changes in such variables as wage rates, capital costs, and income.

Let's begin with the supply curve S in Figure 2.2. This curve shows how much producers are willing to sell as a function of market price. For example, at a price Pv the quantity produced and sold would be Qr Now suppose the cost of raw materials falls. How does this affect supply?

Lower raw material costs, indeed lower costs of any kind, make production more profitable, encouraging existing firms to expand production and enabling new firms to enter the market and produce. So if the market price stayed constant at Py, we would expect to observe a greater supply of output than be-

FIGURE 2.2 Shift in Supply. If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price. The supply curve shifts to the right.

Price

Q i Q3 Quantity

Q i Q3 Quantity

FIGURE 2.3 New Equilibrium Following Shift in Supply. When the supply curve shifts to the right, the market clears at a lower price Pi and a larger quantity Qs.

fore. In Figure 2.2 this is shown as an increase from <2, to Q2. Output increases no matter what the market price happens to be, so the entire supply curve shifts to the right, which is shown in the figure as a shift from S to S'.

Another way of looking at the effect of lower raw material costs is to imagine that the quantity produced stays fixed at Qx and consider what price firms would require to produce this quantity. Because their costs are lower, the price they would require would also be lower-P2 in Figure 2.2. This will be the case no matter what quantity is produced. Again, we see in the figure that the supply curve must shift to the right.

Of course, neither price nor quantity will always remain fixed when costs fall. Usually both will change as the new supply curve comes into equilibrium with the demand curve. This is illustrated in Figure 2.3, where the supply curve has shifted from S to S1 as it did in Figure 2.2. As a result, the market price drops (from Px to P3), and the total quantity produced increases (from Q\ to Q3). This is just what we would expect: Lower costs result in lower prices and increased sales. (And indeed, gradual decreases in costs resulting from technological progress and better management are an important driving force behind economic growth.)

Now let's turn to Figure 2.4 and the demand curve labeled D. How would an increase in disposable income affect demand?

With greater disposable income, consumers can spend more money on any good, and some consumers will do so for most goods. If the market price were held constant at Pv we would therefore expect to see an increase in quantity demanded, say, from Qx to Q2. This would happen no matter what the market price was, so that the result would be a shift to the right of the entire demand

Price

Qi Qi Quantity

Qi Qi Quantity

FIGURE 2.4 Shift in Demand. The demand for a product depends on its price but may also depend on other variables, such as income, the weather,and the prices of other goods. For most products, demand increases when income rises. A higher income level shifts the demand curve to the right.

curve. In the figure, this is shown as a shift from D to D '. Alternatively, we can ask what price consumers would pay to purchase a given quantity Qv With greater disposable income, they should be willing to pay a higher price, say, P2 instead of Pl in Figure 2.4. Again, the demand curve will shift to the right.

In general, neither price nor quantity remains constant when disposable income increases. A new price and quantity result after demand comes into equilibrium with supply. As shown in Figure 2.5, we would expect to see consumers pay a higher price P3 and firms produce a greater quantity Qs as a result of an increase in disposable income.

Changes in the prices of related goods also affect demand. For example, copper and aluminum are substitute goods. Because one can often be substituted for the other in industrial use, the demand for copper will increase if the price of aluminum increases. Automobiles and gasoline, on the other hand, are complementary goods (i.e., they tend to be used together). Therefore a decrease in the price of gasoline increases the demand for automobiles. So the shift to the right of the demand curve in Figure 2.5 could also have resulted from an increase in the price of a substitute good or from a decrease in the price of a complementary good.

In most markets both the demand and supply curves shift from time to time. Consumers' disposable incomes change as the economy grows (or contracts, during economic recessions). The demands for some goods shift with the seasons (e.g., fuels, bathing suits, umbrellas), with changes in the prices of related goods (an increase in oil prices increases the demand for natural gas), or sim-

FIGURE 2.5 New Equilibrium Following Shift in Demand. When the demand curve shifts to the right, the market clears at a higher price P3 and a larger quantity Qy

FIGURE 2.6 New Equilibrium Following Shifts in Supply and Demand. Supply and demand curves shift over time as market conditions change. In this example, rightward shifts of the supply and demand curves lead to slightly higher price and a much larger quantity. In general, changes in price and quantity depend on the amount by which each curve shifts and the shape of each curve.

ply with changing tastes. Similarly wage rates, capital costs, and the prices of raw materials also change from time to time, which shifts supply.

Supply and demand curves can be used to trace the effects of these changes. In Figure 2.6, for example, shifts to the right of both supply and demand result in a slightly higher price (from Pl to P2) and a much larger quantity (from Qi to Q2). In general, price and quantity will change depending both on how much the supply and demand curves shift and on the shapes of those curves. To predict the sizes and directions of such changes, we must be able to quantitatively characterize the dependence of supply and demand on price and other variables. We will turn to this in the next section.

EXAMPLE 2.1 THE PRICE OF EGGS AND THE PRICE OF A COLLEGE EDUCATION

In Example 1.2 we saw that from 1970 to 1993, the real (constant dollar) price of eggs fell by 56 percent, while the real price of a college education rose by

(1970 dollars per dozen)

(1970 dollars per dozen)

(billion dozens)

(annual cost in 1970 dollars)

4099

2530

(annual cost in 1970 dollars)

4099

2530

(millions of students enrolled)

(millions of students enrolled)

FIGURE 2.7a Market for Eggs. The supply curve for eggs shifted down as production costs fell, and the demand curve shifted to the left as consumer preferences changed. As a result, the real price of eggs fell sharply, and egg consumption fell slightly. FIGURE 2.7b Market for College Education. The supply curve for a college education shifted up as the costs of equipment, maintenance, and staffing rose. The demand curve shifted to the right as a growing number of high school graduates desired a college education. As a result, both price and enrollments rose sharply.

62 percent. What caused this large decline in egg prices and large increase in the price of college?

We can understand these price changes by examining the behavior of supply and demand for each good, as shown in Figure 2.7. For eggs, the mechanization of poultry farms sharply reduced the cost of producing eggs, shifting the supply curve downward over this period. At the same time, the demand curve for eggs shifted to the left as a more health (and cholesterol) conscious population changed its eating habits, tending to avoid eggs. As a result, not only did the real price of eggs decline sharply, but total annual consumption fell somewhat (from 5300 billion dozen to 4900 billion dozen).

For college, supply and demand shifted in the opposite directions. Increases in the costs of equipping and maintaining modern classrooms, laboratories, and libraries, along with increases in faculty salaries, pushed the supply curve up. At the same time, the demand curve shifted to the right as a larger and larger percentage of a growing number of high school graduates decided that a college education was essential. Thus, despite the increase in price, 1993 found over 14 million students enrolled in college degree programs, compared to 8.6 million in 1970.

The early 1970s was a period of public concern about the earth's natural resources. Groups like the Club of Rome predicted that our energy and mineral resources would soon be depleted, so that prices would skyrocket and bring an end to economic growth.1 But these predictions ignored basic microeconomics. The earth does indeed have only a finite amount of minerals, such as copper, iron, and coal. Yet during the past century, the prices of these and most other minerals have declined or remained roughly constant relative to overall prices. For example. Figure 2.8 shows the price of iron in real terms (adjusted for inflation), together with the quantity of iron consumed from 1880 to 1985. (Both are shown as an index, with 1880 =1.) Despite short-term variations in price, no significant long-term increase has occurred, even though annual consumption is now about 20 times greater than in 1880. Similar patterns hold for other mineral resources, such as copper, oil, and coal.2

1 See, for example, Dennis Meadows et al., The Limits to Growth (New York: Potomac Associates, 1972). This book and others like it struck a resonant chord in the public consciousness. Unfortunately these studies ignored such basic economic phenomena as cost reduction resulting from technical progress, experience, and economies of scale, and substitution of alternative resources (including nonde-pletable ones) in response to higher prices. For a discussion of these issues, see Julian L. Simon, The Ultimate Resource{Princeton, N J.: Princeton University Press, 1981).

The data in Figure 2.8 are from Robert S. Manthy, Natural Resource Commoditie-A Century of Statistics (Baltimore: Johns Hopkins University Press, 1978), supplemented after 1973 with data from the U.S. Bureau of Mines.

FIGURE 2.8 Consumption and Price of Iron, 1880-1985. Annual consumption has increased about twentyfold, but the real (inflation-adjusted) price has not changed much.

Price

Price

1950

'1950

1950

Si 990

■ Long-Run Path of Price and Consumption

1900

1900

'1950

1990

Quantity

FIGURE 29 Long-Run Movements of Supply and Demand for Mineral Resources.

Demand for most resources has increased dramatically over the past century, but prices have fallen or risen only slightly in real (inflation-adjusted) terms because cost reductions have shifted the supply curve to the right just as dramatically.

The demands for these resources grew along with the world economy. (These shifts in the demand curve are illustrated in Figure 2.9.) But as demand grew, production costs fell. This was due first to the discovery of new and bigger deposits, which were cheaper to mine, and then to technical progress and the economic advantage of mining and refining on a large scale. As a result, the supply curve shifted to the right over time. Over the long term, these shifts in the supply curve were greater than the shifts in the demand curve, so that price often fell, as shown in Figure 2.9.

This is not to say that the prices of copper, iron, and coal will decline or remain constant forever-these resources are finite. But as their prices begin to rise, consumption will likely shift at least in part to substitute materials. For example, copper has already been replaced in many applications by aluminum, and more recently in electronic applications by fiber optics. (See Example 2.6 for a more detailed discussion of copper prices.)

Wheat is an important agricultural commodity, and the market for it has been studied extensively by agricultural economists. During the 1980s, changes in the wheat market had major implications for American farmers and for U.S. agricultural policy. To understand what happened, let us examine the behavior of supply and demand.

From statistical studies, we know that for 1981 the supply curve for wheat was approximately as follows:3

where price is measured in dollars per bushel and quantities are in millions of bushels per year. These studies also indicate that in 1981 the demand curve for wheat was

By setting supply equal to demand, we can determine the market-clearing price of wheat for 1981:

Qs=QD

For a survey of statistical studies of the demand and supply of wheat and an analysis of evolving market conditions, see Larry Salathe and Sudchada Langley, "An Empirical Analysis of Alternative Export Subsidy Programs for U.S. Wheat," Agricultural Economics Research 38, No. 1 (Winter 1986). The supply and demand curves in this example are based on the studies they survey.

The demand for wheat has two components-domestic demand (i.e., demand by U.S. consumers) and export demand (i.e., demand by foreign consumers). By the mid-1980s, the domestic demand for wheat had risen only slightly (due to modest increases in population and income), but export demand had fallen sharply. Export demand had dropped for several reasons. First and foremost was the success of the Green Revolution in agriculture-developing countries like India that had been large importers of wheat became increasingly self-sufficient On top of this, the increase in the value of the dollar against other currencies made U.S. wheat more expensive abroad. Finally, European countries adopted protectionist policies that subsidized their own production and imposed tariff barriers against imported wheat. In 1985, for example, the demand curve for wheat was

(The supply curve remained more or less the same as in 1981.)

Now we can again equate supply and demand and determine the market-clearing price for 1985:

We see, then, that the major shift in export demandled to a sharp drop in the market-clearing price of wheat-from $3.46 in 1981 to $1.80 in 1985.

Was the price of wheat actually $3.46 in 1981, and did it actually fall to $1.80 in 1985? No-consumers paid about $3.70 in 1981 and about $3.20 in 1985. Furthermore, in both years American farmers received more than $4 for each bushel they produced. Why? Because the U.S. government props up the price of wheat and pays subsidies to farmers. We discuss exactly how this is done and evaluate the costs and benefits for consumers, farmers, and the federal budget in Chapter 9.

Was this article helpful?

0 0
Improving Your Financial IQ

Improving Your Financial IQ

Taking Control Of Your Finances In A Fun And Easy Way. 23 Pages, Letter-Sized, PDF Format, Instant Download. This book will be one of the most important financial books you will ever read. Discover the truth behind why most network marketers fail to make money or break even because of their lack of financial knowledge plus so much more.

Get My Free Ebook


Post a comment