Market Equilibrium:
Supply and Demand
The Production Possibilities Frontier demonstrated that there are trade-offs -- in the form of Opportunity Costs -- when society's with scarce resources decide what, and how much, of each good to produce. The natural next question is how society determines the allocation of resources?
In most countries, markets do the allocating of resources. The basic idea is that the price in a market moves to be sure that those consumers who value the good the most -- in terms of their willingness to pay -- are the ones who end up consuming the good. On the other side, the desire to maximize profits leads the sellers who are able to produce the good at the lowest price -- i.e. most efficiently -- are the ones who enter the market and sell the good to consumers.
The lecture video and textbook work through specific examples, with numbers, to motivate and derive the market demand and supply curves. These examples begin with the demand curves for individuals, and the supply curves for individual firms. Then aggregates them to come up with the market demand and supply that determines the equilibrium price and quantity. In the end, we end up with a graph like the one showed above.
The purpose of this page is to provide some interactive examples, combined with some self-checking quizzes, to further strengthen your understanding of the market equilibrium. This part of the course forms the back bone for all of the material that is to follow in the course. Thus, it is essential that you really understand this material.
Lecture Video
This page is a supplement, with hands on practice, to the lecture videos on the Canvas page. It is most directly related to the video below, which provides examples of changes in the market equilibrium. Before continuing, you should watch the videos that precede this one.
Shifting Supply and Demand Curves
The demand curve tells us how much quantity of the good consumers are willing to buy at a given price, i.e. it is the mathematical relationship between price of a good and the quantity demanded.
The supply curve tells us how much quantity of the good producers are willing to supply/produce at a given price, i.e. it is the mathematical relationship between price of a good and the quantity supplied.
Economists are fond of the phrase "all else equal." That is because there are many factors that if they were to change would change the behavior of people and firms. These relationships between price and quantity demanded or quantity supplied tell us how quantity demanded/supplied will change as the price changes while holding everything else constant, like changes in consumer preferences, the prices of related goods, the costs of input and other "market" conditions. By holding "all else equal" we can draw the downward-sloping demand curve and upward sloping supply curve like in the picture at the top of this page. Then by looking at where demand=supply, we can calculate the equilibrium price and quantity.
But, the most interesting questions in economics involve looking at what happens as something disturbs demand or supply, that is when all else isn't equal. For example, if a sudden fad increases the demand for smart watches. Or, an unexpected freeze in Orange County wipes out the crop of oranges.
To answer these questions, we need to know how they impact the demand and supply curves. That is, how the relationship between price and quantity demanded/supplied is changed when an important variable changes. These types of changes are called shift factors.
The Mankiw textbook has an excellent section in the Appendix to chapter 2 on graphing and the difference between "moving along a curve" and shifting a curve. Additionally, these ideas were reviewed in the Aplia tutorial. It is highly recommended that you review this material.
Demand Shifts
The trick in answering questions about how an event, or change in a factor, will affect a market's equilibrium is to figure out whether the change affects demand, supply or both. Most of the time, you can use your intuition and common sense to figure this out.
Generally, a demand shift -- called a change in demand -- fits into one of the following categories:
- a change in consumer preferences: for example, a really cold day increases the demand for hot coffee, while a really hot day increases the demand for iced coffee.
- a change in income: for example, an increase in consumer incomes relax budget constraints and lead to an increase demand for normal goods (see the text for the difference between normal and inferior goods).
- a change in related prices: for example, if the price of Disneyland tickets go up, then the demand for movie tickets will go up; alternatively, if the price of popcorn goes up then the demand for movie tickets will go down.
Supply Shifts
A supply shift -- called a change in supply -- fits into one of the following categories:
- a change in production costs: for example, if the wages/salaries paid to workers goes up, it raises the marginal cost of production: firms will produce less at any given price.
- a change in market conditions: for example, expectations about future conditions will change how much firms are willing to supply today; or, the number of competitors will affect how much is produced.
- changes in technology: new technologies/machines that allow firms to produce more for a given amount of inputs.
You are now ready to try graphing examples on your own. Answer the following questions using the Interactive Graph.
Self-check Quiz
The period 2007-2009 is known as the Great Recession. A large global financial crisis resulted in widespread job losses, difficulties for unemployed workers to find new jobs, and paycuts for employed workers. How did this impact the equilibrium price and quantity in the market for iPhones? Hint | AnswerHint: try changing the maximum production of both goods equally..
Self-check Quiz
The technological breakthrough that allows people to watch movies on their computers, tablets and phones have increased the demand for these goods, which in turn leads to higher prices. How would this impact the equilibrium price and quantity of televisions, a substitute good? Hint | AnswerHint: try changing the maximum production of both goods equally..
Self-check Quiz
A new U.S. president launches a trade war with China. As a result, there is a decrease in the number of sellers for smart phones in the U.S. smart phone market. How does this affect the equilibrium price and quantity of smart phones? Hint | AnswerHint: try changing the maximum production of both goods equally..