Chapter 3  Supply and Demand

III.  Market Equilibrium

Now we put together the behavior of buyers (part one) and the behavior of sellers (part two) to have a model of the whole market for pizza.

Market Equilibrium

Recall the demand and supply schedules for pizza delivered in Oswego in a week:

 Price of pizza Quantity of pizza demanded (per week in Oswego) Quantity of pizza supplied (per week in Oswego) \$25 100 800 \$20 210 700 \$15 300 625 \$10 500 500 \$5 650 300

Note that at a price of \$10, the quantity supplied = the quantity demanded = 500.
If we plot the supply and demand curves on the same set of axes, we get the following illustration of the pizza market:

The supply and demand curves intersect at the point where quantity supplied = quantity demanded. This intersection is what we call an equilibrium price. This is the price where the intentions of both the buyer and seller are compatible: Buyers want to buy the exact amount the sellers want to sell.

Why is (500, \$10) an equilibrium? To understand why, let's think about what would happen if the price was greater than or less than \$10.

• If the price is greater than \$10, say \$20, the quantity demanded = 210 and the quantity supplied = 700. The result would be a huge surplus of 490 pizzas produced, with no one willing to buy them for \$20. This surplus would force prices to fall, causing pizza supplies to cut back production and pizza buyers would be willing to buy more pizzas as the price falls, until the price reaches \$10.
• If the price is less than \$10, say \$5, the quantity demanded = 650 and the quantity supplied = 300. The result would be a shortage of 350 pizzas. This shortage would force prices up, causing pizza suppliers to produce more and consumers to buy less, until the price reaches \$10.
So an equilibrium point is a point of rest, where there is no incentive for buyers or sellers to change their decisions. However, if one of the other factors affecting demand and supply change, then the demand and/or supply curves will shift, and a new equilibrium will result. Let's consider a few examples

Changes in Equilibrium

Let's consider a few examples.

Example 1: Suppose that the price of Chinese food delivery rises. What happens to the market for pizza? Let's figure this out with a 3 step approach:

• Step 1: Will this affect the demand or supply curve? Chinese food is a substitute for pizza, so the price of chinese food affects the demand curve
• Step 2: In what direction will the affected curve move? The price of chinese food, a substitute, INCREASES, so the demand for pizza INCREASES, or the demand curve shifts right.
• Step 3: What is the resulting impact on the equilibrium price and quantity? This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and larger quantity. An increase in demand results in an increase in price and quantity.

Example 2: Suppose instead that the Chinese food business is incredibly popular and profitable. What happens to the market for pizza? Again, we use the same three step approach:

• Step 1: Will this affect the demand or supply curve? The chinese food business is an alternative to the pizza business, affecting the supply curve
• Step 2: In what direction will the affected curve move? The profitability of chinese food means that some pizza places will switch to chinese food places, so the supply of pizza DECREASES, or the supply curve shifts left.
• Step 3: What is the resulting impact on the equilibrium price and quantity? This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and smaller quantity. An decrease in supply results in an increase in price and a decrease in quantity.

Example 3: Now lets combine examples 1 and 2 so that the demand for pizza increases AND the supply of pizza decreases. What happens to the market for pizza?

• we know an increase in demand will increase equilibrium price and increase quantity.
• we know a decrease in supply will increase equilibrium price and decrease quantity.
• put both together the equilibrium price will increase but the affect on quantity is uncertain, and depends on whether the shift in demand is smaller or larger than the shift in supply. As I have draw the graph below, there is no change in quantity.

The table below summarizes how changes in demand and supply affect equilibrium price (P) and quantity (Q).

 no change in demand (no shift) increase in demand (shift right) decrease in demand (shift left) no change in supply (no shift) no change in P no change in Q P increases Q increases P decreases Q decreases increase in supply (shift right) P decreases Q increases P ? Q increases P decreases Q ? decrease in supply (shift left) P increases Q decreases P increases Q? P? Q decreases

Want to test your understanding? The links below will allow you to test your understanding of supply and demand. Your CD ROM also has self-quizzes on chapter 3.