Module 4: Market Equilibrium

1. Module 4: Market Equilibrium Objectives: Define a market equilibrium, use a demand-supply graph to represent a market equilibrium. Understand what is a shortage, how to calculate the amount of shortage, and how to eliminate a shortage in a free market. Understand what is a surplus, how to calculate the amount of surplus, and how to eliminate a surplus in a free market. Analyze changes in equilibrium using a demand-supply graph. Module 4: Market Equilibrium

2. Objective 1: Define a market equilibrium, use a demand-supply graph to represent a market equilibrium • A market equilibrium is a situation where quantity demanded equal quantity supplied. • In an equilibrium there are no shortages or surpluses. The Coffee Market Demand and Supply Schedules The Coffee Market At a price of $3, quantity demanded = quantity supplied= 500 cups. At any other price, there is either a shortage or a surplus. Module 4: Market Equilibrium

3. Objective 2: Understand what is a shortage, how to calculate the amount of shortage and how to eliminate a shortage in a free market. • A Shortage or excess demand is a situation in which consumers are willing to buy more than producers are willing to sell. It is measured by the difference between quantity demanded and quantity supplied when price is below the market equilibrium price. In a free market, price must rise to eliminate the shortage. At a price of $1.50, quantity demanded is 800 and quantity supplied is 200, resulting in a shortage of 600 cups. Module 4: Market Equilibrium

4. Objective 3: Understand what is a shortage, how to calculate the amount of shortage and how to eliminate a shortage in a free market. • A Surplus or excess supply is a situation in which producers are willing to sell more than consumers are willing to buy. It is measured by the difference between quantity supplied and quantity demanded when price is above the market equilibrium price. In a free market, price must fall to eliminate the surplus. At a price of $4.00, quantity demanded is 300 while quantity supplied is 700, resulting in a surplus of 400 cups. Module 4: Market Equilibrium

5. Objective 4: Analyzing Changes in Equilibrium We can use the supply-and-demand diagram to analyze how an event affects a market and to predict what happens to the equilibrium price and quantity. There’s a simple 3-step process used to analyze changes in equilibrium. Unless stated otherwise, the analysis begins from an initial equilibrium. Step 1: Determine whether the event shifts the supply curve or demand curve or both Step 2: Determine which direction the curve shifts. Step 3: Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity. Module 4: Market Equilibrium

6. Example 1:What happens to equilibrium price and quantity in the beef market if the price of corn feed falls? Step 1: Consider the event: a fall in the price of corn feed which essentially lowers the cost of producing beef. Hence, the supply curve shifts. Step 2: Since the cost of production falls, the supply curve shifts right (at at any given price, producers are now willing and able to produce a larger quantity). Step 3: Now conclude what happens to equilibrium price and quantity. The equilibrium price falls and the equilibrium quantity increases. Let’s take a closer look at the adjustment process. At the initial price P0, following the increase in supply, there is a surplus given by the distance a to c, Quantity demanded = a, new quantity supplied = c. It is this surplus that causes price to fall. Module 4: Market Equilibrium

7. Analyzing Changes in Equilibrium Example 2:What happens in the market for spam, an inferior good, if students’ incomes decrease? Step 1: Consider the event: a fall in income which is a demand determinant. Hence, the demand curve shifts. Step 2: Since the product in question is an inferior good, a decrease in income leads to an increase in demand Thus, the demand curve shifts right. Step 3: Now conclude what happens to equilibrium price and quantity. The equilibrium price rises and the equilibrium quantity increases. Let’s take a closer look at the adjustment process. At the initial price P0, following the increase in demand, there is a shortage given by the distance a to c, Quantity supplied = a, new quantity demanded = c. It is this shortage that causes price to rise. Module 4: Market Equilibrium

8. Simultaneous Shifts of Demand and Supply We will now analyze changes in equilibrium when both the demand and supply curves shift at the same time. There are four possible combinations of simultaneous shifts: • Increase in both demand and supply • Decrease in demand and supply • Increase in demand and decrease in supply 4.Decrease in demand and increase in supply The methodology used to analyze simultaneous shifts is as follows: 1. Analyze the demand shift and the supply shift separately using the 3-step process 2. Add the results from each shift to arrive at the combined effect Example 3: Suppose a frost destroys the grape crop. At the same time, the demand for wines has increased. Analyze the impact of these events in the wine market. Event 1: A frost destroys the grape crop. This event shifts the supply curve to the left. In the new equilibrium, P* ↑ and Q* ↓ Module 4: Market Equilibrium

9. Event 2: The demand for wines has increased. This event shifts the wine demand curve to the right. In the new equilibrium, P* ↑ and Q* ↑ The next step is to combine the effects on P* and Q* from the two events. The combined effects of the two events are: . Price rises unambiguously. The effect on quantity is indeterminate; it depends on which effect dominates. • If the supply effect dominates, equilibrium quantity falls. • If the demand effect dominates, equilibrium quantity rises. • If the demand and supply are of equal magnitudes, the equilibrium quantity remains the same. Module 4: Market Equilibrium