By Muhammad Shahid Iqbal Module No. 03 Equilibrium & Disequilibrium Engineering Economics

 Supply and demand is an economic model of price determination in a market.  It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equlibrium of price and quantity. Equilibrium in Market

 The four basic laws of supply and demand are:  If demand increases and supply remains unchanged, then it leads to higher equilibrium price and quantity.  If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and quantity.  If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity.  If supply decreases and demand remains unchanged, then it leads to higher price and lower quantity. Equilibrium in Market

Shortage  Let’s say that Loony’s uptown decides to sell their CDs for $3 each.  More than likely there will be a lot more people wanting to buy CDs than Loony’s has to sell.  Why? Because at such a low price, the quantity demanded is quite high. But Loony’s does not want to sell that many at such a low price.  This situation is called a shortage  Shortage - when Qd > Qs at current market price. Amount of Shortage = Qd - Qs Note - it is not correct to say Demand exceeds Supply, but rather quantity demanded exceeds quantity supplied.

Result of Shortage:  If you are the manager of Loony’s and you find that you are selling out of CDs at $3, what do you want to do? Raise the price  Buyers can’t get all they want. Therefore, competition among buyers drive prices up.  P will increase Results of Shortage P Q S D E P* Q* 0 P sh QsQs QdQd

 Let’s say that as the manager, you raised the prices of CDs to $20.  At $20 you would love to sell a lot of CDs, but not a lot of people are willing to pay $20 for a CD.  So the CDs keep piling up as they come in from your supplier, but they don’t seem to be going out the door in sales.  This situation is called a surplus  Surplus - when Q s > Q d at current market price. Amount of surplus = Q s - Q d Note - not correct to say Supply exceeds Demand, but rather that quantity supplied exceeds quantity demanded. Surplus

Result of Surplus:  As manager you have to decide what do with all these CDs that are piling up and not selling. What do you do? Have a sale!  Firms have more than they can sell. Therefore, firms lower price to sell the product.  As price decreases, Q d increases and Q s decreases  P will decrease Results of Surplus P Q S D E P* Q* 0 P sur QdQd QsQs Amount of Surplus

Note that if the price is below P* then there will be a shortage causing price to rise If the price is above P* then there will be a surplus causing price to fall It’s as if P* is a magnet that keeps drawing price to it (and consequently quantity to Q*) This magnet is sometimes called “The Invisible Hand” Equilibrium - where quantity demanded equals quantity supplied represented by the intersection of the demand and supply curves. Equilibrium Price (P*) - price where equilibrium occurs. Equilibrium in the Market

 Remember that Supply and Demand are drawn under the ceteris paribus assumption.  Any factors which cause Supply and/or Demand to change will affect equilibrium price and quantity.  Demand will change for any of the factors discussed previously.  An outward (rightward) shift in demand increases both equilibrium price and quantity  When consumers increase the quantity demanded at a given price, it is referred to as an increase in demand.  Increased demand can be represented on the graph as the curve being shifted to the right. At each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. Increase in Demand

In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. there has been an increase in demand which has caused an increase in (equilibrium) quantity. The increase in demand could also come from changing tastes and fashions, incomes, price changes in complementary and substitute goods, market expectations, and number of buyers. This would cause the entire demand curve to shift changing the equilibrium price and quantity. Increase in Demand P Q S D1D1 E P1P1 Q1Q1 0 D2D2 E’ P2P2 Q2Q2

 If the demand decreases, there is a shift of the curve to the left.  If the demand starts at D1, and decreases to D2  The equilibrium price will decrease, and the equilibrium quantity will also decrease.  The quantity supplied at each price is the same as before the demand shift, reflecting the fact that the supply curve has not shifted;  but the equilibrium quantity and price are different as a result of the change (shift) in demand. Decrease in Demand P Q S D1D1 E P1P1 Q1Q1 0 D2D2 E’ P2P2 Q2Q2

 An outward (rightward) shift in supply reduces the equilibrium price but increases the equilibrium quantity  When the suppliers' unit input costs change, or when technological progress occurs, the supply curve shifts.  Assume that someone invents a better way of growing wheat so that the cost of growing a given quantity of wheat decreases.  So, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 outward, to S2.  This increase in supply causes the equilibrium price to decrease from P1 to P2.  The equilibrium quantity increases from Q1 to Q2 as consumers move along the demand curve to the new lower price.  As a result of a supply curve shift, the price and the quantity move in opposite directions. Changes in Supply

P Q S1S1 D E P1P1 Q1Q1 0 S2S2 P2P2 Q2Q2 E’ Increase in Supply

 If the quantity supplied decreases,  If the supply curve starts at S2, and shifts leftward to S1,  The equilibrium price will increase and the equilibrium quantity will decrease as consumers move along the demand curve to the new higher price and associated lower quantity demanded.  Due to the change (shift) in supply, the equilibrium quantity and price have changed. Decrease in Supply P Q S1S1 D P1P1 Q1Q1 0 S2S2 P2P2 Q2Q2 E’ E

 Supply will change for any of the factors discussed previously.  For instance, let’s say that the government lowers taxes on CDs Changes in Supply P Q S D E P* Q* 0 S’ P*’ Q*’ E’

To determine the impact of both supply and demand changing:  First examine what happens to equilibrium price and quantity when just demand shifts.  Second, examine what happens to equilibrium price and quantity when just supply changes  Finally, add the two effects together. General Results:  When supply and demand move in the same direction Equilibrium price is ambiguous  When supply and demand move in opposite directions Equilibrium quantity is ambiguous Changes in Demand and Supply

Increase in Supply and Demand P Q S D E P* Q* 0 D’ E’ P*’ Q*’ S’

P Q S D E P* Q* 0 D’ E’ P*’= Q*’ S’ Increase in Supply and Demand