1. Chapter 3 Market Equilibrium and Shifts McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Learning Objectives Define excess supply and excess demand. Explain market equilibrium, and identify the equilibrium point on a supply-demand diagram. Describe the impact of supply and demand shifts. Discuss some causes of market shifts. Illustrate how changes in income affect the demand curve. Review the basics of elasticity. 3-2

3. Matching Supply and Demand Buyers and sellers are the two sides of markets. –Buyers determine demand. –Sellers determine supply. The buying and selling decisions are made independently. Thus, there is no reason why the amount buyers want to purchase is equal to the amount sellers want to produce. 3-3

4. Matching Supply and Demand Since the purchase and production decisions are independent, quantity demanded need not equal quantity supplied. There are 3 possible cases: –The case of excess demand –The case of excess supply –The case of market equilibrium 3-4

5. The Case of Excess Demand Excess demand occurs when, at a given price, buyers want to purchase more of a good or service than sellers are prepared to supply. Excess demand means that at a given price, quantity demanded exceeds quantity supplied. In this case, the market is in disequilibrium and prices are under upward pressure. 3-5

6. The Case of Excess Supply Excess supply occurs when, at a given price, sellers want to produce more of a good or service than buyers are willing to purchase. Excess supply means that at a given price, quantity supplied exceeds quantity demanded. In this case, the market is in disequilibrium and prices are under downward pressure. 3-6

7. Eliminating Excess Demand or Excess Supply The gap between quantity demanded and quantity supplied is closed by the market mechanism through changes in prices. Adam Smith, in The Wealth of Nations, used the term invisible hand to describe the market mechanism. Individual actions by buyers and sellers result in a positive outcome without any government intervention. 3-7

8. The Case of Market Equilibrium A market equilibrium occurs when quantity supplied and quantity demanded are equal. The equilibrium price is the price that causes quantity supplied to equal quantity demanded. At equilibrium, the market is in balance, and the amount that buyers want to purchase is equal to the amount sellers want to produce. Few markets are exactly in equilibrium. Markets are always moving toward equilibrium. 3-8

9. Supply-Demand Diagram The market equilibrium can be shown visually by drawing the demand and supply curves on the same graph. The equilibrium price is where the two curves intersect. At this price, quantity demanded equals quantity supplied. At any other price, quantity demanded and quantity supplied are not equal. 3-9

10. Supply and Demand for New Motor Vehicles Graph illustrates market equilibrium in new motor vehicle market At a price of $28,500, buyers are willing to purchase 16.5 million vehicles. At the same price, vehicle manufacturers are willing to produce 16.5 million vehicles. The market is in equilibrium since quantity demanded equals quantity supplied. 3-10

11. Supply and Demand Schedule for Go-Karts Price (Dollars) Quantity Demanded Quantity Supplied $6006,0003,000 $8005,5003,500 $1,0005,0004,000 $1,2004,500 $1,4004,0005,000 $1,6003,5005,500 $1,8003,0006,000 3-11

12. Equilibrium in Go-Kart Market At a price of $1,200, the market is in equilibrium. If price is $1,600, quantity demanded is 3,500, while quantity supplied is 5,500. This is a situation of excess supply. If price is $800, quantity demanded is 5,500, while quantity supplied is 3,500. This is a situation of excess demand. 6000 0 200 400 600 800 1000 1200 1400 1600 1800 2000 300035004000450050005500 Quantity of go-karts demanded and supplied Price of go-karts (dollars) A Demand curve Supply curve 3-12

13. Market Shifts The supply or demand curve shifts due to changes in factors other than price. A demand shift changes the amount buyers purchase at a given price. A supply shift changes the amount sellers provide at a given price. 3-13

14. Market Shifts and Equilibrium A market shift leads to a new equilibrium. Looking at the graph, the original equilibrium was at point A. The introduction of the Internet reduced demand for music CDs, causing the demand curve to shift to the left. 3-14

15. Market Shifts and Equilibrium The reduction in demand (shift of the demand curve) causes the equilibrium to shift to point B. At point B, the price is lower, and quantity demanded and quantity supplied is lower. Note: At point B, as at point A, quantity demanded equals quantity supplied. 3-15

16. Demand Shifts in the Cement Market A construction boom in China increased the world demand for cement. As a result, there was a shift to the right in the demand curve for cement, with the market equilibrium going from point A to point B. 3-16

17. Supply Shift: Market for Gasoline The graph to the left shows the impact of Hurricane Katrina on the gasoline market. Before the hurricane, equilibrium was at point A. The hurricane caused the supply curve to shift to the left, resulting in higher prices. 3-17

18. Shifts versus Movements It is critical to distinguish between a shift in the demand curve and a movement along the curve. When the demand curve shifts (right or left), the quantity demanded will increase or decrease while the price remains the same. A movement along the curve means that the demand curve remains constant, but the price changes. 3-18

19. Summary of the Effects of Supply and Demand Shifts Shift and Direction How We Say It Effect on Equilibrium Price Effect on Equilibrium Quantity Demand curve shifts left. “Demand decreases.” __ Demand curve shifts right. “Demand increases.” ++ Supply curve shifts left. “Supply decreases.” +_ Supply curve shifts right. “Supply increases.” _+ 3-19

20. Causes of Market Shifts Technological changes have a major impact on supply and demand. –Mass production has an impact on supply. –The Internet has an impact on demand for music CDs. By bringing in new buyers and sellers, globalization causes shifts in supply and demand. –Example: impact of China’s 1.3 billion consumers on world demand. 3-20

21. Causes of Market Shifts The financial markets play a large role by impacting the cost of borrowing money. –The interest rate is the cost of borrowing. Lower interest rates make it less costly to borrow, causing the demand to increase (shift to right) for products such as automobiles, homes, etc. 3-21

22. Impact of Rising Interest Rates on the Car Market Original demand curve for cars Q P Demand curve for cars with higher interest rates Price per car Q1Q1 Quantity of cars bought/sold Supply curve for cars P1P1 B A 3-22

23. Causes of Market Shifts Government action through spending and new regulation can impact supply and demand. –Demand for headphones is affected by hands-free legislation. Change in raw material prices is a major source of shifts in supply. Shifts in demand are often caused by changes in consumer tastes. 3-23

24. The Effect of Income on Demand Income is a major factor determining demand. In general, higher income leads to a shift to the right in the demand curve. But this is not true for all goods and services. Q Quantity demanded Price Demand curve for high income household Q1Q1 P Demand curve for low income household 3-24

25. Relationship between Income and Consumption Classify goods and services into three categories: –A normal good is one where demand rises more or less in step with income. –A luxury good is one whose demand rises sharply as income rises. –Inferior goods are ones whose demand actually falls as income rises. 3-25

26. Elasticity Measures to what extent quantity demanded or quantity supplied changes as prices change Demand is elastic if a small increase or decrease in price has a big impact on quantity demanded. Demand is inelastic if the quantity demanded doesn’t change very much, even if the price changes a lot. 3-26