Tutorial on Supply and Demand Model for a Competitive Market

7/29/2019 Tutorial on Supply and Demand Model for a Competitive Market

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In this tutorial we will develop the supply and demand model for a competitive market. We cover the

following specific concepts:

Demand Curve

Supply Curve

Market Equilibrium

Using the Model

A market is the place where buyers and sellers trade goods and services. A competitive market is a

market in which there are many buyers and sellers of the same good or service. Take tomatoes, for

example. You could buy tomatoes at several places.

Let's consider the Farmer's Market, where many farmers bring their tomatoes to a designated area, say

a public plaza or a parking lot, and display them to potential buyers. We will use this market to develop

a model of how a competitive market for tomatoes works: the Supply and Demand Model.

We begin by first collecting information on how many tomatoes buyers are willing to buy and at what

price. We gather this information into a table with two columns we call a Demand Schedule.

As you can see from the table, the quantity of tomatoes demanded decreases as the price of tomatoes

increases and vice versa. This inverse relationship between price and quantity is so common (for most

goods and services) that economists call it the Law of Demand.

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The Law of Demand: a higher price for a good or service, other things equal, leads people to demand a

smaller quantity of that good or service.

The information from the table can also be converted into a set of coordinates in the

x-y plane. The information from the quantity demanded column is labeled on the x-axis, while the

information in the price column is labeled on the y-axis.

So for instance, at a price of $1.00 per pound, the quantity demanded is 100 pounds of tomatoes. This is

our first x,y coordinate on the graph.

The second coordinate is found by reading the second row in the table, namely a price of $2.00 per

pound and a quantity demanded of 80 pounds of tomatoes.

We can continue to transfer the information from the table into the x,y plane by locating the rest of the

x,y (or price and quantity) combinations in the table.

Once we locate all the possible coordinates, we can trace a curve over them and construct what

economists term the Demand Curve.

Notice that the demand curve is downward sloping and illustrates the law of demand, which you will

remember states that a higher price for a good or service, other things equal, leads people to demand a

smaller quantity of that good or service.

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The Law of Demand: a higher price for a good or service, other things equal, leads people to demand asmaller quantity of that good or service.

Now that we have derived the demand curve we can analyze how changes in the price of tomatoes

affect the quantity of tomatoes demanded. Let's begin with an initial price and quantity combination of

$3 per pound and a quantity demanded of 60 pounds. Now let's ask the following question: holding

everything else the same, what would be the effect of an increase in the price of tomatoes to $4 per

pound?

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QUESTION: What would be the effect of an increase in the price of tomatoes to $4 per pound?

Using the information in the demand curve, it is clear that a price of $4 per pound corresponds to a

quantity demanded of 40 pounds of tomatoes. The effect of an increase in the price of tomatoes is a

reduction in the quantity demanded of tomatoes and a movement along the curve to a new set of x and

y coordinates.



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ANSWER: a movement along the demand curve due to a change in the price of the good.

Now let's try the reverse. Again, we'll start with the case of a price of $3 per pound and 60 pounds

demanded. Holding everything else constant, what would be the effect of a decrease in the price of

tomatoes to $2 per pound?

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QUESTION: What would be the effect of a decrease in the price of tomatoes to $2 per pound?

The effect is exactly the opposite of what happened when the price went up. If everything else stays the

same, then the effect of a reduction in the price would be an increase in the quantity demanded of

tomatoes (to 80 pounds) and a movement along the curve down to a set of new x and y coordinates (at

80, $2).

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ANSWER: a movement along the demand curve due to a change in the price of the good.

As we continue to analyze demand, it will help to keep in mind that a change in the quantity of

tomatoes demanded has to do with the affordability of tomatoes. When the price of tomatoes

increases, the quantity of tomatoes demanded (consumed) decreases because some buyers are not

ABLE to afford as many tomatoes as before. Notice that the buyer's willingness to buy tomatoes does

not change with the increase in price; she will want to buy tomatoes as much as before. She simply

cannot because tomatoes cost more than before.

True or False? A reduction in the price of tomatoes increases the demand for tomatoes.

This is false. Why? Look carefully at what we said earlier: A change in the price causes a movement along

the demand curve and a change in the quantity demanded of tomatoes. A change in price will affect the

quantity demanded, not demand itself. Confusing? Let's explore this further.



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FALSE: A change in the price causes a movement along the demand curve and a change in the quantity

demanded of tomatoes.

DEMAND VERSUS QUANTITY DEMANDED

What if Oprah swore that her latest diet, The Tomato Diet, was the most effective diet she ever tried?

What would happen to the market for tomatoes?

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QUESTION: What would happen to the demand for tomatoes in the United States if a new diet

promoting the importance of eating at least two tomatoes every day became popular?

In order to answer this question, let's consider the effect on the market for tomatoes using three means

of analysis:

intuition

demand schedule

demand curve

First, let's use our intuition. As we mentioned in the previous section, a change in the quantity of

tomatoes demanded has to do with the affordability of tomatoes. For instance, when the price of

tomatoes increase the quantity of tomatoes demanded (consumed) decreases because buyers are not

ABLE to afford as many tomatoes as before. It should be clear that this is not the effect of Oprah's

announcement since initially the cost of tomatoes is not going to change as a result of it. But, the new

Tomato Diet would increase the value buyers assign to tomatoes and hence they would be willing to buy

more tomatoes at every price than before, other things the same.

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QUESTION: What would happen to the demand for tomatoes in the United States if a new diet

promoting the importance of eating at least two tomatoes every day became popular?



ANSWER: In general, consumers would value tomatoes more than they did before. Consumers would be

willing to buy more tomatoes at every price than before.

Now let's use the demand schedule to analyze the effect of the Tomato Diet on the market. As we saw

in the second section of this tutorial, a change in price means a movement down the rows of the

demand schedule. For instance, an increase in the price of tomatoes from $3 per pound to $4 per poundmeans a movement down the demand schedule from a quantity demanded of 60 pounds to a quantity

demanded of 40 pounds.

But how would the demand schedule change to reflect the change in demand caused by the Tomato

Diet? If the willingness to buy tomatoes increases then all the values in the second column of the

demand schedule would increase. The result is that demand for tomatoes at every price is larger than

before. So now, for instance the quantity demanded at a price of $3 per pound has increased, from 60

tomatoes to 80.

So now let's consider what would happen to the demand curve. We now have two sets of coordinates,

one set that shows the quantity demanded before the Tomato Diet became popular, and the other that

shows quantity demanded after it became the rage.

If we move these new coordinates to the x-y axes we see that the demand curve actually shifts to the

right.

CHANGE IN QUANTITY DEMANDED REFLECTS:

A change in quantity buyers are able to afford.

Movement up or down the rows of demand schedule

Movement along the demand curve

CHANGE IN DEMAND RELECTS:

A change in how much buyers are willing to buy at every price.

A change in the values of the demand schedule

Shift of demand curve

Let's take another look at our earlier true or false question.

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False. We now understand that a change in the price will cause a movement along the demand curve

and a change in the quantity demanded of tomatoes, but it will not change the demand for tomatoes

across the board. The demand for tomatoes changes every time some determinant factor of demand,

other than the price, changes.



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FALSE.

SHIFTING THE DEMAND CURVE

The principal factors that determine the demand for any good are the price of the good, buyers'

preferences (or tastes), buyers' available income, the price of related goods, number of buyers, and

buyers' future expectations. And, in contrast to the effect of the price, which only changes the quantity

demanded, a change in any of the other factors will change the demand. We will examine each of thefactors to understand how they affect demand.

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Factors affecting demand:

Price

Buyers' preferences (or tastes)

Buyers' income

Price of related goods

Number of buyers

Buyers' Expectations

We begin with price. As we learned in an earlier segment of this tutorial, a change in the price of a good

results in a change in quantity demanded and a movement along the demand curve. A change in any of

the other determinants of demand for tomatoes would change the amount of tomatoes demanded at

every price and hence shift the demand curve.

Now let's consider buyers' preferences. What would happen to buyers' preferences if a scientific study

was published showing that eating tomatoes reduces the incidence of cancer in all populations? Well,

since most people care about their health, buyers would now value tomatoes more. In other words,

there would be a change in buyers' preferences or tastes for tomatoes. Let's recreate the effect of this

by using the demand schedule and the demand curve.



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QUESTION: How will a change in consumer tastes affect demand?

We will concentrate first on the demand schedule. Note that we have the two schedules, the first

showing demand before the report's publication and the second showing the increase in buyers' values

for tomatoes following the report. As you can see from the table, all the values in column 3 are larger

than the corresponding values in column 2. There has been a uniform increase in the demand for

tomatoes since people are willing to buy more tomatoes at every price.

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To obtain the new demand curve we locate the coordinates for the new column on the x-y plane. Notice

that the y coordinates stay the same, but the x coordinates are replaced by the information in the new

quantity demanded column. As you can see, this process will generate a completely new demand curve.

Also notice that this curve is located to the right of the original curve.

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So, to summarize, an increase in the preference buyers have for a good increases the demand for that

good and hence the demand curve shifts to the right. The opposite would happen if preferences

decreased.

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ANSWER: A change in consumer tastes changes the demand which leads to a shift of the demand curve.

An increase in buyer's preferences shifts demand curve to the right.

A decrease in buyers' preferences shifts demand curve to the left.



Now we'll explore what happens when there is a change in buyers' income. Let's say there is a recession

and the average income of all consumers goes down. What would be the effect of this on the demand

schedule and demand curve for tomatoes? Since consumers now have less purchasing power, their

consumption of most food products, including tomatoes, would go down. This means consumers would

be willing to buy fewer tomatoes at every price. In other words, the demand for tomatoes in all cases

would be lower than it was before. Let's create another hypothetical example using the demand

schedule and the demand curve to analyze this.

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QUESTION: What would be the effect of a drop in income on the demand schedule and demand curve

for tomatoes?

In the demand schedule, the lower demand is represented by a new column to the right of the original

one. As you can see, the numbers in this new column are all lower than the numbers in the originalcolumn. This represents a decrease in the demand for tomatoes since buyers are now willing to buy

fewer tomatoes at every price.

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for tomatoes?

At the same time, if we transferred the information in the new column to the x and y plane, as we did in

an earlier example, we would generate a new demand curve. This new demand curve will be located to

the left of the original demand curve.

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for tomatoes?

Therefore, a decrease in the demand resulted in a leftward shift of the demand curve. The opposite

would occur if the average income of tomato buyers increased.

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for tomatoes?



ANSWER: A change in buyers' incomes changes the demand which leads to a shift of the demand curve:

A decrease in buyers' income shifts demand curve to the left.

An increase in buyers' income shifts demand curve to the right.

Another factor that affects demand is a change in the price of related goods. What are related goods?

These goods are complements, goods that are usually consumed together, like peanut butter and jelly

or oatmeal and raisins. So what if the price of lettuce skyrocketed because of an invasion of a lettuce-

killing pest? How would demand for tomatoes, a standard ingredient in house salad, be affected?

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Complements goods that are consumed together (e.g. peanut butter and jelly or oatmeal and raisins).

QUESTION: how would the demand schedule and demand curve for TOMATOES change as a result of

this increase in the price of LETTUCE?

Even if the price of tomatoes stays the same, with the cost of lettuce higher than it was before, the cost

of a house salad is also higher than before. This means those buyers of tomatoes who only use tomatoes

as an ingredient in their house salads will be able to afford fewer quantities of house salads; hence they

will require fewer tomatoes. Buyers of tomatoes are now willing to buy fewer tomatoes at every price.

Again, in terms of the demand schedule, this means lower numbers in the quantity demanded column of the table.

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In terms of the demand curve, this means a shift to the left of the demand curve. The opposite would

occur if the price of lettuce went down. So in general, we can say that a change in the price of related

goods changes the demand and causes a shift in the demand curve. Be careful to note though, that in

this scenario, the cost (price) of tomatoes has not changed. People want to buy fewer tomatoes at every

price.

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Complements are not the only related goods that would affect demand. Consider the relationship

between butter and margarine. You may use either butter or margarine on your toast but not both.

Butter and margarine are substitutes, or goods that serve the same function in the mind of consumers.For these types of goods a rise in the price of one of the goods leads to an increase in the demand for

the other good. So for instance, an increase in the price of margarine will lead to an increase in the

demand for butter

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Substitutes: goods that serve the same function or service in the mind of consumers.



ANSWER: A change in the price of related good changes the demand which leads to a shift of the

demand curve.

For complements, an increase in the price of the complement decreases the demand for the main good.

For substitutes, an increase in the price of the substitute increases the demand for the other good.

An increase in the population also changes the demand curve for any good. For instance, imagine what

would happen to the demand for tomatoes at your local farmer's market if a new housing development

is finished and 4,000 more families move into your neighborhood.

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QUESTION: What would you expect to happen to the demand for tomatoes at your local farmer's

market if a new housing development is finished and 4,000 more families move into your

neighborhood?

Other things equal, there will be more people visiting the farmers market and we can assume many of

them will probably buy tomatoes. Therefore, the result of the increase in population around your

neighborhood is an increase in the demand for tomatoes at every price. By now you should be familiar

with the effect of an increase in the willingness to buy tomatoes at every price. So, an increase in the

population increases the demand for tomatoes which means a shift to the right of the demand curve.



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QUESTION: What would you expect to happen to the demand for tomatoes at your local farmer's

market if a new housing development is finished and 4,000 more families move into your

neighborhood?

ANSWER: a change in the number of buyers changes the demand which leads to a shift in the demand

curve.

The final factor affecting demand that we will consider here will be a change in buyers' expectations.

What if in May your city council announces a plan to close the Farmers' market this year in August, two

months before the originally planned end of season date? What would happen to the demand for

tomatoes? We could expect that those people considering buying tomatoes in September will probably

decide to buy them sooner. Demand in August would increase and the demand curve would shift to the

right. So in general, we can say that a change in buyers' expectations causes a shift in the demand curve.

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QUESTION: What would happen to the demand for tomatoes at your local farmer's market if your City

Council announces a plan to close the Farmers' market two months early this year?

ANSWER: A change in buyers' expectations changes the demand which leads to a shift of the demand

curve.

Here is a summary of all that we have said about the demand curve.

THE SUPPLY CURVE

We now move to the other side of the market: the supply of goods. We will continue to use the example

of the market for tomatoes at the local farmer's market. We begin by collecting information on how

many tomatoes sellers are willing to sell at different prices in a table called a supply schedule. This table

has two columns: the first column lists the price per pound of tomatoes, and the second column lists thequantity of tomatoes sold at different prices.

Now as we did with the demand schedule in the earlier segment of this tutorial, we fill in the table with

information on how many tomatoes sellers will sell and at what price.

Specifically, when the price of tomatoes is $2.00 per pound, the quantity supplied is 40 pounds.



When the price of tomatoes is $3.00 per pound, the quantity supplied is 60 pounds.

When the price of tomatoes is $4.00 per pound, the quantity supplied is 80 pounds, and so on.

As you can see from the table, the quantity of tomatoes supplied increases as the price of tomatoes

increases and vice versa.

The information from the table can also be converted into a set of coordinates in the x-y plane. The

information from the quantity supplied column is labeled on the x-axis, while the information in the

price column is labeled on the y-axis.

So for instance, at a price of $1.00 per pound, the quantity supplied is 20 pounds of tomatoes. This is our

first x,y coordinate on the graph.

The second coordinate is found by reading the second row in the table, namely a price of $2.00 per

pound and a quantity supplied of 40 pounds of tomatoes.

We can continue to transfer the information from the table into the x,y plane by locating the rest of the

x,y (or price and quantity) combinations in the table.

Once we locate all the possible coordinates, we can trace a curve over them and construct what

economists term the supply curve.

Notice that the information represented by the supply curve is exactly the same information we had in

the supply schedule. Also notice the supply curve is upward-slopping.

We can use the supply curve for tomatoes to analyze how changes in the price of tomatoes affect the

quantity of tomatoes supplied. Let's begin with an initial price and quantity combination; say, $3 per

pound and a quantity supplied of 60 pounds. Now let's ask ourselves the following question: holding

everything else constant, what would be the effect of an increase in the price of tomatoes to $4 per

pound?

Using the information in the supply curve, it is clear that a price of $4 corresponds to a quantity supplied

of 80 pounds of tomatoes. So the effect of the increase in the price of tomatoes is an increase in the

quantity supplied of tomatoes and a movement along the curve to a new set of x,y coordinates.

Now let's try the reverse. Again, starting with the case of the $3 price per pound and 60 pound quantity

supplied. Ask yourself the question, holding everything else the same, what would be the effect of a

decrease in the price of tomatoes to $2 per pound?

Exactly the opposite of what happened when the price went up. If everything else stays the same, then

the effect of a reduction in the price would be a decrease in the quantity supplied of tomatoes (to 40

pounds) and a movement along the curve down to a new set of coordinates.

SHIFTING THE SUPPLY CURVE



As we can see on our supply curve, when the price of tomatoes changes, there is a change in the

quantity supplied and a movement along the supply curve.

Now consider the effect of an increase in the cost of gas. From the farmer's perspective, gasoline is

needed in order to transport tomatoes from the farm to the farmers market. If the price of gasoline

were to increase, the cost of selling tomatoes would also increase. As a result, farmers would be willingto sell fewer tomatoes than before the increase in costs. In other words, since farmers have to pay more

to transport tomatoes to the farmers market, they are going to adjust accordingly and supply fewer

tomatoes at every price.

Gasoline is considered here an input of production, a good that is used to produce another good. In the

market for tomatoes, it is a determinant factor of supply in that a change in the price of gasoline will

change the amount of tomatoes supplied at every price and hence shift the supply curve.

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Input of production: a good that is used to produce another good.

Other principal factors of supply include changes in technology, the number of sellers, and sellers'

expectations. The relationship of these factors can be shown in the form of an equation, in which the

supply for any product is a function of the change in that factor. So in the case of our tomato market,

supply of tomatoes is a function of the price of the inputs needed to produce or sell tomatoes, the level

of technology needed to sell tomatoes, and sellers' expectations.

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Factors affecting supply include changes in:

Price

Price of inputs

Technology

Number of sellers

Sellers' expectations

Let's explore how changes in these factors affect the supply schedule and supply curve beginning first

with an increase in the price of gasoline. We could represent a decrease in the supply for tomatoes by

adding a new column representing a whole new supply schedule. This new supply schedule represents

the fact that the sellers' cost of producing tomatoes has increased due to the higher transportation

costs. As you can see from the table, all the values in column 3 are smaller than the corresponding



values in column 2. There has been a uniform decrease in the supply for tomatoes since farmers are

willing to sell fewer tomatoes at every price.

Now we will locate the new column in the diagram by using the same y coordinates and replacing the x

coordinates with the information in the new quantity supplied column.

The change in the price of inputs changes the supply which leads to a shift of the supply curve. An

increase in the price of the inputs shifts the supply curve to the left, and a decrease in the price of the

inputs shifts the supply curve to the right.

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Bottom line: A change in the price of inputs changes the supply which leads to a shift of the supply

curve.

An increase in the price of the inputs shifts the supply curve to the left.

A decrease in the price of the inputs shifts the supply curve to the right.

A change in technology used to produce a good also changes the supply for that good. For instance,

supposed a new fertilizer is introduced for the cultivation of tomatoes. This new fertilizer increases the

productivity of the land by allowing farmers to produce more tomatoes per acre of farm land. What

would be the effect of this on the supply for tomatoes? If we assume this new and more productive

fertilizer costs the same as the old one, then farmers using the new fertilizer are able to produce more

tomatoes without increasing their costs. Therefore, farmers at the farmer's market will be willing to

offer more tomatoes at every price. In other words, the supply for tomatoes will increase.

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QUESTION: How would the supply schedule and supply curve change as a result of this change in the

productivity of the land? (Assume the new fertilizer costs the same as the old one)

An increase in the productivity of the land due to a better fertilizer is an increase in the technology used

to produce tomatoes. In terms of the supply schedule, this means higher numbers in the quantity

supplied column of the table.

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In terms of the supply curve, this means a shift to the right of the supply curve.

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So a change in the technology changes the supply which leads to a shift of the supply curve. An increase

in the technology shifts the supply curve to the right, and a decrease in the technology shifts the supply

curve to the left.

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ANSWER: A change in the technology changes the supply which leads to a shift of the supply curve.

An increase in the technology shifts the supply curve to the right.

A decrease in the technology shifts the supply curve to the left.

So a change in the technology changes the supply which leads to a shift of the supply curve. An increase

in the technology shifts the supply curve to the right, and a decrease in the technology shifts the supply

curve to the left.

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ANSWER: A change in the technology changes the supply which leads to a shift of the supply curve.

An increase in the technology shifts the supply curve to the right.

A decrease in the technology shifts the supply curve to the left.

A decrease in the number of sellers also changes the supply curve for any good. For instance, imagine

what would happen to the supply for tomatoes in your local farmer's market if all of a sudden a storm

destroyed half the harvest of tomatoes and drove half of the farmers out of business.

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QUESTION: How would the supply schedule and supply curve change as a result of the decrease in the

number of farmers? (Assume everything else stayed the same)

Other things equal, there will be fewer numbers of farmers selling their tomatoes at the farmer's

market. Therefore, the result of the now fewer number of farmers would be a decrease in the supply of

tomatoes at every price.

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In terms of the supply schedule, this means smaller numbers in the quantity supplied column of the

table. In terms of the supply curve, this means a shift to the left of the supply curve.

So a change in the # of sellers changes the supply which leads to a shift of the supply curve. An increase

in the # of sellers shifts the supply curve to the right, and a decrease in the # of sellers shifts the supply

curve to the left.

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ANSWER: A change in the # of sellers changes the supply which leads to a shift of the supply curve.

An increase in the # of sellers shifts the supply curve to the right.

A decrease in the # of sellers shifts the supply curve to the left.

Finally, a change in sellers' expectations also changes the supply for any particular good. For instance,

suppose in May your city council announces a plan to close the Farmers' market this year in August, two

months before the originally planned date. What would happen to the supply for tomatoes at your local

farmer's market if your City Council announces a plan to close the Farmers' market two months sooner

than the original date?

______________________



QUESTION: What would happen to the supply curve for tomatoes at your local farmer's market if your

City Council announces a plan to close the Farmers' market two months sooner than the original date?

(Assume everything else stayed the same)

An announcement like this one in May will also change how willing farmers are to sell their tomatoes in

May. Since they will be worried about not being able to sell their entire inventory, farmers will begin tobring more tomatoes to every farmer's market. In other words, the supply for tomatoes in May would

increase.

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QUESTION: What would happen to the supply curve for tomatoes at your local farmer's market if your

City Council announces a plan to close the Farmers' market two months sooner than the original date?

(Assume everything else stayed the same)

ANSWER: Since farmers will be worried about not being able to sell their entire inventory, they will

begin to bring more tomatoes to every farmer's market. In other words, the supply curve for tomatoes

in May would shift to the right.

MARKET EQUILIBRIUM

Now let's analyze supply and demand together. For this, we will combine both the supply and demand

schedule for tomatoes in the farmer's market into one. At the same time, we will put the demand and

supply curves we constructed into the same diagram.

As you can see from both the table and the diagram, there is one specific price at which both the

quantity demanded and the quantity supplied is exactly the same. At a price of $3.00 per pound both

the quantity demanded and the quantity supplied of tomatoes is 60 pounds.

Suppose the price for tomatoes at the farmer's market were $2.00 instead of $3.00. At this price of

$2.00, buyers want to buy 80 pounds of tomatoes but sellers are willing to sell only 40. Since there are

more people willing to buy than willing to sell we say there is a shortage of supply in this market.

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Shortage: when the quantity demanded exceeds the quantity supplied.

If quantity demanded is greater than quantity supplied, sellers have an incentive to increase the price.

Over the long-run, what would happen in this market if the market price for tomatoes were $2 (so that

the market was not in equilibrium)? It might help to think of a shortage as the equivalent of a long line.



Imagine what would happen in the farmers' market if there were more tomatoes demanded by buyers

than what farmers were willing to sell. There would be a long line of buyers at every tomato stand

waiting to buy tomatoes. Many of these buyers would happily pay a higher price in order to avoid the

wait. Farmers know this, so they would raise the price of tomatoes in order to collect larger revenues.

This shortage will give an incentive to sellers to increase the price and hence the market will movetowards equilibrium.

Suppose the price for tomatoes in the farmer's market were $4.00 per pound instead of $3.00. At this

price of $4.00, buyers want to buy only 40 pounds of tomatoes but sellers are willing to sell 80 pounds.

Since there are more people willing to sell than willing to buy we say there is a surplus in this market.

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Surplus: when the quantity supplied exceeds the quantity demanded.

Over the long-run, what would happen in this market if the market price for tomatoes were $4 (so that

the market was not in equilibrium)? Most farmers will end up with tomatoes left at the end of the day.

They would have to take all these tomatoes back and perhaps try to store them until next week's

market. Since there would be a cost associated with transporting and storing these leftover tomatoes,

many farmers would be happy to lower the price of their tomatoes in order to get rid of them this week.

The result of this would be a decrease in the price of tomatoes.

Over the long-run, this excess will give an incentive to sellers to decrease the price and hence the

market will move towards equilibrium. This incentive for sellers to reduce the price would stop at a price

of $3, since at that price the excess of tomatoes is eliminated.

So, to summarize, if the market price were lower than the equilibrium price, there would be a shortage

of supply in this market. On the other hand, if the equilibrium price were higher than the equilibrium

price, there would be an excess of supply in this market. The result of either situation would be an

incentive for sellers to change their prices to a price closer to the equilibrium price.

USING MODEL

The supply and demand model can be used to make predictions about the effect of a particular change

that occurs in a market, specifically the effect of the change over the equilibrium price and the

equilibrium quantity. We begin by assuming that the market is currently in equilibrium. This is the statusquo. A good framework to analyze the effect of a change to the status quo is to ask the following

questions about the affect of the change: Which curve is going to shift? Which direction is the shift?

What happens to the equilibrium price and the equilibrium quantity?

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For every change to the status quo, try to answer the following four questions:

Which curve is going to shift?

Which direction is the shift?

What happens to the equilibrium price?

What happens to the equilibrium quantity?

To see how this works, let's analyze the effect of an increase in the available income buyers have to buy

tomatoes. What would be effect of an increase in the available income buyers have to buy tomatoes?

To see how this works, let's analyze the effect of an increase in the available income buyers have to buy

tomatoes. What would be effect of an increase in the available income buyers have to buy tomatoes?

First question: which curve is going to shift? Remember buyers' income is one of the factors that

determine the demand for a good. So an increase in buyers' available income to buy tomatoes willprobably affect the demand for tomatoes.

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Question:


Now the second question: which direction is the shift? As discussed before, the result of an increase in

the available income for buyers will be an increase in demand and hence a shift to the right of the

demand curve. In other words, since buyers have more purchasing power they are going to be willing to

buy more tomatoes at every price.

______________________

Questions:



Third question: what happens to the equilibrium price? Following the diagram, the shift in the demand

curve increases the equilibrium price in the market.

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Questions:




And finally the fourth question: what happens to the equilibrium quantity? If the equilibrium price goes

up we know the quantity supplied will increase, and this is evident in the diagram by a larger quantity

supplied at the new equilibrium price.

______________________

Questions:





Therefore, the result of the increase in buyers' income was a shift of the demand curve to the right and

an increase in both the equilibrium price and quantity of tomatoes

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Bottom line: an increase in the available income for buyers (assuming this is a normal good) shifts the

demand curve to the right, increases the equilibrium price and increases the equilibrium quantity in the

market.

Let's do another example. What would be the effect of an increase in the price farmers have to pay for

the gasoline they use to transport their tomatoes to the farmer's market? Before moving on, first try to

analyze the scenario by answering the four questions we used for the first example.

______________________

Questions:







As discussed before, the result of an increase in the price sellers pay for the inputs needed to produce

tomatoes is a decrease in supply and hence a shift of the supply curve.

Following the diagram, the shift in the supply curve also increases the equilibrium price in the market.

If the equilibrium price goes up we know the quantity demanded will go down, and this is evident in the

diagram by a smaller quantity of tomatoes demanded at the new equilibrium price.

The result of the increase in the price of the inputs was a shift to the left of the supply curve, an increase

in the equilibrium price and a decrease in equilibrium quantity of tomatoes.

______________________

Bottom line: an increase in price of any of the inputs shifts the demand curve to the left, increases the

equilibrium price and decreases the equilibrium quantity in the market.

Summing It Up

When the demand curve shifts to the right the equilibrium price and equilibrium quantity increase.

When the demand curve shifts to the left the equilibrium price and equilibrium quantity decrease.

When the supply curve shifts to the left the equilibrium price increases and equilibrium quantity

decreases. When the supply curve shifts to the right the equilibrium price decreases and equilibrium

quantity increases. When both the supply and demand curve shift to the right the equilibrium quantity

increases. The equilibrium price is ambiguous in this case. When both the supply and demand curve shift

to the left the equilibrium quantity decreases. The equilibrium price is ambiguous in this case. When the

demand curve shifts to the right and the supply curve shifts to the left the equilibrium price increases.

The equilibrium quantity is ambiguous in this case. When the demand curve shift to the left and the

supply curve shifts to the right the equilibrium price decreases. The equilibrium quantity is ambiguous in

this case.

The supply and demand model is the cornerstone of modern economic theory. It has a wide range of

applications. For example, it can be used to understand issues such as: the effect of higher gas prices on

sales of SUVs, the effect of the minimum wage on unemployment, the effect on the market of a

decrease in the price of flights by one airline, etc.



The model can also be used to answer many other questions regarding your daily life such as: how hard

should you study for your next exam? Or what are your chances of finding a date to go to the movies

with you this weekend?

So you will use it regularly throughout the course. It's important for you to become very familiar with it.

Go over this tutorial more than once if you have to, but do make sure you become an expert on the

material.

Documents

Tutorial on Supply and Demand Model for a Competitive Market