Markets can be relatively erratic if consumers are fickle, forever changing their minds. Changes in income, the prices of related goods, expectations, or taxes also shift demand curves. Fluctuations in the business climate disrupt the supply side; resource prices vary, and technology advances, altering costs and, thus, supplies. Changes in the prices of related products, producer expectations, or taxes and regulations also shift supply curves.
Changes in Supply
Suppose the initial supply and demand for American wheat are S0 and D0 in Figure 1; Q0 bushels of wheat sell at price P0 at equilibrium point a. If fantastic weather yields a bumper crop, expanding supply from S0 to S1 in Panel A, the market now clears at point b. Price drops from P0 to P1, and the equilibrium quantity rises from Q0 to Q1. Conclusion? Expanding supplies push down prices and increase the quantities sold.
Figure 1 Price and Quantity Effects of Changes in Supply
Panel A illustrates that increases in supply put downward pressures on prices. When supply increases from S0 to S1, prices fall to P1 and quantities sold rise from Q0 to Q1 (equilibrium point a to point b). The opposite is true when supply falls, as depicted in Panel B. Supply declines from S0 to S2, causing prices to rise and quantity sold to fall (from point a to point c).
Now consider what happens if higher seed or fuel prices raise farmers' costs. Starting at the original equilibrium point a, now shown in Panel B, supply declines from S0 to S2. The equilibrium price rises from P0 to P2 at point c, while equilibrium quantity falls from Q0 to Q2. Thus, decreases in supply exert upward pressures on prices and decrease the quantities traded in the market.
We have held demand constant while shifting supply. Let's hold supply constant to see how shifts of demand curves affect equilibrium prices and quantities.
Changes in Demand
The original demand D0 and supply S0 from Figure 1 are replicated in Figure 2. If rising oil prices stimulated gasohol production from grain, the demand for wheat would grow to, say, D1 in Panel A. Equilibrium price would rise to P1, and quantity to Q1 (point b). Thus, expanding demand exerts upward pressure on both prices and quantities.
Figure 2 Price and Quantity Effects of Changes in Demand
Increases in demand put upward pressures on price. In Panel A, when demand increases from D0 to D1, equilibrium price rises to P1 and equilibrium quantity sold rises as well, to Q1. As Panel B illustrates, declines in demand (from D0 to D2) cause prices to fall (from P0 to P2) and equilibrium quantity to decline (from Q0 to Q2).
Now suppose that a horde of dietary faddists replace wheat bread with oatbran loaf, reducing demand for U.S. wheat from D0 to D2 in Panel B of Figure 2. Equilibrium price and quantity both fall (point c). Thus, declines in demand exert downward pressures on both prices and quantities.
In Chapter 3, we distinguished a change in demand from a change in the quantity demanded, and changes in supply from changes in the quantity supplied: Changes in demand (supply) refer to shifts of the curve, while changes in the quantity demanded (supplied) refer to movements along a curve. Compare the two equilibrium positions in Figure 1. Notice that changes in the quantities demanded result from changes in supply. It would be wrong to say that demand changed; it was supply that shifted. Similarly, Figure 2 shows that changes in quantities supplied are caused by changes in demand. Demand shifted; supply did not change. This illustrates how failing to keep your terminology straight in this area can lead to confusion and error.
Please review any of this analysis that seems a bit murky before reading on because now we are going to shift supply and demand curves simultaneously.
Shifts in Supply and Demand
Multiple and conflicting forces sometimes bombard markets. For example, technology may advance when consumer tastes are also changing. We need to fit each change into our supply/demand framework to assess net changes in equilibrium prices and quantities, which depend on the slopes of supply and demand curves and the relative magnitudes of shifts.
The wheat market is now shown in Figure 3, allowing us to examine what happens when supply and demand curves shift in the same direction. Demand and supply are originally at D0 and S0, respectively, with equilibrium price at P0 and equilibrium output at Q0 (point a).
Figure 3 Price and Quantity Effects of Increases in Both Supply and Demand
When both supply and demand increase, equilibrium quantity traded must rise, but the change in price depends upon the relative magnitudes of the two shifts. When supply and demand both decline, quantity must fall, and again, the price change is uncertain, being dependent on the relative magnitudes of the two shifts.
Suppose Russia began buying more U.S. wheat in a year we experienced a bumper crop. These events would increase both demand and supply in Figure 3. This information by itself leaves us unsure whether the price at the new equilibrium (point b) is higher or lower than P0, but equilibrium quantity (now Q1) definitely exceeds its old value of Q0. Thus, when both demand and supply grow, quantity increases but price changes are unknowable without more information.
You may have realized whether the new price of wheat will be above or below P0 depends on the relative magnitudes of the two shifts. For example, if Russia's new demand were relatively large and drove market demand to D2, equilibrium price would rise (point c). Symmetric results occur if both demand and supply decrease, say, from D1 and S1 to D0 and S0: Quantity falls, but price changes cannot be predicted without more information.
What happens if supplies and demands move in opposite directions? The wheat market is again initially in equilibrium at point a in Figure 4. Equilibrium moves to point b if population growth boosts demand to D1 while drought cuts supply to S1. Price increases to P1, but we need more information to be sure whether quantity increases, decreases, or remains constant. In this case, quantity changes depend on the relative magnitudes of shifts and relative slopes of the demand curves and supply curves. Thus, if demand rises while supply falls, the price rises, but we cannot predict quantity changes without more information.
Figure 4The Effects of an Increase in Demand and a Decrease in Supply
How the price changes is predictable when demand and supply curves move in opposite directions, but the quantity adjustment is not. When demand grows and supply falls, price will rise, but the change in equilibrium quantity depends on the nature of the two shifts. When demand declines and supply increases, prices will fall, but again the change in quantity is uncertain without more information.
Similar results occur if demand falls and supply rises. Thus, declines in demand and increases in supply cause prices to fall, but predicting quantity changes requires more data. Figure 5 summarizes how changes in supplies and demands affect prices and quantities in the short run. A good review of this section is to match the relevant segments of Figure 5 with the possible adjustments listed in its caption.
Figure 5 Summary of Price and Quantity Responses to Changing Demands and Supplies
Volatile prices and production sometimes plague market economies. High prices and abundant profit opportunities cause existing firms to expand and new firms to enter the market, boosting supply and driving the high price down. Low prices and inadequate profits, on the other hand, cause some firms to exit an industry, while the survivors cut back on output and reduce their hiring. This pushes low prices up. There may be long lags between planning for production and selling output, so prices and outputs can swing wildly before finally settling at equilibrium.
Suppose, for example, that wheat prices soared after a drought devastated a crop. The high price relative to cost could cause wheat farmers to overproduce in the next year, driving the price down. This low price could cause discouraged farmers to cut production back too much in the third year, causing the price to again rise far above production costs. And so on. Similarly cyclical price swings have been observed for engineering wages (it takes four years to get an engineering degree) and in other markets in which training and/or production take a long time.