1.2 Module 5: Supply and Equilibrium

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The Supply Curve

Some parts of the world are especially well suited to growing cotton, and the United States is one of those. But even in the United States, some land is better suited to growing cotton than other land. Whether American farmers restrict their cotton-growing to only the most ideal locations or expand it to less suitable land depends on the price they expect to get for their cotton. Moreover, there are many other areas in the world where cotton could be grown—such as Pakistan, Brazil, Turkey, and China. Whether farmers there actually grow cotton depends, again, on the price.

So just as the quantity of cotton that consumers want to buy depends on the price they have to pay, the quantity that producers are willing to produce and sell—the quantity supplied—depends on the price they are offered.

The Supply Schedule and the Supply Curve

The table in Figure 5-1 shows how the quantity of cotton made available varies with the price—that is, it shows a hypothetical supply schedule for cotton.

The supply schedule for cotton is plotted to yield the corresponding supply curve, which shows how much of a good producers are willing to sell at any given price. The supply curve and the supply schedule reflect the fact that supply curves are usually upward sloping: the quantity supplied rises when the price rises.

A supply schedule works the same way as the demand schedule shown in Figure 4-1: in this case, the table shows the number of pounds of cotton farmers are willing to sell at different prices. At a price of $0.50 per pound, farmers are willing to sell only 8 billion pounds of cotton per year. At $0.75 per pound, they’re willing to sell 9.1 billion pounds. At $1, they’re willing to sell 10 billion pounds, and so on.

In the same way that a demand schedule can be represented graphically by a demand curve, a supply schedule can be represented by a supply curve, as shown in Figure 5-1. Each point on the curve represents an entry from the table.

Suppose that the price of cotton rises from $1 to $1.25; we can see that the quantity of cotton farmers are willing to sell rises from 10 billion to 10.7 billion pounds. This is the normal situation for a supply curve, reflecting the general proposition that a higher price leads to a higher quantity supplied. Some economists refer to this relationship as the law of supply.

Shifts of the Supply Curve

Until recently, cotton remained relatively cheap for several decades. One reason is that the amount of land cultivated for cotton expanded by more than 35% from 1945 to 2007. However, the major factor accounting for cotton’s relative cheapness was advances in the production technology, with output per acre more than quadrupling from 1945 to 2007. Figure 5-2 illustrates these events in terms of the supply schedule and the supply curve for cotton.

The adoption of improved cotton-growing technology generated an increase in supply—a rise in the quantity supplied at any given price. This event is represented by the two supply schedules—one showing supply before the new technology was adopted, the other showing supply after the new technology was adopted—and their corresponding supply curves. The increase in supply shifts the supply curve to the right.

The table in Figure 5-2 shows two supply schedules. The schedule before improved cotton-growing technology was adopted is the same one as in Figure 5-1. The second schedule shows the supply of cotton after the improved technology was adopted. Just as a change in demand schedules leads to a shift of the demand curve, a change in supply schedules leads to a shift of the supply curve—a change in supply. This is shown in Figure 5-2 by the shift of the supply curve before the adoption of new cotton-growing technology, S₁, to its new position after the adoption of new cotton-growing technology, S₂. Notice that S₂ lies to the right of S₁, a reflection of the fact that quantity supplied rises at any given price.

As in the analysis of demand, it’s crucial to draw a distinction between such shifts of the supply curve and movements along the supply curve—changes in the quantity supplied arising from a change in price. We can see this difference in Figure 5-3. The movement from point A to point B is a movement along the supply curve: the quantity supplied rises along S₁ due to a rise in price. Here, a rise in price from $1 to $1.50 leads to a rise in the quantity supplied from 10 billion to 11.2 billion pounds of cotton. But the quantity supplied can also rise when the price is unchanged if there is an increase in supply—a rightward shift of the supply curve. This is shown by the rightward shift of the supply curve from S₁ to S₂. Holding the price constant at $1, the quantity supplied rises from 10 billion pounds at point A on S₁ to 12 billion pounds at point C on S₂.

The increase in quantity supplied when going from point A to point B reflects a movement along the supply curve: it is the result of a rise in the price of the good. The increase in quantity supplied when going from point A to point C reflects a shift of the supply curve: it is the result of an increase in the quantity supplied at any given price.

Understanding Shifts of the Supply Curve

Figure 5-4 illustrates the two basic ways in which supply curves can shift. When economists talk about an “increase in supply,” they mean a rightward shift of the supply curve: at any given price, producers supply a larger quantity of the good than before. This is shown in Figure 5-4 by the rightward shift of the original supply curve S₁ to S₂. And when economists talk about a “decrease in supply,” they mean a leftward shift of the supply curve: at any given price, producers supply a smaller quantity of the good than before. This is represented by the leftward shift of S₁ to S₃.

Any event that increases supply shifts the supply curve to the right, reflecting a rise in the quantity supplied at any given price. Any event that decreases supply shifts the supply curve to the left, reflecting a fall in the quantity supplied at any given price.

Economists believe that shifts of the supply curve for a good or service are mainly the result of five factors (though, as in the case of demand, there are other possible causes):

• Changes in input prices
• Changes in the prices of related goods or services
• Changes in technology
• Changes in expectations
• Changes in the number of producers

Changes in Input PricesTo produce output, you need inputs. For example, to make vanilla ice cream, you need vanilla beans, cream, sugar, and so on. An input is any good or service that is used to produce another good or service. Inputs, like outputs, have prices. And an increase in the price of an input makes the production of the final good more costly for those who produce and sell it. So producers are less willing to supply the final good at any given price, and the supply curve shifts to the left. For example, fuel is a major cost for airlines. When oil prices surged in 2007–2008, airlines began cutting back on their flight schedules and some went out of business. Similarly, a fall in the price of an input makes the production of the final good less costly for sellers. They are more willing to supply the good at any given price, and the supply curve shifts to the right.

Changes in the Prices of Related Goods or ServicesA single producer often produces a mix of goods rather than a single product. For example, an oil refinery produces gasoline from crude oil, but it also produces heating oil and other products from the same raw material. When a producer sells several products, the quantity of any one good it is willing to supply at any given price depends on the prices of its other co-produced goods.

This effect can run in either direction. An oil refiner will supply less gasoline at any given price when the market price of heating oil rises, shifting the supply curve for gasoline to the left. But it will supply more gasoline at any given price when the market price of heating oil falls, shifting the supply curve for gasoline to the right. This means that gasoline and other co-produced oil products are substitutes in production for refiners.

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In contrast, due to the nature of the production process, other goods can be complements in production. For example, producers of crude oil—oil-well drillers—often find that oil wells also produce natural gas as a by-product of oil extraction. The higher the price at which a driller can sell its natural gas, the more oil wells it will drill and the more oil it will supply at any given price for oil. As a result, natural gas is a complement in production for crude oil.

Changes in TechnologyWhen economists talk about “technology,” they don’t necessarily mean high tech—they mean all the methods people can use to turn inputs into useful goods and services. In that sense, the whole complex sequence of activities that turn cotton from Pakistan into the pair of jeans hanging in your closet is technology.

Improvements in technology enable producers to sell more of their product at the same price. When a better technology becomes available, reducing the cost of production, supply increases, and the supply curve shifts to the right. Improved technology enabled farmers to more than quadruple cotton output per acre planted over the past several decades. Improved technology is also the main reason that, until recently, cotton remained relatively cheap even as worldwide demand grew.

Changes in ExpectationsJust as changes in expectations can shift the demand curve, they can also shift the supply curve. When suppliers have some choice about when they put their good up for sale, changes in the expected future price of the good can lead a supplier to supply less or more of the good today.

For example, consider the fact that gasoline and other oil products are often stored for significant periods of time at oil refineries before being sold to consumers. In fact, storage is usually part of producers’ business strategy. Knowing that the demand for gasoline peaks in the summer, oil refiners usually store some of their gasoline produced during the spring for summer sale. Similarly, knowing that the demand for heating oil peaks in the winter, they usually store some of their heating oil produced during the fall for winter sale. In each case, there’s a decision to be made between selling the product now versus storing it for later sale. Which choice a producer makes depends on a comparison of the current price versus the expected future price. This example illustrates how changes in expectations can alter supply: an increase in the anticipated future price of a good or service reduces supply today, a leftward shift of the supply curve. But a fall in the anticipated future price increases supply today, a rightward shift of the supply curve.

Changes in the Number of ProducersJust as changes in the number of consumers affect the demand curve, changes in the number of producers affect the supply curve. Let’s examine the individual supply curve, which shows the relationship between quantity supplied and price for an individual producer. For example, suppose that Mr. Silva is a Brazilian cotton farmer and that panel (a) of Figure 5-5 shows how many pounds of cotton he will supply per year at any given price. Then S_Silva is his individual supply curve.

Panel (a) shows the individual supply curve for Mr. Silva, S_Silva, the quantity of cotton he will sell at any given price. Panel (b) shows the individual supply curve for Mr. Liu, S_Liu. The market supply curve, which shows the quantity of cotton supplied by all producers at any given price, is shown in panel (c). The market supply curve is the horizontal sum of the individual supply curves of all producers.

The market supply curve shows how the combined total quantity supplied by all individual producers in the market depends on the market price of that good. Just as the market demand curve is the horizontal sum of the individual demand curves of all consumers, the market supply curve is the horizontal sum of the individual supply curves of all producers.

Assume for a moment that there are only two producers of cotton, Mr. Silva and Mr. Liu, a Chinese cotton farmer. Mr. Liu’s individual supply curve is shown in panel (b). Panel (c) shows the market supply curve. At any given price, the quantity supplied to the market is the sum of the quantities supplied by Mr. Silva and Mr. Liu. For example, at a price of $2 per pound, Mr. Silva supplies 3,000 pounds of cotton per year and Mr. Liu supplies 2,000 pounds per year, making the quantity supplied to the market 5,000 pounds.

Clearly, the quantity supplied to the market at any given price is larger with Mr. Liu present than it would be if Mr. Silva were the only supplier. The quantity supplied at a given price would be even larger if we added a third producer, then a fourth, and so on. So an increase in the number of producers leads to an increase in supply and a rightward shift of the supply curve.

For a review of the factors that shift supply, see Table 5-1.

!world_eia!ONLY CREATURES SMALL AND PAMPERED

During the 1970s, British television featured a popular show titled All Creatures Great and Small. It chronicled the real life of James Herriot, a country veterinarian who tended to cows, pigs, sheep, horses, and the occasional house pet, often under arduous conditions, in rural England during the 1930s. The show made it clear that in those days the local vet was a critical member of farming communities, saving valuable farm animals and helping farmers survive financially. And it was also clear that Mr. Herriot considered his life’s work well spent.

But that was then and this is now. According to a recent article in the New York Times, the United States has experienced a severe decline in the number of farm veterinarians over the past two decades. The source of the problem is competition. As the number of household pets has increased and the incomes of pet owners have grown, the demand for pet veterinarians has increased sharply. As a result, vets are being drawn away from the business of caring for farm animals into the more lucrative business of caring for pets. As one vet stated, she began her career caring for farm animals but changed her mind after “doing a C-section on a cow and it’s 50 bucks. Do a C-section on a Chihuahua and you get $300. It’s the money. I hate to say that.”

Higher spending on pets means fewer veterinarians are available to tend to farm animals.

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How can we translate this into supply and demand curves? Farm veterinary services and pet veterinary services are like gasoline and fuel oil: they’re related goods that are substitutes in production. A veterinarian typically specializes in one type of practice or the other, and that decision often depends on the going price for the service. America’s growing pet population, combined with the increased willingness of doting owners to spend on their companions’ care, has driven up the price of pet veterinary services. As a result, fewer and fewer veterinarians have gone into farm animal practice. So the supply curve of farm veterinarians has shifted leftward—fewer farm veterinarians are offering their services at any given price.

In the end, farmers understand that it is all a matter of dollars and cents; they get fewer veterinarians because they are unwilling to pay more. As one farmer, who had recently lost an expensive cow due to the unavailability of a veterinarian, stated, “The fact that there’s nothing you can do, you accept it as a business expense now. You didn’t used to. If you have livestock, sooner or later you’re going to have deadstock.” (Although we should note that this farmer could have chosen to pay more for a vet who would have then saved his cow.)

Supply, Demand, and Equilibrium

We have now covered the first three key elements in the supply and demand model: the demand curve, the supply curve, and the set of factors that shift each curve. The next step is to put these elements together to show how they can be used to predict the actual price at which the good is bought and sold, as well as the actual quantity transacted.

In competitive markets this interaction of supply and demand tends to move toward what economists call equilibrium. Imagine a busy afternoon at your local supermarket; there are long lines at the checkout counters. Then one of the previously closed registers opens. The first thing that happens is a rush to the newly opened register. But soon enough things settle down and shoppers have rearranged themselves so that the line at the newly opened register is about as long as all the others. This situation—all the checkout lines are now the same length, and none of the shoppers can be better off by doing something different—is what economists call equilibrium.

The concept of equilibrium helps us understand the price at which a good or service is bought and sold as well as the quantity transacted of the good or service. A competitive market is in equilibrium when the price has moved to a level at which the quantity of a good demanded equals the quantity of that good supplied. At that price, no individual seller could make herself better off by offering to sell either more or less of the good and no individual buyer could make himself better off by offering to buy more or less of the good. Think of shoppers at the supermarket who cannot make themselves better off (cannot save time) by changing lines. Similarly, at the market equilibrium, the price has moved to a level that exactly matches the quantity demanded by consumers to the quantity supplied by sellers.

The price that matches the quantity supplied and the quantity demanded is the equilibrium price; the quantity bought and sold at that price is the equilibrium quantity. The equilibrium price is also known as the market-clearing price: it is the price that “clears the market” by ensuring that every buyer willing to pay that price finds a seller willing to sell at that price, and vice versa. So how do we find the equilibrium price and quantity?

Finding the Equilibrium Price and Quantity

The easiest way to determine the equilibrium price and quantity in a market is by putting the supply curve and the demand curve on the same diagram. Since the supply curve shows the quantity supplied at any given price and the demand curve shows the quantity demanded at any given price, the price at which the two curves cross is the equilibrium price: the price at which quantity supplied equals quantity demanded.

Figure 5-6 combines the demand curve from Figure 4-1 and the supply curve from Figure 5-1. They intersect at point E, which is the equilibrium of this market; $1 is the equilibrium price and 10 billion pounds is the equilibrium quantity.

Market equilibrium occurs at point E, where the supply curve and the demand curve intersect. In equilibrium, the quantity demanded is equal to the quantity supplied. In this market, the equilibrium price is $1 per pound and the equilibrium quantity is 10 billion pounds per year.

Let’s confirm that point E fits our definition of equilibrium. At a price of $1 per pound, cotton farmers are willing to sell 10 billion pounds a year and cotton consumers want to buy 10 billion pounds a year. So at the price of $1 a pound, the quantity of cotton supplied equals the quantity demanded. Notice that at any other price the market would not clear: every willing buyer would not be able to find a willing seller, or vice versa. More specifically, if the price were more than $1, the quantity supplied would exceed the quantity demanded; if the price were less than $1, the quantity demanded would exceed the quantity supplied.

© Dan Piraro, 1996 Dist. by Universal Press Syndicate

The model of supply and demand, then, predicts that given the demand and supply curves shown in Figure 5-6, 10 billion pounds of cotton would change hands at a price of $1 per pound. But how can we be sure that the market will arrive at the equilibrium price? We begin by answering three simple questions:

1. Why do all sales and purchases in a market take place at the same price?
2. Why does the market price fall if it is above the equilibrium price?
3. Why does the market price rise if it is below the equilibrium price?

Why Do All Sales and Purchases in a Market Take Place at the Same Price?

There are some markets where the same good can sell for many different prices, depending on who is selling or who is buying. For example, have you ever bought a souvenir in a “tourist trap” and then seen the same item on sale somewhere else (perhaps even in the shop next door) for a lower price? Because tourists don’t know which shops offer the best deals and don’t have time for comparison shopping, sellers in tourist areas can charge different prices for the same good.

But in any market where the buyers and sellers have both been around for some time, sales and purchases tend to converge at a generally uniform price, so we can safely talk about the market price. It’s easy to see why. Suppose a seller offered a potential buyer a price noticeably above what the buyer knew other people to be paying. The buyer would clearly be better off shopping elsewhere—unless the seller were prepared to offer a better deal. Conversely, a seller would not be willing to sell for significantly less than the amount he knew most buyers were paying; he would be better off waiting to get a more reasonable customer. So in any well-established, ongoing market, all sellers receive and all buyers pay approximately the same price. This is what we call the market price.

Why Does the Market Price Fall if It Is Above the Equilibrium Price?

Suppose the supply and demand curves are as shown in Figure 5-6 but the market price is above the equilibrium level of $1—say, $1.50. This situation is illustrated in Figure 5-7. Why can’t the price stay there?

The market price of $1.50 is above the equilibrium price of $1. This creates a surplus: at a price of $1.50, producers would like to sell 11.2 billion pounds but consumers want to buy only 8.1 billion pounds, so there is a surplus of 3.1 billion pounds. This surplus will push the price down until it reaches the equilibrium price of $1.

As the figure shows, at a price of $1.50 there would be more pounds of cotton available than consumers wanted to buy: 11.2 billion pounds versus 8.1 billion pounds. The difference of 3.1 billion pounds is the surplus—also known as the excess supply—of cotton at $1.50.

This surplus means that some cotton farmers are frustrated: at the current price, they cannot find consumers who want to buy their cotton. The surplus offers an incentive for those frustrated would-be sellers to offer a lower price in order to poach business from other producers and entice more consumers to buy. The result of this price cutting will be to push the prevailing price down until it reaches the equilibrium price. So the price of a good will fall whenever there is a surplus—that is, whenever the market price is above its equilibrium level.

Why Does the Market Price Rise if It Is Below the Equilibrium Price?

Now suppose the price is below its equilibrium level—say, at $0.75 per pound, as shown in Figure 5-8. In this case, the quantity demanded, 11.5 billion pounds, exceeds the quantity supplied, 9.1 billion pounds, implying that there are would-be buyers who cannot find cotton: there is a shortage, also known as an excess demand, of 2.4 billion pounds.

The market price of $0.75 is below the equilibrium price of $1. This creates a shortage: consumers want to buy 11.5 billion pounds, but only 9.1 billion pounds are for sale, so there is a shortage of 2.4 billion pounds. This shortage will push the price up until it reaches the equilibrium price of $1.

When there is a shortage, there are frustrated would-be buyers—people who want to purchase cotton but cannot find willing sellers at the current price. In this situation, either buyers will offer more than the prevailing price or sellers will realize that they can charge higher prices. Either way, the result is to drive up the prevailing price. This bidding up of prices happens whenever there are shortages—and there will be shortages whenever the price is below its equilibrium level. So the market price will always rise if it is below the equilibrium level.

Using Equilibrium to Describe Markets

We have now seen that a market tends to have a single price, the equilibrium price. If the market price is above the equilibrium level, the ensuing surplus leads buyers and sellers to take actions that lower the price. And if the market price is below the equilibrium level, the ensuing shortage leads buyers and sellers to take actions that raise the price. So the market price always moves toward the equilibrium price, the price at which there is neither surplus nor shortage.

Module 5 Review

Check Your Understanding

PITFALLS: SUPPLY VERSUS QUANTITY SUPPLIED

SUPPLY VERSUS QUANTITY SUPPLIED

Where does the writer of this statement go wrong? Economists generally agree that when demand decreases, the price falls. But a fall in price leads to a decrease in supply that, in turn, causes the price to rise again.

THE WRITER CONFUSES A SHIFT OF THE SUPPLY CURVE (A DECREASE IN SUPPLY) AND A MOVEMENT ALONG THE SUPPLY CURVE (A CHANGE IN THE QUANTITY SUPPLIED). While economists agree that a decrease in demand leads to a fall in price, the fall in price leads only to a movement along the supply curve, not a shift of the supply curve. So that part of the statement is false. Always be careful to distinguish between a shift of the supply curve and a movement along the supply curve. A corrected statement would read:

Economists generally agree that when there is a decrease in demand, the price falls. And when the price falls, this leads to a decrease in the quantity supplied. It’s as simple as that!

To learn more, see Figure 5-3, which illustrates a movement along the supply curve versus a shift of the supply curve.