Changes in Supply and Demand

The 2010 floods in Pakistan came as a surprise, but the subsequent increase in the price of cotton was no surprise at all. Suddenly there was a fall in supply: the quantity of cotton available at any given price fell. Predictably, a fall in supply raises the equilibrium price.

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AP® Exam Tip

A shift of the demand curve changes the price, which changes the quantity supplied. A shift of the supply curve also changes the price, which changes the quantity demanded. Note that these price changes cause movements along the curve that didn’t shift. A shift of the demand curve never causes a shift of the supply curve, and a shift of the supply curve never causes a shift of the demand curve.

The flooding in Pakistan is an example of an event that shifted the supply curve for a good without having much effect on the demand curve. There are many such events. There are also events that shift the demand curve without shifting the supply curve. For example, a medical report that chocolate is good for you increases the demand for chocolate but does not affect the supply. Events often shift either the supply curve or the demand curve, but not both; it is therefore useful to ask what happens in each case.

We have seen that when a curve shifts, the equilibrium price and quantity change. We will now concentrate on exactly how the shift of a curve alters the equilibrium price and quantity.

What Happens When the Demand Curve Shifts

Cotton and polyester are substitutes: if the price of polyester rises, the demand for cotton will increase, and if the price of polyester falls, the demand for cotton will decrease. But how does the price of polyester affect the market equilibrium for cotton?

Figure 7.4 shows the effect of a rise in the price of polyester on the market for cotton. The rise in the price of polyester increases the demand for cotton. Point E1 shows the equilibrium corresponding to the original demand curve, with P1 the equilibrium price and Q1 the equilibrium quantity bought and sold.

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Figure 7.4: Equilibrium and Shifts of the Demand CurveThe original equilibrium in the market for cotton is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of polyester, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise.

An increase in demand is indicated by a rightward shift of the demand curve from D1 to D2. At the original market price P1, this market is no longer in equilibrium: a shortage occurs because the quantity demanded exceeds the quantity supplied. So the price of cotton rises and generates an increase in the quantity supplied, an upward movement along the supply curve. A new equilibrium is established at point E2, with a higher equilibrium price, P2, and higher equilibrium quantity, Q2. This sequence of events reflects a general principle: When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise.

AP® Exam Tip

The graph never lies! If asked to determine what happens to price and quantity when supply or demand shifts, draw the graph first and then look where the old equilibrium was and compare it to the new equilibrium. Draw quick graphs whenever you can to help you answer multiple choice questions about changes in quantity and price.

What would happen in the reverse case, a fall in the price of polyester? A fall in the price of polyester reduces the demand for cotton, shifting the demand curve to the left. At the original price, a surplus occurs as quantity supplied exceeds quantity demanded. The price falls and leads to a decrease in the quantity supplied, resulting in a lower equilibrium price and a lower equilibrium quantity. This illustrates another general principle: When demand for a good or service decreases, the equilibrium price and the equilibrium quantity of the good or service both fall.

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To summarize how a market responds to a change in demand: An increase in demand leads to a rise in both the equilibrium price and the equilibrium quantity. A decrease in demand leads to a fall in both the equilibrium price and the equilibrium quantity.

What Happens When the Supply Curve Shifts

In the real world, it is a bit easier to predict changes in supply than changes in demand. Physical factors that affect supply, like weather or the availability of inputs, are easier to get a handle on than the fickle tastes that affect demand. Still, with supply as with demand, what we can best predict are the effects of shifts of the supply curve.

As we mentioned earlier, devastating floods in Pakistan sharply reduced the supply of cotton in 2010. Figure 7.5 shows how this shift affected the market equilibrium. The original equilibrium is at E1, the point of intersection of the original supply curve, S1, and the demand curve, with an equilibrium price P1 and equilibrium quantity Q1. As a result of the bad weather, supply falls and S1 shifts leftward to S2. At the original price P1, a shortage of cotton now exists and the market is no longer in equilibrium. The shortage causes a rise in price and a fall in quantity demanded, an upward movement along the demand curve. The new equilibrium is at E2, with an equilibrium price P2 and an equilibrium quantity Q2. In the new equilibrium, E2, the price is higher and the equilibrium quantity lower than before. This can be stated as a general principle: When supply of a good or service decreases, the equilibrium price of the good or service rises and the equilibrium quantity of the good or service falls.

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Figure 7.5: Equilibrium and Shifts of the Supply CurveThe original equilibrium in the market for cotton is at E1. Bad weather in cotton-growing areas causes a fall in the supply of cotton and shifts the supply curve leftward from S1 to S2. A new equilibrium is established at E2, with a higher equilibrium price, P2, and a lower equilibrium quantity, Q2.

What happens to the market when supply increases? An increase in supply leads to a rightward shift of the supply curve. At the original price, a surplus now exists; as a result, the equilibrium price falls and the quantity demanded rises. This describes what happened to the market for cotton as new technology increased cotton yields. We can formulate a general principle: When supply of a good or service increases, the equilibrium price of the good or service falls and the equilibrium quantity of the good or service rises.

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AP® Exam Tip

You can do supply and demand analysis in three easy steps. First, draw the graph before the change. Be sure to label the equilibrium price and quantity on the appropriate axes. Second, identify which line shifts and add the shift to your graph. Third, label the new equilibrium price and quantity on the appropriate axes and note how each value changed.

To summarize how a market responds to a change in supply: An increase in supply leads to a fall in the equilibrium price and a rise in the equilibrium quantity. A decrease in supply leads to a rise in the equilibrium price and a fall in the equilibrium quantity.

Simultaneous Shifts of Supply and Demand Curves

Finally, it sometimes happens that events shift both the demand and supply curves at the same time. This is not unusual; in real life, supply curves and demand curves for many goods and services shift quite often because the economic environment continually changes. Figure 7.6 illustrates two examples of simultaneous shifts. In both panels there is an increase in demand—that is, a rightward shift of the demand curve, from D1 to D2—say, for example, representing an increase in the demand for cotton due to changing tastes. Notice that the rightward shift in panel (a) is larger than the one in panel (b): we can suppose that panel (a) represents a year in which many more people than usual choose to buy jeans and cotton T-shirts and panel (b) represents a normal year. Both panels also show a decrease in supply—that is, a leftward shift of the supply curve from S1 to S2. Also notice that the leftward shift in panel (b) is relatively larger than the one in panel (a): we can suppose that panel (b) represents the effect of particularly bad weather in Pakistan and panel (a) represents the effect of a much less severe weather event.

In both cases, the equilibrium price rises from P1 to P2, as the equilibrium moves from E1 to E2. But what happens to the equilibrium quantity, the quantity of cotton bought and sold? In panel (a) the increase in demand is large relative to the decrease in supply, and the equilibrium quantity rises as a result. In panel (b), the decrease in supply is large relative to the increase in demand, and the equilibrium quantity falls as a result. That is, when demand increases and supply decreases, the actual quantity bought and sold can go either way, depending on how much the demand and supply curves have shifted.

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Figure 7.6: Simultaneous Shifts of the Demand and Supply CurvesIn panel (a) there is a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the increase in demand is relatively larger than the decrease in supply, so the equilibrium price and equilibrium quantity both rise. In panel (b) there is also a simultaneous rightward shift of the demand curve and leftward shift of the supply curve. Here the decrease in supply is relatively larger than the increase in demand, so the equilibrium price rises and the equilibrium quantity falls.

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In general, when supply and demand shift in opposite directions, we can’t predict what the ultimate effect will be on the quantity bought and sold. What we can say is that a curve that shifts a disproportionately greater distance than the other curve will have a disproportionately greater effect on the quantity bought and sold. That said, we can make the following prediction about the outcome when the supply and demand curves shift in opposite directions:

But suppose that the demand and supply curves shift in the same direction. Before 2010, this was the case in the global market for cotton, where both supply and demand had increased over the past decade. Can we safely make any predictions about the changes in price and quantity? In this situation, the change in quantity bought and sold can be predicted, but the change in price is ambiguous. The two possible outcomes when the supply and demand curves shift in the same direction (which you should check for yourself) are as follows:

Makin’ Bacon?

“Pork plight looming: Worldwide bacon shortage ‘unavoidable’ after drought, pig farmers warn.” So read a recent headline in Canada’s National Post. Behind the gloom and doom were droughts in 2012 that reduced the supply of corn. Why was the supply of bacon threatened? Because of what happens to the equilibrium price of corn, a key ingredient in a pig’s dinner, when its supply decreases. High corn prices make it more expensive to raise the pigs whose bellies become bacon. This added expense reduced the supply of bacon. And with that, the price of bacon rose by 26 percent between mid-2012 and mid-2013.

Was there a shortage? No. There would have been a shortage if something prevented the price from rising to the equilibrium level. But as we have seen in our models, rising prices close the gap between the quantity supplied and the quantity demanded. Or, as explained by Andrew Dickson, general manager of the Manitoba Pork Council, “Is there less pork in the world? Probably, but I wouldn’t call it a shortage. You give me the right price, and I will produce as much bacon as you want.”

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A decrease in the supply of bacon may cause consumers to squeal, but it won’t cause a lasting shortage, because higher bacon prices will decrease the quantity demanded and increase the quantity supplied.
Lisovskaya Natalia/Shutterstock