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Tutorial 3: Demand and Supply (cont.)

 

Comparative Statics Analysis of Market Equilibria

The comparison of two market equilibria is referred to as the method of comparative statics. It is this method of analysis that allows us to see how equilibrium price and quantity adjust to changes in the economic conditions underlying a market.

 

Shifts in Demand Top of page.

Suppose the number of high school graduates desiring a college education rises during the period 1975 to 1990. What effect would this have on the equilibrium price (tuition, etc.) and quantity of students enrolled in college?

An increase in the number of buyers results in an increase in the demand for a college education at any given market price. This is depicted graphically by a rightward shift in the demand curve from D to D1 in the graph below. As a result of the increased demand (price as yet unchanged), a shortage develops. This puts upward pressure on price as colleges increase tuition and fees to cover the increased cost of providing for more students. The higher price brings about an increase in the quantity of "seats" made available for students (increased quantity supplied) while simultaneously decreasing the quantity of students demanding a college education. This process continues until the shortage is eliminated at a new equilibrium price of P* = $122.50/unit and a new equilibrium quantity of Q* = 245 units/t.

 

Graph of an increase in market demand.

 

Shifts in Supply Top of page.

Suppose the cost of equipment, maintenance, and staffing at colleges and universities rose over the same time period. What effect would this have on the equilibrium price (tuition, etc.) and quantity of students enrolled in college?

An increase in the cost of producing a college education results in a decrease in the supply of "seats" at any given market price. This is depicted graphically by a leftward shift in the supply curve from S to S1 in the graph below. As a result of the decreased supply (price as yet unchanged), a shortage develops. This puts upward pressure on price as colleges increase tuition and fees to cover the increased cost of providing for more students. The higher price brings about an increase in the quantity of "seats" made available for students (increased quantity supplied) while simultaneously decreasing the quantity of students demanding a college education. This process continues until the shortage is eliminated at a new equilibrium price of P* = $122.50/unit and a new equilibrium quantity of Q* = 155 units/t.

 

Graph of a decrease in market supply.

Caution: An "increase" does not mean an upward shift. Remember we are talking about changes in the Quantity demanded or supplied at a given price as a result of changes in a non-price determinant. These changes in quantity are measured on the x-axis. So an increase in demand means an increase in the quantity demanded at the current price; a rightward shift in the demand curve. Similarly, a decrease in supply means a decrease in the quantity supplied at the current price; a leftward shift in the supply curve. [Return to Shifts in Demand or Shifts in Supply.]

 

Shifts in Demand and Supply Top of page.

Both of these events occured over the same time period. So now let's analyze the impact on the market for college education of both these events.

When both the demand for and the supply of a good or service change at the same time, the combined effect on equilibrium price or quantity cannot be known with certainty unless the relative size of each shift is known. In this example, for instance, the increase in demand (in isolation) resulted in an increase in equilibrium price and quantity. The decrease in supply (in isolation) resulted in an increase in equilibrium price but a decrease in equilibrium quantity. Put the two together and we can be certain that the increase in demand coupled with a decrease in supply will raise equilibrium price. But we cannot be certain what will happen to the equilibrium level of enrollment; if the decrease in supply is smaller than the increase in demand, equilibrium enrollment will rise. If the decrease in supply is larger than the increase in demand, equilibrium enrollment will fall. Finally, if the decrease in supply is equal to the increase in demand, equilibrium enrollment will not change. Table 1 summarizes the analysis for this case.

 

Table 1: Changes in equilibrium when both curves shift
  Change in
equilibrium
price?
Change in
equilibrium quantity?

Increase in demand:

increase

increase

Decrease in supply:

increase

decrease

Net effect:

increase

uncertain
[depends on the relative size of the shifts]

 

It is important to remember that when both curves shift simultaneously, one must analyze each shift independently then add them together to predict the "net effect" on equilibrium price and quantity.

Now it's time to "do the thing".

Click on the following link to download the Demand and Supply Workbook. Work through Comparative Statics Questions 1 - 9 to improve your understanding of how changes in Demand, Supply, or both, alter equilibrium price and quantity.

Return here when you have finished.

(Need help downloading the Excel file?)

 

Now we look at the effect of government intervention in the market mechanism...