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Competition, if not prevented, tends to bring about a state of affairs in which: rst, everything will be produced which somebody knows how to produce and which he can sell protably at a price at which buyers will prefer it to the available alternatives; second, everything that is produced is produced by persons who can do so at least as cheaply as anybody else who in fact is not producing it; and third, that everything will be sold at prices lower than, or at least as low as, those at which it could be sold by anybody who in fact does not do so. Friedrich A. Hayek

n the heart of New York City, Fred Liebermans small grocery is dwarfed by the tall buildings that surround it. Yet it is remarkable for what it accomplishes. Liebermans carries thousands of items, most of which are not produced locally, and some of which come from other parts of this country or the world, thousands of miles away. A man of modest means, with little knowledge of production processes, Fred Lieberman has nevertheless been able to stock his store with many if not most of the foods and toiletries his customers need and want. Occasionally Liebermans runs out of certain items, but most of the time the stock is ample. Its supply is so dependable that customers tend to take it for granted, forgetting that Liebermans is one small strand in an extremely complex economic network.

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How does Fred Lieberman get the goods he sells, and how does he know which ones to sell and at what price? The simplest answer is that the goods he offers and the prices at which they sell are determined through the market process the interaction of many buyers and sellers trading what they have (their labor or other resources) for what they want. Lieberman stocks his store by appealing to the private interests of suppliers by paying them competitive prices. His customers pay him extra for the convenience of purchasing goods in their neighborhood grocery appealing to his private interests in the process. To determine what he should buy, Fred Lieberman considers his suppliers prices. To determine what and how much they should buy, his customers consider the prices he charges. The economist Friedrich Hayek (1945) has suggested that the market process is manageable for people such as Fred Lieberman, his suppliers, and his customers, precisely because prices condense a great deal of information into a useful form, signaling quickly what people want, what goods cost, and what resources are readily available. Prices guide and coordinate the sellers production decisions and consumers purchases. How are prices determined? That is an important question for people in business, simply because an understanding of how prices are determined can help businesspeople understand the forces that will cause prices to change in the future and, therefore, the forces that affect their businesses bottom lines. Theres money to be made in being able to understand the dynamics of prices. Our most general answer to the question of how prices are determined is deceptively simple: in competitive markets, the forces of supply and demand establish prices. However, there is much to be learned through the concepts of supply and demand. Indeed, we suspect that most MBA students will nd supply and demand the most useful business concepts and tools of analysis developed in this book (and perhaps their entire MBA program). To understand supply and demand, you must rst understand that the market process is inherently competitive.

Part A Theory and public policy applications

The competitive market process
So far, our discussion of markets and their consequences has been rather casual. In this section, we shall dene precisely such terms as market and competition. In later sections, we shall examine the way competitive markets work and learn why, in a limited sense, markets can be considered efcient systems for determining what and how much to produce. Markets, along with the prices that emerge in them, make the problem of scarcity less pressing than it otherwise would be.

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The market setting

Most people tend to think of a market as a geographical location a shopping center, an auction hall, a business district. From an economic perspective, however, it is more useful to think of a market as a process. You may recall from chapter 1 that a market is dened as the process by which buyers and sellers determine what they are willing to buy and sell and on what terms. That is, a market is the process by which buyers and sellers decide the prices and quantities of goods to be bought and sold. The market process can work within the connes of a building, but also through the Internet that extends to all points on the globe. In this process, individual market participants search for information relevant to their own interests. Buyers ask about the models, sizes, colors, and quantities available and the prices they must pay for them. Sellers inquire about the types of goods and services buyers want and the prices they are willing to pay. This market process is self-correcting. Buyers and sellers routinely revise their plans on the basis of experience. As economist Israel Kirzner has written:
The overly ambitious plans of one period will be replaced by more realistic ones; market opportunities overlooked in one period will be exploited in the next. In other words, even without changes in the basic data of the market, the decision made in one period one time generates systematic alterations in corresponding decisions for the succeeding period. (Kirzner 1973, 10)

But then overly ambitious plans do affect the basic data people receive through resulting changes in prices, which affect the quantities and qualities of goods produced. The market consists of people consumers and entrepreneurs attempting to buy and sell on the best terms possible. Through the groping process of give and take, they move from relative ignorance about others wants and needs to a reasonably accurate understanding of how much can be bought and sold and at what price. The market functions as an ongoing information and exchange system.

Competition among buyers and among sellers

Competition is the process by which market participants, in pursuing their own interests, attempt to outdo, outprice, outproduce, and outmaneuver each other. By extension, competition is also the process by which market participants attempt to avoid being outdone, outpriced, outproduced, or outmaneuvered by others.

Part and parcel of the market process is the concept of competition. Competition does not occur between buyer and seller, but among buyers or among sellers. Buyers compete with other buyers for the limited number of goods on the market. To compete, they must discover what other buyers are bidding and offer the seller better terms a higher price or the

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same price for a lower-quality product. Sellers compete with other sellers for the consumers dollar. They must learn what their rivals are doing and attempt to do it better or differently to lower the price or enhance the products appeal. This kind of competition stimulates the exchange of information, forcing competitors to reveal their plans to prospective buyers or sellers. The exchange of information can be seen clearly at auctions. Before the bidding begins, buyers look over the merchandise and the other buyers, attempting to determine how high others might be willing to bid for a particular piece. During the auction, this specic information is revealed as buyers call out their bids and others try to top them. Information exchange is less apparent in department stores, where competition is not as transparent. Even there, however, comparison-shopping by buyers across stores will often reveal some sellers who are offering lower prices in an attempt to attract consumers.
In competing with each other, sellers reveal information that is ultimately of use to buyers. Buyers likewise inform sellers. From the consumers point of view, the function of competition is precisely to teach us who will serve us well: which grocer or travel agent, which department store or hotel, which doctor or solicitor, we can expect to provide the most satisfactory solution for whatever particular personal problem we may have to face. (Hayek 1948, 97)

From the sellers point of view say, the auctioneers competition among buyers brings the highest prices possible. Competition among sellers takes many forms, including the price, quality, weight, volume, color, texture, durability, and smell of products, as well as the credit terms offered to buyers. Sellers also compete for consumers attention by appealing to their hunger and sex drives or their fear of death, pain, and loud noises. All these forms of competi- Perfect competition (in extreme form) is a tion can be divided into two basic categories price market composed of numerous independent sellers and buyers of an identical product, and nonprice competition. Price competition is of such that no one individual seller or buyer has particular interest to economists, who see it as an the ability to affect the market price by important source of information for market partic- changing the production level. Entry into and exit from a perfectly competitive market is ipants and a coordinating force that brings the unrestricted. Producers can start up or shut quantity produced into line with the quantity con- down production at will. Anyone can enter sumers are willing and able to buy. In the following the market, duplicate the good, and compete sections, we shall construct a model of the compet- for consumers dollars. Since each competitor produces only a small share of the total itive market and use it to explore the process of price output, the individual competitor cannot competition under intense competitive market con- signicantly inuence the degree of ditions called perfect competition. Nonprice compe- competition or the market price by entering or leaving the market. tition will be covered in a later section.

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Supply and demand: a market model

A fully competitive market is made up of many buyers and sellers searching for opportunities or ready to enter the market when opportunities arise. To be described as competitive, therefore, a market must include a signicant number of actual or potential competitors. A fully competitive market offers freedom of entry: there are no legal or articial barriers to producing and selling goods in the market. Our market model assumes perfect competition an idealized situation that is seldom, if ever, achieved in real life but that will simplify our calculations. This kind of market is well suited to graphic analysis and helps us clarify the pricing forces afoot in all competitive markets. Our discussion concentrates on how buyers and sellers interact to determine the price of tomatoes, a product Fred Lieberman almost always carries. It will employ two curves. The rst represents buyers behavior, which is called their demand for the product.

The elements of demand

Demand is the assumed inverse relationship between the price of a good or service and the quantity consumers are willing and able to buy during a given period, all other things held constant.

To the general public, demand is simply what people want, but to economists, demand has much more technical meaning. The concept of demand is important because it is so widely applicable to human behavior, not just in business, but in everyday life.

Demand as a relationship
The relationship between price and quantity is normally assumed to be inverse. That is, when the price of a good rises, the quantity sold, ceteris paribus (Latin for everything else held constant), will go down. Conversely, when the price of a good falls, the quantity sold goes up. Demand is not a quantity but a relationship. A given quantity sold at a particular price is properly called the quantity demanded. Both tables and graphs can be used to describe the assumed inverse relationship between price and quantity.

Demand as a table or a graph

Demand may be thought of as a schedule of the various quantities of a particular good consumers will buy at various prices. As the price goes down, the quantity purchased goes up and vice versa. Table 3.1 contains a hypothetical schedule of the demand for tomatoes in the New York area during a typical week. Column (2) shows prices that might be charged. Column (3) shows the number of bushels consumers will buy at those prices. Note that as the price rises from zero to $11 a bushel, the number of bushels purchased drops from 110,000 to zero.

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Table 3.1 Market demand for tomatoes

Pricequantity combinations (1) A B C D E F G H I J K L

Price per bushel ($) (2) 0 1 2 3 4 5 6 7 8 9 10 11

No. (000) of bushels (3) 110 100 90 80 70 60 50 40 30 20 10 0

12 l Price per bushel of tomatoes ($) 10 k j P2 8 6 P1 4 i h g f e d 2 c b a 0 20 Q1 40 60 Q2 80 100 120 Demand

Figure 3.1 Market demand for tomatoes

Demand, the assumed inverse relationship between price and quantity purchased, can be represented by a curve that slopes down toward the right. Here, as the price falls from $11 to zero, the number of bushels of tomatoes purchased per week rises from zero to 110,000.

Bushels of tomatoes per week (000)

Demand may also be thought of as a curve. If price is scaled on a graphs vertical axis and quantity on the horizontal axis, the demand curve has a negative slope (downward and to the right), reecting the assumed inverse relationship between price and quantity. The shape of the market demand curve is shown in gure 3.1, which is based on the data from table 3.1. Points a through l on the graph correspond to the pricequantity combinations A through L in the table. Note that as the price

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falls from P2 ($8) to P1 ($5), consumers move down their demand curve from a quantity of Q1 (30,000) to the larger quantity Q2 (60,000). [See online Video Module 3.1 Demand]

The slope and determinants of demand Price and quantity are assumed to be inversely related, for two elemental reasons. (See chapter 6 for more detailed explanations of the downward sloping demand curve.) First, as the price of a good decreases (and the prices of all other goods remain the same), the good becomes relatively cheaper, and consumers will substitute that good for others. This response is called the substitution effect. The substitution can come from within product categories, say, fruit. If the price of oranges falls (the price of apples remains constant), people can be expected to buy more oranges and fewer apples. But then a price reduction for oranges can cause some people to move from nonconsumption of fruit to the consumption of oranges. That is, consumers can move from consuming cookies to oranges to satisfy their desire for something with sugar content. In addition, as the price of a good decreases (and the prices of all other goods stay the same remember ceteris paribus), the purchasing power of consumer incomes rises. That is, their real incomes increase. More consumers are able to buy the good, and many will buy more of most (but not all) goods. This response is called the income effect. In sum, when the price of tomatoes (or razor blades, or any other good) falls, more tomatoes will be purchased because more people will be buying them for more purposes. Moreover, embedded in the downward sloping demand curves for many goods can be large and small behavioral changes among consumers. When the price of gasoline goes up, drivers can be expected to economize on their uses of gasoline in a variety of ways. For example, drivers can be expected to reduce the number of times they stomp down on the cars accelerators when leaving stoplights and, if they have more than one car, to use their more fuel-efcient cars more frequently, behavioral changes that can enable them to buy fewer gallons of gasoline. Although price is an important part of the denition of demand, it is not the only determinant of how much of a good people will want. It may not even be the most important. The major factors that affect market demand are called the determinants of demand. They are:
* * * * *

consumer tastes or preferences the prices of other goods consumer incomes the number of consumers expectations concerning future prices and incomes.

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12

Figure 3.2 Shifts in the demand curve

An increase in demand is represented by a rightward, or outward, shift in the demand curve, from D1 to D2. A decrease in demand is represented by a leftward, or inward, shift in the demand curve, from D1 to D3.

Price per bushel of tomatoes ($)

10 P3 8 6 P2 4 D2 P1 2 D3 0 20 Q1 40 60 Q2 80 Q3 100 120 D1

Decrease in demand Increase in demand

Bushels of tomatoes per week (000)

A host of other factors, such as weather, may also inuence the demand for particular goods ice cream, for instance. A change in any of these determinants of demand will cause either an increase or a decrease in demand:
*

An increase in demand is an increase in the quantity demanded at each and every price. It is represented graphically by a rightward, or outward, shift in the demand curve. A decrease in demand is a decrease in the quantity demanded at each and every price. It is represented graphically by a leftward, or inward, shift of the demand curve.

Figure 3.2 illustrates the shifts in the demand curve that result from a change in one of the determinants of demand. The outward shift from D1 to D2 indicates an increase in demand: consumers now want more of a good at each and every price. For example, they want Q3 instead of Q2 tomatoes at price P2. Consumers are also now willing to pay a higher price for any quantity. For example, they will pay P3 instead of P2 for Q2 tomatoes. The inward shift from D1 to D3 indicates a decrease in demand: consumers want less of a good at each and every price Q1 instead of Q2 tomatoes at price P2. And they are willing to pay less than before for any quantity P1 instead of P2 for Q2 tomatoes. A change in a determinant of demand may be translated into an increase or decrease in current market demand in numerous ways. An increase in market demand can be caused by:

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An increase in consumers desire or taste for the good. If people truly want the good more, they will buy more of the good at any given price or pay a higher price for any given quantity. An increase in the number of buyers. If, because more people consume the good, more of the good will be purchased at any given price, then the price will be higher at any given quantity. An increase in the price of substitute goods (which can be used in place of the good in question). If the price of oranges increases, the demand for grapefruit will increase. A decrease in the price of complementary goods (which are used in conjunction with the good in question). If the price of MP3 players falls, the demand for downloadable songs will rise. If the price of gasoline falls, the overall demand for automobiles can increase. (But the demand for various models can rise or fall, depending on their gas consumption: the demand for SUVs can fall while the demand for hybrids can rise.) Generally speaking (but not always), an increase in consumer incomes. An increase in peoples incomes may increase the demand for luxury goods, such as new cars. It may also decrease demand for low-quality goods (such as hamburger) because people can now afford better-quality products (such as steak). An expected increase in the future price of the good in question. If people expect the price of cars to rise faster than the prices of other goods, then (depending on exactly when they expect the increase) they may buy more cars now, thus avoiding the expected additional cost in the future. An expected increase in future incomes of buyers. College seniors demand for cars tends to increase as graduation approaches and they anticipate a rise in income.

The determinants of a decrease in market demand are just the opposite:

* * * * * * *

a decrease in consumers desire or taste for the good a decrease in the number of buyers a decrease in the price of substitute goods an increase in the price of complementary goods generally speaking (but not always), a decrease in consumer incomes an expected decrease in the future price of the good in question an expected decrease in the future incomes of buyers.

As will be noticeable throughout this book, much attention will be placed on how changes in price affect the quantity demanded, while little attention will be given to how changes in tastes affect the quantity demanded. The differential treatment of price and tastes does not presume that price is more important than tastes in determining the consumption level of any good. Rather, economists concentrate

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on price because they seek a theory of price determination (not a theory of taste determination, which is a major interest of psychology). In addition, the effect of price changes on quantity demanded is viewed as being highly predictable, given extensive consumer theory and empirical observation. The inverse relationship between price and quantity consumed is viewed as a law, or the law of demand. Tastes, on the other hand, are an amorphous, subjective concept. Hence, predicting the impact of changes in tastes on quantity demanded is, for economists (but perhaps not for psychologists), problematic. Similarly, as will be discussed in chapter 6, the impact of a change in buyers real income on quantity bought has an element of uncertainty. Granted, for most normal goods, the relationship between income and quantity of a good bought can be positive, as indicated above, in which case the substitution and income effects have the same direction impact on quantity consumed. However, the relationship can be inverse for some goods (so-called inferior goods). When low-income people experience an increase in real income, they may switch between low-quality sources of, say, protein beans to high-quality sources meat. In this case, the negative effect of an increase in real income works against the substitution effect on the quantity demanded of beans. However, economists have found that for most goods the substitution and income effects compound one another or the positive substitution effect dominates any negative income effect, which means demand curves of most if not almost all goods slope downward.

The elements of supply

On the other side of the market are the producers of goods. The average person thinks of supply as the quantity of a good producers are willing to sell. To economists, however, supply means something quite different. As with demand, supply is not a given quantity that is called the quantity supplied. Supply is a relationship between price Supply is the assumed relationship between the quantity of a good producers are willing and quantity. As the price of a good rises, producers to offer during a given period and the price, are generally willing to offer a larger quantity. The everything else held constant. Generally, reverse is equally true: as price decreases, so does because additional costs tend to rise with expanded production, this relationship is quantity supplied. Like demand, supply can be presumed to be positive (a point that is described in a table or a graph. developed with care in chapters 7 and 8).

Supply as a table or a graph

Supply may be described as a schedule of the quantity that producers will offer at various prices during a given period of time. Table 3.2 shows such a supply schedule. As the price of tomatoes goes up from zero to $11 a bushel, the quantity offered rises

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Table 3.2 Market supply of tomatoes

Pricequantity combinations (1) Price per bushel ($) (2) No. (000) of bushels (3) A B C D E F G H I J K L 0 1 2 3 4 5 6 7 8 9 10 11 0 10 20 30 40 50 60 70 80 90 100 110

from zero to 110,000, reecting the assumed positive relationship between price and quantity. Supply may also be thought of as a curve. If the quantity producers will offer is scaled on the horizontal axis of a graph and the price of the good is scaled on the vertical axis, the supply curve will slope upward to the right, reecting the assumed positive relationship between price and quantity. In gure 3.3, which was plotted from the data in table 3.2, points a through l represent the pricequantity combinations A through L. Note how a change in the price causes a movement along the supply curve. [See online Video Module 3.2 Supply]

The slope and determinants of supply

The quantity producers will offer on the market depends on their production costs. Obviously the total cost of production will rise when more is produced because more resources will be required to expand output. The Marginal cost is the additional cost of additional or marginal cost of each additional bushel producing an additional unit of output. produced also tends to rise as total output expands (beyond some point, which will be explained in chapter 7). In other words, when it costs more to produce the second bushel of tomatoes than the rst, and more to produce the third than the second, rms will not expand their output unless they can cover their progressively higher marginal costs with a progressively higher price. This is the reason the supply curve is thought to slope upward.

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12 Supply 10 Price per bushel of tomatoes ($) j 8 h 6 f 4 d 2 b a 0 20 40 60 80 100 Bushels of tomatoes per week (000) 120 c e g i k l

Figure 3.3 Supply of tomatoes

Supply, the assumed relationship between price and quantity produced, can be represented by a curve that slopes up toward the right. Here, as the price rises from zero to $11, the number of bushels of tomatoes offered for sale during the course of a week rises from zero to 110,000.

Anything that affects production costs will inuence supply and the position of the supply curve. Such factors, which are called determinants of supply, include:
* * *

change in productivity due to a change in technology change in the protability of producing other goods change in the scarcity (and prices) of various productive resources.

Many other factors, such as the weather, can also affect production costs and therefore supply. A change in any of these determinants of supply can either increase or decrease supply:
*

An increase in supply is an increase in the quantity producers are willing and able to offer at each and every price. It is represented graphically by a rightward, or outward, shift in the supply curve. A decrease in supply is a decrease in the quantity producers are willing and able to offer at each and every price. It is represented graphically by a leftward, or inward, shift in the supply curve.

In gure 3.4, an increase in supply is represented by the shift from S1 to S2. Producers are willing to produce a larger quantity at each price Q3 instead of Q2 at price P2, for example. They will also accept a lower price for each quantity P1

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Figure 3.4 Shifts in the supply curve

S3 Price per bushel of tomatoes ($) S1 P3 Decrease in supply P2 Increase in supply P1 S2

A rightward, or outward, shift in the supply curve, from S1 to S2, represents an increase in supply. A leftward, or inward, shift in the supply curve, from S1 to S3, represents a decrease in supply.

Q1

Q2

Q3

Bushels of tomatoes per week (000)

instead of P2 for quantity Q2. Conversely, the decrease in supply represented by the shift from S1 to S3 means that producers will offer less at each price Q1 instead of Q2 at price P2. They must also have a higher price for each quantity P3 instead of P2 for quantity Q2. A few examples will illustrate the impact of changes in the determinants of supply. If rms learn how to produce more goods with the same or fewer resources, the cost of producing any given quantity will fall. Because of the technological improvement, rms will be able to offer a larger quantity at any given price or the same quantity at a lower price. The supply will increase, shifting the supply curve outward to the right. Similarly, if the protability of producing oranges increases relative to grapefruit, grapefruit producers will shift their resources to oranges. The supply of oranges will increase, shifting the supply curve to the right. Finally, if lumber (or labor or equipment) becomes scarcer, its price will rise, increasing the cost of new housing and reducing the supply of new houses coming onto the market. The supply curve of new houses will shift inward to the left.

Market equilibrium
Supply and demand represent the two sides of the market sellers and buyers. By plotting the supply and demand curves together, as in gure 3.5, we can explore the conditions under which the decisions of buyers and sellers will be inconsistent with

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12 S

Figure 3.5 Market surplus

Surplus

Price per bushel of tomatoes ($)

10 P2 8

6 P1 4

If a price is higher than the intersection of the supply and demand curves, a market surplus a greater quantity supplied, Q3, than demanded, Q1 results. Competitive pressure will push the price down to the equilibrium price, P1, the price at which the quantity supplied equals the quantity demanded, Q2.

2 D 0 20 Q1 40 60 Q2 80 Q3 100 120

Bushels of tomatoes per week (000)

each other, and why a market surplus or shortage of tomatoes will result. We can also illuminate the competitive market forces at work to push the market price toward the market-clearing price or the price at which the market is said to be in equilibrium, at Market equilibrium occurs when the forces of which the forces of supply and demand balance supply and demand are in balance with no net pressure for the price and output level to one another with no net pressure for the price and change. output to move up or down.

Market surpluses
Suppose that the price of a bushel of tomatoes is $9, or P2 in gure 3.5. At this price, the quantity demanded by consumers is 20,000 bushels, much less than the quantity offered by producers 90,000. There is a market surplus, or excess supply, of 70,000 bushels. A market surplus is the amount by which the quantity supplied exceeds the quantity Graphically, an excess quantity supplied occurs at demanded at any given price. any price above the intersection of the supply and demand curves. What will happen in this situation? Producers who cannot sell their tomatoes will have to compete by offering to sell at a lower price, forcing other producers to follow suit. All producers might agree that holding the price above equilibrium can be in their common interest, since an above-equilibrium price can generate extra prots for all (even though sales might be undercut). However, in competitive markets producers are in a large-group setting in which their individual curbs on

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production to pursue their common interest will have an inconsequential impact on total market supply. They each can reason that they can possibly gain market share by individually lowering their price, if all others hold to the higher price. And each can reason that all others are thinking the same way, which means they can expect other producers to lower their prices. The logic leads the producers to do what is not in their common interest and to act competitively, which is cut their prices. As the competitive process forces the price down, the quantity that consumers are willing to buy will expand, while the quantity that producers are willing to sell will decrease. The result will be a contraction of the surplus, until it is nally eliminated at a price of $5.50 or P1 (at the intersection of the two curves). At that price, producers will be selling all they want; they will see no reason to lower prices further. Similarly, consumers will see no reason to pay more; they will be buying all they want. This point at which the wants of buyers and sellers intersect is called the equilibrium, with the price and quantity at that point called equilibrium price and equilibrium quantity:
*

The equilibrium price is the price toward which a competitive market will move, and at which it will remain once there, everything else held constant. It is the price at which the market clears that is, at which the quantity demanded by consumers is matched exactly by the quantity offered by producers. At the equilibrium price, the quantity sellers are willing to supply and the quantity buyers want to consume are equal. This is the equilibrium quantity. The equilibrium quantity is the output (or sales) level toward which the market will move, and at which it will remain once there, everything else held constant.

In sum, a surplus emerges when the price asked is above the equilibrium price. It will be eliminated, through competition among sellers, when the price drops to the equilibrium price.

Market shortages
Suppose that the price asked is below the equilibrium price, as in gure 3.6. At the relatively low price of $1, or P1, buyers want to purchase 100,000 bushels substantially more than the 10,000 bushels producers are willing to A market shortage is the amount by which the offer. The result is a market shortage. Graphically, a quantity demanded exceeds the quantity market shortage is the shortfall that occurs at any supplied at any given price. price below the intersection of the supply and demand curves. As with a market surplus, competition will correct the discrepancy between buyers and sellers plans. Buyers who want tomatoes but are unable to get them at a price of $1 will bid higher prices, as at an auction. Many buyers might have a

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12 S

Figure 3.6 Market shortages

A price that is below the intersection of the supply and demand curves will create a shortage a greater quantity demanded, Q3, than supplied, Q1. Competitive pressure will push the price up to the equilibrium price P2, the price at which the quantity supplied equals the quantity demanded (Q2).

Price per bushel of tomatoes ($)

10

P2

2 P1 0 Q1 20 40

Shortage D 60 Q2 80 100 Q3 120

Bushels of tomatoes per week (000)

common interest to hold the price below the equilibrium price (even with fewer units of the good they can buy). However, as with producers when there was a market surplus, buyers are in a large-group setting, with each individual buyer reasoning that not offering a higher price will not affect the market outcomes, because other buyers will offer a higher price. Each buyer can reason that they might as well offer a higher price just to get the units they want. As the price rises, a larger quantity will be supplied because suppliers will be better able to cover their increasing production costs. Simultaneously, the quantity demanded will contract as buyers seek substitutes that are now relatively less expensive compared with tomatoes. At the equilibrium price of $5.50, or P2, the market shortage will be eliminated. Buyers will have no reason to bid prices up further; they will be getting all the tomatoes they want at that price. Sellers will have no reason to expand production further; they will be selling all they want at that price. The equilibrium price will remain the same until some force shifts the position of either the supply or the demand curve. If such a shift occurs, the price will move toward a new equilibrium at the new intersection of the supply and demand curves. In our graphical treatment of supply and demand, movement toward equilibrium can be thought of as instantaneous. Real-world movements in price will necessarily take some time, which means that the equilibrium price and quantity toward which the market will ultimately settle can shift with changes in supply and demand.

The effect of changes in demand and supply

Figure 3.7 shows the effects of shifts in demand and supply on the equilibrium price and quantity. In gure 3.7(a), an increase in demand from D1 to D2 raises the

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(a) Price per bushel of tomatoes S

(b) Price per bushel of tomatoes

P2 P1

P2 P1 D1 D2 0 Q1 Q2 Q3 Bushels of tomatoes per week

D2 D1 0 Q1 Q2 Q3 Bushels of tomatoes per week

(c) S1 Price per bushel of tomatoes S2

(d) S2 Price per bushel of tomatoes S1 P2 P1

P2 P1

D 0 Q1 Q2 Q3 Bushels of tomatoes per week 0 Q1 Q2 Q3 Bushels of tomatoes per week

Figure 3.7 The effects of changes in supply and demand

An increase in demand panel (a) raises both the equilibrium price and the equilibrium quantity. A decrease in demand panel (b) has the opposite effect: a decrease in the equilibrium price and quantity. An increase in supply panel (c) causes the equilibrium quantity to rise but the equilibrium price to fall. A decrease in supply panel (d) has the opposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity.

equilibrium price from P1 to P2 and quantity from Q1 to Q2. The equilibrium price rises because at the moment the demand curve shifts out to the right, a market shortage develops at the initial price P1. The quantity demanded at that initial price is Q3; the quantity supplied is less, Q1. Those buyers who want the good but are unable to get it will bid the price up. As the price goes up, producers can justify incurring the higher marginal costs of producing more, but some buyers will retreat on their purchases. The market will clear or quantity supplied and demand will be equal at the higher price of P2.

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Figure 3.7(b) shows the reverse effects of a decrease in demand. When the demand initially falls, a market surplus develops at price P2. At P2, the quantity demanded is Q1 while the quantity supplied is Q3. Producers who want to sell their output will put downward pressure on the price. As the price falls, buyers increase their purchases while producers curb their output. Equilibrium is reestablished at a price of P1 and quantity Q2. An increase in supply from S1 to S2 gure 3.7(c) has a different effect. The equilibrium quantity rises from Q1 to Q2, but the equilibrium price falls from P2 to P1. When supply initially expands, a market surplus emerges at price P2. The quantity demanded is Q1 while the quantity supplied is Q3, which makes for a market surplus. As producers try to sell what they produce, they put downward pressure on the price. As the price falls toward P1, the quantity produced contracts from Q3 to Q2. The quantity demanded rises from Q1 to Q2. A decrease in supply from S1 to S2 gure 3.7(d) causes the opposite effect: the equilibrium quantity falls from Q3 to Q2, and the equilibrium price rises from P1 to P2. At the time supply decreases, a shortage develops, with the quantity supplied at Q1 and the quantity demanded at Q3. Buyers who want more units of the good than are available at P1 will bid the price up. As the price rises from P1 toward P2, the quantity demanded decreases from Q3 to Q2; the quantity supplied rises from Q1 to Q2. [See online Video Modules 3.3 Changes in supply and demand and 3.4 Applications of supply and demand]

The efciency of the competitive market model

Early in this chapter we asked how Fred Lieberman knows what prices to charge for the goods he sells. The answer is now apparent: he adjusts his prices until his customers buy the quantities that he wants to sell. If he cannot sell all the fruits and vegetables he has, he lowers his price to attract customers and cuts back on his orders for those goods. If he runs short, he knows that he can raise his prices and increase his orders. His customers then adjust their purchases accordingly. Similar actions by other producers and customers all over the city move the market for produce toward equilibrium. The information provided by the orders, reorders, and cancellations from stores such as Liebermans eventually reaches the suppliers of goods and then the suppliers of resources. Similarly, wholesale prices give Fred Lieberman information on suppliers costs of production and the relative scarcity and productivity of resources. The use of the competitive market system to determine what and how much to produce has two advantages. First, it coordinates the decisions of consumers and producers very effectively. Most of the time the amount produced in a competitive market system is very close to the amount consumers want at the prevailing price no more, no less. Second, the market system maximizes the amount of output that is acceptable to both buyer and seller. In gure 3.8(a), note that all the pricequantity