Changes in equilibrium price and quantity: the four-step process |...

Changes in equilibrium price and quantity: the four-step process

Posted 2023-02-16 13:07:37

Key points

There is a four-step process that allows us to predict how an event will affect the equilibrium price and quantity using the supply and demand framework.
Step one: draw a market model (a supply curve and a demand curve) representing the situation before the economic event took place.
Step two: determine whether the economic event being analyzed affects demand or supply.
Step three: decide whether the effect on demand or supply causes the curve to increase (shift to the right) or decrease (shift to the left) and to sketch the new demand or supply curve on the diagram.
Step four: identify the new equilibrium price and quantity and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

Changes in equilibrium price and quantity: the four-step process

Let's start thinking about changes in equilibrium price and quantity by imagining a single event has happened. It might be an event that affects demand—like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. Or, it might be an event that affects supply—like a change in natural conditions, input prices, technology, or government policies that affect production.

How do we know how an economic event will affect equilibrium price and quantity? Luckily, there's a four-step process that can help us figure it out!

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

Establishing this model requires four standard pieces of information:

A downward sloping demand curve
An upward sloping supply curve
Correctly labeled axes: a vertical axis labeled price and a horizontal axis labeled quantity
An initial equilibrium price and quantity. It is a good practice to indicate these on the axes, rather than in the interior of the graph.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

In other words, does the event refer to something in the list of demand factors or supply factors?

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

You can think about it this way: Does the event change the amount consumers want to buy or the amount producers want to sell?

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

The best way to get at this process is to try it out a couple of times! Let’s first consider an example that involves a shift in supply, then we'll move on to one that involves a shift in demand. Finally, we'll consider an example where both supply and demand shift.

Shift in supply: good weather for salmon fishing

In the summer of 2000, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helped the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton—the microscopic organisms at the bottom of the ocean food chain—providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather.

How did these climate conditions affect the quantity and price of salmon? We can get to the answer by working our way through the four-step process you learned above.

The demand and supply model and table below provide the information we need to get started!

Salmon Fishing
Price per pound	Quantity supplied in 1999	Quantity supplied in 2000	Quantity demanded
$2.00	80	400	840
$2.25	120	480	680
$2.50	160	550	550
$2.75	200	600	450
$3.00	230	640	350
$3.25	250	670	250
$3.50	270	700	200

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

In this example, our demand and supply model will illustrate the market for salmon in the year before the good weather conditions began—you can see it above. The demand curve start text, D, 0, end text and the supply curve start text, S, 0, end text show that the original equilibrium price was $3.25 per pound and the original equilibrium quantity was 250,000 fish. This price per pound is what commercial buyers pay at the fishing docks; what consumers pay at the grocery is higher.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

In our fishing example, good weather is an example of a natural condition that affects supply.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

We need to determine if the the effect on supply in our example was an increase or a decrease. Good weather is a change in natural conditions that increases the quantity supplied at any given price. Because of this, the supply curve shifts to the right, moving from the original supply curve start text, S, 0, end text to the new supply curve start text, S, 1, end text. You can see the shift in both the demand and supply model and in the table.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

At the new equilibrium start text, E, 1, end text, the equilibrium price falls from $3.25 to $2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.

What do those numbers mean exactly? In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.

Shift in demand: newspapers and the internet

According to the Pew Research Center for People and the Press, more and more people—especially younger people—are getting their news from online and digital sources. The majority of US adults now own smartphones or tablets, and most of those Americans say they use these devices in part to get the news. From 2004 to 2012, the share of Americans who reported getting their news from digital sources increased from 24% to 39%.

How has this shift in behavior affected consumption of print news media and radio and television news?

Let's use our four-step process again to figure it out. You'll find all the info you need in the demand and supply model below.

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

In this case, we want our demand and supply model to represent the time before many Americans began using digital and online sources for their news. You'll notice in this demand and supply model—above—that the analysis was performed without specific numbers on the price and quantity axes.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

A change in tastes from traditional news sources—print, radio, and television—to digital sources caused a change in demand for the former.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from start text, D, end text, start subscript, 0, end subscript to start text, D, end text, start subscript, 1, end subscript.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

The new equilibrium—start text, E, end text, start subscript, 1, end subscript—occurs at a lower quantity and a lower price than the original equilibrium—start text, E, end text, start subscript, 0, end subscript.

So, what do we know now about the effect of the increased use of digital news sources? We know—based on our four-step analysis—that fewer people desire traditional news sources, and that these traditional news sources are being bought and sold at a lower price.

A combined example: the US Postal Service

In the real world, many factors affecting demand and supply can change all at once. For example, more and more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others, and at the same time, compensation for postal workers tends to increase most years due to cost-of-living increases.

Additionally, an increase in the use of digital forms of communication will affect many markets, not just the postal service. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus—Latin for "other things equal"—assumption. We must look at how each economic event affects each market, one event at a time, holding all else constant. Then, we combine the analyses to see the net effect.

Let's use our four-step analysis to determine how the increased use of digital communication and the increase in postal worker compensation will affect the viability of the Postal Service.

Since this problem involves two disturbances, we need two four-step analyses—the first to analyze the effects of higher compensation for postal workers and the second to analyze the effects of many people switching from "snail mail" to email and other digital messages.

Analysis of increase in postal worker compensation

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

In this example, we want our demand and supply model to illustrate what the market looked like before US postal worker compensation increased. The demand curve start text, D, end text, start subscript, 0, end subscript and the supply curve start text, S, end text, start subscript, 0, end subscript in demand and supply model A—above left—show the original relationships.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

Labor compensation is a cost of production. A change in production costs causes a change in supply for the postal services.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from start text, S, end text, start subscript, 0, end subscript to start text, S, end text, start subscript, 1, end subscript.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

The new equilibrium—start text, E, end text, start subscript, 1, end subscript—occurs at a lower quantity and a higher price than the original equilibrium—start text, E, end text, start subscript, 0, end subscript.

Analysis of increase in use of digital communication

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

In this example, we want our demand and supply model to illustrate what the market looked like before the use of digital communication increased. The demand curve start text, D, end text, start subscript, 0, end subscript and the supply curve start text, S, end text, start subscript, 0, end subscript in demand and supply model B—above right—show the original relationships. Note that demand and supply model B is independent from demand and supply model A.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

A change in tastes away from "snail mail" toward digital messages will cause a change in demand for the Postal Service.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

A shift to digital communication will tend to mean a lower quantity demanded of traditional postal services at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from start text, D, end text, start subscript, 0, end subscript to start text, D, end text, start subscript, 1, end subscript.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity. The new equilibrium—start text, E, 2, end text—occurs at a lower quantity and a lower price than the original equilibrium—start text, E, end text, start subscript, 0, end subscript.

The final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. One way to do this is to graphically superimpose the two diagrams one on top of the other, as we've done below.

By examining the combined demand and supply model, we can come to the following conclusions.

Effect on quantity: Higher postal worker labor compensation raises the cost of production of postal services, which decreases the equilibrium quantity. A change in tastes away from "snail mail" also decreases the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of postal services—start text, Q, end text, start subscript, 3, end subscript. We can see this graphically since start text, Q, end text, start subscript, 3, end subscript is to the left of start text, Q, end text, start subscript, 0, end subscript.

Effect on price: The overall effect on price is more complicated. Higher postal worker labor compensation raises the cost of production, increasing the equilibrium price. But, a change in tastes away from "snail mail" decreases the equilibrium price. Since the two effects are in opposite directions, the overall effect is unclear, unless we know the magnitudes of the two effects. But don't worry; we haven't done anything wrong! When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity but not on the equilibrium price. In other cases, it might be the opposite.

It's also important to keep in mind that economic events that affect equilibrium price and quantity may seem to cause immediate change when examining them using the four-step analysis. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Indeed, even as they are moving toward one new equilibrium, prices are often then pushed by another change in demand or supply toward another equilibrium.

And finally, a word of caution—one common mistake when analyzing the affects of an economic event using the four-step system is to confuse shifts of demand or supply with movements along a demand or supply curve.

Summary

When using the supply and demand framework to think about how an event will affect the equilibrium price and quantity, proceed through four steps:

Step 1. Draw a demand and supply model representing the situation before the economic event took place.

Step 2. Decide whether the economic event being analyzed affects demand or supply.

Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram.

Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.

Self-check questions

From August 2014 to January 2015, the price of jet fuel decreased roughly 47%. Using the four-step analysis, how do you think this fuel price decrease affected the equilibrium price and quantity of air travel?

A tariff is a tax on imported goods. Suppose the US government cuts the tariff on imported flatscreen televisions. Using the four-step analysis, how do you think the tariff reduction will affect the equilibrium price and quantity of flatscreen TVs?

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