Demand,Supply & Market Equilibrium

Chapter 3

Rationing Function of Prices

The ability of the competitive forces of supply and demand to establish a price at which selling and buying decisions are consistent is called the rationing function of prices. In our case, the equilibrium price of $3 clears the market, leaving no burdensome surplus for sellers and no inconvenient shortage for potential buyers.

Efficient Allocation

Competition among corn producers forces them to use the best technology and right mix of productive resources. If they didn't, their costs would be too high relative to the market price, and they would be unprofitable. The result is productive effiency: the production of any particular good in least costly way.

Changes in Supply, Demand, and Equilibrium

Demand might change because of fluctuations in consumer tastes or incomes, changes in consumer expectations, or variations in the prices of related goods. Supply changes in response to changes in resource price, technology, or taxes.

Change in Demand

An increase in demand raises both equilibrium price and equilibrium quantity. A decrease in demand reduces both equilibrium price and equilibrium quantity.

Changes in Supply

The new intersection of supply demand is located at a lower equilibrium price but at a higher equilibrium quantity. An increase in supply reduces equilibrium price but increases equilibrium quantity.

Complex Cases

When both supply and demand change, the effect is a combination of the individual effects.

Supply Increase; Demand Decrease

Both changes decrease price, so the net result is a price drop greater than that resulting from either change alone. The effects of the changes in supply and demand opposed: the increase in supply increases equilibrium quantity, but the decrease in demand reduces it.

Supply Decrease; Demand Increase

A decrease in supply and an increase in demand for some good, both increase price.

Supply Increase; Demand Increase

A supply increase drops equilibrium price, while a demand increase boosts it. If the increase in supply is greater than the increase in demand, the equilibrium price will fall. If the opposite holds, the equilibrium price will rise.

Supply Decrease; Demand Decrease

If the decrease in supply is greater than the decrease in demand, equilibrium price will rice. If the reverse is true, equilibrium price will fall.

Application: Government-Set Prices

Prices in most market are free to rise or fall to their equilibrium levels, no matter how high or low those levels might be. Government sometimes concludes that supply and demand will produce prices that unfairly high for buyers or unfairly low for sellers.

Price Ceilings on Gasoline

A price ceiling sets the maximum legal price a seller may charge for a product or service. A price at or below the ceiling is legal; a price above it is not.

Price Floors on Wheat

A price floor is a minimum price fixed by the government. A price at or above the price floor is legal; a price below it is not.