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IB DP Economics Study Notes

2.3.2 Changes in Equilibrium

Market equilibrium is a fundamental concept in economics, representing the point where the quantity demanded equals the quantity supplied. However, this equilibrium is not static. Various external and internal factors can influence either the demand or supply, leading to shifts in the equilibrium position.

Factors Causing Shifts

Market shifts are primarily driven by changes in either demand or supply. Let's delve deeper into the specific factors that can cause these shifts:

Demand Factors

  • Income:
    • An increase in consumers' income generally leads to an increase in the quantity of goods and services they can afford. For normal goods, this will lead to a rightward shift in the demand curve. However, for inferior goods (goods for which demand decreases as income increases), the demand curve might shift leftward.
    • Conversely, a decrease in income can lead to a decrease in demand for normal goods but an increase for inferior goods.
  • Tastes and Preferences:
    • These can be influenced by various factors such as cultural shifts, advertising, and societal trends. For instance, if a celebrity endorses a product, it might become more popular, leading to an increase in demand.
  • Price of Related Goods:
    • Substitutes: If the price of a substitute (e.g., tea for coffee) falls, consumers might switch to the substitute, leading to a decrease in the demand for the original product.
    • Complements: If the price of a complementary good (e.g., printers for computers) falls, the demand for the related product might increase.

To understand more about how non-price factors affect demand, read about the non-price determinants of demand.

Graph of change in market equilibrium due to rise in demand

A graph illustrating the change in market equilibrium due to a rise in demand.

Image courtesy of economicshelp

Supply Factors

  • Costs of Production:
    • If the costs of raw materials, labour, or other inputs rise, it might become more expensive for firms to produce the same output level. This can lead to a decrease in supply, shifting the supply curve to the left.
    • Conversely, a decrease in production costs can increase supply, leading to a rightward shift.
  • Technological Advancements:
    • Innovations can lead to more efficient production processes, allowing firms to produce more at a lower cost, leading to an increase in supply.
  • Taxes and Subsidies:
    • Taxes increase the cost of production, potentially leading to a decrease in supply. On the other hand, subsidies, which are financial aids from the government, can reduce production costs and increase supply.

For a deeper dive into how production costs and government interventions such as taxes influence supply, visit non-price determinants of supply and taxation.

Graph of change in market equilibrium due to rise in supply

A graph illustrating the change in market equilibrium due to a rise in supply.

Image courtesy of economicshelp

Shortage vs. Surplus

When the market isn't in equilibrium, it can lead to either a shortage or a surplus.

Shortage

  • Characteristics: A shortage occurs when the quantity demanded exceeds the quantity supplied at the current price. Consumers desire more of the product than producers are willing to supply.
  • Implications: Persistent shortages can lead to consumer frustration, potential rationing, and even the emergence of black markets in extreme cases.

Surplus

  • Characteristics: A surplus arises when the quantity supplied exceeds the quantity demanded. Producers are left with unsold stock, indicating that they've overestimated the market's appetite at the current price.
  • Implications: Prolonged surpluses can lead to wasted resources, potential storage costs for unsold goods, and might force producers to sell at a loss.

Market Adjustments

The beauty of free markets lies in their self-correcting nature. When there's a shortage or surplus, market forces work to restore equilibrium.

Adjusting to a Shortage

  • Price Increase: High demand and limited supply provide an incentive for producers to raise prices. This can lead to increased revenue and potentially higher profits.
  • Quantity Supplied Increases: As prices rise, it becomes more profitable for producers to increase their output. This can lead to an expansion in the industry, with firms either increasing their production capacity or new firms entering the market.
  • Quantity Demanded Decreases: As prices rise, some consumers might be priced out of the market, or they might choose to buy less, leading to a decrease in quantity demanded.

To explore how price changes influence supply and demand, review price elasticity of demand (PED) and factors affecting price elasticity of supply (PES).

Adjusting to a Surplus

  • Price Decrease: With excess stock on their hands, producers might opt to reduce prices to stimulate sales. This can lead to promotional offers or discounts.
  • Quantity Supplied Decreases: If the reduced price isn't covering the costs, some producers might cut back on production. In extreme cases, some firms might exit the market altogether.
  • Quantity Demanded Increases: Lower prices can attract more consumers, leading to an increase in the quantity demanded.

In both scenarios, the price mechanism plays a pivotal role. It acts as a signal and a motivator for producers and consumers alike. Rising prices signal a high demand, prompting producers to produce more, while falling prices indicate excess supply, signalling producers to cut back. Over time, these price signals help markets adjust, ensuring efficient resource allocation. However, it's crucial to note that external factors, such as government interventions or external shocks, can sometimes impede these adjustments.

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A summary table of the causes of changes in market equilibrium and the effects on equilibrium price and quantity.

FAQ

Several factors can delay a market's adjustment to a new equilibrium. Production lags are a primary reason; even if producers want to increase supply in response to higher prices, it might take time to source raw materials, ramp up production, and distribute products. Contractual obligations, such as long-term supply contracts at fixed prices, can also hinder quick adjustments. Additionally, imperfect information can slow reactions; if firms aren't aware of market changes immediately, they can't respond promptly. Lastly, external interventions, like government regulations or price controls, can impede the natural adjustment process of the market.

Government price controls can disrupt the natural equilibrium determined by the forces of supply and demand. A price ceiling, which sets a maximum allowable price, can lead to a shortage if set below the equilibrium price. At this artificially low price, quantity demanded exceeds quantity supplied. On the other hand, a price floor, which sets a minimum allowable price, can result in a surplus if set above the equilibrium price. Here, quantity supplied exceeds quantity demanded. Both scenarios can lead to inefficiencies in the market, with potential welfare losses and misallocation of resources. The longer these controls are in place, the more pronounced their effects can become.

Elasticity measures the responsiveness of quantity demanded or supplied to a change in price. If demand is elastic, consumers are very responsive to price changes, and a small price change can lead to a significant change in quantity demanded. Similarly, if supply is elastic, producers can quickly adjust their output in response to price changes. In markets where either demand or supply (or both) is highly elastic, adjustments to a new equilibrium after a shift in demand or supply will typically be faster. Conversely, in markets with inelastic demand or supply, adjustments can be slower, as consumers or producers are less responsive to price changes.

Consumer expectations about the future can significantly influence current demand. If consumers expect prices to rise in the future, they might decide to purchase more of a product now, leading to an increase in current demand. Conversely, if they anticipate a price drop or believe that the economic situation will worsen, they might hold off on purchases, reducing current demand. These shifts in demand due to expectations can move the market away from its current equilibrium. It's worth noting that these changes are based on perceptions and beliefs, which might not always align with actual future events. Thus, markets can sometimes overreact or underreact based on collective consumer sentiments.

External shocks refer to unforeseen and unexpected events that can disrupt the usual functioning of a market. These could be natural disasters, geopolitical events, or sudden technological breakthroughs. When such a shock occurs, it can lead to abrupt changes in either demand or supply. For instance, a natural disaster might severely limit the supply of a particular agricultural product, leading to a leftward shift in the supply curve. Conversely, a sudden health scare related to a product might drastically reduce its demand. In both cases, the equilibrium price and quantity would be affected. The market, through the price mechanism, will eventually adjust to this new reality, but the time it takes to reach a new equilibrium can vary based on the magnitude of the shock and the market's inherent flexibility.

Practice Questions

Explain the role of the price mechanism in adjusting to a market surplus.

The price mechanism plays a pivotal role in addressing market surpluses. When there's a surplus, it indicates that the quantity supplied exceeds the quantity demanded at the current price. As a result, producers are left with unsold stock. To stimulate sales and reduce this excess inventory, producers might opt to decrease prices. This reduction in price serves two primary functions: it makes the product more attractive to consumers, leading to an increase in quantity demanded, and it might discourage some producers from supplying as much, especially if the reduced price isn't covering their costs, leading to a decrease in quantity supplied. Over time, these adjustments driven by the price mechanism help the market move back towards equilibrium, where quantity supplied equals quantity demanded.

Distinguish between the effects of a change in consumer income on the demand for a normal good and an inferior good.

A change in consumer income can have varying effects on the demand for different types of goods. For a normal good, as consumers' income increases, the demand for the good also rises, leading to a rightward shift in the demand curve. This is because consumers can afford to buy more of the product or service with their increased purchasing power. Conversely, for an inferior good, an increase in income leads to a decrease in demand. As consumers become wealthier, they tend to buy less of the inferior good in favour of higher-quality substitutes, resulting in a leftward shift in the demand curve. This inverse relationship between income and demand for inferior goods is a distinguishing characteristic that sets them apart from normal goods.

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