How is equilibrium price related to market equilibrium refer to your completed cluster diagram?

1 SECTION 1 Seeking Equilirium: Demnd nd Supply OBJECTIVES KEY TERMS TAKING NOTES In Setion 1, you will explore mrket eq...

SECTION

1

Seeking Equilibrium: Demand and Supply

OBJECTIVES

KEY TERMS

TA K I N G N O T E S

In Section 1, you will

market equilibrium, p. 164

• explore market equilibrium and see how it is reached

equilibrium price, p. 164

• explain how demand and supply interact to determine equilibrium price

shortage, p. 167

As you read Section 1, complete a cluster diagram like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com

surplus, p. 167 disequilibrium, p. 169

market equilibrium

• analyze what causes surplus, shortage, and disequilibrium

Equilibrium

• identify how changes to demand and supply affect the equilibrium price

disequilibrium

The Interaction of Demand and Supply KE Y CON CE P T S

QUICK REFERENCE

Market equilibrium

occurs when the quantity demanded and the quantity supplied at a particular price are equal. Equilibrium price is the price at which the quantity demanded and the quantity supplied are equal.

In Chapters 4 and 5, you learned about how demand and supply work in the market. Recall that a market is any place or situation in which people buy and sell goods and services. Since the market is the place where buyers and sellers come together, it is also the place where demand and supply interact. As buyers and sellers interact, the market moves toward market equilibrium, a situation in which the quantity demanded of a good or service at a particular price is equal to the quantity supplied at that price. Equilibrium price is the price at which the quantity of a product demanded by consumers and the quantity supplied by producers are equal. E X A MP L E

Market Demand and Supply Schedule

Let’s look at an example of how this concept works in a particular market. Karen runs a sandwich shop near an office park. Recently, she decided to offer a new product at lunchtime—prepared salads. On the first day, she makes up 40 salads and offers them at $10 each. She is disappointed when she sells only 10 and has to throw the rest away. The next day she is more cautious. She lowers 164 Chapter 6

the price to $4 each and makes only 15 salads. She discovers that 35 customers wanted her salads at the lower price. How can Karen find the right price? Over the course of a week, Karen experiments with different combinations of price and quantity of salads supplied until she discovers market equilibrium at $6 per salad. At that price, she is willing to offer 25 salads for sale, and she sells all of them. When she has either too many or too few salads, she is motivated to change her price. Market equilibrium is the point at which quantity demanded and quantity supplied are in balance. FIGURE 6.1

K A REN ’ S MA RKE T DEMAND AND SU PPLY SCHEDULE

Price per Salad ($)

Quantity Demanded

Quantity Supplied

10

10

40

8

15

a

35

6

25

25

4

35

b c

2

40

a

At prices above $6, quantity supplied exceeds quantity demanded.

b

At the price of $6, the quantity demanded and the quantity supplied are equal.

c

At prices below $6, the quantity demanded exceeds the quantity supplied.

15 10

Only at the equilibrium price of $6 are the quantity demanded and the quantity supplied equal.

ANALYZE TABLES 1. What is the difference between quantity supplied and quantity demanded when the price is $10? What is the difference when the price is $2?

Use an interactive market demand and supply schedule and curve at ClassZone.com

2. How does this market demand and supply schedule illustrate the laws of demand and supply?

Look at Figure 6.1 to see the information that Karen gathered from her first week selling prepared salads. This table is a combined market demand and supply schedule that shows the quantities of salads supplied and demanded at various prices. Notice that quantity demanded and quantity supplied are different at every line of the schedule except one. That line represents market equilibrium and shows the equilibrium price of $6. When Karen offers salads at prices above $6, she produces more salads than she can sell and has to throw some away. When she offers salads at prices below $6, there is unmet demand because people want more salads than Karen is willing to offer at those prices. Karen’s experience shows how the laws of demand and supply interact in the market. She wants to offer more salads at higher prices than at lower prices because she wants to earn more profit. Her costs would make it impossible to earn much, if any, profit if she were to sell the number of salads that the office workers would like to buy at the lower prices. In a similar way, while the office workers may like the idea of fresh salads for lunch, they are not willing to buy the quantity of salads that Karen wants to sell at higher prices.

Find an update on market equilibrium at ClassZone.com

Demand, Supply, and Prices 165

E X A MP L E

Market Demand and Supply Curve

Just as it is possible to convert a market demand schedule to a market demand curve or a market supply schedule to a market supply curve, it is possible to graph a combined market demand and supply schedule. Figure 6.2 portrays Karen’s market demand and supply schedule on a combined graph. On the graph, the vertical axis shows the various prices at which salads are offered for sale and bought. The horizontal axis shows the quantity of salads, whether it is the quantity demanded or the quantity supplied. The demand curve (D) is plotted using the prices and the quantities demanded (Figure 6.1, columns 1 and 2). The supply curve (S) is plotted using the prices and the quantities supplied from the combined schedule (Figure 6.1, columns 1 and 3). You can read each individual curve the same way that you did in Chapters 4 and 5, when demand and supply were shown on separate graphs. Each point on the demand curve shows the intersection of price and quantity demanded. Each point on the supply curve shows the intersection of price and quantity supplied. FIGURE 6.2

MARKET DEMAND AND SUPPLY CURVES

Price per salad (in dollars)

10

S

8

10 8 6 4 2

c

10 15 25 35 40

40 35 25 15 10

b

The supply curve (S) shows quantity supplied at various prices and slopes up.

c

This is the point of market equilibrium, where quantity supplied and demanded are equal.

b

2

0

The demand curve (D) shows quantity demanded at various prices and slopes down.

Price per Quantity Quantity Salad ($) Demanded Supplied

6 4

a

a 10

20

30

D

40

50

Quantity of salads

ANALYZE GRAPHS 1. What is the quantity supplied at $8? What is the quantity demanded at $8?

2. How do these market demand and supply curves illustrate the concept of equilibrium price?

Look at Figure 6.2 again and notice that the two curves intersect at only one point; this is the point of market equilibrium. It occurs when quantity demanded and quantity supplied are the same—25 salads at $6. Showing the two curves together allows you to see the interaction of demand and supply graphically. A P P L ICAT ION

Applying Economic Concepts

A. Create a combined market demand and supply schedule for pizza at prices of $25, $20, $15, $10, and $5, where $10 is the price at which there is equilibrium. 166 Chapter 6

Reaching the Equilibrium Price KE Y C ONCE P T S

It’s clear from the example of Karen’s salads that markets don’t arrive at equilibrium price instantly; they often require a process of trial and error. The market may experience a surplus, which is the result of quantity supplied being greater than quantity demanded, usually because prices are too high. Or a shortage may occur, the result of quantity demanded being greater than quantity supplied, usually because prices are too low. E XAM P L E

Surplus, Shortage, and Equilibrium

In Figure 6.3, we can see how Karen’s experience demonstrates the concepts of surplus and shortage. It also shows that equilibrium occurs when there is neither a surplus nor a shortage, because quantity demanded and quantity supplied are equal.

QUICK REFERENCE

Surplus is the result of

quantity supplied being greater than quantity demanded. Shortage is the result of quantity demanded being greater than quantity supplied.

FIGURE 6.3 SURPLUS , SHORTAGE , AND EQUILIBRIUM

Price per salad (in dollars)

10

S

a

a

When the price is above $6, quantity supplied exceeds quantity demanded, and there is a surplus (shaded in orange).

b

When the price is below $6, quantity demanded exceeds quantity supplied, and there is a shortage (shaded in blue).

c

At the equilibrium price, there is neither a surplus nor a shortage.

8

c

6 4

b 2

0

D

10

20

30

40

50

Quantity of salads ANALYZE GRAPHS 1. Is there a surplus or a shortage when the price is $10? How big is that surplus or shortage? How great is the surplus or shortage when the price is $2?

2. What does this graph illustrate about surplus, shortage, and equilibrium price?

In Figure 6.3, there is a surplus in the area shaded orange. As Karen discovered when she tried to sell salads at prices above $6, she had too many and had to throw some away. The amount of surplus is measured by the horizontal distance between the two curves at each price. For example, at the price of $8, the distance shown by the black line between 15 and 35 shows a surplus of 20 salads. When there is a surplus, prices tend to fall until the surplus is sold and equilibrium is reached. Producers might also choose to cut back their production to a quantity that is more in line with what consumers demand at the higher prices. Demand, Supply, and Prices 167

The blue area in Figure 6.3 represents where there is a shortage. When Karen decided to charge less than $6, she had too few salads and lots of unhappy customers who weren’t able to get the salads they wanted. As with the surplus, the amount of shortage is measured by the horizontal distance between the two curves at each price. For example, at the price of $4, the distance shown by the black line between 15 and 35 salads shows a shortage of 20 salads. When there is a shortage, producers raise prices in an attempt to balance quantity supplied and quantity demanded. Producers may also try to increase quantity supplied to meet the quantities demanded at the lower prices. E XA MP L E

Holiday Shortages

Consumer tastes often cause spikes in demand for certain items during the holidays.

The concepts of surplus and shortage and the move to equilibrium are active in many markets at different times. Perhaps they are most visible in the market for toys during the holiday shopping season. Toys are often fads, and children’s tastes change rapidly. It is difficult for marketers to know how much to supply and at what price to best meet the quantities demanded by consumers. Sometimes they overestimate a toy’s popularity and end up with a surplus. If they underestimate popularity, they are faced with a shortage. In 1996, for example, Tyco Toys Inc. introduced Tickle Me Elmo. The toy included a microchip that made the toy laugh when it was touched. Tyco expected the toy to be popular and ordered about 500,000 for the holiday season. It was priced around $30. Sales started slowly, and stores thought they might have a surplus. But after several popular television personalities promoted it, Tickle Me Elmo became the hottest toy of that holiday season, and a shortage developed. Even when prices increased markedly, buyers were undeterred. They continued to purchase the toys until they were all gone. Tyco tried to increase its supply, but the factories that made Tickle Me Elmo were located in Asia, and the shortage persisted throughout the holiday season. By spring, the quantity supplied had doubled. By then, however, the height of the fad was over. Initially, stores tried to sell the toys at the same high prices charged during the holiday season. But consumers were reluctant to buy, and a surplus resulted. Eventually, the market reached equilibrium at a price of about $25. When you see suppliers reducing prices, it is often because they have a surplus of products to sell. Consider, for example, what happens to the prices of clothing items that are out of season or no longer in fashion. On the other hand, if an item becomes particularly popular or is in short supply for some other reason, suppliers will raise prices. The market does not always reach equilibrium quickly, but it is always moving toward equilibrium. A P P L ICAT ION

Create a demand and supply curve at ClassZone.com

168 Chapter 6

Holiday Toys

Applying Economic Concepts

B. Look back at the market demand and supply schedule you created for Application A on p. 166. Use it to create a graph showing the interaction of demand and supply and mark it to show surplus, shortage, and equilibrium.

Equilibrium Price in Real Life KE Y C ONCE P T S

In theory, the relationship between demand and supply in the market seems straightforward. The real world, however, is more complex. In earlier chapters, you learned that there are several factors that can cause demand and supply to change. When there is an imbalance between quantity demanded and quantity supplied, a state of disequilibrium exists, and the process of finding equilibrium starts over again. E XAM P L E

QUICK REFERENCE

Disequilibrium occurs

when quantity demanded and quantity supplied are not in balance.

Change in Demand and Equilibrium Price

Let’s take a look at how the market moves from disequilibrium by considering the effect of changes in demand on the equilibrium price for athletic shoes. Recall that a change in demand occurs when one of six factors—income, consumer taste, consumer expectations, market size, substitutes, and complements—prompts consumers to change the quantity demanded at every price. In Figures 6.4 and 6.5, the intersection of the demand curve (D1) and the supply curves (S) shows an equilibrium price of $75, with quantity demanded and supplied of 3,000 pairs of shoes. When a change in consumer taste causes a decrease in demand for athletic shoes at every price, the demand curve shifts to the left, as shown in Figure 6.4. Notice that this new demand curve (D2) intersects the supply curve at a lower price, around $65. This becomes the new equilibrium price. At this FIGURES 6.4

AND

6.5 CHANGES IN DEMAND AND EQUILIBRIUM PRICE

DECREASE IN DEMAND

FIGURE 6.4

125

S Price per pair (in dollars)

Price per pair (in dollars)

125 100

a 75

c 50 25 D2 0

1

2

3

4

INCREASE IN DEMAND

FIGURE 6.5

7

b

In Figure 6.5, demand increases; the demand curve shifts right and intersects the supply curve at a higher point.

c

When demand decreases (Fig. 6.4), the equilibrium price falls to about $65.

d

When demand increases (Fig. 6.5), the equilibrium price rises to about $90.

100

d 75

b 50 25 D1

6

In Figure 6.4, demand decreases; the demand curve shifts left and intersects the supply curve at a lower point.

S

D1 5

a

0

Quantity of shoes (in thousands)

ANALYZE GRAPHS 1. What happens to quantity demanded at $100 when demand decreases? What happens to quantity demanded at $100 when demand increases?

2. Does change in demand have a direct or inverse relationship to equilibrium price? Explain your answer.

1

2

3

4

5

D3

6

7

Quantity of shoes (in thousands)

Use an interactive market demand and supply curve to see changes in demand, supply, and equilibrium price at ClassZone.com

Demand, Supply, and Prices 169

new, lower equilibrium price, the quantity demanded decreases to 2,500 pairs of shoes. In other words, when consumers demand fewer goods and services at every price, the equilibrium price will fall and suppliers will sell fewer units—even though the price is lower. Suppose that an increase in the number of young adults causes demand for athletic shoes to increase. When there is an increase in demand, the demand curve shifts to the right, as shown in Figure 6.5. Notice that the new demand curve (D3) intersects the supply curve at a higher price, around $90. As the equilibrium price increases to this higher level, the quantity demanded also increases to 3,500 pairs of shoes. When consumers demand more goods and services at every price, equilibrium price will rise and suppliers will sell more, even at higher prices. E X A MP L E

Change in Supply and Equilibrium Price

Now let’s consider how changes in supply might affect equilibrium price. Recall that a change in supply occurs when something in the market prompts producers to offer different amounts for sale at every price. Remember from Chapter 5 that the six factors that can change supply are input costs, productivity, technology, government action, producer expectations, and number of producers. In Figures 6.6 and 6.7, the intersection of the supply curve (S1) and the demand curve (D) shows an equilibrium price of $75, with quantity supplied and demanded of 3,000 pairs of shoes. If the price of the raw materials needed to produce athletic shoes increases, the result is a decrease in supply of these shoes at every price. FIGURES 6.6

AND

6.7 CHANGES IN SUPPLY AND EQUILIBRIUM PRICE

DECREASE IN SUPPLY

FIGURE 6.6

S2

100

c 75

a 50 25 D 0

1

2

3

4

5

INCREASE IN SUPPLY

125

S1 Price per pair (in dollars)

Price per pair (in dollars)

125

FIGURE 6.7

6

Quantity of shoes (in thousands)

7

In Figure 6.6, supply decreases; the supply curve shifts left and intersects the demand curve at a higher point.

b

In Figure 6.7, supply increases; the supply curve shifts right and intersects the demand curve at a lower point.

c

When supply decreases (Fig. 6.6) the equilibrium price rises to about $90.

d

When supply increases (Fig. 6.7) the equilibrium price falls to about $55.

S3

S1

100

b

75

d

50 25

D 0

1

2

3

4

5

6

7

Quantity of shoes (in thousands)

ANALYZE GRAPHS 1. What happens to quantity supplied at $100 when supply decreases? What happens to quantity supplied at $100 when supply increases?

2. How do these graphs illustrate the relationship between change in supply and change in equilibrium price?

170 Chapter 6

a

In this situation, the supply curve shifts to the left, as shown in Figure 6.6. Notice that the new supply curve (S2) intersects the demand curve at a higher price, around $90. This is the new equilibrium price. Because of this increase in price, the quantity demanded at equilibrium decreases to 2,500 pairs of shoes. In other words, when there are fewer goods and services available at every price, equilibrium price will rise. When new technology allows the manufacturer to produce shoes more efficiently, supply increases, and the supply curve shifts to the right, as Technology Both supply and equilibrium price are affected when technology shown in Figure 6.7. Notice that the improves the manufacturing process. new supply curve (S3) intersects the demand curve at a lower price, about $55. This is the new equilibrium price. Because of this decrease in price, the quantity demanded at equilibrium increases to about 4,100 pairs of shoes. In other words, when there are more goods and services available at every price, equilibrium price will fall. Look at Figures 6.4, 6.5, 6.6, and 6.7 once more and notice which situations cause equilibrium price to fall and which cause equilibrium price to rise. The relationships between changes in demand or supply and changes in equilibrium price are illustrated in Figure 6.8. Equilibrium price falls when there is a decrease in demand or an increase in supply. Equilibrium price rises when there is an increase in demand or a decrease in supply. In other words, when consumers want less or producers supply more, prices will fall. When consumers want more or producers supply less, prices will rise. FIGURE 6.8

EQUILIBRIUM PRICE AND CHANGES IN DEMAND AND SUPPLY

If demand decreases

supply increases OR

AP P LIC AT ION

THEN

equilibrium price falls.

If demand increases

supply decreases OR

THEN

equilibrium price rises.

Analyzing Effects

C. If one of the three pizza parlors in your neighborhood closes, what will happen to the supply of pizza? How will that affect the equilibrium price of pizza?

Demand, Supply, and Prices 171

ECONOMICS SKILLBUILDER

For more on interpreting graphs, see the Skillbuilder Handbook, page R29.

Interpreting Graphs: Shifting Curves Graphs show statistical information in a visual manner. A graph that shows a shifting curve should immediately alert the reader to one of the following: a change in quantity demanded at every price, or a change in quantity supplied at every price. In Figure 6.9, a change in the number of producers has caused an increase in supply at every price. The sandwich shop across the street from Forest View High School now has a competitor. TECHNIQUES FOR ANALYZING SHIFTING CURVES Use the following strategies,

along with what you learned throughout Section 1, to analyze the graph. Use the title to identify the main idea of the graph. If supply has shifted, then we know that quantity supplied at every price has either increased or decreased.

FIGURE 6.9

Use the annotations to find key elements of the graph. Annotation a shows the equilibrium price where curve S1 meets curve D.

SHIFT IN SUPPLY OF SANDWICHES

6

S1

S2

5 Price (in dollars)

b

Read the axis labels carefully. When both quantity supplied and demanded are present, look for an intersection to find equilibrium price.

4

a

a

This is the initial equilibrium price.

b

Curve shifts to the right.

c

This is the new equilibrium price.

3 Notice that b shows a shift to the right. An increase in supply always shows a rightward shift; a decrease in supply always causes a leftward shift.

c 2 1 D

0

20

40

60

80

100

120

Notice the new equilibrium price, c . An increase in supply results in a lower equilibrium price.

Quantity of sandwiches demanded and supplied

T H IN K IN G E CON OMICA LLY

Analyzing

1. What are the pre-shift and post-shift equilibrium prices for a sandwich? Will an increase in quantity supplied at every price always result in a lower equilibrium price? Why? 2. Imagine that instead of an increase in supply, there is a decrease in demand. How will the equilibrium price change? Why? 3. On a separate sheet of paper, sketch intersecting quantity supplied and demanded curves with an equilibrium price of $4 at 80 sandwiches. How have the curves shifted from those that appear in Figure 6.9? 172 Chapter 6

SECTION

1

Assessment

ClassZone.com

E C O N O M I C S I N P R AC T I C E

REVIEWING KEY CONCEPTS 1. Explain the differences between the terms in each of these pairs: a. market equilibrium disequilibrium

b. surplus shortage

2. How are surplus and shortage related to equilibrium price? 3. Why is equilibrium price represented by the intersection of the supply and demand curves in a particular market? 4. Why do changes in demand or supply cause disequilibrium? 5. Why is the market always moving toward equilibrium? 6. Using Your Notes How is equilibrium price related to market equilibrium? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com

market equilibrium Equilibrium disequilibrium

CRITICAL THINKING 7. Analyzing Data Look at Figures 6.4, 6.5, 6.6, and 6.7 again. What happens to surplus and shortage as equilibrium price changes in each graph? What general conclusions can you draw from this information? 8. Analyzing Causes Suppose that the federal government decides to increase the excise tax on cellular phone services by 0.1 percent. Why will this action cause the equilibrium price of cellular phone services to rise? 9. Applying Economic Concepts Between 2003 and 2005, there was huge growth in the market for premium blue jeans priced at $200 or more per pair. The growth was largely fueled by popular magazines showing celebrities wearing certain brands. Then, in the summer of 2005, major department stores started cutting prices on the jeans; they were also found on Web sites that offer jeans at discount prices. Use the economic concepts that you learned in this section to describe what is happening in this market. 10. Challenge Study Figures 6.4, 6.5, 6.6, and 6.7 again. What would happen if a change in consumer taste caused an increase in demand for athletic shoes and more suppliers entered the market at the same time? Assume that the increases in demand and in supply are proportionately the same. How would this result be different if each of these changes happened separately?

Finding Equilibrium Price Suppose that you are a manufacturer of a new mini refrigerator for college dorm rooms. You expect your product to be popular because of its compact size and high tech design. After a few weeks in the market you are able to develop the following market demand and supply schedule. Price per Refrigerator ($)

Quantity Demanded

Quantity Supplied

225

500

6,000

200

1,000

4,500

175

1,500

3,500

150

2,500

2,500

125

4,000

1,500

Create a Demand and Supply Curve Use this market demand and supply schedule to create a market demand and supply curve and determine the equilibrium price. Challenge Calculate surplus or shortage at every price and suggest ways the manufacturer could try to eliminate the surplus and raise the equilibrium price.

Demand, Supply, and Prices 173

How is equilibrium price related to market equilibrium?

How is equilibrium price determined with diagram?

What is market equilibrium explain with diagram?

How do you explain equilibrium price?