3.7 – Changes in Equilibrium Price and Quantity: The Four-Step Process

Step 1. Develop a demand and supply model to think about what the market looked like before the event. Price is on the vertical axis and quantity is on the horizontal axis. The original quanity is Q₀ and the original price is P₀. The demand curve D₀ and the supply curve S₀ shows the original relationships. In this case, we perform the analysis without specific numbers on the price and quantity axis.  The supply curve S₀ is concave trending upward from left to right. The demand curve D₀ is concave trending downward from left to right and intersects with the supply curve at E₀ equilibrium price occuring at (Q₀, P₀).

Step 2. Did the described change affect supply or demand? 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. Was the effect on demand positive or negative? 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 D₀ to D₁. The supply curve S₀ remains the same.  Quanity is lower, shifting left to Q₁, and price is also lower shifting downward to P₁ and is at the point where the new demand curve D₁  instersects with supply curve S₀ equilibrium price is now E₁.

Step 4. Compare the new equilibrium price and quantity (E₁)  to the original equilibrium price (E₀). The new equilibrium (E₁) occurs at a lower quantity and a lower price than the original equilibrium (E₀).

The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they received their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans obtaining their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own over the last 15 years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not obtain their news from television at all?

The Interconnections and Speed of Adjustment in Real Markets

In the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.

Moreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.

A Combined Example

The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service? Figure 3.7c and the text below illustrate this using the four-step analysis to answer this question.

Figure 3.7c Higher Compensation for Postal Workers: A Four-Step Analysis (a) Higher labour compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.

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

Figure 3.7c (a) shows the shift in supply discussed in the following steps.

Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D₀ and the supply curve S₀ show the original relationships.

Step 2. Did the described change affect supply or demand? Labour compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.

Step 3. Was the effect on supply positive or negative? Higher labour 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 S₀ to S₁.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E₁) occurs at a lower quantity and a higher price than the original equilibrium (E₀).

Figure 3.7c (b) shows the shift in demand in the following steps.

Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D₀ and the supply curve S₀ show the original relationships. Note that this diagram is independent from the diagram in panel (a).

Step 2. Did the change described affect supply or demand? A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.

Step 3. Was the effect on demand positive or negative? A change in tastes away from snailmail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D₀ to D₁.

Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E₂) occurs at a lower quantity and a lower price than the original equilibrium (E₀).

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. Graphically, we superimpose the previous two diagrams one on top of the other, as in Figure 3.7d.

Figure 3.7d Combined Effect of Decreased Demand and Decreased Supply (Text Version)

The vertical axis is Price and the horizontal axis is Quantity. The original supply curve (S0) slopes upward from left to right. The original demand curve (D0) slopes downward from left to right.

Where the original supply curve (S0) and original demand curve (D0) intersects is the original equilibrium at point P0 Q0.

Effect on Quantity: The effect of higher labour compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. Both the demand and supply curve shift: D0 shifts to the left to D1 and S0 shifts to the left to S1. The decrease in the equilibrium quantity of Postal Services (Q3) results in a new equilibrium (E3), which occurs where S1 and D1 intersect.

Effect on Price: There are different factors that can affect the price equilibrium:

The effect of higher labour compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. Quantity decreases and S0 shifts to the left to Q1; however, D0 remains the same. S1 and D0 intersect at the new equilibrium E1 at P1, Q1.

The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Quantity decreases and D0 shifts to the left to Q2; however, S0 remains the same. D1 and S0 intersect at the new equilibrium E2 at P2, Q2.

Following are the results:

Effect on Quantity: The effect of higher labour compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snail mail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q₃). This is easy to see graphically, since Q₃ is to the left of Q₀.

Effect on Price: The overall effect on price is more complicated. The effect of higher labour compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. 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.

The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.

Clear It Up

What is the difference between shifts of demand or supply versus movements along a demand or supply curve?

One common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:

“Well, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S₀ to S₁ on the diagram (Shift 1). The equilibrium moves from E₀ to E₁, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shows the shift from S₁ to S₂, shows on the diagram (Shift 2), so that the equilibrium now moves from E₁ to E₂. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D₀ to D₁ on the diagram (labeled Shift 3), and the equilibrium moves from E₂ to E₃.”

Figure 3.7e Shifts of Demand or Supply versus Movements along a Demand or Supply Curve (Text Version)

The vertical axis is Price and the horizontal axis is Quantity. The original supply curve (S₀) is linear sloping upwards from left to right in the middle of the graph. The original demand curve (D₀) is slightly curved sloping downward from left to right and intersects with S₀ at Point E₀, the original equilibrium.

Shift 1: S₀ shifts furthest to the left to S₁; E0 also shifts to the left where S₁ and D₀ intersect, denoted by Point E₁.

Shift 2: S₁ then shifts slightly back to the right becoming S₂;  E₁ also shifts to the right to where S₂ and D₀ intersect, denoted by Point E₂.

Shift 3: D₀ shifts to D₁ shifts to the left; E₂ shifts downward to a new point of equilibrium at S₂ and D₁.

 

At about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lee’s logic, and then read the answer that follows.

Answer: Lee’s first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D₀), from E₀ to E₁. The rest of Lee’s argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S₁ to S₂. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D₀ to D₁. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.

Think carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.

In the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. 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. Even as they are moving toward one new equilibrium, a subsequent change in demand or supply often pushes prices toward another equilibrium.

Attribution

Except where otherwise noted, this chapter is adapted from “Changes in Equilibrium Price and Quantity: The Four-Step Process” and “Key Concepts and Summary” In Principles of Economics 2e (OpenStax) by Steven A. Greenlaw & David Shapiro, licensed under CC BY 4.0.

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