4.3 Predicting Market Changes
So far, we’ve seen that the intersection of market supply and demand curves determines the equilibrium price and quantity. We’re now going to harness this powerful insight to predict how prices will change when economic conditions change.
Shifts in Demand
The market demand curve summarizes people’s current buying plans, but if those plans shift, then so will the market demand curve. As you likely recall from your study of demand in Chapter 2, there are several factors that shift demand, including income, preferences, the price of related goods, expectations, congestion and network effects, and the type and number of buyers. But remember: A change in the price will not cause a shift in demand.
Any change that leads you (or others) to buy a larger quantity at each price is an increase in demand, shifting the demand curve to the right. And if the change leads people to buy a smaller quantity at each price, it’s a decrease in demand, shifting the demand curve to the left. Again, don’t confuse these shifts in the demand curve with a movement along the demand curve due to a change in price, which leads to a change in the quantity demanded.
Figure 4 illustrates how the market equilibrium changes when the demand curve shifts. The original or old equilibrium in this market—shown as the black dot—occurs when gas sells for $3 per gallon, and 2 billion gallons of gas are sold each week. But following a shift in demand, the market will move to a new equilibrium.
Figure 4 | Shifts in the Demand Curve
An increase in demand leads to a higher price and a larger quantity.
Panel A shows the consequences of an increase in demand, which is a shift of the demand curve to the right. The new equilibrium occurs at the point where this new demand curve intersects the supply curve, and you can read off the new equilibrium price ($4) and quantity (2.5 billion gallons). This new equilibrium price is higher than in the old equilibrium ($4, compared with $3), as is the new equilibrium quantity (2.5 billion gallons, compared with 2 billion). What’s causing this change? An increase in demand means that buyers want to buy more at the old price of $3, but sellers don’t want to supply any more. If the price didn’t change, a shortage would result. But the prospect of a shortage leads the price to be bid up to $4, and that higher price is the incentive that leads suppliers to increase the quantity they supply as they move along their supply curve. The end result is that an increase in demand causes an increase in both the price and quantity.
A decrease in demand leads to a lower price and a smaller quantity.
Panel B shows that the opposite shift has the opposite effect. It shows a decrease in demand, which shifts the demand curve to the left, moving the market to a new equilibrium where this new demand curve cuts the supply curve. Comparing the new equilibrium to the old one, you’ll see that this decrease in demand causes a reduction in both the equilibrium price (to $2 per gallon) and quantity (to 1.5 billion gallons). Again, pause to reflect on why this happens. There’s decreased demand, but at the old price of $3, no change in supply. If the price didn’t change, a surplus would result. The prospect of a surplus leads the price to be bid down to $2, and that lower price is the incentive that leads suppliers to decrease the quantity they supply as they move along their supply curve. The end result is that a decrease in demand causes a decrease in both the price and quantity.
Demand shifts lead price and quantity to move in the same direction.
Notice that the equilibrium price and quantity both increase following an increase in demand, and they both decrease following a decrease in demand. And so in both cases, shifts in demand cause price and quantity to change in the same direction. As we’re about to see, that’s not true for shifts in supply.
Shifts in Supply
The market supply curve summarizes managers’ current selling plans, and if those plans shift, then so will the market supply curve. As you recall from your study of supply in Chapter 3, there are several factors that shift supply, including input prices, productivity and technology, other opportunities and the prices of related outputs, expectations, and the type and number of sellers. But remember: A change in the price will not cause a shift in supply.
A shift that increases the quantity suppliers plan to sell at each price is an increase in supply, and it shifts the supply curve to the right. The opposite—a decrease in supply—shifts the curve to the left. As we explore the consequences of shifts in the supply curve, be sure not to confuse them with movements along the supply curve, which occur when businesses change their quantity supplied in response to a change in price.
Figure 5 illustrates the consequences of shifts in supply. Once again, the original or old equilibrium in this market occurs when gas sells for $3 per gallon and 2 billion gallons of gas are produced. But if there’s a shift in supply, the market will move to a new equilibrium.
Figure 5 | Shifts in the Supply Curve
An increase in supply leads to a lower price and a larger quantity.
Panel A shows an increase in supply, when the supply curve shifts to the right. The new equilibrium occurs at the point where this new supply curve cuts the demand curve, and it results in a new equilibrium price (of $2) and quantity (of 2.4 billion gallons). This new equilibrium price is lower than in the old equilibrium ($2, compared with $3), and the new quantity is larger (2.4 billion gallons, compared with 2 billion). To see what’s going on, realize that an increase in supply means that managers want to sell more at the old price of $3, but buyers don’t want to demand any more. If the price didn’t change, this increase in supply would lead to a surplus. And this is what causes the price to be bid down to $2. That lower price is the incentive that leads buyers to increase the quantity they demand as they move along their demand curve. The end result is that an increase in supply causes a decrease in price and an increase in quantity.
A decrease in supply leads to a higher price and a smaller quantity.
Panel B shows that the opposite shift has the opposite effect. It shows a decrease in supply, which shifts the supply curve to the left, moving the market to a new equilibrium where this new supply curve cuts the demand curve. Comparing the new equilibrium to the old one, you’ll see that this decrease in supply causes an increase in the equilibrium price (to $4 per gallon) and a decrease in the quantity (to 1.6 billion gallons). Again, pause to reflect on why this happens. There’s decreased supply, but no change in demand. If the price didn’t change from $3, this decreased supply would lead to a shortage. The prospect of this shortage leads the price to be bid up to $4, and that higher price is the incentive that leads buyers to decrease the quantity they demand as they move along their demand curve. The end result is that a decrease in supply causes an increase in the price and a decrease in quantity.
Supply shifts lead price and quantity to move in opposite directions.
Notice that an increase in supply causes the price to fall and the quantity to rise, while a decrease in supply causes the price to rise and the quantity to fall. That is, a shift in supply causes price and quantity to move in opposite directions. By contrast, your analysis of demand shifts revealed that a shift in demand causes price and quantity to move in the same direction. As you work through further examples, you can use these rules to check your analysis.
Predicting Market Outcomes
Congratulations! You have now built the foundations of a powerful framework for predicting market outcomes. The study of buyers that you began in Chapter 2 tells you which factors shape and shift the demand curve. Likewise, your study of sellers that you began in Chapter 3, tells you about the supply side. Now, when you put these together, you can predict how markets will respond to changing economic conditions. This simple supply-and-demand framework is the most powerful predictive device I know.
Okay, let’s practice actually applying the supply-and-demand approach, by analyzing a few real-world business questions. When you work through these examples, you should use the following simple three-step recipe that will help you predict real-world market outcomes.
- Step one: Is the supply or demand curve shifting (or both)?
- Remember that any change affecting buyers or their marginal benefits will shift the demand curve, while any change affecting sellers or their marginal costs will shift the supply curve.
- Step two: Is that shift an increase, shifting the curve to the right? Or is it a decrease, shifting the curve to the left?
- An increase in marginal benefit is an increase in demand, while an increase in marginal cost creates a decrease in supply.
- Step three: How will prices and quantities change in the new equilibrium?
- Compare the old equilibrium with the new equilibrium.
Let’s see how the three-step recipe works, using a few simple examples.
Example one: A major retailer announces plans to install charging stations for electric cars in 400 parking spaces in 120 cities. How will this affect the demand for electric cars?
- Step one: Because buyers of electric cars will have greater access to charging stations while running errands, the convenience—and therefore marginal benefit—of owning an electric car will be higher so this will shift the demand curve.
- Step two: The increased convenience will increase demand for electric cars, shifting the demand curve to the right.
- Step three: At the new equilibrium, this increased demand will raise both the price and quantity of electric vehicles. This is good news for electric car manufacturers.
Example two: Amazon announces that it is developing technology to deliver orders to customers within 30 minutes. Owners of local brick-and-mortar stores want to know how this will affect their company’s sales.
- Step one: Since the people who normally buy from their local stores will have a closer substitute for buying goods that they want quickly, this will shift the demand curve.
- Step two: These buyers will find buying from Amazon to be more attractive, making them less likely to buy from local brick-and-mortar stores. This is a decrease in demand for goods from local stores, shifting the demand curve to the left.
- Step three: Reduced demand will lead to a new equilibrium with both a lower price and a lower quantity. This is bad news for local stores.
Example three: The federal government announces a plan to fund research that will eventually lower the cost of the batteries used in hybrid cars. The head of General Motors’ hybrid vehicle division wants to know how these innovations will affect the hybrid car market.
- Step one: Since the new manufacturing technologies will affect the seller’s marginal cost of producing each hybrid car, this will shift the supply curve.
- Step two: Because these cheaper batteries will reduce the cost of an important input into making hybrid cars, it will lower their marginal costs. Lower marginal costs lead to an increase in supply, shifting the supply curve to the right.
- Step three: This increased supply will mean a lower price and higher quantity of hybrid cars sold—a welcome development for those who would like to see more “green” vehicles on the roads.
Example four: Due to a drought in California, farmers face rising costs for water. Almond farming is a water-intensive process. How will the drought affect the market for almonds?
- Step one: Since water is an input into almond farming, the scarcity of the input will increase the seller’s marginal cost of producing almonds, which will shift the supply curve.
- Step two: Because the marginal cost of producing almonds will rise, supply will decrease, shifting the supply curve to the left.
- Step three: This decrease in supply will lead to a new equilibrium involving a higher price and lower quantity of almonds.
Do the Economics
Think you’ve got this business of predicting outcomes all figured out? Here’s your chance to check, as you work through a dozen more examples.
- If some U.S. states lower the legal drinking age, what will be the effect on the market for beer?
- More consumers
- → An increase in demand
- Result: Higher price, higher quantity.
- It’s now illegal for restaurants in New York City to cook with trans fats, a cheap but unhealthy ingredient used in fast food. What effect does this have on the market for French fries?
- Higher cost of input
- → A decrease in supply
- Result: Higher price, lower quantity.
- How did decreasing gas prices affect the market for fuel-efficient hybrids?
- Lower price of a substitute (less fuel-efficient cars)
- → A decrease in demand
- Result: Lower price, lower quantity.
- Fishermen can now use a “fishfinder” to locate schools of fish in the ocean. How might this affect the market for fish?
- Greater productive efficiency
- → An increase in supply
- Result: Lower price, higher quantity.
- Before a hurricane, people stock up on essential supplies such as food and water. How will this affect the market for groceries?
- Consumers prefer greater quantities
- → An increase in demand
- Result: Higher price, higher quantity.
- Increasingly, corn is being turned into biofuel instead of being used as food. What has this done to the market for corn as a food?
- Biofuel and feed corn are substitutes-in-production
- → A decrease in supply
- Result: Higher price, lower quantity.
- Sony reduced the price of its latest PlayStation videogame console. What effect will this have on the market for competing consoles such as the Xbox?
- Lower price of substitute goods
- → A decrease in demand
- Result: Lower price, lower quantity.
- Coal is burned to produce electricity. What happens in the market for electricity when the price of coal decreases?
- Lower cost of input
- → An increase in supply
- Result: Lower price, higher quantity.
- An Indian car company plans to sell cars in the United States. What will be the effect on the market for cars in the United States?
- More sellers in the market
- → An increase in supply
- Result: Lower price, higher quantity.
- Incomes fell during the last recession. How did this affect the market for luxury jewelry?
- Lower incomes
- → A decrease in demand (since luxury jewelry is a normal good)
- Result: Lower price, lower quantity.
- It was found that certain types of plastic water bottles release harmful chemicals. What happened in the market for metal water bottles?
- Consumer tastes shifted
- → An increase in demand
- Result: Higher price, higher quantity.
- During the Irish potato famine in the 1840s, much of the potato crop was destroyed. What was the effect on the market for potatoes?
- Decreased productivity of farms
- → A decrease in supply
- Result: Higher price, lower quantity.
Recap: Summary of the consequences of shifting supply and demand.
Let’s summarize where we are so far. Figure 6 sums up what we’ve learned from analyzing shifts in supply and demand.
Figure 6 | Consequences of Shifts in Demand or Supply
When Both Supply and Demand Shift
So far, we’ve analyzed what happens when either supply or demand shifts. But what happens when both curves shift at the same time? Fortunately, the same rules still hold, and when more than one curve shifts, you can simply add up the effects. Let’s see how with an example.
A few years back, the gasoline market was hit by two sharp changes: The U.S. economy entered a severe recession, and the price of crude oil (which is a crucial input for gasoline) rose sharply. A recession reduces the incomes of gas consumers, which causes a decrease in their demand for gas. Higher oil prices raise costs for gasoline suppliers, decreasing supply. What’s the likely impact of these simultaneous shifts on the market for gasoline?
Let’s begin by considering each of these shifts separately. When you have more than one shock, you can start by looking at each shift separately and then adding up the effects.
Consider the first shift. The recession caused a decrease in the demand for gasoline at each price. This decrease in demand lowers the equilibrium quantity and price. (You can check this with a quick supply-and-demand sketch, or by looking up at the second row of Figure 6.) The second shift is a rise in the price of oil which caused a decrease in the supply of gasoline. This shift lowers the equilibrium quantity but raises the equilibrium price. (Again, confirm this with a quick sketch.) Finally, add up each of these effects. Both of these shifts lower the equilibrium quantity. The effect on the price is a bit trickier: While the first shift (the decrease in demand) suggests the price will fall, the second shift (the decrease in supply) suggests it will rise. The total change in the price is therefore unclear. Thus, the combined effect of these two shifts is that quantity will fall, but the price could either rise or fall.
In fact, when supply and demand both shift, your conclusion will often be “it depends.” That’s because a change in supply might cause the price or quantity to move in one direction, and then the change in demand can cause it to move in the opposite direction. The total effect depends on which shift has the biggest impact.
The effect of two shifts can depend on which curve shifts the most.
Figure 7 illustrates this point, by showing two extreme cases. Case 1 shows what happens when the demand shift is much bigger than the shift in supply. Case 2 shows the opposite extreme, with a small shift in demand and a much bigger shift in supply. Just as we predicted, the equilibrium quantity declines in both cases. But in Case 1, the price of gas falls, while in Case 2, the price of gas rises. This follows the prediction that the price can either rise or fall, and it shows that the outcome depends on whether the shift in demand or shift in supply dominates. (In fact, the price might even stay the same if the two effects exactly offset each other.)
Figure 7 | Shifts in Supply and Demand
Use the morning-evening method to work out the effects of two curves shifting.
So far we’ve analyzed what happens when demand and supply both decrease. You’re now in a position to analyze all the different cases in which there are simultaneous shifts that lead both supply and demand to either increase or decrease. Figure 8 shows how to work through each possibility, and introduces a shortcut you might find helpful, called the morning-evening method.
Figure 8 | When Both Supply and Demand Curves Shift
Here’s the idea. Analyzing two curves shifting on the same day can get messy. Instead, it can be simpler to think about it as if the demand curve shifts in the morning and the supply curve shifts in the evening. (The order doesn’t really matter.) This way you can just think about one shift at a time. And to find out the total change over the course of the day, simply add up the morning effect and the evening effect.
Let’s try it, starting with the first row of Figure 8: What happens when there’s an increase in both demand and supply? To be concrete, think about the market for lifeguards in the summer, which is flooded with new buyers as pools open for the season (increasing demand) and new suppliers as students become available (increasing supply).
Summertime means overtime; winter time means out of work.
Start with the morning, when the increase in demand leads to an increase in the quantity of lifeguards hired, and an increase in the price they’re paid (that is, their wage). Next, evaluate the changes that occur in the evening. An increase in supply will lead to an increase in quantity, and a decrease in price. Finally, to evaluate what happened over the day as a whole, simply add up what happened in the morning and the evening. The quantity rose in the morning and rose again in the evening, so it must have risen over the day as a whole. But the effect on the price is a bit thornier: It rose in the morning and fell in the evening. Over the whole day, the change in the price is unclear—it might have risen or fallen, depending on whether the demand shift had a bigger or smaller effect than the supply shift. In fact, this analysis provides an accurate diagnosis of how the market for lifeguards changes in the summer: The quantity rises, while the price can either rise or fall.
The second row of Figure 8 asks you to work through the implications of an increase in demand, combined with a decrease in supply, while the third row asks you to work out what happens when demand decreases but supply increases. You should work through each of these examples for yourself, following the logic discussed above. The fourth row shows the final possibility—a decrease in demand and a decrease in supply—which is exactly what happened in the gasoline example we discussed above (and illustrated in Figure 7).
Bottom line: When more than one curve shifts, you can consider the implications first of one shift, and then of the other and then add them together. And don’t be surprised if your prediction for changes in price or quantity is, “It depends.”
Interpreting Market Data
So far, we’ve used supply and demand to help you predict the consequences of changing market conditions. Let’s now turn to an alternative way of thinking, in which supply and demand are diagnostic tools to help you diagnose what is happening in the economy. In order to do this, you need to remember two key rules:
- Rule one: If prices and quantities move in the same direction, then the demand curve has definitely shifted. (It’s possible that the supply curve may also have shifted.)
- Rule two: If prices and quantities move in opposite directions, then the supply curve has definitely shifted. (It’s possible that the demand curve may also have shifted.)
Notice that while these rules can tell you if a particular curve shifted, each comes with a parenthetic aside (“It’s possible . . .”) that is there to remind you that you shouldn’t read this as evidence that the other curve didn’t shift.
Armed with these rules, let’s work through some examples of how changes in prices and quantities are important clues that’ll help you figure out what’s driving changing market conditions.
Interpreting the DATA
How did the advent of e-books change the publishing industry?
Electronic book readers, such as the Amazon Kindle, have given consumers the choice to buy the latest bestseller either as a printed book or as an e-book. In response, the quantity of most bestsellers sold rose (summing across electronic and paper editions), while the average price paid per book fell. What do these price and quantity changes tell us?
Because price and quantity moved in opposite directions, we can infer that this reflects a shift in the supply curve, and the fact that the quantity rose implies that supply increased. Why? An e-book can be produced at a much lower marginal cost (there’s no expensive paper or binding or warehousing or shipping), and a decline in marginal costs will increase supply.
Interpreting the DATA
Why do house sales boom during the summer, but house prices don’t?
Every summer, the quantity of houses sold rises dramatically, but the price of housing doesn’t change much. What do these market movements tell us?
It’s easy to see why many buyers want to move in the summer—work is typically slower, and their kids won’t have to change schools during the school year. Consequently, the demand for housing increases. But if this were the whole story, then housing prices would typically rise in the summer, when in reality they’re usually flat. This suggests that there is also an increase in supply. In fact, this makes sense: Many people trying to buy a new house are also trying to sell their old house. Consequently, both supply and demand increase in the summer. Both of these forces lead to an increase in the quantity sold. And because the increase in supply is roughly equal to the increase in demand, the pressure on housing prices to rise (due to increasing demand) is offset by pressure on them to fall (due to increasing supply).
Interpreting the DATA
How did 9/11 affect the market for Manhattan office space?
The terrorist attacks that toppled the World Trade Center on September 11, 2001, had a chilling effect on the country as well as the economy. Consider the market for Manhattan office space. The destruction of the Twin Towers reduced the available supply of office space, shifting the supply curve to the left. If this were all that happened, we would expect the price of office space to rise, and the quantity to fall. But over ensuing months, the price of office space actually fell. What do these changes tell us?
Because price and quantity moved in the same direction, we can infer that the demand for Manhattan office space also declined. It is likely that this decrease was due to the perception that Manhattan was now a less safe location for an office building, and some businesses chose to locate elsewhere as a result.