question_answer

Market for a good is in equilibrium. There is simultaneous 'increase' both in demand and supply of the good. Explain its effect on market price.

Or

Market for a good is in equilibrium. There is simultaneous "decrease" both in demand and supply of the good. Explain its effect on market price.

 

Answer:

The simultaneous increase in demand and supply affects the equilibrium price and output depending on the magnitude of the change in demand and supply. The simultaneous increase in the demand and supply can be bifurcated into the following three conditions.

(i) When Demand and Supply Increase in the Same Proportion

According to the diagram,\[{{E}_{1}}\] is the initial equilibrium with equilibrium price\[{{P}_{1}}\] and equilibrium output\[{{q}_{1}}\].

Now let us suppose, the demand increases to\[{{D}_{2}}{{D}_{2}}\] and the supply increases to\[{{S}_{2}}{{S}_{2}}\] by the same proportion to that of demand. The new demand curve and the new supply curve intersect at point\[{{E}_{2}}\], which is the new equilibrium point.

At the new equilibrium point, new equilibrium output is\[o\,{{q}_{2}}\] while the equilibrium price remains the same at\[o\,{{P}_{1}}\].

Thus, an increase in the demand and the supply by same proportion leaves the equilibrium price unchanged.

(ii) When Demand Increases More than Increase in Supply

The initial demand curve and the initial supply curve intersect each other at point\[{{E}_{1}}\], with initial equilibrium price\[o{{P}_{1}}\] and initial equilibrium output\[o{{q}_{1}}\].

Now let us suppose that, demand increases and thereby demand curve shifts to\[{{D}_{2}}{{D}_{2}}\]. Simultaneously, the supply also rises and the supply curve shift to \[{{S}_{2}}{{S}_{2}}\]. However, the increase in the supply is less than the increase in the demand. The new supply curve and the new demand curve intersect each other at point. \[{{E}_{2}}\], with higher equilibrium price\[o\,{{P}_{2}}\] and higher equilibrium output\[o\,{{q}_{2.}}\]. Thus, when the demand increases more than the increase in supply, the equilibrium price rises.

(iii) When Demand Increases but Lesser than the Increase in Supply

Let the initial equilibrium be at point\[{{E}_{1}}\], with the equilibrium price\[o{{P}_{1}}\] and the equilibrium output\[o{{q}_{1}}\]. Now, suppose that the demand increase to\[{{D}_{2}}{{D}_{2}}\] and supply increases to\[{{S}_{2}}{{S}_{2}}\]. However, the increase in supply is more than that of the increase in demand. The new demand curve\[{{D}_{2}}{{D}_{2}}\] and the new supply curve\[{{S}_{2}}{{S}_{2}}\] intersect at point\[{{E}_{2}}\], with lower equilibrium price\[o\,{{P}_{2}}\]. Thus, when the increase in demand is less than the increase in supply, the equilibrium price falls.

Or

The simultaneous decrease in demand and supply affects the equilibrium price and output depending on the magnitude of the change in demand and supply. The simultaneous decrease in the demand and supply can be bifurcated into the following three conditions.

(i) When Demand and Supply Decreases in the Same Proportion

Let \[{{S}_{1}}{{S}_{1}}\] and \[{{D}_{1}}{{D}_{1}}\] be the initial supply curve and the initial demand curve respectively. The initial equilibrium is at point\[E{{ & }_{1}}\], with equilibrium price at\[o{{P}_{1}}\] and equilibrium output\[o{{q}_{1}}\].

Suppose that both demand and supply decrease by the same proportion. Consequently, the demand curve shifts to\[{{D}_{2}}{{D}_{2}}\] and the supply curve shifts to\[{{S}_{2}}{{S}_{2}}\]. The new equilibrium is at point\[{{E}_{2}}\] with lower equilibrium output\[o\,{{q}_{2.}}\]but the same equilibrium price\[o\,{{P}_{2}}\]. Thus, when both demand and supply decrease in the same proportion, the equilibrium price remains the same, but the equilibrium quantity falls.

(ii) When Demand Decreases More than the Decrease in Supply

Let\[{{D}_{1}}{{D}_{1}}\] and\[{{S}_{1}}{{S}_{1}}\] be the initial demand curve and the initial supply curve, respectively. The initial equilibrium is at point\[E{{ & }_{1}}\] with equilibrium price\[{{P}_{1}}\] and equilibrium output\[{{q}_{1}}\].

Now let us suppose that, demand decrease to\[{{D}_{2}}{{D}_{2}}\] and supply decreases by lesser proportion to\[{{S}_{2}}{{S}_{2}}\]. Consequently, the new equilibrium is established at point\[{{E}_{2}}\]. At the new equilibrium, the equilibrium price falls to\[o\,{{P}_{2}}\] and equilibrium output falls to\[o{{q}_{2}}\]. Thus, when decrease in demand is more than the decrease in supply, the equilibrium price falls accompanied by the fall in equilibrium output.

(iii) When Decrease in Demand is Lesser then Decrease in Supply.

Let the initial equilibrium be at point\[{{E}_{1}}\], determined by the intersection of the initial demand curve\[{{D}_{1}}{{D}_{1}}\]and the initial supply curve\[{{S}_{1}}{{S}_{1}}\]. The equilibrium price is\[o{{P}_{1}}\] and the equilibrium output is\[o{{q}_{1}}\].

Now suppose that, the demand decreases but lesser than the decrease in the supply. The demand curve shifts to\[{{D}_{2}}{{D}_{2}}\] while the supply curve shifts to\[{{S}_{2}}{{S}_{2}}\]. The new equilibrium determined by the intersection of\[{{D}_{2}}{{D}_{2}}\] and\[{{S}_{2}}{{S}_{2}}\] is at point\[{{E}_{2}}\], where the equilibrium price increases to\[o\,{{P}_{2}}\] and the equilibrium quantity falls to\[o\,{{q}_{2.}}\].  Thus, when decrease in demand is lesser then the decrease in supply then the equilibrium price rises and equilibrium output falls to\[o\,{{q}_{2.}}\].