The shortage causes a decrease in the equilibrium price to P3 and a decrease in the equilibrium quantity to Q3. Intuitively, less demand for first-class mail leads to a lower equilibrium quantity and ceteris paribus a lower equilibrium price. Parts 1 and 2 are straightforward, but when we put them together it becomes more complex. Think about it this way: In Part 1, the equilibrium quantity fell due to decreased supply. In Part 2, the equilibrium quantity also fell, this time due to the decreased demand.
So putting the two parts together, we would expect to see the final equilibrium quantity Q3 to be smaller than the original equilibrium quantity Q1. So far, so good. Now consider what happens to the price. In Part 1, the equilibrium price increased due to the reduction in supply. But in Part 2, the equilibrium price decreased due to the decrease in demand!
What will happen to the equilibrium price? To understand why the balance must occur, examine what happens when there is no balance, such as when market price is below that shown as P in Image 1. At any price below P, the quantity demanded is greater than the quantity supplied. In such a situation, consumers would clamour for a product that producers would not be willing to supply; a shortage would exist. In this event, consumers would choose to pay a higher price in order to get the product they want, while producers would be encouraged by a higher price to bring more of the product onto the market.
The end result is a rise in price, to P, where supply and demand are in balance. Similarly, if a price above P were chosen arbitrarily, the market would be in surplus with too much supply relative to demand. If that were to happen, producers would be willing to take a lower price in order to sell, and consumers would be induced by lower prices to increase their purchases.
Only when the price falls would balance be restored. A market price is not necessarily a fair price, it is merely an outcome. It does not guarantee total satisfaction on the part of buyer and seller.
Typically, some assumptions about the behaviour of buyers and sellers are made, which add a sense of reason to a market price. For example, buyers are expected to be self-interested and, although they may not have perfect knowledge, at least they will try to look out for their own interests.
Meanwhile, sellers are considered to be profit maximizers. This assumption limits their willingness to sell to within a price range, high to low, where they can stay in business. When either demand or supply shifts, the equilibrium price will change.
The section on understanding supply factors explains why a market component may move. The examples below show what happens to price when supply or demand shifts occur. When a bumper crop develops, supply shifts outward and downward, shown as S2 in Image 2, more product is available over the full range of prices.
With no immediate change in consumers' willingness to buy crops, there is a movement along the demand curve to a new equilibrium. Consumers will buy more but only at a lower price.
How much the price must fall to induce consumers to purchase the greater supply depends upon the elasticity of demand. In Image 2, price falls from P1 to P2 if a bumper crop is produced. If the demand curve in this example was more vertical more inelastic , the price-quantity adjustments needed to bring about a new equilibrium between demand and the new supply would be different.
To understand how elasticity of demand affects the size of adjustment in prices and quantities when supply shifts, try drawing the demand curve or line with a slope more vertical than that depicted in Image 2. Then compare the size of price-quantity changes in this with the first situation.
With the same shift in supply, equilibrium change in price is larger when demand is inelastic than when demand is more elastic. The opposite is true for quantity. These are as follows.
Remember that, in a perfectly competitive market, producers are price-takers. Individually, none of them can effect a price change. All buyers and sellers have perfect information about the quantities available for sale and the prevailing price. For example, if supply was controlled by a monopoly, the latter could set the price wherever it liked. However, a monopoly is still bound by how much the market demands at any given price.
Now consider a situation where the suppliers are price-takers, but information about market conditions is not widely available. However, in a competitive environment we have price independently determining where suppliers and consumers position themselves along their respective supply and demand curves.
We also have the equilibrium price being determined by the interaction of supply and demand. At the point of equilibrium there is no reason for the market to move away from this position unless either the supply or the demand curve moves.
You should recall from the previous two sections the factors that are likely to bring about a shift in either of these two curves. If either the supply or demand curve shifts, a new equilibrium price will be created. A shift in the demand curve to the right will raise the equilibrium price. A movement of supply to the right will reduce the equilibrium price.
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