Price Changes

How the equilibrium changes

When demand or supply shifts, the market moves to a new equilibrium. There are only four basic cases, and every question is one of them:

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The one students invert is supply: more supply means a lower price. More of something available makes it cheaper.

The steps to explain

Never just state the outcome. Marks are awarded for the process:

1. The cause
2. which curve shifts and in which direction
3. excess demand or excess supply at the old price
4. price rises or falls
5. movements along both curves
6. the new equilibrium price and quantity.

When both curves shift

Sometimes demand and supply both change. Then one outcome is certain and the other depends on which shift is bigger.

For example, if demand and supply both increase, the quantity definitely rises, but the price could rise, fall, or stay the same, depending on which curve moved more. Saying "it depends on the relative size of the shifts" is the correct answer, not a dodge.

Consequences of price changes

This is the second half of the topic and often carries the most marks. Always think about three groups.

Consumers

• A higher price means a lower standard of living, because income buys less. It hurts most when the good is a necessity, since buyers cannot easily go without.
• A lower price means consumers can buy more, or have money left for other goods.
• The impact depends on price elasticity of demand (2.7): if demand is inelastic, consumers cannot avoid the higher price.

Producers

• A higher price usually means higher revenue and profit, so firms may expand and invest.
• A lower price squeezes profit margins; some firms may leave the market.
• Again elasticity matters: if demand is elastic, a higher price loses so many sales that revenue falls.

Workers

• If firms expand because prices and profits rise, they hire more workers, employment rises and wages may rise.
• If prices fall and firms contract, workers may lose their jobs.
• Because demand for labour is derived from demand for the product, changes in a product market pass through to the labour market.

Also worth mentioning where relevant: the government (tax revenue changes) and other countries (if the good is exported).

Worked example

New technology sharply reduces the cost of making solar panels.

1. Lower production costs
2. supply shifts right, from S1 to S2
3. at the old price there is now excess supply
4. firms cut prices to sell their output
5. as the price falls, quantity demanded rises and quantity supplied falls along the curves
6. the new equilibrium has a lower price and a higher quantity.

Consequences:

• Consumers gain: solar panels are cheaper and more households can afford them.
• Producers face a lower price per panel, but sell many more. Whether revenue rises depends on elasticity, for a good with elastic demand, the extra sales more than make up for the lower price.
• Workers in the solar industry benefit as firms expand and hire. But workers in competing industries, for example coal, may lose jobs as demand shifts away from them.

That last point, about a related market, is the kind of detail that lifts an answer.

Common exam mistakes

• Saying an increase in supply raises the price.
• Giving the new equilibrium without explaining the adjustment.
• Forgetting to mention quantity as well as price.
• Discussing only consumers, when the question asks about the effects on several groups.
• Ignoring elasticity when discussing what happens to producers' revenue.
• Claiming a definite outcome for both price and quantity when both curves shift.

Exam technique

Draw the diagram with axes labelled price and quantity, both curves labelled, and both equilibria marked with dotted lines.

Then write the chain in words. Examiners award marks for each link, so "supply shifts left, causing excess demand at the old price, so the price is bid up" scores better than "the price rises".

When the question asks about consequences, organise your answer by group, consumers, producers, workers, and use elasticity to judge how big each effect is.

Building an answer

4 marks, "Explain the effect of a fall in the price of a substitute on the market for tea."

If coffee becomes cheaper, some tea drinkers switch to coffee, so demand for tea falls at every price and the tea demand curve shifts left.
With supply unchanged, there is a surplus at the old price, so the price of tea falls and the quantity traded falls.

Two marks for the shift and its cause, two for the market outcome. Note that coffee's price change shifts tea's demand, the price of the good itself never shifts its own curve.

6 marks, "Analyse the effect on the market for petrol cars of a fall in the price of electric cars."

Electric cars are a substitute, so a lower price for them makes them relatively more attractive and demand for petrol cars shifts left.
At the existing price there is now excess supply of petrol cars, so price falls and quantity traded falls.
The size of the effect depends on cross elasticity of demand: the closer the substitutes, the larger the shift.
There is also a complement effect worth noting, falling demand for petrol cars reduces demand for petrol itself, which is a complementary good, so that market contracts too.

Substitutes and complements, and the direction each moves

The pattern to remember: substitutes move demand the same way as their own price; complements move it the opposite way.

A real case to quote

Streaming and cinema tickets. As subscription streaming became cheaper and more comprehensive, cinema admissions fell in many markets, a substitute becoming cheaper shifting demand left. At the same time, demand for large televisions and home sound systems rose, because those are complements to streaming. One price change, two markets moving in opposite directions.

Quick revision

• D right → P↑ Q↑. D left → P↓ Q↓. S right → P↓ Q↑. S left → P↑ Q↓.
• Explain the chain: cause → shift → excess demand/supply → price change → new equilibrium.
• Both curves shift → one outcome is uncertain; say which and why.
• Consumers: higher prices lower living standards, especially for necessities.
• Producers: revenue depends on elasticity, not just price.
• Workers: demand for labour is derived, so product prices affect jobs.

Check you have it

Question 1

The diagram shows the demand for and supply of plastic bags. The original equilibrium price is P.
How would the introduction of a unit tax on plastic bags be shown?

ADemand would shift to D2.BDemand would shift to D3.CSupply would shift to S2.DSupply would shift to S3.

Question 2

The diagram shows the market for beef in the US with the original equilibrium at X. What will be the new equilibrium position if incomes in the US rise?

APoint ABPoint BCPoint CDPoint D

Question 3

In the diagram, suppliers have set the price of a product at P S. Economic theory predicts that the equilibrium price of the product will rise to P E.
What is the reason for this movement in price?

ADemand for the product will increase.BNo more of the product can be supplied.CSome consumers are willing to pay higher prices.DSuppliers are facing rising costs.

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