Changes in Market Equilibrium: Impact of Increase and Decrease (2024)

Changes in Market Equilibrium: Impact of Increase and Decrease!

Changes in either demand or supply cause changes in market equilibrium. Several forces bring­ing about changes in demand and supply are constantly working which cause changes in market equilibrium, that is, equilibrium prices and quantities.

The demand may increase or decrease, the supply curves remaining unchanged. This would cause a change in equilibrium price and quantity.

Similarly, the increase or decrease in supply, the demand curve remaining constant, would have an impact on equilibrium price and quantity. Both supply and demand for goods may change simultaneously causing a change in market equilibrium.

Supply-demand analysis is an im­portant tool of economics with which we can make forecasts about how prices and quantities will change in response to changes in demand and supply. We explain below the impact of changes in demand and supply on equilibrium price and quantity.

Impact of Increase in Demand on Market Equilibrium:

Increase in demand affects prices and quantities. Suppose there is increase in income of the working class due to the enhancement of their salaries by the Pay Commission. As a result of this increase in income, their demand for cloth for shirting will increase causing a shift in the entire demand curve for cloth to the right.

This will raise the equilibrium price and quantity of cloth, the supply curve of cloth remaining unchanged as is shown in Fig. 24.2. It is important to understand the chain of causation which leads to the increase in price and quantity as a result of increase in demand.

Consider Fig. 24.2, in which D₀D₀ and SS are the initial demand and supply curves of cloth. The increase in income causes a shift in the entire demand curve to the right to the new position D₁D₁ while the supply curve SS remains constant. It will be observed from Fig. 24.2, that with the shift in demand curve to D₁D₁ at the old price OP₀ excess demand of cloth equal to E₀A has emerged. This excess demand of the good exerts upward pressure on price.

This will result in rise in price to OP where again quantity demanded equals quantity supplied and new market equilibrium is attained and excess demand is eliminated. It is worth noting that increase in demand is the most important factor causing inflation, that is, rise in prices and is generally described as demand-pull inflation.

Though the term inflation is used in the context of a rise in general price level, but it has roots at the micro level (i.e., in case of individual goods). Apart from increase in income, a favourable change in consumer’s preferences for a particular good, rise in price of its substitutes will also cause an in­crease in demand for a good.

Impact of Decrease in Demand on Market Equilibrium:

Now, take the opposite case of the impact of decrease in demand on market equilibrium, the supply curve remaining the same. The decrease in demand causes a shift in the entire demand curve to the left. This is graphically shown in Fig. 24.3, where originally demand curve D₀D₀ intersects the supply curve SS of eggs at point E₀ and determines equilibrium price equal to OP₀ and equilibrium quantity OQ₀. Now, suppose that doctors advise the people to take less eggs as it contains greater quantity of cholesterol which increases the risk of heart disease.

Consequently, demand for eggs decreases causing a shift in the demand curve to the left to the new position D₂D₂. The new equilibrium between demand and supply is attained at price P, and quantity Q₂ which are lower than the initial equilibrium price OP₀ and quantity OQ₀.

Thus, the decrease in demand leads to the fall in both price and quantity. How does this come about? With the decrease in demand and consequently leftward shift in the demand curve to D₂D₂ supply curve remaining unchanged, at the original price OP₀, the surplus E₀B of the quantity supplied over the quantity demanded emerges which exerts a downward pressure on price.

The sellers which cannot sell the quantity which they want to sell at the original price will make offers to sell eggs at a lower price. As a result, price will fall. As price falls, the quantity supplied of eggs is reduced. At the new price OP₂ the quantity supplied again equals quantity demand and surplus is eliminated.

Apart from the changes in preferences for a good as in case of eggs considered above, the decrease in incomes of the people such as when a large number of people are rendered unemployed during depression, the reduction of crop production in agriculture due to failure of Monsoon leading to the drop in incomes of the Indian farmers can also cause a decrease in demand for goods resulting in lowering of prices and quantities of goods.

Impact of Changes in Supply on Market Equilibrium:

Now, we explain the impact of changes in supply on price and output of commodity, the demand for the commodity remaining the same. Let us first examine the case of increase in supply. Suppose in a year there is good Monsoon in India yielding bumper crop of wheat.

This will increase the supply of wheat in the market causing a shift in its supply curve to the right. The impact of increase in supply of wheat on equilibrium price and quantity is graphically depicted in Fig. 24.4. Originally, demand curve DD and supply curve 55 of wheat intersect at point E and determine equilibrium price equal to OP and equilibrium quantity OQ exchanged between the sellers and buyers.

Now, due to good monsoon resulting in bumper crop of wheat the supply curve of wheat shifts to the right from SS to the new position S₁S₁. The new supply curve S₁S₁ intersects the given demand curve DD at point E₁, at which the new lower equilibrium price OP₁ and larger quantity OQ₁ are determined. Thus, the increase in supply leads to the fall in price and increase in equilibrium quantity.

Improvements in technology, reduction in the prices of factors and resources used in the pro­duction of a commodity or lowering of excise duty on a commodity also leads to the increase in supply of the commodity.

For example, in recent years improvements in technology in the manufac­ture of personal computers have served to increase the supply of personal computers causing their supply curve to shift to the right. This has resulted in lowering the prices of personal computers.

A personal computer which was available at price above Rs. 60,000 a few years ago are now available at about Rs. 20,000. Similarly, in the Central Budget for 1993-94, the Finance Minister Dr. Manmohan Singh reduced excise duties on several commodities with the hope that producers it would pass it on to the consumers and result in shifting their supply curve to the right and thereby causing the drop in their prices. At lower prices, he argued, more of these commodities would be demanded and there­fore it would help the industries which were facing demand recession.