Chapter 2 · Competitive markets: Demand and supply
Shift of the demand curve
Explain an increase or decrease in demand and its effects on equilibrium price and quantity. Distinguish a demand shift from a movement along demand.
The economic idea
A competitive market brings buyers and sellers together. Demand is the quantity consumers are willing and able to buy at different prices during a given period. Supply is the quantity producers are willing and able to sell. Each curve holds other influences unchanged: ceteris paribus.
The law of demand describes an inverse relationship between own price and quantity demanded. The law of supply describes a positive relationship between price and quantity supplied. Market equilibrium occurs where quantity demanded equals quantity supplied; a shortage tends to push price up and a surplus tends to push it down.
Demand shifts when a non-price determinant changes what consumers would buy at each price. An increase shifts demand right; a decrease shifts it left. A change in the good’s own price instead changes quantity demanded along the existing curve. The key question is whether the whole relationship changed or buyers responded to a different price.
Demand determinants include income, tastes, expectations, the prices of related goods and the number or composition of buyers. Higher income raises demand for a normal good but lowers it for an inferior good. A higher substitute price raises demand for the other good; a higher complement price lowers it.
The price mechanism signals relative scarcity, rations goods among buyers and gives producers incentives to adjust quantity supplied. After a demand shift, the supply curve can remain unchanged even though the quantity supplied changes.
An increase in demand
“Quantity” is measured on the horizontal axis. Moving to the right represents a greater quantity exchanged in the market.
“Price” is measured on the vertical axis. Moving upward represents a higher price per unit.
“D₁” is a market demand curve. Each point shows the total quantity consumers are willing and able to buy at the corresponding price during the stated time period, ceteris paribus. It records the initial demand conditions before the non-price determinant changes.
“S” is a market supply curve. Each point shows the total quantity producers are willing and able to offer for sale at the corresponding price during the stated time period, ceteris paribus. It is held constant so that the effect of the change in demand can be isolated.
“D₂” is a market demand curve. Each point shows the total quantity consumers are willing and able to buy at the corresponding price during the stated time period, ceteris paribus. It records demand after the non-price determinant changes and must be compared with the initial demand curve.
Starting point: E₁
“D₁” meets “S” at “E₁”, giving the original equilibrium price “P₁” and quantity “Q₁”. At this point quantity demanded equals quantity supplied, so the market has neither a shortage nor a surplus.
The change: D₁ to D₂
“D₂” lies to the right of “D₁” over the visible market range. Demand has increased: at each price consumers are willing and able to buy a greater quantity.
The market adjustment
At the old price “P₁”, “D₂” shows that quantity demanded is now greater than quantity supplied on “S”. The market develops excess demand—a shortage.
The shortage allows sellers to raise price. This is the rationing function of the price mechanism: the higher price reduces the number of consumers willing and able to buy.
As price rises, producers increase quantity supplied along “S”, while consumers reduce quantity demanded along the new “D₂” curve. Neither of these movements is another curve shift.
The process stops at “E₂”, where “D₂” meets “S” and the shortage has been eliminated.
Equilibrium price rises from “P₁” to “P₂” and equilibrium quantity rises from “Q₁” to “Q₂”.
Use the new demand curve when judging the outcome
The final price is a result of the demand change. Compare the initial intersection with the intersection of “D₂” and “S”; do not use the old demand curve to explain buyers’ decisions after the shift.
A higher price after demand increases does not by itself show that consumers are worse off, because their willingness and ability to buy has also changed. Likewise, a shift of demand is not automatically a market failure or a deadweight loss. Any welfare judgement needs the relevant curves and the assumptions of the market model.
Common mistakes to avoid
- “S” did not shift. The change from “Q₁” to “Q₂” includes a movement along supply caused by the changing market price.
- The shift from “D₁” to “D₂” is the cause; the movement along “D₂” during price adjustment is a change in quantity demanded after the shift.
- The size of the price and quantity changes depends partly on the price elasticity of supply. A more inelastic supply curve converts more of the demand change into a price change and less into a quantity change.
- The curves show a relationship, not which non-price determinant changed. Use a supplied context to identify a cause.
How to draw this diagram
- Label the axes “Price” and “Quantity”; draw “D₁” and “S” and mark their intersection.
- Draw “D₂” consistently right for increased demand or left for decreased demand. Keep “S” unchanged.
- Mark and label the new intersection, then project its price and quantity to the axes. If the curves coincide or cross, show that comparison honestly instead of forcing a standard shift.
Assumptions and limitations
- The explanation assumes supply and all other relevant demand determinants remain constant while the selected determinant changes.
- The diagram shows the direction of the new equilibrium but not the speed of adjustment or the precise magnitude of the response.
- The size of the price and quantity changes depends on the price elasticities of demand and supply and on the size of the demand change.
- If the demand curves cross, they do not represent a uniform textbook increase or decrease in demand across the market range.
- The model does not establish whether the new equilibrium is equitable or socially efficient when market failures are present.