Market Dynamics

When we use the world “dynamics,” we simply mean that things change with time,
that they do not stay the same. We defined the equilibrium in a market as the point
where the supply and demand curves intersect, which is also called the “market
clearing” point, where the amount and price of goods that sellers want to sell
matches the price and quantity that buyers want to pay. An equilibrium is a “steady
state” that things tend towards, and where they will tend to stay unless there is some
upsetting force. If you think of a marble in a salad bowl: if you drop the marble from
the rim of the bowl, it will move around for a while, but it will settle in the bottom of
the bowl, and will not move unless some external force is applied to it – unless it is
disturbed.

A market tends towards an equilibrium, but the equilibrium does not stay still. Think
about this: the price of a good, and the quantity sold, does not tend to stay the same
over time for many goods. For example, in 1998, the average price of gasoline was
$1.03/gallon, and about 350 million gallons per day were consumed in the US. By
2007, the price had risen to $2.80, and the consumption had risen to 390 million
gallons/day. But in 2009, the average price was $2.35 and consumption had dropped
to 378 million gallons/day. Each of these three points represents an equilibrium, and
each is quite different.

Figure 4.3 is a plot of the annual average equilibria for gasoline in the United States
from 1992 to 2015. The point at the start of the line, near the lower left corner, is the
equilibrium for 1992, and the line then travels through the next 24 years.
Figure 4.3 Annual Gasoline Equilibria, 1992-2015
Credit: B. Posner

In this chart, I have population-weighted sales by simply dividing sales by annual

average population. You might notice that the path that is followed is pretty
predictable for much of the period – the price is fairly stable for several years, from
about 1992 to 2002, after which it climbs pretty steadily through 2008. We also see
the quantity of sales per person growing quite steadily from 1992 to 2005. Over this
period, the average person was consuming more gasoline, but the price was pretty
stable. In 2005, volumes were 16% higher than 1992. Then something strange
happens – for the years 2006-2012, the path of the equilibrium has “doubled back” on
itself, with quantity falling as price tended to rise (if we take out the anomalous bom-
bust of 2008 and 2009, prices rose quite steadily from 2005 through 2012. Then,
starting in 2013, this trend reversed, and now we are starting to see some modest
growth in consumption. We saw a big jump in 2015 as the price dropped a great deal
after the oil price crash of Fall 2014. We will talk a little more about “why" in the next
section, but I am showing you this path here to illustrate the idea of economic
dynamics: how things change with time. Each point on Figure 4.3 represents an
equilibrium, an intersection of (not shown) supply and demand curves. But the
equilibrium moves with time, with both the equilibrium price and quantity shifting. If
each point is an intersection of two lines, clearly one or both of the lines are moving
with time. When you look at a standard supply and demand diagram, you are looking
at something that is in two dimensions: it has length and width, or price and quantity,
and these are both variable, but there is a third variable that we cannot see on the S-D
diagram: time. If we had some sort of 3-D paper, there would be not two but three
axes intersecting at the origin: price, quantity, and time, and the supply and demand
curves would not be lines, but planes that have three dimensions, planes that are
wavy and twisty, not flat.

This is a rather long-winded way of saying: things change with time. All things change
with time, and markets are no exception.

Results of Changes in the Market

In the previous two lessons, we talked about what causes the movements of the
supply and demand curves, here we will model the results of these changes. That is,
what happens to the equilibrium as market dynamics occur?

Our model of a market consists of two things: a demand curve, and a supply curve. So,
when we look at market dynamics, we are looking at a movement of either the
demand curve or the supply curve, or, more likely, a movement of both. Let’s take a
look at these one at a time first, and then together.

Movements of the Demand Curve

Below, we have a basic, properly-labeled supply and demand diagram. The axes are
labeled as price, P (the y-axis), and quantity, Q (the x-axis), the upward-sloping supply
curve in red, labeled “S”, the downward-sloping demand curve in blue, labeled “D”,
and the equilibrium, at the intersection of the supply and demand curves, labeled “e”,
and the equilibrium price and quantity, shown as P* and Q*.

Figure 4.4 Supply and Demand diagram

Credit: B. Posner
It is important for me to state here: an equilibrium is ALWAYS an ordered pair: (P*,
Q*). If I ask a question in a quiz or exam where I ask for an equilibrium, and you give
me only a price or a quantity, you will be giving me only half of the answer. Price and
quantity.

So, focusing on the demand curve, for the sake of simplicity, we will leave the slope
unchanged, and simply look at side-to-side movements. The demand curve can be
shifted to the right. This is the same as shifting it upwards, or the same as shifting it
diagonally away from the origin. This is called an “outward” shift of the demand
curve, as it moves out from the origin. Such a movement is shown in Figure 4.5.

Figure 4.5 "Outward" shift of the demand curve

Credit: B. Posner

Figure 4.5 shows a movement of the demand curve, from D1 (in light blue) to D2 (in
dark blue). Look at what has happened to the equilibrium: it has shifted from (P*1,
Q*1) to (P*2, Q*2). Note that P*2 > P*1, and Q*2 > Q*1. In other words, an outward
shift of the demand curve results in a larger quantity of goods being sold, and at a
higher price. Why? Well, remember that the demand curve is a functional
relationship that defines how much people are willing to pay for any given quantity of
goods, and this willingness to pay is based on how much happiness people get from
consuming one more unit of the goods in question (the marginal utility). When the
demand curve shifts outward like this, it means that people are willing to pay more
for any given amount of goods. So, given the same upward-sloping supply curve, we
can expect more goods to be sold, and at a higher price, because people are willing to
pay more, and because they are willing to pay more, producers make more to match
their marginal cost with the higher price.

Notice that the equilibrium has moved from e1 to e2. It has moved “along” the supply
curve. The demand curve moved outwards, and the equilibrium “slid” along the static
supply curve. If you read the popular press, you’ll often see writers talking about
“demand for a good increasing.” What they really should say is, “The demand curve
has moved outwards, and the equilibrium quantity has increased.”

I will leave it as an exercise for you to figure out what happens when the demand
curve moves to the left (which is the same as the demand curve moving downwards,
or towards the origin), known as an “inward” movement of the demand curve.

Movements of the Supply Curve

A movement of the demand curve is pretty unambiguous: if the curve moves

outwards, equilibrium price and quantity both increase. If the demand curve moves
inwards, then equilibrium price and quantity both decrease. Things are a little bit
more complicated for movements of the supply curve.

First, let us look at a downward (or rightward) shift of the supply curve while holding
the demand curve steady. This is shown in Figure 4.6, with the supply curve shifting
from its original position, S1 (in red), to a second position, S2 (in green).

Figure 4.6 Downward shift of the supply curve

Credit: B. Posner

See how the equilibrium has “slid” along the demand curve, from e1 to e2. Now,
notice that at e2, quantity has increased (Q*2 > Q*1), but equilibrium price has
moved down (P*2 < P*1). This tells us that a movement of the supply curve
downwards means that more goods will be sold, and at a lower price. This sounds like
a good thing, at least from the consumer’s point of view, but the phrase “supply
shifting downwards” might lead a person to think that fewer goods will be made.
What is happening? Well, the supply curve is a functional relationship (there’s that
phrase again) which describes the marginal cost of producing a given quantity of
goods. If the curve shifts down, it means that the cost of producing the nth instance of
the good has decreased. Repeating myself: costs have come down. Producers are
willing to accept a lower payment for each unit of the good in question because it
does not cost as much to produce. A lot of technology goods follow a path like this:
when I bought my first personal computer in 1989 it cost me over $3,000, and there
were far fewer sold than today. The same goes for my first CD player and first cell
phone. As these technologies improved, prices dropped and the volumes sold
increased, sometimes dramatically.

So, what happens in the opposite case, an upwards shift of the supply curve? I will
leave the diagram to you, but it is not too hard to understand that equilibrium price
will increase, and the quantity sold will decrease.

Movements of Both Curves

It is typically true that both supply and demand curves observe shifts over time. Let’s
take a look at what happens when both move at the same time. First case, what
about an outward shift of the demand curve and downwards shift of the supply
curve? This is shown in Figure 4.7.

Figure 4.7 Movements of both curves

Credit: B. Posner

I have put some arrows on Figure 4.7 to show the downward movement of the supply
curve, from S1 to S2, and the upward movement of the demand curve, from D1 to D2.
The equilibrium has shifted from point e1 to point e2.

What has happened to equilibrium quantity? It has increased – Q*2 > Q*1. Both
movements have led to an increase in Q*. What about equilibrium price? Well, the
demand curve movement caused P* to increase, but the supply curve movement
caused P* to decrease. One step up, one step down. Which one is bigger? Well, on
the diagram, it looks like P*2 is a little bit lower than P*1, but I should make it very
clear that this diagram is an illustration, and not to scale. There are no numbers on it.
In a real life situation, we will be measuring things and will be able to determine the
answer, but here, in the theoretical abstract, we do not know which one is bigger.
We know that Q* increases because the supply curve movement makes the
equilibrium move to the right, and then the demand curve movement also makes the
equilibrium move to the right. Both changes push quantity in the same direction, so
we know that Q* must increase. But P*, we don’t know.

So, to summarize, if D shifts up and S shifts down, then Q* increases and the change
in P* is undetermined.

I will leave it up to you to draw diagrams of the other three combinations, but I will
give you a shorthand summary of the four results:

 If D↑ and S↓, then Q*↑ and P*?

 If D↑and S↑, then Q*? and P*↑
 If D↓ and S↓, then Q*? and P↓
 If D↓ and S↑, then Q*↓ and P*?

Take Aways

After working through the material on this page and reading the associated textbook
content, you should be able to confidently:

 understand and describe the changes in market equilibrium caused by an

outward movement of the demand curve;
 understand and describe the changes in market equilibrium caused by an
inward movement of the demand curve;
 understand and describe the changes in market equilibrium caused by an
upward movement of the supply curve;
 understand and describe the changes in market equilibrium caused by an
downward movement of the supply curve;
 understand and describe the results of combinations of movements of the
supply and demand curves;
 understand the difference between the movement of a curve and the change in
equilibrium - that is, the movementOF a curve versus the movement of an
equilibrium ALONG a curve.
Market Dynamics Examples

Suppose orange demand function in a small town is given by P=5−0.002 Q D . Also,

supply function is given by P=2+0.001 Q S . Where P is the price of one pound of
orange ($/lb) and Q is the total pounds of orange demanded/supplied in the market
(lb). Find the equilibrium price and quantity.

5−0.002 Q D =2+0.001 Q S

At equilibrium Q D = Q S =Q*

5−0.002Q*=2+0.001Q*
0.003Q*=3
Q*=1000lbs
P*=5−0.002Q*=5−0.002(1000)=$3/lb

Assume hurricane damages some orange farms this year. Consequently, supply curve
is shifted upward. The new supply curve will be P=2.75+0.001 Q S . Find the
equilibrium price and quantity.

P=5−0.002 Q D
P=2.75+0.001 Q S

5−0.002 Q D =2.75+0.001 Q S

At equilibrium, Q D = Q S =Q*

5−0.002Q*=2.75+0.001Q*
0.003Q*=2.25
Q*= 2.25 0.003 =750
P*=5−0.002Q*=5−0.002 750 =$3.5/lb

As we can see from the result upward movement of supply shifts the new equilibrium
to ( P*=$3/lb, Q*=750lb ). The new equilibrium has higher price and lower quantity.

Following the previous example, we found that if demand and supply functions for a
local orange market are P=5−0.002 Q D and P=2+0.001 Q S , then market equilibrium
will be ( P*=$3/lb, Q*=1000lb )

Now assume, results of a recently published study shows that eating an orange a day
will have significant health benefit. And this causes the demand curve to shift outward
(to the right). Assume new demand function will be PD=9.5−0.002 Q D
Find the equilibrium price and quantity

P=9.5−0.002 Q D
P=2+0.001 Q S
9.5−0.002 Q D =2+0.001 Q S

At equilibrium, Q D = Q S =Q*

9.5−0.002Q*=2+0.001Q*
0.003Q*=7.5
Q*=2500lbs of oranges
P*=9.5−0.002Q*=9.5−0.002 2500 =$4.5lbs

Then, new equilibrium is P*=$4.5/lb,Q*=2500lbs , which indicates that outward (to

the right) shift of demand curve increase equilibrium price and quantity.

And let’s find the equilibrium considering both supply and demands shifts. Assume
hurricane damages some orange farms causing the supply curve to shift upward with
new supply curve of P=2.75+0.001 Q S . Also, the recently published study causes the
demand curve to shift outward (to the right) with new demand function
of PD=9.5−0.002 Q D . Find the new equilibrium in the market. What are your
expectations on the new equilibrium price and quantity? Higher or lower compared to
initial case?

P=9.5−0.002 Q D
P=2.75+0.001 Q S

9.5−0.002 Q D =2.75+0.001 Q S

At equilibrium Q D = Q S =Q*

9.5−0.002Q*=2.75+0.001Q*
0.003Q*=6.75
Q*=2250lbs of orange
P*=9.5−0.002Q*=9.5−0.002 2250 =$5/lb

The new equilibrium will be P*=$5/lb,Q*=2250lbs

Causes of Market Dynamics I

In Chapter 7 ("Consumer Choice and Elasticity"), there is coverage of material

concerning complements, substitutes, and income elasticities. You may wish to refer
back to this chapter to complement the content here.

In the previous section, we examined what happens to the market equilibrium when
the supply and/or demand curves move. Because markets are dynamic things, that is,
they are always changing with time, the market equilibrium is always moving. From
the previous section, you should understand what happens to a market when the
demand and supply curves move up or down (or in or out.) Now we want to consider
why these curves move.

It is important to remember that the supply and demand diagram is a static object,
but the economy is not static, and things are changing all the time. A supply and
demand diagram is only a snapshot of a market at some fixed point in time. We need
to understand what causes changes, and what results from these changes.

Causes of Demand Curve Movements

When thinking of things like this, I always like to go back to “first principles.” Or what
are sometimes called “fundamentals.” That is, when trying to understand why
something happens, try to go back to the underlying root causes. To do that in this
instance, we first have to understand what a demand curve is. You should be able to
tell me at this point: it is a functional relationship that describes the quantity of goods
that consumers in a market will want to purchase at any given price. Digging a bit
deeper into the fundamentals, we understand where the demand curve comes from:
marginal utility, or how much happiness the consumers obtain from consuming the
good.

So, if the demand curve comes from the amount of utility a consumer will get from
consuming the good, then the demand curve can only change if the consumers get a
different amount of utility from the good in question.

That’s a bit of a mouthful. I’ll try to make it simpler: demand curves change because
people change their willingness to pay. They want to buy more or less of the good.
The next question then arises: what causes this change in utility?

There are several factors that can cause the demand curve to shift. If the curve shifts
upwards (or outwards, away from the origin), then more of a good is demanded by
the consumers at a given price. Or, looked at another way, for a fixed quantity, the
price will be higher. This means that people derive more utility from a unit of the
good. If the reverse happens, and the curve shifts down (or inwards, toward the
origin) then less is demanded at a given price, or a lower price will be offered for a
certain quantity, and this happens because something has caused the consumer to
derive less utility from consumption of the good.

Some Causes of Demand Shifts

Cause #1 – Population

This one is pretty trivial. As we know, a market demand curve is simply an aggregation
of every consumer’s individual demand curve. So, it is a matter of arithmetic to
understand that if there are more consumers, then there are more individual demand
curves to add together, and therefore, the demand curve will be further to the right.
There are many examples of this. For example, when Penn State was a much smaller
school, in the 1960s and 1970s, there were far fewer apartment complexes in State
College. We now have many more apartments than we had in 1970 because there are
far more students, and not because students today want to consume more
apartments than they did 40 years ago.

Cause #2 – Income

As a person makes more money, their ability to consume more goods increases. The
“willingness to pay” increases because the consumer has more money to spend. For
this reason, for a lot of goods, as a person makes more money, the individual demand
curve shifts to the right. In a community, the wealthier the community, the more the
aggregate demand curve moves outwards. This explains why stores that sell luxury
goods are usually in well-to-do suburbs, and not poor, inner-city neighbourhoods.

To describe this situation, we define something called the “income elasticity of

demand.” This is written as follows:

η (I) = %ΔQ %ΔI = Q 2 − Q 1 Q 1 I 2 − I 1 I 1

where “I” is the symbol for income

Spelled out, this means “the percent change in the quantity demanded for a given
percent change in income.” If your consumption of sushi goes from 2 times a month
to 3 when your salary goes up 10%, then your income elasticity of demand for sushi
is 50% 10% =5 .

Example, assume demand for economy car falls from 4000 to 3000 units per year if
the average real income of the customers decreases from $60,000 to $50,000. Find
the income elasticity of demand for the economy car in this town.
Q 1 =4,000
Q 2 =3,000
I 1 =60,000
I 2 =50,000

Using the income elasticity of demand formula,

η (I) = %ΔQ %ΔI = Q 2 − Q 1 Q 1 I 2 − I 1 I 1

η (I) = 3,000−4,000 4,000 50,000−60,000 60,000 =1.25

The income elasticity can either be positive or negative. If it is positive, then the
quantity demanded increases as income increases (a positive number divided by a
positive number). Goods that have positive income elasticities are usually referred to
as “normal” goods by economists. Luxury cars have positive income elasticities.

It is also possible for a good to have a negative income elasticity. This means that as I
increases, Q decreases (a negative number divided by a positive number = a negative
number). What does this mean? It means that as a person makes more money, their
marginal utility from consuming a certain good declines. I mentioned above that while
luxury cars have positive income elasticities, we might say that used cars, or economy
cars, have negative elasticities: as people in a society make more money, they are less
likely to consume a good. I know that as I have gone through life, my willingness to
buy new cars has increased, and my desire to purchase used cars has declined.

Another example might be ramen noodles: students typically do not have a lot of
money, so they buy a lot of cheap food, and ramen noodles are about as cheap as it
comes. However, when students graduate and get jobs, they can afford to eat better,
more satisfying meals, and given that most of us eat a fixed amount of food, this
means that the quantity of ramen noodles decreases as income rises. (For the record,
I still like a brick of noodles every once in a while, but I do not eat them nearly as
much as when I was a student.)

Goods that have negative income elasticities are referred to by economists as

“inferior” goods. An inferior good is one that we consume less of as we become
wealthier. As we have more money, we can substitute for the inferior good with
something that is more expensive, but more enjoyable. We will talk more about
substitutes in a minute.

Cause #3 – The Price of Other Goods

The willingness to pay for a good is always relative to the willingness to pay for any
and all other goods. The price of some other good can have an effect on our
consumption choices.
When we think of how the price of one good can affect the demand curve for another
good, we have to define two categories of goods: substitutes and complements.

A substitute is a good that you would consume instead of the good in question. As
mentioned above, ramen noodles and steaks can be thought of as substitutes: if you
are eating a lot of one, you are likely not eating a lot of the other. Life is full of
substitution options: working instead of going to school, taking the bus instead of
driving, renting a house instead of buying, taking an expensive vacation versus buying
football tickets, going to a movie instead of going to a nightclub, and so on.

A complement is a good that you consume in addition to the good in question, with the
condition that without one, you would not consume the other. For example, cars and
gasoline (and tires) are all complements. On their own, each of these goods is fairly
useless. But use them together, and they suddenly have more value. And, as you
consume more of one, you are likely to consume more of another. Think of DVDs and
DVD players, or iPods and earbuds, or shoes and shoelaces.

Now, we have to think about how the price of one good can affect the price of
another. For this, we define the term “cross-elasticity of demand”. This is defined as
follows:

η (XY) = %Δ Q X %Δ P Y Q X2 − Q X1 Q X 1 P Y2 − P Y1 P Y1

where X and Y are subscripts denoting the two goods in question.

Spelled out, this statement reads: the cross-elasticity of goods X and Y is the percent
change in the quantity of good X demanded that corresponds to a percent change in
the price of good Y.

Assume demand for chicken is 2000 lbs per day and beef price $3/lb. Holding
everything else constant, demand for chicken increases to 2000 lbs per day when beef
price increase to $4/lb. Calculate cross-elasticity of demand for chicken.

Q X1 =2000lbs/day
Q X2 =3000lbs/day
P Y1 =$3/lb
P Y2 =$4/lb

η (XY) = Q X2 − Q X1 Q X 1 P Y2 − P Y1 P Y1 = 3000−2000 2000 4−3 3 =1.5

The cross-elasticity can be either positive or negative, and the sign will tell us if goods
are substitutes or complements. In the previous example cross-elasticity of chicken
and beef is positive. So, we can say they are substitutes.
Let’s think of two common substitutes: chicken and beef. It is not hard to understand
that if the price of beef goes up while the price of chicken stays the same, then people
will tend to substitute chicken for beef. So, as the price of beef increases, the quantity
of chicken demanded increases. The cross-elasticity in this case is a positive number
divided by a positive number (or a negative divided by a negative), which gives us a
positive number. Therefore, substitute goods have a positive cross-elasticity.

Now, let us think about complements. In the 1980s, CD players came on to the
market. At first, CD players were very expensive, and very few people had them.
Correspondingly, there were fewer music CDs sold. Over time, the price of CD players
came down, and as a result, the quantity of CDs sold increased dramatically (even
though the price did not change much for many years). It is easy to see that CD
players and CDs are complements: one of the two is of little use without the other. So,
when we look at our formula for the cross-elasticity, a decrease in the price of CD
players led to an increase in the quantity of CDs demanded. A positive number
( Δ Q X ) is divided by a negative number ( Δ P Y ). Thus, the cross-elasticity is negative.

This leads to the definition of a handy rule: if the cross-elasticity of two goods can be
shown to have a consistently positive value, then the goods are substitutes. If the
cross-elasticity is shown to be consistently negative, the goods are complements. If
the cross elasticity is either zero, or inconsistent, then it is likely that the goods are
neither complements nor substitutes, but unrelated. Obviously, in our complicated
economy, everything is related to everything else - the price of jet planes in Europe
probably has some effect on the price of corn in Illinois, but the effect of one on the
other is so dispersed as to be unobservable in any meaningful manner.