Application of The Theory of

Demand and Supply

Economics, R.A. Arnold, 9th ed. (Ch. 3 & 4)
 From One Equilibrium to Another
In Ch. 3 we saw a market may experience a shortage or surplus,
but then it moves towards equilibrium. A market should remain
in equilibrium unless the demand or supply curve shifts. If the
demand or supply curve shifts then the market may move to a
new equilibrium.

This is illustrated in the next slide. In diagram (a) the market is

initially in equilibrium (point 1). Then the number of buyers
increase and the demand curve shifts right (to D2). The market
moves to a new equilibrium point (2). This gives us the new
equilibrium price (P2) and Q, which is greater than the previous
equilibrium price (P1) and Q. So if the demand increases, the
market price and Q is likely to increase (a prediction of the
model).
 Continued

In the figure (b), second diagram of last slide,

we are analyzing the demand of coffee. Assume,
a new report finds coffee consumption leads to
high blood pressure. Hence, buyers will prefer
less coffee. Demand curve of coffee shifts left
and a new equilibrium is established at (2). As a
result, the price of coffee and quantity of coffee
in the market decreases. You can analyze the
other diagrams yourself.
Equilibrium and Predictions: An Application of
The Theory of Supply and Demand

Further examples (Remember: shortage in market

causes price to rise and surplus causes price to fall):
Education market: Current situation indicates a
shortage in this market. Many students can’t get
admitted due to limited seats. In the future tuition
fees of private universities may increase.
**Remember: a good theory should be able to
accurately predict what happens in the real world
(Ch. 1)**
 The Economy (Society) and its Markets

An economy or society that allocates its resources

through the price changes in the market is called a
market economy. Most economies in the world are
market economies.

E.g. Bangladesh (BD) has a limited amount of land

and labor (resources) and it can use (allocate) them
to produce rice or clothes. How will BD decide how
much resource to use in rice production and how
much in clothes production?
 Continued
The market of rice and clothes can help in
making the decision (allocation).
If the price of rice increases in the market of
rice, then QS of rice will increase (law of supply),
and more labor, land will be used (allocated) to
produce rice. Hence, the market helps in the
allocation of resources of the economy.
 Market Interventions
In a market economy, usually, the government does
not interfere (intervene) with the market. But
sometimes, the government might feel the
equilibrium price of a product is too low (e.g. in
case of cigarettes: 15 taka). In this case, the
government might intervene and impose a price
floor (a minimum price for the product: 20 taka).
That is cigarettes cannot be sold at less than 20
taka. This will lead to lower consumption of
cigarettes (high price; less quantity demanded). But
it will also lead to a surplus in the market. Next slide
 Continued
Similarly, the government (gov) might feel the
equilibrium price of a product is too high (e.g.
price of eggs: 12 taka per piece). So, the gov
imposes a price ceiling (the maximum price at
which a product can be sold: 8 taka per egg).
The gov might think more people will be able to
buy eggs now. But remember at a low price
sellers will not want to sell too many eggs. So
gov’s plan may not work. Next slide.
 Taxes and Subsidies
The Government can affect the market using
taxes and subsidies as well.

For example, to reduce the consumption and

production of cigarettes, the government can
impose a tax on cigarettes. Because of the tax,
the price of cigarettes increase and people
consume less cigarettes.
 Continued
To increase the production and consumption of a
product, the government can provide subsidies
(money, resources) to the sellers for producing
the product.
For example, the government can provide subsidy
to the farmers to increase the production of fruits
and vegetables. If the supply of fruits increase,
then the price decreases, and more fruits are
consumed by the society.