Question

If supply decreases by more than demand decreases, what happens to equilibrium price?

Short answer

If supply decreases more than demand decreases, the equilibrium price will increase.

Step-by-step solution

Understanding Demand and Supply

The demand-supply model indicates that the price of any good adjusts to bring the quantity demanded and quantity supplied into balance. As an effect, we achieve an equilibrium price where demand equals supply.

Change in Demand and Supply

In the given scenario, both demand and supply have decreased. It means consumers want to buy less of the good, and producers want to sell less. But the decrease in supply is more than the decrease in demand. Hence, the overall situation is one of reduced supply being available for diminished but relatively steadier demand.

Understanding the effect on Equilibrium Price

When supply decreases more than demand, it creates a shortage in the market. To combat this shortage, the price of the product tends to increase. This is to balance the decreased supply with the still present demand. Therefore, the decrease in supply results in an increase in the equilibrium price. This becomes our new equilibrium point.

Key concepts

Demand and Supply Model

The demand and supply model is a fundamental concept in economics. It explains how the market determines the price and quantity of goods. In this model:

• **Demand**: Represents consumers' desire to purchase goods at various price levels.
• **Supply**: Shows how much of a good producers are willing to sell at different prices.

This model works by adjusting the price so the amount consumers want (demand) corresponds with the amount sellers want to provide (supply).
It operates under the assumption that all else is equal. Market equilibrium is achieved when demand equals supply, meaning all goods produced are sold at the market price, and there’s no surplus or shortage.

Shortage

A shortage occurs when the demand for a good exceeds its supply at the current price. This situation arises when supply cannot meet the demand at the existing price level.

• Shortages usually happen when there is a sudden surge in demand or a reduction in supply.
• This imbalance causes unmet consumer demand.

In the context of the provided exercise, a significant decrease in supply compared to demand decrease results in shortage. This shortage encourages price to rise as consumers compete to purchase the limited goods available.

Market Equilibrium

Market equilibrium is the point where the quantity supplied equals the quantity demanded. At this point, the market "clears," meaning there's no excess supply or demand.
When both supply and demand decrease, the equilibrium may shift due to changes in available goods and consumer interest.

• If supply declines more than demand, there's a tendency for the equilibrium price to rise.
• The opposite occurs if demand decreases more than supply.

Equilibrium changes ensure that the market continues to operate efficiently even with fluctuations in demand or supply.

Price Adjustment

Price adjustment is the market's way of reaching equilibrium after a disruption. When discrepancies cause either shortages or surpluses, prices move to restore equilibrium.

• If a shortage is present, prices rise to reduce demand or increase supply.
• Conversely, an oversupply causes prices to fall until demand increases or supply decreases.

In our scenario, the price rises in response to greater supply reduction compared to demand. This rise aligns with the law of supply and demand, bringing the market back to a new equilibrium point.