Question

Start by drawing a supply and demand equilibrium situation.Using your diagram demonstrate graphically and explain verbally the impact of a decrease in supply on equilibrium price and quantity.What could cause this shift?

Answer 1

We have drawn a downward sloping demand curve D₁ and an upward sloping supply curve S₁. Now, initially, equilibrium is attained at the point where demand curve intersects the supply curve at e₁. Here, equilibrium quantity is Q₁ and equilibrium price level is P₁.

Now, suppose, there is a fall in supply in the market without any change in price level. This shifts the supply curve to the left to S₂. As a result, equilibrium quantity falls to Q₂ and equilibrium price rises to P₂ (a lower supply at the same demand increases price level).

Similarly, if supply rises in the market without any change in price level, supply curve will shift to the right. As a result, equilibrium quantity rises and equilibrium price falls.

Price remaining same, shift in the supply curve may be seen due to various factors as follows:

1) If better technologies are used, supply rises and vice-versa.

2) If taxes rise, supply falls and vice-versa. If subsidies rise, supply rises and vice-versa.

3) If number of sellers in the market rises, supply rises and vice-versa.

4) If there are change in price of related goods, supply changes. If price of raw materials rises, supply falls and vice-versa.