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Unit 3: Supply and Market Equilibrium

Supply and demand theory can be used to analyse simple problems and make predictions. Notes
Suppose, for instance, the question is how the following changes would affect the market for
text books:
1. A large fall in incomes.

2. The introduction of relatively cheap computerised printing methods.
In (a), a fall in income will have at least two effects on this market. First, students will have
less money to spend on all goods and services, including textbooks. Secondly, the Government
will receive less money in tax revenue and might, therefore, have to reduce expenditure on
school books. The demand curve shifts to the left, price falls and the quantity supplied contracts.
Case III provides a suitable diagram (Figure 3.7) which could be used to illustrate this
reasoning.
An answer to (b) would incorporate a diagram (Figure 3.8) similar to Case II as in this case the
reduction in costs of production can be expected to shift the supply curve to the right.

3.4.2 Price Ceiling and Price Floors

A price ceiling occurs when the price is artificially held below the equilibrium price and is
not allowed to rise. There are many examples of price ceilings. Most price ceilings involve the
government in some way. For example, in many cities, there are rent controls. This means that
the maximum rent that can be charged is set by a governmental agency. This rent is usually

allowed to rise a certain percent each year to keep up with inflation. However, the rent is below
the equilibrium rent.
If the price ceiling is above the market price, then there is no direct effect. If the price ceiling is
set below the market price, then a “shortage” is created; the quantity demanded will exceed the
quantity supplied. The shortage may be resolved in many ways. One way is “queuing”; people
have to wait in line for the product, and only those willing to wait in line for the product will
actually get it. Sellers might provide the product only to family and friends, or those willing to
pay extra “under the table”. Another effect may be that sellers will lower the quality of the good
sold. “Black markets” tend to be created by price ceilings.

Figure 3.9: Price Ceiling and Price Floor

Price floor Surplus Supply
due to P 1
price support Q > Q D
S

P
2

Price ceiling Shortage
due to P 3 Demand
price control Q > Q S
D
Q Q Q
1 2 3
Figure 3.9 depicts the effect of price ceiling and price fl oor.

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