Tuesday, July 25, 2017

How to answer basic Demand and Supply Problems in 3 easy steps.

Determining which curve to shift in the simple Demand and Supply model can be a challenge for students.

Students tend to rush and "over-think" the problem and/or they want to jump ahead a step or two and look at the subsequent effect a particular scenario has on a market.

My advice is "KISS!" (Keep It Simple Students!).

Here is my recommendation as to how to logically think about a given scenario and to get the curve shift right every time.  All in 3 easy steps.

First, you need to be familiar with the Determinants of Demand or Supply:

Factors that affect DEMAND (cause the Demand Curve to SHIFT):
  • change in consumer tastes
  • change in the number of buyers
  • change in consumer incomes
  • change in the prices of complementary and substitute goods
  • change in consumer expectations
Factors the affect SUPPLY*** (cause the Supply Curve to SHIFT):
  • change in input prices
  • change in technology
  • change in taxes and subsidies
  • change in the prices of other goods
  • change in producer expectations
  • change in the number of suppliers
***With SUPPLY, the primary reason you will encounter for Supply Curve shifts is a change in the COST OF PRODUCTION.  When the Costs of Production increases, Supply decreases (curve shifts LEFT). When Costs of Production decrease, Supply Increases (curve shifts RIGHT).

With these determinants in mind, here are the next questions you will want to ask yourself when confronted with a scenario that will shift either the Demand or Supply Curve.
1. Ceterus Paribus (holding all other variables constant--except the one we are addressing) ask yourself  "Is this scenario a function of Demand or Supply?"  Look at your Determinants listed above---make sure you confine yourself to these determinants and do not read more into it! 
2.  After determining which curve to shift ask yourself: ""Will this scenario have a POSITIVE ("good") or NEGATIVE ("bad") impact on Demand or Supply (whichever you decided in question #1)
3.  (a)  If it has a positive impact the curve will shift RIGHT.  This is true whether you    are shifting the Demand OR Supply Curve.
     (b) If it has a negative impact the curve will shift LEFT.  This is true whether you are          shifting the Demand OR Supply Curve.
After you shift the appropriate curve, simply locate the new equilibrium point where Demand and Supply intersect showing a new Price and Market Quantity.

Here is a link to a Google Doc that has some examples for you to work on. Once you establish a rhythm, these get very easy to do.

BIG CAVEAT:  This works well with basic introductory problems in Supply and Demand analysis. HOWEVER, when we go a bit deeper you will encounter at least one situation where the answers are counter-intuitive to the above explanation, especially on the Demand-side.  That is when the scenario suggests that the good is a "Normal Good" or an "Inferior Good" as it relates to a CHANGE IN INCOME (a function of Demand).  For instance, if the good is "Inferior" and incomes INCREASE, then the demand for that Inferior good will DECREASE (shift LEFT). If income Decreases, Demand for the Inferior good INCREASES.  Be careful with this one!

View My Stats