Question

Market for a good is in equilibrium. There is an ‘increase’ in demand for this good. Explain the chain of effects of this change. Use diagram. 

Answer 1

Market equilibrium is a state or a position where market demand equals market supply. Now, if the market demand increases, then it results in a change in the equilibrium. 

Suppose D₁D₁ and S₁S₁ are the initial market demand curve and the initial market supply curve, respectively. The initial equilibrium is established at point E₁, where the market demand curve and the market supply curve intersects each other. Accordingly, the equilibrium price is OP₁ and the equilibrium quantity demanded is Oq₁.

Now, if there is an increase in the market demand, the market demand curve shifts parallely rightwards to D₂D₂ from D₁D₁, while the market supply curve remains unchanged at S₁S_1. This implies that at the initial price OP₁, there exist excess demand equivalent to (Oq'₁ − Oq₁) units. This excess demand will increase competition among the buyers and they will now be ready to pay a higher price to acquire more units of the good. This will further raise the market price. The price will continue to rise till it reaches OP₂. The new equilibrium is established at point E₂, where the new demand curve D₂D₂intersects the supply curve S₁S₁.

At the new equilibrium E_2'

Equilibrium output has increased from Oq₁ to Oq₂

Equilibrium price has increased from OP₁ to OP₂

Hence, an increase in demand with supply remaining constant, results in rise in the equilibrium price as well as the equilibrium quantity.

Increase in Demand ⇒ Excess Demand at the Existing Price ⇒ Competition Among the Buyers ⇒ Rise in the Price Level ⇒ New Equilibrium ⇒ Rise in both Quantity Demanded as well as Price.