Question

Market for a product is in equilibrium. Supply of the product decreases. Explain the chain of effects of this change until the market reaches equilibrium.

Answer 1

Effect of a decrease in the supply of a good on its equilibrium price and the equilibrium quantity is discussed with reference to the figure given below:

In the figure, D is the initial demand curve and $S_1$ is the initial supply curve. F is the initial equilibrium where supply and demand curves intersect each other. $O{Q}_1$ is the equilibrium quantity and $O{P}_1$ is the equilibrium price. Owing to a decrease in supply, supply curve shifts to the left, from $S_1$ to $S_2$. As an immediate impact of the decrease in supply, there is excess demand equal to EF (at the existing price). Due to the pressure of excess demand, the price of the commodity tends to be higher than the equilibrium price. The rise in price leads to expansion of supply and contraction of demand. The expansion of supply occurs from point F towards point K. Contraction of demand occurs from point F towards point K. The process of expansion of supply and contraction of demand continues until the excess demand is fully eliminated. K is the point of new equilibrium where the market clears itself once again. Corresponding to the new equilibrium, equilibrium price increases from $O{P}_1$ to $O{P}_2$, and equilibrium quantity decreases front $O{Q}_1$ to $O{Q}_2$.