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Modelling other influences

27 January, 2016 - 15:57

How are such changes reflected in our economic model? Let us say that market research quantifies the degree to which the demand curve shifts: Market analysis indicates that the new demand curveis given by P = 13 - Q. Note that the intercept is greater while the slope is unchanged, so the demand curve in this instance shifts outward while maintaining the same slope; it is parallel to the original demand curve.

The new market equilibrium can be established by solving for the intersection of the new demand curve with the existing supply curve. Let us do it.

Demand: P = 13 - Q

Supply: P = 1+(1/2)Q

Equating the two yields:

13-Q = 1+(1/2)Q\Rightarrow 13-1 = Q+(1/2)Q\Rightarrow 12 = 1.5Q

Therefore,

Q = 12/1.5 = 8

Eight units of gas are now traded, rather than 6. The new equilibrium price is obtained as before, by estimating the price at which 8 units of gas will be supplied or demanded. Inserting Q = 8 in either the supply or (new) demand function yields a value of $5. As a result of the demand increase, therefore, both the equilibrium quantity traded and the equilibrium price in the market increase (see Figure 3.2).

We may well ask why so much emphasis in our diagrams and analysis is placed on the relationship between price and quantity, rather than on the relationship between quantity and its other determinants. The answer is that we could indeed draw diagrams with quantity on the horizontal axis and a measure of one of these other influences on the vertical axis. But the price mechanism plays a very important role. Variations in price are what equilibrate the market. By focusing primarily upon the price, we see the self-correcting mechanism by which the market reacts to excess supply or excess demand.

In addition, this analysis illustrates the method of comparative statics—examining the impact of changing one of the other things that are assumed constant in the supply and demand diagrams.

\mid Comparative static analysis compares an initial equilibrium with a new equilibrium, where the difference is due to a change in one of the other things that lie behind the demand curve or the supply curve.

Comparative obviously denotes the idea of a comparison, and static means that we are not in a state of motion. Hence we use these words in conjunction to indicate that we compare one outcome with another, without being concerned too much about the transition from an initial equilibrium to a final equilibrium. The transition would be concerned with dynamics rather than statics. In Figure 3.2 we explain the difference between the points Eo and E_{1} by indicating that there has been a change in incomes or in the price of a substitute good. We do not attempt to analyze the details of this move or the exact path from Eo to E_{1}.