Market Adjustment to Change

Market systems are favored by Neoclassical economists for three primary reasons.

First, agents only need information about their own objectives and alternatives. The markets provide information to agents that may be used to identify and evaluate alternative choices that might be used to achieve objectives.

Second, each agent acting in a market has incentives to react to the information provided.

Third, given the information and incentives, agents within markets can adjust to changes. The process of market adjustment can be visualized as changes in demand and/or supply.

Shifts or Changes in Demand

The demand function was defined from two perspectives;

• A schedule of quantities that individuals were willing and able to buy at a schedule of prices during a given period, ceteris paribus.

• The maximum prices that individuals are willing and able to pay for a schedule of quantities or a good during a given time period, ceteris paribus.

In both cases the demand function is perceived as a negative or inverse relationship between price and the quantity of a good that will be bought. The relationship between price and quantity is shaped by other factors or variables. Income, prices of substitutes, prices of compliments, preferences, number of buyers and expectations are among the many possible variables that influence the demand relationship. The demand function was expressed:

Qx = f x(Px, Pc, Ps, M, Preferences, #buyers,...)

Pc is the price of complimentary goods. Ps is the price of substitutes. M is income. Such proxies as gender, age, ethnicity, religion, etc represent preferences. Remember that a change in the price of the good (Px) is a change in quantity demanded or a movement along a demand function. A change in any other related variable will result in a shift of the demand function or a change in demand.

In Figure the effects of a shift in demand are shown.

P_x

D D1 S

Р₁

Ре D2 E

P2

S D

0 Q₂ Qе Q₁ Q_x

If supply is constant, an increase in demand will result in an increase in both equilibrium price and quantity. A decrease in demand will cause both the equilibrium price and quantity to fall.

Given the supply (S) and the demand (D), the equilibrium price in the market is Pe. The equilibrium quantity is Qe. An increase in demand is represented by a shift of demand from D to D1. This will cause and increase in equilibrium price from Pe to P1 and equilibrium quantity from Qe to Q1. A decrease in demand to D2 will cause equilibrium price to fall to P2 and quantity to Q2.