market for a good is in equilibrium. Supply of a good decreases. Explain the chain effects of this change.Use diagram
In the figure below, the DD represents the initial demand curve and SS represents the initial supply curve. The initial equilibrium point is at E and the initial equilibrium price is OP1 and initial equilibrium quantity is OQ1.
Now, let's assume that the supply of the good decreases. As a result, the supply curve shifts parallely leftwards to S2S2 from S1S1. Thus, at the initial price OP1, holding demand unchanged, there exist excess demand equivalent to (Oq1 – Oq1') units of output. This excess demand will lead some of the consumers to pay a higher price in order to obtain the extra units of output. The rise in the market price will continue until it reaches OP2, where the new supply curve S2S2 intersects the initial market demand curve D1D1. The new equilibrium is established at point E2 with equilibrium price as OP2 and equilibrium output as Oq2. Observe that at the new equilibrium, the equilibrium price has risen, whereas, the equilibrium quantity has fallen.
To summarise,
Decrease in supply⇒ Excess demand at the existing price ⇒ Rise in the price level ⇒ New equilibrium ⇒ Rise in price and fall in quantity demanded.
