25.4 General Equilibrium Supply Response to a Shift in Demand

We’ve established how firms collectively respond to prices. Let’s conclude this chapter by looking at an example of how an increase in the demand for one good causes both an increase in the quantity produced of that good and a decrease in the quantity produced of other goods.

In particular, let’s think of the classic “guns and butter” example used in many high school econ texts. The idea is that an economy can produce two unrelated goods (“guns,” or military goods, and “butter,” or civilian goods) with a single resource (labor). Let’s suppose the country suddenly finds itself at war, and the government wants to buy a lot more guns; but that civilian demand for butter remains unchanged.

The first effect is that the increased demand for guns will bid up the price of guns. This, in turn will increase the demand for labor by gun manufacturers:

[ See interactive graph online at https://www.econgraphs.org/graphs/scarcity/general_equilibrium/labor_demand ]

The next effect, as we discussed earlier, is that the increased demand for labor by gun manufacturers drives up the wage rate for all firms. This, in turn, causes all firms’ marginal costs to increase, shifting the supply curves of both guns and butter to the left:

[ See interactive graph online at https://www.econgraphs.org/graphs/scarcity/general_equilibrium/guns_butter_eqm ]

As you can see, a result of the shift in the supply of butter, the price of butter increases and the quantity decreases. The supply curve of guns also shifts slightly to the left, but this is a second-order effect on the market for guns: overall, the quantity of guns increases because the first-order effect of the increase in demand dominates the second-order effect of the increased equilibrium wage rate.