Market Equilibrium: The Invisible Hand Randy Rucker Professor Department of Agricultural Economics and Economics June 19, 2013

Review: Consumer Choice and Demand Determinants of the Demand for a Good: Price of the good of interest Prices of Substitutes Prices of Complements Incomes Tastes and Preferences Quality etc. 2

The Demand Curve Shows the Relationship Between the Price of a Good and the Quantity of that Good Demanded Ceteris Paribus (Other Factors are Held Constant) The Law of DemandWhat does it say? Review: Consumer Choice and Demand 3

A Change in Price Causes a Change in Quantity Demanded This is a movement along the demand curve. A Change in Other Factors (e.g., Income) Causes a Change in Demand This is a shift in the demand curve. Review: Consumer Choice and Demand 4

Determinants of the Supply of a Good: Price of the good of interest Prices of Inputs Changes in Technology Number of Firms in the Industry Quality etc. Review: Firms, Profits, and Supply 5

The Supply Curve Shows the Relationship Between the Price of a Good and the Quantity of that Good Supplied Ceteris Paribus (Other Factors are Held Constant) The Law of SupplyWhat does it say? 6

Review: Firms, Profits, and Supply A Change in Price Causes a Change in Quantity Supplied This is a movement along the supply curve. A Change in Other Factors (e.g., an input price) Causes a Change in Supply This is a shift in the supply curve. 7

Market Equilibrium Now, lets put Demand and Supply on the same Graph... 8

Market Equilibrium What Will Be the Price and Quantity that Clear the Market? To Answer This, Suppose the Price Is Initially Below the Price Where the Demand and Supply Curves Intersect ($4). What Will Happen? 9

10 Shortage: Weekly Supply and Demand for Babysitting

Market Equilibrium At a Price of $2 per Hour, there is a Shortage. At that Price, the quantity demanded exceeds the quantity supplied. Babysitters have way more requests than they are willing to provide at $2 per hour. What will happen? 11

Market Equilibrium Parents who cant get a babysitter, and are willing to pay more than $2 per hour, will offer, say $3 per hour. This higher price will cause some parents to stay home, or not stay out as long. That is, quantity demanded will fall. The higher price will also induce some babysitters to work more hours. That is, quantity supplied will increase. Thus, the shortage gets smaller and these market forces will continue to drive prices up. 12

Market Equilibrium Alternatively, Suppose the Price Is Initially Above the Price Where the Demand and Supply Curves Intersect. What Will Happen? 13

Surplus: Weekly Supply and Demand for Babysitting 14

Market Equilibrium At a price of $6 per hour, there is a Surplus. At that price, the quantity supplied exceeds the quantity demanded. Babysitters are willing to work way more hours than parents are willing to purchase. What will happen? 15

Market Equilibrium Some babysitters who cant get any work at $6 per hour, and are willing to babysit for less, will offer their services for, say $5 per hour. This lower price will induce some parents to go out on a date. That is, quantity demanded will increase. The lower price will also cause some babysitters to work fewer hours. That is, quantity supplied will decrease. Thus, the surplus gets smaller and these market forces will continue to drive prices down. 16

Market Equilibrium So, if price is below $4, there will be a shortage, and price will increase. Alternatively, if price is above $4, there will be a surplus and price will fall. In each case above, what causes prices to change? An all-knowing central planner? Happenstance? Market forces? 17

Market Equilibrium When the price is equal to $4, quantity supplied is equal to quantity demanded. That is, the market clearsall parents who are willing to pay that price for a babysitter are able to get one, and all babysitters who are willing to babysit at that price are able to. 18

Market Equilibrium Note: If market forces are allowed to work, prices will adjust and shortages and surpluses will go away. Think: What if prices are not allowed to adjust? Lets come back to this if we have time. 19

Market Equilibrium The fundamental forces just described in the market for babysitters will also be at work in markets for other goods. QUESTIONS??? 20

Market Equilibrium Next, lets apply these principles to see what happens if the market equilibrium described above is disturbed... NOTE: Such disturbances are the rule rather than the exception. Markets are always adjusting to changing conditions. 21

Market Equilibrium First, what happens to the market for Tenderloin Steaks if incomes increase? Recall that Tenderloin Steaks are a normal good. 22

The Market for Tenderloin Steaks Price ($/Q) The Initial Equilibrium Price and Quantity Q (Quantity/week) P0P0 Q0Q0 D0D0 S0S0 23

Impacts of an Increase in Demand Resulting from an Increase in Incomes Q0Q0 Price ($/Q) Q (Quantity/week) P0P0 D0D0 S0S0 P1P1 2 2 Q1Q1 D1D1 1 The Market for Tenderloin Steaks 24

Market Equilibrium Second, what happens to the market for Top Ramen if incomes increase? Recall that Top Ramen is an inferior good. 25

The Market for Top Ramen Price ($/Q) The Initial Equilibrium Price and Quantity Q (Quantity/week) P0P0 Q0Q0 D0D0 S0S0 26

The Market for Top Ramen Impacts of a Decrease in Demand Resulting from an Increase in Income Price ($/Q) Q (Quantity/week) P0P0 Q0Q0 D0D0 S0S0 D1D1 1 P1P1 2 Q1Q1 2 27

Market Equilibrium Third, what happens in the wheat market if there is an increase in supply due to favorable growing conditions in China and Russia? 28

The Market for Wheat Price ($/Q) The Initial Equilibrium Price and Quantity Q (Bushels/year) P0P0 Q0Q0 D0D0 S0S0 29

D0D0 Q (Bushels/year) Price ($/Q) S0S0 P0P0 Q0Q0 The Market for Wheat 2 P1P1 Q1Q1 2 1 S1S1 Impacts of an Increase in Supply Resulting from Good Growing Conditions 30

Market Equilibrium Fourth, what happens to the market for peanut butter if there is a drought in the Southeastern United States? 31

The Market for Peanut Butter Price ($/Q) The Initial Equilibrium Price and Quantity Q (Quantity/year) P0P0 Q0Q0 D0D0 S0S0 32

S1S1 1 Q1Q1 2 2 P1P1 Q (Quantity/year) Price ($/Q) Impacts of a Drought in the Southeastern United States S0S0 D0D0 P0P0 Q0Q0 33 The Market for Peanut Butter

QUESTIONS??? 34

Cautionary Notes Choose your examples carefully Why babysitters, steaks, Top Ramen, wheat, and peanuts? Rather than, say Cars, houses, or shoes? 35

Cautionary Notes (cont.) Analyze the effects of one change at a time. It is easy to try to analyze real-world examples and create confusion because more than one factor is changing. Examples 36

Cautionary Notes (cont.) Shortages and surpluses and the media. Does a decrease in supply cause a shortage? Does an increase in supply cause a surplus? 37

Cautionary Notes (cont.) What if prices are not allowed to adjust? Quickly? or Another day? These stories can be complex... 38

Cautionary Notes (cont.) Maximum prices (price ceilings) Apartments in NYC and CA Anti-price gouging laws Gas price controls in the 1970s Rationing of health care services Others... 39

Cautionary Notes (cont.) Minimum prices (price floors or price supports) Minimum wages Farm programs Proposal for minimum price for alcohol in the U.K. Others... 40