Equilibrium By J.A. SACCO

MARKET EQUILIBRIUM Market equilibrium Equilibrium price When the quantity demanded equals the quantity supplied—when buyers’ and sellers’ plans are consistent. Equilibrium price The price at which the quantity demanded equals the quantity supplied. Equilibrium quantity The quantity bought and sold at the equilibrium price.

MARKET EQUILIBRIUM Figure shows the equilibrium price and equilibrium quantity. 1. Market equilibrium at the intersection of the demand curve and the supply curve. 2. The equilibrium price is $1 a bottle. 3. The equilibrium quantity is 10 million bottles a day.

MARKET EQUILIBRIUM Price: A Market’s Automatic Regulator Law of market forces When there is a shortage, the price rises. When there is a surplus, the price falls. Shortage or Excess Demand The quantity demanded exceeds the quantity supplied. Surplus or Excess Supply The quantity supplied exceeds the quantity demanded. The law of market forces is important, so you want your students to grasp why prices are driven to the equilibrium. You can choose a good, like concert tickets to the hottest band. Draw a demand-supply graph with a reasonable equilibrium price and quantity. Ask the students what would happen if the concert promoter decided to charge only $10 a ticket. Would students line up before dawn to buy them? Yes! Explain that this is a case of excess demand. Ask them what could the promoter do to get the crowds to go away? Hopefully they will answer, “Raise ticket prices!” Show them how the market pressures the price to rise to the equilibrium price and use the graph to show how the promoter and students move up their respective supply and demand curves. You can do the same thing for excess supply. Let the promoter try to sell tickets for $1,000 each. Again, move down along the supply and demand curves as the market pressures the price to fall.

MARKET EQUILIBRIUM Figure (a) market achieves equilibrium. At 75 cents a bottle: 1. Quantity is demanded 11 million bottles. 2. Quantity supplied is 9 million bottles. The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve got the time, with hard evidence in the form of further class activity. If you did the demand experiment, you might want to begin with that and explain that in the classroom market, the supply was fixed (so there was vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve. Then, if you did the supply experiment, you can explain that in that classroom market, demand was fixed (so there was a vertical demand curve) at the quantity that you had decided to buy. The equilibrium occurred where the market supply curve (supply by the students) intersected your demand curve. Point out that the trades you made in your classroom economy made buyers and sellers better off. If you want to devote a class to equilibrium and the gains from trade in a market, you might want to run a double oral auction. There are lots of descriptions of these and one of the best is at Charlie Holt’s http://veconlab.econ.virginia.edu/admin.htm 3. There is a shortage of 2 million bottles. 4. Price rises until the shortage is eliminated and the market is in equilibrium.

MARKET EQUILIBRIUM Figure (b) market achieves equilibrium. At $1.50 a bottle: 1. Quantity supplied is 11 million bottles. 2. Quantity demanded is 9 million bottles. 3. There is a surplus of 2 million bottles. 4. Price falls until the surplus is eliminated and the market is in equilibrium.

MARKET EQUILIBRIUM Predicting Price Changes: Three Questions We can work out the effects of an event by answering: Does the event change demand or supply? Does the event increase or decrease demand or supply—shift the demand curve or the supply curve rightward or leftward? What are the new equilibrium price and equilibrium quantity and how have they changed? The whole chapter builds up to using the demand/supply model to predict changes in the equilibrium price and quantity. Students are too ready to guess the consequences of events that change either demand, or supply or both. They must be encouraged to work out the answer and draw the diagram. Encourage the students to break all exercises about the effects of events in a market into three questions: Question 1 Does the event change demand, supply, both, or neither? Question 2 Does the event increase or decrease demand or supply—shift the demand curve or the supply curve rightward or leftward? Question 3 What are the new equilibrium price and equilibrium quantity and how have they changed? Proceed in five steps: Step 1 Draw a demand-supply graph and label the axes with the price and quantity of the good or service in question. Step 2 Think about the event or events and answer Question 1: does it change demand, supply, both or neither. Step 3 Think about the event or events and answer Question 2: what is the direction of change? Step 4 Draw the new demand curve and supply curve on the diagram. Step 5 Look at the diagram and answer Question 3: how have the price and quantity changed? Walk the students through the steps and have one or two students work some examples in front of the class.

MARKET EQUILIBRIUM Effects of Changes in Demand Event: A new study says that tap water is unsafe. To work out the effects on the market for bottled water: With tap water unsafe, demand for bottled water changes. The demand for bottled water increases, the demand curve shifts rightward. What are the new equilibrium price and equilibrium quantity and how have they changed?

MARKET EQUILIBRIUM Figure (a) illustrates the outcome. 1. An increase in demand shifts the demand curve rightward. 2. At $1.00 a bottle, there is a shortage, so the price rises. Tell students that they will do much better on the exam if they DRAW the demand-supply graph to answer a question. Show them how much easier it is to see the effects of a change in demand or a change in supply or both on the equilibrium price and equilibrium quantity if they draw the graph. 3. Quantity supplied increases along the supply curve. 4. Equilibrium quantity increases.

MARKET EQUILIBRIUM Event: A new zero-calorie sports drink is invented. To work out the effects on the market for bottled water: The new drink is a substitute for bottled water, so the demand for bottled water changes The demand for bottled water decreases, the demand curve shifts leftward. What are the new equilibrium price and equilibrium quantity and how have they changed?

MARKET EQUILIBRIUM Figure (b) shows the outcome. 1. A decrease in demand shifts the demand curve leftward. 2. At $1.00 a bottle, there is a surplus, so the price falls. Now emphasize the distinction between a change in supply and a change in the quantity supplied. 3. Quantity supplied decreases along the supply curve. 4. Equilibrium quantity decreases.

MARKET EQUILIBRIUM When demand changes: The supply curve does not shift. But there is a change in the quantity supplied. Equilibrium price and equilibrium quantity change in the same direction as the change in demand.

MARKET EQUILIBRIUM Effects of Changes in Supply Event: Europeans produce bottled water in the United States. To work out the effects on the market for bottled water: With more suppliers of bottled water, supply changes. The supply of bottled water increases, the supply curve shifts rightward. What are the new equilibrium price and equilibrium quantity and how have they changed?

MARKET EQUILIBRIUM Figure (a) shows the outcome. 1. An increase in supply shifts the supply curve rightward. 2. At $1.00 a bottle, there is a surplus, so the price falls. 3. Quantity demanded increases along the demand curve. 4. Equilibrium quantity increases.

MARKET EQUILIBRIUM Event: Drought dries up some springs in the United States. To work out the effects on the market for bottled water: Drought changes the supply of bottled water. The supply of bottled water decreases, the supply curve shifts leftward. What are the new equilibrium price and equilibrium quantity and how have they changed?

MARKET EQUILIBRIUM Figure (b) shows the outcome. 1. A decrease in supply shifts the supply curve leftward. 2. At $1.00 a bottle, there is a shortage, so the price rises. 3. Quantity demanded decreases along the demand curve. 4. Equilibrium quantity decreases.

MARKET EQUILIBRIUM When supply changes: The demand curve does not shift. But there is a change in the quantity demanded. Equilibrium price changes in the same direction as the change in supply. Equilibrium quantity changes in the opposite direction to the change in supply.