MODERN PRINCIPLES OF ECONOMICS Third Edition Equilibrium: How Supply and Demand Determine Prices Chapter 4

Outline  Equilibrium and the Adjustment Process  A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade)  Does the Model Work? Evidence from the Laboratory  Shifting Demand and Supply Curves 2

Outline  Terminology: Demand Compared with Quantity Demanded and Supply Compared with Quantity Supplied  Understanding the Price of Oil 3

Definition Equilibrium : The price at which the quantity demanded is equal to the quantity supplied. 4

5Equilibrium equilibrium quantity equilibrium price

Equilibrium  Equilibrium occurs at the intersection of the demand and supply curves.  Equilibrium price and quantity are the only ones that are stable in a free market.  At any other point, economic forces push prices and quantities back toward equilibrium. 6

Definition Surplus : A situation in which quantity supplied is greater than quantity demanded. 7

Adjustment Process: Surplus Price Quantity (MBD) Supply Demand 700 $60 // 8 Equilibrium

Adjustment Process: Surplus Price Quantity (MBD) 700 $60 $ // Supply Demand Price Above Equilibrium

Adjustment Process: Surplus Price Quantity (MBD) 700 $60 $ // Supply Demand Q D = 500 Q S = 900 SURPLUS Q S > Q D

Adjustment Process: Surplus Price Quantity (MBD) 700 $60 $ // Supply Demand SURPLUS Q S > Q D Price is driven down towards equilibrium

Self-Check When there is a surplus in a competitive market: a.Price will increase. b.Price will decrease. c.Price will remain the same. 12 Answer: b – excess supply will cause suppliers to decrease price.

Definition 13 Shortage : A situation in which quantity demanded is greater than quantity supplied.

Adjustment Process: Shortage Price Quantity (MBD) 700 $60 $ // Supply Demand Price Below Equilibrium

Adjustment Process: Shortage Price Quantity (MBD) 700 $60 $ // Supply Demand Q S = 500 Q D = 900 SHORTAGE Q D > Q S

Adjustment Process: Shortage Price Quantity (MBD) 700 $60 $ // Supply Demand Price is driven up towards equilibrium SHORTAGE Q D > Q S

Self-Check When there is a shortage in a competitive market: a.Price will increase. b.Price will decrease. c.Price will remain the same. 17 Answer: a – excess demand will cause price to increase.

Equilibrium and Gains From Trade  A free market maximizes the gains from trade. 1.Available goods are bought by buyers with the highest willingness to pay. 2.Goods are sold by the sellers with the lowest costs. 3.Between buyers and sellers, there are no unexploited gains from trade or any wasteful trades.  These three conditions imply that the gains from trade are maximized. 18

Buyers are willing to pay $90 Unexploited Gains From Trade Price Quantity (MBD) Supply Demand 70 $70 // 19 Suppose quantity is less than equilibrium quantity (say 50) $50 $90 Sellers are willing to supply for $50

Buyers are willing to pay $90 Unexploited Gains From Trade Price Quantity (MBD) Supply Demand 70 $70 // $50 $90 Sellers are willing to supply for $50 Any trade between $50 and $90 will make both parties better off Unexploited gains from trade

Wasted Resources Price Quantity (MBD) Supply Demand 70 $70 // 21 Suppose quantity is greater than equilibrium (say 90) $50 $90 Sellers are willing to supply for $90 Buyers are only willing to pay $50

Wasted Resources Price Quantity (MBD) Supply Demand 70 $70 // $50 $90 Sellers are willing to supply for $90 Buyers are only willing to pay $50 Sellers will not sell units they are losing money on Waste of resources

Self-Check 23 If the quantity traded is less than equilibrium quantity: a.Resources will be wasted. b.Suppliers will only supply goods at equilibrium price. c.Some gains from trade will be lost. Answer: c – some gains from trade will be lost.

Evidence from the Laboratory  In 1956, Vernon Smith tested the supply and demand model in a lab.  The model accurately and consistently predicted market behavior. 24  In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics. J. SCOTT APPLEWHITE/AP PHOTO

Shifting Demand and Supply Quantity Original Supply Demand Price PaPa QaQa 25 New Supply Surplus Supply increases Creates surplus at original price

Shifting Demand and Supply Quantity Original Supply Demand Price PaPa QaQa 26 New Supply Competition drives price down Surplus PbPb

Shifting Demand and Supply Quantity Original Supply Demand Price PaPa QaQa 27 New Supply New equilibrium at lower price, higher quantity PbPb Lower price increases quantity demanded QbQb

Self-Check 28 A decrease in supply will: a.Increase both price and quantity. b.Decrease price and increase quantity. c.Increase price and decrease quantity. Answer: c – lower supply causes a shortage, increasing price and causing consumers to buy less.

Shifting Demand and Supply Quantity Supply Original Demand Price PaPa QaQa 29 Demand increases Creates shortage at original price New Demand Shortage

Shifting Demand and Supply Quantity Supply Original Demand Price PaPa QaQa 30 New Demand Buyers bid prices up PbPb

Shifting Demand and Supply Quantity Supply Original Demand Price PaPa QaQa 31 New Demand QbQb PbPb New equilibrium at higher price and quantity Higher price increases quantity supplied

Self-Check 32 A decrease in demand will: a.Decrease both price and quantity. b.Decrease price and increase quantity. c.Increase price and decrease quantity. Answer: a – lower demand causes a surplus, lowering prices and causing suppliers to supply less.

Demand and Quantity Demanded  There is a big difference between demand and quantity demanded.  A change in the quantity demanded is a movement along a fixed demand curve.  A change in demand is a shift of the entire demand curve (up and to the right). 33

Demand and Quantity Demanded 34

Supply and Quantity Supplied  A change in supply is a shift of the entire supply curve  A change in quantity supplied is a movement along a fixed supply curve. 35

Supply and Quantity Supplied 36

Understanding the Price of Oil 37 The supply and demand model can explain oil prices.

Takeaway  We can use supply and demand to answer questions about the world.  Market competition brings about an equilibrium in which the quantity supplied is equal to the quantity demanded.  Only one price/quantity combination is a market equilibrium.  Incentives for both buyers and suppliers enforce the market equilibrium. 38

Takeaway  The sum of consumer and producer surplus (the gains from trade) is maximized at the equilibrium price and quantity.  Factors which shift supply or demand will change the equilibrium price and quantity.  A change in demand (or supply) shifts the whole curve.  A change in quantity demanded (or supplied) is a move to a different point on the existing curve. 39