Equilibrium: How Supply and Demand Determine Prices Chapter 4 Equilibrium: How Supply and Demand Determine Prices

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

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

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

Equilibrium equilibrium price equilibrium quantity Figure 4-1 (4-1): Price Is Determined by Supply and Demand equilibrium quantity

Equilibrium Qs = Qd 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.

Tyler Cowen and Alex Tabarrok Market Equilibrium There is ONLY ONE PRICE where Qs = Qd No shortages No surpluses FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE Thinking About Equilibrium Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

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

Adjustment Process: Surplus Price Supply Equilibrium $60 Demand // Quantity (MBD) 700 9

Adjustment Process: Surplus Price Above Equilibrium Price Supply $75 $60 Demand // Quantity (MBD) 500 700 900 10

Adjustment Process: Surplus QS > QD Price Supply $75 $60 QD = 500 QS = 900 Demand // Quantity (MBD) 500 700 900 11

Adjustment Process: Surplus QS > QD Price Supply $75 Price is driven down towards equilibrium $60 Demand // Quantity (MBD) 500 700 900 12

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

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

Adjustment Process: Shortage Price Below Equilibrium Price Supply $60 $55 Demand // Quantity (MBD) 500 700 900 15

Adjustment Process: Shortage Price SHORTAGE QD > QS Supply QS = 500 QD = 900 $60 $55 Demand // Quantity (MBD) 500 700 900 16

Adjustment Process: Shortage Price SHORTAGE QD > QS Supply Price is driven up towards equilibrium $60 $55 Demand // Quantity (MBD) 500 700 900 17

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

Equilibrium and Gains From Trade A free market maximizes the gains from trade. Available goods are bought by buyers with the highest willingness to pay. Goods are sold by the sellers with the lowest costs. 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.

Unexploited Gains From Trade Price Buyers are willing to pay $90 Supply $90 Suppose quantity is less than equilibrium quantity (say 50) $70 $50 Sellers are willing to supply for $50 Demand // Quantity (MBD) 50 70 90 20

Unexploited Gains From Trade Price Buyers are willing to pay $90 Supply $90 Any trade between $50 and $90 will make both parties better off Unexploited gains from trade $70 $50 Sellers are willing to supply for $50 Demand // Quantity (MBD) 50 70 90 21

Wasted Resources Sellers are willing to supply for $90 Supply Price Sellers are willing to supply for $90 Supply $90 Suppose quantity is greater than equilibrium (say 90) $70 $50 Buyers are only willing to pay $50 Demand // Quantity (MBD) 50 70 90 22

Wasted Resources Sellers are willing to supply for $90 Supply Price Sellers are willing to supply for $90 Supply $90 Sellers will not sell units they are losing money on Waste of resources $70 $50 Buyers are only willing to pay $50 Demand // Quantity (MBD) 50 70 90 23

Gains from Trade are Maximized at the Equilibrium Price and Quantity Figure 4-4 (4-4): A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade) Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

Equilibrium and Total Surplus Equilibrium in a free market yields two important results: Goods must be produced at the lowest possible cost. Goods must satisfy the highest valued demands. These results indicate that total surplus (both of the consumer and producer) is maximized in free markets.

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

Self-Check Economists often say that prices are a “rationing mechanism.” If the supply of a good falls, how do prices “ration” these now-scarce goods in a competitive market? Prices allocate goods to the people with the highest willingness to pay. Prices allocate goods to the people with the lowest willingness to pay. Prices allocate goods to those with the lowest value of their own time. Prices allocate goods to the people who deserve them the most

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. J. SCOTT APPLEWHITE/AP PHOTO In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics. 28

Evidence from the Laboratory Figure 4-5 (4-5): Economics as an Experimental Science Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

Evidence from the Laboratory “I am still recovering from the shock of the experimental results. The outcome was unbelievably consistent with competitive price theory. ” Vernon Smith, winner of 2002 Nobel Prize in Economics, on his 1956 experiments designed to disprove the supply and demand model. Figure 4-5 (4-5): Economics as an Experimental Science Tyler Cowen and Alex Tabarrok Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

Shifting Demand and Supply Supply increases Original Supply Price New Supply Surplus Pa Creates surplus at original price Demand Quantity Qa 31

Shifting Demand and Supply Competition drives price down Original Supply Price New Supply Surplus Pa Pb Demand Quantity Qa 32

Shifting Demand and Supply New equilibrium at lower price, higher quantity Original Supply Price New Supply Pa Lower price increases quantity demanded Pb Demand Quantity Qa Qb 33

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

Shifting Demand and Supply Demand increases Price Supply Creates shortage at original price Shortage Pa New Demand Original Demand Quantity Qa 35

Shifting Demand and Supply Buyers bid prices up Price Supply Pb Pa New Demand Original Demand Quantity Qa 36

Shifting Demand and Supply New equilibrium at higher price and quantity Price Supply Higher price increases quantity supplied Pb Pa New Demand Original Demand Quantity Qa Qb 37

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

Examples

Examples #1: New machine is invented that lowers the cost of harvesting oranges.

Examples #2: The FDA announces health benefits to eating oranges.

Examples #2: The income of consumers falls and some orange growers quit the business and turn their orange groves into housing developments..

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).

Demand and Quantity Demanded Figure 4-1 (4-1): Price Is Determined by Supply and Demand (TOP)

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.

Supply and Quantity Supplied Figure 4-1 (4-1): Price Is Determined by Supply and Demand (BOTTOM)

Understanding the Price of Oil Figure 4-9 (4-9): The Price of Oil, 1960–2012 The supply and demand model can explain oil prices. 47

Market Adjustment The cure for high prices is…..high prices Consumer buy less (Law of Demand) Producers produce more (Law of Supply) The cure for low prices is…..low prices Etc, etc

Algebra Problem Example A free market can be described by the equations Qd = 180 – 3P and Qs = –50 + 2P. What are the equilibrium conditions in this market (that is, find equilibrium P and Q) and what are the maximum gains from trade in this market? Answer: Solve for P via Qd = Qs 180 – 3P = -50 + 2P yields P = 46 Solve for Q using either equation: Q = 180 – 3(46) = 42 Gains from trade: solve for triangle with Q = 46 D curve price intercept: 0 = 180 – 3P  P = 60 S curve price intercept: 0 = -50 + 2P  P = 25 Area of triangle: ½ * (60 – 25) * 42 = $735

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.

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.