Chapter 2 Equilibrium P45-50 Chapter 2 Equilibrium P45-50

PRICE AND OUTPUT DETERMINATION We call the price that obtains in the market, the market price, We call the price that obtains in the market, the market price, or the Equilibrium price,or the Equilibrium price, and the quantity demanded and supplied equilibrium output.and the quantity demanded and supplied equilibrium output. We find this by plotting the demand and the Supply curves.We find this by plotting the demand and the Supply curves.

Equilibrium price and output : The Market Demand and Supply of Potatoes (Monthly)

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand The determination of market equilibrium (potatoes: monthly)

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand The determination of market equilibrium (potatoes: monthly) Where the two lines cross is called the equilibrium point P e =12 Q e =350

P e = 12, Q e = 350 So why do we call this an EQUILIBRIUM?So why do we call this an EQUILIBRIUM? To see this let’s consider a point where we are not in equilibrium.To see this let’s consider a point where we are not in equilibrium. For example, consider the price, P=8.For example, consider the price, P=8. What are the quantities demanded and supplied at this price?What are the quantities demanded and supplied at this price?

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand SHORTAGE ( ) The determination of market equilibrium (potatoes: monthly) QSQS QDQD

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e Supply Demand ( ) The determination of market equilibrium (potatoes: monthly) SHORTAGE, So Price must rise QSQS QDQD

P e = 12, Q e = 350 Similarly, suppose that price was initially above equilibriumSimilarly, suppose that price was initially above equilibrium For example, consider the price, P=16.For example, consider the price, P=16. What are the quantities demanded and supplied at this price?What are the quantities demanded and supplied at this price?

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e SURPLUS ( ) Supply Demand The determination of market equilibrium (potatoes: monthly) QSQS QDQD

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e SURPLUS So price must fall ( ) Supply Demand The determination of market equilibrium (potatoes: monthly) QSQS QDQD

So if the price is above equilibrium (Surplus) the tendency is for it to move downSo if the price is above equilibrium (Surplus) the tendency is for it to move down And if the price is below equilibrium (Shortage) the tendency is for it to move upAnd if the price is below equilibrium (Shortage) the tendency is for it to move up

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e QeQe PePe Supply Demand The determination of market equilibrium (potatoes: monthly) So forces pushing system towards P e and Q e

Quantity (tonnes: 000s) Price (pence per kg) E D C B A a b c d e QeQe PePe Supply Demand The determination of market equilibrium (potatoes: monthly)

Notice in the these diagrams we have determined the equilibrium price P e, and equilibrium quantity, Q e.Notice in the these diagrams we have determined the equilibrium price P e, and equilibrium quantity, Q e. This is why we call these the Endogenous variables. They are determined within the system (diagram).This is why we call these the Endogenous variables. They are determined within the system (diagram).

PRICE AND OUTPUT DETERMINATION The next issue we are interest in, is the effect of SHIFTS on either the demand or supply curves. Shifts are caused by changes in the exogenous variablesThe next issue we are interest in, is the effect of SHIFTS on either the demand or supply curves. Shifts are caused by changes in the exogenous variables First: Effects of shifts in the demand curveFirst: Effects of shifts in the demand curve

Effect of a shift in the demand curve P Q O Pe1Pe1 Qe1Qe1 S D1D1 g

P Q O Pe1Pe1 Qe1Qe1 S D1D1 D2D2 g

P Q O Pe1Pe1 Qe1Qe1 S g h D1D1 D2D2 At P 0 quantity demanded exceeds quantity supplied

P Q O Pe1Pe1 Qe1Qe1 S g h D1D1 D2D2 Effect of a shift in the demand curve So Price must rise At P 0 quantity demanded exceeds quantity supplied

P Q O Pe1Pe1 Pe2Pe2 Qe1Qe1 Qe2Qe2 S g h i D1D1 D2D2 Effect of a shift in the demand curve

PRICE AND OUTPUT DETERMINATION Notice the demand curve SHIFTEDNotice the demand curve SHIFTED But the Price MOVED ALONG the Supply curve.But the Price MOVED ALONG the Supply curve.

P Q O Pe1Pe1 Pe2Pe2 Qe1Qe1 Qe2Qe2 S g h i D1D1 D2D2 Effect of a shift in the demand curve

P Q O Pe1Pe1 Pe2Pe2 Qe1Qe1 Qe2Qe2 S g h i D1D1 D2D2

What about a shift in the Supply Curve? Suppose the Price of Oil and Petrol were to rise. Suppose the Price of Oil and Petrol were to rise. This would make production more costly and supply would shift in.This would make production more costly and supply would shift in.

P Q O Pe1Pe1 Qe1Qe1 D S1S1 g Effect of a shift in the supply curve

P Q O Pe1Pe1 Qe1Qe1 D S1S1 S2S2 g

P Q O Pe1Pe1 Qe1Qe1 D S1S1 S2S2 g But now at P 0 Quantity Demanded exceeds Quantity Supplied

P Q O Pe1Pe1 Qe1Qe1 D S1S1 S2S2 g Effect of a shift in the supply curve But now at P 0 Quantity Demanded exceeds Quantity Supplied So Price must rise

P Q O Pe1Pe1 Qe1Qe1 D S1S1 S2S2 jg Effect of a shift in the supply curve

P Q O Pe1Pe1 Pe3Pe3 Qe3Qe3 Qe1Qe1 D S1S1 S2S2 jg k At the new equilibrium price has risen and output has fallen

PRICE AND OUTPUT DETERMINATION Making sense of Economics DataMaking sense of Economics Data Identifying the position of demand and supply curvesIdentifying the position of demand and supply curves

P OQ p 30p b a Suppose I observe two sets of prices and quantities How do I make sense of these two observations?

P OQ p 30p b a Suppose I observe two sets of prices and quantities How do I make sense of these two observations? They may be on the same demand curve D0D0

P OQ S1S1 S2S p 30p b a and thus the two observations were generated by a shift in the supply curve D0D0

Alternative Explanation However, we are only assuming the two points were on the original demand curve. We don’t know this.However, we are only assuming the two points were on the original demand curve. We don’t know this. Consider the following possibility.Consider the following possibility.

P OQ S1S p 30p b a D1D1 Assume Point A was the original

P OQ S1S1 S2S p 30p b a D1D1 D2D2 It is possible that both the demand and the supply curve have shifted as in this example.

So in the second case point b lies on a different demand and supply curveSo in the second case point b lies on a different demand and supply curve Looking at raw data and trying to figure out what is going on is a difficult problem.Looking at raw data and trying to figure out what is going on is a difficult problem. The problem above is known as the identification problemThe problem above is known as the identification problem

Econometrics So interpreting data has many pitfallsSo interpreting data has many pitfalls In the following years you will study various statistical procedures which will help you to analyse what is really happening in the data we observe.In the following years you will study various statistical procedures which will help you to analyse what is really happening in the data we observe. The main course we do this is in Econometrics next yearThe main course we do this is in Econometrics next year IT and Applied Economics & Quantitative Methods this year will help prepare you.IT and Applied Economics & Quantitative Methods this year will help prepare you.