1. Market Equilibrium The price mechanisms and Market efficiency IB Economics

2. Learning Objectives At the end of this section you should be able to
Explain the concept of equilibrium
Explain the effect of changes in demand and supply upon the equilibrium
Explain the concepts of excess demand and excess supply
HL – calculate the market price and quantity using linear functions
Plot changing market equilibriums, identifying new equilibrium points, excess demand and excess supply

3. Bringing market demand and supply curves together
Bringing buyers (demanders) and sellers (suppliers) together creates what economist call a market
When we picture a market in our heads we tend to think of a fruit and veg market but a market does not even have to be physical - it is just where buyers and sellers interact. Transactions can by carried out by phone, mail order or over the internet.

4. Watch the mjm foodie video

5. Equilibrium In order to analyse how a market works we
bring the demand and supply curve together and from now on we always draw our diagrams with both curves
Equilibrium is when supply satisfies demand and vice versa
Everything produced in the market will be sold
They are equal, there is balance/stability and there is no tendency for the market to change without external change
In theory the price system should produce equilibrium as we will see later
Equilibrium point S
The free market equilibrium price is Pe and quantity is Qe Pe
Market clearing price D Qe
Quantity of Coffee

6. Market disequilibrium and eliminating excess supply
Equilibrium is self righting in a free market
Lets says the producers increase their price to P1
At this price there will be Q1 demand
At this price there will be Q2 supply
There is too much supply (excess supply) of Q1 – Q2
The market is said to be in disequilibrium
To get rid of the surplus producers will have to supply at a lower price
As they do the quantity demanded will increase until once again demand equals supply and there is equilibrium once more
Price S P1 P D O Q1 Q Q2 Q
Excess Supply = Q2 – Q1

7. Market disequilibrium and eliminating excess demand
This time producers tried to lower their price
There is too much demand at Q2 and not enough supply at Q1
the market is in disequilibrium because there is excess demand
Q2 will be demanded but only Q1 will be supplied which means there will be a shortage (suppliers will sell out)
There is a shortage off Q2 – Q1
In order to eliminate the shortage producers have to raise their prices
As they do the quantity demanded will fall
Eventually demand and supply will be equal again giving equilibrium
Quantity D P Q S P1 Q1 Q2
Excess demand = Q2 – Q1

8. The effects of changes in demand and supply on the equilibrium
Previously we looked at factors that shift the demand curve and supply curve – these are outside disturbances (nothing to do with the price although they will change the price)
Now we need to look at what those shifts do to the equilibrium price and quantities
In real life lots of things may change at the same time but to make it simple we only deal with single changes and assume that the ceteris paribus condition is met
Ceteris paribus is Latin for ‘all things being equal’ – in other words nothing else has changed
Lets take the example of an increase in income for consumers of foreign holidays
When there is an increase in income there will be an increase in the demand for holidays
Ceteris paribus there will be a shift of the demand curve to the right
Price of holidays ($) S1 P1 D2 D1 Q1 Q2
Quantity of holidays (days)

9. The effects of changes in demand and supply on the equilibrium
Initially the price remains at the equilibrium price
Q1 will be supplied
Q2 will be demanded
There will be excess demand (a shortage)
To get rid of the shortage prices will need to rise
Until once again equilibrium is restored but at a higher price of P2
The new equilibrium quantity is Q3
Whenever there is a shift of the demand or supply curve the market (if it is left alone) will adjust to a new equilibrium or market clearing price
Complete student workpoint 3.1 P37
Price of holidays ($) S1 P2 P1 D2 D1 Q1 Q3 Q2
Quantity of holidays (days)

10. The role of the price mechanism
Resources are allocated and re-allocated in response to changes in price
If there is an increase in the price of a good due to an increase in demand for the good there is a signal to the producers
The price signal tells producers that consumers wish to buy this good
We assume that producers are rational and wish to maximise their profits
There is an incentive for them to produce more
Producers allocate more resources to those goods where the demand is highest (they will make more profit)
There is not central planning agency
Adam Smith said it was like there was an invisible hand moving the factors of production around to produce the goods and services wanted by the buyers in the economy
Price mechanism = the forces of supply and demand

11. Market efficiency – Consumer Surplus Watch the video
Consumer surplus = the extra satisfaction (or utility) gained by consumers from paying a price that is lower than that they are prepared to pay
Consumer surplus video:

12. Market efficiency – Producer surplus Watch the video
Read through page 38
Make notes
Ask questions if you don’t understand
Producer surplus = the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output
Producer surplus video:

13. Allocative efficiency
Allocative efficiency means that resources are allocated in the most efficient way from society’s point of view
This kind of efficiency is not the same as being efficient at operating like within a firm. This is called productive efficiency and we will learn about that later
If we add consumer and producer surplus together this is the community surplus
Community surplus is the total benefit to society
At the equilibrium community surplus is maximised
This is the point of allocative efficiency
There is no other combination of price or quantity that could give greater community surplus
This is therefore the optimal allocation of resources from the point of view of society as a whole
Allocative efficiency = when a market is in equilibrium, with no external influences, it is said to be socially efficient or in a state of allocative efficiency

14. Allocative efficiency
The supply curve is largely determined by the industry’s costs of production
When we assume that the costs of the industry are equal to the costs to society then the supply curve represents the social cost curve
When we analyse efficiency we call this the marginal social cost curve (we will learn more about this later)
Marginal social costs (MSC) curve = the supply curve represents the marginal social cost curve when the costs to industry are equal to the costs of society

15. Allocative efficiency
The demand curve is determined by the utility, or benefits, that the consumption of a good or service brings to the consumers
If we assume the benefits in the market are equal to the benefits to society we can use the demand curve to represent the social benefits
When we analyse efficiency we refer to the demand curve as the marginal social benefit curve (MSB)
Marginal social benefits (MSB) curve = the demand curve represents the marginal social benefits curve when the benefits in the market are equivalent to the benefits to society

16. Allocative efficiency
This is only a brief introduction to allocative efficiency
We will come back to it in a lot more detail later
In conclusion
A free market leads to allocative efficiency
Community surplus is maximised so it is the optimum allocation of resources from society’s point of view
This occurs when demand is equal to supply or marginal social costs are equal to marginal social benefits
Before we get to the HL bit here is the homework

17. Complete the data response question on P44 (copper)
Homework for all
Complete the data response question on P44 (copper)
Make sure you read the assessment advice

18. The HL bit!

19. Calculating and illustrating market equilibrium using linear demand and supply functions
If you are given the demand function and the supply function you easily plot the graphs of both and where they cross is the equilibrium
Alternatively you can work out the equilibrium using simultaneous equations
Work through page 39 to 43 and then complete student workpoint 3.3