Market Equilibrium: The Invisible Hand Randy Rucker Professor Department of Agricultural Economics and Economics June 19, 2013.

Market Equilibrium:

The Invisible HandRandy Rucker

Professor

Department of Agricultural Economics

and Economics

June 19, 2013

Review: Consumer Choice and Demand

Determinants of the Demand for a Good: Price of the good of interest Prices of Substitutes Prices of Complements Incomes Tastes and Preferences Quality etc.

2

The Demand Curve Shows the Relationship Between the Price of a Good and the Quantity of that Good Demanded

Ceteris Paribus (Other Factors are Held Constant)

The Law of Demand—What does it say?

Review: Consumer Choice and Demand

3

A Change in Price Causes a Change in Quantity Demanded

This is a movement along the demand curve.

A Change in Other Factors (e.g., Income) Causes a Change in Demand

This is a shift in the demand curve.

Review: Consumer Choice and Demand

4

Determinants of the Supply of a Good: Price of the good of interest Prices of Inputs Changes in Technology Number of Firms in the Industry Quality etc.

Review: Firms, Profits, and Supply

5

Review: Firms, Profits, and Supply

The Supply Curve Shows the Relationship Between the Price of a Good and the Quantity of that Good Supplied

Ceteris Paribus (Other Factors are Held Constant)

The Law of Supply—What does it say?

6

Review: Firms, Profits, and Supply

A Change in Price Causes a Change in Quantity Supplied This is a movement along the supply curve.

A Change in Other Factors (e.g., an input price) Causes a Change in Supply This is a shift in the supply curve.

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Market Equilibrium Now, let’s put Demand and Supply on the

same Graph . . .

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Market Equilibrium

What Will Be the Price and Quantity that “Clear the Market”?

To Answer This, Suppose the Price Is Initially Below the Price Where the Demand and Supply Curves Intersect ($4).

What Will Happen?

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Shortage: Weekly Supply and Demand for Babysitting

Market Equilibrium

At a Price of $2 per Hour, there is a “Shortage.” At that Price, the quantity demanded exceeds the quantity supplied.

Babysitters have way more requests than they are willing to provide at $2 per hour.

What will happen?

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Market Equilibrium Parents who can’t get a babysitter, and are willing

to pay more than $2 per hour, will offer, say $3 per hour.

This higher price will cause some parents to stay home, or not stay out as long. That is, quantity demanded will fall.

The higher price will also induce some babysitters to work more hours. That is, quantity supplied will increase.

Thus, the shortage gets smaller and these “market forces” will continue to drive prices up.

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Market Equilibrium

Alternatively, Suppose the Price Is Initially Above the Price Where the Demand and Supply Curves Intersect.

What Will Happen?

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Surplus: Weekly Supply and Demand for Babysitting

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Market Equilibrium

At a price of $6 per hour, there is a “Surplus.” At that price, the quantity supplied exceeds the quantity demanded.

Babysitters are willing to work way more hours than parents are willing to purchase.

What will happen?

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Market Equilibrium Some babysitters who can’t get any work at $6

per hour, and are willing to babysit for less, will offer their services for, say $5 per hour.

This lower price will induce some parents to go out on a date. That is, quantity demanded will increase.

The lower price will also cause some babysitters to work fewer hours. That is, quantity supplied will decrease.

Thus, the surplus gets smaller and these “market forces” will continue to drive prices down.

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Market Equilibrium So, if price is below $4, there will be a

shortage, and price will increase.

Alternatively, if price is above $4, there will be a surplus and price will fall.

In each case above, what causes prices to change? An all-knowing central planner? Happenstance? Market forces?

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Market Equilibrium When the price is equal to $4, quantity

supplied is equal to quantity demanded. That is, the market clears—all parents who

are willing to pay that price for a babysitter are able to get one,

and all babysitters who are willing to babysit at

that price are able to.

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Market Equilibrium Note: If market forces are allowed to work,

prices will adjust and shortages and surpluses will go away.

Think: What if prices are not allowed to adjust? Let’s come back to this if we have time.

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Market Equilibrium The fundamental forces just described in

the market for babysitters will also be at work in markets for other goods.

QUESTIONS???

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Market Equilibrium

Next, let’s apply these principles to see what happens if the market equilibrium described above is disturbed . . .

NOTE: Such disturbances are the rule rather than the exception. Markets are always adjusting to changing conditions.

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Market Equilibrium

First, what happens to the market for Tenderloin Steaks if incomes increase? Recall that Tenderloin Steaks are a “normal

good.”

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The Market for Tenderloin SteaksPrice($/Q)

The Initial Equilibrium Price and Quantity

Q

(Quantity/week)

P0

Q0

D0

S0

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Impacts of an Increase in Demand Resulting from an Increase in Incomes

Q0

Price($/Q)

Q

(Quantity/week)

P0

D0

S0

P1 2

2

Q1

D1

1

The Market for Tenderloin Steaks

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Market Equilibrium

Second, what happens to the market for

Top Ramen if incomes increase? Recall that Top Ramen is an “inferior good.”

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The Market for Top RamenPrice($/Q)

The Initial Equilibrium Price and Quantity

Q

(Quantity/week)

P0

Q0

D0

S0

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The Market for Top Ramen

Impacts of a Decrease in Demand Resulting from an Increase in Income

Price($/Q)

Q

(Quantity/week)

P0

Q0

D0

S0

D1

1

P1

2

Q1

2

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Market Equilibrium

Third, what happens in the wheat market if there is an increase in supply due to favorable growing conditions in China and

Russia?

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The Market for WheatPrice($/Q)

The Initial Equilibrium Price and Quantity

Q

(Bushels/year)

P0

Q0

D0

S0

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D0

Q (Bushels/year)

Price ($/Q) S0

P0

Q0

The Market for Wheat

2

P1

Q1

2

1

S1

Impacts of an Increase in Supply Resulting from Good Growing Conditions 30

Market Equilibrium

Fourth, what happens to the market for peanut butter if there is a drought in the Southeastern United States?

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The Market for Peanut ButterPrice($/Q)

The Initial Equilibrium Price and Quantity

Q

(Quantity/year)

P0

Q0

D0

S0

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S1

1

Q1

2

2

P1

Q (Quantity/year)

Price ($/Q)

Impacts of a Drought in the Southeastern United States

S0

D0

P0

Q0

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The Market for Peanut Butter

QUESTIONS???

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Cautionary Notes

■ Choose your examples carefully Why babysitters, steaks, Top

Ramen, wheat, and peanuts?

Rather than, say

Cars, houses, or shoes?

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Cautionary Notes (cont.)

■ Analyze the effects of one change at a time. It is easy to try to analyze real-world

examples and create confusion because more than one factor is changing.

Examples

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Cautionary Notes (cont.)

■ Shortages and surpluses and the media. Does a decrease in supply cause a

shortage? Does an increase in supply cause a

surplus?

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Cautionary Notes (cont.)

■ What if prices are not allowed to adjust?

Quickly?

or

Another day?

These stories can be complex . . .38

Cautionary Notes (cont.)

■ Maximum prices (price ceilings) Apartments in NYC and CA Anti-price gouging laws Gas price controls in the 1970s Rationing of health care services Others . . .

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Cautionary Notes (cont.)

■ Minimum prices (price floors or price supports)

Minimum wages Farm programs Proposal for minimum price for alcohol

in the U.K. Others . . .

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