Third Edition Equilibrium: How Supply and Demand Determine … · 2018-08-10 · Third Edition Equilibrium: How Supply and Demand Determine Prices Chapter 4. Outline ... Between buyers

MODERN PRINCIPLES OF ECONOMICSThird Edition

Equilibrium: How Supply and Demand Determine Prices

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

5

Equilibrium

equilibrium quantity

equilibrium price

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.

6

Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition

Copyright © 2015 by Worth Publishers

Market Equilibrium

� There is ONLY ONE PRICE

where Qs = Qd

• No shortages

• No surpluses

FREE MARKETS

ALWAYS MOVE

TOWARD

EQUILIBRIUM PRICE

Definition

Surplus:

A situation in which quantity supplied is

greater than quantity demanded.

8

Adjustment Process: Surplus

Price

Quantity(MBD)

Supply

Demand

700

$60

//

9

Equilibrium


Price

Quantity(MBD)700

$60

$75

500//

900

10

Supply

Demand

Price Above Equilibrium


Price

Quantity(MBD)700

$60

$75

500//

900

11

Supply

Demand

QD = 500 QS = 900

SURPLUSQS > QD


Price

Quantity(MBD)700

$60

$75

500//

900

12

Supply

Demand

SURPLUSQS > QD

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.

13

Answer: b – excess supply will causesuppliers to decrease price.

Definition

14

Shortage:

A situation in which quantity demanded

is greater than quantity supplied.

Adjustment Process: Shortage

Price

Quantity(MBD)700

$60

$55

500//

900

15

Supply

Demand

Price Below Equilibrium


Price

Quantity(MBD)700

$60

$55

500//

900

16

Supply

Demand

QS = 500 QD = 900

SHORTAGEQD > QS


Price

Quantity(MBD)700

$60

$55

500//

900

17

Supply

Demand

Price is driven up towards equilibrium

SHORTAGEQD > QS

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.

18

Answer: a – excess demand will causeprice 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.

19

Buyers are willing to pay $90

Unexploited Gains From Trade

Price

Quantity(MBD)

Supply

Demand

70

$70

//

20

Suppose quantity is less than equilibrium

quantity (say 50)

50 90

$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

//

21

50 90

$50

$90


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

//

22

Suppose quantity is greater than

equilibrium (say 90)

50 90

$50

$90


Buyers are only willing to pay $50

Wasted Resources

Price

Quantity(MBD)

Supply

Demand

70

$70

//

23

50 90

$50

$90


Buyers are only willing to pay $50

Sellers will not sell units they are losing

money on

Waste of resources



Gains from Trade are Maximized at the Equilibrium Price and Quantity

Equilibrium and Total Surplus

25

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

26

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.

Self-Check

27

� 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?a) Prices allocate goods to the people with the

highest willingness to pay.

b) Prices allocate goods to the people with the lowest willingness to pay.

c) Prices allocate goods to those with the lowest value of their own time.

d) 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.

28

� In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics.

J. SCOTT APPLEWHITE/AP PHOTO







“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.

Shifting Demand and Supply

Quantity

OriginalSupply

Demand

Price

Pa

Qa31

New Supply

Surplus

Supply increases

Creates surplus at original price


Quantity

OriginalSupply

Demand

Price

Pa

Qa32

New Supply

Competition drives price down

Surplus

Pb


Quantity

OriginalSupply

Demand

Price

Pa

Qa33

New Supply

New equilibrium at lower price, higher

quantity

PbLower price increases

quantity demanded

Qb

Self-Check

34

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.


Quantity

Supply

OriginalDemand

Price

Pa

Qa35

Demand increases

Creates shortage at original price

New Demand

Shortage


Quantity

Supply

OriginalDemand

Price

Pa

Qa36

New Demand

Buyers bid prices up

Pb


Quantity

Supply

OriginalDemand

Price

Pa

Qa37

New Demand

Qb

Pb

New equilibrium at higher price and quantity

Higher price increases quantity supplied

Self-Check

38

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.

Examples

39

Examples

40

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

Examples

41

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

Examples

42

#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).

43

Demand and Quantity Demanded

44

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.

45

Supply and Quantity Supplied

46

Understanding the Price of Oil

47The supply and demand model can explain oil prices.

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

48

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 = $73549

Market Adjustment

� What if there were no prices?

� https://www.youtube.com/watch?v=zkPGfTEZ_r4&t=1s

50

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.

51

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.

52

Third Edition Equilibrium: How Supply and Demand Determine … · 2018-08-10 · Third Edition Equilibrium: How Supply and Demand Determine Prices Chapter 4. Outline ... Between buyers

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