Equilibrium: How Supply and Demand Determine Prices

Equilibrium and the Adjustment Process Shifting Demand and Supply Curves Gains from Trade Are Maximized at the Equilibrium Price and Quantity Terminology: Demand Compared to Quantity Demanded and Supply Compared to Quantity Supplied Does the Model Work? Evidence from the Laboratory Understanding the Price of Oil For applications, click here Inside and Outside the Classroom Activities Market Equilibrium Experiment Conducting an experiment to illustrate market equilibrium can serve as a powerful teaching tool.Many software packages can be used with students linked at computer terminals where the computer matches buyers and sellers and automatically calculates how efficient the market was. If you don’t have access to such programs or a computer lab a simple experiment can be done manually in a traditional classroom. You will need to: 1. Create a set of cards with buyer values and seller costs on them. Each card will represent one spot on the demand or supply curve. If you have between 20 and 30 students in your class, you should create enough cards so that each student has one. In larger classes you should have some students pair up and work as a team with a single card. Otherwise the process takes longer and is harder to control. 2. Set the equilibrium that should be generated by your supply and demand schedules.The equilibrium should be set so more than half, perhaps even three-quarters, of your students have an opportunity to experience gains from exchange. Assigning too many cards to the right of the equilibrium value will leave too many students standing around without being able to find a partner.You must assign some students values to the right of equilibrium, though, otherwise there is no potential for the market to be inefficient. 3. Have the buyers and sellers stand facing each other and allow them to call out offers.You should stand at the blackboard.When two parties agree to a trade they should walk away from the two groups together and come to you to record their trade on the blackboard and then they should remain away from the rest of the group. 4. Once no other people remaining are able to agree (or a suitable amount of time has passed) reassemble the entire group and allow trading to begin CHAPTER 3 • Equilibrium: How Supply and Demand Determine Prices • 27 again starting completely from scratch (but with the same cards). Repeat this process for three to six rounds. By then they should have converged to equilibrium values. 5. Collect the buyer values and seller costs from the students (or have each show you their card one at a time so each student can see who was where on the curves). Use these to plot the supply and demand curve on the blackboard point by point. Show where equilibrium price and quantity should occur.Then compare this with the prices that were traded at each round and the number of trades made. 6. You should find that at first some inefficiency was in the market and prices varied. But by rounds 3 and 4 most trades should be near equilibrium prices and the correct quantity should be exchanged.  To Try it! questions To Video

Would you prefer an economic system where goods were rationed by: Need Equality/fairness Who can pay the most No right answer. Have students discuss in small groups. This slide is designed to get students thinking (and talking) about the benefits and costs of a price rationing system. To next Try it!

Market Equilibrium When Qs = Qd at a certain price, the market is in equilibrium, the amount consumers would purchase at this price is matched exactly by the amount producers wish to sell.

FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE Market Equilibrium There is ONLY ONE PRICE where Qs = Qd This is “equilibrium price and quantity” No shortages No surpluses FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE

Equilibrium and the Adjustment Process Quantity of Oil (MBD) Price of Oil per Barrel Price is Determined by Supply and Demand Supply Curve Demand Curve 65 $30 Equilibrium Price Equilibrium Quantity Instructor Notes: Figure 3.1: Price Is Determined by Supply and Demand Equilibrium occurs when the quantity demanded equals the quantity supplied. The quantity demanded equals the quantity supplied only when the price is $30 and the quantity exchanged is 65 MBD; hence, $30 is the equilibrium price and 65 MBD the equilibrium quantity.

How Markets Find Equilibrium When Price is Too High Energy Drinks At P = $5.00: Qs = 25, Qd = 15 S . $5.00 4.00 Price will fall to equilibrium ($4.00) and Qd will rise to 20, Qs will fall to 20 and Qd = Qs 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $5.00, a SURPLUS of 10 energy drinks (25-15) exists… suppliers are left with stock on the shelves- they take action to get the surplus sold and raise revenue.

How Markets Find Equilibrium When Price is Too Low Energy Drinks At P = $3.00: Qs = 15, Qd = 25 S $5.00 Price will rise to equilibrium ($4.00) and Qd will fall to 20, Qs will rise to 20 and Qd = Qs 4.00 . . 3.00 2.00 1.00 D Q 5 10 15 20 25 At a price of $3.00, a SHORTAGE of 10 energy drinks (25-15) exists… buyers compete with each other for purchases- sellers see their chance to raise price and revenue

Take a look… For a look at a real-world equilibrium pricing mechanism, click the picture below to see the Aalsmeer Dutch Tulip auction in action. (3 minutes) http://video.kera.org/video/1283843915/ http://video.kera.org/video/1283843915/

Shifting Demand and Supply Curves Price of energy drinks An increase in demand S Q1 P1 Causes the equilibrium to change to a higher P and Q D1 P0 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Q0 Quantity of energy drinks

Shifting Demand and Supply Curves Price of energy drinks A decrease in demand D1 S Causes the equilibrium to change to a lower P and Q P0 Q1 P1 D0 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? Q0 Quantity of energy drinks

Shifting Demand and Supply Curves Price of energy drinks An increase in supply S0 S1 P0 Causes the equilibrium to change to a lower P and higher Q Q1 P1 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Q0 Quantity of energy drinks

Shifting Demand and Supply Curves Price of energy drinks A decrease in supply S1 S0 Q1 P1 Causes the equilibrium to change to a higher P and lower Q Q0 P0 Figure Caption: Figure 3-14: Equilibrium and Shifts of the Demand Curve The original equilibrium in the market for coffee is at E1, at the intersection of the supply curve and the original demand curve, D1. A rise in the price of tea, a substitute, shifts the demand curve rightward to D2. A shortage exists at the original price, P1, causing both the price and quantity supplied to rise, a movement along the supply curve. A new equilibrium is reached at E2, with a higher equilibrium price, P2, and a higher equilibrium quantity, Q2. When demand for a good or service increases, the equilibrium price and the equilibrium quantity of the good or service both rise. Note to the instructor: An example from sports: The recent successes of Red Socks (Boston’s Baseball Team) caused an increase in demand for the tickets of Red Socks games. In 10 years, global warming may increase the demand for land in parts of the world earlier considered “too cold”. Question for Class Discussion: Coffee and tea are substitutes: if the price of tea rises (falls), the demand for coffee will increase (decrease). But how does the price of tea affect the market for coffee? D0 Quantity of energy drinks

Economists often say that prices are a “rationing mechanism 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. To next Try it!

Work it out To next Try it!

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

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

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

Gains from Trade Are Maximized at Equilibrium Price and Quantity Unexploited Gains from Trade Exist when Quantity is Below the Equilibrium Quantity Quantity of Oil (MBD) Price of Oil per Barrel $15 $57 Satisfied Wants 24 Demand Curve Supply Curve $30 65 Unsatisfied Wants Unexploited Gains from Trade At Q=24, there are buyers who value buying the good more than sellers value selling the good (there are unexploited gains from trade up until 65 units) Equilibrium Price Instructor Notes: Figure 3.3: At the Equilibrium Quantity There Are no Unexploited Gains from Trade nor any Wasteful Trades (Panel A) Unexploited gains from trade exist when quantity is below the equilibrium quantity. Buyers are willing to pay $57 for the 24th unit and sellers are willing to sell the 24th unit for $15, so not trading the 24th unit leaves $42 in unexploited gain from trade. Only at the equilibrium quantity are there no unexploited gains from trade. Equilibrium Quantity

Gains from Trade Are Maximized at Equilibrium Price and Quantity Wasteful Trades Exist when Quantity is Above the Equilibrium Quantity Quantity of Oil (MBD) Price of Oil per Barrel Demand Curve Supply Curve $30 65 Equilibrium Price Equilibrium Quantity 95 Value of Wasted Resources $15 $50 But at the Equilibrium Quantity There Are No Unexploited Gains from Trade nor Any Wasteful Trades! Instructor Notes: Figure 3.3: At the Equilibrium Quantity There Are no Unexploited Gains from Trade nor any Wasteful Trades (Panel B) Resources are wasted at quantities greater than the equilibrium quantity. Sellers are willing to sell the 95th unit for $50, but buyers are willing to pay only $15, so selling the 95th unit wastes $35 in resources. Only at the equilibrium quantity are there no wasted resources.

Gains from Trade Are Maximized at Equilibrium Price and Quantity A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade) Price of Oil per Barrel Demand Curve Supply Curve $30 65 Buyers Non-Sellers Consumer Surplus Equilibrium Price Producer Surplus Sellers Instructor Notes: Figure 3.4: A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade) A free market maximizes the gains from trade because (1) buyers are willing to pay more for the good than non-buyers, (2) sellers are willing to sell the good at a lower price than non-sellers, and (3) there are no mutual profitable deals between non-sellers and non-buyers. Non-Buyers Quantity of Oil (MBD) Equilibrium Quantity

Consumer Surplus=$6; Producer Surplus=$4; Total Gains from Trade=$10 If this market is in equilibrium, what is the total producer surplus? The total consumer surplus? What are the total gains from trade? Consumer Surplus=$6; Producer Surplus=$4; Total Gains from Trade=$10 CS=$11; PS=$1; Total Gains from Trade=$12 CS=$250; PS=$200; Total Gains from Trade=$450 CS=$150; PS=$100; Total Gains from Trade=$250 To next Try it!

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.

Who is made better off and who is made worse off by a legal doctrine that says tenants must have hot water? If tenants benefit from a law that says apartments must have hot water then surely a law that says tenants must have hot water and a dishwasher benefits them even more, right? What about a law that says tenants must have hot water, a dishwasher and cable tv? For a thought experiment that suggests BOTH parties are harmed when the market is tampered with, see this post on Worth’s STIH resource bank. See http://blogs.worthpublishers.com/seetheinvisiblehand/category/equilibrium/ for the full post. Alex Tabarrok suggests an example to drive home the point that both tenant and landlord are likely harmed by such a law: Let’s suppose that after much bargaining the tenant and landlord have agreed upon the rent and the amenities - each party to the contract is profit maximizing, doing as well as they can given market conditions and the interests of the other. Now suppose that tenants value the hot water benefit at $100 and that it costs the landlord $150 to provide the hot water. At these prices the tenant does not buy the hot water. The law is passed; by how much does the rent increase? By at least $100 but no more than $150. The landlord knows for certain that he can increase the rent by $100 because this will make the tenant just as well off as he was before, which by assumption was an equilibrium price. Similarly, if the landlord could profitably raise the rent by more than his cost he would have done so already - the fact that he did not indicates that an increase of more than $150 would not be profitable Thus the rent rises somewhere between $100 and $150, the precise amount to be determined by bargaining power. Suppose that the rent increases by $120. Then the tenant gets a benefit worth $100 at a price of $120 and is worse off by $20 and the landlord gets a benefit of $120 at a cost of $150 and so is worse off by $30. The law makes both the landlord and tenant worse off!

“I am still recovering from the shock of the experimental results “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. Vernon Smith proved the invisible hand was there.

The Price of Oil, 1960-2005

Terminology: Shifts vs. Movement along Supply and Demand curves A shift in a demand (supply) curve is called a “Change in Demand (Supply)” Not to be confused with: Movement ALONG a demand (supply) curve is called “Change in Quantity Demanded (Supplied)

Changes in Demand vs. Change in Quantity Demanded Change in Demand Change in Quantity Demanded 80 80 Price ($) Price ($) D1 40 D0 D0 20 40 20 40 Quantity (computer games) Quantity (computer games)

Changes in Supply vs. Change in Quantity Supplied Change in Supply Change in Quantity Supplied S0 S0 S1 80 80 40 Price ($) Price ($) 40 20 20 40 Quantity (computer games) Quantity (computer games)

Shifting Demand and Moving along Supply Curve Price of energy drinks An increase in demand S Q1 P1 causes a movement along the Supply curve… a “Change in Quantity Supplied” D1 P0 D0 Q0 Quantity of energy drinks

Shifting Supply and Moving along Demand Curve Price of energy drinks A decrease in supply S1 S0 Q1 P1 causes a movement along the Demand curve… a “Change in Quantity Demanded” Q0 P0 D0 Quantity of energy drinks

At a price of $3, quantity supplied is ______ and quantity demanded is ______, leading to a _______. 6; 2; surplus of 4 units 2; 4; surplus of 2 units 2; 6; shortage of 8 units 4; 2; shortage of 2 units To next Try it!

If garden gnomes regain widespread popularity, what will happen? Equilibrium Price and Quantity both fall. Equilibrium Price and Quantity both rise. Equilibrium Price falls and Quantity rises. Equilibrium Price rises and Quantity falls. To next Try it! 34

If the cost of wood falls, what will happen in the violin market? Equilibrium Price and Quantity both fall. Equilibrium Price and Quantity both rise. Equilibrium Price falls and Quantity rises. Equilibrium Price rises and Quantity falls. Back to 35