Modern Principles: Macroeconomics Tyler Cowen and Alex Tabarrok Copyright © 2010 Worth Publishers Modern Principles: Macroeconomics Cowen/Tabarrok Chapter 3 Equilibrium: How Supply and Demand Determine Prices

Slide 2 of 42 Supply and Demand The model of supply and demand is a simple presentation of exchange. Every exchange involves both a buyer and a seller. So, to complete the model, supply and demand must be brought together.

Slide 3 of 42 Equilibrium When the supply curve and the demand curve for a particular good are drawn on the same graph, a unique a point emerges – Equilibrium.  Graphically, equilibrium exists at the intersection of the supply curve and the demand curve. The price at this point is known as the Equilibrium Price, and the quantity at this point is called the Equilibrium Quantity. At the equilibrium price, quantity demanded equals quantity supplied.

Slide 4 of 42 Equilibrium and the Adjustment Process Demand Curve Supply Curve 65 $30 Equilibrium Price Equilibrium Quantity Quantity of Oil (MBD) Price of Oil per Barrel Price is Determined by Supply and Demand

Slide 5 of 42 Equilibrium and the Adjustment Process In a free market (a market free of outside interference) the equilibrium price and quantity are the only prices and quantities that are stable. At any other prices and quantities, economic forces naturally emerge in a free market and push those prices and quantities toward equilibrium.

Slide 6 of 42 Excess Supply At prices greater than the equilibrium price, the quantity supplied is greater than the quantity demanded. Economists refer to this as Excess Supply or Surplus. In this situation sellers must reduce their prices to induce buyers to purchase all of this extra product. In a free market, price will continue to fall until equilibrium is reached.

Slide 7 of 42 Excess Supply Excess Supply Drives Prices Down Quantity of Oil (MBD) Price per Barrel $50 Surplus Demand Curve Supply Curve 65 $30Equilibrium Price Equilibrium Quantity

Slide 8 of 42 Excess Demand At prices less than the equilibrium price, the quantity supplied is greater than the quantity demanded. Economists refer to this as Excess Demand or Shortage. In this situation buyers will offer sellers higher prices in order to outbid other buyers. These higher prices will also induce sellers to bring more product to market In a free market price will continue to rise until equilibrium is reached.

Slide 9 of 42 Excess Demand Excess Demand Drives Prices Up Quantity of Oil (MBD) Price per Barrel Demand Curve Supply Curve $15 Shortage $30 Equilibrium Price Equilibrium Quantity

Slide 10 of 42  If high gasoline prices lead to a decrease in the demand for SUVs, what will automobile companies do to sell trucks and SUVs already manufactured?  Consider clothes sold at outlet malls. Have sellers produced too few or too many of the particular items based on demand? What actions are sellers taking to move their goods out the door?

Slide 11 of 42 Equilibrium and Gains from Trade Gains from trade are maximized at the equilibrium price and quantity in a free market.  Gains from trade are possible when the price buyers are willing to pay for a particular good exceeds the price sellers are willing to accept.  There are unexploited gains from trade at any quantity less than the equilibrium quantity.  Free markets will not allow unexploited gains from trade to last long.

Slide 12 of 42 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 Unsatisfied Wants Unexploited Gains from Trade $15 $57 Satisfied Wants 24 Demand Curve Supply Curve $30 65 Equilibrium Price Equilibrium Quantity

Slide 13 of 42 Equilibrium and Gains from Trade Additionally, resources are not wasted at the equilibrium price and quantity in a free market.  When quantity supplied exceeds the equilibrium quantity, suppliers incur costs greater than the value buyers place on those goods.  Resources needed to produce this additional output could be used to produce other goods buyers value more highly.  Free markets will not allow wasted resources to last long.

Slide 14 of 42 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 95 Value of Wasted Resources $15$50 Demand Curve Supply Curve $30 65 Equilibrium Price Equilibrium Quantity

Slide 15 of 42 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.

Slide 16 of 42 Gains from Trade Are Maximized at Equilibrium Price and Quantity Sellers Consumer Surplus Producer Surplus BuyersNon-Sellers Non-Buyers Quantity of Oil (MBD) Price of Oil per Barrel A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade) Demand Curve Supply Curve $30 65 Equilibrium Quantity Equilibrium Price

Slide 17 of 42  As the price of cars goes up, which marketplace wants will be the first to stop being satisfied? Give an example.  In the late 1990s, telecommunication firms laid greater quantities of fiber-optic cable than the market equilibrium quantity (as proven by later events). Describe the nature of the losses from too much investment in fiber-optic cable. What market incentives exist to avoid these losses?

Slide 18 of 42 Changes in Equilibrium In free markets, supply or demand (or both) can change quite frequently. When supply or demand changes, equilibrium must also change. The supply and demand model allows for predictions of equilibrium when supply or demand changes in a free market.

Slide 19 of 42 Gains from Trade Are Maximized at Equilibrium Price and Quantity Suppose that a decrease in the cost of producing a particular good arises. What happens to equilibrium?  Supply increases shifting the supply curve down and to the right.  At the original equilibrium price, excess supply exists in the market.  Sellers will lower price to induce buyers for this surplus.  As the price falls, quantity demanded rises.  The price will continue to fall and quantity will rise until equilibrium is reached.  In a free market, the equilibrium price will adjust rather quickly.

Slide 20 of 42 Shifting Demand and Supply Curves Quantity Effect of Increase in Supply on Equilibrium Price and Quantity Price New Supply Curve New Equilibrium Price New Equilibrium Quantity Old Supply Curve Demand Curve Old Equilibrium Price Old Equilibrium Quantity

Slide 21 of 42 Shifting Demand and Supply Curves Suppose that an increase in the demand for a particular good arises. What happens to equilibrium?  Demand increases shifting the demand curve up, out, and to the right.  At the original equilibrium price, excess demand exists in the market.  Buyers will drive up the price to outbid other buyers for this shortage.  As the price rises, quantity supplied rises.  The price and quantity will continue to rise until equilibrium is reached.  In a free market, the equilibrium price will adjust rather quickly.

Slide 22 of 42 Shifting Demand and Supply Curves Quantity Price per Unit Effect of Increase in Demand on Equilibrium Price and Quantity Old Demand Curve Supply Curve Old Equilibrium Price Old Equilibrium Quantity New Demand Curve New Equilibrium Price New Equilibrium Quantity

Slide 23 of 42  Flooding in Iowa destroys some of the corn and soybean crop. What will happen to the price and quantity for each of these crops?  Resveratrol, which is found in the plant Japanese knotweed (and is also a component of red wine), has recently been shown to increase life expectancy in worms and fish. What are your predictions about the price and quantity grown of Japanese knotweed?  With the increase in gasoline prices, demand has shifted away from large cars and SUVs, and toward hybrid cars such as the Prius. Draw a graph showing the supply and demand for hybrid cars before and after an increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?

Slide 24 of 42  With the increase in gasoline prices, demand shifted away from large cars and SUVs, and toward hybrid cars such as the Prius. Draw a graph showing the supply and demand for hybrid cars before and after an increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?

Slide 25 of 42 Changes in Equilibrium - Extra! Individual changes in supply or demand have predictable effects on equilibrium price and quantity. Often, however, supply and demand both simultaneously change. This case involves a bit of uncertainty because changes in supply and changes in demand can have opposite effects on equilibrium price and quantity.

Slide 26 of 42 Changes in Equilibrium - Extra! When supply and demand move in the same direction, equilibrium quantity changes in a predictable manner, but the change in equilibrium price is uncertain. This ambiguity arises because the changes in supply and demand have opposite effects on equilibrium price.

Slide 27 of 42 Changes in Equilibrium - Extra! The relative magnitude of the changes in supply and demand will ultimately determine the change in equilibrium price.  A simultaneous increase (decrease) in both supply and demand involves opposing forces on equilibrium price.  If the increase (decrease) in supply is greater than the increase (decrease) in demand, equilibrium price must fall (rise).  If the increase (decrease) in supply is less than the increase (decrease) in demand, equilibrium price must rise (fall).  If the increase (decrease) in supply equals the increase (decrease) in demand, equilibrium price does not change.

Slide 28 of 42 Changes in Equilibrium - Extra! When supply and demand move in the opposite direction, equilibrium price changes in a predictable manner, but the change in equilibrium quantity is uncertain. This ambiguity arises because the changes in supply and demand have opposite effects on equilibrium quantity.

Slide 29 of 42 Changes in Equilibrium - Extra! The relative magnitude of the changes in supply and demand will ultimately determine the change in equilibrium quantity.  A simultaneous increase (decrease) in supply and a decrease (increase) in demand involves opposing forces on equilibrium quantity.  If the increase (decrease) in supply is greater than the decrease (increase) in demand, equilibrium quantity must rise (fall).  If the increase (decrease) in supply is less than the decrease (increase) in demand, equilibrium quantity must fall (rise).  If the increase (decrease) in supply equals the decrease (increase) in demand, equilibrium quantity does not change.

Slide 30 of 42 Changes in Equilibrium - Extra! A Simultaneous Increase in Supply and Demand of the Same Magnitude Leaves Equilibrium Price Unchanged Price Quantity Old Supply Old Demand Old Quantity Old Price New Demand New Supply New Quantity = New Price

Slide 31 of 42 Changes in Equilibrium - Extra! Equilibrium Price Rises with a Larger Increase in Demand than an Increase in Supply Price Quantity Old Supply Old Demand Old Quantity Old Price New Demand New Supply New Quantity New Price

Slide 32 of 42 Changes in Equilibrium - Extra! No ChangeIncrease in SupplyDecrease in Supply No Change in Demand P same Q same P down Q up P up Q down Increase in Demand P up Q up P ambiguous Q up P up Q ambiguous Decrease in Demand P down Q down P down Q ambiguous P ambiguous Q down Summary of Changes in Supply and Demand

Slide 33 of 42 Demand and Quantity Demanded A change in quantity demanded is NOT the same as a change in demand.  Quantity demanded changes only when the price of a good changes.  Graphically, a change in quantity demanded is represented by a movement along a fixed demand curve.  Demand changes only when a non-price factor changes.  Graphically, a change in demand is represented by a shift in the entire demand curve.

Slide 34 of 42 Supply and Quantity Supplied A change in quantity supplied is NOT the same as a change in supply.  Quantity supplied changes only when the price of a good changes.  Graphically, a change in quantity supplied is represented by a movement along a fixed supply curve.  Supply changes only when a non-price factor changes.  Graphically, a change in supply is represented by a shift in the entire supply curve.

Slide 35 of 42 Supply and Quantity Demanded Price Quantity An Increase Supply Increases Quantity Demanded Old Supply Curve $25 70 Demand Curve $12 New Supply Curve 90

Slide 36 of 42 Demand and Quantity Supplied Quantity Price per Unit An Increase In Demand Increases Quantity Supplied $25 70 Supply Curve Old Demand Curve New Demand Curve $35 80

Slide 37 of 42 Understanding the Price of Oil The supply and demand model can be used to explain some of the major events that have determined the price of oil over the past half century.  There have been six significant shocks to the oil markets since the 1970s.  All of the shocks influenced the price of oil but each was caused by different events.

Slide 38 of 42 Understanding the Price of Oil

Slide 39 of 42  In Figure 3.9, you will notice a jump in oil prices around What happened in this year to increase price? Was it a supply shock or a demand shock?  In Figure 3.9, during what period would you include a small figure for positive supply shocks (increases in supply)? Explain the causes behind the positive supply shock and the effect of these shocks on the price of oil.

Slide 40 of 42 To complete the model of exchange, supply and demand must be brought together. Equilibrium in the supply and demand model occurs where the two curves intersect. At equilibrium the quantity supplied equals the quantity demanded. In a free market, the equilibrium price and quantity are the only prices and quantities that are stable.

Slide 41 of 42 At prices greater than the equilibrium price, the quantity supplied is greater than the quantity demanded, and price will fall toward equilibrium. At prices less than the equilibrium price, the quantity demanded is greater than the quantity supplied, and price will rise toward equilibrium.

Slide 42 of 42 When supply or demand changes, equilibrium will change. An increase (decrease) in supply will cause equilibrium price to fall (rise) and equilibrium quantity to rise (fall). An increase (decrease) in demand will cause the equilibrium price to rise (fall) and equilibrium quantity to rise (fall).