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Chapter 4: Market Equilibrium

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Presentation on theme: "Chapter 4: Market Equilibrium"— Presentation transcript:

1 Chapter 4: Market Equilibrium
Demand & Supply Together

2 Bringing Supply and Demand Together
How is the price of a good determined? The market forces of supply AND demand work simultaneously to determine the price. The law of supply and demand The price of any good will adjust to bring the quantity supplied and quantity demanded into balance. Lecture notes: We have examined supply and demand separately. Now it is time to see how the two interact. The real power and potential of supply and demand analysis is how it predicts prices and output in the entire market. Think about a scissors cutting a piece of paper. Which blade does the cutting? Both blades work together to cut the paper.

3 Supply and Demand Equilibrium point Equilibrium price
Graphically, the intersection of supply and demand Equilibrium price The price that causes quantity supplied to equal quantity demanded. The price that “clears the market” Equilibrium quantity The numerical quantity (supplied and demanded) at the equilibrium price Lecture notes: In economics, important points on graphs usually occur at intersections or points of tangency. The equilibrium price and quantity are sometimes labeled on the graph as P* and Q*, respectively.

4 Shortages and Surpluses
QD > QS Occurs at any price below equilibrium Price will rise over time toward equilibrium Why does price rise over time with a shortage? Consumers who value the product will “outbid” other consumers or otherwise show a higher willingness to pay. Suppliers will see that the price can be raised without a decrease in sales. Lecture notes: QD = quantity demanded QS = quantity supplied Shorthand like this will speed up note taking. Shortage: not all consumers get to buy what they want. Surplus: too much, the firm has leftovers it wants to sell, but can’t Price rises over time with a shortage. Why? Consumers may bid prices upward if they are desperate to purchase the good. Think of an auction

5 Shortages and Surpluses
QS > QD Occurs at any price above equilibrium Price will fall over time toward equilibrium. Why does price fall over time with a surplus? Firms will have to eventually get rid of mounting inventories of goods. To do this, they must lower their prices. Lecture notes: QD = quantity demanded QS = quantity supplied Shorthand like this will speed up note taking. Shortage: not all consumers get to buy what they want. Surplus: too much, the firm has leftovers it wants to sell, but can’t. Price falls over time with a surplus. Why? Producers need to unload mounting inventories. To do this, the price must be lowered.

6 Supply and Demand Image: Animated Figure 3.9 Lecture tips: Spend A LOT of time talking about this graph, and talk about it in two parts. Lecture notes: In the figure, we can see that when the price of salmon fillets is $10, consumers demand 500 fillets and producers supply 500 fillets. This is represented graphically at the point E, known as the equilibrium point, where the demand curve and the supply curve intersect. At this point, the two opposing forces of supply and demand are perfectly balanced. Equilibrium: Notice that there is only one price, $10, at which the quantity demanded equals the quantity supplied. At this price, all the fillets that sellers in the market supply are sold. Every buyer is able to find a salmon fillet, and every producer is able to sell his entire stock of fillets. When this is the case, we say that $10 is the equilibrium price, where the quantity supplied equals the quantity demanded. The equilibrium price is also called the “market-clearing price,” since this is the only price where no surplus or shortage of the good exists. Similarly, there is also an equilibrium quantity, of 500 fillets, where the quantity supplied equals the quantity demanded. When the market is in equilibrium, we sometimes say that “the market clears,” or that “the price clears the market.” The equilibrium has a special place in economics because movements away from that point throw the market out of balance. The equilibrium process is so powerful that it is often referred to as the law of supply and demand. According to the law of supply and demand, market prices adjust to bring the quantity supplied and quantity demanded into balance. Shortage: At any price below the equilibrium price of $10, we will have a situation where Qd > Qs, referred to as a shortage.  In this case, at a price of $5, Qd (at point B) is 750 and Qs (at point A) is 250.  The difference between 750 and 250 is 500, meaning that at a price of $5, consumers want to buy 500 more pounds of the good than suppliers are willing to sell.  This is the shortage. Surplus: At any price above the equilibrium price of $10, we will have a situation where Qs > Qd, referred to as a surplus.  In this case, at a price of $15, Qs (at point F) is 750 and Qd (at point C) is 250.  The difference between 750 and 250 is 500, meaning that at a price of $15, suppliers want to sell 500 more pounds of the good than consumers are willing to buy.  This is the surplus.

7 Supply and Demand Together
Equilibrium - a situation Market price has reached the level : Quantity supplied = quantity demanded Equilibrium price - the price: Balances quantity supplied and quantity demanded Equilibrium quantity Quantity supplied and the quantity demanded at the equilibrium price

8 The equilibrium of supply and demand
8 The equilibrium of supply and demand $3.00 2.50 2.00 1.50 1.00 0.50 Price of Ice-Cream Cones Supply Demand Equilibrium price Equilibrium Equilibrium quantity 12 10 11 9 1 2 3 4 5 6 7 8 Quantity of Ice-Cream Cones The equilibrium is found where the supply and demand curves intersect. At the equilibrium price, the quantity supplied equals the quantity demanded. Here the equilibrium price is $2.00: At this price, 7 ice-cream cones are supplied, and 7 ice-cream cones are demanded.

9 Supply and Demand Together
Surplus Quantity supplied > quantity demanded Excess supply Downward pressure on price Shortage Quantity demanded > quantity supplied Excess demand Upward pressure on price

10 Markets not in equilibrium
9 Markets not in equilibrium (a) Excess Supply (b) Excess demand Price of Ice Cream Cones Price of Ice Cream Cones Supply Supply Surplus Demand Demand $2.50 4 Quantity demanded 10 Quantity supplied 2.00 $2.00 7 7 1.50 4 Quantity supplied 10 Quantity demanded Shortage Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones In panel (a), there is a surplus. Because the market price of $2.50 is above the equilibrium price, the quantity supplied (10 cones) exceeds the quantity demanded (4 cones). Suppliers try to increase sales by cutting the price of a cone, and this moves the price toward its equilibrium level. In panel (b), there is a shortage. Because the market price of $1.50 is below the equilibrium price, the quantity demanded (10 cones) exceeds the quantity supplied (4 cones). With too many buyers chasing too few goods, suppliers can take advantage of the shortage by raising the price. Hence, in both cases, the price adjustment moves the market toward the equilibrium of supply and demand

11 Supply and Demand Together
Law of supply and demand The price of any good adjusts Bring the quantity supplied and the quantity demanded into balance In most markets Surpluses and shortages are temporary

12 Supply and Demand Together
Three steps to analyzing changes in equilibrium Decide: the event shifts the supply curve, the demand curve, or both curves Decide: curve shifts to right or to left Use supply-and-demand diagram Compare initial and new equilibrium How the shift affects equilibrium price and quantity

13 Three steps for analyzing changes in equilibrium
3 Three steps for analyzing changes in equilibrium Decide whether the event shifts the supply or demand curve (or perhaps both). Decide in which direction the curve shifts. Use the supply-and demand diagram to see how the shift changes the equilibrium price and quantity.

14 How an increase in demand affects the equilibrium
10 How an increase in demand affects the equilibrium Price of Ice-Cream Cones Supply Hot weather increases the demand for ice cream . . . D2 2. …resulting in a higher price . . . D1 $2.50 New equilibrium 10 2.00 7 Initial equilibrium 3. …and a higher quantity sold. Quantity of Ice-Cream Cones An event that raises quantity demanded at any given price shifts the demand curve to the right. The equilibrium price and the equilibrium quantity both rise. Here an abnormally hot summer causes buyers to demand more ice cream. The demand curve shifts from D1 to D2, which causes the equilibrium price to rise from $2.00 to $2.50 and the equilibrium quantity to rise from 7 to 10 cones

15 Supply and Demand Together
Shifts in curves versus movements along curves Shift in the supply curve Change in supply Movement along a fixed supply curve Change in the quantity supplied Shift in the demand curve Change in demand Movement along a fixed demand curve Change in the quantity demanded

16 Supply and Demand Together
Example: A change in market equilibrium due to a shift in supply One summer - a hurricane destroys part of the sugarcane crop Price of sugar - increases Effect on the market for ice cream? Change in price of sugar - supply curve Supply curve - shifts to the left Higher equilibrium price; lower equilibrium quantity

17 How a decrease in supply affects the equilibrium
11 How a decrease in supply affects the equilibrium Price of Ice-Cream Cones 1. An increase in the price of sugar reduces the supply of ice cream . . . S2 2. …resulting in a higher price . . . Demand S1 $2.50 New equilibrium 4 2.00 7 Initial equilibrium 3. …and a smaller quantity sold. Quantity of Ice-Cream Cones An event that reduces quantity supplied at any given price shifts the supply curve to the left. The equilibrium price rises, and the equilibrium quantity falls. Here an increase in the price of sugar (an input) causes sellers to supply less ice cream. The supply curve shifts from S1 to S2, which causes the equilibrium price of ice cream to rise from $2.00 to $2.50 and the equilibrium quantity to fall from 7 to 4 cones

18 Supply and Demand Together
Example: shifts in both supply and demand One summer: hurricane and heat wave Heat wave – shift demand curve; hurricane – shift supply curve Demand curve shifts to the right; Supply curve shifts to the left Equilibrium price raises If demand increases substantially while supply falls just a little: equilibrium quantity –rises If supply falls substantially while demand rises just a little: equilibrium quantity falls

19 A shift in both supply and demand
12 A shift in both supply and demand Price of Ice Cream Cones (a) Price Rises, Quantity Rises Price of Ice Cream Cones (b) Price Rises, Quantity Falls S2 Small increase in demand New equilibrium D2 S2 Large increase in demand S1 S1 New equilibrium D2 D1 P2 P2 D1 Q2 Q2 Large decrease in supply Small decrease in supply P1 P1 Initial equilibrium Q1 Q1 Initial equilibrium Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Here we observe a simultaneous increase in demand and decrease in supply. Two outcomes are possible. In panel (a), the equilibrium price rises from P1 to P2, and the equilibrium quantity rises from Q1 to Q2. In panel (b), the equilibrium price again rises from P1 to P2, but the equilibrium quantity falls from Q1 to Q2.

20 What happens to price and quantity when supply or demand shifts?
4 What happens to price and quantity when supply or demand shifts? No change In Supply An increase A decrease In supply In demand P same Q same P up Q up P down Q down P ambiguous P Down Q ambiguous

21 Impact on Price and Quantity
Graphs of Shifts Change Illustration Impact on Price and Quantity Demand increases The demand curve shifts to the right. As a result, the equilibrium price and equilibrium quantity increase. Supply increases The supply curve shifts to the right. As a result, the equilibrium price declines and the equilibrium quantity increases.

22 Impact on Price and Quantity
Graphs of Shifts Change Illustration Impact on Price and Quantity Demand decreases The demand curve shifts to the left. As a result, the equilibrium price and equilibrium quantity decrease. Supply decreases The supply curve shifts to the left. As a result, the equilibrium price increases and the equilibrium quantity decreases.

23 Conclusion If you take away just one thing from this course, it will probably be “supply and demand.” In competitive markets, supply and demand allow prices to adjust toward equilibrium. In equilibrium, the markets clears. This means there are no surpluses or shortages.

24 Summary Supply and demand play a key role in determining prices in the market economy. Prices established through this process help allocate resources.  A market consists of a group of buyers and sellers for a particular product or service. The demand curve is downward-sloping. The supply curve is upward-sloping.

25 Summary A change in the price of a good will cause
A movement along the demand curve A movement along the supply curve Changes other than price Cause a shift in demand Cause a shift in supply Supply and demand interact through the process of market coordination. The equilibrium is the balancing point between the two opposing forces. The market clearing price and output are determined at the equilibrium point. Shortages and surpluses are resolved in competitive markets.


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