1. Equilibrium: How Supply and Demand Determine Prices
Chapter 4
Equilibrium: How Supply and Demand Determine Prices

2. 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

3. Outline
Terminology: Demand Compared with Quantity Demanded and Supply Compared with Quantity Supplied
Understanding the Price of Oil

4. Definition Equilibrium:
The price at which the quantity demanded is equal to the quantity supplied.

5. Equilibrium equilibrium price equilibrium quantity
Figure 4-1 (4-1): Price Is Determined by Supply and Demand
equilibrium quantity

6. 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.

7. Tyler Cowen and Alex Tabarrok
Market Equilibrium
There is ONLY ONE PRICE where Qs = Qd
No shortages
No surpluses
FREE MARKETS ALWAYS MOVE TOWARD EQUILIBRIUM PRICE
Thinking About Equilibrium
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

8. Definition
Surplus:
A situation in which quantity supplied is greater than quantity demanded.

9. Adjustment Process: Surplus
Price
Supply
Equilibrium
$60
Demand //
Quantity
(MBD)
700 9

10. Adjustment Process: Surplus
Price Above Equilibrium
Price
Supply
$75
$60
Demand //
Quantity
(MBD)
500
700
900 10

11. Adjustment Process: Surplus
QS > QD
Price
Supply
$75
$60
QD = 500
QS = 900
Demand //
Quantity
(MBD)
500
700
900 11

12. Adjustment Process: Surplus
QS > QD
Price
Supply
$75
Price is driven down towards equilibrium
$60
Demand //
Quantity
(MBD)
500
700
900 12

13. Self-Check When there is a surplus in a competitive market:
Price will increase.
Price will decrease.
Price will remain the same.
Answer: b – excess supply will cause suppliers to decrease price.

14. Definition
Shortage:
A situation in which quantity demanded is greater than quantity supplied.

15. Adjustment Process: Shortage
Price Below Equilibrium
Price
Supply
$60
$55
Demand //
Quantity
(MBD)
500
700
900 15

16. Adjustment Process: Shortage
Price
SHORTAGE
QD > QS
Supply
QS = 500
QD = 900
$60
$55
Demand //
Quantity
(MBD)
500
700
900 16

17. Adjustment Process: Shortage
Price
SHORTAGE
QD > QS
Supply
Price is driven up towards equilibrium
$60
$55
Demand //
Quantity
(MBD)
500
700
900 17

18. Self-Check When there is a shortage in a competitive market:
Price will increase.
Price will decrease.
Price will remain the same.
Answer: a – excess demand will cause price to increase.

19. Equilibrium and Gains From Trade
A free market maximizes the gains from trade.
Available goods are bought by buyers with the highest willingness to pay.
Goods are sold by the sellers with the lowest costs.
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.

20. Unexploited Gains From Trade
Price
Buyers are willing to pay $90
Supply
$90
Suppose quantity is less than equilibrium quantity (say 50)
$70
$50
Sellers are willing to supply for $50
Demand //
Quantity
(MBD) 50 70 90 20

21. Unexploited Gains From Trade
Price
Buyers are willing to pay $90
Supply
$90
Any trade between $50 and $90 will make both parties better off
Unexploited gains from trade
$70
$50
Sellers are willing to supply for $50
Demand //
Quantity
(MBD) 50 70 90 21

22. Wasted Resources Sellers are willing to supply for $90 Supply
Price
Sellers are willing to supply for $90
Supply
$90
Suppose quantity is greater than equilibrium (say 90)
$70
$50
Buyers are only willing to pay $50
Demand //
Quantity
(MBD) 50 70 90 22

23. Wasted Resources Sellers are willing to supply for $90 Supply
Price
Sellers are willing to supply for $90
Supply
$90
Sellers will not sell units they are losing money on
Waste of resources
$70
$50
Buyers are only willing to pay $50
Demand //
Quantity
(MBD) 50 70 90 23

24. Gains from Trade are Maximized at the Equilibrium Price and Quantity
Figure 4-4 (4-4): A Free Market Maximizes Producer Plus Consumer Surplus (the Gains from Trade)
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

25. 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.

26. Self-Check If the quantity traded is less than equilibrium quantity:
Resources will be wasted.
Suppliers will only supply goods at equilibrium price.
Some gains from trade will be lost.
Answer: c – some gains from trade will be lost.

27. Self-Check
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

28. 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.
J. SCOTT APPLEWHITE/AP PHOTO
In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics. 28

29. Evidence from the Laboratory
Figure 4-5 (4-5): Economics as an Experimental Science
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

30. Evidence from the Laboratory
“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.
Figure 4-5 (4-5): Economics as an Experimental Science
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition Copyright © 2015 by Worth Publishers

31. Shifting Demand and Supply
Supply increases
Original Supply
Price
New Supply
Surplus Pa
Creates surplus at original price
Demand
Quantity Qa 31

32. Shifting Demand and Supply
Competition drives price down
Original Supply
Price
New Supply
Surplus Pa Pb
Demand
Quantity Qa 32

33. Shifting Demand and Supply
New equilibrium at lower price, higher quantity
Original Supply
Price
New Supply Pa
Lower price increases quantity demanded Pb
Demand
Quantity Qa Qb 33

34. Self-Check A decrease in supply will:
Increase both price and quantity.
Decrease price and increase quantity.
Increase price and decrease quantity.
Answer: c – lower supply causes a shortage, increasing price and causing consumers to buy less.

35. Shifting Demand and Supply
Demand increases
Price
Supply
Creates shortage at original price
Shortage Pa
New Demand
Original Demand
Quantity Qa 35

36. Shifting Demand and Supply
Buyers bid prices up
Price
Supply Pb Pa
New Demand
Original Demand
Quantity Qa 36

37. Shifting Demand and Supply
New equilibrium at higher price and quantity
Price
Supply
Higher price increases quantity supplied Pb Pa
New Demand
Original Demand
Quantity Qa Qb 37

38. Self-Check A decrease in demand will:
Decrease both price and quantity.
Decrease price and increase quantity.
Increase price and decrease quantity.
Answer: a – lower demand causes a surplus, lowering prices and causing suppliers to supply less.

39. Examples

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

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

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

43. 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).

44. Demand and Quantity Demanded
Figure 4-1 (4-1): Price Is Determined by Supply and Demand (TOP)

45. 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.

46. Supply and Quantity Supplied
Figure 4-1 (4-1): Price Is Determined by Supply and Demand (BOTTOM)

47. Understanding the Price of Oil
Figure 4-9 (4-9): The Price of Oil, 1960–2012
The supply and demand model can explain oil prices. 47

48. 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

49. 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 = P 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 = P  P = 25
Area of triangle: ½ * (60 – 25) * 42 = $735

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.