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.
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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.
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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.
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Adjustment Process: Surplus
Price
Quantity(MBD)
Supply
Demand
700
$60
//
9
Equilibrium
Adjustment Process: Surplus
Price
Quantity(MBD)700
$60
$75
500//
900
10
Supply
Demand
Price Above Equilibrium
Adjustment Process: Surplus
Price
Quantity(MBD)700
$60
$75
500//
900
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Supply
Demand
QD = 500 QS = 900
SURPLUSQS > QD
Adjustment Process: Surplus
Price
Quantity(MBD)700
$60
$75
500//
900
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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.
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Answer: b – excess supply will causesuppliers to decrease price.
Definition
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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
Adjustment Process: Shortage
Price
Quantity(MBD)700
$60
$55
500//
900
16
Supply
Demand
QS = 500 QD = 900
SHORTAGEQD > QS
Adjustment Process: Shortage
Price
Quantity(MBD)700
$60
$55
500//
900
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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.
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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.
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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
//
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50 90
$50
$90
Sellers are willing to supply for $50
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
//
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Suppose quantity is greater than
equilibrium (say 90)
50 90
$50
$90
Sellers are willing to supply for $90
Buyers are only willing to pay $50
Wasted Resources
Price
Quantity(MBD)
Supply
Demand
70
$70
//
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50 90
$50
$90
Sellers are willing to supply for $90
Buyers are only willing to pay $50
Sellers will not sell units they are losing
money on
Waste of resources
Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Gains from Trade are Maximized at the Equilibrium Price and Quantity
Equilibrium and Total Surplus
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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
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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
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� 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.
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� In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics.
J. SCOTT APPLEWHITE/AP PHOTO
Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Evidence from the Laboratory
Tyler Cowen and Alex TabarrokModern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
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.
Shifting Demand and Supply
Quantity
OriginalSupply
Demand
Price
Pa
Qa31
New Supply
Surplus
Supply increases
Creates surplus at original price
Shifting Demand and Supply
Quantity
OriginalSupply
Demand
Price
Pa
Qa32
New Supply
Competition drives price down
Surplus
Pb
Shifting Demand and Supply
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.
Shifting Demand and Supply
Quantity
Supply
OriginalDemand
Price
Pa
Qa35
Demand increases
Creates shortage at original price
New Demand
Shortage
Shifting Demand and Supply
Quantity
Supply
OriginalDemand
Price
Pa
Qa36
New Demand
Buyers bid prices up
Pb
Shifting Demand and Supply
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
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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).
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Demand and Quantity Demanded
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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.
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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
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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
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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.
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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.
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