Embed Size (px)
Citation preview
MODERN PRINCIPLES OF ECONOMICSThird Edition
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.
4
5
Equilibrium
equilibrium quantity
equilibrium price
Equilibrium
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.
6
Definition
Surplus:
A situation in which quantity supplied
is greater than quantity demanded.
7
Adjustment Process: Surplus
Price
Quantity (MBD)
Supply
Demand
700
$60
//
8
Equilibrium
Adjustment Process: Surplus
Price
Quantity (MBD)700
$60
$75
500//
900
9
Supply
Demand
Price Above Equilibrium
Adjustment Process: Surplus
Price
Quantity (MBD)700
$60
$75
500//
900
10
Supply
Demand
QD = 500 QS = 900
SURPLUSQS > QD
Adjustment Process: Surplus
Price
Quantity (MBD)700
$60
$75
500//
900
11
Supply
Demand
SURPLUSQS > QD
Price is driven down towards equilibrium
12
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.
Answer: b – excess supply will causesuppliers to decrease price.
Definition
13
Shortage:
A situation in which quantity
demanded is greater than quantity
supplied.
Adjustment Process: Shortage
Price
Quantity (MBD)700
$60
$55
500//
900
14
Supply
Demand
Price Below Equilibrium
Adjustment Process: Shortage
Price
Quantity (MBD)700
$60
$55
500//
900
15
Supply
Demand
QS = 500 QD = 900
SHORTAGEQD > QS
Adjustment Process: Shortage
Price
Quantity (MBD)700
$60
$55
500//
900
16
Supply
Demand
Price is driven up towards equilibrium
SHORTAGEQD > QS
17
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.
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.
18
Buyers are willing to pay $90
Unexploited Gains From Trade
Price
Quantity (MBD)
Supply
Demand
70
$70
//
19
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
//
20
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
//
21
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
//
22
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
23
Self-Check
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.
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.
24
In 2002, Smith was awarded the Nobel Prize for establishing laboratory experiments as an important tool in economics.
J. SCOTT APPLEWHITE/AP PHOTO
Shifting Demand and Supply
Quantity
OriginalSupply
Demand
Price
Pa
Qa25
New Supply
Surplus
Supply increases
Creates surplus at original price
Shifting Demand and Supply
Quantity
OriginalSupply
Demand
Price
Pa
Qa26
New Supply
Competition drives price down
Surplus
Pb
Shifting Demand and Supply
Quantity
OriginalSupply
Demand
Price
Pa
Qa27
New Supply
New equilibrium at lower price, higher
quantity
PbLower price increases
quantity demanded
Qb
28
Self-Check
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
Qa29
Demand increases
Creates shortage at original price
New Demand
Shortage
Shifting Demand and Supply
Quantity
Supply
OriginalDemand
Price
Pa
Qa30
New Demand
Buyers bid prices up
Pb
Shifting Demand and Supply
Quantity
Supply
OriginalDemand
Price
Pa
Qa31
New Demand
Qb
Pb
New equilibrium at higher price and quantity
Higher price increases quantity supplied
32
Self-Check
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.
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).
33
Demand and Quantity Demanded
34
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.
35
Supply and Quantity Supplied
36
Understanding the Price of Oil
37The supply and demand model can explain oil prices.
38
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.
39
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.
