CHAPTER
4
DYNAMIC P OWERP OINT™ S LIDES BY S OLINA L INDAHL
Equilibrium: How Supply and
Demand Determine Prices
CHAPTER OUTLINE
Equilibrium and the
Adjustment Process
Shifting Demand and
Supply Curves
Gains from Trade Are
Maximized at the
Equilibrium Price and
Quantity
Terminology: Demand
Compared to Quantity
Demanded and Supply
Compared to Quantity
Supplied
Does the Model Work?
Evidence from the
Laboratory
Understanding the Price of
Oil
For applications, click here
To Try it!
questions
To
Video
Food for Thought….
Some good blogs and other sites to get the juices flowing:
Try it!
Would you prefer an economic
system where goods were
rationed by:
a) Need
b) Equality/fairness
c) Who can pay the most
To next
Try it!
Market Equilibrium
When Qs = Qd at a certain price, the
market is in equilibrium,
the amount consumers would purchase
at this price is matched exactly by the
amount producers wish to sell.
BACK TO
Market Equilibrium
There is ONLY ONE PRICE
where Qs = Qd
This is “equilibrium price and
quantity”
No shortages
No surpluses
FREE MARKETS ALWAYS
MOVE TOWARD
EQUILIBRIUM PRICE
BACK TO
Equilibrium and the Adjustment Process
Price is Determined by Supply and Demand
Price of Oil
per Barrel
Equilibrium
Price
Supply Curve
$30
Demand Curve
65
Quantity of
Oil (MBD)
Equilibrium
Quantity
BACK TO
How Markets Find Equilibrium
When Price is Too High
P
Energy Drinks
At P = $5.00:
S
.
$5.00
Qs = 25, Qd = 15
.
4.00
Price will fall to
equilibrium ($4.00)
and Qd will rise to 20,
Qs will fall to 20 and
3.00
Qd = Qs
2.00
1.00
D
Q
0
5
10
15
20
25
At a price of $5.00, a SURPLUS of 10 energy drinks (25-15) exists… suppliers are
left with stock on the shelves- they take action to get the surplus sold and raise
revenue.
BACK TO
How Markets Find Equilibrium
When Price is Too Low
P
Energy Drinks
At P = $3.00:
S
Qs = 15, Qd = 25
$5.00
4.00
.
3.00
Price will rise to
equilibrium ($4.00)
and Qd will fall to 20,
Qs will rise to 20 and
.
Qd = Qs
2.00
1.00
D
Q
0
5
10
15
20
25
At a price of $3.00, a SHORTAGE of 10 energy drinks (25-15) exists… buyers
compete with each other for purchases- sellers see their chance to raise price
and revenue
BACK TO
Take a look…
For a look at a real-world equilibrium pricing
mechanism, click the picture below to see the
Aalsmeer Dutch Tulip auction in action. (3
minutes)
http://video.kera.org/video/1283843915/
Shifting Demand and Supply Curves
Price of
energy
drinks
An increase in
demand
S
Causes the
equilibrium to
change to a
P1
higher P and Q
P0
D0
Q0
Q1
D1
Quantity of energy
drinks
BACK TO
Shifting Demand and Supply Curves
Price of
energy
drinks
A decrease in
demand
S
Causes the
equilibrium to
change to a
P0
lower P and Q
P1
D01
Q1
Q0
Quantity of energy
drinks
BACK TO
Shifting Demand and Supply Curves
Price of
energy
drinks
An increase in
supply
SS10
P0
Causes the
equilibrium to
change to a
lower P and
higher Q
P1
D0
Q0
Q1
Quantity of energy
drinks
BACK TO
Shifting Demand and Supply Curves
Price of
energy
drinks
A decrease in
supply
SS0 1
P1
Causes the
equilibrium to
change to a
higher P and
lower Q
P0
D0
Q1
Q0
Quantity of energy
drinks
BACK TO
Try it!
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)
b)
c)
d)
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.
To next
Try it!
Try it!
To next
Try it!
Try it!
#1: New machine is invented that lowers the cost of harvesting oranges.
Try it!
#2: The FDA announces health benefits to eating oranges.
Try it!
#2: The income of consumers falls and some orange growers quit the business
and turn their orange groves into housing developments..
Gains from Trade Are Maximized at
Equilibrium Price and Quantity
Unexploited Gains from Trade Exist when Quantity is Below the Equilibrium Quantity
Price of Oil
per Barrel
Satisfied Wants
$57
Supply Curve
Unsatisfied Wants
At Q=24, there are buyers who
value buying the good more than
sellers value selling the good
(there are unexploited gains from
trade up until 65 units)
Equilibrium
$30
Price
$15
Unexploited
Gains from
Trade
24
Demand Curve
65
Equilibrium
Quantity
Quantity of Oil
(MBD)
BACK TO
Gains from Trade Are Maximized at
Equilibrium Price and Quantity
Wasteful Trades Exist when Quantity is Above the Equilibrium Quantity
Price of Oil
per Barrel
Supply Curve
$50
But at the Equilibrium
Quantity
There
Are No
Value
of
Wasted Gains from
Unexploited
Resources
Trade nor Any Wasteful
Trades!
Equilibrium
Price
$30
$15
Demand Curve
65
Equilibrium
Quantity
95
Quantity of Oil
(MBD)
BACK TO
Gains from Trade Are Maximized at
Equilibrium Price and Quantity
A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade)
Price of Oil
per Barrel
Supply Curve
Buyers
Equilibrium
Price
$30
Non-Sellers
Consumer
Surplus
Producer
Surplus
Sellers
Non-Buyers
Demand Curve
65
Quantity of Oil
(MBD)
Equilibrium Quantity
BACK TO
Try it!
If this market is in equilibrium, what is the total producer
surplus? The total consumer surplus? What are the total
gains from trade?
a) Consumer Surplus=$6; Producer Surplus=$4; Total
Gains from Trade=$10
b) CS=$11; PS=$1; Total Gains from Trade=$12
c) CS=$250; PS=$200; Total Gains from Trade=$450
d) CS=$155; PS=$100; Total Gains from Trade=$250
To next
Try it!
Equilibrium and Total Surplus
Equilibrium in a free market yields two
important results:
Goods must be produced at the lowest
possible cost.
Goods must satisfy the highest valued
demands.
These results indicate that total surplus
(both of the consumer and producer) is
maximized in free markets.
BACK TO
SEE THE INVISIBLE HAND
Who is made better off and who is made worse off
by a legal doctrine that says tenants must have hot
water?
If tenants benefit from a law that says apartments
must have hot water then surely a law that says
tenants must have hot water and a dishwasher
benefits them even more, right? What about a law
that says tenants must have hot water, a dishwasher
and cable tv?
For a thought experiment that suggests BOTH parties
are harmed when the market is tampered with, see
this post on Worth’s STIH resource bank.
SEE THE INVISIBLE HAND
“I am still recovering from
the shock of the
experimental results. The
outcome was
unbelievably consistent
with competitive price
theory. ”
Vernon Smith proved
the invisible hand was
there.
Vernon Smith, winner of 2002 Nobel
Prize in Economics, on his 1956
experiments designed to disprove the
supply and demand model.
BACK TO
The Price of Oil, 1960-2005
BACK TO
Terminology: Shifts vs. Movement along
Supply and Demand curves
A shift in a demand (supply)
curve is called a “Change in
Demand (Supply)”
Not to be confused with:
Movement ALONG a
demand (supply) curve is
called “Change in Quantity
Demanded (Supplied)
BACK TO
Changes in Demand vs. Change in
Quantity Demanded
Change in Demand
Change in Quantity Demanded
D1
Price ($)
80
Price ($)
80
40
D0
D0
20
40
Quantity (computer games)
20
40
Quantity (computer games)
BACK TO
Changes in Supply vs. Change in
Quantity Supplied
Change in Supply
Change in Quantity Supplied
S0
S0
S1
80
Price ($)
Price ($)
80
40
20
40
Quantity (computer games)
20
40
Quantity (computer games)
BACK TO
Shifting Demand and Moving along
Supply Curve
Price of
energy
drinks
An increase in
demand
S
causes a movement
along the Supply
curve… a “Change in
Quantity Supplied”
P1
P0
D0
Q0
Q1
D1
Quantity of energy
drinks
BACK TO
Shifting Supply and Moving along
Demand Curve
Price of
energy
drinks
A decrease in
supply
SS0 1
P1
causes a movement
along the Demand
curve… a “Change in
Quantity Demanded”
P0
D0
Q1
Q0
Quantity of energy
drinks
BACK TO
Try it!
At a price of $3, quantity
supplied is ______ and
quantity demanded is
______, leading to a
_______.
a) 6; 2; surplus of 4 units
b) 2; 4; surplus of 2 units
c) 2; 6; shortage of 8
units
d) 4; 2; shortage of 2
units
To next
Try it!
Try it!
If garden gnomes regain
widespread popularity,
what will happen?
a) Equilibrium Price and
Quantity both fall.
b) Equilibrium Price and
Quantity both rise.
c) Equilibrium Price falls and
Quantity rises.
d) Equilibrium Price rises and
To next
Quantity falls.
Try it!
Try it!
If the cost of wood falls,
what will happen in the
violin market?
a) Equilibrium Price and
Quantity both fall.
b) Equilibrium Price and
Quantity both rise.
c) Equilibrium Price falls and
Quantity rises.
d) Equilibrium Price rises
and Quantity falls.
BACK TO