Chapter 4
Equilibrium: How
Supply and Demand
Determine Prices
MODERN PRINCIPLES OF ECONOMICS
Third Edition
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
Equilibrium
equilibrium
price
equilibrium quantity
5
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.
6
Market Equilibrium
 There is ONLY ONE PRICE
where Qs = Qd
• No shortages
• No surpluses
FREE MARKETS
ALWAYS MOVE
TOWARD
EQUILIBRIUM PRICE
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Definition
Surplus:
A situation in which quantity supplied is
greater than quantity demanded.
8
Adjustment Process: Surplus
Price
Supply
Equilibrium
$60
Demand
//
700
Quantity
(MBD)
9
Adjustment Process: Surplus
Price Above Equilibrium
Price
Supply
$75
$60
Demand
//
500
700
900
Quantity
(MBD)
10
Adjustment Process: Surplus
SURPLUS
QS > QD
Price
Supply
$75
$60
QS = 900
QD = 500
Demand
//
500
700
900
Quantity
(MBD)
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Adjustment Process: Surplus
SURPLUS
QS > QD
Price
$75
Supply
Price is driven down
towards equilibrium
$60
Demand
//
500
700
900
Quantity
(MBD)
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 cause
suppliers to decrease price.
13
Definition
Shortage:
A situation in which quantity demanded
is greater than quantity supplied.
14
Adjustment Process: Shortage
Price Below Equilibrium
Price
Supply
$60
$55
Demand
//
500
700
900
Quantity
(MBD)
15
Adjustment Process: Shortage
Price
SHORTAGE
QD > QS
$60
Supply
QD = 900
QS = 500
$55
Demand
//
500
700
900
Quantity
(MBD)
16
Adjustment Process: Shortage
Price
SHORTAGE
QD > QS
Supply
Price is driven up
towards equilibrium
$60
$55
Demand
//
500
700
900
Quantity
(MBD)
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 cause
price to increase.
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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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Unexploited Gains From Trade
Price
Buyers are
willing to
pay $90
$90
Supply
Suppose quantity is
less than equilibrium
quantity (say 50)
$70
$50
Sellers are willing
to supply for $50
//
50
70
90
Demand
Quantity
(MBD)
20
Unexploited Gains From Trade
Price
Buyers are
willing to
pay $90
$90
Supply
Any trade between
Unexploited
$50 and $90gains
will
from
trade
make
both
parties
better off
$70
$50
Sellers are willing
to supply for $50
//
50
70
90
Demand
Quantity
(MBD)
21
Wasted Resources
Price
Sellers are willing
to supply for $90
$90
Supply
Suppose quantity is
greater than
equilibrium (say 90)
$70
$50
Buyers are only
willing to pay $50
//
50
70
90
Demand
Quantity
(MBD)
22
Wasted Resources
Price
Sellers are willing
to supply for $90
Supply
$90
Sellers will not sell
Waste
of losing
units
they are
resources
money on
$70
$50
Buyers are only
willing to pay $50
//
50
70
90
Demand
Quantity
(MBD)
23
Gains from Trade are Maximized at the
Equilibrium Price and Quantity
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
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.
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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.
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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?
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
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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.
 In 2002, Smith was awarded the Nobel Prize
for establishing laboratory experiments as
an important tool in economics.
J. SCOTT APPLEWHITE/AP PHOTO
28
Evidence from the Laboratory
Tyler Cowen and Alex Tabarrok
Modern 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.
Tyler Cowen and Alex Tabarrok
Modern Principles: Macroeconomics, Third Edition / Modern Principles of Economics, Third Edition
Copyright © 2015 by Worth Publishers
Shifting Demand and Supply
Price
Supply increases
Surplus
Pa
Original
Supply
New
Supply
Creates surplus
at original price
Demand
Qa
Quantity
31
Shifting Demand and Supply
Price
Competition drives
price down
Surplus
Original
Supply
New
Supply
Pa
Pb
Demand
Qa
Quantity
32
Shifting Demand and Supply
Price
New equilibrium at
lower price, higher
quantity
Original
Supply
New
Supply
Pa
Lower price increases
quantity demanded
Pb
Demand
Qa
Qb
Quantity
33
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.
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Shifting Demand and Supply
Price
Demand increases
Supply
Creates shortage
at original price
Shortage
Pa
New
Demand
Original
Demand
Qa
Quantity
35
Shifting Demand and Supply
Price
Buyers bid prices up
Supply
Pb
Pa
New
Demand
Original
Demand
Qa
Quantity
36
Shifting Demand and Supply
Price
New equilibrium at
higher price and quantity
Supply
Higher price increases
quantity supplied
Pb
Pa
New
Demand
Original
Demand
Qa
Qb
Quantity
37
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.
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Examples
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Examples
#1: New machine is invented that lowers the cost of harvesting oranges.
40
Examples
#2: The FDA announces health benefits to eating oranges.
41
Examples
#2: The income of consumers falls and some orange growers quit the business
and turn their orange groves into housing developments..
42
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).
43
Demand and Quantity Demanded
44
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.
45
Supply and Quantity Supplied
46
Understanding the Price of Oil
The supply and demand model can explain oil prices. 47
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
48
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 = $735
49
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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