Chapter 3 equilibrium how supply and demand determine prices
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Chapter 3 Equilibrium: How Supply and Demand Determine Prices. Supply and Demand. The model of supply and demand is a simple presentation of exchange. Every exchange involves both a buyer and a seller. So, to complete the model, supply and demand must be brought together. Equilibrium.

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Chapter 3 Equilibrium: How Supply and Demand Determine Prices

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Chapter 3 equilibrium how supply and demand determine prices

Chapter 3

Equilibrium: How Supply and Demand Determine Prices


Supply and demand

Supply and Demand

The model of supply and demand is a simple presentation of exchange.

Every exchange involves both a buyer and a seller.

So, to complete the model, supply and demand must be brought together.


Equilibrium

Equilibrium

When the supply curve and the demand curve for a particular good are drawn on the same graph, a unique a point emerges – Equilibrium.

Graphically, equilibrium exists at the intersection of the supply curve and the demand curve.

The price at this point is known as the Equilibrium Price, and the quantity at this point is called the Equilibrium Quantity.

At the equilibrium price, quantity demanded equals quantity supplied.


Equilibrium and the adjustment process

Equilibrium and the Adjustment Process

Price is Determined by Supply and Demand

Price of Oil per Barrel

Supply Curve

Equilibrium Price

$30

Demand Curve

Quantity of Oil (MBD)

65

Equilibrium Quantity


Equilibrium and the adjustment process1

Equilibrium and the Adjustment Process

In a free market (a market free of outside interference) the equilibrium price and quantity are the only prices and quantities that are stable.

At any other prices and quantities, economic forces naturally emerge in a free market and push those prices and quantities toward equilibrium.


Excess supply

Excess Supply

At prices greater than the equilibrium price, the quantity supplied is greater than the quantity demanded.

Economists refer to this as Excess Supply or Surplus.

In this situation sellers must reduce their prices to induce buyers to purchase all of this extra product.

In a free market, price will continue to fall until equilibrium is reached.


Excess supply1

Excess Supply

Excess Supply Drives Prices Down

Price per Barrel

Supply Curve

Surplus

$50

Equilibrium Price

$30

Demand Curve

Quantity of Oil (MBD)

32

100

65

Equilibrium Quantity


Excess demand

Excess Demand

At prices less than the equilibrium price, the quantity supplied is greater than the quantity demanded.

Economists refer to this as Excess Demand or Shortage.

In this situation buyers will offer sellers higher prices in order to outbid other buyers. These higher prices will also induce sellers to bring more product to market

In a free market price will continue to rise until equilibrium is reached.


Excess demand1

Excess Demand

Excess Demand Drives Prices Up

Price per Barrel

Supply Curve

Equilibrium Price

$30

$15

Shortage

Demand Curve

Quantity of Oil (MBD)

24

95

65

Equilibrium Quantity


Chapter 3 equilibrium how supply and demand determine prices

  • If high gasoline prices lead to a decrease in the demand for SUVs, what will automobile companies do to sell trucks and SUVs already manufactured?

  • Consider clothes sold at outlet malls. Have sellers produced too few or too many of the particular items based on demand? What actions are sellers taking to move their goods out the door?


Equilibrium and gains from trade

Equilibrium and Gains from Trade

Gains from trade are maximized at the equilibrium price and quantity in a free market.

Gains from trade are possible when the price buyers are willing to pay for a particular good exceeds the price sellers are willing to accept.

There are unexploited gains from trade at any quantity less than the equilibrium quantity.

Free markets will not allow unexploited gains from trade to last long.


Gains from trade are maximized at equilibrium price and quantity

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

Supply Curve

$57

Unsatisfied Wants

Equilibrium Price

$30

Unexploited Gains from Trade

$15

Demand Curve

Quantity of Oil (MBD)

24

65

Equilibrium Quantity


Equilibrium and gains from trade1

Equilibrium and Gains from Trade

Additionally, resources are not wasted at the equilibrium price and quantity in a free market.

When quantity supplied exceeds the equilibrium quantity, suppliers incur costs greater than the value buyers place on those goods.

Resources needed to produce this additional output could be used to produce other goods buyers value more highly.

Free markets will not allow wasted resources to last long.


Gains from trade are maximized at equilibrium price and quantity1

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

Value of Wasted Resources

Equilibrium Price

$30

$15

Demand Curve

Quantity of Oil (MBD)

95

65

Equilibrium Quantity


Equilibrium and total surplus

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.


Gains from trade are maximized at equilibrium price and quantity2

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

Non-Sellers

Consumer Surplus

Equilibrium Price

$30

Producer Surplus

Sellers

Non-Buyers

Demand Curve

Quantity of Oil (MBD)

65

Equilibrium Quantity


Chapter 3 equilibrium how supply and demand determine prices

  • As the price of cars goes up, which marketplace wants will be the first to stop being satisfied? Give an example.

  • In the late 1990s, telecommunication firms laid greater quantities of fiber-optic cable than the market equilibrium quantity (as proven by later events). Describe the nature of the losses from too much investment in fiber-optic cable. What market incentives exist to avoid these losses?


Changes in equilibrium

Changes in Equilibrium

In free markets, supply or demand (or both) can change quite frequently.

When supply or demand changes, equilibrium must also change.

The supply and demand model allows for predictions of equilibrium when supply or demand changes in a free market.


Gains from trade are maximized at equilibrium price and quantity3

Gains from Trade Are Maximized at Equilibrium Price and Quantity

Suppose that a decrease in the cost of producing a particular good arises. What happens to equilibrium?

Supply increases shifting the supply curve down and to the right.

At the original equilibrium price, excess supply exists in the market.

Sellers will lower price to induce buyers for this surplus.

As the price falls, quantity demanded rises.

The price will continue to fall and quantity will rise until equilibrium is reached.

In a free market, the equilibrium price will adjust rather quickly.


Shifting demand and supply curves

Shifting Demand and Supply Curves

Effect of Increase in Supply on Equilibrium Price and Quantity

Price

Old Supply Curve

New Supply Curve

Old Equilibrium Price

New Equilibrium Price

Demand Curve

Quantity

Old Equilibrium Quantity

New Equilibrium Quantity


Shifting demand and supply curves1

Shifting Demand and Supply Curves

Suppose that an increase in the demand for a particular good arises. What happens to equilibrium?

Demand increases shifting the demand curve up, out, and to the right.

At the original equilibrium price, excess demand exists in the market.

Buyers will drive up the price to outbid other buyers for this shortage.

As the price rises, quantity supplied rises.

The price and quantity will continue to rise until equilibrium is reached.

In a free market, the equilibrium price will adjust rather quickly.


Shifting demand and supply curves2

Shifting Demand and Supply Curves

Effect of Increase in Demand on Equilibrium Price and Quantity

Price per Unit

Supply Curve

New Equilibrium Price

Old Equilibrium Price

New Demand Curve

Old Demand Curve

Quantity

Old Equilibrium Quantity

New Equilibrium Quantity


Chapter 3 equilibrium how supply and demand determine prices

  • Flooding in Iowa destroys some of the corn and soybean crop. What will happen to the price and quantity for each of these crops?

  • Resveratrol, which is found in the plant Japanese knotweed (and is also a component of red wine), has recently been shown to increase life expectancy in worms and fish. What are your predictions about the price and quantity grown of Japanese knotweed?

  • With the increase in gasoline prices, demand has shifted away from large cars and SUVs, and toward hybrid cars such as the Prius. Draw a graph showing the supply and demand for hybrid cars before and after an increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?


Chapter 3 equilibrium how supply and demand determine prices

  • With the increase in gasoline prices, demand shifted away from large cars and SUVs, and toward hybrid cars such as the Prius. Draw a graph showing the supply and demand for hybrid cars before and after an increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?

  • With the increase in gasoline prices, demand shifted away from large cars and SUVs, and toward hybrid cars such as the Prius. Draw a graph showing the supply and demand for hybrid cars before and after an increase in the price of gasoline. What do you predict will happen to the price of hybrids as the price of gasoline rises?


Changes in equilibrium extra

Changes in Equilibrium - Extra!

Individual changes in supply or demand have predictable effects on equilibrium price and quantity.

Often, however, supply and demand both simultaneously change.

This case involves a bit of uncertainty because changes in supply and changes in demand can have opposite effects on equilibrium price and quantity.


Changes in equilibrium extra1

Changes in Equilibrium - Extra!

When supply and demand move in the same direction, equilibrium quantity changes in a predictable manner, but the change in equilibrium price is uncertain.

This ambiguity arises because the changes in supply and demand have opposite effects on equilibrium price.


Changes in equilibrium extra2

Changes in Equilibrium - Extra!

The relative magnitude of the changes in supply and demand will ultimately determine the change in equilibrium price.

A simultaneous increase (decrease) in both supply and demand involves opposing forces on equilibrium price.

If the increase (decrease) in supply is greater than the increase (decrease) in demand, equilibrium price must fall (rise).

If the increase (decrease) in supply is less than the increase (decrease) in demand, equilibrium price must rise (fall).

If the increase (decrease) in supply equals the increase (decrease) in demand, equilibrium price does not change.


Changes in equilibrium extra3

Changes in Equilibrium - Extra!

When supply and demand move in the opposite direction, equilibrium price changes in a predictable manner, but the change in equilibrium quantity is uncertain.

This ambiguity arises because the changes in supply and demand have opposite effects on equilibrium quantity.


Changes in equilibrium extra4

Changes in Equilibrium - Extra!

The relative magnitude of the changes in supply and demand will ultimately determine the change in equilibrium quantity.

A simultaneous increase (decrease) in supply and a decrease (increase) in demand involves opposing forces on equilibrium quantity.

If the increase (decrease) in supply is greater than the decrease (increase) in demand, equilibrium quantity must rise (fall).

If the increase (decrease) in supply is less than the decrease (increase) in demand, equilibrium quantity must fall (rise).

If the increase (decrease) in supply equals the decrease (increase) in demand, equilibrium quantity does not change.


Changes in equilibrium extra5

Changes in Equilibrium - Extra!

A Simultaneous Increase in Supply and Demand of the Same Magnitude Leaves Equilibrium Price Unchanged

Price

Old Supply

New Supply

Old Price

=

New Price

New Demand

Old Demand

Quantity

Old Quantity

New Quantity


Changes in equilibrium extra6

Changes in Equilibrium - Extra!

Equilibrium Price Rises with a Larger Increase in Demand than an Increase in Supply

Price

Old Supply

New Supply

New Price

Old Price

New Demand

Old Demand

Quantity

Old Quantity

New Quantity


Changes in equilibrium extra7

Changes in Equilibrium - Extra!

Summary of Changes in Supply and Demand


Demand and quantity demanded

Demand and Quantity Demanded

A change in quantitydemanded is NOT the same as a change in demand.

Quantity demanded changes only when the price of a good changes.

Graphically, a change in quantity demanded is represented by a movement along a fixed demand curve.

Demand changes only when a non-price factor changes.

Graphically, a change in demand is represented by a shift in the entire demand curve.


Supply and quantity supplied

Supply and Quantity Supplied

A change in quantity supplied is NOT the same as a change in supply.

Quantity supplied changes only when the price of a good changes.

Graphically, a change in quantity supplied is represented by a movement along a fixed supply curve.

Supply changes only when a non-price factor changes.

Graphically, a change in supply is represented by a shift in the entire supply curve.


Supply and quantity demanded

Supply and Quantity Demanded

An Increase Supply Increases Quantity Demanded

Price

Old Supply Curve

New Supply Curve

$25

$12

Demand Curve

Quantity

70

90


Demand and quantity supplied

Demand and Quantity Supplied

An Increase In Demand Increases Quantity Supplied

Price per Unit

Supply Curve

$35

New Demand Curve

$25

Old Demand Curve

Quantity

70

80


Understanding the price of oil

Understanding the Price of Oil

The supply and demand model can be used to explain some of the major events that have determined the price of oil over the past half century.

There have been six significant shocks to the oil markets since the 1970s.

All of the shocks influenced the price of oil but each was caused by different events.


Understanding the price of oil1

Understanding the Price of Oil


Chapter 3 equilibrium how supply and demand determine prices

  • In Figure 3.9, you will notice a jump in oil prices around 1991. What happened in this year to increase price? Was it a supply shock or a demand shock?

  • In Figure 3.9, during what period would you include a small figure for positive supply shocks (increases in supply)? Explain the causes behind the positive supply shock and the effect of these shocks on the price of oil.


Chapter 3 equilibrium how supply and demand determine prices

  • To complete the model of exchange, supply and demand must be brought together.

  • Equilibrium in the supply and demand model occurs where the two curves intersect.

  • At equilibrium the quantity supplied equals the quantity demanded.

  • In a free market, the equilibrium price and quantity are the only prices and quantities that are stable.


Chapter 3 equilibrium how supply and demand determine prices

  • At prices greater than the equilibrium price, the quantity supplied is greater than the quantity demanded, and price will fall toward equilibrium.

  • At prices less than the equilibrium price, the quantity demanded is greater than the quantity supplied, and price will rise toward equilibrium.


Chapter 3 equilibrium how supply and demand determine prices

  • When supply or demand changes, equilibrium will change.

  • An increase (decrease) in supply will cause equilibrium price to fall (rise) and equilibrium quantity to rise (fall).

  • An increase (decrease) in demand will cause the equilibrium price to rise (fall) and equilibrium quantity to rise (fall).


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