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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. 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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  1. Chapter 3 Equilibrium: How Supply and Demand Determine Prices

  2. 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.

  3. 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.

  4. 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

  5. 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.

  6. 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.

  7. 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

  8. 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.

  9. 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

  10. 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?

  11. 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.

  12. 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

  13. 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.

  14. 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

  15. 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.

  16. 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

  17. 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?

  18. 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.

  19. 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.

  20. 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

  21. 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.

  22. 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

  23. 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?

  24. 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?

  25. 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.

  26. 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.

  27. 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.

  28. 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.

  29. 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.

  30. 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

  31. 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

  32. Changes in Equilibrium - Extra! Summary of Changes in Supply and Demand

  33. 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.

  34. 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.

  35. Supply and Quantity Demanded An Increase Supply Increases Quantity Demanded Price Old Supply Curve New Supply Curve $25 $12 Demand Curve Quantity 70 90

  36. 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

  37. 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.

  38. Understanding the Price of Oil

  39. 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.

  40. 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.

  41. 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.

  42. 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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