4.3 MarketEquilibrium

• An equilibrium     is a situation in which opposing forces balance.

• The     equilibrium     price     is the price at which the quantity demanded equals the quantity supplied.     The equilibrium     quantity     is the quantity bought and sold at the equilibrium price. In the figure,     the equilibrium price is $3 and the equilibrium quantity is 30 per week.

There is an old joke inthe economics profession: “If you can teach a parrot to say demand and supplyyou've taught the bird how to become an economist.” This is one occasion wherereality mirrors humor rather than the other way around. Stress to students thatdemand and supply analysis is so powerful that a large number of questions canbe answered in economics by relying on it. Remind them that if they havedifficulty at first that they should not be embarrassed. After all, it took theeconomics profession about a hundred years before it finalized this model.Indeed, back in the dim mists of time, circa 1870 orso, economists struggled to understand if it was the supply or thedemand that determined the price and quantity of a good. Nowadays we know thatthese efforts were misguided. To borrow from the great economist AlfredMarshall, demand and supply curves are like the blades on a pair of scissors.It does not make sense to ask which blade does the cutting because the cuttingtakes both blades and occurs at the intersection of the two blades. Likewise,it takes both the demand and supply to determine the price and quantityand the price and quantity are determined at the intersection of the demand andsupply curves.

Price: AMarket’s Automatic Regulator

• The law of market forces states “When     there is a shortage, the price rises; and when there is a surplus, the     price falls.

·        Surplus (or excesssupply):A situation in which the quantity supplied exceeds the quantity demanded. Ifthe price is above the equilibrium price, firms plan to sell more thanconsumers plan to buy. A surplus results, which forces the price lower, towardthe equilibrium price. In the figure, there is a surplus at any price above $3and so the price is forced lower, toward the equilibrium price.

·        Shortage (or excessdemand):A situation in which the quantity demanded exceeds the quantity supplied. Ifthe price is below the equilibrium price, consumers plan to buy more than firmsplan to sell. A shortage results, which forces the price higher, toward theequilibrium price. In the figure, there is a shortage at any price below $3 andso the price is forced higher, toward the equilibrium price.

Classroom activity: The law of market forces is important, so you want your studentsto grasp why prices are driven to the equilibrium. You can choose a good, likeconcert tickets to the hottest band. Draw a demand-supply graph with areasonable equilibrium price and quantity. Ask the students what would happenif the concert promoter decided to charge only $20 a ticket. Would studentsline up before dawn to buy them? Yes! Explain that this is a case of excessdemand. Ask them what could the promoter do to get the crowds to go away? Hopefullythey will answer, “Raise ticket prices!” Show them how the market pressures theprice to rise to the equilibrium price and use the graph to show how thepromoter and students move up their respective supply and demand curves. Youcan do the same thing for excess supply. Let the promoter try to sell ticketsfor $1,000 each. Again, move down along the supply and demand curves as themarket pressures the price to fall. Market forces pushing towards theequilibrium can be compared to a buoy in the ocean. The natural state for thebuoy is to point straight up (equilibrium), though sometimes forces act uponthat buoy that cause it to rock to one side or the other. When this happens,the buoy tries to right itself to point straight up again (equilibrium). It’snot to say that a buoy (or markets) will always be at equilibrium, but when itdeviates from equilibrium it will be pushed back towards it.

Predicting Price Changes: Three Questions

Todetermine how an event affects the equilibrium, answer three questions:

• Does the event     affect the demand or the supply?

• Does the event     increase or decrease demand or supply? This question determines whether     the demand or supply curve shifts rightward or leftward.

• What are the     new equilibrium price and quantity and how have they changed?

Effects of Changesin Demand

• If the demand for a good     or service increases, the demand curve shifts rightward. As a result, the     equilibrium price and the equilibrium quantity increase.

• If the demand     for a good or service decreases, the demand curve shifts leftward. As a result,     the equilibrium price and the equilibrium quantity decrease.

• Supply does not     change and the supply curve does not shift. Instead there is a change in     the quantity supplied and a movement along the supply curve.

• The figure     illustrates an increase in demand. In the figure the demand curve shifts     from D₀ to D₁. As a result, the     equilibrium price rises from $3 to $4 and the equilibrium quantity     increases from 30 to 40. The supply curve does not shift; there is a     movement along the supply curve.

Effects ofChanges in Supply

• If the supply of a good or     service increases, the supply curve shifts rightward. As a result, the     equilibrium price falls and the equilibrium quantity increases.

• If the supply     of a good or service decreases, the supply curve shifts leftward. As a     result, the equilibrium price rises and the equilibrium quantity decreases.

• Demand does not     change and the demand curve does not shift. There is a change in the     quantity demanded and a movement along the demand curve.

• The figure     illustrates an increase in supply. In the figure the supply curve shifts     from S₀ to S₁. As a result, the     equilibrium price falls from $3 to $2 and the equilibrium quantity     increases from 30 to 40. The demand curve does not shift; there is a     movement along the demand curve.