Market Equilibrium
Supply and Demand Continued
Suppose there is a drought that reduces the amount of corn available
How do you communicate to households that they need to consume less corn b/c there isn’t the same amount to eat as before?
Could publish newspaper article telling people. Would they read it?
How would each family know how much they needed to decrease their corn consumption by in order to for the total amount of corn bought=total amount of corn grown?
Should someone who likes corn a lot have to decrease their corn consumption by as much as someone who doesn’t like corn that much
Basically impossible to organize this type of system
Why organized economies fail
Prices=mechanism by which participants in the market communicate
A drought will affect the price of corn by decreasing the supply. The higher price causes individuals to naturally consume less
Market Equilibrium
Literally, "equal balance"
Item or market will stay as it is until an exogenous shock occurs - will move to new equilibrium
There exists a combination P*, Q* at which the amount consumers want to buy at P* equals the amount producers want to sell at P*.
Graphical explanation of why an equilibrium exists:
Consider the market for chocolate chip cookies.
Suppose that P*=$1.00. Check that this market equilibrium makes sense (ie., that if you start at any other P, you eventually end up back at P*=$1.00 )
Suppose P=$0.50. -- Qs<Qd -- At a price of $0.50, more cookies are demanded than supplied (shortage)-- people will bid up the price of cookies.
Suppose P=$1.50 -- Qd<Qs -- more cookies are supplied than demanded (surplus)-- stores offer deals.
No matter what price you start at, you end up at P*,Q*.
(Hint: Pick a different type of industry and some different numbers and make sure you really understand the logic.)
How might we move away from the equilibrium P*=$1.00, Q*=100?
Exogenous shock: change in taste for cookies, change in income, change in price of chocolate chips, etc
Ex) (Equation)
Qs= -100+2P
Qd=200-P
Calculate P*, Q*.
Ex) (Table) What are P*, Q*?
-
P
Qd
Qs
$1
892
2
$5
310
10
$10
130
40
$15
59
59
$20
25
100
$30
6
300
Reinterpretation of Supply and Demand
Demand represents for any quantity, the highest amount people are willing to pay for that marginal unit.
For an extra unit of a good, people are willing to pay their marginal benefit from consuming the good.
Thus, the demand curve represents marginal benefit or willingness to pay
Supply represents for any quantity, the minimum amount firms need in order to produce that marginal unit.
This minimum amount is the marginal cost of producing the good.
Thus, the supply curve represents marginal cost or willingness to accept
An equilibrium occurs when Qs=Qd or MB=MC
Application of marginal principle
Comparative Statics: Single Shock
Q: How do equilibrium price and quantity change given an exogenous shock (X factor)?
Ex) Chicken market: Announcement that eating chicken is better for your health. What happens immediately and what happens to equilibrium price and quantity in the chicken market?
Method:
Identify what market you are trying to analyze
Does change affect S or D?
Shift left or right?
Draw new S or D
Compare equilibrium P and Q
D curve shifts right
Immediate result: At P0*, Qs<Qd -- shortage -- price will increase, causing Qs to fall and Qd to rise -- process continues until Qs=Qd -- new equilibrium: P1*, Q1*.
Comparative statics: equilibrium price increases and equilibrium quantity increases
Note: Recall that we are just doing partial equilibrium analysis. We are looking at initial shock in a few related markets.
Note: When doing economic analysis, don't make value judgements about how new equilibrium compares to original equilibrium
Ex) Ag market: Frost kills crop
Farmers whose crop is killed are worse off. Farmers whose crop isn't harmed, are better off. Consumers pay a higher price.
Ex)Disease kills large percentage of avocado trees. What happens to equilibrium price and quantity in the avocado market?
Note: It is essential that you draw the graph!!!! Numerous mistakes will be avoided.
Ex) Given the above shocks, what happens to P*, Q* in the guacamole market?
Ex) Suppose guacamole and salsa are substitutes. What happens to P*, Q*in the salsa market?
Note: it is important not to "overthink" these problems. If a determinant isn't mentioned, assume it isn't changing.
Ex) Suppose there is a large increase in the number of black bean farmers. Black beans are an input into black bean burritos. Salsa and black bean burritos are complements. What happens in the salsa market?
Study hint: Make up your own problems!
Ex) Originally in the tofu market, Qd=12-P and Qs=P-4. Suppose demand changes to Qd=6-P. Do equilibrium price and quantity increase or decrease?
Comparative statics: multiple shocks
Ex) Cinnamon raisin bagel market: Assume cinnamon raisin bagels are a normal good. Suppose US personal income increases and the cost of raisins increase. What happens to the equilibrium price and quantity of cinnamon raisin bagels?
Method:
1) Analyze each shock separately (for each change draw a different graph) -- find out what happens to equilibrium price and quantity from that particular shock
2) Compare changes in equilibrium
Why ambiguity?
Suppose huge increase in income and small increase in raisin prices
Suppose small increase in income and huge increase in raisin prices
Ex) Suppose the number of gardenburger producers increases. At the same time, news reports advocate eating garderburgers instead of hamburgers for health reasons. Which effect must be stronger (producer, tastes) for the equilibrium price of gardenburgers to increase?
Activity: Create a comparative static problem. Trade with partner and have them solve.
Mad Cow example
Peanut Example
Apple experiment
Thacher: Micro Principles Supply and Demand 2 8
