Lesson-8. Equilibrium of Supply and Demand

Transcription

1 Introduction to Equilibrium Lesson-8 Equilibrium of Supply and Demand In economic theory, the interaction of supply and demand is understood as equilibrium. We may think of demand as a force tending to increase the price of a good, and of supply as a force tending to reduce the price. When the two forces balance one another, the price would neither rise nor fall, but would be stable. This analogy leads us to think of the stable or natural price in a particular market as the equilibrium price. This sort of equilibrium exists when the price is just high enough so that the quantity supplied just equals the quantity demanded. If we superimpose the demand curve and the supply curve in the same diagram, we can easily visualize this equilibrium price. It is the price at which the two curves cross. The corresponding quantity is the quantity that would be traded in a market equilibrium. We have already developed two behavioral statements, or assertions, about how people will act. The first says that the amount buyers are willing and ready to buy depends on price and other factors which are assumed constant. The second says that the amount sellers are willing and ready to sell depends on price and other factors which are assumed constant. In mathematical terms, our model is Qd = f (price, constants) Qs = g (price, constants) This is not a complete model. Mathematically, the problem is that we have three variables (Qd, Qs and price) and only two equations, and this system will not have a solution. To complete the system, we add a simple equation containing the equilibrium condition: Qd = Qs In other words, equilibrium exists if the amount sellers are willing to sell is equal to the amount buyers are willing to buy. If we combine the supply and demand tables discussed in earlier lessons, we get the following Table A. It should be obvious that the price of $3.00 is the equilibrium price and the quantity of 70 is the equilibrium quantity. At any other price, sellers would want to sell a different amount than buyers want to buy. Price of Widgets Supply and Demand Number of Widgets People want to buy $ Number of Widgets Sellers want to sell

2 $ $ $ Table A The same information can be shown with the help of a graph in the Figure A. On the graph, the equilibrium price and quantity are indicated by the intersection of the supply and demand curves. Figure A If one of the many factors that is being held constant changes, then equilibrium price and quantity will change. Further, if we know which factor changes, we can often predict the direction of changes, though rarely the exact magnitude. For example, the market for wheat fits the requirements of the supply and demand model quite well. Suppose there is a drought in the main wheat-producing areas of the United States. How will we show this on a supply and demand graph? Should we move the demand curve, the supply curve, or both? What will happen to equilibrium price and quantity? A dangerous way to answer these questions is to first try to decide what will happen to price and quantity, and then decide what will happen to the supply and demand curves. This is a route to disaster. Rather, one must first decide how the curves will shift, and from the shifts in the curves decide how price and quantity would change. What should happen as a result of the drought? One begins by asking whether buyers would change the amount they purchased if price did not change, and whether sellers would change the amount sold if price did not change. On reflection, one realizes that this event will change seller behavior at the given price, but is highly unlikely to change buyer behavior (unless one assumes that something more than only the drought occurs, such as a change in expectations caused by the drought). Further, at any price, the drought will reduce the amount sellers will sell. Thus, the supply curve will shift to the left and the demand curve will not change. There will be a change in supply and a change in quantity demanded. The new equilibrium will have a higher price and a lower quantity. These changes are shown below.

3 Figure B What should one predict if a new diet calling for the consumption of two loaves of whole wheat bread sweeps through the U.S.? Again one must ask whether the behavior of buyers or sellers will change if price does not change. Reflection should tell you that it will be the behavior of buyers that will change. Buyers would want more wheat at each possible price. The demand curve shifts to the right which results in higher equilibrium price and quantity. Sellers would also change their behavior, but only because price changed. Assumptions The supply and demand model does not describe all markets. There is too much diversity in the ways buyers and sellers interact for one simple model to explain everything. When we use the supply and demand model to explain a market, we are implicitly making a number of assumptions about that market. For a supply curve to exist, there should be a large number of sellers in the market. And for a demand curve to exist, there must be many buyers. In both cases, there should be enough so that no one believes that what he/she does will influence the price. In terms that were first introduced into economics in the 1950s and that have become quite popular, everyone should be a price taker and no one can be a price searcher. If there is only one seller, then that seller can search along the demand curve to find the most profitable price. A price taker cannot influence the price, but must take or leave it. The ordinary consumer knows the role of price taker well. When he/she goes to the store, he/she can buy one or twenty gallons of milk with no effect on price. The assumption that both buyers and sellers are price takers is a crucial assumption, and often it is not true with regard to sellers. If it is not true with regard to sellers, a supply curve will not exist. This is because the amount a seller will want to sell will depend not on price but on marginal revenue. The model of supply and demand also requires that buyers and sellers be clearly defined groups. Notice that in the list of factors which affected buyers and sellers, the only common factor was price. Few people who buy hamburger know or care about the price of cattle feed or the details of cattle breeding. Cattle raisers do not care what the income

4 of the buyers is or what the prices of related goods are unless they affect the price of cattle. Thus, when one factor changes, it affects only one curve, and not both. When buyers and sellers cannot be clearly distinguished, as in the New York Stock Exchange where people who are buyers one minute may be sellers the next, one cannot talk about distinct and separate supply and demand curves. The model of supply and demand also assumes that both buyers and sellers have good information about the product's qualities and availability. If information is not good, the same product may sell for a variety of prices. Often, however, what seems to be the same product at different prices can be considered a variety of products. A pound of hamburger for which one has to wait 15 minutes in a check-out line can be considered a different product from identical meat that one can buy without waiting. In addition, the supply and demand model needs well-defined private-property rights. We have discussed how private-property rights and markets provide one way of coordinating decisions. When property rights are not clearly defined, the seller may be able to ignore some of the costs of production, which will then be imposed on others. Alternatively, buyers may not get all the benefits from purchasing a product, while others may get some of the benefits without payment. Finally, the supply and demand model requires many buyers and sellers. If there is only one seller, the seller can search along the demand curve of the buyers for the position which is most profitable. In this case, it is not just price that matters, but the slope of the demand curve as well. The seller in this case is not a price taker, but a price searcher. Even if the assumptions underlying supply and demand are not met exactly, and they rarely are, the model often provides a fairly good approximation of a situation. This is good enough so that predictions based on the model are in the right direction. This ability of the model to predict even when some assumptions are not quite satisfied is one reason economists like the model so much. Buyers Equilibrium We have developed the model of supply and demand as an equilibrium model. We have said nothing about how adjustments from disequilibrium to equilibrium take place. To develop this idea, it is useful to take still another view of supply and demand curves, to view demand as points of buyer equilibrium and supply as points of seller equilibrium.

5 Figure C Suppose that price is at P1 in the graph in Figure C above. Will point a be a point on the demand curve? If people would like to buy more than Q1 at price P1, point a must lie to the left of the demand curve. In this case, some consumers are unhappy with the amount they have purchased, and will try to purchase more. If there is nothing more to purchase, some will attempt to offer more money for the product, or they will increase the time they devote to getting the product. The important idea is that if point a lies to the left of the demand curve, people will be unhappy with their situation and will change their behavior. If point a lies to the right of the demand curve, people will decide that they are buying too much of the product and will cut purchases. In conclusion, if a position is not on the demand curve, people will change their behavior. This indicates that only positions on the demand curve are positions of buyer equilibrium. Similar reasoning explains why the demand curve can be considered a boundary. In the graph below in Figure D, buyers are not in equilibrium at point a. But they can be held there and made to adjust in ways that do not change the price. They cannot be held at point c unless there is some way to force people to buy a product when they do not want it. Figure D

6 Point b in the graph is a position of buyer equilibrium. This is because given price P1, people will be satisfied with Q1 and will do nothing to change their behavior. Buyers would, of course, prefer a lower price than P1-- they are always willing to move down the demand curve. However, this is not the issue here. Given P1, Q1 is the preferred quantity. Sellers Equilibrium Just as the demand curve shows positions of buyer equilibrium, the supply curve shows positions of seller equilibrium. At point a in the graph in Figure E below, suppliers find that they could increase profits (or reduce losses) by moving to the right to a larger quantity. If they could not increase profits by moving toward the right, they would stay at point a. Because they do not, they are not in equilibrium and on the supply curve but to the left of it. If they find that they could increase profits by cutting production, they are to the right of the supply curve and out of equilibrium. There is a quantity at the price P1 that maximizes profits and toward which sellers will adjust. This point, shown as b in the graph, is on the supply curve. Figure E It is possible to force a seller to a position left of the supply curve. This is the case in which the seller would like to sell more at the given price, but for some reason cannot. One reason might be that the buyers will not buy as much as the sellers would like to sell. It is virtually impossible-- short of slavery-- to force sellers to the right of the supply curve. This is the situation in which sellers are selling more than they want to at the given price. Thus, the supply curve represents a boundary facing the buyers. If buyers could force sellers to the right of the supply curve, they would find it advantageous to force sellers to a position such as x in graph above, which represents getting something for nothing. Shortage and Surplus

7 Sellers prefer higher prices to lower prices. Although all points on the supply curve represent points of equilibrium, not all are equally preferred by sellers. The above analysis helps explain how an adjustment process takes place in the supply and demand model. If price is originally P1 in the graph below in Figure F, only Q1 will be sold even though buyers would like to buy Q2. The difference Q2 - Q1 represents a shortage. The sellers are in equilibrium in this situation because they can sell everything they want to sell at this price, but buyers are not. Some buyers who cannot obtain the product are willing to offer more, and sellers are always willing to accept a higher price. Therefore, the actions of the buyers, as they compete with each other to obtain the amount that is available, drive the price upward in this model toward market equilibrium. Figure F If price is originally at P2 in the graph below (Figure G), only Q1 will be sold because this is all that buyers will purchase, even though sellers are willing to sell more Q2. The difference Q2 - Q1 is called a surplus. In this situation, the buyers are in equilibrium because they can buy all they want to buy at the going price. However, the sellers are not in equilibrium and will compete among themselves to get rid of the surplus. Some sellers will be willing to offer their product at a lower price. Buyers are always willing to move down the demand curve, so there is a tendency to move downward toward market equilibrium in the picture below.

8 Figure G If left to itself, a supply and demand market tends to adjust to the point where the supply and demand curves cross. The price at this intersection is called the market-clearing price. There is, however, the possibility that the existence of lags in the adjustment process may make the adjustment more complex. Suppose that the price of cattle feed rises sharply. This should affect the supply curve of cattle by shifting it to the left. The profitability of cattle production is reduced at each possible price. Some producers will drop out of the industry while others will curtail production. Looking at the curves, we see that prices should rise and quantity should drop. However, initially, prices might drop and quantity might rise, which is the exact opposite of the prediction from the supply and demand graph. The higher costs of feed will encourage farmers to raise fewer cattle. But, as part of that cutback, they will temporarily send more cattle to the slaughterhouses. The prediction that supply-demand analysis gives will ultimately be correct, but it will not be correct in the process of adjustment. More complicated adjustment patterns are possible. Suppose, for example, that higher beef prices shift the demand for pork to the right. Supply and demand analysis says that this should increase pork prices, and at the higher prices, farmers should produce more hogs. However, hog production takes time, and will only happen if farmers expect the higher prices to continue for a long time. If pork producers do expect the higher prices to last, they may decrease the number of pigs sent to slaughter, further increasing price. A sow can either produce pork or baby pigs, but not both. If farmers expect high prices to last, they will keep their sows for piglet production. In six months to a year, the baby pigs will have grown enough to go to the market. If enough farmers had expected the high prices to last, they may have produced so many pigs that pork prices will now plunge to a level which is considered below normal. The new, abnormally low price can then influence decisions that will not affect the price for many months. Once disturbed, a market with long time lags in production may bounce

9 around for years before it finally finds its way back to equilibrium. If such a market is disturbed often enough, its prices and quantities will never come to rest at equilibrium levels. Microeconomic discussion generally ignores adjustment problems, at least at the introductory level. Microeconomics assumes that markets are clear, i.e. they are always in equilibrium. Its analysis begins with the assumption that equilibrium has been reached and then asks questions about that equilibrium. However, adjustment problems are very important in macroeconomics. Macroeconomics cannot assume there are no adjustment problems, or else it assumes away one of the problems it wants to explain, which is unemployment. In fact, much of macroeconomics is about the forces that bump an economy away from equilibrium, and why, once it is away, it has problems reaching a new equilibrium. Competition and Equilibrium What we have seen is that the price will be in constant motion, up or down, except when quantity demanded is equal to quantity supplied. That is the position of rest. Put another way, it is the price toward which competition pushes the price. At equilibrium, there is no competition either to buy or to sell. This is because everyone can buy or sell as they may wish, at the going price. But whenever the market is away from equilibrium, competition will arise and tend to force it back. Competition eliminates itself, by forcing the market into an equilibrium in which there is no need to compete. (This is a very different concept of competition than the biological "struggle for survival. )