Lecture 3 - Price Theory - Market Equilibrium

Price Theory: Market Equilibrium

Lecture 3

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Textbook has been adopted for use in this course. Several modifications and amendments have been

made to the lecture materials provided.McGraw-Hill/Irwin

Friday, April 7, 2023

Bringing Demand and Supply Together

• A demand curve illustrates consumers’ willingness to demand at particular prices.

• A supply curve illustrates firms’ willingness to supply at particular prices.

• A market is the institution through which buyers and sellers interact and engage in exchange.

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Market Equilibrium

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• Market equilibriumMarket equilibrium is a situation in which, at the current market price, quantity supplied equals quantity demanded (the buyers’ plan matches the sellers’ plan). At one specific price: QS = QD.

• When the market is in equilibrium, there is no tendency for the price to increase or decrease.

Market Equilibrium

• Equilibrium price and quantity

• Surplus and shortage

• Rationing function of price

• Efficient allocation

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Market Equilibrium

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Shortage: Excess Quantity Demanded

• Excess Demand (Shortage) :Excess Demand (Shortage) : A situation in which consumers are willing to buy more than producers are willing to sell. It occurs when market price is lower than equilibrium price.

• An increase in the PriceAn increase in the Price eliminates the shortage by changing both quantity demanded and quantity supplied until the original equilibrium is established.

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Shortage: Excess Quantity Demanded

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Surplus: excess quantity supplied

Excess Supply (Surplus):Excess Supply (Surplus): A situation in which producers are willing to sell more than consumers are willing to buy. It occurs when market price is above equilibrium price.

A decrease in the PriceA decrease in the Price eliminates excess supply by changing both quantity demanded and quantity supplied until the original equilibrium is established.

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Surplus: excess quantity supplied

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Equilibrium and Disequilibria

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4.3 Changes in Supply and Demand

• Higher demand leads to higher equilibrium price and higher equilibrium quantity.

• Higher supply leads to lower equilibrium price and higher equilibrium quantity.

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Changes in Supply and Demand

• Lower demand leads to lower price and lower quantity exchanged.

• Lower supply leads to higher price and lower quantity exchanged.

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Applications of Supply and Demand

Market Effects of an Increase in Population SizeAn increase in demand causes a shortage at the original price.

To eliminate the shortage, price increases from $0.60 to $0.70.

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Market Effects of an Antismoking Campaign

A decrease in the demand for cigarettes would result in a decrease in quantity demanded of cigarettes and a decrease in price.

Applications of Supply and Demand

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Effects of Technological Innovations on the Market for Personal Computers

Technological innovations decrease production costs, shifting the supply curve to the right.

Applications of Supply and Demand

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Applications of Supply and Demand

Effects of Bad Weather on the Coffee Market

Bad weather decreases the supply of coffee beans, shifting the supply curve to the left.

Price increases and quantity exchanged decreases.

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Market Effects of Simultaneous Changes in Supply and Demand

When the magnitude of an increase in demand is smaller than the magnitude of an increase in supply, equilibrium quantity increases and market price decreases.

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Market Effects of Simultaneous Changes in Supply and Demand

D0

S0

e0

D1

S1

Q0

P0 e1P1

Q1

Price

Quantity

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Market Effects of Simultaneous Changes in Supply and Demand

When the magnitude of an increase in demand is larger than the magnitude of an increase in supply, equilibrium quantity increases and market price increases.

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Market Effects of Simultaneous Changes in Supply and Demand

D0

S0

e0

D1

S1

Q0

P0

e1P1

Q1

Price

Quantity

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Government Intervention and Price Regulation

• Price ceilings

• Price floors

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Price Ceiling

• A price ceiling is a regulation (imposed by the government) that makes it illegal to charge a price higher than a specified level (maximum price).

• The implementation of a price ceiling allows consumers to purchase the basic or essential items that were previously unaffordable at a higher price.

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Price Ceiling

• A price ceiling is set below the equilibrium price.

• If the price ceiling is set above the equilibrium, it has no effect. The market works as if there were no price ceiling.

• But if the price ceiling is set below the equilibrium, it has powerful effects.

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Price Ceiling

D

S

Price (RM)

Quantity (unit)

P0

Q0

Pc

5 15

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Price Floor

• A price floor is a regulation (imposed by the government) that makes it illegal to trade at a price lower than a specified level (minimum price).

• If the price floor is set below the equilibrium price, it has no effect. The market works as if there were no price floor.

• If the price floor is set above the equilibrium price, it has powerful effects.

• Normally, the price floor is set higher than the equilibrium price.

• The price floor is implemented to protect producers of unproductive sectors. 3-25

Price Floor

D

S

Price (RM)

Quantity (unit)

P0

Q0 206

Pf

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Consumer Surplus

• Benefit surplus• Maximum willingness to pay (WTP) less

than actual price paidPerson Max WTP Actual Price CSMas $13 $8 $5Farah $12 $8 $4Ahmad $11 $8 $3Kishani $10 $8 $2Vincent $9 $8 $1Morris $8 $8 $0

The difference between the maximum amount that a person is willing to pay for a good and its current market price. 3-27

Consumer Surplus

D

Pri

ce

(P

er B

ag

)

P1

Q1

Quantity (Bags)

ConsumerSurplus

Equilibrium Price = $8

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Producer Surplus

• Benefit surplus• Actual price received more than

minimum acceptable price (AP)

Person Min AP Actual Price PSCarlos $3 $8 $5Courtney $4 $8 $4Chuck $5 $8 $3Cindy $6 $8 $2Craig $7 $8 $1Chad $8 $8 $0

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Producer Surplus

SP

ric

e (

Per

Ba

g)

P1

Q1

Quantity (Bags)

ProducerSurplus Equilibrium

Price = $8

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Efficiency Revisited

• Productive and allocative efficiency

D

SP

ric

e (

Per

Ba

g)

P1

Q1

Quantity (Bags)

ConsumerSurplus

ProducerSurplus

Equilibrium Price = $8

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Key Terms

• Price Mechanism• Market Equilibrium• Equilibrium Price• Equilibrium

Quantity• Surplus• Shortage• Price Ceiling• Price Floor• Consumer Surplus• Producer Surplus

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Next Chapter Preview…

Application of Price Theory: Elasticity

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