Tutorial 3: Demand and Supply (cont.)
The Market Mechanism
In Tutorial 2
we noted that buyers and sellers were motivated to voluntarily
trade goods and services by a personal interest in seeking
the greatest surplus, or net benefit, from such an exchange.
Markets facilitate these exchanges and in so doing generate
the highest possible social surplus.
Now we turn our attention to how a market
generates the price and quantity of a good traded.
We have already generated a graphical model of a demand
curve and a supply
curve. Because a market is an institution that brings buyers
and sellers together, we can overlay the demand and supply
curves to get a graphical depiction of a market:
Excess Supply (aka Market Surplus)
[Not to be confused with buyer's or seller's surplus...]
Once the buyers and sellers are together, suppose an initial
market price of $130 per unit is announced. At that price,
the demand curve (D1) shows that buyers are willing and
able to purchase approximately 140 units/t. The supply curve
(S1) shows that approximately 260 units/t are offered for
sale. This leaves sellers holding 260 - 140 = 120 units
unsold during this time period. These unsold units indicate
that there is an excess supply, or surplus, of goods
at that market price.
How will sellers respond to the existence of these unsold
goods? During the next time period they will reduce production
and, because unit costs will be lower, will drop the price.
As long as a surplus exists, there is pressure on sellers
to push prices downward. As price drops buyers increase
the quantity demanded in part because additional buyers
with lower reservation prices will now be interested in
an exchange. Market price continues to drop until it reaches
$100 per unit, where, because the quantity demanded and
the quantity supplied are equal at 200 units per period,
the surplus is gone.
Excess Demand (aka Market Shortage)
Now suppose an initial market price of $50 per unit is
announced. At that price, the demand curve (D1) shows that
buyers are willing and able to purchase approximately 300
units/t. The supply curve (S1) shows that approximately
100 units/t are offered for sale. This leaves buyers with
an unrealized demand of 300 - 100 = 200 units unpurchaseable
during this time period. Because buyers cannot buy as many
goods as they want, there is an excess demand, or shortage,
of goods at that market price.
How will sellers respond to the existence of excess demand
for their goods? During the next time period they will increase
production and, because unit costs will be higher, will
raise the price. As long as a shortage exists, there
is pressure on sellers to push prices upward. As price
rises, buyers decrease the quantity demanded in part because
some buyers have a reservation price that becomes exceeded
by a rising market price. Market price continues to rise
until it reaches $100 per unit, where, because the quantity
demanded and the quantity supplied are equal at 200 units
per period, the shortage is gone.
Notice that the pressure on sellers to lower or raise price
came out of their goal to gain the most seller's surplus
as possible -- no surplus benefit is enjoyed until a sale
is made. Buyers too are interested in gaining the most buyer's
surplus as possible. They will buy more or less as prices
fall or rise because no surplus is enjoyed until a purchas
is made. Although no one is directing these exchanges, a
price is eventually reached where the quantity offered for
sale is equal to the quantity purchased.
The price at which there is neither shortage nor surplus
is called an equilibrium price, and is shown in the
graph by the symbol P*. The quantity bought/sold
at this price is called an equilibrium quantity,
and is shown in the graph by the symbol Q*.
We can use the mathemagical form of the demand and supply
equations to calcuate the equilibrium price and quantity.
Recall from Tutorial 3a,
that if we hold the P-PINE variables constant and only allow
Price to vary, we can write the equation for demand as:
QD(Price | PPINE) = b0 - b1*Price,
where b0 = b2*Pref - b3*Pc + b4*Ps + b5*In -
b6*Ii + b7*N + b8*E(Price) + b9*E(Inc).
Let b0 = 400 and b1 = 2. The resulting demand
QD(P) = 400 - 2*P.
In Tutorial 3b
we saw that if we hold the SP-PENT variables constant and
only allow Price to vary, we can write the equation for
market supply as:
QS(Price | SP-PENT) = d0 + d1*Price,
where d0 = d2*Sub - d3*Tax - d4*Pi - d5*Ps -
d6*E(Price) + d7*N + d8*T.
Let d0 = 0 and d1 = 2. The resulting
supply equation is
QS(P) = 0 + 2*P.
In equilibrium, QD(P*) = QS(P*), i.e., neither
a shortage nor a surplus exist at the equilibrium price,
P*. To calculate that quantity, set QD(P) = QS(P) and solve
QD(P) = QS(P)
400 - 2*P = 0 + 2*P
400 = 4*P
P* = $100/unit
Once equilibrium price is known, replace P in either the
inverse demand or inverse supply equation with P*:
QD(P*) = 400 - 2*100
Q* = 200 units/t
QS(P*) = 0 + 2*100
Q* = 200 units/t
Now let's explore how the market mechanism
establishes a new equilibrium price and quantity
when any of the non-price variables change demand (P-PINE)
or supply (SP-PENT)...