Unit 3: Markets/Equilibrium

Jim’s Guide for Unit 3: Market Equilibrium – Demand & Supply Together

A market is a group of potential buyers and sellers, all making their own independent decisions. Each has their own willingness and ability to buy or to sell at different prices. Nobody coordinates them. Remember, there is no central boss in a market. So how does a market settle in a price? Well, buyers and sellers come together and begin to explore each other’s offerings. They negotiate. They bargain. They “higgle” as Adam Smith once described it. In some markets the bargaining is obvious: two people are making verbal offers and counter-offers. In some markets, the bargaining is subtle, such as when a store puts a price on sweater on the rack. Then people come into the store, look at the sweater, check its price, and walk-out without buying it. The store then knows the price is too high for those shoppers. The store tries a lower price and then maybe some people buy.

People also look around at what deals other people are making. They look at what prices are being used in real transactions. Both buyers and sellers keep making offers and changing the prices and then observing what happens. When prices stop changing the market has reached what economists call an equilibrium. When a market is at equilibrium, there is no reason for anybody, either buyer or seller, to change their offers. Nobody has a good reason to raise the price or to lower it. We can learn more about what an equilibrium is by looking at what happens when we are not at equilibrium.

When Prices are Not at Equilibrium: Shortages or Surpluses

When prices are not at the equilibrium level, either shortages or surpluses will happen. A shortage occurs the price is too low. Draw both the market demand curve and the supply curve on the same graph. Now pick a price that’s very low (below where the two curves intersect). At this low price, sellers are only willing and able to supply a small quantity of the good. But this same low price causes buyers to want to buy a large quantity. The problem for the buyers is that there simply aren’t enough units of the good available. Some of the buyers who are willing and able to buy simply won’t buy because they can’t find units for sale. This is a shortage. When a shortage occurs, some buyers are disappointed, lines form, and waiting lists emerge. The sellers take their cue from this shortage that they can raise the price. The sellers raise the price. Some of the disappointed buyers offer to pay a higher price just to get the product. As a result, the market price (the actual price of transactions) begins to rise.

Eventually the price may get too high. After all, no “boss” exists to tell everybody what is the “right” price. What happens when price is too high? A surplus exists. A surplus means that the producers are making too much. The high price causes businesses to produce a large quantity and offer it for sale. Yet the high price also sends the signal to buyers that they don’t want to buy very much. High prices cause buyers to buy small quantities. Some of the units produced get sold, but much of what was produced doesn’t sell at the high price. It sits there on store shelves. And what do stores do when they have too much of a product on hand? They run a sale! They mark-down prices. The lower prices cause more buyers to be willing to buy some more. The lower prices also cause some sellers to give up and quit making as many units. The pressure of unsold goods (surplus) forces market prices down.

The only price where there is no pressure on the price to go up (to eliminate shortage) or to go down (to eliminate surplus) is the equilibrium price. Graphically, it is where the market demand and market supply curves intersect. “X” marks the spot. Formally speaking, a market equilibrium exists where the price results in quantity demanded being equal to quantity supplied.

Take a moment to consider this what’s happening in a market at equilibrium. Without any central direction or management, a large group of buyers and sellers have all made independent decisions about their needs and their willingness to buy or sell. They then negotiate with each other. Each buyer and seller is free to say yes or no to any proposed price or deal. Yet what emerges eventually is an equilibrium where the quantity that businesses produce is exactly the quantity that buyers want to buy. No extra or unnecessary units get produced. Likewise, everybody who wants to buy at the market price gets to buy what they want. No disappointed “would-be” buyers. No surplus. No shortage. The buyers got what they wanted. The sellers got what they wanted. Perfect coordination. This is the “invisible hand” that Adam Smith famously described as coordinating buyers and sellers.

Market Controls: When Government Limits the Freedom of The Market

Of course, just because there is no shortage or surplus doesn’t mean everybody is happy with the outcome of the market. Sometimes politicians think the results of the market are “unfair” by an equity standard. Sometimes buyers may have gotten all the units they wanted at the market price, but of course they would love it if they could get even more units at a lower price. But they can’t get more units at a lower price unless sellers are forced (coerced) to do something they are voluntarily unwilling to produce. Likewise, sellers would love to charge a higher price and still sell the same quantity, but they can’t do that unless somebody forces buyers to pay more than buyers are voluntarily willing to do. Sometimes sellers or buyers are able to get the government to force the market to change. A government has the power to limit the prices that can be legally charged or the maximum quantities that can be sold.

When a government interferes with a market and sets a minimum legal price, it is called a price floor. Price floors below the equilibrium price are meaningless. It’s like saying you can’t sell a new automobile for less than $2.00. But if a price floor is above the equilibrium, then government price floor causes a surplus in the market. Similarly, when the government sets a maximum legal price it is called a price ceiling. A price ceiling above equilibrium is irrelevant (do the graph). But a price ceiling that is below equilibrium will create a shortage in the market. When shortages or surpluses occur, other social mechanisms emerge to help ration the goods (deal with shortage) or to get rid of the actual surplus.

At times, governments attempt to disguise their interventions in the marketplace. Instead of outright limiting prices by law with a ceiling or floor, the government may attempt to either establish a quota or a price support. A price support is a disguised price flo

or. With a price support, the government promises to use tax money buy up additional units in the open market until they force the market price up to where the price floor would be. Of course the government has no need of the product itself and often has to then spend more money to get rid of the product they have purchased. In a quota, the government typically licenses a limited number of suppliers on the condition that they limit how many units they supply to the market. Graphically this is an artificial forcing of the market supply curve to the left (reduced supply). Then government lets the market reach an “equilibrium”. The resulting supply-restricted equilibrium has a higher price and lower quantity than what would have happened without the quotas.

There are indeed times when a free, competitive market may not function well socially. Usually such “market failures” involve issues such as public goods or externalities like pollution. In such cases it is necessary to have government interfere with the prices and quantities in the market. However, the record of governments everywhere throughout history has been a tendency to interfere with free markets in many cases where there is no need. The result is inevitably shortages or surpluses, and often higher prices and less goods for consumers.

A Comment on Elasticity

Let’s suppose for a moment that you are either in charge of raising revenue

for the government or that you are in charge of some monopoly business. You want to, in the words of former Secretary of Defense James Schlesinger, extract the maximum amount of resources from taxpayers (or your customers if you are a business). Economically, what do you need to do? If you are a government what should you tax? If you are a business, should you raise the price? Should you lower the price?

At first thought, it seems to make sense to raise the price, right? Charge each customer more money. But the demand curve says that customers will then buy fewer units. So why not lower price? After all there’s the old business cliché about “cut the price and make it up on volume”. Which do you do? Will cutting the price actually bring in more total revenue? Or will charging a higher price bring more total revenue even though customers will buy less?

Economics offers a way to answer these questions called elasticity. Knowing elasticity of demand for example tells us how much the quantity demanded changes compared to a certain sized change in price. If demand is inelastic, the actual quantity figure out why governments levy extra taxes on cigarettes, liquor, gasoline, and telephone service, but not on milk, sweaters, or television. We will figure out why Coca-Cola and Pepsi Cola are often put on sale at the grocery and the drugstore is always running a “sale”, but the electric power utility company never does run a sale.

So far we have described the demand curve in supply and demand market model as just conforming to the “Law of Demand”. Graphically, the “Law of Demand” simply states that Price and Quantity Demanded are inversely related. That is, the demand cur

ve slopes downward and to the right. But, ‘downward and to the right’ covers a lot of possibilities. The demand curve could very, very steep — almost vertical. Or, it could be the opposite – it could have so little slope that the curve is almost flat and horizontal. Or, it could be non-linear –not a straight line at all, but curving throughout. Mathematicians describe the question of the steepness of curve as “slope”. Economists, however, use a measure called elasticity because it is much more meaningful economically.

The concept of elasticity can have very real economic meaning and can tell us something about whether people are willing to substitute other goods for this good. In the case of a demand curve, it elasticity tells us how “price sensitive” the buyers are. Elasticity is similar to the mathematician’s concept of slope, but it is measured differently. The calculation of elasticity is beyond the scope of a basics course in elasticity, but the concept of elasticity isn’t.

Elasticity: Measuring Sensitivity

How sensitive are you to prices? When the price goes up on a good, how do you react? I don’t mean how much do you complain, or what kind of names do you call the seller, I’m talking about how do you change your buying habits when the price goes up?

When the price of gasoline goes up, most of us just keep buying almost the same amount of gas. We may complain. We may have to cut our spending on other things to buy the gas. But, for the most part we buy it. After all, just because the gasoline costs 10% more doesn’t mean I only have to drive 90% of the way to work!. Gasoline purchases, in the short run, are very inelastic. People aren’t really very sensitive (in terms of how much they buy) to the price.

On the other hand, some products seem to encourage very price sensitive behavior. A simple cents-off coupon (a small price cut) on some products in the grocery may cause a huge increase in the quantity people want to buy. Why? Such a product is called “elastic”. People are very price-sensitive for these products because they have alternatives that are very attractive. They have good substitutes available.

Reading Guide – Assigned Readings

In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:

Chapter 3 – Market Equilibrium and Shifts
JIm’s Comment: This is a pretty serious chapter packed with the essence of how a market works. Read and study the entire chapter closely. Pay particular attention to terminology. For example, a “change in quantity demanded” does not mean the same thing as a “shift in demand”. The latter might lead to the former (or it might not), but the former doesn’t mean the latter.

Practice Quiz

Click here for the Unit 3 practice quiz. The practice quiz will open in a new tab/window.

Worksheet

Unit 3 Worksheet – Data and Directions. After you complete the data problems on this worksheet page, you should answer the questions and enter your answers in learning mgt system (Moodlerooms at HFCC).

Closer Look – Need More Help?

Professor Nelson’s (another LCC Professor) Tutorials on Micro that are relevant to this unit:

What’s Next?

In the next unit, we’ll look at the production, costs, and the decision-making of firms. In other words, we take a closer look at the behavior and decisions behind the supply curve.

Econproph [Basic]

JIm's Guide for the Basics of Economics Course