Chapter 2 Equilibrium P45-50 Chapter 2 Equilibrium P45-50

Chapter 2Equilibrium

P45-50

Chapter 2Equilibrium

P45-50

PRICE AND OUTPUT DETERMINATIONPRICE AND OUTPUT DETERMINATION

• We call the price that obtains in the We call the price that obtains in the market, market, the market pricethe market price, ,

• or the or the Equilibrium price,Equilibrium price,

• and the quantity demanded and and the quantity demanded and supplied supplied equilibrium outputequilibrium output..

• We find this by plotting the demand We find this by plotting the demand and the Supply curves. and the Supply curves.

Equilibrium price and outputEquilibrium price and output::The Market Demand and Supply of Potatoes (Monthly)The Market Demand and Supply of Potatoes (Monthly)

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800

Quantity (tonnes: 000s)

Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Supply

Demand

The determination of market equilibriumThe determination of market equilibrium (potatoes: monthly)(potatoes: monthly)

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Supply

Demand


Where the two lines cross is called the equilibrium point

Pe=12

Qe=350

PPee = 12, Q = 12, Qee = 350 = 350

• So why do we call this an So why do we call this an EQUILIBRIUM?EQUILIBRIUM?

• To see this let’s consider a point where we To see this let’s consider a point where we are not in equilibrium.are not in equilibrium.

• For example, consider the price, For example, consider the price, P=8.P=8.

• What are the quantities demanded and What are the quantities demanded and supplied at this price?supplied at this price?

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Supply

Demand

SHORTAGE

(300 000)


QSQD

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Supply

Demand

(300 000)


SHORTAGE, So Price must rise

QS QD

PPee = 12, Q = 12, Qee = 350 = 350

• Similarly, suppose that price was initially Similarly, suppose that price was initially above equilibriumabove equilibrium

• For example, consider the price, For example, consider the price, P=16.P=16.

• What are the quantities demanded and What are the quantities demanded and supplied at this price?supplied at this price?

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

SURPLUS

(330 000)

Supply

Demand


QSQD

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

eSURPLUSSo price must fall

(330 000)

Supply

Demand


QSQD

• So if the price is above equilibrium So if the price is above equilibrium (Surplus)(Surplus) the tendency is for it to move the tendency is for it to move downdown

• And if the price is below equilibrium And if the price is below equilibrium (Shortage)(Shortage) the tendency is for it to move the tendency is for it to move upup

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Qe

Pe

Supply

Demand


So forces pushing system towards

Pe and Qe

0

4

8

12

16

20

0 100 200 300 400 500 600 700 800


Pri

ce (

pen

ce p

er k

g)

E

D

C

B

Aa

b

c

d

e

Qe

Pe

Supply

Demand


• Notice in the these diagrams we have Notice in the these diagrams we have determined the equilibrium price determined the equilibrium price PPee, and , and

equilibrium quantity, equilibrium quantity, QQee..

• This is why we call these the This is why we call these the Endogenous Endogenous variables. They are determined within the variables. They are determined within the system (diagram).system (diagram).


• The next issue we are interest in, is the The next issue we are interest in, is the effect of effect of SHIFTSSHIFTS on either the demand or on either the demand or supply curves. supply curves. ShiftsShifts are caused by are caused by changes in the changes in the exogenousexogenous variables variables

• First: First: Effects of shifts in the demand curveEffects of shifts in the demand curve

Effect of a shift in the demand curveEffect of a shift in the demand curveP

QO

Pe1

Qe1

S

D1

g

P

QO

Pe1

Qe1

S

D1

D2

g

Effect of a shift in the demand curveEffect of a shift in the demand curve

P

QO

Pe1

Qe1

S

g h

D1

D2


At P0 quantity demanded exceeds quantity supplied

P

QO

Pe1

Qe1

S

g h

D1

D2


So Price must rise At P0 quantity

demanded exceeds quantity supplied

P

QO

Pe1

Pe2

Qe1Qe2

S

g h

i

D1

D2



• Notice the demand curve Notice the demand curve SHIFTEDSHIFTED

• ButBut the Price the Price MOVED ALONG MOVED ALONG the Supply the Supply curve.curve.

P

QO

Pe1

Pe2

Qe1Qe2

S

g h

i

D1

D2


P

QO

Pe1

Pe2

Qe1Qe2

S

g h

i

D1

D2


What about a shift in the Supply Curve?What about a shift in the Supply Curve?

• Suppose the Price of Oil and Petrol were to Suppose the Price of Oil and Petrol were to rise.rise.

• This would make production more costly This would make production more costly and supply would shift in.and supply would shift in.

P

QO

Pe1

Qe1

D

S1

g

Effect of a shift in the supply curveEffect of a shift in the supply curve

P

QO

Pe1

Qe1

D

S1

S2

g


P

QO

Pe1

Qe1

D

S1

S2

g


But now at P0 Quantity

Demanded exceeds Quantity

Supplied

P

QO

Pe1

Qe1

D

S1

S2

g


But now at P0 Quantity

Demanded exceeds Quantity

Supplied

So Price must rise

P

QO

Pe1

Qe1

D

S1

S2

j g


P

QO

Pe1

Pe3

Qe3Qe1

D

S1

S2

j g

k


At the new equilibrium price has risen and

output has fallen


• Making sense of Economics DataMaking sense of Economics Data

• Identifying the position of demand and Identifying the position of demand and supply curvessupply curves

P

O Q800 1000

20p

30p b

a

Suppose I observeSuppose I observe two sets of prices and quantities two sets of prices and quantities

How do I make sense of these

two observations?

P

O Q800 1000

20p

30p b

a

Suppose I observeSuppose I observe two sets of prices and quantities two sets of prices and quantities

How do I make sense of these

two observations?

They may be on the same

demand curve

D0

P

O Q

S1

S2

800 1000

20p

30p b

a

and thus the two observations were and thus the two observations were generated by a generated by a shift in the supply curveshift in the supply curve

D0

Alternative ExplanationAlternative Explanation

• However, we are only assuming the two However, we are only assuming the two points were on the original demand curve. points were on the original demand curve. We don’t know this. We don’t know this.

• Consider the following possibility.Consider the following possibility.

P

O Q

S1

800 1000

20p

30p b

a

D1

Assume Point A was the originalAssume Point A was the original

P

O Q

S1S2

800 1000

20p

30p b

a

D1

D2

It is possible that both the demand and the supply It is possible that both the demand and the supply curve have shifted as in this example.curve have shifted as in this example.

• So in the second case point So in the second case point bb lies on a lies on a different demand and supply curvedifferent demand and supply curve

• Looking at raw data and trying to figure out Looking at raw data and trying to figure out what is going on is a difficult problem.what is going on is a difficult problem.

• The problem above is known as the The problem above is known as the identificationidentification problem problem

EconometricsEconometrics

• So interpreting data has many pitfallsSo interpreting data has many pitfalls• In the following years you will study In the following years you will study

various statistical procedures which will various statistical procedures which will help you to analyse what is really help you to analyse what is really happening in the data we observe. happening in the data we observe.

• The main course we do this is in The main course we do this is in Econometrics next yearEconometrics next year

• IT and Applied EconomicsIT and Applied Economics & & Quantitative Quantitative MethodsMethods this year will help prepare you. this year will help prepare you.

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Chapter 2 Equilibrium P45-50 Chapter 2 Equilibrium P45-50