Market EquilibriumThe price mechanisms

and Market efficiency

IB Economics

Learning Objectives

At the end of this section you should be able to Explain the concept of equilibriumExplain the effect of changes in demand and supply

upon the equilibriumExplain the concepts of excess demand and excess

supplyHL – calculate the market price and quantity using

linear functionsPlot changing market equilibriums, identifying new

equilibrium points, excess demand and excess supply

Bringing market demand and supply curves together Bringing buyers (demanders) and sellers (suppliers) together creates what economist call a marketWhen we picture a market in our heads we tend to think of a fruit and veg market but a market does not even have to be physical - it is just where buyers and sellers interact. Transactions can by carried out by phone, mail order or over the internet.

• Watch the mjm foodie video

• http://www.youtube.com/watch?v=322-ZPjGwGQ&feature=player_embedded

Equilibrium In order to analyse how a market works webring the demand and supply curve together and from now on we always draw our diagrams with both curvesEquilibrium is when supply satisfies demand and vice versaEverything produced in the market will be sold They are equal, there is balance/stability and there is no tendency for the market to change without external changeIn theory the price system should produce equilibrium as we will see later

Quantity of Coffee

D

Pe

Qe

The free market equilibrium price is Pe and quantity is Qe

SEquilibrium point

Market clearing

price

Market disequilibrium and eliminating excess supply Equilibrium is self righting in a free marketLets says the producers increase their price to P1At this price there will be Q1 demandAt this price there will be Q2 supplyThere is too much supply (excess supply) of Q1 – Q2The market is said to be in disequilibriumTo get rid of the surplus producers will have to supply at a lower priceAs they do the quantity demanded will increase until once again demand equals supply and there is equilibrium once more

Price

Q

D

P

Q

S

P1

Q1 Q2

Excess Supply = Q2 – Q1

O

Market disequilibrium and eliminating excess demand This time producers tried to lower their priceThere is too much demand at Q2 and not enough supply at Q1the market is in disequilibrium because there is excess demand Q2 will be demanded but only Q1 will be supplied which means there will be a shortage (suppliers will sell out) There is a shortage off Q2 – Q1

Excess demand = Q2 – Q1

In order to eliminate the shortage producers have to raise their pricesAs they do the quantity demanded will fallEventually demand and supply will be equal again giving equilibrium

Quantity

D

P

Q

S

P1

Q1 Q2

The effects of changes in demand and supply on the equilibriumPreviously we looked at factors that shift the demand curve and supply curve – these are outside disturbances (nothing to do with the price although they will change the price)Now we need to look at what those shifts do to the equilibrium price and quantitiesIn real life lots of things may change at the same time but to make it simple we only deal with single changes and assume that the ceteris paribus condition is metCeteris paribus is Latin for ‘all things being equal’ – in other words nothing else has changedLets take the example of an increase in income for consumers of foreign holidaysWhen there is an increase in income there will be an increase in the demand for holidaysCeteris paribus there will be a shift of the demand curve to the right

Quantity of holidays

(days)

S1

Q1

D1

Q2

P1

D2

Pric

e of

hol

iday

s ($

)

The effects of changes in demand and supply on the equilibriumInitially the price remains at the equilibrium priceQ1 will be suppliedQ2 will be demandedThere will be excess demand (a shortage)To get rid of the shortage prices will need to riseUntil once again equilibrium is restored but at a higher price of P2The new equilibrium quantity is Q3Whenever there is a shift of the demand or supply curve the market (if it is left alone) will adjust to a new equilibrium or market clearing priceComplete student workpoint 3.1 P37

Quantity of holidays

(days)

S1

Q1

D1

Q2

P1

D2

Pric

e of

hol

iday

s ($

)

P2

Q3

The role of the price mechanismResources are allocated and re-allocated in response to changes in priceIf there is an increase in the price of a good due to an increase in demand for the good there is a signal to the producersThe price signal tells producers that consumers wish to buy this goodWe assume that producers are rational and wish to maximise their profitsThere is an incentive for them to produce moreProducers allocate more resources to those goods where the demand is highest (they will make more profit)There is not central planning agencyAdam Smith said it was like there was an invisible hand moving the factors of production around to produce the goods and services wanted by the buyers in the economy

Price mechanism = the forces of supply and demand

Market efficiency – Consumer SurplusWatch the video

Consumer surplus = the extra satisfaction (or utility) gained by consumers from paying a price that is lower than that they are prepared to pay

Consumer surplus video: http://www.youtube.com/watch?feature=player_detailpage&v=qTxniCLYgok

Market efficiency – Producer surplusWatch the videoRead through page 38

Make notesAsk questions if you don’t understand

Producer surplus = the excess of actual earnings that a producer makes from a given quantity of output, over and above the amount the producer would be prepared to accept for that output

Producer surplus video: http://www.youtube.com/watch?v=MinxczZXtKA&feature=player_detailpage

Allocative efficiencyAllocative efficiency means that resources are allocated in the most efficient way from society’s point of viewThis kind of efficiency is not the same as being efficient at operating like within a firm. This is called productive efficiency and we will learn about that laterIf we add consumer and producer surplus together this is the community surplusCommunity surplus is the total benefit to societyAt the equilibrium community surplus is maximisedThis is the point of allocative efficiencyThere is no other combination of price or quantity that could give greater community surplusThis is therefore the optimal allocation of resources from the point of view of society as a whole

Allocative efficiency = when a market is in equilibrium, with no external influences, it is said to be socially efficient or in a state of allocative efficiency

Allocative efficiencyThe supply curve is largely determined by the industry’s costs of productionWhen we assume that the costs of the industry are equal to the costs to society then the supply curve represents the social cost curveWhen we analyse efficiency we call this the marginal social cost curve (we will learn more about this later)

Marginal social costs (MSC) curve = the supply curve represents the marginal social cost curve when the costs to industry are equal to the costs of society

Allocative efficiencyThe demand curve is determined by the utility, or benefits, that the consumption of a good or service brings to the consumersIf we assume the benefits in the market are equal to the benefits to society we can use the demand curve to represent the social benefitsWhen we analyse efficiency we refer to the demand curve as the marginal social benefit curve (MSB)

Marginal social benefits (MSB) curve = the demand curve represents the marginal social benefits curve when the benefits in the market are equivalent to the benefits to society

Allocative efficiencyThis is only a brief introduction to allocative efficiencyWe will come back to it in a lot more detail laterIn conclusion

A free market leads to allocative efficiencyCommunity surplus is maximised so it is the optimum allocation of resources from society’s point of viewThis occurs when demand is equal to supply or marginal social costs are equal to marginal social benefits

Before we get to the HL bit here is the homework

Homework for allComplete the data response question on P44 (copper)Make sure you read the assessment advice

The HL bit!

Calculating and illustrating market equilibrium using linear demand and supply functionsIf you are given the demand function and the supply function you easily plot the graphs of both and where they cross is the equilibriumAlternatively you can work out the equilibrium using simultaneous equationsWork through page 39 to 43 and then complete student workpoint 3.3