Supply, Demand, and Market Equilibrium

Chen Zhao
University of Hong
Kong
Example: Basis for exchange
• Paul is a house painter whose roof needs replacing and Ron is a roofer
whose house needs painting.
• Although Paul is a painter, he also knows how to install roofing. Ron, for his
part, knows how to paint houses.
• Should Paul roof his own house? Should Ron paint his own house?

Time required by each to complete each type of job:

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs
Example: Gains from exchange

Painting Roofing
Paul 300 hrs 400 hrs
Ron 200 hrs 100 hrs

o If Paul roofs his house he needs 400 hours. If Ron paints his house he
needs 200 hours.
o By contrast when Paul paints Ron’s house and Ron’s paints Paul’s house,
each saves 100.
o This is when ToT is 1 painting/roofing.
o What determines the ToT?
Example: Gains from Trade
o John is willing to pay $10 for an apple.
o Mary can produce an apple at the cost of $4.

o If they trade, together they can gain

o $6 (=10-4)

o Trade results in gains. The question is how to split the gain.

o What goes to John?
o What goes to Mary?
The split is all about bargaining power
# of buyers One Many Many
Bargaining power very much negligible negligible
+ + + +
# of sellers Many One Many
Bargaining power negligible very much negligible

Market Structure Monopsony Monopoly Perfect

competition

When we know that we have negligible bargaining power, we had no choice

but take the price as given.
Markets and Prices
The market for any good or
service consists of all (actual
or potential) buyers or sellers
of that good or service.

Shau Kei Wan Market

Sai Kung Pier Market
Supply (sellers) and demand (buyers)
jointly determine the market price.
But… each participant is too small to
affect the market price.
The market for lobsters
• The market for lobsters in Portland, Maine, on July 20,
2004.
The demand for lobsters
• The demand curve depicts the relationship between the price of a
certain good/service and the amount of it that consumers are willing and
able to purchase.

Price ($/lobster) D
10
8
6

4
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Horizontal interpretation of the demand curve
• If buyers face a price of $4/lobster, together they will wish to purchase 4000
lobsters a day.

Horizontally: How much buyers are

Price ($/lobster) D willing and able to purchase at a
10 certain price.
8
6

4
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Vertical interpretation of the demand curve
• If buyers are currently buying 4000 lobsters a day, the demand curve tells us
that the “marginal” buyer would be willing to pay at most $4 for one
additional lobster.

Price ($/lobster) D Vertically: The highest price buyers

10 are willing to pay for an additional
8
unit at a certain quantity.
6

4
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Why are demand curves downward sloping
1. Buyers/ consumers have different values of the good.
– When price is high, goods are only bought by those who are willing to pay a high price.
– When the price is low, goods are also bought by those who are willing to pay a lower
price.

2. For a given consumer:

– As the good becomes more expensive, people switch to substitutes. (Substitution
effect)
– As the good becomes more expensive, people can’t afford to buy as much of it.
(Income effect)
Consumer Surplus
o Consumer Surplus (economic surplus to consumer) is the consumer’s gain
from exchange,
o For each consumer, consumer surplus is the difference between his/her
willingness to pay and the actual price paid.

o Total consumer surplus is the sum of consumer surplus of all buyers.

Example: Calculating Consumer Surplus
o Your roommate just bought an a concert ticket for $600. She would have
been willing to pay $1,000 for a concert. How much consumer surplus does
your roommate enjoy from the concert?
(a) $600
(b) $400
(c) $1600
(d) $1400
Example: Calculating Consumer Surplus
The demand curve depicts a
hypothetical market for a good with
8 potential buyers, each of whom
can buy a maximum of one unit of
the good. The first potential buyer’s
willingness to pay for the product is
$20; the second buyer’s reservation
price is $18; the third buyer’s
reservation price is $16; and so on.

Suppose this good were available at

a price of $12 per unit. How much
total consumer surplus would
buyers in this market reap?
Example: Calculating Consumer Surplus
Suppose this good were available at a price of $12 per unit.
How much total consumer surplus would buyers in this
market reap?

Total Consumer Surplus

= 8 + 6 + 4 + 2 = 20 dollars
Example: Calculating Consumer Surplus

How much do buyers benefit

Price
from their participation in this
($/pound)
market for cashews if the price
12 is $8 per pound?
S
10
8
6
4 D Quantity
2
0 (1000s of
2 4 6 8 10 12 pounds/day)
Example: Calculating Consumer Surplus

Note that this area is a right triangle whose

vertical arm is h=$4/pound and whose horizontal
arm is b=4,000 pounds/day.
Price
($/pound)
12 Since the area of any triangle is equal to (1/2)bh,
S consumer surplus in this market is equal to
10 (1/2)x(4,000 pounds/day)x($4/pound) =
8 $8,000/day.
6
4 D Quantity
2
0 (1000s of
2 4 6 8 10 12 pounds/day)
Market demand
Given two individual demand curves, how do we obtain the market demand curve?
Market demand
Fixed a price, add the quantity demanded.
Market demand
Fixed a price, add the quantity demanded.
Repeat with other prices.

Demand (Market)
The supply of lobsters
• The supply curve is a graphical representation of the relationship between
the price of a good or service and the quantity supplied.

Price ($/lobster)
10 S

8
6
4
2
S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
Horizontal interpretation of the supply curve
• If sellers face a price of $4/lobster, they will wish to sell 2000 lobsters a day.

Price ($/lobster)
10 S
Horizontally: How much
8
suppliers are willing and able
6 to sell at a certain price.
4
2 S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
Vertical interpretation of the supply curve
• If sellers are currently selling 2000 lobsters a day, the marginal cost of a
lobster is $4.

Price ($/lobster)
10 S
8 Vertically: The minimum price
6 for which suppliers are willing
to sell an additional unit at a
4 certain quantity.
2 S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
Why is the supply curve upward sloping?
o The cost of producing a good is not equal across all suppliers.
o At a low price, a good is produced and sold only by the lowest cost
suppliers.
o At a high price, a good is also produced and sold by higher cost suppliers.

o For the same supplier, the marginal cost to produce an additional unit of
output increases.
o The Low-Hanging Fruit Principle
Producer Surplus
o Producer Surplus is the producer’s gain from exchange
o For each producer, the difference between the price received and the
minimum price at which producers would be willing to sell.

o Total producer surplus is the sum of the producer surplus of each seller.

o Graphically, total producer surplus is measured by the area above the supply
curve and below the price.
Producer Surplus
Price of Oil Producer Surplus is the Area Above the Supply
per Barrel
Curve and Below the Price
$60
Supply Curve

$40

$20

Total Producer Surplus at a

Price of $40
Quantity of Oil (MBD)
20 40 60 80
Market Supply
Given two individual supply curves, how do we obtain the market supply curve?
Market Supply
Fixed a price, add the quantity supplied.
Market Supply
Fixed a price, add the quantity supplied.
Repeat with other prices.
Markets and Prices
• Why does Jeremy Lin earn more than Prof. Xiang Zhang?
Markets and Prices
• Why do diamonds cost more than water?
Markets and Prices
• Why do the crabs of Qi BaiShi ( 齊白石 ) sell for more than the real ones?
Markets and Prices

• Is it cost of production that

determines prices (as Adam Smith
thought)?
Markets and Prices

• Or is it willingness to pay that

determines prices (as Stanley Jevons
thought)?
Markets and Prices

• Alfred Marshall (Principles of

Economics, 1890) was the first to
explain clearly how both costs and
willingness to pay interact to
determine market prices.
Markets and Prices
The market for any good or
service consists of all (actual
or potential) buyers or sellers
of that good or service.

Shau Kei Wan Market

Sai Kung Pier Market
Supply (sellers) and demand (buyers)
jointly determine the market price.
But… each participant is too small to
affect the market price.
The demand for lobsters
• The demand curve is the set of all price-quantity pairs for which buyers are
satisfied. ("Satisfied" means being able to buy the amount they want to at
any given price.)

Price ($/lobster) D
10
8
6

4
2 D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
The supply of lobsters
• The supply curve is the set of price-quantity pairs for which sellers are
satisfied. ("Satisfied" means being able to sell the amount they want to at
any given price.)

Price ($/lobster)
10 S

8
6
4
2
S Quantity
(1000s of lobsters/day)
0
1 2 3 4 5 6
Market Equilibrium Quantity and Price
• Equilibrium occurs at the price-quantity pair for which both buyers and
sellers are satisfied.

Price ($/lobster)
D S
10 At the market equilibrium
8 price of $6 per lobster,
buyers and sellers are each
6 able to buy or sell as many
lobsters as they wish to.
4
2 D
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Market Equilibrium
o Equilibrium:
o the condition of a system in which all competing influences are balanced,
such that the system has no tendency to deviate from the current
condition.

o When Qs = Qd at a certain price, the market is in equilibrium,

o the amount consumers would purchase at this price is matched exactly by
the amount producers wish to sell.
o When both consumers and producers are satisfied, the current condition
(characterized by P and Q) will have no tendency to change.
Excess supply
• A situation in which price exceeds its equilibrium value is called one of
excess supply, or surplus.

excess
Price ($/lobster) supply
D S
10
At $8, there is an excess
8 supply of 2000 lobsters
6 in this market.
4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
From disequilibrium to equilibrium

Price ($/lobster) At prices above

D S
10 equilibrium, sellers are not
selling as much as they
8 want to. The impulse of a
dissatisfied seller is to
6
reduce his price.
4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Excess Demand
• A situation in which price lies below its equilibrium value is referred to as one
of excess demand.

Price ($/lobster)
D S
10
At a price of $4 in this
8 excess lobster market, there is
demand an excess demand of
6
2000 lobsters.
4
2 D
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
From disequilibrium to equilibrium

Price ($/lobster)
D S At prices below the
10 equilibrium value, buyers
cannot obtain the
8 quantities they wish to
6 purchase. Some buyers
adjust by offering slightly
4 higher prices.
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Zero excess supply and demand
• Equilibrium occurs at the price-quantity pair for which both buyers and
sellers are satisfied.

Price ($/lobster)
D S
10
At the market
8 equilibrium price of
6 $6, both excess
demand and excess
4 supply are exactly
2 D zero.
S
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
The Trading Locus
• When price differs from the equilibrium price, trading in the marketplace will
be constrained -- by the behavior of buyers if the price lies above
equilibrium, by the behavior of sellers if below.

Price ($/lobster)
D S
10
Trading locus
8
6

4
2
S D
0 Quantity
1 2 3 4 5 (1000s of lobsters/day)
Gains from Trade Are Maximized at Equilibrium Price and
Quantity
Unexploited Gains from Trade Exist when Quantity is Below the Equilibrium Quantity
Price of Oil per
Barrel
Satisfied Wants Supply Curve

$57 Unsatisfied Wants

At Q=24, there are buyers who value

buying the good more than sellers
Equilibrium value selling the good (there are
Price $30 unexploited gains from trade up until
65 units)

$15 Unexploited
Gains from
Trade Demand Curve
Quantity of Oil
(MBD)
24 65
Equilibrium
Quantity
Unexploited Gains from Trade
o John is willing to pay $10 for an apple.
o Mary can produce an apple at the cost of $4.

o If they trade, together they can gain

o $6 (=10-4)

o This gain from exchange is also called the total economic surplus from the
exchange. If this trade is not allowed to happen, they lose the gain from trade of $6.
Gains from Trade Are Maximized at Equilibrium Price and
Quantity
Wasteful Trades Exist when Quantity is Above the Equilibrium Quantity
Price of Oil
per Barrel
Supply Curve
$50

Equilibrium Value of
Price $30 Wasted
Resources

$15
Demand Curve

Quantity of Oil
65 95 (MBD)
Equilibrium
Quantity
Value of Wasted Resources
o John is willing to pay $4 for an apple.
o Mary can produce an apple at the cost of $10.

o If they are forced to trade, together they can gain

o -$6 (=4-10)

o This gain from exchange is negative. If this trade is allowed not to

happen, they can jointly avoid the negative gain from trade of -$6.
Gains from Trade Are Maximized at Equilibrium Price and
Quantity
Price of Oil
per Barrel
Supply Curve

Consumer
Equilibrium Surplus At the Equilibrium Quantity There
Price $30 Are No Unexploited Gains from
Producer Trade nor Any Wasteful Trades!
Surplus

Demand Curve

Quantity of Oil
65 (MBD)
Equilibrium
Quantity
Gains from Trade Are Maximized at Equilibrium Price and
Quantity
“The Invisible hand”
Price of Oil
per Barrel Supply Curve

Buyers Non-Sellers

Equilibrium
Price $30

Sellers Non-Buyers

Demand Curve
Quantity of Oil
65 (MBD)
Equilibrium Quantity
Equilibrium and Total Surplus
o Equilibrium in a free market yields two important results:
o Goods must be produced at the lowest possible cost.
o Goods must satisfy the highest valued demands.

o These results indicate that total surplus (the sum of consumer and producer)
is maximized in free markets.
o The market equilibrium price and quantity are socially optimal.

o The market equilibrium price and quantity are socially optimal

o when all relevant production costs are incurred by sellers, and
o when all relevant product benefits accrue to buyers.