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6SUPPLY AND DEMAND I: HOW MARKETS WORK
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SUPPLY AND DEMAND
TOGETHER
Equilibrium refers to a situation in which the
price has reached the level where quantity
supplied equals quantity demanded.
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SUPPLY AND DEMAND
TOGETHER Equilibrium Price
The price that balances quantity supplied andquantity demanded.
On a graph, it is the price at which the supply and
demand curves intersect.
Equilibrium Quantity
The quantity supplied and the quantity demanded at
the equilibrium price.
On a graph it is the quantity at which the supply and
demand curves intersect.
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At $2.00, the quantity demandedis equal to the quantity supplied!
SUPPLY AND DEMAND
TOGETHERDemand Schedule Supply Schedule
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Figure 9 Markets Not in Equilibrium
Price of
Ice-CreamCone
0
Supply
Demand
(a) Excess Supply
Quantity
demandedQuantity
supplied
Surplus
Quantity of
Ice-Cream
Cones
4
$2.50
10
2.00
7
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Equilibrium
Surplus
When price > equilibrium price, then quantitysupplied > quantity demanded.
There is excess supply or a surplus.
Suppliers will lower the price to increase sales, therebymoving toward equilibrium.
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Equilibrium
Shortage
When price < equilibrium price, then quantitydemanded > the quantity supplied.
There is excess demand or a shortage.
Suppliers will raise the price due to too many buyerschasing too few goods, thereby moving toward
equilibrium.
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Figure 9 Markets Not in Equilibrium
Price of
Ice-CreamCone
0 Quantity of
Ice-Cream
Cones
Supply
Demand
(b) Excess Demand
Quantity
suppliedQuantity
demanded
1.50
10
$2.00
74
Shortage
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Equilibrium
Law of supply and demand
The claim that the price of any good adjusts to bringthe quantity supplied and the quantity demanded for
that good into balance.
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Three Steps to Analyzing Changes in
Equilibrium
Decide whether the event shifts the supply or
demand curve (or both). Decide whether the curve(s) shift(s) to the left
or to the right.
Use the supply-and-demand diagram to see how
the shift affects equilibrium price and quantity.
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Figure 10 How an Increase in Demand Affects theEquilibrium
Price of
Ice-Cream
Cone
0 Quantity of
Ice-Cream Cones
Supply
Initial
equilibrium
D
D
3. . . . and a higherquantity sold.
2. . . . resulting
in a higher
price . . .
1. Hot weather increasesthe demand for ice cream . . .
2.00
7
New equilibrium$2.50
10
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Three Steps to Analyzing Changes in
Equilibrium
Shifts in Curves versus Movements along
Curves A shift in the supply curve is called a change in
supply.
A movement along a fixed supply curve is called achange in quantity supplied.
A shift in the demand curve is called a change in
demand.
A movement along a fixed demand curve is called a
change in quantity demanded.
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Figure 11 How a Decrease in Supply Affects theEquilibrium
Price of
Ice-Cream
Cone
0 Quantity of
Ice-Cream Cones
Demand
Newequilibrium
Initial equilibrium
S1
S2
2. . . . resultingin a higherprice of ice
cream . . .
1. An increase in theprice of sugar reducesthe supply of ice cream. . .
3. . . . and a lowerquantity sold.
2.00
7
$2.50
4
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Table 4 What Happens to Price and Quantity When Supplyor Demand Shifts?
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SURPLUSPRODUSEN
DANKONSUMEN
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CONSUMER SURPLUS
Consumer surplus is the buyers
willingness to pay for a good minus the
amount the buyer actually pays for it.
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Figure How the Price Affects Consumer Surplus
Consumer
surplus
Quantity
(a) Consumer Surplus at Price P
Price
0
Demand
P1
Q1
B
A
C
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Figure How the Price Affects Consumer Surplus
Initial
consumer
surplus
Quantity
(b) Consumer Surplus at Price P
Price
0
Demand
A
BC
D E
F
P1
Q1
P2
Q2
Consumer surplus
to new consumers
Additional consumer
surplus to initial
consumers
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PRODUCER SURPLUS Producer surplus is the amount a seller is paid
for a good minus the sellers cost. It measures the benefit to sellers participating in
a market.
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Figure How the Price Affects Producer Surplus
Producersurplus
Quantity
(a) Producer Surplus at Price P
Price
0
Supply
B
A
C
Q1
P1
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Figure How the Price Affects Producer Surplus
Quantity
(b) Producer Surplus at Price P
Price
0
P1B
C
Supply
A
Initialproducer
surplus
Q1
P2
Q2
Producer surplusto new producers
Additional producer
surplus to initialproducers
D EF
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MARKET EFFICIENCYConsumer Surplus
= Value to buyers Amount paid by buyers
and
Producer Surplus
= Amount received by sellers Cost to sellers
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MARKET EFFICIENCYTotal surplus
= Consumer surplus + Producer surplus
or
Total surplus
= Value to buyers Cost to sellers
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MARKET EFFICIENCY Efficiency is the property of a resource
allocation of maximizing the total surplusreceived by all members of society.
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MARKET EFFICIENCY In addition to market efficiency, a social
planner might also care about equity thefairness of the distribution of well-being among
the various buyers and sellers.
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Figure 7 Consumer and Producer Surplus in the MarketEquilibrium
Producersurplus
Consumersurplus
Price
0 Quantity
Equilibrium
price
Equilibrium
quantity
Supply
Demand
A
C
B
D
E
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MARKET EFFICIENCY Three Insights Concerning Market Outcomes
Free markets allocate the supply of goods to thebuyers who value them most highly, as measured by
their willingness to pay.
Free markets allocate the demand for goods to thesellers who can produce them at least cost.
Free markets produce the quantity of goods that
maximizes the sum of consumer and producersurplus.
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Figure 8 The Efficiency of the Equilibrium Quantity
Quantity
Price
0
Supply
Demand
Cost
to
sellers
Costto
sellers
Valueto
buyers
Value
to
buyers
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
Equilibrium
quantity
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Evaluating the Market Equilibrium
Because the equilibrium outcome is an efficient
allocation of resources, the social planner canleave the market outcome as he/she finds it.
This policy of leaving well enough alone goes
by the French expression laissez faire.
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Evaluating the Market Equilibrium
Market Power
If a market system is not perfectly competitive,market powermay result.
Market power is the ability to influence prices.
Market power can cause markets to be inefficient becauseit keeps price and quantity from the equilibrium of supply
and demand.
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Evaluating the Market Equilibrium
Externalities
created when a market outcome affects individualsother than buyers and sellers in that market.
cause welfare in a market to depend on more than
just the value to the buyers and cost to the sellers. When buyers and sellers do not take
externalities into account when deciding how
much to consume and produce, the equilibriumin the market can be inefficient.