equilibrium: how supply and demand determine prices ka-fu wong university of hong kong 1

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Equilibrium: How Supply and Demand Determine Prices

Ka-fu WongUniversity of Hong Kong

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Markets and Prices

• Why does Jeremy LIN earn more than Ka-fu WONG (an award winning teacher)?

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Markets and Prices

• Why do diamonds cost more than water?

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Markets and Prices

• Why do Picasso’s paintings sell for more than Leroy Nieman’s?

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Markets and Prices

• Why do the crabs of Qi BaiShi (齊白石 ) sell for more than the real ones?

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Markets and Prices

• Is it cost of production that determines prices (as Adam Smith thought)?

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Markets and Prices

• Or is it willingness to pay that determines prices (as Stanley Jevons thought)?

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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.

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Markets and Prices

• The market for any good or service consists of all (actual or potential) buyers or sellers of that good or service.

o Supply (sellers) and demand (buyers) jointly determine the market price.

Shau Kei Wan Market

Sai Kung Pier Market

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The market for lobsters

• The market for lobsters in Portland, Maine, on July 20, 2004.

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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)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

D

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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)

Quantity (1000s of lobsters/day)

10

8

6

4

2

0

S

S

1 2 3 4 5 6

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Market Equilibrium Quantity and Price

• Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

SAt the market equilibrium price of $6 per lobster, buyers and sellers are each able to buy or sell as many lobsters as they wish to.

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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 has no tendency to change.

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Excess supply

• A situation in which price exceeds its equilibrium value is called one of excess supply, or surplus.

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

S

excess supply

At $8, there is an excess supply of 2000 lobsters in this market.

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From disequilibrium to equilibrium

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

SAt prices above equilibrium, sellers are not selling as much as they want to. The impulse of a dissatisfied seller is to reduce his price.

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Excess Demand

• A situation in which price lies below its equilibrium value is referred to as one of excess demand.

At a price of $4 in this lobster market, there is an excess demand of 2000 lobsters.

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

S

excess demand

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From disequilibrium to equilibrium

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

S At prices below the equilibrium value, buyers cannot obtain the quantities they wish to purchase. Some buyers adjust by offering slightly higher prices.

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Zero excess supply and demand

• Equilibrium occurs at the price-quantity pair for which both buyers and sellers are satisfied.

Price ($/lobster)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

SAt the market equilibrium price of $6, both excess demand and excess supply are exactly zero.

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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)

Quantity (1000s of lobsters/day)

10

8

6

4

2

01 2 3 4 5

D

DS

STrading locus

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Comparative StaticsShifting Demand and Supply Curves

D1

Q0

P0

S

D0

Price of energy drinks

Quantity of energy drinks

Q1

P1

Causes the equilibrium to change to a higher P and Q

An increase in demand

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Comparative StaticsShifting Demand and Supply Curves

D0

S

Price of energy drinks

Quantity of energy drinks

Q0

P0

D1

Q1

P1

Causes the equilibrium to change to a lower P and Q

A decrease in demand

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Comparative StaticsShifting Demand and Supply Curves

S1

D0

S0

Price of energy drinks

Quantity of energy drinks

Q0

P0

Q1

P1

Causes the equilibrium to change to a lower P and higher Q

An increase in supply

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Comparative StaticsShifting Demand and Supply Curves

S1

D0

S0

Price of energy drinks

Quantity of energy drinks

Q0

P0

Q1

P1

Causes the equilibrium to change to a higher P and lower Q

A decrease in supply

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Gains from Trade Are Maximized at Equilibrium Price and Quantity

Unexploited Gains from Trade Exist when Quantity is Below the Equilibrium Quantity

Quantity of Oil (MBD)

Price of Oil per Barrel

Unsatisfied Wants

Unexploited Gains from Trade

$15

$57

Satisfied Wants

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Demand Curve

Supply Curve

$30

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Equilibrium Price

Equilibrium Quantity

At Q=24, there are buyers who value buying the good more than sellers value selling the good (there are unexploited gains from trade up until 65 units)

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Gains from Trade Are Maximized at Equilibrium Price and Quantity

Quantity of Oil (MBD)

Price of Oil per Barrel

95

Value of Wasted Resources

$15

$50

Demand Curve

Supply Curve

$30

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Equilibrium Price

Equilibrium

Quantity

Wasteful Trades Exist when Quantity is Above the Equilibrium Quantity

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Gains from Trade Are Maximized at Equilibrium Price and Quantity

Quantity of Oil (MBD)

Price of Oil per Barrel

Demand Curve

Supply Curve

$30

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Equilibrium Price

Equilibrium

Quantity

At the Equilibrium Quantity There Are No Unexploited Gains from Trade nor Any

Wasteful Trades!

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Gains from Trade Are Maximized at Equilibrium Price and Quantity

Sellers

Consumer Surplus

Producer Surplus

Non-Buyers

Non-SellersBuyers

Quantity of Oil (MBD)

Price of Oil per Barrel

A Free Market Maximizes Producer plus Consumer Surplus (the gains from trade)

Demand Curve

Supply Curve

$30

65Equilibrium Quantity

Equilibrium Price

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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 (both of the 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.

Fine print

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The Price of Oil, 1960-2005

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Prediction

o An oil shock will cause the price oil to increase, quantity to decrease.

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Hong Kong examples

• Impact of X on the price and quantity various kinds of meat, and on the price of wine and quantity of wine– Fishing holiday – Avian Flu– Mad-cow disease

• The impact of development of genetic modified food

• The expansion of HKU on the housing prices in the Western District.

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Conclusion

o We observed an increase in price and a decrease in quantity.

o Likely a supply shock had occurred.

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Policy

o The housing price is too high. What can government do to lower the price?

o Increase the supply.o Price will be lower and quantity will be higher.

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Example: Impact of food aid

An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

A. plant more seeds as the food aid established a minimum price for grain.

B. plant more seeds as the farmers’ confidence is restored.C. plant the same amount of seeds as they would have

without the food aid.D. plant less seeds as consumers’ demand for grain is

completely price elastic. E. plant less seeds as the price of grain will be lower with the

food aid.

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Example: Impact of food aid

• Donate five hundred tons of grain next year means that the demand for domestic production of grain will be lowered by the same amount at all prices?

D’

Q’Quantity (tons of grain)

Q

P’

P

SPrice

D

500 tons

Anticipating a lower market equilibrium price next year, farmer would want to supply less quantity next year.

They do so by planting less seeds this year.

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Example: Impact of food aid

An important determinant of the amount of grains harvested next year by Ethiopian farmers is the amount of seeds planted this year. Given that Western nations have guaranteed to donate five hundred tons of grain next year, this year the Ethiopian farmers will:

A. plant more seeds as the food aid established a minimum price for grain.

B. plant more seeds as the farmers’ confidence is restored.C. plant the same amount of seeds as they would have

without the food aid.D. plant less seeds as consumers demand for grain is

completely price elastic. E. plant less seeds as the price of grain will be lower with the

food aid.

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Example: Two or more shifting factors

• What will happen to the equilibrium price and quantity in the fresh seafood market if both of the following events occur: – a scientific report is issued saying that fish

contains mercury, which is toxic to humans; and

– the price of diesel fuel falls significantly?

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Example: Two or more shifting factors

• The equilibrium price will go down, but the equilibrium quantity may go either up (right panel) or down (left panel)

P

Q

P

Q

DD'

S S'

DD'

SS'

S'

S

S'S

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Example: Rental Regulation

Suppose the supply and demand curves for two-bedroom Collegetown rental apartments are as shown.

1 2 3

500

1000

1500Supply

Demand

Quantity(thousands of apartments per month)

Monthly Rent($/apartment)

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Example: Rental Regulation

• The city council is concerned that many students cannot afford the equilibrium rent of $1000 per month and is considering a regulation forbidding landlords from charging more than $500.

• What will be the likely consequences of adopting this regulation?

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Example: Rental Regulation

• Rent Controls Produce Excess Demand in the Housing Market.

At this quantity, the marginal buyer is willing to pay 1000 more to obtain an apartment.

1 2 3

500

1000

1500Supply

Demand

Quantity(thousands of apartments per month)

Monthly Rent($/apartment)

Controlled Rent

At this price, excess demand = 2000 apartments.

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Example: Rental Regulation

• Responses to excess demand in a regulated housing market:

finder’s feeskey depositsrequired furniture rentalexcessive damage depositscurtailed maintenanceapartment conversion

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Alternative to helping the poor (students?)

• There are much more effective ways to help poor people than to regulating prices of apartments and other goods at artificially low levels.

For example, income transfers:

Wage subsidiesPublic service jobs

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Examples of price control in Hong Kong?

• Rent control– Cheung, S.N.S. (1979), “Rent Control and Housing

Reconstruction: The Postwar Experience of Prewar Premises in Hong Kong”, Journal of Law & Economics, 22 (1), pp. 27-53.

• Designated LPG pump stations• Brokerage fee of trading stock• Public housing• Taxi fare

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Taxi regulations

• Taxi is in excess supply at the regulated taxi fare.– Every day, a lot of taxi line up at the airport

for customers. Some of them have to wait several hours for business.

– Some offer discount to customers.• Number of taxi license is also regulated.

TITLE Conflicting interests in taxi-fare regulation / Yue-Chim Richard Wong, Ka-Fu Wong.

IMPRINT Hong Kong : Asia Case Research Centre, The University of Hong Kong, c2005.

http://library.hku.hk/record=b3580220

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Taxi Regulations

Taxi services

S

D1 (economy in a recession)

D2

(economy in a boom)

Taxi Fare

Regulated fare

Economy in a recession:Excess supply

Economy in a boom:Excess demand