Market Equilibrium

It's easy to train economists. Just teach a parrot to say "Supply and Demand."                                                                                                                                                         .                                                                Thomas Carlyle

Buyers and sellers use prices to signal their respective wants, and then exchange money for goods or resources, or vice versa. You accept or reject thousands of offers during every trip to a shopping center or perusal of a newspaper. Prices efficiently transmit incredible amounts of information that is relevant for decisions to buy or sell, and make a lot of other information (or misinformation) irrelevant. For example, during the nineteenth century, Ghana exported cocoa to England, believing that the British used it for fuel. Their mistake was not a problem, however, because their decision to produce depended on the price of cocoa, not its final use.

Supply and demand jointly determine prices and quantities so that markets achieve equilibrium.

In an equilibrium, any pressures for change must be offset by opposing forces.

All sciences, including economics, use this powerful concept extensively. Astronomers, for example, describe the moon as following a fairly stable equilibrium path as it circles our earth. But what creates equilibrium in a market?

Suppose every potential buyer and seller of a good submitted demand and supply schedules to an auctioneer, who then calculated the price at which the quantities demanded and supplied were equal. All buyers' demand prices (the maximum they are willing to pay) and all sellers' supply prices (the minimum they will accept per unit for a given amount) are equal. There is market equilibrium, so the market clears.

Market equilibrium occurs at the price/quantity combination where the quantities demanded and supplied are equal.

The amounts buyers will purchase at the equilibrium price exactly equal the amounts producers are willing to sell. Let's examine the sense in which this is an equilibrium.

Figure 11 summarizes the market supplies and demands for paperbacks. (Note that there are more buyers and sellers than in our earlier examples.) After studying the supply and demand schedules, our auctioneer ascertains that at \$5 per book, the quantities demanded and supplied both equal 300 million books annually. Sellers will provide exactly as many novels as readers will buy at this price, so the market clears.

Figure 11

But what if the auctioneer set a price of \$6 per book, or \$4 per book? First, let us deal with the problem of a price set above equilibrium.

A surplus is the excess of the quantity supplied over quantity demanded when the price is above equilibrium.

At \$6 per book, publishers would print 400 million books annually, but readers would only buy 200 million books. The surplus of 200 million books shown in Figure 11 would wind up as excess inventories in the hands of publishers.

Most firms would cut production as their inventories grew, and some might cut prices, hoping to unload surplus paperbacks on bargain hunters. (Publishers call this "remaindering.") Other firms with swollen inventories would join in the price war. Prices would fall until all surplus inventories were depleted. Some firms might stop production as prices fell; others might permanently abandon the publishing industry.

How much the quantity supplied would decline is shown in the table accompanying Figure 11. When the price falls to \$5 per book, consumers will buy 300 million books annually while publishers will supply 300 million books—the quantity demanded equals the quantity supplied. The market-clearing price is \$5 per book. At this market equilibrium, any pressures for price or quantity changes are exactly counterbalanced by opposite pressures.

A shortage is created when the price is below equilibrium, so the quantity of a good demanded exceeds the quantity supplied.

A shortage is the excess of quantity demanded over quantity supplied when the price is below equilibrium.

At \$4 per book, readers demand 400 million books, but firms only print 200 million; a shortage of 200 million books annually is depicted in Figure 11. Publishers will try to satisfy unhappy, bookless customers who clamor for the limited quantities available by raising the price until the market clears; then books will be readily available for the people most desperate to buy them. (Clearing occurs because quantity supplied rises as price rises while quantity demanded falls; they become equal at the equilibrium price.)

Equilibration is not instantaneous. Firms experiment with output prices in a process resembling an auction. Inventories vanishing from store shelves are signals that prices may be too low. Retailers will order more goods and, because the market will bear it, may also raise prices. If retail orders grow rapidly, prices also tend to rise at the wholesale level, quickly eliminating most shortages. People refer to "tight" markets or "sellers' markets" when shortages are widespread. Suppliers easily sell all they produce, so quality may decline somewhat while sellers raise prices. Many sellers also exercise favoritism in deciding which customers to serve during shortages.

When prices exceed equilibrium, surpluses create "buyers' markets" and force sellers to consider price cuts. This is especially painful if production costs are resistant to downward pressures even though sales drop. (Most workers stubbornly oppose wage cuts.) In many cases, firms can shrink inventories and cut costs only by laying workers off and drastically reducing production. The price system ultimately forces prices down if there are continuing surpluses.

In 1776, Adam Smith described these types of self-corrections as the invisible hand of the marketplace. Price hikes eliminate shortages fairly rapidly, and price cuts eventually cure surpluses, but such automatic market adjustments may seem like slow torture to buyers and sellers. How rapidly markets adjust to changed circumstances depends on (a) the quality of information and how widely and quickly the relevant information is disseminated, and (b) market structure—the vigor or lack of competition.

Evidence that adjustment processes may be long and traumatic includes huge losses by major firms and sluggish economies in many industrial states during the recession of 1990—1991. Contrary evidence includes rapid changes in the prices of stock in response to changes in profits reported by major corporations.  Different views about the speed of typical market mechanisms in the economy as a whole are central to debates between modern advocates of various schools of macroeconomic thought. Most economists agree, however, that long-term shortages or surpluses are, almost without exception, consequences of governmental price controls. We discuss price controls and other applications of supply and demand in Chapter 4.

## Supplies and Demands Are Independent

Although specific demands and supplies jointly determine prices and quantities, it is important to realize that they are normally independent of each other, at least in the short run. Many people have difficulty with the idea that demands and supplies are independent. It would seem that demand depends on availability—or that supply depends on demand. The following examples show that supplies and demands are normally independent in the short run.

1.         Suppose nonreusable "teleporter buttons" could instantly transport you anywhere you chose. Your demand price to go on the first, most valuable tour might be quite high, but it would decline steadily for subsequent journeys. Short shopping trips would be economical only if teleporters were very inexpensive. By asking how many buttons you would buy at various prices, we can construct your demand curve for such devices even though there is no supply.

2.         Would you have made more mud pies when you were a kid if your parents had paid you a penny for each one? At two cents each, might you have hired playmates to help you? If mud pies sold for \$1 each today, might you be a mud pie entrepreneur? Our point is that supply curves can be constructed for mud pies even if there is no demand for them.

3.         You might be willing to pay a little to hear some professors' lectures even if you did not receive college credit for gathering the pearls of wisdom they offer. Some professors, however, like to talk even more than you like to listen. A set of such demand and supply curves is illustrated in Figure 12. It is fortunate for both you and your professors that your demands for their lectures are supplemented by contributions from taxpayers, alumni, and possibly your parents—because only later and upon mature reflection will you realize how valuable those lectures really were!

Figure 12

We hope these examples convince you that specific supplies and demands are largely independent of each other, and that they are relevant for markets only when they intersect at positive prices. Markets establish whether the interests of buyers from the demand side are compatible with the interests of sellers from the supply side, and then coordinate decisions where mutually beneficial exchange is possible.

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