Market Equilibrium and Welfare Analysis for AP Economics (page 3)
The review questions for this study guide can be found at:
Main Topics: Equilibrium, Shortages, Surpluses, Changes in Demand, Changes in Supply, Simultaneous Changes
Demanders and suppliers are both motivated by prices, but from opposite camps. The consumer is a big fan of low prices; the supplier applauds high prices. If a good were available, consumers would be willing to buy more of it, but only if the price is right. Suppliers would love to accommodate more consumption by increasing production, but only if justly compensated. Is there a price and a compatible quantity where both groups are content? Amazingly enough, the answer is a resounding "maybe." Discouraged? Don't be. For now we assume that the good is exchanged in a free and competitive market, and if this is the case, the answer is "yes." We explore the "maybes" in a later chapter.
The market is in a state of equilibrium when the quantity supplied equals the quantity demanded at a given price. Another way of thinking about equilibrium is that it occurs at the quantity where the price expected by consumers is equal to the price required by suppliers. So if suppliers and demanders are, for a given quantity, content with the price, the market is in a state of equilibrium. If there is pressure on the price to change, the market has not yet reached equilibrium. Let's combine our lemonade tables from the earlier sections in Table 6.4.
At a price of 75 cents, the daily quantity demanded and quantity supplied are both equal to 80 cups of lemonade. The equilibrium (or market clearing) price is therefore 75 cents per cup. In Figure 6.7 the equilibrium price and quantity are located where the demand curve intersects the supply curve. Holding all other demand and supply variables constant, there exists no other price where Qd = Qs.
A shortage exists at a market price when the quantity demanded exceeds the quantity supplied. This is why a shortage is also known as excess demand. At prices of 25 cents and 50 cents per cup, you can see the shortage in Figure 6.7. Remember that consumers love low prices so the quantity demanded is going to be high. However, suppliers are not thrilled to see low prices and therefore decrease their quantity supplied. At prices below 75 cents per cup, lemonade buyers and sellers are in a state of disequilibrium. The disparity between what the buyers want at 50 cents per cup and what the suppliers want at that price should remedy itself. Thirsty demanders offer lemonade stand owners prices slightly higher than 50 cents and, receiving higher prices, suppliers accommodate them by squeezing lemons. With competition, the shortage is eliminated at a price of 75 cents per cup.
A surplus exists at a market price when the quantity supplied exceeds the quantity demanded. This is why a surplus is also known as excess supply. At prices of $1 and $1.25 per cup, you can see the surplus in Figure. 6.7. Consumers are reluctant to purchase as much lemonade as suppliers are willing to supply and, once again, the market is in disequilibrium. To entice more consumers to buy lemonade, lemonade stand owners offer slightly discounted cups of lemonade and buyers respond by increasing their quantity demanded. Again, with competition, the surplus would be eliminated at a price of 75 cents per cup.
- Shortages and surpluses are relatively short-lived in a free market as prices rise or fall until the quantity demanded again equals the quantity supplied.
Changes in Demand
While our discussion of market equilibrium implies a certain kind of stability in both the price and quantity of a good, changing market forces disrupt equilibrium, either by shifting demand, shifting supply, or shifting both demand and supply.
Increase in Demand
About once a winter a freak blizzard hits southern states like Georgia and the Carolinas. You can bet that the national media shows video of panicked southerners scrambling for bags of rock salt and bottled water. Inevitably a bemused reporter tells us that the price of rock salt has "skyrocketed" to $17 per bag. What is happening here? In Figure 6.8, the market for rock salt is initially in equilibrium at a price of $2.79 per bag. With a forecast of a blizzard, consumers expect a lack of future availability for this good. This expectation results in a feverish increase in the demand for rock salt and, at the original price of $2.79, there is a shortage and the market's cure for a shortage is a higher equilibrium price. (Note: The equilibrium quantity of rock salt might not increase much since blizzards are short-lived and the supply curve might be nearly vertical.)
Decrease in Demand
The most recent recession was damaging to the automobile industry. When average household incomes fell in the United States, the demand for cars, a normal good, decreased. Manufacturers began offering deeply discounted sticker prices, zero-interest financing, and other incentives to reluctant consumers so that they might purchase a new car. In Figure 6.9 you can see that the original price of a new car was $18,000. Once the demand for new cars fell, there was a surplus of cars on dealer lots at the original price. The market cure for a surplus is a lower equilibrium price, therefore fewer new cars were bought and sold.
- When demand increases, equilibrium price and quantity both increase.
- When demand decreases, equilibrium price and quantity both decrease.
Changes in Supply
Increase in Supply
Advancements in computer technology and production methods have been felt in many markets. Figure 6.10 illustrates how, because of better technology, the supply of laptop computers has increased. At the original equilibrium price of $4000, there is now a surplus of laptops. To eliminate the surplus the market price must fall to P2 and the equilibrium quantity must rise to Q2.
Decrease in Supply
Geopolitical conflict in the Middle East usually slows the production of crude oil. This decrease in the global supply of oil can be seen in Figure 6.11. At the original equilibrium price of $20 per barrel, there is now a shortage of crude oil on the global market. The market eliminates this shortage through higher prices and, at least temporarily, the equilibrium quantity of crude oil falls.
- When supply increases, equilibrium price decreases and quantity increases.
- When supply decreases, equilibrium price increases and quantity decreases.
Simultaneous Changes in Demand and Supply
When both demand and supply change at the same time, predicting changes in price and quantity becomes a little more complicated. An example should illustrate how you need to be careful.
An extremely cold winter results in a higher demand for energy such as natural gas. At the same time, environmental safeguards and restrictions on drilling in protected wilderness areas have limited the supply of natural gas. An increase in demand, by itself, creates an increase in both price and quantity. However, a decrease in supply, by itself, creates an increase in price and a decrease in quantity. When these forces are combined, we see a double-whammy on higher prices. But when trying to predict the change in equilibrium quantity, the outcome is uncertain and depends upon which of the two effects is larger.
One possible outcome is shown in Figure 6.12 where the initial equilibrium outcome is labeled E1. A relatively large increase in demand with a fairly small decrease in supply results in more natural gas being consumed. The new equilibrium outcome is labeled E2.
The other possibility is that the increase in demand is relatively smaller than the decrease in supply. This is seen in Figure 6.13 and, while the price is going to increase again, the equilibrium quantity is lower than before.
"If you don't know the answer, it is probably where the sticks cross."
—Chuck, AP Student
- When both demand and supply are changing, one of the equilibrium outcomes (price or quantity) is predictable and one is ambiguous.
- Before combining the two shifting curves, predict changes in price and quantity for each shift, by itself.
- The variable that is rising in one case and falling in the other case is your ambiguous prediction.
Main Topics: Total Welfare, Consumer Surplus, Producer Surplus
The competitive market, free of government and externalities, produces an equilibrium outcome that provides the maximum amount of total welfare for society. Society consists of all consumers and all producers and, in the marketplace, each party seeks the other so that they can make an acceptable transaction at the going market price. Each party expects to gain in these transactions. Total welfare is the sum of two measures of these gains: consumer surplus and producer surplus.
Consumer Surplus: You know that great feeling you get when you pay a price that is lower than you expected, or is lower than you were willing to pay? That's consumer surplus, the difference between your willingness to pay and the price you actually pay. The market demand curve, at each quantity, measures, society's willingness to pay (the price). You can see consumer surplus in Figure 6.14. At a price of $5, three units of the good are purchased. The first two units receive some amount of consumer surplus because the willingness to pay exceeds $5. The consumer of the third unit pays a price exactly equal to his willingness to pay so he earns no consumer surplus. Total consumer surplus is the total amount earned by these three consumer transactions.
Producer Surplus: Producers are ecstatic when they receive a price for their product that is above the marginal cost of producing it. This is producer surplus, the difference between the price received and the marginal cost of producing the good. The market supply curve, at each quantity, measures society's marginal cost. You can see producer surplus in Figure 6.15. At a price of $5, three units of the good are produced. The first two units earn producer surplus because $5 is above the marginal cost. The third unit earns no additional producer surplus since the marginal cost is exactly equal to the price received. Total producer surplus is the total amount earned by these three producer transactions.
- The area under the demand curve and above the market price is equal to total consumer surplus.
- The area above the supply curve and below the market price is equal to total producer surplus.
So, is market equilibrium conducive to increasing total welfare for society? Combining Figures 6.14 and 6.15 completes the market pictured in Figure 6.16. We see that the combined consumer and producer surplus, or total welfare, is greatest at the equilibrium price of $5 and quantity of three units.
At a lesser quantity (e.g., two units), the combined area is smaller than at a quantity of three. At greater quantities (i.e., q = 4) the price of $5 exceeds MB so consumer surplus is being lost. If this weren't bad enough, the MC exceeds the price at q = 4 so producer surplus is being lost. Thus, if total welfare is falling at quantities less than three and at quantities greater than three, total welfare must be maximized at the market equilibrium quantity of three and price of $5.
The review questions for this study guide can be found at:
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