How are prices set in a market? The interactions of buyers (demand) and sellers (supply) determine the price of a good or service. The equilibrium price is the

How are prices set in a market? The interactions of buyers (demand) and sellers (supply) determine the price of a good or service.

The equilibrium price is the price where the quantity demanded is equal to the quantity supplied. That quantity is known as the equilibrium quantity.

 

You can visual the equilibrium price as a ball in bowl. The bowl can can be tipped and the ball will move, but it will find its way back to a stable place. The equilibrium price works that same way. At any other price, forces are put into play that will push the price back towards equilibrium.

 

The first thing you need to understand about this process is how the competition works. Buyers are competing against other buyers and sellers are competing against other sellers. Buyers are not competing sellers.

 

Let’s examine how this works with oil. If oil is $50 per barrel, but the equilibrium price is $30 per barrel, what happens? Well, the quantity demanded is lower than the quantity supplied – there’s a surplus. Sellers can’t sell as much as they’d like at $50 per barrel, so they lower the price. And what happens to demand? It goes up! Eventually, the price reaches equilibrium and the quantity demanded equals the quantity supplied.

 

When the price of oil is too low and the quantity demanded is higher than the quantity supplied, there’s a shortage. The correction process in this case works much the same way. Buyers compete by bidding up the price so that they can get more oil. Sellers have an incentive to raise the price so that, once again, price and quantity reaches equilibrium.
 

To recap, the only stable price is the equilibrium price. If the price is not at equilibrium, the actions of buyers and sellers will push the price back towards equilibrium.

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We know from previous lessons that the demand curve and the supply curve show how buyers and sellers respectively respond to changes in the price of a good. In this lesson, we'll show you how the interactions of buyers and sellers determine the price.



Let's start with the punch line. The equilibrium price is the price where the quantity demanded is equal to the quantity supplied, right here, and this is the equilibrium quantity. Why is this the equilibrium price? At any other price, forces are put into play that will push the price towards the equilibrium price. It's kind of like a ball in a bowl where the ball always returns to one stable position. The equilibrium price is the only place where the price is stable.



To see why, the first thing to understand is that buyers don't compete against sellers. Buyers compete against other buyers. A buyer obtains goods by bidding higher than other buyers. And sellers compete against other sellers by offering to sell at lower prices. Think about it. At an auction, the buyer with the highest bid gets the item and the seller with the lowest price makes the sale.



So let's say the price of oil is currently $50 a barrel, that's above the equilibrium price of $30 a barrel. At $50 a barrel, the quantity supplied is more than the quality demanded. So we say there is a surplus, so what happens? It's sale time! When there's a surplus, sellers can't sell as much as they would like to at the going price, so sellers have an incentive to lower their price a little bit so they could out compete other sellers and sell more. The price will continue to fall until the quantity demanded is equal to the quantity supplied and equilibrium is reached.



Now let's say the price is less than the equilibrium price, say $15 a barrel. At $15 a barrel, the quantity demanded exceeds the quantity supplied, a shortage. And what happens now? When there's a shortage, buyers can't get as much of the good as they want at the going price so they compete to buy more by bidding up the price. Now since buyers are easy to find sellers also have an incentive to raise the price. The price will continue to rise until quantity demanded is equal to the quantity supplied and equilibrium is reached.



At any price other than the equilibrium price, the incentives of the buyers and sellers push the price towards the equilibrium price. Only the equilibrium price is stable.



Now let's take a deeper look at the market equilibrium and some of its properties. Remember that there are many different users of oil and many different uses for oil each with substitutes, alternatives, and values. At any specific price of oil, there's a group of buyers who value oil enough to demand it at that price. And as the price changes, so do the buyers and their users. On the supply side, at each price on the supply curve, we're looking at a group of suppliers who's cost of extraction is low enough to be profitable at that price.



At the equilibrium price, these higher value groups are the buyers and these lower value groups are the non-buyers. Also notice that every seller has lower cost than any of the non-sellers. Since the buyers with the highest values buy and the sellers with the lowest costs sell, the gain from trade, the difference between the value a good creates and its cost, is maximized. In addition, at the equilibrium quantity, every trade that can generate value does generate value up until the very last trade where the value to buyers is just equal to the cost to sellers.



In a free market, there are no unexploited gains from trade and there are no wasteful trades. If the quantity exchanged were greater than equilibrium quantity for example, we would be drilling deep and expensive oil wells just to produce more rubber duckies and that would be wasteful. In a free market, buyers and sellers acting in their own self-interest end up at a price and quantity that allocates oil to the highest value buyers produced by the lowest cost sellers in a way that maximizes the gains from trade, the sum of the benefits to buyers and sellers.



This is one of the reasons Adam Smith said that the market process works like an invisible hand to promote the social good.

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Show 1 Answer (Answer provided by Ion Sterpan)
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Equilibrium price means the price at which the quantity supplied will happen to be just equal to quantity demanded. We start reasoning from quantity supplied and quantity demanded (the X axis).
If the quantity supplied is in excess to the equilibrium quantity (and so today's price is higher than the equilibrium), there would be gains for sellers from selling the excess supply at the equilibrium price, because otherwise buyers would not buy the excess supply at all. (And yes, they would not buy it because their cost from buying would be higher than the value of the good baught). There are also gains for buyers from that trade, because at a higher price they would not be willing to buy it at all, and so they would not have any gains.
If the quantity demanded is in excess to the quantity supplied (and so today's price is lower than the equilibrium price), that means demanders are willing to pay up to the equilibrium price to get more products than are available. The trade which will take place at the equilibrium price will bring gains to demanders -- since they asked for it -- as well as to producers, who, according to the supply curve, ar able and willing to produce the equilibrium quantity demanded provided they can sell it at the equilibrium price.
The gains need not be minimal. If there is a lot of excess supply, the gains from trading that supply at the equilibrium price will be high. If there is a lot of excess demand is very large, so will be the gains from the trade which responds to it.

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Ah that will be the subject of a later video I am sure but that is good you thought of this.

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Depends on growth rate of supply vs demand and which one is more elastic. In cases where growth is equal for supply and demand, if demand is more inelastic than supply, equilibrium price will fall and if demand is more elastic than supply, equilibrium price will rise. If supply and demand are equally elastic/inelastic, equilibrium price does not change. Quantity increases in all cases.

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Adam Smith uses the metaphor "invisible hand" in Book IV, Chapter II, paragraph IX of The Wealth of Nations.

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Since at equilibrium price Qd = Qs, we have 249-P = P-17 Thus P = 133 and Q = 116

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Hi Joseph,
We do not offer individual homework help. Best of luck in your course.
Cheers,
Meg

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It depends on what "everyone valued oil the same way" means. The video suggests thinking of different people as demanding oil for different uses, but it is not really important that there are different people involved. It is also not essential that the good seem to have different uses (e.g. jet fuel and rubber duckies). What matters is that the first unit of the good purchased provides more value to someone than the second unit and so on.

Economics is about marginal benefits (or "marginal value" or "MV") and marginal costs (or "MC"), and it can get confusing because at different levels of analysis the MV and MC refer to different things. When looking at supply and demand for a single good, the demand curve is said to represent the MV to buyers, while the supply curve represents the MC of providing that good. But both the demand curve and supply curve themselves come about because of individuals comparing their MV to their MC! At every single point along the demand curve, buyers are equating their MV to their MC. For example, if you buy grapes, you may enjoy their sweet taste (the benefit to you), but you are giving up buying apricots instead (your "opportunity cost"). As the price of grapes increases, you have to give up more apricots for every grape you buy, so you decrease the quantity of grapes you demand and substitute toward buying more apricots. This in no way depends on grapes tasting worse to you after eating a bunch of them or on you getting full (how I imagine you might be thinking of different values of uses). If the first apricot is more enjoyable to you than the second (and so on), then as the price of grapes goes up and you have to give up more and more apricots to buy the same number of grapes, your cost of buying those grapes increases, giving you a downward-sloping demand curve for grapes.

It gets a little complicated if you suppose that every good you can buy gives you constant pleasure, but that is a very poor representation of the world, and the result (that you probably should ignore) is still a demand curve that is non-increasing and sometimes decreasing (as you switch between spending all your income on different goods).

Similarly, an upward-sloping supply curve for oil does not require that getting more oil be harder (in the sense of having to drill further down, for instance) because as we put more resources into extracting oil, producers are giving up opportunities to use the capital and skills they are using for that task in producing something else. As we produce more and more oil, we are taking workers away from other tasks, and just imagine how valuable one farmer's crops would be if everyone else in the world were busy extracting oil.

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Demand would be a straight horizontal line, quantity demanded increases at the same price there will be no increase in demand so increase in price. Supply would be a straight vertical line with exactly that much of quantity to have an equilibrium. There is no incentive for supplier to supply more as there is no additional profit (marginal profit) by suppling more oil. So we come to a stagnant.

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