In this lesson, we investigate how prices reach equilibrium and how the market works like an invisible hand coordinating economic activity. At equilibrium, the

In this lesson, we investigate how prices reach equilibrium and how the market works like an invisible hand coordinating economic activity. At equilibrium, the price is stable and gains from trade are maximized. When the price is not at equilibrium, a shortage or a surplus occurs. The equilibrium price is the result of competition amongst buyers and sellers.

Download
Options
Translate Practice Questions

Transcript

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.

Ask a Question

 
Show 1 Answer (Answer provided by Ion Sterpan)
user's picture

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.

Please register or login to answer a question
 
user's picture
 
user's picture

Sorry. I do not see the mistakes . Please shıow me . Thanks billion

If the price is higher than the equilibrium price, demand has to go down all things being equal.

Please register or login to answer a question
 
Please register or login to answer a question
 
user's picture

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

user's picture

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.

Please register or login to answer a question
 
Please register or login to answer a question
 
user's picture

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

Please register or login to answer a question
 
user's picture

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

Please register or login to answer a question
 
user's picture

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.

Please register or login to answer a question
 
user's picture

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

Please register or login to answer a question
Please register or login to ask a question