Supply and Demand
Efficiency, Supply and Demand, and Market Clearing The optimizing behavior of producers and consumers leads to a resource allocation that is efficient, in the sense that no one could be made better off without making someone else worse off. Here is a summary of the complete set of problems solved by decentralized markets. 1. How do we know that goods and services could not be better allocated between consumers? That is, how do we know that a consumer could not find another consumer and make a trade that would make them both better off? For this efficiency condition to be met, the marginal rate of substitution between any two goods must be the same for all consumers. Otherwise, there are welfare-enhancing trades to be made. For example, suppose that at the margin you think that one apple is worth three scoops of ice cream, and I think that one apple is worth one scoop of ice cream. In that case, if I were to trade you one apple for two scoops of ice cream, both of us would be better off. Decentralized markets can achieve the efficient allocation because consumers set their marginal rates of substitution equal to relative prices. All consumers face the same set of prices. Each consumer sets marginal utility equal to price. Therefore, for any two goods, the ratios of the marginal utilities will be the same for all consumers. That is, the marginal rate of substitution will be the same for all consumers. 2. How do we know that firms are producing the optimal mix of output? That is, how do we know that a firm could not make the economy better off by producing less of one output and more of another output? For this efficiency condition to be met, the marginal rate of transformation in production must be equal to the marginal rate of substitution in consumption. Suppose that the marginal rate of substitution in consumption is that one apple is worth two scoops of ice cream. In that case, if it were possible to shift production around to increase ice cream production by three while reducing apple production by only one, then that would be more efficient. Decentralized markets can achieve equality between the marginal rate of transformation and the marginal rate of substitution because firms set the marginal rate of transformation between two goods equal to the relative price. All firms face the same set of prices. Each firm sets the marginal rate of product transformation equal to the the relative price of the two outputs. Since the ratio of the relative prices is also the ratio of the marginal utilities, the rate of product transformation is the same as the ratio of the marginal utilities. This says that there is no gain in utility to be had from producing more of one output and less than another. 3. How do we know that the choice of inputs is efficient? That is, how do we know that the economy could not produce more output by changing the mix of inputs used in different products? This efficiency condition states that the economy must use the lowest-cost production methods. If a firm can substitute $4 of one input for $5 of another input and produce the same total output, then that is a more efficient production technique. Decentralized markets can achieve efficiency in production by having firms equate the marginal rate of
Supply and Demand Prices play a central role in the efficiency story. Here is the whole picture. so that it would have a very long line. Firms set the marginal rate of substitution between inputs equal to their relative prices. 4. How are prices determined? Economic theory says that the price of something will tend toward a point where the quantity demanded is equal to the quantity supplied. and also would mean that the marginal cost to society is greater than the additional output's value. Market clearing is based on the famous law of supply and demand. and producers will be stuck with the excess. If the price is too high. If the price were $15. consumers demand less of it and more supply enters the market. If shifting some inputs from my company to your company would yield more valuable output. consumers demand more of it and less supply enters the market. in which firms add input right up to the point where price equals marginal cost. then the current allocation is not efficient. For a particular Saturday night. if the price were as low as $12 a couple. including wage rates. Producers and consumers rely on prices as signals of the cost of making substitution decisions at the margin. the supply will be greater than demand. This price is known as the market-clearing price. To produce more output would mean incurring a loss at the margin. because it "clears away" any excess supply or excess demand. All firms face the same prices for inputs and outputs.com/econ/…/efficiency. That means that it is impossible to switch around inputs in order to produce the same output at lower cost. All firms face the same prices for inputs. as the price of a good goes down. There are five restaurants. Conversely.html
. There are 250 couples willing to go out for dinner. we look at the willingness of restaurants in Wheaton to supply a nice dinner for two and the willingness of couples to dine out in Wheaton. depending on the price of the dinner. not too much and not too little? This efficiency condition states that one firm does not use inputs that could be used more efficiently by another firm. As the price of a good goes up. Price of a Dinner for Two Supply offered by restaurants Demand from consumers $12
arnoldkling. Each firm supplies output until the point where the marginal cost of producting the next unit is equal to its price. To produce less output would mean passing up an opportunity to have higher profits and to increase overall well-being. If the price is too low. everyone would show up at the one restaurant. but the others require higher prices. Here is an example to illustrate the law of supply and demand.1/7/2010
Supply and Demand
substition between inputs to the relative prices of those inputs. each with a seating capacity of 30 couples. Twenty couples would be willing to pay as much as $80. and some consumers will be unable to obtain as much as they would like at that price--we say that supply is rationed. Only 30 lucky couples would get to eat. How do we know that firms use the right level of inputs. but everyone else requires lower prices. demand will exceed supply. Decentralized markets achieve an efficient allocation of inputs across firms by the process of profit maximization. One restaurant is willing to supply a nice dinner for $15 a couple.
com/econ/…/efficiency. if the specialist gets a large market order to buy Freddie Mac stock. The individual gas station does not have control over the impersonal market forces that determine the equilibrium price for gasoline. There might be another order that says. who decides which price will best balance supply and demand. In addition to limit orders. "Sell 1000 shares if the price reaches 60-1/2.70 in order to sell more gasoline. However.75 and consumers cut back on gasoline purchases as a result. the outstanding orders to buy or sell at specific price limits make up what is called the limit order book for the specialist.75 a gallon will not get much business. then a station that charges $1. but will accept a price of 60-1/2 or higher. There might be an order that says. "Buy 800 shares if the price falls to 59-1/2. we say that the market-clearing price is set by the impersonal forces of supply and demand." There might be another other that says. This reduces demand at the other stations. All of the orders to buy and sell Freddie Mac stock are delivered to the specialist. The specialist moves the price of Freddie Mac stock up and down. For an example of a market where a single individual sets the price. and a station that charges $1. That price becomes the new market price for Freddie Mac stock." A market order is an order to buy or sell a specific quantity of stock at the market price--whatever that happens to be. $1. say. she has to figure out how high to set the price in order to trigger enough limit-order sales to fulfill the market order.25 a gallon will get plenty of business but probably lose money. so that
Supply and Demand
$15 $25 $35 $45 $65 $80
30 60 60 90 120 150
200 140 60 50 40 20
At what prices is there excess supply? At what prices is there excess demand? At what price are supply and demand in balance? How many couples will have a nice dinner for two? Who Sets the Market-clearing Price? In economics. "Sell 800 shares if the price reaches 60-3/4. there are "market orders." The seller will not accept a lower price. This type of order is called a limit order.html 3/6
. The individual who sets the price of Freddie Mac stock is called a specialist. in the market for gasoline. At any moment when the exchange is open. sellers set the price. consider the market on the New York Stock Exchange for shares of Freddie Mac stock. individual service stations set the price. For example.50 a gallon for regular unleaded gasoline. even though markets have different institutional structures." All together. that does not mean that sellers control the price. For example. If every station charges $1. This will cause other stations to have more excess capacity. In most goods markets. If most stations charge $1. One station will try to cut the price to $1. by cutting its price to. then every station will find itself with a little bit of excess capacity. the specialist will have a list of orders to buy and sell at a particular price. depending on the pressure that she gets from market orders.65 per gallon. so then another station will try to reduce its excess capacity. That is because the law of supply and demand always operates.
the same as the price set by a higher-price restaurant.
arnoldkling. If it sets a wage that is too low. and their impact is summarized below. so that there is no excess supply or demand. Equilibrium and Disturbances When the price is just right. This is a common pattern with disturbances. In this case. prices move by a lot. oil producing countries occasionally have engineered supply disruptions. it is the buyers (producers) who typically set the price. In the labor market. an unfavorable supply disturbance.html 4/6
. However. We call these events disturbances. the prices of oil products tend to settle down. it will find that 60 customers is more than it can handle. this tends to cause a spike in prices of oil products.50 (assuming that is where supply and demand are in balance). which will reduce the total demand for restaurant meals. a positive demand disturbance. We use the example of the market for restaurant meals in Wheaton. If the wage rate a company sets is too high.com/econ/…/efficiency. with 25 going to each restaurant that charges that price. we say that the market is in equilibrium. For example. such as gasoline. Effect on Equilibrium Price Effect on Equilibrium Quantity Transacted rises
Favorable Supply Meat and wine wholesalers drop their prices falls for supplying restaurants Disturbance Unfavorable Supply Disturbance A fire burns down a restaurant rises
Positive Demand A bunch of people from out of town come to spend the weekend in Wheaton Disturbance Negative Demand Many Wheaton residents lose their jobs because a local employer shuts down Disturbance
Come up with two more examples each of a favorable supply disturbance. In general. there are four types of supply and demand disturbances. the wage rate will be driven to the level that balances supply and demand. and a negative demand disturbance. suppose that a fire burns down one of the low-price restaurants in Wheaton. So they will raise their prices. In the short run. workers are the source of supply and producers are the source of demand.1/7/2010
Supply and Demand
they will reduce their prices. If the other low-priced restaurant keeps its price at $35 a meal. At this price. events are always happening that cause changes to the equilibrium. In the long run. it will lose workers to competing firms. The new equilibrium price might be $45. This is a negative supply disturbance. 50 couples will dine out. The process will continue until the price reaches $1. In the long run. Eventually. In the short run. it will overpay its workers and lose money. Short Run and Long Run In the past. which is called the wage rate. new supply comes in and demand diminishes.
Eventually. there were few professionals with experience in the new language. in the short run people do not change their driving habits much in response to an increase in gasoline prices. When elasticities are high. When the computer language Java first was released in 1996. Next. The elasticity of supply was low--no matter how much you were willing to pay for a Java programmer.000 . the demand for Java programmers shot up. in the oil market. There are more substitution possibilities in the long run than in the short run. The new demand for Java programmers in the short run was given by H = 10. For example. they may drive less and switch to more fuel-efficient cars. it is easy for new firms to get started. the demand for Java programmers was low.40W = 10W
arnoldkling. in the lawn mowing business.000 . which helps to bring on more supply.000 . oil exploration rises when prices are higher. we would expect the elasticity of supply to be very high. In the short run. to $200 an hour and more.html 5/6
. The elasticities of supply and demand usually are higher in the long run than in the short run.com/econ/…/efficiency.40W Suppose that in the short run the supply of Java programmers was given by H = 10W Setting supply equal to demand. In the long run. Overall. The elasticity of demand also was low. In the short run. the wages for Java programmers shot up. The elasticity of supply is the percentage increase in supply in response to a one percent increase in price. the wage rate for Java programmers settled down to something more reasonable. market disturbances tend to affect prices relatively little and quantities transacted relatively a lot. in that companies that wanted to develop in Java were reluctant to substitute alternative languages. suppose that once Java was released officially. A this point. Suppose that before Java became an official language. In the long run. It is also easy for people to get out of the business if demand drops off.40W Supply and demand were equal when W = $40 and H = 400. with these low elasticities. in dollars. The elasticity of supply in an industry will be very large if there is no important resource that is fixed. the supply of Java programmers was given by H = 10W where H is hours of labor and W is the wage rate. In the long run. many companies wanted to try using Java in Web applications.1/7/2010
Supply and Demand
For example. so that we could have a large increase in the demand for lawn mowing service without having a large impact on price. and it is easy to add new capital and labor to the industry. It was given by H = 2. more people learned Java and some companies postponed Java projects to save on expense. competing suppliers cannot increase production much in response to an increase in price. we have 10. The elasticity of demand is the percentage decrease in demand in response to a one percent increase in price.
In the long run. We can summarize the results as follows: Situation Prior to Disturbance Equilibrium Wage Equilibrium Hours $40 400 2000 8000
Short Run After Disturbance $200 Long Run After Disturbance $50
Overall. In the short run. when the elasticities of demand and supply are low.
arnoldkling. so that the equilibrium quantity is 2000 hours of Java programming. The hours of Java programming are now 8000. In the long-run supply schedule. when we solve for W we get $50 for the equilibrium wage rate. not enough programmers have this training. this example illustrates that in the short run. In the short-run supply schedule. each $1 increase in wages increases hours supplied by 160. This means a much higher elasticity of supply. Now. programmers who are earning $40 an hour using other languages will obtain training in Java.1/7/2010
Supply and Demand
Solving for W gives a value of $200 for equilibrium wage rate. however. when elasticities are higher. a disturbance tends to have a large impact on price and a small impact on quantity.html
. each $1 increase in wages only increased hours supplied by 10. so that we have H = 160W In the long run.com/econ/…/efficiency. This means that H is 2000. suppose that the long-run elasticity of supply were higher. Next. the disturbance has a lower impact on price and a larger impact on quantity.