Exploring Equilibrium

In this video, I want to review just a little bit equilibrium and the adjustment process. Ordinarily, we won't be doing much review in this class since you can always go back and re-watch a video. But in this case I want to emphasize a few points and the material is very important. Let's review but we'll do so quickly.

Okay, here's the equilibrium price, the price where the quantity demanded is equal to the quantity supplied. Why is that the equilibrium price? Because at any other price, forces are put into play which push the price towards the equilibrium price. So at a price of $80 per barrel for example, we would have a surplus. The quantity supplied would be greater than the quantity demanded. Sellers have more goods than they have customers and because of that they had incentive to push the price down towards the equilibrium price.

What if the price is less than the equilibrium price? Well, in this case the quantity demanded will exceed the quantity supply. Buyers will want the good but there won't be enough of the good to go around. In other words, there'll be a shortage because the buyers have to compete to obtain the good, they're going to push the price up again towards the equilibrium price. The equilibrium price is the only stable price. Through a similar kind of argument we can show why this quantity, the quantity such that quantity demanded is equal to quantity supply by this quantity is the equilibrium quantity. Namely, choose any other quantity and let's show that that can't be an equilibrium.

So suppose that the quantity bought and sold was 50 million barrels of oil per day. Notice that for this last barrel of oil which is being bought and sold, buyers are willing to pay up to $90 for that barrel of oil where for one more barrel of oil they're willing to pay $90. On the other hand, sellers are willing to sell that barrel of oil or one more barrel of oil for just $50. So there's a big potential gain from trade here of $40. Indeed, for any quantity below the equilibrium quantity there are unexploited gains from trade.

Now in economics we assume that if you put a potential gain from trade in front of people, they're going to find it. They're going to be able to realize that if only they bought and sold a little bit more, both the buyers and the sellers could be better off. So that's why we assume that the quantity bought and sold will be pushed to the equilibrium quantity because it's only at the equilibrium quantity that all the gains from trade have been exploited.

In a free market, could the quantity bought and sold be greater than the equilibrium quantity? Well not for any significant period of time. Imagine for example that 90 million barrels of oil were being bought and sold. Well, for this last barrel of oil the suppliers are willing to sell that barrel of oil for $90, that's their cost. They require at least $90 to stay in business and sell that barrel of oil.

On the other hand, buyers are willing to pay for that barrel of oil only $50. So there's a lot of waste going on here. Suppliers are spending more to produce the barrel than the barrel is worth to buyers. Indeed at any quantity above the equilibrium quantity there is waste. And we don't expect waste to last very long in this market precisely because if without any intervention suppliers are not going to be able to sell a product to buyers for more than the buyers are willing to pay for that product, for more than the product is worth to the buyers. So for this reason we don't expect waste to last in a free market either. So a free market maximizes the gains from trade. Remember also that the gains from trade can be broken down into two parts, the consumer surplus and of course the producer surplus.

Couple of other points just to finish this off. Notice that the equilibrium price splits the demand curve into two parts. The goods are bought by the buyers who value them the most, the buyers with the highest demands. These are therefore the buyers and these are the non-buyers and goods are sold by the sellers with the lowest costs. So these are the sellers and these with the higher cost are the non-sellers.

Okay, let's summarize this whole thing. Free market maximizes the gains from trade or the gain from trade are maximized at the equilibrium price and quantity. And what this means is that the supply of goods is bought by the buyers with the highest willingness to pay. The supply of goods are sold by the suppliers with the lowest costs. And between the buyers and the sellers, there are no unexploited gains from trade and no wasteful trades. Okay, that concludes our review on to some new material.