Supply and Demand Together 18:30

Having discussed supply and demand separately, Baetjer explains how, together, they describe the way markets operate.

Transcript

Howard Baetjer: All right, here’s the final lecture in the set of three on supply and demand analysis and price determination using supply and demand. What we’ll do in this one is put supply and demand together and look at how we can use these. Again these are ways of thinking that can help us make [00:00:30] sense of a very complex reality, how we can use this idea of this artificial arrangement of a demand curve and artificial arrangement of a supply curve to help us understand why prices tend to where they tend, why the market quantities are what they are. When things change, how is that going to affect market prices and the quantities that change hands.

There are three main elements of this lecture, first of all we’ll think about [00:01:00] what equilibrium is, the famous market equilibrium, what does that mean? What is an equilibrium there? At least two things are. Then we’ll look at why market prices move toward equilibrium as determinedly as they do. I’ll finish by talking about some limitations of supply and demand analysis that it’s very good to keep in mind. We want to remember that supply and demand analysis are a tool for thought, they are not a portrait of the way the world is [00:01:30] and even less the way the world should be. They’re a tool of thought, a limited but wonderful tool of thought.

Okay, first point is that there is a very strong tendency in all free markets toward equilibrium, toward reaching that equilibrium. What do we mean by equilibrium? I just remembered something I learned the other day about where there is [00:02:00] a not very strong movement toward equilibrium and I’ll add that in. But for now, let’s think in our standard analysis. There’s the equilibrium price and quantity. The price is there, P* often the textbooks say, that’s the equilibrium price, and here’s the equilibrium quantity, Q*. The first thing we want to think about is, why do we call that equilibrium? You [00:02:30] hear in that word equilibrium the root of the word equal. What’s equal here? There are two things we could say, probably. What’s equal? At this price what’s equal?

Student: The quantity supplied and the quantity demanded?

Howard Baetjer: Perfect. The quantity supplied equals the quantity demanded. At this price and only at this price, right? That’s the only price at which quantity demanded will equal the quantity [00:03:00] supplied. So that’s one thing that’s meant by equilibrium, quantity demanded equals quantity supplied. What else is equal at that equilibrium point? This is one, I confess, that I haven’t even been teaching until recently because I didn’t see it clearly for myself until recently. It’s much less emphasized but we should emphasize it. It [00:03:30] was last term in fact, it was one of my football players who answered this. I thought, “By God, he’s right.” What else is equal there?

Let me give you a hint. Start at that equilibrium quantity and go upward to the equilibrium point and tell me what … Don’t you have two pieces of information? When you come up from here you hit two curves and the curves are giving you different information, but there’s something equal there. [00:04:00] At that equilibrium the value to the buyer, to the marginal buyer equals the cost to the marginal seller. At that market equilibrium, at that price, that price is simultaneously the cost of producing that, of bringing it to market to that marginal seller and it’s the value of that additional or last unit to the marginal buyer. [00:04:30] There’s a lot we could say about that. That’s a piece of information that emerges out of the market process that cannot be determined in any other way, which is sort of a cool thing.

Okay, I’d like to give you another term for this. In addition to calling it the equilibrium price, actually I prefer the market clearing price. That term, the market clearing price, think about what that may mean. In what sense does the market clear at this price [00:05:00] and at no other price? In what sense does the market clear? Think of market sort of clearing out at that price. Any guesses to that?

Student: As many products are demanded, or as many that are sold.

Howard Baetjer: Yes, okay, good. So are there any disappointed buyers saying, “I would like to buy at that price.”? No, because everyone who wants to buy at that price was able to buy at that price. Are there any sellers left there saying, “Hey, I’d still like [00:05:30] to sell more at this price?” No, they’re all gone too. All the sellers who were willing to sell at that price have been able to sell at that price. So you can think of it as the buyers clear out, the sellers clear out at that price, nobody else, nobody is disappointed. I’d like that term better because there’s a kind of a pathology in economics about equilibrium. When we get too textbook-y economists can start to think well that equilibrium is somehow is the natural state.

No, equilibrium [00:06:00] is not the natural state, things are always in disequilibrium and changing so this theoretical equilibrium is a kind of a theoretical aiming point. It’s where things would settle if nothing changed, but of course everything is always changing so we never really get to equilibrium. For that reason I sort of dislike the term equilibrium, I prefer the term market clearing price.

Okay, that’s the first of three [00:06:30] main points in the lecture, the second is this: why does that price, that equilibrium or market clearing price tend so strongly to prevail? Why in well-organized markets is that almost always the price? Why when I run experiments following the work of Nobel prizewinner Vernon Smith who has done experimental economics … In my micro classes I have 70, 80 students at at time in a computer [00:07:00] mediated experiment and the price zeros right in on there very quickly, why? Why that price and no other? That’s the main thing I want you to be clear on now and rather ask you, I’ll lecture a little bit.

That price tends to prevail so strongly in practice because in a world of scarcity buyers are competing with other buyers. In a kind of an implicit auction. [00:07:30] If you’re a buyer and you’re willing to pay more than the going market price but you can’t get what you want, you’ll bid a little bit more so as to be one of the purchasers. So in that way the buyers are always sort of outbidding one another and pushing price up. Meanwhile the sellers know there is a limited number of customers for their product, they are forced by one another to lower their prices to undercut one another to be the ones who make the sale.

You have these two forces going in opposite directions. Buyers [00:08:00] tending to push price upward, as long as one of the buyers sees some advantage in offering more, and at the same time you have this downward pressure on prices from the sellers, all of whom are willing to lower their prices a little bit as long as they see some advantage in lowering it at all.

The two sort of meet in the middle at what is the equilibrium or market clearing price, where there is no incentive for buyers to offer a higher price because everyone [00:08:30] who is willing to pay that given price is able to buy, and there’s no longer any incentive for the sellers to offer a lower price because at the going price they’re able to sell all they have for sale.

There’s no longer any incentive for price to be pushed up or to be pushed downward by the competition of buyers and buyers or the competition of sellers and sellers. That’s why the prices tend towards equilibrium.

Now when supply or demand change what happens [00:09:00] to the market price? This is really the payoff from the supply and demand analysis because you can anticipate and make sense of how prices change when conditions in the world change. Let me start you with this one. You all probably are familiar with the tremendous change in the market for natural gas and oil in the world that has come as a result of the technological development of [00:09:30] horizontal drilling and hydraulic fracturing, known as fracking. With these technologies people who were producing natural gas and oil can drill way the devil down in the ground, two miles down or something. Then turn the drill bits on their side, how they do it I have no idea, and drill out into these deposits of shale rock, which until this technology was developed was not a resource [00:10:00] but now the ultimate resource, human ingenuity, has developed a way to get natural gas out of these oceans of rock down in the ground. With that technological ability has come the ability to get more natural gas out of the ground at a given cost. Is that a change in supply or demand?

Student: Supply.

Howard Baetjer: In supply. Is that an increase in supply or a decrease in supply?

Students: Increase.

Howard Baetjer: Increase in supply, [00:10:30] so let’s put it on our graph here. We have the first … We say there’s the supply curve number one. Now an increase in supply at any price more natural gas can be produces, so we’ll call that supply curve number two. So this first one becomes ancient history so we forget about that. That’s years ago, that’s what the supply used to be. Today the supply is this new point and we get a new equilibrium, which [00:11:00] suggests if you follow the logic of it, what’ll happen to the price of natural gas now? What has happened to the price of natural gas, glory hallelujah in the last months?

Student: It’s fallen.

Howard Baetjer: It’s fallen dramatically because of this increase in supply. This use of the apparatus of supply and demand can help you understand why. At the same time, what has happened to the quantity of natural gas that is offered for sale on world markets? Increase or decrease?

Students: Increase.

Howard Baetjer: Okay. [00:11:30] Now not to beat a dead horse but to make sure we’re clear on things, why would the price decrease? What actions would people take to bring about this decrease in price from the old equilibrium price to the new equilibrium price. I’ll call it P1. You can see just by looking at the intersections, well the first intersection was at a higher price than the second intersection. If you take [00:12:00] economics from me and tell me the price went down because the lines cross lower on the page, you’ll fail because economics is about human action and human exchange, not lines on a page. What does this represent? What were people doing so as to bring about that lower price, so as to decrease the price? There’re probably a number of things we can think of, what comes to mind? Why did the price go down?

Student: They were more comfortable taking road trips or [00:12:30] just spending more money on gas. Not spending more money but because it was lower they were able to buy more.

Howard Baetjer: Okay. Are you talking about suppliers or demanders there?

Student: Demanders?

Howard Baetjer: Demanders because they’re willing to … Why are they willing to buy more?

Student: Because the price is lower.

Howard Baetjer: Okay, good. You’ve put the cart before the horse that I had in mind.

Student: Okay.

Howard Baetjer: My question was why did the price go … You’re quite right, but you jumped one step. Why did the price go down? [00:13:00] Who lowered it? It’s not going to be these different natural gas molecules in the pipeline saying, “You know our price should be lower now.” Or “Our price is too high.” Natural gas doesn’t do anything, people do things. What people lowered that price?

Student: Sellers.

Student: Suppliers.

Howard Baetjer: Sellers, suppliers. What sort of suppliers and why?

Student: Competitive ones.

Howard Baetjer: Competitive ones, the people who are able to get the stuff out of the shale at a reasonable [00:13:30] cost. Say, “Well we’ve got this additional natural gas, if we’re going to sell it we’re going to have to do it at a lower price. That price is still above our costs so we’ll still make some profit. Let’s undercut the existing sellers, lower the price.” So the price starts to come down and it’ll keep coming down as long as there are sellers who see an advantage to them because they can still make some money by selling a little more at a lower price.

Try not to think of the changes in price [00:14:00] as mechanical consequences of the geometry, think about it as the result of human action. Human beings who see an opportunity, they have an incentive for their own betterment to take an action by lowering the price. In this case it would be the people who’ve brought the new natural gas out of the ground using this terrific new technology. They see that they can sell it at lower than the going price and sell all that they’ve brought out of the ground [00:14:30] so they undercut their competitors. Their competitors have to respond and the price decreases. It decreases until there’s no longer any advantage to lowering it further. Okay?

Now, there was one other thing I wanted to … I’ll get back to that in just a moment. First of all I want to spend a moment on the limitations of supply and demand analysis. Boy, there are some serious limitations on it. Remember it’s just a tool of [00:15:00] thought. The main limitation is that this supply and demand analysis, where I’ve got here price here and quantity, the main limitation is that all it considers is price and quantity. What about location? What about friendliness of service, if we’re thinking about the demand for groceries or something? Hours of operation, friendliness of salespeople, availability of parking, location, packaging, availability of free financing [00:15:30] or free shipping. All these things affect markets. Is that represented here? No, just price in quantity. So keep in mind that real markets are much richer than can be represented on a graph like this.

There’s an even more important limitation, this is a snapshot in time, or each of the curves is a snapshot in time. Things are happening over time and you need to keep in mind the changes that will occur as time passes. [00:16:00] One of the main things that’s the difference between good economists and bad economists is that good economists are always asking, “And then what happens? And then what happens?” How are other people that we haven’t considered so far affected? What incentives will that change for somebody else? Always thinking about the follow-on consequences.

So let’s just start with this decreased price of natural gas. Do you suppose [00:16:30] the decreased price of natural gas affects anyone’s incentives? Does a lower price of natural gas give anybody an incentive to do anything different? And then what happens? What is likely to happen in response to the lower price of natural gas? You could probably think of a thousand things, let’s just … can you name some of them?

Student: People start using natural gas to replace other fuels, you’ll see a natural gas stove instead of a wood stove perhaps.

Howard Baetjer: Sure, very good, [00:17:00] and that will have what effect on the price of natural gas?

Student: That’ll push it up.

Howard Baetjer: That will increase in demand. We’re using it for stoves, that’ll tend to push price back up. You have often in a real economy a kind of a cycle where some technology like fracking will lower a price of things. Well at a lower price it becomes economical to change our technology for heating our house. Use natural gas rather than wood or something. That’ll change demand and prices will come back up. Another one I had here for [00:17:30] example, on the supply side for natural gas is as that prices comes down a lot of drillers are mothballing the wells. Say, “We’re not going to put any more money into it. The price goes back up we’ll reopen this well, but now we’re not going to produce anything from it.” That reduces the new supply coming along.

Okay, and that’s the end of the formal presentation on supply, demand and price determination. We’ll finish with any questions on [00:18:00] that.