No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Five: Supply & Demand: Markets at Work 116 To introduce you to how the market process works to determine an equilibrium price, watch this short video: THE MARKET PROCESS IN ACTION The intersection of supply and demand is actually a point—the only thing we ever “see” in reality is the point at which market transactions take place, identified by P* and Q* in Figure 5.4 . From our previous discussion, we know logically that there is a whole series of points that make up the demand and supply curves, but empirically (real world data), we only see the point of the market transaction—the equilibrium point . This equilibrium price is the market transaction price—the price at which all sellers and buyers are able to sell or purchase all they want. While many economists will gather data over a period of time to try and define a good or services supply/ demand curve, they have to assume ceteris paribus . Ceteris paribus (all other things equal) is an assumption which almost certainly is never valid; things constantly change in the market process including individuals in the market, their knowledge of market conditions, the whole complex of production interrelationships, etc. Yet if things aren’t changing that much, it may nevertheless be a very useful abstraction. But the only data we know is the market transaction revealed at the equilibrium point. Nevertheless, by the logic of the law of supply and demand, we can trace out the implications of economic action. But we should be very skeptical of the false precision of some economic analyses that purport to know far more than they do. In Figure 5.4 we drew arrows to highlight that if the market price differs from the underlying demand or supply curves, there is a tendency to move back towards equilibrium. Let’s look at an example of how this market process works. Assume that the market price is above the equilibrium price; perhaps Apple has just introduced a new version of the iPhone, and their estimate of the price consumers are willing to pay is too high. At that point, as seen in Figure 5.5 , the quantity supplied will exceed the quantity demanded. Inventories will Figure 5.5, Surplus in the Market Process. If the price is greater than the underlying supply and demand fundamentals, the quantity supplied will be greater than the quantity demanded and we will see a surplus (the distance between Q D and Q S bold line above). Suppliers will respond by cutting prices and reducing production, which is reflected in the downward blue arrow. Meanwhile, every drop in price stimulates an additional marginal demander to make a purchase and we travel down the red arrow until we finally reach an equilibrium. P ($) Q (#) Q * P* S D Q D Q S Q S Q D << Surplus P 1 Equilibrium point: a price which would allow all willing sellers to sell and all willing buyers to buy. This equilibrium point is almost always changing, to reflect the changing valuations of consumers and changing opportunity costs of producers. Nevertheless, equilibrium is a point to which the market process continually tends toward. The Equilibrium Price and Quantity