We have an abstraction for consumer behavior. It's called the demand curve. We have the same for firm or producer behavior. It's called a supply curve. We want to now look at equilibrium in a market where we have such of these constructions. So, let's draw them out. On the horizontal axis we're measuring quantity which we represent by Q. On the vertical axis we're measuring price P. We have a demand curve which we'll call D-0 the original demand curve. We have a supply curve which we'll call S-0. Again, the supply curve represents how producers will respond by putting certain amounts on the market, higher prices up to this range lots more output lower prices not much output. Same for the demand curve, except it's now inverse higher prices, people don't want to buy as much, lower prices people want to by a lot more. Recall what we're trying to discover here if we want to figure out how markets make allocation decisions. Prices are rationing devices. We're going to find a price which basically rations the output across these consumers. So, that price quantity combination. I think most people would expect that at this intersection and that is in fact correct. We'll call this P sub E and we'll call this Q sub E. What we want to do is we want to discover something that economists call equilibrium. It's fundamentally important to our understanding. Equilibrium for us it's a very simple definition. "No tendency for change." You're in a physics class they talk about equilibrium they take a serial bowl and they put a ball bearing at the bottom of it. It's just sitting there. That's an equilibrium. If you bump the bowl the ball bearing away rolling around and rolling around. It's an out of equilibrium situation eventually or rest again at the bottom of that bowl that's equilibrium. No tendency for change. Of course conditional upon some external shock. That's what we're looking for here. Is what's the price that once we arrive at that price there's no tendency for either party to change what they're doing. I wrote down that that's the equilibrium price PE and QE, that's our equilibrium. In order to believe it we have to think about proving it. So, the proof we're going to use, don't get most people when they hear proof they say Oh I don't like to do proofs. Well, this is a simple proof. It's called a proof by contradiction. Suppose, I told you that the price was instead some arbitrary price lower than P sub E. I just arbitrarily picked that P sub one. It's just some arbitrary price less than P sub E. At that price we know that suppliers are willing to put Alpha on the market. But consumers really want to buy Beta. Now, that's not an equilibrium situation. Can consumers want more of the product than what the farmer is willing to put out there at that price. Economists have a name for this not very clever we call it shortage. Shortage is an out of equilibrium situation. Something's got to give. Remember, we talked about the fact that scarcity means there's not enough to go around. This is a situation where that arbitrary price P-1 it's not doing its job. Lots of more people want the product than the product is available. Again, we have an allocation problem here. The market's going to take over and the market is going to do what? Well, the market is going to put upward pressure on that price. As the market puts upward pressure on there price two things are going to happen. One, firms are going to be willing to put more on the market at that higher price. Okay, that's helping to alleviate this shortage issue. Simultaneously, as price goes up, consumers want to buy less. Quantity demanded is falling. Those two things, the fall in quantity demanded and the increase in quantity supplied, are working to alleviate this shortage. As you can see, this upward pressure on price will continue until price gets exactly here. Because any time that price was lower than at P sub E, there's still going to be some excess quantity demanded over quantity supplied. That's an out of equilibrium situation. There's still going to have to be able to pay that price to go up to get just a little bit more quantity supplied and a little bit less quantity demanded to get to that spot. So, that was a proof for us that no price less than PE could be in equilibrium. We have to finish our proof by contradiction by trying a second price. Let's try some arbitrary price P sub two, which is above P sub E and we'll call this point X. We'll call this point Y. X is the quantity demanded at this high price not very much. Y is the quantity supplied at that high price, firms want to put a lot out there that very attractive higher price. This gap, economists call by the name Surplus. That's an out of equilibrium situation. Too much output is being put on the market, not more output that firms [inaudible] consumers want to buy, something's got to given and that gave is that prices are going to have to go down. Firms are going to run sales they're going to get rebates.They're going to do all sorts of things to get rid of this extra product. As that price goes down. Once again, two simultaneous events are happening as price goes down. Some of these consumers are saying, you know I want more of that product after all. Simultaneously as price goes down the firms are cutting back on their own particular production stopping with all the extra inventory going. Both of these are working to get rid of this surplus, and as you can see, that reduction in price will continue until it gets right here. Any price higher than PE you'll have a reduction in excess of what consumers wish to buy, and this little gap it's not very big. But it's still an out of equilibrium situation. So, we've now come to a conclusion that the price will settle where demand equals to supply and that price will clear the market. The amount people voluntarily wish to purchase is equal to what people voluntarily wish to supply. Now, let's take and look at an example using that. Let's think about the market for orange juice. So, we'll draw our axes system. On the vertical axis we have price and the horizontal axis we have the quantity and this is orange juice OJ. We have an initial demand curve, we have an initial supply curve, and that gives us an equilibrium price and quantity. You know it's three bucks a gallon or whatever there's some price and quantity in the market. Now, you get up in the morning for breakfast, you turn your radio on you having a cup of coffee and you hear. Or maybe you're watching on CNN, and you see these videos of orange groves in Florida with one inch thick ice on the oranges. The very first thing you think is oh no, the price of orange juice is going to go up and that's true. We all lived through this many times in this particular product happens every now normally have a freeze that's unusually deep far southern Florida. This stuff happens such as an analyst which we're trying to get. An analyst how would you show this price increase? Well, if neither of these curves move that price isn't going to change. Remember, these curves price wants to go that's the equilibrium wants to go to the intersection of these curves. If neither of the curves move there's not going to be a change in price. But we actually know what's going to happen. What's going to happen is that there's going to be a reduction in the supply curve. Why? Well, all that's left is the Texas and California orange groves. The Florida ones were wiped out by this freeze. So, there's just not as much supply as there was before, the day before. If price tried to stay the same, look what happens. At this price if price doesn't move, then suppliers are only willing to put out Alpha. At that price, consumers say well I still want this amount because that's what I wanted yesterday at that price. My demand curve tells me how much I wish to purchase at that price, out of equilibrium situation. Or orange juice is demanded than can be supplied by the producers given the laws of the Florida crop. What will happen? Well, we know what will happen, price will be pushed up and as price is pushed up. There'll be more orange juice coming out of the remaining suppliers. They'll divert some of their production from sort of just whole oranges to juice. At the same time as price goes up, some consumers will say you know I just don't need an orange juice. At this expense I'll have diets soda for breakfast or just drink water or something like that. This will continue until what point? Well, we know it's going to continue until we find the new equilibrium. Let's call this P1. That's a price high enough that given the smaller supply of the remaining producers in the orange juice industry. The amount they're willing to sell at this high price is exactly equal to the amount consumers wish to purchase, the new equilibrium.
