Notes on Equilibrium

Now work through 3) Equilibrium in Demand, Supply, and Equilibrium Tutorial by Frieda Mendelsohn.

We are now ready to put the demand for coffee and the supply of coffee together. Let’s try some examples:

Suppose the National Institutes of Health announces the results of a new study proving that green tea has no health benefits.

  1. Some people who had been drinking green tea will switch back to coffee (note that it doesn’t require that all do so);
  2. The total demand for coffee increases (note: the quantity demanded of coffee at each price increases);
  3. At the current price, consumers want to buy more coffee than suppliers are willing to sell;
  4. Some consumers will offer higher prices to sellers to obtain the coffee they want (and other consumers will now decide that coffee is too expensive).
  5. The supply of coffee does not change; instead, the change in price moves the market along the supply curve (encourages suppliers to produce more coffee or shift the sale of coffee to this market from some other market).

Resource allocation result: Through the interaction of buyers and sellers, the price rises to reflect buyers’ increased willingness to buy coffee and the sellers respond by making more coffee available to them.

Suppose that there’s a crop failure in Brazil (ignore, for the moment, the different species of coffees): this is a decrease in the supply of coffee.

  1. Consumers still want the same amount of coffee they usually drink – there is no change in their demand;
  2. Suppliers don’t have enough coffee to go around at the current price and some consumers have trouble finding it;
  3. Consumers bid up the price of coffee until there’s enough to go around;
  4. There is no change in demand; instead, consumers have moved along their demand curve to find the price which allocates the smaller crop to those who want it and are able and willing to pay more.

Resource allocation result: Through the interaction of buyers and sellers, the price rises to reflect the reduced amount of coffee available; buyers are now willing to buy less coffee but all buyers who are willing to buy coffee at the new price can obtain all of the coffee they want to buy. The coffee has been allocated to those for whom it has the highest value.

Excess Demand
Excess demand means that, at the given price, the quantity that consumers are willing to buy is greater than the quantity that sellers are willing to sell. How can this last for any length of time? There is only one way that this can happen — something is keeping the price too low. Consumers are thrilled – the price is low enough so that everyone can afford great coffee! But sellers look at the price and decide not to supply to the market. You can recognize excess demand in the marketplace as empty shelves and consumers unable to buy all they want (and are able to pay for).

Wait, you say! What else can they do with the coffee except send it to the marketplace? If they don’t sell it, they won’t make any money at all. Well… the likelihood is that the market price is not too low in a market somewhere else in the world. Generally, a price that is too low to clear the market is held there by government action (e.g., price or rent control) so it’s likely to be a regional problem rather than a global problem.

Remember: What could they do instead?

Excess supply
If excess demand occurs when the price is too low, then excess supply must occur when the price is too high: the quantity of coffee that sellers are willing to bring to the marketplace is greater than the quantity that consumers are willing to buy. Again, the only way that this situation is likely to continue for long is if government action supports the price.

The rationale for government doing this is generally that farmers need a living wage — can you think of how economists would respond to this? You can recognize excess supply by seeing the product build up (think agriculture policy and grain silos).

Equilibrium
If excess demand means the price is too low and must, therefore, be bid higher; and if excess supply means the price is too high and must be allowed to fall; then equilibrium is clearly the resting point where the price is just right.

You can recognize the equilibrium point because the market is “cleared” — while the shelves may not be empty, they have only the amount of product on them that the sellers planned as a safety stock. Product isn’t piling up (excess supply) and consumers aren’t screaming for more (excess demand).

Putting these concepts to work: coffee

Think about your coffee drinking. You might drink it because

  • caffeine gets you going in the morning
  • caffeine keeps you awake when you need it
  • coffee tastes good
  • Starbuck’s coffee tastes good
  • Starbuck’s mochachino is the only coffee worth drinking
  • How might you use economic concepts to explain your demand for coffee?