In this part of the lesson, we get to some of the really fun stuff. This is where I will show you how the forces of supply and demand lead to a so-called equilibrium in the market and thereby set the market price. Let's start out by defining what an equilibrium is. The concept of an equilibrium comes from physics specifically classical mechanics. To say something is in equilibrium is to say that the dynamic forces pushing on it cancel each other out. In the context of the analysis of supply and demand, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. To put this another way, the equilibrium price is the price towards which the invisible hand of the market, the dynamic forces of supply and demand, drives the ultimate outcome. Let's illustrate this point with this figure. Note that where the two curves cross, the price is P1 and the quantity is Q1. Now here is my claim, through the forces of supply and demand, the equilibrium price will, in fact, be here where the two curves cross. Let me prove that to you with a couple of experiments. Let's first suppose that the price is above P1 at P2. In this case, firms are willing to supply Q3 at point A on the supply curve. However, consumers demand only Q2 at that price at point B on the demand curve. At this price then, we have a so-called surplus in the market. In this key definition, a surplus exists when there is an excess of the quantity supplied over the quantity demanded. Again, looking at the figure, what is the total surplus here at a price of P2? Did you calculate Q3 minus Q2? That is the difference between the quantity at point B versus the quantity at point A. What do you think happens next in this market because of the surplus? Well, with that surplus of product piling up in their warehouses, firms will start lowering their price and it will keep lowering price right up to the point where the surplus disappears at the intersection of supply and demand and a quantity of Q1. So that's the case where the price is set too high and the market winds up with a surplus. What about the opposite case when the price is set below a point where the supply and demand curves cross? Take a look at this figure where the price is set at P3 instead of P1. In this case, consumers will demand Q3. However, producers will only supply Q2. In this case, we have a shortage. In this key definition, a shortage is defined simply as an excess of the quantity demanded in the market over the quantity supplied. So how big would you calculate the shortage to be in this case? It is simply the difference between Q3 and Q2. What do you think firms are going to do in this shortage situation? Of course, with consumers clamoring for more of their product, firms are likely to raise the price and they will keep on raising that price right up until it reaches the point where demand and supply are once again balanced. At this equilibrium point in the jargon of economics, the market is said to clear. By now you should be getting the hang of just how powerful the dynamic forces of supply and demand are. What we want to do next is illustrate how supply or demand shifts in one market can ripple through to other markets. In fact, this is the essence of economic analysis in a business context. If you can understand these economic ripples and waves, you will become a much better manager. To see why, let's run through this scenario. Suppose a major drought hits key wheat growing areas of the globe like China, India, and Australia and this drought severely damages the wheat harvest. How would you represent this situation in the market for a finished product like bread that relies heavily on wheat as a factor of production? And what do you think will happen in the market for rice, which is a substitute for bread? Please think this one carefully through and have fun with it. As you pause the presentation now and use supply and demand analysis to depict the situation using this figure as your starting point. Of course, when you are ready, resume the presentation and that's one of the nicer things about online education, you are in control. Let's start with the bread market on the left. Because of the drought, bakers will have to pay more for a key factor input namely wheat. This will result in an inward shift of the baker's supply curve for bread. As bakers offer less bread to consumers at any given price, price will rise to P2 and quantity will fall to Q2. Did you get that right? Now, what about the market for rice depicted on the right hand side of the figure? Well, we know that rice is a substitute for bread. Therefore, we can expect consumers to increase their rice consumption as the price of bread rises because of both an income and a substitution effect. This can be depicted in the figure by a rightward and outward shift at the demand curve for rice. At new equilibrium, you can see that both price and quantity rise. So, the bottom line, the bad wheat harvest not only affects price and quantity in the bread market equilibrium, it also drives the outcome in the rice market. So how is this kind of analysis helpful in business? Well, if you are an agricultural commodities trader or perhaps a large Asian restaurant chain that uses a lot of rice, this kind of supply and demand framework can be invaluable in helping you maintain profitability, or perhaps just help you prevent taking a big loss. Let's let the business toon team explain why. I read today in the newspaper that the global price of wheat is going up because of a drought. Yes, that's right. And I learned last night at business school that a rise in the price of wheat is also going to drive up rice prices because of income and substitution effects. So if I'm a commodities trader, I might buy rice futures. That way, if the price of rice does go up as expected, I will make a profit on that trade. That would certainly be an intelligent speculation based on sound micro-economic analysis. But how about if I am a top manager at a large chain of Asian restaurants, won't higher rice prices eat into my company's profits? Yes, higher rice prices will hurt. But you can use a financial instrument called a hedge. A hedge can insulate you from higher rice costs. What exactly is a hedge? It is a tool to protect against price changes in your supply chain, but you will have to wait for a more detailed definition until we come to the class some later on in this course. Okay, but let's go have Asian food tonight before the price might go up. Okay, we've got one more task in this module, and that is to take a bit more of a sophisticated look at how to interpret changes in price and quantity that we observe in the marketplace. Suppose then you go to the store and see that the price of butter has doubled. Has the demand for butter risen? This might happen, for example, because a new study comes out that says butter is actually good for your heart rather than a contributor to heart disease. Fat chance there, pun intended. Or alternatively, maybe butter has become more expensive because of the supply side effect. For example, a rise in feed prices for cows might trigger an inward supply side shift. So what do you think, is the rise in prices likely to be caused by a demand side or supply side effect? Well, this is kind of a trick question because without more information, you simply can't know. It could be either a supply or demand effect or even both effects simultaneously. In fact, economists in businesses must deal with this kind of fundamental question all the time. Specifically, when prices or quantities change in a market, does the situation reflect a fundamental change in demand or supply? Here's a key tip to help you sort this out. Sometimes in simple situations by looking at price and quantity simultaneously you may find the clue to solving the mystery. For example, a rise in the price of bread accompanied by a decrease in quantity suggests that the supply curve has shifted inward to the left. In contrast, a rise in price accompanied by increasing quantity indicates that the demand curve has probably shifted outward into the right. Got it? Okay. Then take a rest and when you're ready, just move on to the next module to study the scintillating topic of price floors and price ceilings.
