 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, and again these are ways of thinking that can help us make 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. And when things change, how is that going to affect market demand? How's 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 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. And 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're not a portrait of the way the world is 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. So what do we mean by equilibrium? And I just remembered something I learned the other day about where there is 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, so the price is there. P star, often the textbooks say that's the equilibrium price and here's the equilibrium quantity, Q star. So the first thing we want to think about is why do we call that equilibrium? You 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? The quantity supplied and the quantity demanded. 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 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 when 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 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. At that equilibrium, the value to the buyer, to the marginal buyer, equals the cost to the marginal seller. So 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. 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 a 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 and at no other price? In what sense does the market clear? I think of market sort of clearing out at that price. Any guesses to that? Savannah? As many products are demanded are as many that are sold. 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 to sell more at this price? No, they're all gone too. All the sellers who are 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's disappointed. I'd like that term better because there's a kind of a pathology in economics about equilibrium. When we get too textbooky, economists can start to think, well, that equilibrium is somehow the natural state. No, equilibrium 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. So for that reason, I sort of dislike the term equilibrium. I prefer the term market clearing price. Okay, that's the first of three 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 Prize winner, Vernon Smith, who has done experimental economics. In my micro classes, I have 70, 80 students at a time in a computer mediated experiment, and the price zeroes 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 than 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. 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 are a limited number of customers for their products. They are forced by one another to lower their prices, to undercut one another, to be the ones who make the sale. So you have these two forces going in opposite direction. Buyers 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. And the two sort of meet in the middle at what is the equilibrium or market clearing price, where there's no incentive for buyers to offer a higher price because everyone who's 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 toward equilibrium. Now, when supply or demand change, what happens to the market price? And 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 horizontal drilling and hydraulic fracturing known as fracking. With these technologies, people who are producing natural gas and oil 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. 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. Well, 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? Supply. In supply. Is that an increase in supply or a decrease in supply? Increase. Increase in supply. 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 produced. So we'll call that supply curve number two. 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 means, which suggests, if you follow the logic of it, what will happen to the price of natural gas now? What has happened to the price of natural gas? Glory, hallelujah. In the last months, it's fallen dramatically because of this increase in supply. And 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? Increase. Okay. Now, not to beat a dead horse, but to make sure we're clear on things. Why would the supply, sorry, 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. And if you take 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 are probably a number of things we can think of. What comes to mind? Why did the price go down? They were more comfortable taking road trips or just spending more money on gas. Or not spending more money, but because it was lower, they were able to buy more gas. Okay. Are you talking about suppliers or demanders there? Demanders. Demanders. Because they're willing to pay, why are they willing to buy more? Because the price is lower. Okay, good. You've put the cart before the horse that I had in mind. Okay. My question was why did the price go down? You're quite right. But you jumped one step. Why did the price go down? 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. Our price is too hot. Natural gas doesn't do anything. People do things. What people lowered that price? Sellers. Sellers. Sellers. Suppliers. What sort of suppliers and why? Competitive ones. Competitive ones. The people who are able to get the stuff out of the shale at a reasonable 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, and 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 as sort of 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 so they undercut their competitors. Their competitors have to respond and the price decreases. And it decreases until there's no longer any advantage to lowering it further. 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. And boy, there are some serious limitations on it. Remember, it's just a tool of 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 or free shipping. All these things affect markets. Is that represented here? No. Just price and 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, and things are happening over time. And we need to keep in mind the changes that will occur as time passes. One of the main things that 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 a decreased price of natural gas affects anyone's incentives? Does the 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 air some of them. People start using natural gas to replace other fuels. You'll see a natural gas stove instead of a wood stove, perhaps? Sure. Very good. And that will have what effect on the price of natural gas? Price of natural gas. That'll push it up. That'll be an increase in demand. We're using it for stoves. That'll tend to push price back up. A real economy. A kind of a cycle where some technology, like fracking, will lower 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. And that'll change demand and prices will come back up. Another one I had here, for example, on the supply side for natural gases, as that price has come down, a lot of drillers are mothballing the wells. Say, we're not going to put any more money into it. The price back up will reopen this well. But now, we're not going to produce anything from it. And that reduces the new supply coming on. Okay. And that's the end of the formal presentation on supply, demand, and price determination. We'll finish with any questions on that.