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It is one thing to define equilibrium as we have done, but we should also understand the mechanism for reaching equilibrium. That mechanism is what takes place when the market is not in equilibrium. Consider our hypothetical example. We found that the equilibrium price was 3, but what would happen if, by some chance, price was actually equal to 4? To find out, we need to see how much buyers would demand at that price and how much sellers would offer to sell by inserting 4 into the demand function and into the supply function.
In the case of quantity demanded, we find that
and in the case of quantity supplied,
Clearly, the quantity supplied is greater than the quantity demanded, resulting in a condition called excess supply, as illustrated in Exhibit 8. In our example, there are 5,400 more units of this good offered for sale at a price of 4 than are demanded at that price.Exhibit 8. Excess Supply as a Consequence of Price above Equilibrium Price
Alternatively, if the market was presented with a price that was too low, say 2, then by inserting the price of 2 into Equations 21 and 22, we find that buyers are willing to purchase 5,400 more units than sellers are willing to offer. This result is shown in Exhibit 9.Exhibit 9. Excess Demand as a Consequence of Price below Equilibrium Price
To reach equilibrium, price must adjust until there is neither an excess supply nor an excess demand. That adjustment is called the market mechanism, and it is characterized in the following way: In the case of excess supply, price will fall; in the case of excess demand, price will rise; and in the case of neither excess supply nor excess demand, price will not change.EXAMPLE 7
In the local market for e-books, the aggregate demand is given by the equation
and the aggregate supply by the equation
Determine the amount of excess demand or supply if price is €12.
Determine the amount of excess demand or supply if price is €8.
Insert the presumed price of €12 into the demand function to find Qdeb = 6,360 – 400(12) = 1,560. Insert a price of €12 into the supply function to find Qseb = –1,116 + 300(12) = 2,484. Because quantity supplied is greater than quantity demanded at the €12 price, there is an excess supply equal to 2,484 − 1,560 = 924.
Insert the presumed price of €8 into the demand function to find Qdeb = 6,360 – 400(8) = 3,160. Insert a price of €8 into the supply function to find Qseb = –1,116 + 300(8) = 1,284. Because quantity demanded is greater than quantity supplied at the €8 price, there is an excess demand equal to 3,160 – 1,284 = 1,876.
It might be helpful to consider the following process in our hypothetical market. Suppose that some neutral agent or referee were to display a price for everyone in the market to observe. Then, given that posted price, we would ask each potential buyer to write down on a slip of paper a quantity that he/she would be willing and able to purchase at that price. At the same time, each potential seller would write down a quantity that he/she would be willing to sell at that price. Those pieces of paper would be submitted to the referee who would then calculate the total quantity demanded and the total quantity supplied at that price. If the two sums are identical, the slips of paper would essentially become contracts that would be executed, and the session would be concluded by buyers and sellers actually trading at that price. If there was an excess supply, however, the referee’s job would be to discard the earlier slips of paper and display a price lower than before. Alternatively, if there was an excess demand at the original posted price, the referee would discard the slips of paper and post a higher price. This process would continue until the market reached an equilibrium price at which the quantity willingly offered for sale would just equal the quantity willingly purchased. In this way, the market could tend to move toward equilibrium.2
It is not really necessary for a market to have such a referee for it to operate as if it had one. Experimental economists have simulated markets in which subjects (usually college students) are given an “order” either to purchase or sell some amount of a commodity for a price either no higher (in the case of buyers) or no lower (in the case of sellers) than a set dollar limit. Those limits are distributed among market participants and represent a positively sloped supply curve and a negatively sloped demand curve. The goal for buyers is to buy at a price as far below their limit as possible, and for sellers to sell at a price as far above their limit as possible. The subjects are then allowed to interact in a simulated trading pit by calling out willingness to buy or sell. When two participants come to an agreement on a price, that trade is then reported to a recorder who displays the terms of the deal. Traders are then allowed to observe current prices as they continue to search for a buyer or seller. It has consistently been shown in experiments that this mechanism of open outcry buying and selling (historically, one of the oldest mechanisms used in trading securities) soon converges to the theoretical equilibrium price and quantity inherent in the underlying demand and supply curves used to set the respective sellers’ and buyers’ limit prices.
In our hypothetical example of the gasoline market, the supply curve is positively sloped, and the demand curve is negatively sloped. In that case, the market mechanism would tend to reach an equilibrium whenever price was accidentally “bumped” away from it. We refer to such an equilibrium as being stable because whenever price is disturbed away from equilibrium, it tends to converge back to that equilibrium.3 It is possible, however, for this market mechanism to result in an unstable equilibrium. Suppose that not only the demand curve has a negative slope but also the supply curve has a negatively sloped segment. For example, at some level of wages, a wage increase might cause workers to supply fewer hours of work if satisfaction (“utility”) gained from an extra hour of leisure is greater than the satisfaction obtained from an extra hour of work. Then two possibilities could result, as shown in Panels A and B of Exhibit 10.Exhibit 10. Stability of Equilibria: I
Notice that in Panel A both demand (D) and supply (S) are negatively sloped, but S is steeper and intersects D from above. In this case, if price is above equilibrium, there will be excess supply and the market mechanism will adjust price downward toward equilibrium. In Panel B, D is steeper, which results in S intersecting D from below. In this case, at a price above equilibrium there will be excess demand, and the market mechanism will dictate that price should rise, thus leading away from equilibrium. This equilibrium would be considered unstable. If price were accidentally displayed above the equilibrium price, the mechanism would not cause price to converge to that equilibrium, but instead to soar above it because there would be excess demand at that price. In contrast, if price were accidentally displayed below equilibrium, the mechanism would force price even further below equilibrium because there would be excess supply.
If supply were non-linear, there could be multiple equilibria, as shown in Exhibit 11.Exhibit 11. Stability of Equilibria: II
Note that there are two combinations of price and quantity that would equate quantity supplied and demanded, hence two equilibria. The lower-priced equilibrium is stable, with a positively sloped supply curve and a negatively sloped demand curve. However, the higher-priced equilibrium is unstable because at a price above that equilibrium price there would be excess demand, thus driving price even higher. At a price below that equilibrium there would be excess supply, thus driving price even lower toward the lower-priced equilibrium, which is a stable equilibrium.
Observation suggests that most markets are characterized by stable equilibria. Prices do not often shoot off to infinity or plunge toward zero. However, occasionally we do observe price bubbles occurring in real estate, securities, and other markets. It appears that prices can behave in ways that are not ultimately sustainable in the long run. They may shoot up for a time but ultimately, if they do not reflect actual valuations, the bubble can burst resulting in a “correction” to a new equilibrium.
As a simple approach to understanding bubbles, consider a case in which buyers and sellers base their expectations of future prices on the rate of change of current prices: if price rises, they take that as a sign that price will rise even further. Under these circumstances, if buyers see an increase in price today, they might actually shift the demand curve to the right, desiring to buy more at each price today because they expect to have to pay more in the future. Alternately, if sellers see an increase in today’s price as evidence that price will be even higher in the future, they are reluctant to sell today as they hold out for higher prices tomorrow, and that would shift the supply curve to the left. With a rightward shift in demand and a leftward shift in supply, buyers’ and sellers’ expectations about price are confirmed and the process begins again. This scenario could result in a bubble that would inflate until someone decides that such high prices can no longer be sustained. The bubble bursts and price plunges.