Lecture Outline – Equilibrium: How Supply and Demand Determine Prices1. Equilibrium and the Adjustment Process· What is a surplus? (Note: This is not referring to consumer or producer surplus.) How do market participants (i.e., the buyers and sellers) respond when a surplus ex-ists? What happens to the market price?o Equilibrium Price - price at which quantity demanded equals quantity sup-plied. No incentive for the quantity to changeo Shortage - situation in which quantity demanded is greater than quantity sup-plied at a given price Buyers will offer higher priceso Surplus - situation in which quantity supplied is greater than quantity de-manded. Sellers will offer lower prices· What is a shortage? How do market participants respond when a shortage exists? What happens to the market price?o Quantity demanded is greater than quantity supplied at a given price. Buyers will offer higher prices.· What is the relationship between the quantity demanded and the quantity supplied at the equilibrium price? Why won’t prices change if the market is at the equilibrium price?· Summary: fully explain the process that generates the equilibrium price.o Increase in supply = temporary surplus, market forces drive the rice down and there is an increase in equilibrium quantity has increased and market price hasfallen.1o Decrease in supply = increase in equilibrium price and decrease in equilibriumquantity.o Increase in demand = shortage at original price, competition drives prices up until you reach new equilibrium price where equilibrium price and quantity are both higher.2. Gains from Trade are Maximized at the Equilibrium Price and Quantity· Review: How do we measure the gains from trade for consumers? Producers?· Gains from trade are maximized because:· Supply of goods is bought by buyers with the highest willingness to pay.· The supply of goods is sold by the sellers with the lowest costs.· Between buyers and sellers, there are no unexploited gains from trade or any wastefultrades.· “Total Surplus” = CS + PS. Show that total surplus is equal to the difference betweenthe price the consumer is willing to pay (WTP) and the price the sellers are willing to sell for (WTS). Identify this area for a market that is currently in equilibrium.· What do we mean when we say “unexploited gains from trade?” Use a graph to illus-trate your answer.o Producing less than equilibrium quantityo Unexplioted gains from trade - Consumer surplus that is unrealized and pro-ducer surplus is unrealized. Selling or buying below the equilibrium price and quantity. Top of the triangle is the consumer surplus that is unrealized and the bottom triangle is the producer surplus that is unrealized· What do we mean when we say “resources are wasted?” Use a graph to illustrate your answer.o Producing more than the equilibrium quantity2o Consumers value is less than the actual cost of those resourceso Triangle represents decrease in total surplus. For each transaction, extra cost exceeded the extra benefit.o Minimum price the seller is willing to sell is less than the maximum amount the consumer is willing to pay.· Draw a graph of the market for coffee. Assume the market is in equilibrium. Identifythe equilibrium price, equilibrium quantity, consumer surplus and producer surplus.o Use your demand curve to identify the consumers that can buy the product and those that can’t.o Use your supply curve to identify the sellers that can sell the product and those that can’t.33. Shifting Demand and Supply Curves· Assume the market is originally in equilibrium and then “Demand Increases.” An-swer the following:o Is there a shortage or surplus at the original market price? Shortage at original market price.o How do the market participants respond to the shortage/surplus? What hap-pens to the market price? When the market price changes, what happens to the “quantity demanded” and the “quantity supplied?” Explain why “de-mand” and “supply” do not change. In a shortage, buyers will offer higher prices. If the market price goes up, the quantity demanded decreases. If the market price goes down, demand increases causing more of a shortage. Price changed to not cause a shift in the demand or supply curve.o Compare the new equilibrium price and quantity to the original equilibrium price and quantity. Has the equilibrium price increased/decreased? Has the equilibrium quantity increased/decreased? When demand increases, the new equilibrium price and quantity are greater than the original price and quantity.· Do the same exercise for each of the following scenarios. Draw a separate supply anddemand curve for each and only study one scenario at a time.o Demand Decreases There is a surplus at the original market price. In a surplus, sellers will compete for lower prices. Quantity demanded and equilibrium price will be lower at the new equilibrium point.o Supply Increases4 At original price, there is a surplus. quantity supplied exceeds quantity demanded so firms will compete to lower prices New equilibrium = market price has fallen and quantity has increasedo Supply Decreases Shortage. Consumers will pay more/ Buyers will offer higher prices. Increase in equilibrium price and decrease in equilibrium quantity•Free market maximizes the gains from trade•Free market maximizes producer plus consumer