Now let's get to the really fun stuff, showing how the forces of supply and demand lead to a so-called equilibrium in the market and thereby set the market price. And let's start out by defining what an equilibrium is. The concept itself 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 supply and demand analysis, equilibrium means that the upward pressure on price is exactly offset by the downward pressure on price. The equilibrium price is the price towards which the invisible hand drives the market. Let's illustrate this point with this figure. Here we marry the supply and demand curves that we developed in our corn flakes example. Note that where the two curves cross, the price is 3 and the quantity is 12. Now, my claim is that through the forces of supply and demand, this is where the equilibrium price is going to be. And let me prove that to you with a couple of experiments. Let's first suppose that the price is 5 instead of 3. In this case, firms are willing to supply 18 million boxes of corn flakes, but consumers demand only 9 million at that price. At this price then, we have a surplus in the market. An excess of quantities supplied over quantity demanded. This surplus by the way, is equal to point b in the curve minus point a, or 9 million boxes. So what you think happens next? You guessed it. With all those extra boxes of corn flakes piling up in their warehouses, firms will start lowering their price, and they will keep lowering it right up until a point where the surplus disappears at point C in the graph. Now, how about instead of the price being too high, it starts out too low in the cornflakes market, say at 2 instead of 3. In this case, consumer will demands 15 million boxes, but firms will be willing to supply only 7 million boxes. In this case, we have a shortage of 8 million boxes. A excess of quantity demanded over quantity supplied. So what you think firms are going to do in this situation? With consumers clamoring for their product, the best guess is that they will raise the price and they will keep on raising the price right up until it reaches the point where demand and supply are in balance in the market clears. By now you should be getting to see just how powerful the apparatus of supply and demand is in helping us to predict changes in our market system. For example, suppose a drought in the Midwest severely damages the wheat harvest. Since wheat is a key ingredient of bread, this will shift the supply curve for bread to the left. This is illustrated in this figure. Where the bread supply curve has shifted from S S to S prime S prime. Note however that the demand curve has not shifted. This is because people have the same desire for their daily sandwich whether the harvest is good or bad. So what do you think happens next? Well, the bad harvest causes bakers to produce less bread at the old price. So quantity demanded exceeds quantity supplied. The price of bread therefore rises encouraging production and thereby raising quantity supplied. This simultaneously discourages consumption and lowers quantity demanded. And the price continues to rise until at the new equilibrium price, the amounts demanded and supplied are once again equal. This new equilibrium is founded E double prime. The intersection of the new supply curve, S prime S prime and the original demand curve. Thus a bad harvest or any leftward shift at the supply curve, raises prices and by the law of downward slope in demand, lowers quantity demanded. In contrast, suppose that a new baking technology lowers costs and therefore increases supply. This means the supply curve shifts down in to the right. Try drawing this curve, and you see why the equilibrium price is lower and the equilibrium quantity higher at E double prime. This table summarizes the effect of price and quantity of different demand and supply shifts. Try and replace the question marks with up or down arrows. Does your table look like this?
