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- [Alex] Now that we understand[br]supply and demand

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and the equilibrium process,[br]we can ask, "Does the model work?"

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Some of the most impressive[br]evidence was developed in 1956

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by Vernon Smith,[br]one of the founders

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of experimental economics.

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Smith actually expected[br]that his lab experiments,

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which I'll describe[br]in more detail shortly,

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he expected that they[br]would disprove the model.

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But he was shocked when time[br]and time again,

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the model predicted[br]exactly what happened.

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Vernon Smith[br]was awarded the Nobel Prize

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in economics in 2002.

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Let's take a look at what he did.

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Smith's first experiments[br]were very simple.

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He gave a group of students,[br]called the buyers,

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cards similar to these,[br]which told them the value

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that they placed on a good,[br]the maximum they would be willing

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to pay for the good.

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He then did the same thing[br]for sellers, giving them cards,

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which told them their costs,[br]the minimum price

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at which they would be willing[br]to sell the good.

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Notice that the distribution[br]of buyer values

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determines a demand curve.

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At a price of $3.50, for example,[br]the quantity demanded would be 1.

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But as the price falls[br]to let's say just below $3,

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the quantity demanded[br]would increase to 2.

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Similarly, the distribution[br]of cards for the supplier costs

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determines a supply curve.

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Moreover, because Smith[br]knew the values

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that he distributed,[br]he could calculate the demand

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and the supply curves[br]and the predicted

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equilibrium prices and quantity.

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Smith let the students make trades[br]in a double oral auction.

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Traders would call out,[br]"I'll sell for $2,"

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"I'll buy for $1," and so forth.

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Any time two traders agreed[br]to a deal, the price

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would be called out,[br]"Sale at a price of $1.50."

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If a buyer and a seller,[br]say this buyer and this seller,

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agree to make a trade[br]at let's say a price of $1,

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then the seller would earn[br]the price minus their cost.

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In this case, the seller[br]would earn a profit of 25 cents,

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the price minus their cost.

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Similarly, the buyer[br]would earn their value,

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$2.25 in this case,[br]minus the price, $1,

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for a profit of $1.25.

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Now, here was another key[br]to Smith's market.

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He actually paid the traders[br]their profits in real money.

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So Smith's experimental market[br]was a real market,

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with a real demand curve,[br]a real supply curve,

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and traders who had an incentive[br]to maximize the gains from trade.

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So what happened?

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Here are the results from one[br]of Smith's remarkable experiments.

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The demand and supply curve[br]calculated by Smith

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are shown here on the left.

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The model predicts[br]an equilibrium price of $2,

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and an equilibrium quantity[br]of 5 or 6 units.

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What actually happened[br]is shown on the right.

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The actual market price[br]quickly went to $2

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or very close to it.

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The market quantity[br]quickly went to 5 or 6 units.

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Moreover, exactly as predicted[br]by the model,

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the buyers with the highest[br]values bought,

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and the sellers[br]with the lowest costs sold.

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In short, almost all the gains[br]from trade were exploited,

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leading to near maximum efficiency,[br]exactly as predicted by the model.

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Another way to test the model[br]is to examine its predictions

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about what happens[br]when the demand

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or supply curves shift.

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In fact, what makes the demand[br]and supply curve model so powerful

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is that you can analyze any change[br]in market conditions

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using a shift in either the demand[br]or a shift in the supply curve.

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That will produce a prediction[br]about what will happen.

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You should be very familiar[br]with demand and supply

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curve shifts.

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Let's run through a few examples.

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The key here is to understand[br]the logic, not to try to memorize

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the results[br]of every possible shift.

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If you understand the logic,[br]then with a few curves,

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you'll always be able to duplicate[br]and to understand exactly

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what the model predicts.

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Here's the market for laptops,[br]for the demand and the supply

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of laptops.

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We all know that technology[br]has reduced the cost

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of computer chips --[br]Moore's Law and all that.

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The reduction in the price[br]of computer chips reduces the cost

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of producing laptops.

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A reduction in costs is modeled[br]by an increase in supply.

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The supply curve moves[br]to the right and down.

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So what does the model predict?

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The model predicts, therefore,[br]that the price of laptops will fall

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and the quantity bought[br]and sold will increase.

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Pretty good prediction.

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Now, let's look at the market[br]for portable generators.

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Let's suppose that a hurricane[br]is approaching.

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What will the approaching hurricane[br]do to the demand for generators?

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Well, it will increase the demand,[br]shifting the demand curve up

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and to the right.

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What does the model predict?

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The model predicts[br]an increased price of generators

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and a greater quantity exchanged.

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Also, pretty good prediction.

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Using the simple but powerful model[br]of supply and demand,

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you can also understand[br]important events in world history.

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Let's look at the price of oil[br]over the last 50 or 60 years.

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Here's the price of oil since 1960.[br]We can see a few key events.

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In 1973, for example,[br]OPEC first flexed its power

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by reducing the supply[br]of oil in an embargo.

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What you can see is that the price[br]of oil skyrocketed.

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The big price increase makes sense

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because there aren't[br]many good substitutes for oil

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in the short run.

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We're gonna be talking more[br]about the elasticity of demand

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in future videos.

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The Iranian revolution[br]and the Iran-Iraq war

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were also important supply shocks,[br]negative supply shocks,

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which pushed up the price of oil.

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A higher price, however,[br]encouraged more exploration.

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And as additional sources of oil[br]were discovered in the North Sea

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and in Mexico,[br]the price of oil began to fall.

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Another key event occurred[br]in the 2000s as growth in China

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and India increased.

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That increased the demand for oil,[br]pushing up the price.

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For the first time,[br]millions of people

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were able to afford a car,[br]and that increased

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the demand for oil.

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You can see that increased demand[br]continued until this big drop

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in the price of oil in 2008, 2009.

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What's that?

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That, of course, is the demand shock[br]from the big recession

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and the financial crisis,[br]which hit the United States

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and Europe especially hard,[br]reducing the demand for oil,

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at least until the recovery[br]has started to occur.

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What you can see here

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is that the simple supply[br]and demand model

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provides a very useful framework[br]for understanding our world.

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Thanks.

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- [Narrator] If you want[br]to test yourself,

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click "Practice Questions."

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Or, if you're ready to move on,[br]just click "Next Video."

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