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♪ [music] ♪

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- [Alex] Now that we understand
supply and demand

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

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Some of the most impressive
evidence was developed in 1956

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by Vernon Smith,
one of the founders

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of experimental economics.

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Smith actually expected
that his lab experiments,

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which I'll describe
in more detail shortly,

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he expected that they
would disprove the model.

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But he was shocked when time
and time again,

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the model predicted
exactly what happened.

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Vernon Smith
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
were very simple.

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He gave a group of students,
called the buyers,

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cards similar to these,
which told them the value

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that they placed on a good,
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
for sellers, giving them cards,

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which told them their costs,
the minimum price

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at which they would be willing
to sell the good.

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Notice that the distribution
of buyer values

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determines a demand curve.

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

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

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the quantity demanded
would increase to 2.

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Similarly, the distribution
of cards for the supplier costs

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determines a supply curve.

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Moreover, because Smith
knew the values

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that he distributed,
he could calculate the demand

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and the supply curves
and the predicted

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equilibrium prices and quantity.

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

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Traders would call out,
"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
to a deal, the price

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

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If a buyer and a seller,
say this buyer and this seller,

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

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then the seller would earn
the price minus their cost.

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

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the price minus their cost.

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Similarly, the buyer
would earn their value,

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$2.25 in this case,
minus the price, $1,

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for a profit of $1.25.

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

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He actually paid the traders
their profits in real money.

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So Smith's experimental market
was a real market,

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with a real demand curve,
a real supply curve,

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

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So what happened?

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

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The demand and supply curve
calculated by Smith

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are shown here on the left.

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The model predicts
an equilibrium price of $2,

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and an equilibrium quantity
of 5 or 6 units.

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What actually happened
is shown on the right.

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The actual market price
quickly went to $2

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or very close to it.

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The market quantity
quickly went to 5 or 6 units.

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Moreover, exactly as predicted
by the model,

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the buyers with the highest
values bought,

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and the sellers
with the lowest costs sold.

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In short, almost all the gains
from trade were exploited,

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

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Another way to test the model
is to examine its predictions

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about what happens
when the demand

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or supply curves shift.

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

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is that you can analyze any change
in market conditions

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using a shift in either the demand
or a shift in the supply curve.

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That will produce a prediction
about what will happen.

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You should be very familiar
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
the logic, not to try to memorize

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the results
of every possible shift.

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If you understand the logic,
then with a few curves,

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you'll always be able to duplicate
and to understand exactly

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what the model predicts.

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Here's the market for laptops,
for the demand and the supply

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of laptops.

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We all know that technology
has reduced the cost

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

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The reduction in the price
of computer chips reduces the cost

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of producing laptops.

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A reduction in costs is modeled
by an increase in supply.

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The supply curve moves
to the right and down.

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So what does the model predict?

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

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and the quantity bought
and sold will increase.

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Pretty good prediction.

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

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Let's suppose that a hurricane
is approaching.

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What will the approaching hurricane
do to the demand for generators?

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Well, it will increase the demand,
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
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
of supply and demand,

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you can also understand
important events in world history.

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

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

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In 1973, for example,
OPEC first flexed its power

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by reducing the supply
of oil in an embargo.

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

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The big price increase makes sense

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because there aren't
many good substitutes for oil

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in the short run.

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

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in future videos.

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The Iranian revolution
and the Iran-Iraq war

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were also important supply shocks,
negative supply shocks,

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which pushed up the price of oil.

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A higher price, however,
encouraged more exploration.

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

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

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Another key event occurred
in the 2000s as growth in China

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and India increased.

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That increased the demand for oil,
pushing up the price.

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For the first time,
millions of people

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were able to afford a car,
and that increased

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the demand for oil.

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You can see that increased demand
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
from the big recession

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and the financial crisis,
which hit the United States

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and Europe especially hard,
reducing the demand for oil,

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at least until the recovery
has started to occur.

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What you can see here

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is that the simple supply
and demand model

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provides a very useful framework
for understanding our world.

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Thanks.

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- [Narrator] If you want
to test yourself,

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click "Practice Questions."

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

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♪ [music] ♪