Does the Equilibrium Model Work

{'type': u'plain'}

♪ [music] ♪

- [Alex] Now that we understand
supply and demand

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

Some of the most impressive
evidence was developed in 1956

by Vernon Smith,
one of the founders

of experimental economics.

Smith actually expected
that his lab experiments,

which I'll describe
in more detail shortly,

he expected that they
would disprove the model.

But he was shocked when time
and time again,

the model predicted
exactly what happened.

Vernon Smith
was awarded the Nobel Prize

in economics in 2002.

Let's take a look at what he did.

Smith's first experiments
were very simple.

He gave a group of students,
called the buyers,

cards similar to these,
which told them the value

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

to pay for the good.

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

which told them their costs,
the minimum price

at which they would be willing
to sell the good.

Notice that the distribution
of buyer values

determines a demand curve.

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

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

the quantity demanded
would increase to 2.

Similarly, the distribution
of cards for the supplier costs

determines a supply curve.

Moreover, because Smith
knew the values

that he distributed,
he could calculate the demand

and the supply curves
and the predicted

equilibrium prices and quantity.

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

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

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

Any time two traders agreed
to a deal, the price

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

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

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

then the seller would earn
the price minus their cost.

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

the price minus their cost.

Similarly, the buyer
would earn their value,

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

for a profit of $1.25.

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

He actually paid the traders
their profits in real money.

So Smith's experimental market
was a real market,

with a real demand curve,
a real supply curve,

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

So what happened?

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

The demand and supply curve
calculated by Smith

are shown here on the left.

The model predicts
an equilibrium price of $2,

and an equilibrium quantity
of 5 or 6 units.

What actually happened
is shown on the right.

The actual market price
quickly went to $2

or very close to it.

The market quantity
quickly went to 5 or 6 units.

Moreover, exactly as predicted
by the model,

the buyers with the highest
values bought,

and the sellers
with the lowest costs sold.

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

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

Another way to test the model
is to examine its predictions

about what happens
when the demand

or supply curves shift.

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

is that you can analyze any change
in market conditions

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

That will produce a prediction
about what will happen.

You should be very familiar
with demand and supply

curve shifts.

Let's run through a few examples.

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

the results
of every possible shift.

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

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

what the model predicts.

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

of laptops.

We all know that technology
has reduced the cost

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

The reduction in the price
of computer chips reduces the cost

of producing laptops.

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

The supply curve moves
to the right and down.

So what does the model predict?

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

and the quantity bought
and sold will increase.

Pretty good prediction.

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

Let's suppose that a hurricane
is approaching.

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

Well, it will increase the demand,
shifting the demand curve up

and to the right.

What does the model predict?

The model predicts
an increased price of generators

and a greater quantity exchanged.

Also, pretty good prediction.

Using the simple but powerful model
of supply and demand,

you can also understand
important events in world history.

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

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

In 1973, for example,
OPEC first flexed its power

by reducing the supply
of oil in an embargo.

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

The big price increase makes sense

because there aren't
many good substitutes for oil

in the short run.

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

in future videos.

The Iranian revolution
and the Iran-Iraq war

were also important supply shocks,
negative supply shocks,

which pushed up the price of oil.

A higher price, however,
encouraged more exploration.

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

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

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

and India increased.

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

For the first time,
millions of people

were able to afford a car,
and that increased

the demand for oil.

You can see that increased demand
continued until this big drop

in the price of oil in 2008, 2009.

What's that?

That, of course, is the demand shock
from the big recession

and the financial crisis,
which hit the United States

and Europe especially hard,
reducing the demand for oil,

at least until the recovery
has started to occur.

What you can see here

is that the simple supply
and demand model

provides a very useful framework
for understanding our world.

Thanks.

- [Narrator] If you want
to test yourself,

click "Practice Questions."

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

♪ [music] ♪