Does the Equilibrium Model Work
-
0:09 - 0:15- Now that we understand supply and demand
and the equilibrium process, we can ask, -
0:15 - 0:26"Does the model work?" Some of the most
impressive evidence was developed in 1956 -
0:26 - 0:32by Vernon Smith, one of the founders of
experimental economics. Smith actually -
0:32 - 0:37expected that his lab experiments, which
I'll describe in more details shortly, he -
0:37 - 0:42expected that they would disprove the
model, but he was shocked when time and -
0:42 - 0:48time again, the model predicted exactly
what happened. Vernon Smith was awarded -
0:48 - 0:55the Nobel Prize in economics in 2002.
Let's take a look at what he did. Smith's -
0:55 - 0:59first experiments were very simple.
He gave a group of students, called the -
0:59 - 1:06buyers, cards similar to these, which told
them the value that they placed on a good, -
1:06 - 1:11the maximum they would be willing to pay
for their good. He then did the same thing -
1:11 - 1:17for sellers, given them cards, which told
them their cost, the minimum price at -
1:17 - 1:21which they would be willing to sell the
good. Notice that the distribution of -
1:21 - 1:27buyer values determines a demand curve. At
a price of 3.50, for example, the quantity -
1:27 - 1:34demanded would be one. But as the price
falls to let's say just below $3, the -
1:34 - 1:41quantity demanded would increase to two.
Similarly, the distribution of cards for -
1:41 - 1:47the supplier cost determines a supply
curve. Moreover, because Smith knew the -
1:47 - 1:53values that he distributed, he could
calculate the demand and the supply curves -
1:53 - 1:58and the predicted equilibrium prices and
quantity. Smith let the students make -
1:59 - 2:05trades in a double oral auction.
Traders would call out, "I'll sell for $2. -
2:05 - 2:10I'll buy for $1," and so forth. Any time
two traders agree to a deal, the price -
2:10 - 2:16would be called out, "Sell it at a price
of $1.50." If a buyer and a seller, say -
2:16 - 2:23this buyer and this seller, agree to make
a trade at let's say a price of $1, then -
2:23 - 2:29the seller would earn the price minus
their cost. In this case, the seller would -
2:29 - 2:36earn a profit of 25 cents, the price minus
their cost. Similarly, the buyer would -
2:36 - 2:46earn their value, 2.25 in this case, minus
the price, $1, for a profit of $1.25. Now, -
2:47 - 2:53here was another key to Smith's market. He
actually paid the traders their profits in -
2:53 - 2:59real money. So Smith's experimental market
was a real market, with a real demand -
2:59 - 3:06curve, a real supply curve, and traders
who had an incentive to maximize the gains -
3:06 - 3:12from trade. So what happened? Here are the
results from one of Smith's remarkable -
3:12 - 3:17experiments. The demand and supply curve
calculated by Smith are shown here on the -
3:18 - 3:25left. The model predicts an equilibrium
price of $2 and an equilibrium quantity of -
3:25 - 3:32five or six units. What actually happened
is shown on the right. The actual market -
3:33 - 3:38price quickly went to $2 or very close to
it. The market quantity quickly went to -
3:38 - 3:45five or six units. Moreover, exactly as
predicted by the model, the buyers with -
3:45 - 3:52the highest values bought and the sellers
with the lowest cost sold. In short, -
3:52 - 3:57almost all the gains from trade were
exploited, leading to near maximum -
3:57 - 4:01efficiency, exactly as predicted
by the model. -
4:01 - 4:05Another way to test the model is to
examine its predictions about what happens -
4:05 - 4:11when the demand or supply curves shift. In
fact, what makes the demand and supply -
4:11 - 4:17curve model so powerful is that you can
analyze any change in market conditions -
4:17 - 4:23using a shift in either the demand or a
shift in the supply curve. That will -
4:23 - 4:28produce a prediction about what will
happen. You should be very familiar with -
4:28 - 4:33demand and supply curve shifts. Let's run
through a few examples. The key here is to -
4:33 - 4:39understand the logic, not to try to
memorize the results of every possible -
4:39 - 4:45shift. If you understand the logic, and
with a few curves, you'll always be able -
4:45 - 4:51to duplicate and to understand exactly
what the model predicts. Here's the market -
4:51 - 4:56for laptops for the demand and the supply
of laptops. We all know that technology -
4:56 - 5:02has reduced the cost of computer chips,
Moore's Law and all that. The reduction in -
5:02 - 5:07the price of computer chips reduces the
cost of producing laptops. A reduction in -
5:07 - 5:13cost is modeled by an increase in supply.
The supply curve moves to the right and -
5:13 - 5:19down. So what does the model predict? The
model predicts therefore that the price of -
5:19 - 5:24laptops will fall and the quantity bought
and sold will increase. Pretty good -
5:24 - 5:30prediction. Now, let's look at the market
for portable generators. Let's suppose -
5:30 - 5:35that a hurricane is approaching. What will
the approaching hurricane do to the demand -
5:35 - 5:41for generators? Well, it will increase the
demand, shifting the demand curve up and -
5:41 - 5:47to the right. What does the model predict?
The model predicts an increased price of -
5:48 - 5:54generators and a greater quantity
exchanged. Also, pretty good prediction. -
5:55 - 6:00Using the simple but powerful model of
supply and demand, you can also understand -
6:00 - 6:04important events in world history.
Let's look at the price of oil over the -
6:04 - 6:11last 50 or 60 years. Here's the price of
oil since 1960. We can see a few key -
6:11 - 6:18events. In 1973, for example, OPEC first
flexed its power by reducing the supply of -
6:19 - 6:24oil in an embargo. What you can see is
that the price of oil skyrocketed. The big -
6:25 - 6:29price increase makes sense because there
aren't many good substitutes for oil in -
6:30 - 6:35the short run. We're gonna be talking more
about the elasticity of demand in future -
6:36 - 6:40videos. The Iranian revolution and the
Iran-Iraq war were also important supply -
6:41 - 6:46shocks, negative supply shocks, which
pushed up the price of oil. A higher -
6:46 - 6:50price, however, encouraged more
exploration. And as additional source of -
6:50 - 6:57oil were discovered in the North Sea in
Mexico, the price of oil began to fall. -
6:57 - 7:03Another key event occurred in the 2000s as
growth in China and India increased. That -
7:03 - 7:09increased the demand for oil, pushing up
the price. For the first time, millions of -
7:09 - 7:15people were able to afford a car, and that
increased the demand for oil. You can see -
7:15 - 7:19that increased demand continued until this
big drop in the price of oil in 2008, -
7:19 - 7:262009. What's that? That, of course, is the
demand shock from the big recession in the -
7:26 - 7:31financial crisis, which hit the United
States and Europe especially hard, -
7:31 - 7:36reducing the demand for oil, at least
until the recovery has started to occur. -
7:36 - 7:41What you can see here is that the simple
supply and demand model provides a very -
7:41 - 7:46useful framework for understanding
our world. Thanks. -
7:48 - 7:51- If you want to test yourself, click
Practice Questions -
7:52 - 7:56Or if you're ready to move on,
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- Title:
- Does the Equilibrium Model Work
- Description:
-
{'type': u'plain'}
- Video Language:
- English
- Team:
- Marginal Revolution University
- Project:
- Micro
- Duration:
- 08:01
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