Does the Equilibrium Model Work

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- [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.

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