Homework 2 Market Equilibrium and Shocks

(a) Why do we single out this intersection and call the price there “equilibrium price”? What makes this price different from other prices, and what do we mean by equilibrium?ANSWER. This special price at the intersection is the market clearing price. It is (usually) the only price at which the quantity demanded of the good is equal to the quantity supplied. We (economists) tend to believe that market forces will push the price for a good toward this clearing price in equilibrium. Why? When an economic system is in equilibrium it means that none of the participants have an incentive to change their behavior. In the type of market environments we are talking about, this means that buyers (demand) have no incentive to change the quantity the buy each period and suppliers have no incentive to change the quantity they produce and sell each period. Our claim is that the market clearing price is the equilibrium price. To see why, imagine that the price is above the market clearing price. Then the quantity suppliers are willing to bring to market exceeds the quantity demanders are willing to purchase. Suppliers will be left with unsold goods at the end of the trading period. Do they have incentive to change their behavior? Yes! Unless they want to pay the cost of keeping large inventories, at the very least they will have incentive to produce less output in the next period. Alternatively, they could continue to produce the same amount and lower the post a lower price so that they sell more. Or they may pursue some blend of these tactics. Either way, the price and quantity in the next period would move in the direction of the market clearing price and associated quantity.