Download Theorem of Exchange

[98/B2]
The intersection of market demand and supply is
said to determine the equilibrium market price.
Explain why this is so without using the concepts
of ‘surplus’ or ‘shortage’.
(Hints: Think in terms of the theorem of
exchange.)
Buyer’s MUV curve = demand curve
P
• To the buyer,
DD = Buyers’ MUV curve
0
MUV shows the
maximum amount of
other goods one is
willing to give up for
an extra unit
buyer’s MUV curve
= demand curve
Q
Sellers’ MUV curve = supply curve
P
• To the seller,
SS = Seller’s MUV curve
Q
0
MUV shows the
minimum amount of
compensation required
for the seller to forgo
the good
seller’s MUV curve
= supply curve
Example: Exchange of good X
(John & Mary)
P
In the following diagram,
SS
Demand for good X
~Mary’s MUV curve =
Supply of good X
P2
0
~John’s MUV curve =
Q2
The intersection of DD
and
SS
=
the
equilibrium
DD
market price (P2) &
Q quantity (Q2)
P
SS
P2
At Q1,
• John’s MUVx is higher
than Mary’s MUVx
• Both will gain if he buy
some X from Mary at a
price lower than his
MUVx,( i.e.P2) but
higher than Mary’s
MUVx
DD
Q
0
Q1
Q2
• So exchange takes
place:
P
SS = Mary’s MUV curve
P2
~ John (higher-MUV party)
= buyer
~ Mary (lower-MUV party)
= seller
DD = John’s MUV curve
0
Q1
Q
Q2
P
SS = Mary’s MUV curve
P2
• Trade goes on:
~ John will have more
X, so his MUVx
decreases
~ Mary will have fewer
X ,so her MUVx for
the remaining X rises
Trade goes on as long
as their MUVx are not
equal.
DD = John’s MUV curve
0
Q1
Q
Q2
• Equilibrium in
exchange is attained at
point E, when
P
**Buyer’s
SS = Mary’s MUV curve
E
P2
DD = John’s MUV curve
0
Q1
Q
Q2
MUVx =
price = seller’s
MUVx
• At point E,
equilibrium is attained
because all gains from
trade have been
maximized.
• Buyer’s and seller’s
gains from trade:
P
SS = Mary’s MUV curve
G
P2
K
E
DD = John’s MUV curve
0
Q1
Q
Q2
buyer (John):
~ Total expenditure on
Q1Q2
=Q1KEQ2
~ Total use value
=Q1GEQ2
~ His gain from trade
(consumer surplus)
=KGE
• Buyer’s and seller’s
gains from trade
P
G
P2
K
H
0
Q1
Seller (Mary):
~ Total income from
SS = Mary’s MUV curve
selling Q1Q2
=Q1KEQ2
E
~ Minimum compensation
=Q1HEQ2
~ Her gain from trade
DD = John’s MUV curve (producer surplus)
=HKE
Q
Q2