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[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