- [Instructor] In this video, we're gonna start talking about markets. We'll start from scratch with one buyer and one seller and eventually build up to a simulation of a market with many buyers and many sellers. And then, hey, why not, we'll risk getting a bit political by examining the market we've built to understand some basic arguments for why markets are good on their own and some arguments for why they sometimes need intervention.
Okay, in the market we're going to build, the blue blobs will offer to sell, what else, rockets. And the orange blobs will buy the rockets, assuming the price is right. A seller blob places a certain value on a rocket which we'll show with this vertical bar.
This value comes from some combination of the cost of obtaining the rocket in the first place and perhaps how much the seller would enjoy keeping the rocket for itself. It would gladly sell a rocket for a price above this value if it can, but at a price below this number, it would prefer just to keep the rocket. This blue bar effectively sets a minimum price for the rocket.
And similarly, a buyer has a maximum price of what it would be willing to pay. It would love to pay less if possible, but it's just not worth it to pay more. If this buyer and sell get together, they could end up making a transaction for any price between this maximum and minimum and they'd both be pretty happy about it.
To put some concrete numbers on this, let's say the buyer's maximum is $40 and the seller's minimum is $20. And then let's say they end up transacting in the middle at $30. The rocket is worth $40 to the buyer, but it only had to pay $30, so it comes out ahead in the interaction by $10.
The seller would have sold for as little as $20, but it got $30, 10 more than it needed, so it was worthwhile for both of them. If you wanted to quantify how worthwhile it was, you could say that they each gained $10 of value. To toss some economics lingo at you, this is called surplus.
It's a measure of how worthwhile the trade was. And it's worth pausing here to appreciate this. The concept of value is a bit slippery and subjective, but we just figured a way to quantify it by comparing possible alternatives.
Anyway, these blobs have developed a wonderful business relationship, but now what happens if we add another buyer? This buyer is going to have a different price limit than the other buyer. Let's just say it's a little bit lower, so this second orange blob likes rockets, but a little bit less than that first one did or maybe it has a bit less money, or maybe it has other things it would like to spend its money on.
Whatever the reasons deep in its heart, it's willing to pay just a little bit less than the other buyer. And we're actually gonna simulate this situation to see what happens, so let's go over the simulation rules. Each day the sellers will set up shop, offering a rocket for a certain price, and then in a randomly determined order, the buyers will approach the sellers and buy the rockets if they're satisfied with the price.
The buyers and sellers have their absolute limits, but each day, they'll have some different price in mind that they expect to get. Just like real people, they want to get a good deal. For example, our original buyer is theoretically willing to pay up to $40, but it's gotten used to the price of $30, so if this seller suddenly demanded 35, the buyer wouldn't accept that price, at least not right away.
The day continues until every rocket has been sold or until all the remaining buyers have refused to buy from all the remaining sellers. Though, at the end of the day, they are willing to accept a slightly worse price if they have to, but only slightly. And then after the day ends, the blobs take some time to reflect and adjust their expected prices for the next day.
They get more aggressive with their prices if they made a transaction, and they get a little bit less aggressive if they didn't. Essentially, just like real people, the blobs are trying to get the best price they can, adjusting their expectations as they go. Now that we have all the rules for this simulation, let's start by seeing what happens with just our original buyer and seller.
And we'll keep track of the price limits, expected prices, and the surplus each day over here. Okay, so with just these two, nothing really happens. They keep trying to get a better price, but since there's just the two of them, neither of them has an advantage and they keep setting the same price over and over again.
But now, what if we add that second buyer with the lower maximum price? What do you expect to happen? The price of rockets ends up creeping upward.
Every single day, at least one of the buyers doesn't get to take home a rocket, so that buyer ends up raising the price it's willing to pay, but the sellers almost always able to make a deal with one of the buyers, so they also end up raising their expected price. This continues until the price is at or above one of the buyer's absolute limits. And after that, it's basically back to the one-on-one situation.
The fact that the two buyers are competing for the one rocket results in them paying more. And an important thing to notice here is that most of the surplus generated with each transaction ends up going to the seller. When the buyers compete, it's good for the sellers.
All right, so what if we have a new situation where we add two more sellers, so now we have three total. And just like with the buyers, the sellers vary in how much they fundamentally value the rockets. One of these two new sellers with have a higher price limit than the original seller.
Maybe it's just not as efficient in making or obtaining the rockets. And the other sell will be the opposite with a lower price limit. Now that there's three sellers and two buyers, what do you think will happen here?
Okay, you might have seen this coming. Now that we have three sellers and only two buyers, there's always at least one seller who can't make a sale, so they end up lowering their asking price. And the two buyers can almost always make a deal, so they also end up lowering their price.
And eventually, the price fallss far enough to where one of the sellers just can't keep competing. Here again, it's important to notice where the surplus is going. This time, the buyers get most of the surplus.
When sellers compete, it's good for buyers. Now comes an interesting question. If we add one more buyer which has a lower maximum price than the other two, so we now have three of each, what do you expect to happen?
And actually, before we hit go here, there's starting to kind of be a lot of blobs, so let's reorganize things a bit and show the buyers and sellers separately. All right. So the interesting thing here is that even though there are three sellers and three buyers, we end up in a situation where only two rockets are sold each day.
This is because not every pair of buyers and sellers can make a deal. The buyer with the lowest price limit and the seller with the highest price limit could never be satisfied by the same price. If we artificially set the price up high, all three sellers will be in the game, but only two or fewer buyers will be willing to buy, so the three sellers will keep competing until the price gets too low for one of them and then there will be two buyers and two sellers.
On the other hand, if we set the price low, all three buyers will then compete until the price gets too high for one of them. The price of the rockets will be balanced or in equilibrium at some price where the number of buyers and sellers willing to transact at that price is equal. To put this in economics language, it's the price where the quantity supplied is equal to the quantity demanded.
This same phenomenon happens with lots and lots of buyers and sellers. By mixing randomly and adjusting their prices based on their own experience, the blobs together end up settling on a stable price and quantity. And when we talk about large markets with thousands or millions or more participants, it's more convenient to just draw curves to show the price limits of the buyers and sellers.
The curve showing the price limit of the sellers is called the supply curve. The curve showing the price limits of the buyers is called the demand curve. An equilibrium price and quantity is where the two curves cross.
Okay, so we've hit a milestone. We've built a market and saw how supply and demand combine to determine an equilibrium price and quantity. Now that we have this market model, we can start to get down to what economics is really about, which is arguing about what the model means for how we should organize things in the real world.
This is an everlasting discussion and the specifics are different depending on which market or industry in the real world they're talking about, so I'm not about to try to make any sweeping conclusions here. But it is worth outlining the broad-strokes arguments at play so we don't have to start from scratch every time we wanna argue about economics. So what's good about this market model we made?
Well, first, as we already talked about, it organizes itself, so that's pretty nice, but there's a deeper good thing about it, which we can see if we look at the amount of surplus generated. Since it might be a newish term, it's worth saying again that the surplus is a measure of worthwhile the transactions are. It turns out that at the equilibrium price and quantity, the market generates the maximum possible surplus.
This won't be a mathematically rigorous proof, but a way I intuitively make sense of this is by noticing that if the next buyer and the next seller made a transaction, the surplus in that case would actually be negative. At that point, the buyer just isn't willing to pay what the seller needs. The flip side of this is another good thing.
The buyers and sellers that don't end up participating in the rocket market can go spend their time and money on something else, since their participation in this particular market is actually counterproductive. Bringing these arguments together, we have a system that results in the maximum possible surplus and determines the right number of participants. This is what people when they say markets are efficient.
This efficiency makes it all the more amazing and valuable that is happens automatically. And just to throw one more term at you, you might refer to the invisible hand at the market. When people say invisible hand, they're just referring to the fact that everything happens automatically.
All right, so that's the basic argument that a free market is good on its own, now what about arguments that markets need regulation? Well, first, we can ask whether an idealized market, like the one we just made, is actually a good model of a given real world market. The answer here depends a lot on which market you're talking about, but there are some common important factors.
In general, for all those good things we said about markets to be true, there needs to be many buyers and sellers who can freely switch who they buy from and who they sell to and are able to exchange voluntarily, they're not forced to go through with the deal, they can walk away if they want, and who have good information about the prices and products so they know when to switch or walk away. Some real markets are actually pretty close to this ideal, but others can be quite far. For the second kind of argument for regulation, we can ask whether maximizing surplus, the way we defined it earlier, is actually the right goal.
Remember that when we defined surplus as a measure of value, we were only comparing alternatives for one blob at a time. It's very possible that this society of blobs could decide to measure value in a way that looks at all of the blobs at once. Again, the exact arguments will depend on the market in question, but for example, in markets like food, labor, and healthcare, a government might take some action to allow more buyers and/or sellers to participate and get some individual surplus for themselves, even if that means less total surplus in the whole system.
Without endorsing any particular government program, I think it's reasonable to say that there could be some value in making sure that everyone can eat, earn money, and get the medical attention they need. But, hey, that's up to the blobs. So again, this was a bit of a whirlwind, and there is, of course, a lot more that could be said, but I hope I made the case that markets aren't fundamentally good or bad.
They're a tool and just like any tool, they're the most helpful when we understand them well and when we're thoughtful about how and when to use them. So that's it for the main message of this video, but I do want to briefly mention a real world industry where the role of markets is especially confusing, which is educational videos distributed freely over the internet. I don't claim to know how all that works in detail, but by liking, subscribing, sharing, or by supporting directly on Patreon, you can send signals about the quantity demanded, which will, in turn, affect the quantity supplied in the long run.
In any case, thanks for watching till the end.
