Simulating Supply and Demand - YouTube

- [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.