The Supply And Demand Game

I played it in each class I taught. A former colleague taught it to me many years ago. As far as I know, I use the game invented by Edward Chamberlin and refined by Vernon Smith. Click here to see the Lessons From the Supply and Demand Game (a couple of people have emailed me about it recently). Or just read it all here.

Part 1: How the Game Works

The class played a game to earn extra credit points called the “The Supply and Demand Game.” Please also note, as far as I can tell, this game was invented by EH Chamberlin and later modified by Vernon Smith. I think I use the modified version. Several rounds of the game were played. In each round a student was either a buyer or a seller. Each student got a card at the beginning of a round that told them if they were a buyer or a seller. The object of the game was for buyers and sellers to make transactions with each other and maximize their surplus value.

Each buyer card had a maximum bid price on it which told the buyer the highest price they could pay in a transaction. The surplus value was the difference between the transaction price and the maximum bid price. For example, if a buyer’s card had a maximum bid price of $10 and they made a deal with a seller for $7.50, they got $2.50 in surplus value.

Each seller card had a minimum offer price on it which told the seller the lowest price they could accept in a transaction. If a seller had a minimum offer price of $5.00 and they made a deal with a buyer for $7.50, they got $2.50 in surplus value.

The more surplus value a student got, the more extra credit they got. In general, the object of the game was for buyers to make a deal for the lowest possible price and for sellers to make a deal for the highest possible price. Buyers and sellers walked around the class room looking for someone to make a deal with. There was no actual product for sale. Just buyers looking for sellers. After each round of the game, the prices of all the transactions were recorded. When the game was over, an average price per round and an average quantity (or number of transactions) was computed. Why was this important? Because the average price and quantity came very close to the equilibrium.

All of the buyer cards combine to make a demand curve that can be graphed and all of the seller cards combine to make a supply curve that can be graphed. If there are 24 students in the class, there will be 12 buyer cards and 12 seller cards. There will be exactly one card with each of the following maximum bid prices:

 

$    4
$    5
$    6
$    7
$    8
$    9
$   10
$   11
$   12
$   13
$   14
$   15

 

Since there is just one card with a maximum bid price of $15, only one buyer will be able to buy at that price (recall that the buyers have to buy at a price below their maximum bid price–I should say $14.99, but that is close enough to $15). So the quantity demanded (Q_d) at $15 is going to be one since only one person can buy that high. At a price of $14, the Q_d will be two because someone with a $15 card can buy at $14 and so can the person with the $14 card. Then the Q_d at $13 is three. Below is the complete demand schedule:

 

Price	Qd
$    4	12
$    5	11
$    6	10
$    7	9
$    8	8
$    9	7
$   10	6
$   11	5
$   12	4
$   13	3
$   14	2
$   15	1

 

These numbers form the demand curve in the graph below.

We can do the same thing with supply. There will be exactly one card with each of the following  minimum offer prices:

 

$    1
$    2
$    3
$    4
$    5
$    6
$    7
$    8
$    9
$   10
$   11
$   12
$   13
$   14
$   15

 

Since there is just one card with a minimum offer price of $1, only one seller will be able to sell at that price (recall that the sellers have to sell at a price above their minimum offer price–I should say $1.01, but that is close enough to $1). So the quantity supplied (Q_s) at $1 is going to be one since only one person can sell that low. At a price of $2, the Q_s will be two because someone with a $1 card can sell at $2 and so can the person with the $2 card. Then the Q_s at $3 is three. Below is the complete supply schedule:

 

Price	Qs
$    1	1
$    2	2
$    3	3
$    4	4
$    5	5
$    6	6
$    7	7
$    8	8
$    9	9
$   10	10
$   11	11
$   12	12

 

These numbers form the demand curve in the graph below.

The supply and demand lines intersect at a price of $7.50 and a quantity of 7.50. When the game is played in class, the average price for the whole game and the average quantity (number of transactions) per round is always very close to these numbers. Why is this good?

Part 2: What the Game Teaches Us

Moral of the Story

Selfish, rational maximizers, acting without government intervention or regulation, arrived at an efficient price. An efficient price is one that creates no shortages and no surpluses. It is, therefore, socially optimal.

In the game, everyone was acting in their own self-interest. There were no rules telling people who they could or could not trade with or what price they had to charge.

So this is a demonstration of Adam Smith’s concept of the Invisible Hand which says that selfishness serves society. The players in the game acted based on their self-interest and the price and quantity that resulted were the best that could exist. Why?

By having a quantity at equilibrium, there is no surplus or shortage. Getting the price right helps in this process.

A  surplus is wasteful and inefficient because too much of a product is produced. Scarce resources are used to make goods that no one wants. A  shortage is wasteful and inefficient because too little of a product is being produced.  All of society’s wants or needs would not be met.

Now another way to get just the right amount produced would be for the government to set the price of each good. But how would they know what price to set? They would have to know the supply and demand curves for every good. This is very unlikely since it is a very difficult statistical problem to determine the supply and demand curves for just one good. And we know that the curves move all the time.

So if a government bureaucrat tried to set the price, they might set it too high (surplus results) or too low (shortage results). They would just as easily make the same mistakes if they tried to set the quanity.

Part 3-Conditions Necessary For the Unregulated Market to Achieve Socially Optimal Results

In the game, the class was a mini society and so was a perfect laboratory setting. The real world is not always so ideal. To have the unregulated market achieve the optimal results, certain conditions must be met. Sometimes they are not met in the real world.

1. Equal access to information-When one side has more information that the other, too little of the good is produced or offered for sale or the price is not at equilibrium.

In the game, if the buyers were required to show their maximum bid price to the sellers (while the sellers were not required to show their minimum offer price to the buyers), the sellers would have been able to get a higher price since they would have had an advantage. But then the market would not achieve the optimal result since the price would have been above equilibrium.

In the real world, we have markets without equal access to information. The used car market is an example. The seller knows more about the product that the buyer. If a seller has a car that is truly worth $1,000, no one will be willing to pay that much because potential customers will be suspicious due to their lack of knowledge. Perhaps they would offer only $750. So some car owners pull their cars off the market, not wanting to take less than it is worth. So fewer cars are traded (a below equilibrium quantity and therefore not optimal). Also, there is a danger that the only cars left will be “lemons.” They will be worth less than the price you pay (Economist George Ackerlof developed the “theory of lemons”).

The insurance market has this problem, too. The custormers don’t always tell their insurance company their bad habits (like smoking, riding a motor cycle without a helmut, etc.). So they don’t know how risky you are and therefore don’t know what price to charge you.

2. No monopolies-Monopolies charge a higher price than competitive markets. With monopolies, too litte is produced. Q is less than it should be (a below equilibrium quantity and therefore not optimal).

If just one student had been given all of the seller cards, they would have been a monopoly and would have raised the price above the normal equilibrium. In the real world, there are monopolies, like Microsoft and CPS.

3. No Externalities-Pollution is an example of an externality. When we drive, we, as individuals, do not consder the cost to others. Too much driving is produced (an above equilibrium quantity and therefore not optimal). Q is greater than it should be.

In the game, there were no externalities. No one was harmed by any transaction done by others. But in the real world we do have externalities.