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Nobel Prize winner Vernon Smith conducted experiments testing this model and found that time and time again, the model did indeed work. Some of the most impressive evidence was developed in 1956 by Vernon Smith, one of the founders of experimental economics. Smith actually expected that his lab experiments, which I’ll describe in more detail shortly, he expected that they would disprove the model, but he was shocked when time and time again, the model predicted exactly what happened. Vernon Smith was awarded the Nobel Prize in economics in 2002. Let’s take a look at what he did. Smith’s first experiments were very simple. He gave a group of students, called the buyers, cards similar to these, which told them the value that they placed on a good, the maximum they would be willing to pay for the good.

He then did the same thing for sellers, giving them cards, which told them their cost, the minimum price at which they would be willing to sell the good. Notice that the distribution of buyer values determines a demand curve. 50, for example, the quantity demanded would be one. 3, the quantity demanded would increase to two. Similarly, the distribution of cards for the supplier costs determines a supply curve. Moreover, because Smith knew the values that he distributed, he could calculate the demand and the supply curves and the predicted equilibrium prices and quantity.

Smith let the students make trades in a double oral auction. 1, then the seller would earn the price minus their cost. In this case, the seller would earn a profit of 25 cents, the price minus their cost. Similarly, the buyer would earn their value, 2. Now, here was another key to Smith’s market. He actually paid the traders their profits in real money. So Smith’s experimental market was a real market, with a real demand curve, a real supply curve, and traders who had an incentive to maximize the gains from trade.

Here are the results from one of Smith’s remarkable experiments. The demand and supply curve calculated by Smith are shown here on the left. 2 and an equilibrium quantity of five or six units. What actually happened is shown on the right. 2 or very close to it. The market quantity quickly went to five or six units. Another way to test the model is to examine its predictions about what happens when the demand or supply curves shift.

In fact, what makes the demand and supply curve model so powerful is that you can analyze any change in market conditions using a shift in either the demand or a shift in the supply curve. That will produce a prediction about what will happen. You should be very familiar with demand and supply curve shifts. Let’s run through a few examples. The key here is to understand the logic, not to try to memorize the results of every possible shift. If you understand the logic, with a few curves, you’ll always be able to duplicate and understand exactly what the model predicts. Here’s the market for laptops for the demand and the supply of laptops.

We all know that technology has reduced the cost of computer chips, Moore’s Law and all that. A reduction in the price of computer chips reduces the cost of producing laptops. A reduction in cost is modeled by an increase in supply. The supply curve moves to the right and down.