2.7 - Price Determination - notes
2.7 - Price Determination
What market equilibrium is and how it is determined
Market equilibrium occurs when the quantity supplied in a market exactly matches the quantity demanded, resulting in a stable price and output level. At this point, the market clears, meaning all goods offered for sale are purchased, with no shortages or surpluses.
How market equilibrium is determined
In a free market, equilibrium is set by the interaction of supply and demand, often called market forces. The equilibrium price and quantity are found where the supply curve (upward-sloping) and demand curve (downward-sloping) intersect.
Example of market equilibrium using a table
The table below shows supply and demand for chocolate bars at different prices.
| Price (£) | Quantity demanded per week | Quantity supplied per week |
|---|---|---|
| 1.00 | 12000 | 0 |
| 2.00 | 10000 | 2000 |
| 3.00 | 8000 | 4000 |
| 4.00 | 6000 | 6000 |
| 5.00 | 4000 | 8000 |
| 6.00 | 2000 | 10000 |
From the data, the equilibrium price is £4.00, where quantity demanded (6000) equals quantity supplied (6000). The diagram below plots the two curves: the equilibrium point E sits where the supply curve (S) and demand curve (D) intersect, at a price of £4.00 and a quantity of 6000 chocolate bars.
Disequilibrium
When supply and demand do not match, the market is in disequilibrium, leading to either excess supply or excess demand. These imbalances are temporary in a free market, as prices adjust to restore balance. Supply and demand curves can represent entire markets or individual firms and consumers.
Excess supply and excess demand in markets
Excess supply and excess demand create imbalances that market forces correct by adjusting prices. These situations arise when prices are set away from the equilibrium level.
Excess supply
Excess supply, or a surplus, happens when quantity supplied exceeds quantity demanded, often because the price is too high. For example, if chocolate bars are priced at £5.00, supply might be 8000 units while demand is only 4000, creating a surplus of 4000 units. The diagram below shows this: at £5.00 the supply curve (S) gives a quantity of 8000 while the demand curve (D) gives only 4000, and the surplus is the gap between them. The surplus forces the price down, so quantity supplied contracts and quantity demanded extends until equilibrium is reached at E (£4.00 and 6000 units).
Excess demand
Excess demand occurs when quantity demanded exceeds quantity supplied, usually due to a price that is too low. For instance, at £2.00 per chocolate bar, demand could be 10000 units but supply only 2000, resulting in a shortage of 8000 units. The diagram below shows this: at £2.00 the demand curve (D) gives a quantity of 10000 while the supply curve (S) gives only 4000, and the shortage is the gap between them. The shortage pushes the price up, so quantity demanded contracts and quantity supplied extends until equilibrium is restored at E (£4.00 and 6000 units).
How shifts in demand or supply change market equilibrium
Shifts in the demand or supply curve, while the other remains unchanged, alter the equilibrium price and quantity. These shifts create new intersection points on graphs.
Effects of shifts in the demand curve
- Increase in demand - The demand curve shifts right (e.g., from D to D1), raising the equilibrium price (from Pe to P1) and increasing quantity (from Qe to Q1), moving the equilibrium from E to E1.
- Decrease in demand - The demand curve shifts left (e.g., from D to D2), lowering the equilibrium price (to P2) and reducing quantity (to Q2), moving the equilibrium to E2.
The diagram below shows both shifts along the unchanged supply curve (S), with the original equilibrium at E.
Effects of shifts in the supply curve
- Increase in supply - The supply curve shifts right (e.g., from S to S1), decreasing the equilibrium price (to P1) and increasing quantity (to Q1), moving the equilibrium from E to E1.
- Decrease in supply - The supply curve shifts left (e.g., from S to S2), increasing the equilibrium price (to P2) and decreasing quantity (to Q2), moving the equilibrium to E2.
The diagram below shows both shifts along the unchanged demand curve (D), with the original equilibrium at E (price Pe, quantity Qe).
The influence of elasticity on new equilibrium points
Price elasticity of supply (PES) and price elasticity of demand (PED) determine how much equilibrium price and quantity change after a curve shift. Elasticity measures responsiveness to price changes.
How elasticity affects equilibrium changes
- Price inelastic supply or demand - Shifts have a greater impact on price than on quantity, as responses to price changes are limited.
- Price elastic supply or demand - Shifts affect quantity more than price, due to high responsiveness.
For example, a rightward demand shift along an elastic supply curve mainly increases quantity, with a small price rise. Along an inelastic supply curve, the same shift causes a larger price increase but a smaller quantity change.