Market equilibrium

Market equilibrium occurs in a competitive market where the forces of demand and supply interact to set a stable price and quantity. This balance ensures that resources are allocated efficiently without excess or shortfall.

Market equilibrium

Market equilibrium is the point where the quantity demanded by buyers equals the quantity supplied by sellers at a specific price. At this point, there is no tendency for the price to change because all participants in the market are satisfied.

Key terms:

• Quantity demanded (QD) - The amount of a good or service that consumers are willing and able to buy at a given price.
• Quantity supplied (QS) - The amount of a good or service that producers are willing and able to sell at a given price.
• Equilibrium price - The price at which QD equals QS, often denoted as P_e.
• Equilibrium quantity - The quantity bought and sold at the equilibrium price, often denoted as Q_e.

This equilibrium is achieved in a competitive market, where many buyers and sellers interact freely without any single entity controlling the price.

Graphical representation of market equilibrium

Market equilibrium can be shown on a graph with price on the vertical axis and quantity on the horizontal axis.

Key features:

• The demand curve slopes downward from left to right, showing that as price decreases, QD increases.
• The supply curve slopes upward from left to right, showing that as price increases, QS increases.
• Equilibrium is at the intersection of the demand and supply curves, where QD = QS.

For example, if the demand curve is D and the supply curve is S, their intersection point determines P_e and Q_e. At this point, the market clears, meaning all goods supplied are purchased, and there is no leftover inventory or unmet demand.

Disequilibrium: surpluses and shortages

Disequilibrium happens when the market price is not at the equilibrium level, leading to imbalances between quantity demanded and quantity supplied. These conditions create pressure for price changes to restore balance.

Surplus

A surplus, also known as excess supply, occurs when the market price is above the equilibrium price. At this higher price, QS exceeds QD, resulting in unsold goods. Producers may lower prices to sell off excess inventory, which increases QD and decreases QS until equilibrium is reached.

Shortage

A shortage, also known as excess demand, occurs when the market price is below the equilibrium price. At this lower price, QD exceeds QS, leading to unmet demand. Buyers may bid up prices to secure the limited supply, which decreases QD and increases QS until equilibrium is restored.

How prices adjust to restore equilibrium

Market forces naturally drive prices toward equilibrium during imbalances.

Price adjustment mechanisms:

• In a surplus: Sellers compete by reducing prices. As prices fall, QD rises (more buyers enter the market) and QS falls (some producers cut back), closing the gap until QD = QS.
• In a shortage: Buyers compete by offering higher prices. As prices rise, QD falls (some buyers drop out) and QS rises (producers increase output), eliminating the shortage until QD = QS.

This adjustment process relies on flexible prices in competitive markets, ensuring efficient resource allocation over time.

Graphical representation of disequilibrium

On a demand and supply graph:

• A surplus appears as a horizontal distance to the right of the equilibrium point at a price above P_e, where the supply curve is to the right of the demand curve.
• A shortage appears as a horizontal distance to the left of the equilibrium point at a price below P_e, where the demand curve is to the right of the supply curve.

Arrows can indicate price adjustments: downward for surpluses and upward for shortages, moving toward the equilibrium intersection.

Calculating surpluses or shortages in disequilibrium

To quantify disequilibrium, calculate the difference between QS and QD at a given price. This helps analyze the extent of the imbalance.

Formula for surplus or shortage

$\text{Surplus or shortage}=\text{QS}-\text{QD}$

Where:

• A positive result indicates a surplus (QS > QD).
• A negative result indicates a shortage (QD > QS).
• Use absolute values for the magnitude of the imbalance.

Worked example - Calculating a surplus in disequilibrium

Suppose the demand function is QD = 100 - 2P and the supply function is QS = 20 + 3P. At a market price of $25, calculate the surplus or shortage.

Step 1: Identify the values

• Price (P) = $25
• Demand function: QD = 100 - 2P
• Supply function: QS = 20 + 3P

Step 2: Calculate QD at P = $25

QD = 100 - 2(25) = 100 - 50 = 50 units

Step 3: Calculate QS at P = $25

QS = 20 + 3(25) = 20 + 75 = 95 units

Step 4: Calculate the surplus or shortage

Surplus or shortage = QS - QD = 95 - 50 = 45 units

Step 5: Interpretation

There is a surplus of 45 units at $25, meaning excess supply that would pressure prices downward toward equilibrium.

Worked example - Calculating a shortage in disequilibrium

Using the same functions: QD = 100 - 2P and QS = 20 + 3P. At a market price of $10, calculate the surplus or shortage.

Step 1: Identify the values

• Price (P) = $10
• Demand function: QD = 100 - 2P
• Supply function: QS = 20 + 3P

Step 2: Calculate QD at P = $10

QD = 100 - 2(10) = 100 - 20 = 80 units

Step 3: Calculate QS at P = $10

QS = 20 + 3(10) = 20 + 30 = 50 units

Step 4: Calculate the surplus or shortage

Surplus or shortage = QS - QD = 50 - 80 = -30 units

Step 5: Interpretation

There is a shortage of 30 units (absolute value) at $10, indicating excess demand that would drive prices upward toward equilibrium.

Changes in demand and supply affecting equilibrium

Changes in the determinants of demand or supply can shift the curves, leading to a new equilibrium price and quantity. Determinants are non-price factors that influence overall demand or supply.

Effects of changes in demand

• Increase in demand - The demand curve shifts rightward. This raises both equilibrium price and quantity, as more is demanded at every price.
• Decrease in demand - The demand curve shifts leftward. This lowers both equilibrium price and quantity.

Examples of demand determinants include consumer income, tastes, prices of related goods, and expectations.

Effects of changes in supply

• Increase in supply - The supply curve shifts rightward. This lowers equilibrium price but raises equilibrium quantity, as more is supplied at every price.
• Decrease in supply - The supply curve shifts leftward. This raises equilibrium price but lowers equilibrium quantity.

Examples of supply determinants include production costs, technology, number of sellers, and government policies.

Combined effects and graphical representation

When both curves shift, the net effect depends on the relative magnitudes.

On a graph, a rightward shift moves the curve outward, while a leftward shift moves it inward. The new equilibrium is at the new intersection point, showing adjusted P_e and Q_e.