Topic #9: Market Equilibrium

Dr David Penn

Associate Professor of Economics and Director of the Business and Economic Research Center

Market equilibrium

The interaction of supply and demand describes a market equilibrium: a balancing of the forces of supply and demand.

When a competitive market is in equilibrium, the price of the good has moved to a level at which the quantity demanded of the good equals quantity supplied of the good.

In equilibrium, quantity demanded = quantity supplied.

Market Equilibrium

The intersection of the supply curve and the demand curve is market equilibrium.

At equilibrium, quantity supplied is equal to quantity demanded (both at 9.5 billion lbs).

Equilibrium price is $1.38 per pound.

Equilibrium for Cotton

Quantity supplied and quantity demanded are equal at 9.5 billion pounds.

The price that creates equilibrium is $1.38 (halfway between $1.25 and $1.50).

No other price can balance quantity supplied with quantity demanded.

Price of cotton

(per lb)

Quantity of cotton supplied

(billion lbs)

Quantity of cotton

demanded (billion lbs)

2.00$ 12 71.75$ 11 81.50$ 10 91.25$ 9 101.00$ 8 110.75$ 7 120.50$ 6 13

What if the market price is higher than the equilibrium price?

The price is above equilibrium at $1.75 per pound.

At this price quantity supplied is 11 billion pounds but quantity demand is 8 billion pounds.

A surplus of 3 billion pounds exists at this price.

8

$1.75

Surplus

What if the market price is higher than the equilibrium price?

Market incentives will cause the surplus to shrink and reduce to zero.

How do the incentives work? If a surplus exists, producers have too much product inventory on hand. To reduce the inventory, producers cut the price. As we know price is a strong market incentive.

Price cuts cause consumers to buy more and producers to produce less. The result is a movement down both the supply and demand curves.

When does the process stop? When producers no longer have an incentive to cut price. This occurs when quantity supplied is again equal to quantity demanded (equilibrium). At the equilibrium price, consumers purchase just the quantity that producers wish to produce.

Once equilibrium is reached, there is no incentive for further price changes.

What if the market price is lower than the equilibrium price?

Suppose the price is now below equilibrium at $0.75 per pound.

At this price quantity supplied is 7 billion pounds and quantity demand is 12 billion pounds.

A shortage of 5 billion pounds exists at this price.

12

$0.75

Shortage

What if the market price is lower than the equilibrium price?

Again, market incentives will eventually cause the shortage to disappear.

When a shortage exists, producers have produced too little; inventory is very difficult if not impossible to keep on hand. Producers increase price.

The price increase causes consumers to buy less and producers to produce more. The result is a movement up both the supply and demand curves.

The process stops when producers no longer have an incentive to raise price. This occurs when quantity supplied is again equal to quantity demanded (equilibrium). At the equilibrium price, consumers purchase just the quantity that producers wish to produce.

Once equilibrium is reached, there is no incentive for further price changes.

The power of the market

Markets tend to have one price, the equilibrium price.

If the current price is not the equilibrium price, the market automatically causes the price to adjust either lower or higher. Thus markets tend to move to equilibrium, one of the important principles we discussed. Notice that the adjustment does not require shifting either demand or supply curves.

If the price is above equilibrium, consumers and producers will take action that result in bringing the price down. And if the price is lower than equilibrium, the actions of consumers and producers cause the price to rise.

So, the market price tends to move towards equilibrium, moving to a price at which the quantity supplied is just equal to quantity demanded.