1.6 - Market Equilibrium, Disequilibrium & Changes in Equilibrium

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.

The diagram below shows this. The demand curve D and the supply curve S cross, and dashed guides from that intersection give the equilibrium price P_e and the equilibrium quantity 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

In the first diagram below the price sits at P₁, above the equilibrium price P_e. Quantity supplied Q_S exceeds quantity demanded Q_D, and the horizontal distance between them is the surplus. The arrow on the price axis points down, because sellers cut prices to clear the excess.

In the second the price sits at P₁, below P_e. Now quantity demanded Q_D exceeds quantity supplied Q_S, and the horizontal distance between them is the shortage. The arrow on the price axis points up, because buyers bid the price up to secure the limited supply.

Calculating surpluses or shortages

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

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

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

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.

The diagram below works through one of these rows. Demand shifts right from D₁ to D₂ while supply stays where it is, so the equilibrium moves up along S: the price rises from P₁ to P₂ and the quantity rises from Q₁ to Q₂. The other three rows are the same picture with the shift reversed or applied to supply instead.