2.4 - Demand, Supply & Market Equilibrium

What market equilibrium is

Market equilibrium occurs through the interaction of consumers and producers, where demand and supply balance each other out.

Market equilibrium exists when the quantity demanded equals the quantity supplied, with no pressure for the price to adjust. This point is found at the intersection of the demand and supply curves. At this intersection, the price is known as the equilibrium price, and the quantity is the equilibrium quantity. The diagram below shows that intersection: the demand curve D crosses the supply curve S at point e, where the price per unit is P and the quantity per period is Q. P is the only price at which the market clears, because at any other price the quantity demanded and the quantity supplied differ.

The equilibrium stays the same only if both demand and supply do not change. If a factor alters either demand or supply, the relevant curve shifts, leading to a new equilibrium point.

Excess demand and excess supply

Imbalances in demand and supply create pressures that move the market towards equilibrium.

Excess demand

Excess demand, or a shortage, happens when the quantity demanded is greater than the quantity supplied at the current price. This creates upward pressure on the price. In the diagram below the price per unit is P1, below the equilibrium price P. At P1 producers supply only QS1, at point j on the supply curve S, while consumers want QD1, at point v on the demand curve D. Excess demand is the gap between j and v, and it pushes the price up towards P, the price at point e, where the quantity per period settles at Q.

Excess supply

Excess supply, or a surplus, occurs when the quantity supplied exceeds the quantity demanded at the current price. This leads to downward pressure on the price. In the diagram below the price per unit is P2, above the equilibrium price P. At P2 producers supply QS2, at point f on the supply curve S, while consumers only want QD2, at point h on the demand curve D. Excess supply is the gap between h and f, and it drags the price down towards P at point e, where the quantity per period is Q.

Key conditions for equilibrium:

• If quantity demanded > quantity supplied: excess demand causes prices to rise, so not equilibrium.
• If quantity supplied > quantity demanded: excess supply causes prices to fall, so not equilibrium.
• If quantity demanded = quantity supplied: the market clears with no price pressure, achieving equilibrium.

Effects of changes in demand on equilibrium

Shifts in demand alter the equilibrium by changing the balance between buyers and sellers.

Increase in demand

An increase in demand shifts the demand curve to the right, from D1 to D2 in the diagram below. The market starts at point h, where the price per unit is P1 and the quantity per period is Q1. At that original price P1 consumers now want the quantity at point k on D2, which is more than producers supply, so there is excess demand and the price is pushed up. As the price rises there is a movement along the supply curve S from h to g and along D2 from k to g, until the excess demand has gone. The new equilibrium is at point g, with a higher price P2 and a higher quantity Q2.

For example, if consumer incomes rise and coffee is a normal good, demand for coffee increases.

Decrease in demand

A decrease in demand shifts the demand curve to the left, from D1 to D2 in the diagram below. The market again starts at point h, where the price per unit is P1 and the quantity per period is Q1. At P1 consumers now want only the quantity at point k on D2, which is less than producers supply, so there is excess supply and the price is pulled down. As the price falls there is a movement along the supply curve S from h to g and along D2 from k to g. The new equilibrium is at point g, with a lower price P2 and a lower quantity Q2.

For instance, if the price of tea (a substitute) falls, demand for coffee decreases.

Effects of changes in supply on equilibrium

Changes in supply affect how much producers are willing to offer, impacting the market balance.

Increase in supply

An increase in supply shifts the supply curve to the right, from S1 to S2 in the diagram below. The market starts at point j, where the price per unit is P1 and the quantity per period is Q1. At that price producers are now willing to offer the quantity at point k on S2, more than consumers want, so excess supply emerges and the price is driven down. As the price falls there is a movement along the demand curve D from j to h and along S2 from k to h. The new equilibrium is at point h, with a lower price P2 but a higher quantity Q2.

For example, advances in farming methods boost rice supply.

Decrease in supply

A decrease in supply shifts the supply curve to the left, from S1 to S2 in the diagram below. Starting again at point j, where the price per unit is P1 and the quantity per period is Q1, producers will now only offer the quantity at point k on S2 at that price, which is less than consumers want, so excess demand arises and the price is forced up. The rise in price brings a movement along the demand curve D from j to h and along S2 from k to h. The new equilibrium is at point h, with a higher price P2 but a lower quantity Q2.

For instance, removing government subsidies for soybeans reduces supply.

Effects when both demand and supply change

When factors affect both demand and supply at the same time, both curves shift, and the new equilibrium depends on the size of each shift.

The final impact on price and quantity is determined by comparing the magnitudes of the shifts, often shown on a diagram.