3.5 The determination of equilibrium market prices

Market demand curve showing market equilibrium

page 63

Define equilibrium

A state of rest or balance between opposing forces

Define disequilibrium

A situation which opposing forces are out of balance

Define market equilibrium

A market is in equilibrium when planned demand equals planned supply, where the demand curve crosses the supply curve

Define market disequilibrium

Exists at any other price than the equilibrium price (excess demand/supply exists)

Define excess supply

When firms wish to sell more than consumers wish to buy, with the price above the equilibrium price

Define excess demand

When consumers wish to buy more than firms wish to sell, with the price below the equilibrium price.

Diagram showing market equilibrium and disequilibrium

page 64

How does a shift in supply disturb market equilibrium

(page 64) Once supply equals demand in a market - for example, at point X in the diagram - the market remains in equilibrium until an external event hits the market and causes either the market supply curve or the market demand curve to shift to a new position.

The diagram demonstrates what happens in the tomato market when an event such as a bumper harvest causes the supply curve of tomatoes to shift rightwards from s1 to s2. Before the shift of the supply curve, p1 was the equilibrium price of tomatoes. However, once the supply curve shifts, p1 becomes a disequilibrium price. Too many tomatoes are offered for sale at this price which means there is excess supply in the market. The excess supply is Q2-Q1, or the distance between X and V.

To get rid of this unsold stock, tomato producers reduce the price they are prepared to accept. The market price falls from p1 to p2 which eliminates the excess supply. In the new equilibrium, planned supply once again equals planned demand, but at the lower equilibrium price of p2.

How does a shift of demand disturb market equilibrium?

(page 65) The diagram shows what happens in a market for tomatoes following an increase in consumers incomes. Tomatoes are usually considered a normal good: that is, a good for which demand increases as income increases. Before the increase in consumers incomes, the equilibrium price was p1, determined at the intersection of curves d1 and S. At this price, planned demand equals planned supply. However, increased incomes shift the market demand curve rightward from D1 to D2. Immediately, disequilibrium replaces equilibrium in the market. The rightward shift of demand creates excess demand in the market, as ling as the price remains at P1. Excess demand is shown by Q2-Q1, or the distance between H and K.

The market adjustment mechanism now swings into action to get rid of excess demand. The price increases to P2 to eliminate the excess demand and the quantity of tomatoes bought and sold rises to Q3. In response to the increase in demand from H to K, there is movement along the supply curve between H and J (an extension of supply) to establish the new equilibrium.