2.5 The determination of equilibrium market prices

Equilibrium price and quantity

• This is when supply meets demand. On the diagram, this is shown by P1 and Q1.

• At market equilibrium, price has no tendency to change, and it is known as the market clearing price.

Excess Demand

• At Q2, price is at P2 which is below market equilibrium. Demand is now greater than supply, which can be calculated by Q3-Q2. This is of disequilibrium. The demand price does not equal the supply price, and the quantity demanded does not equal the quantity supplied.

• This is a shortage in the market. This pushes prices up and causes firms to supply more. Since prices increase, demand will contract.

• Once supply meets demand again, price will reach the market cleaning price, P1

Excess Supply

• This is when price is above P1

• Supply is now at Q2 and demand is at Q1. There is a surplus of Q2-Q1. Price will fall back to P1 as firms lower their prices and try to sell their goods. The market will clear and return to equilibrium.

New Market Equilibrium

• When the demand or supply curve shift due to the PIRATES or PINTSWC reasons, new market equilibriums are established.

• For example, if there was an increase in the size of the population, demand would shift from D1 to D2.

• Price would increase to P2 and suppliers would supply a larger quantity of Q2. A new market equilibrium is established at P2 Q2.