Equilibrium

Price Determination in markets

• In a market system, prices for goods/services are determined by the interaction of demand and supply 

  • A market is any place that brings buyers and sellers together

  • Markets can be physical (e.g. McDonald's) or virtual (e.g. eBay)

• Buyers and sellers meet to trade at an agreed-upon price

  • Buyers agree the price by purchasingthe good/service

  • If they do not agree on the price, then they do not purchase the good/service and are exercising their consumer sovereignty

• Based on this interaction with buyers, sellers will gradually adjust their pricesuntil there is an equilibrium price and quantity that works for both parties

  • At the equilibrium price, sellers will be satisfied with the rate/quantity of sales

  • At the equilibrium price, buyers are satisfied with the utility that the product provides

Market Equilibrium

Diagram analysis

• Equilibrium occurs in a market when demand = supply

• At this point, the price is called the equilibrium or market-clearing price

  • This is the price at which sellers are clearing (selling) their stock at an acceptable rate

Any price above or below P creates disequilibrium in this market

• Disequilibrium occurs whenever there is excess demand or excess supply in a market

Market disequilibrium

• Disequilibrium occurs when demand is not equal to supply

  • If demand > supply, the market is facing excess demand

  • If demand < supply, the market is facing excess supply

Disequilibrium: excess demand

Diagram analysis

• Excess demand occurs when the demand is greater than the supply

  • It can occur when prices are too lowor when demand is so high that supply cannot keep up with it

• At a price of P₁, the quantity demanded of electric scooters (Q_d) is greater than the quantity supplied (Q_s)

• There is a shortage (excess demand) in the market equivalent to Q_sQ_d

Market response

• This market is in disequilibrium

  • Sellers are frustrated that products are selling so quickly at a price that is obviously too low

  • Some buyers are frustrated as they will not be able to purchase the product

• Sellers realise they can increase prices and generate more revenue and profits

• Sellers gradually raise prices

  • This causes a contraction in QD as some buyers no longer desire the good/service at a higher price

  • This causes an extension in QS as other sellers are more incentivised to supply at higher prices

• In time, the market will have cleared the excess demand and arrive at a position of equilibrium, P_eQ_e

  • Different markets take different lengths of time to resolve disequilibrium

  • E.g. Retail clothing can do so in a few days. Whereas the housing market may take several months or even years

Disequilibrium: excess supply

Diagram analysis

• Excess supply occurs when the supply is greater than the demand

  • It can occur when prices are too highor when demand falls unexpectedly 

• During the later stages of the pandemic, the market for face masks was in disequilibrium

• At a price of P₁, the quantity supplied of face masks (Q_s) is greater than the quantity demanded (Q_d)

• There is a surplus in the market (excess supply) equivalent to Q_dQ_s

Market response

• This market is in disequilibrium

  • Sellers are frustrated that the masks are not selling and that the price is obviously too high

  • Some buyers are frustrated as they want to purchase the masks but are not willing to pay the high price

• Sellers will gradually lower prices in order to generate more revenue

  • This causes a contraction in QS as some sellers no longer desire to supply masks

  • This causes an extension in QD as buyers are more willing to purchase masks at lower prices

• In time, the market will have cleared the excess supply and arrive at a position of equilibrium, P_eQ_e

Equilibrium in Demand A Supply Schedules

• A demand and supply schedule shows the quantity demanded and the quantity supplied of a product at different price levels

• Demand and supply schedules can be used to identify equilibrium and disequilibrium

• At a price of $500, the market is in equilibrium

  • The QD = QS (800 units)

• At a price of $300 & $400, there is excess demand as the product is more affordable for consumers

  • Producers supply less at lower prices as they make less profit per unit

  • Producers are incentivised to supply more when prices are higher

• At a price of $600 & $700, there is excess supply as the high price has eliminated some buyers from the market

  • Producers would love to sell at this high price but in order to clear their stock, they have to lower the price & move towards equilibrium

Causes A Consequences of Price Changes

• Real world markets are constantly changing and are referred to as dynamic markets

• Market equilibrium can change every few minutes in some markets (e.g. stocks and shares), or every few weeks or months in others (e.g clothing)

•  Any change to a condition of demand or supply will temporarily create disequilibrium, and market forces will then seek to clear the excess demand or supply

Real World Example One: Changes to Demand that Increase Price

Diagram analysis

• During lock downs associated with the Covid-19 pandemic, furniture retailers experienced unexpectedly high demandfor their products (especially desks and sofas)

• Due to the Covid mandated change of working from home, consumers experienced a temporary change in tasteas they sought to set up comfortable home offices

  • This led to an increase in demand for desks from D₁ → D₂

• At the original market clearing price of P₁, a condition of excess demand now exists

  • The demand for desks is greater than the supply

• In response, suppliers raise prices

  • This causes a contraction of demandand an expansion of supply, leading to a new market equilibrium at P₂Q₂

  • Both the equilibrium price (P₂) and the equilibrium quantity (Q₂) are higher than before

  • The excess demand in the market has been cleared

Real World Example Two: Changes to Supply that Increase Price

Diagram analysis

• In September 2022, Hurricane Fionadestroyed much of Puerto Rico's crop of plantains (a necessity in the diet of local people)

• Due to Hurricane Fiona, Puerto Rico is experiencing a supply shock in its plantain market

  • This causes a decrease in supply of S₁ → S₂

• At the original market clearing price of P₁, a condition of excess demand now exists (shortage)

  • The demand for plantain is greaterthan the supply

• In response, sellers in Puerto Rico raised prices

  • This causes a contraction of demandand an expansion of supply leading to a new market equilibrium at P₂Q₂

  • The equilibrium price (P₂) is higher, and the equilibrium quantity (Q₂) is lower than before

  • The excess demand in the market has been cleared

Real World Example Three: Changes to Demand that Decrease Price

Diagram analysis

• Demand for lobsters in Maine, USA, has been falling steadily in recent months

• This has resulted in a price fall from $12.35 per pound on the 1st April to $9.35 per pound on the 1st May

• In recent months, the USA has been experiencing an increasing rate of inflation

  • Inflation lowers the purchasing power of money in a consumer's pocket and so effectively reduces their real income

  • With reduced real income, fewer luxuries are consumed

  • This led to a decrease in demand for lobsters from D₁ → D₂

• At the original market clearing price of P₁, a condition of excess supply now exists

  • The demand for lobsters is less than the supply

• In response, suppliers gradually reduce prices

  • This causes a contraction of supplyand an expansion of demand, leading to a new market equilibrium at P₂Q₂

  • Both the equilibrium price (P₂) and the equilibrium quantity (Q₂) are lower than before

  • The excess supply in the market has been cleared

Real World Example Four: Changes to Supply that Decrease Price

Diagram analysis

• In order to help meet their climate targetsand to lower energy costs for households, the EU is providing subsidies for solar panels 

• To help meet its climate change targets and lower household energy bills, the EU has provided a subsidy to solar panel retailers

  • This causes an increase in supply of S₁ → S₂

• At the original market clearing price of P₁, a condition of excess supply now exists (surplus)

  • The supply of solar panels is greaterthan the demand

• In response, sellers in the EU lower prices

  • This causes an expansion of demandand a contraction of supply, leading to a new market equilibrium at P₂Q₂

  • The equilibrium price (P₂) is lower, and the equilibrium quantity (Q₂) is higher than before

  • The excess supply in the market has been cleared