Microeconomics Notes: Equilibrium, Shortages, Surpluses, and Price Controls

Key concepts

• Market mechanism basics: demand and supply determine price and quantity in a free market.
• Equilibrium price and equilibrium quantity are the point where the quantity demanded equals the quantity supplied: D(P^) = S(P^).
• Equilibrium is a settled point; there is no inherent pressure to move off that point if the market is free from external interventions.
• Disequilibrium occurs when the market price is not at the equilibrium:
  • Shortage: when quantity demanded is greater than quantity supplied (D(P) > S(P)).
  • Surplus: when quantity supplied is greater than quantity demanded (S(P) > D(P)).
• Price dynamics in disequilibrium:
  • Shortages create upward pressure on price as buyers bid more and producers may raise price or reduce quantity; surpluses create downward pressure on price as sellers compete for buyers.
• Consumer surplus (CS) and producer surplus (PS): CS is the benefit to consumers from paying a price lower than what they were willing to pay; PS is the benefit to producers from selling at a price higher than the minimum they would accept.
• Total surplus (TS): CS + PS; TS reflects the overall welfare of the market and is maximized at the equilibrium in a competitive market.
• This balance is based on the value placed on units by consumers and producers, not merely on quantities.
• Market participants and welfare distribution can shift in disequilibrium; who captures surplus depends on price movements and shifts in supply/demand.

Equilibrium, shortages, surpluses

• Equilibrium is the point where demand equals supply: D(P^) = S(P^), with corresponding equilibrium quantity Q^*.
• If the price rises above equilibrium, quantity supplied exceeds quantity demanded: surplus occurs.
• If the price falls below equilibrium, quantity demanded exceeds quantity supplied: shortage occurs.
• The terms shortages and surpluses describe the condition relative to the equilibrium but not necessarily the policy response.
• Real-world implication: in the presence of shortages, buyers may bid up prices; in surpluses, prices fall toward the equilibrium.
• Shortages and surpluses are temporary states as the price mechanism moves toward clearing the market.

Graphical interpretation (qualitative)

• On a standard supply and demand graph, the intersection of the curves is the equilibrium (P^, Q^).
• Shortage region: area where Qd > Qs at a given price, typically below the equilibrium price in a non-binding scenario.
• Surplus region: area where Qs > Qd at a given price, typically above the equilibrium price.
• Consumer surplus is the area under the demand curve and above the price line; producer surplus is the area above the supply curve and below the price line.
• Total surplus is the sum of the two surpluses and is maximized at equilibrium.

Consumer surplus, producer surplus, total surplus

• Consumer surplus (CS): the value consumers receive by paying a price lower than what they were willing to pay.
• Producer surplus (PS): the revenue producers receive above their minimum acceptable price.
• Total surplus (TS): TS = CS + PS.
• At equilibrium, TS is maximized; deviations due to price controls or other interventions reduce TS by creating deadweight loss.
• The “ tug of war ” concept: market prices allocate surplus between buyers and sellers; equilibrium allocates resources efficiently given underlying preferences and costs.

Price controls: price ceilings and price floors

• Price control concepts:
  • Price ceiling (upper limit): an upper bound on price. If binding (set below the equilibrium price), it prevents prices from rising to the equilibrium level.
  • Price floor (lower limit): a lower bound on price. If binding (set above the equilibrium price), it prevents prices from falling to the equilibrium level.
• Binding vs non-binding:
  • A price ceiling is binding if P_c < P^*; it causes a shortage.
  • A price ceiling is non-binding if P_c \,\ge\, P^*; it has no effect on the market.
  • A price floor is binding if P_f > P^*; it causes a surplus.
  • A price floor is non-binding if P_f \le P^*; it has no effect on the market.
• Examples and intuition:
  • Price ceiling example: an upper limit on a price (not necessarily a real market price) can resemble societal norms or regulations that cap what people pay for certain goods.
  • Price floor example: a bottom limit set by the government, such as minimum wage laws for labor markets.
  • In many cases, price ceilings are binding below equilibrium, leading to shortages; price floors above equilibrium create surpluses.
• Specific context: medical price caps and wage policies often involve price floors or ceilings, and whether they are binding depends on the free-market equilibrium price.
• Application to wages:
  • Minimum wage in Kentucky (state policy): 7.25 dollars per hour since February 2009.
  • Discussion of whether this wage is binding depends on the market equilibrium wage for most workers; the class speculated a rough equilibrium wage around 7.35, implying the $7.25 wage is potentially non-binding for many workers but could bind certain groups (e.g., tipped workers or specific labor segments).

Real-world relevance and policy implications

• Gouging laws during disasters: these are often justified to prevent price spikes in shortages, aiming to protect consumers and reduce welfare losses but can limit price signals that allocate scarce resources efficiently.
• Price controls affect incentives and may lead to shortages or surpluses, slowing the market's natural clearing process.
• Ethical and practical considerations: balancing efficiency (economic welfare) with fairness and access during emergencies; policy design must consider both efficiency and equity.

Worked example: market for sandwiches (conceptual)

• Given a market with price and quantities for demand and supply (as discussed in class):
  • At a proposed price of P = 9, students observed that the equilibrium occurs where Qd = Qs (the class emphasized that the price at which the two sides match is the equilibrium).
  • Observed potentially at P = 9: quantity demanded and supplied could indicate either a shortage or surplus depending on the exact numbers; example notes from the session suggested a setup where some quantities indicated a shortage or a surplus (e.g., specific numbers like a demand of 36 versus supply of 16 leading to a shortage, or other numbers indicating a surplus).
• Key takeaway: identify whether at a given price the market has a shortage (D > S) or a surplus (S > D) and locate the equilibrium price where D = S.
• From the session discussion: the equilibrium price identified was P^* = 9 with corresponding equilibrium quantity Q^ where D(P^) = S(P^*).
• You should be able to determine at a given price whether you are in shortage or surplus by comparing Qd and Qs and describe the price-pressure direction (upward in shortage, downward in surplus).

Quick practice and review questions

• Define equilibrium price and quantity and give the equation that characterizes them.
• Explain what happens to price and quantity when the market is in a shortage vs a surplus.
• Distinguish price ceilings from price floors and indicate when each is binding.
• Describe how gouging laws relate to shortages and price controls.
• State the Kentucky minimum wage and discuss whether it is binding based on the given context; provide a rough discussion of why a binding/non-binding classification matters.
• For a given market diagram, identify the consumer surplus area, the producer surplus area, and the total surplus area.
• If a price ceiling is bound below the market-clearing price, what happens to the quantity traded? What welfare effect arises?

Formulas and key relations to remember

• Equilibrium condition: D(P^) = S(P^)
• Shortage condition at price P: if D(P) > S(P), shortage exists; if S(P) > D(P), surplus exists.
• Price control binding conditions:
  • Price ceiling binding if P_c < P^*, causes shortage.
  • Price floor binding if P_f > P^*, causes surplus.
• Surplus and shortage dynamics: shortages push prices up; surpluses push prices down.
• Surplus welfare relation: TS = CS + PS
• Equilibrium maximizes total surplus in a competitive market.

Connections to foundational principles and real-world relevance

• This material ties to the law of demand and law of supply, market-clearing processes, and welfare economics.
• It connects microeconomic theory to real-world policy (minimum wage, price controls, disaster response) and ethical considerations about equity and efficiency.
• Understanding pricing dynamics helps explain why authorities sometimes intervene, and what those interventions imply for welfare and market signals.