Market Equilibrium: Supply and Demand Together

Equilibrium

• The point where the supply and demand curves intersect is called the market’s equilibrium.
• The definition of equilibrium: a situation in which the market price has reached the level at which quantity supplied equals quantity demanded.
• The definition of equilibrium price: the price that balances quantity supplied and quantity demanded.
• The equilibrium price is often called the market-clearing price because both buyers and sellers are satisfied at this price.
• The definition of equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price.

Example of Equilibrium

In the demand and supply schedule, you need to find the price level where quantity supplied is equal to quantity demanded. The following demand and supply schedule (Table 1.3) is from the previous pages. Assume that this demand and supply information is market demand and market supply. When the price level is $3.00, the quantity supplied is equal to the quantity demanded: 12 units.

Table 1.3. Demand and Supply Schedule

Price of pastry	Quantity of pastries demanded	Quantity of pastries supplied
$0.00	24	0
$1.00	20	4
$2.00	16	8
$3.00	12	12
$4.00	8	16
$5.00	4	20
$6.00	0	24

In Figure 1.5, the equilibrium point will be the intersection point between supply and demand curves. In the figure, the equilibrium point, price, and quantity are identified.

If the actual market price is higher than the equilibrium price in the market, then we observe a surplus of the product in the market.

• The definition of surplus: refers to cases where quantity supplied is greater than quantity demanded. The surplus will be eliminated as producers cut the price until the market reaches the equilibrium point where supply balances demand.

• If the actual price is lower than the equilibrium price, there will be a shortage of the good.
  • Definition of shortage: a situation in which quantity demanded is greater than quantity supplied.
  • Sellers will respond to the shortage by raising the price of the good until the market reaches equilibrium.
• The definition of the law of supply and demand: the claim that the price of any good adjusts to bring the supply and demand for that good into balance.

Three Steps to Analyzing Changes in Equilibrium

• Decide whether the event shifts the supply or demand curve (or perhaps both).
• Determine the direction in which the curve shifts.
• Use the supply-and-demand diagram to see how the shift changes the equilibrium price and quantity.

Example: A Change in Market Equilibrium Due to a Shift in Demand (Higher Demand)

The following illustrates the effect of higher income on the market for pastries.

A pastry is a normal good. You have learned that higher incomes increase the demand for normal goods. In this case, the demand curve for pastries will shift to the right. How much it will shift will depend on the size of the increase in income. If demand rises, a shortage will occur at the original equilibrium price. This leads to an increase in price, which causes quantity supplied to rise and quantity demanded to fall until equilibrium is achieved. The end result is an increase in both the equilibrium price and equilibrium quantity.

General rule: When demand increases, at the new equilibrium the price will get higher and the quantity traded will increase too.

Example: A Change in Market Equilibrium Due to a Shift in Demand (Lower Demand)

The following illustrates the effect of declining demand for pastries due to the health issues of consumers on the market for pastries.

You have learned that the changing tastes of consumers can change demand conditions. A lower demand for pastries due to health concerns shifts the demand curve to the left. How much it will shift will depend on the size of the lower preference. At the new equilibrium, the price will get lower, and the quantity traded will decrease too.

General rule: When demand decreases, at the new equilibrium the price will get cheaper, and the quantity traded will fall too.

Example: A Change in Market Equilibrium Due to a Shift in Supply (Lower Supply)

The following illustrates the effect of a hurricane that destroys part of the sugarcane crop and drives up the price of sugar.

Sugar is one of the important inputs for pastry production. Thus, higher sugar prices mean higher costs of production for pastry producers. This leads to a lower supply of pastries. The supply curve of pastries will shift to the left. At the new equilibrium, the price of pastries will increase, and the quantity traded will fall.

General rule: When supply decreases, at the new equilibrium the price will get higher and the quantity traded will fall.

Example: A Change in Market Equilibrium Due to a Shift in Supply (Higher Supply)

The following illustrates the effect of improving technology on the pastry market.

Changes in technology will affect the supply side. Improvements in technology lower the cost of production. Thus, supply will increase, and the supply curve of pastries will shift to the right. At the new equilibrium, the price of pastries will drop, and the quantity traded will increase.

General rule: When supply increases, at the new equilibrium the price will get lower and the quantity traded will increase.

Example: Shifts in Both Supply and Demand (Lower Demand and Lower Supply)

The following illustrates the effect of economic recession on the pastry market. Please note that during an economic recession, income declines (which leads to lower demand for normal goods) and expected profits decline (which leads to a lower supply of goods and services).

What is different in this example is that both the supply and demand sides are affected by one main event. It is suggested that you analyze these effects one by one and then combine them to find the overall effect on the equilibrium price and quantity.

A lower demand (the demand curve shifts to the left) means lower prices and lower quantity traded (see the example above).

A lower supply (the supply curve shifts to the left) means higher prices and lower quantity traded (see the example above).

When these two effects are combined, we can say that the quantity traded will fall in the pastry market because both lower supply and lower demand mean the quantity will get lower. The ultimate effect on the equilibrium price is not clear: Lower demand leads to lower prices; lower supply leads to higher prices. So the price may increase or decrease, depending on the relative sizes of the shifts in the demand and supply curves. If the demand shock is dominant, the equilibrium price will fall. If the supply shock is dominant, the equilibrium price will increase. Thus, if the relative sizes of these shifts (or shocks) aren't known, the end effect on the equilibrium price will be ambiguous.

In Figure 1.11, the demand shift is dominant (its shift is larger than the shift in the supply curve). You can see that in this case, the equilibrium price will end at a lower rate compared to the level before the shifts.

Conclusion: How Prices Allocate Resources

• The model of supply and demand is a powerful tool for analyzing markets.
• Supply and demand together determine the prices of the economy’s goods and services.
  • These prices serve as signals that guide the allocation of scarce resources in the economy.
  • Prices determine who produces each good and how much of each good is produced.
  • Prices serve to allocate resources to their highest-valued uses. For example, suppose that consumers develop an increased taste for electronic products. This leads to an increase in the demand for electronic goods, pushing the price up. This increased price provides incentives to producers to produce more electronic goods. Thus, price signals our wants and desires. This is one reason why markets generally serve as the best way to organize economic activity.