8/18/11

What is market equilibrium? How supply and demand interact to reach equilibrium price and quantity


Finding market equilibrium is a pretty easy task once you understand what to look for.  The easiest way to find it is by looking for the point at which supply and demand cross, but it is a little difficult trying to understand why the market will converge to this point.  This post goes over that process, using the market for educational consultants as an example.

On the graph to the write we have our typical supply and demand graph, with S representing our upward sloping supply curve, and D representing our downward sloping demand curve.  We are now going to experiment with three different price levels and discuss what happens in the market when confronted with those three different prices.
The first price level we are going to experiment with will be above the point where the supply and demand curves cross.  When prices are higher, we see that the line intersects the demand curve before the supply curve.  This means that firms are willing to supply more educational consulting services then will be demanded in the market, so there will be a surplus.  You can see this result in the graph to the left, but why is this happening?  We have a surplus because at high prices suppliers are willing to produce a lot of a good or service because they can make a lot of money doing so, but consumers on the other hand have to pay the higher prices and therefore buy less of the good or service.

The other extreme is to have price below the point where supply and demand intersect.  With this scenario, the price line runs into the supply curve first, and then the demand curve.  Because we have more people demanding the product than those willing to supply it, we have a shortage.  Considering our example, prices are so low that everyone wants to hire an educational adviser, but because prices are so low, not very many firms are willing to supply the service (maybe they will lose money).

So what happens when we have a price that isn't equal to the price where supply and demand cross?  Lets go back to the surplus example first, when there is a surplus there are too many goods on the market.  When this happens, firms need to lower their price in order to get rid of the extra merchandise (ever see clearance signs up at your local mall?  They are trying to get rid of last years model, or surplus inventory).  When the firms lower their price, then more people are willing to buy the good, and firms are less likely to supply it.  This happens until the price lowers to the level shown below, where quantity demanded is equal to quantity supplied:
We can also analyze the shortage scenario.  Here the pries are so low that more of the good is demanded than is being supplied.  This means that market forces direct the price up, so that less people will demand the good, and firms will be more willing to supply it.  This market force keeps pushing prices up until we reach equilibrium, and quantity demanded is equal to quantity supplied.  For an example of this, think of NFL Super Bowl tickets.  If the NFL sells tickets for too low of a price, then demand will be much higher than supply (which in this case is fixed).  In order to reach equilibrium, scalpers will buy up tickets at the cheap price and sell them at a much higher price.  As this price goes higher and higher we may see season ticket holders enter the market, which is our movement along the supply curve.  Eventually we hit price equilibrium and the number of people willing to sell tickets is equal to those willing to buy.

Remember: Market equilibrium occurs at the point where supply and demand intersect.  If the price is too high, we will have a surplus.  If the price is too low we will have a shortage.  In either of this situations, market forces will work to either raise or lower the price until we get to equilibrium, and the number of those willing and able to buy will be equal to those willing and able to sell. 


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