1/16/12

Shortage, surplus and the price mechanism for equilibrium in supply and demand



This post goes over the economics of market equilibrium, and how the price mechanism in markets can correct for a shortage and a surplus without the need to shift either demand or supply.  Check out this past post for more information on determining equilibrium graphically.  Or this one on how to determine equilibrium graphically.

The price of a product and the quantity supplied are directly proportional because of the law of supply.  This law states that firms are willing to supply for of a good or service the higher the price is.  This stems from the fact that firms face an upward sloping marginal cost curve, so they need to receive a higher price for their product if they are going to produce it (which relates to diminishing marginal productivity but you probably don’t need to know this yet).

The price of a product and the quantity demanded are negatively related.  This is because of the law of demand.



If the market price is higher than the equilibrium price, then there is a surplus in the market.  This means that firms are willing to supply a greater quantity of a good or service than consumers are willing and able to pay for.  When there is a surplus in the market, market forces will use the price mechanism, and the price will drop until equilibrium is reached.  This means that quantity demanded, and quantity supplied will change (as the price goes down) until equilibrium is reached.  No shift in either demand or supply will occur, the market will reach equilibrium on its own.



Demand Schedule

Quantity Demanded
Price
0
10
2
9
4
8
6
7
8
6
10
5
12
4
14
3
16
2
18
1
20
0

Supply Schedule

Quantity Supplied
Price
0
0
2
1
4
2
6
3
8
4
10
5
12
6
14
7
16
8
18
9
20
10

For example, look at the supply and demand schedules above.  At a price of $8, quantity demanded is 4 and quantity supplied is 16, there is a surplus of 12 units.  The price in this market will drop, at $7 quantity demanded is 6 and quantity supplied is 14, so there is still a surplus.  The price will continue to drop until a price of $5 is reached, where quantity demanded = quantity supplied at 10 units.

If the price is lower than the equilibrium price, then there will be a shortage in the market.  This means that consumer are willing and able to buy more or a good or service than suppliers are willing and able to produce.  The price will rise in this scenario, changing both quantity supplied and quantity demanded until equilibrium is reached.  No shift in either demand or supply will occur.


Demand Schedule

Quantity Demanded
Price
0
10
2
9
4
8
6
7
8
6
10
5
12
4
14
3
16
2
18
1
20
0

Supply Schedule

Quantity Supplied
Price
0
0
2
1
4
2
6
3
8
4
10
5
12
6
14
7
16
8
18
9
20
10

For example, look at the supply and demand schedules above.  At a price of $2, quantity supplied is 4 and quantity demanded is 16, there is a shortage of 12 units.  The price in this market will drop, at $3 quantity supplied is 6 and quantity demanded is 14, so there is still a shortage.  The price will continue to rise until a price of $5 is reached, where quantity demanded = quantity supplied at 10 units.

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