Market Equilibrium
When quantity demanded is equal to quantity supplied, and there is no tendency for the price to change.
On a graph, this point is called the equilibrium point and it determines the equilibrium price and equilibrium quantity (see Figure 1 below).
Figure 1 showcases the market for $Pencils$, with consumers having a demand shown by curve $D$ and producers having a supply shown by curve $S$ on the diagram below.
Consider the market at price $P_1$. Here the quantity demanded is $Q_1$ and the quantity supplied is $Q_2$.
- At this high price, the quantity demanded of the good is less than the quantity supplied.
- Therefore there is excess supply in the market, or surplus.
Surplus
The extra supply that results when quantity supplied is greater than quantity demanded.
Students often think surplus is caused by "overproduction."
While true in part, the real issue is that the price is too high, discouraging consumers from purchasing the product.
Similarly, consider $P_2$. Here the quantity demanded is $Q_2$ and the quantity supplied is $Q_1$.
- At this low price, the quantity demanded of the good is more than the quantity supplied.
- Therefore there is excess demand in the market, or shortage.
Shortage
The excess of quantity demanded over quantity supplied.
Excess supply and excess demand lead to market equilibrium
Market Equilibrium
When quantity demanded is equal to quantity supplied, and there is no tendency for the price to change.
When there is excess supply, there is a downward pressure on the price:
- Quantity supplied is higher than quantity demanded, $Q_2>Q_1$.
- Producers cannot sell all of their supply and thus will lower prices to encourage consumers to buy their good or service.
- Therefore, as long as there is excess supply, there will be a downward pressure on the price until it reaches $P_e$ and the market is cleared.
When there is excess demand, there is an upward pressure on the price:
- Quantity supplied is lower than quantity demanded, $Q_1 < Q_2$.
- Producers quickly sell their supply and realize more people still demanding their good or service.
- Thus they will increase the price so they can produce more and benefit off the high demand.
- The higher price will start to reduce some of the quantity demanded.
- This will keep happening as long as there is excess demand and through the upward pressure on price till $P_e$.
Hence, whenever there is an excess supply or excess demand:
- The prices will change until the equilibrium price $P_e$ is reached.
- At the equilibrium price $P_e$, there is an equilibrium in the quantity supplied and demanded. This quantity is referred to as the equilibrium quantity $Q_e$.
- This point is the market equilibrium: the forces of supply and demand are balanced since there is no price pressures.
- Any other pricing will lead to a disequilibrium in the market.
