Published On:Thursday, 8 December 2011
Posted by Muhammad Atif Saeed
Market Equilibrium Price
| In this note we bring the forces of supply and demand together to consider the determination of equilibrium prices. The Concept of Market Equilibrium  Equilibrium means a state of equality or a state of balance between market demand and supply. Without a shift in demand and/or supply there will be no change in market price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At any price above P1, supply exceeds demand and at a price below P1, demand exceeds supply. In other words, prices where demand and supply are out of balance are termed points of disequilibrium. Changes in the conditions of demand or supply will shift the demand or supply curves. This will cause changes in the equilibrium price and quantity in the market. Demand and supply schedules can be represented in a table. The example below provides an illustration of the concept of equilibrium. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table:
 The demand curve may shift to the right (increase) for several reasons:
The reverse effects will occur when there is an inward shift of demand. A shift in the demand curve does not cause a shift in the supply curve! Demand and supply factors are assumed to be independent of each other although some economists claim this assumption is no longer valid! Changes in Market Supply and Equilibrium Price  ���� The supply curve may shift outwards if there is
Important note for the exams: A fall in supply might also be caused by the exit of firms from an industry perhaps because they are not making a sufficiently high rate of return by operating in a particular market. A shift in the supply curve does not cause a shift in the demand curve. Instead we move along (up or down) the demand curve to the new equilibrium position. The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:  In the left-hand diagram above, we see an inward shift of supply (caused perhaps by rising costs or a decision by producers to cut back on output at each price level) together with a fall (inward shift) in demand (perhaps the result of a decline in consumer confidence and incomes). Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price. The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market. Moving from one market equilibrium to another Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams in previous pages are reflective of changes in conditions in the market. So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks. The higher price then acts as an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point. We tend to use these diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis. The reality in most markets and industries is much more complex. For a start, many firms have imperfect knowledge about their demand curves – they do not know precisely how demand reacts to changes in price or the true level of demand at each and every price level. Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be available. The importance of price elasticity of demand The price elasticity of demand will influence the effects of shifts in supply on the equilibrium price and quantity in a market. This is illustrated in the next two diagrams. In the left hand diagram below we have drawn a highly elastic demand curve. We see an outward shift of supply – which leads to a large rise in equilibrium price and quantity and only a relatively small change in the market price. In the right hand diagram, a similar increase in supply is drawn together with an inelastic demand curve. Here the effect is more on the price. There is a sharp fall in the price and only a relatively small expansion in the equilibrium quantity.  | |||||||||||||||||||||||||||||||||||||||||||||
| Author: Geoff Riley, Eton College, September 2006 |
