The compilation of these Market Equilibrium Notes makes students exam preparation simpler and organised.
Equilibrium, Excess Demand and Supply
A commodity can only be sold when both consumers and producers consent with a price. At this price, the market forces of demand and supply work in harmony, and the market is said to be in equilibrium. But what happens in the case of excess demand or excess supply? Let’s find out.
Market Equilibrium under Perfect Competition
Recollect that in a perfect competition price is determined by the industry, the most important characteristic is that no individual consumer or producer can alter the price. A firm is merely reduced to a price taker. Equilibrium refers to a state of balance, a position in which there is no tendency to change.
Evidently, perfectly competitive market equilibrium is visualized at a point where market supply becomes equal to market demand. Let’s revisit the market demand and supply.
Market demand is the demand for a commodity in the market. It is the sum total of individuals’ demand by all buyers of the commodity in the market. Similar to the demand curve, a market demand curve also slopes downwards due to the operation of the law of demand.
The market supply is the sum total of individual supplies by all producers of the commodity in the market. Essentially, is the total supply of the commodity. Similar to a supply curve, a market supply curve also slopes upwards due to the operation of the law of supply.
Combining both, the market attains equilibrium when the market supply and market demand of a commodity become equal. The price at which the market attains equilibrium is termed as the equilibrium price and the quantity supplied or demanded (essentially equal at the equilibrium) at this price is known as the equilibrium quantity. Graphically, at equilibrium, the market demand curve and market supply curve intersect with each other. This intersection point is the point of equilibrium.
How does this Equilibrium resist any change?
The point of discussion here is why the market operates at this equilibrium price. This can be easily understood by considering the other cases.
When we look at any price above the equilibrium price, suppliers would increase the supply in order to earn profits. This would create a condition of excess supply which further creates a tense situation among the sellers. In order to sell this surplus, the price would come down to the equilibrium price.
In the case of any price under the equilibrium price, consumers would flock to the market to buy the supply at a reduced price. This would create a situation of excess demand. Under the situation of excess demand, consumers would be willing to pay higher prices to meet increased demand. In essence, the price would rise to the equilibrium level. In a nutshell, the market would ultimately operate at the equilibrium level only.
Excess Demand
When at the current price level, the quantity demanded is more than the quantity supplied, a situation of excess demand is said to arise in the market. Excess demand occurs at a price less than the equilibrium price. Since the prices would decrease, it would act as bait for buyers to flock to markets which would lead to competition among these buyers.
This competition would lead to an increase in prices. As the prices increase the law of demand will operate to decrease the demand and the buyers will start vanishing. Conversely, this increase in prices would lure the suppliers to increase supply with hopes to earn greater profits.
Such a decrease in demand and increase in supply resulted in an effective increase in prices continues until the equilibrium level is attained. Thus automatically the conditions of excess demand are wiped out of the market.
Excess Supply
Excess supply is a market condition when the quantity supplied is greater than the demand for a commodity at the prevailing market price. It occurs at a price greater than the equilibrium price level. As the price will be greater than the equilibrium price the sellers would sense this as an opportunity to earn greater profits and would pump in the supply.
This would lead to an effective increase in stocks and tough competition among the sellers to sell their respective supplies. Consequently, to sell more supply, suppliers would start decreasing the prices to sell the excess stock. This decrease in price maneuvers the market supply and market demand which fall (law of supply) and rise (law of demand) respectively.
This self-adjusting mechanism pulls the price back to the equilibrium level. Effectively excess supply is wiped out of the market.
Example:
Question:
How is market equilibrium represented under perfect competition?
Answer:
The market is said to attain equilibrium when the market supply and market demand become exactly equal to each other. The price at this level is known as equilibrium price and the quantity is known as equilibrium quantity.
Further, diagrammatically, at the equilibrium point, a market demand curve intersects with the market supply curve. The price corresponding to this point on Y-axis is known as the equilibrium price. Similarly, the quantity corresponding to this point on the X-axis is termed as the equilibrium quantity.