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Market equilibrium

31 December, 2015 - 10:54

Let us now bring the demand and supply schedules together in an attempt to analyze what the market place will produce – will a single price emerge that will equate supply and demand? We will keep other things constant for the moment, and explore what materializes at different prices. At low prices, the data in Table 3.1 indicate that the quantity demanded exceeds the quantity supplied – for example, verify what happens when the price is $3 per unit. The opposite occurs when the price is high – what would happen if the price were $8? Evidently, there exists an intermediate price, where the quantity demanded equals the quantity supplied. At this point we say that the market is in equilibrium. The equilibrium price equates demand and supply – it clears the market.

\mid The equilibrium price equilibrates the market. It is the price at which quantity demanded equals the quantity supplied.

In Table 3.1 the equilibrium price is $4, and the equilibrium quantity is 6 thousand cubic feet of gas (we will use the notation ‘k’ to denote thousands). At higher prices there is an excess supply— suppliers wish to sell more than buyers wish to buy. Conversely, at lower prices there is an excess demand. Only at the equilibrium price is the quantity supplied equal to the quantity

\mid Excess supply exists when the quantity supplied exceeds the quantity demanded at the going price.

\mid Excess demand exists when the quantity demanded exceeds the quantity supplied at the going price.

Does the market automatically reach equilibrium? To answer this question, suppose initially that the sellers choose a price of $10. Here suppliers would like to supply 18k cubic feet, but there are no buyers—a situation of extreme excess supply. At the price of $7 the excess supply is reduced to 9k, because both the quantity demanded is now higher at 3k units, and the quantity supplied is lower at 12k. But excess supply means that there are suppliers willing to supply at a lower price, and this willingness exerts continual downward pressure on any price above the price that equates demand and supply.

At prices below the equilibrium there is, conversely, an excess demand. In this situation, suppliers could force the price upward, knowing that buyers will continue to buy at a price at which the suppliers are willing to sell. Such upward pressure would continue until the excess demand is eliminated.

In general then, above the equilibrium price excess supply exerts downward pressure on price, and below the equilibrium excess demand exerts upward pressure on price. This process implies that the buyers and sellers have information on the various elements that make up the marketplace.

Note that, if sales do take place at prices above or below the equilibrium price, the quantity traded always corresponds to the short side of the market: At high prices the quantity demanded is less than supply, and it is the quantity demanded that is traded because buyers will not buy the amount suppliers would like to supply. At low prices the quantity demanded exceeds quantity supplied, and it is the amount that suppliers are willing to sell that is traded. In sum, when trading takes place at prices other than the equilibrium price it is always the lesser of the quantity demanded or supplied that is traded. Hence we say that at non equilibrium prices the short side dominates. We will return to this in a series of examples later in this chapter.

\mid The short side of the market determines outcomes at prices other than the equilibrium.