1.1.4 Market Equilibrium

Syllabus Statement: Explain, using diagrams, how demand and supply interact to produce market equilibrium

MARKET EQUILIBRIUM

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MARKET EQUILIBRIUM: Market situation when quantity demanded equals to quantitiy supplied with no tendency for price to change

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• Equilibrium Price (Pe): Price at market equilibrium

• Equilibrium Quantity (Qe): Quantity at market equilibrium

• If the quantity demanded is smaller than the quantity supplied at a given price level, there exists a surplus where there is excess supply; hence, there is a downward pressure on price, causing price to decrease until this surplus is eliminated at market equilibrium

• If the quantity demanded is greater than the quantity supplied at a given price level, there exists a shortage where there is excess demand; hence, there is an upward pressure on price, causing price to increase until this shortage is eliminated at market equilibrium

• Thus, the existence of a surplus or a shortage in a free market will cause the price to change so that the quantity demanded equals to the quantity supplied at market equilibrium: in the event of a shortage, prices will rise, while in the event of a surplus, prices will fall

Syllabus Statement: Analyse, using diagrams and with reference to excess demand or excess supply, how changes in the determinants of demand and/or supply result in a new market equilibrium

CHANGES IN MARKET EQUILIBRIUM: DEMAND

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Holding supply constant, any change in a non-price determinant of demand will result in a parallel shift of the demand curve, thus resulting in a new market equilibrium

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• Decrease in Demand: Equilibrium price and Equilibrium quantity will decrease

• Increase in Demand: Equilibrium price and Equilibrium quantity will increase

Decrease in Demand

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• Referring to Figure (a), the initial market equilibrium is at Point A, determined by the intersection of the demand curve, D1, and supply curve, S1; hence, the equilibrium price and quantity is Pe1 and Qe1 respectively

• Suppose a non-price determinant of demand causes a decrease in demand, causing a leftward shift of the demand curve from D1 to D2

• At the price level of Pe1, this decrease in demand moves the market from Point A to Point B, where the new quantity demanded is smaller than the quantity supplied, resulting in excess supply

• This excess supply - a surplus - will place downward pressure on price, causing prices to decrease until this surplus is eliminated at Point C, where the new equilibrium is reached

• As a result, the equilibrium price decreases to Pe2, and the equilibrium quantity decreases to Qe2, both forming the new market equilibrium

Increase in Demand

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• Referring to Figure (b), the initial market equilibrium is at Point A, determined by the intersection of the demand curve, D1, and supply curve, S1; hence, the equilibrium price and quantity is Pe1 and Qe1 respectively

• Suppose a non-price determinant of demand causes an increase in demand, causing a rightward shift of the demand curve from D1 to D2

• At the price level of Pe1, this increase in demand moves the market from Point A to Point B, where the new quantity demanded is greater than the quantity supplied, resulting in excess demand

• This excess demand - a shortage - will place upward pressure on price, causing prices to increase until this shortage is eliminated at Point C, where the new equilibrium is reached

• As a result, the equilibrium price increases to Pe2, and the equilibrium quantity increases to Qe2, both forming the new market equilibrium

CHANGES IN MARKET EQUILIBRIUM: SUPPLY

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Holding demand constant, any change in a non-price determinant of supply will result in a parallel shift of the supply curve, thus resulting in a new market equilibrium

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• Decrease in Supply: Equilibrium price will increase, Equilibrium quantity will decrease

• Increase in Demand: Equilibrium price will decrease, Equilibrium quantity will increase

Decrease in Supply

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• Referring to Figure (a), the initial market equilibrium is at Point A, determined by the intersection of the demand curve, D1, and supply curve, S1; hence, the equilibrium price and quantity is Pe1 and Qe1 respectively

• Suppose a non-price determinant of supply causes a decrease in supply, causing a leftward shift of the supply curve from S1 to S2

• At the price level of Pe1, this decrease in supply moves the market from Point A to Point B, where the new quantity supplied is smaller than the quantity demanded, resulting in excess demand

• This excess demand - a shortage - will place upward pressure on price, causing price to increase until this shortage is eliminated at Point C, where the new equilibrium is reached

• As a result, the equilibrium price increases to Pe2, while the equilibrium quantity decreases to Qe2, both forming the new market equilibrium

Increase in Supply

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• Referring to Figure (b), the initial market equilibrium is at Point A, determined by the intersection of the demand curve, D1, and supply curve, S1; hence, the equilibrium price and quantity is Pe1 and Qe1 respectively

• Suppose a non-price determinant of supply causes an increase in supply, causing a rightward shift of the supply curve from S1 to S2

• At the price level of Pe1, this increase in supply moves the market from Point A to Point B, where the new quantity supplied is greater than the quantity demanded, resulting in excess supply

• This excess supply - a surplus - will place downward pressure on price, causing prices to decrease until this surplus is eliminated at Point C, where the new equilibrium is reached

• As a result, the equilibrium price decreases to Pe2, while the equilibrium quantity increases to Qe2, both forming the new market equilibrium

Syllabus Statement: Calculate the equilibrium price and equilibrium quantity from linear demand and supply functions Plot demand and supply curves from linear functions, and identify the equilibrium price and equilibrium quantity State the quantity of excess demand or excess supply in the above diagrams

SOLVING FOR MARKET EQUILIBRIUM: LINEAR EQUATIONS

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The market equilibrium can be obtained by equating the demand and supply functions of a given market:

Market Equilibrium: Qd = Qs ,

Where

Qd is the demand function, represented as Qd = a - bP

Qs is the supply function, represented as Qs = c + dP 

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Method:

1. Solve for equilibrium price, Pe, by equating the demand and supply function (Qd = Qs)

2. Solve for equilibrium quantity, Qe, by plugging equilibrium price, Pe, into either function

Example: Chocolate bars

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    Suppose a market for chocolate has the demand function Qd = 14 - 2P, and the supply function

    Qs = 2 + 2P. What is the Market Equilibrium for the Market for Chocolate?

1. Solve for equilibrium price, Pe, by equating the demand and supply function: 

Market Equilibrium:    Qd = Qs,

14 - 2P = 2 + 2P

4P = 12

P = 3

Equilibrium price:   Pe = $3 

2. Solve for equilibrium quantity, Qe, by plugging equilibrium price, Pe, into either function 

Qd = 14 - 2P                                           Qs = 2 + 2P

 = 14 - 2 (3)                    or                     = 2 + 2 (3)

 = 8                                                         = 8

Equilibrium quantity:   Qe = 8 bars

NOTE: To check answer, equation should be satisfied when corresponding values are substituted

SOLVING FOR MARKET EQUILIBRIUM: PLOTTED GRAPHS

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The market equilibrium of a given market can be derived by finding the point of intersection between the demand and supply curve:

Market Equilibrium: Qd = Qs ,

Where

Qd is the demand function plotted on the graph

Qs is the supply function plotted on the graph 

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Method:

1. Solve for equilibrium price, Pe, by equating the demand and supply function (Qd = Qs)

2. Solve for equilibrium quantity, Qe, by plugging equilibrium price, Pe, into either function

Example: Chocolate bars

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    The demand and supply curve for the market of Chocolate is shown in the graph below. What is the

    Market Equilibrium for the Market for Chocolate?

1. Obtain the equilibrium price, Pe, by finding the price at which the demand and supply curve intersects: 

Equilibrium price:   Pe = $3 

2. Obtain the equilibrium quantity, Qe, by finding the quantity at which the demand and supply curve intersects: 

Equilibrium quantity:   Qe = 8 bars

CALCULATING DISEQUILIBRIUM: EXCESS DEMAND AND SUPPLY

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When the market is at disequilibrium, the excess demand (shortage) or excess supply (surplus) can be calculated by finding the difference between demand and supply, using either linear equations or plotted graphs

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• Excess supply (surplus): quantity supplied is greater than quantity demanded

• Excess demand (shortage): quantity demanded is greater than quantity supplied

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Using Linear Equations:

1. Derive the quantity demanded and quantity supplied at a given price level by plugging the price into both the demand and supply function

2. Quantify the excess demand or excess supply by finding the absolute difference between quantity demanded and quantity supplied

Example: Chocolate bars

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    Suppose a market for chocolate has the demand function Qd = 14 - 2P, and the supply function

    Qs = 2 + 2P. Find the quantity of excess demand or excess supply when P = 4.

1. Derive the quantity demanded and quantity supplied at a given price level by plugging the price into both the demand and supply function: 

Qd = 14 - 2P                                 Qs = 2 + 2P

     = 14 - 2 (4) = 6                             = 2 + 2 (4) = 10

2. Quantify the excess demand or excess supply by finding the absolute difference between quantity demanded and quantity supplied: 

| Qd - Qs | = | 6 - 10 | = 4

At the price level of P = 4, there is an excess supply of 4 chocolate bars

NOTE: When given price is above the equilibrium price, there is excess supply (surplus); when given price is below the equilibrium price, there is excess demand (shortage)

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Using Plotted Graphs:

1. Find the quantity demanded and quantity supplied at the given price level using the graph

2. Quantify the excess demand or excess supply by finding the absolute difference between quantity demanded and quantity supplied

Example: Chocolate bars

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    Suppose emand and supply curve for the market of Chocolate is shown in the graph below.. Find the

    quantity of excess demand or excess supply when P = 2.

1. Find the quantity demanded and quantity supplied at the given price level using the graph:

Qd = 10                    Qs = 6

2. Quantify the excess demand or excess supply by finding the absolute difference between quantity demanded and quantity supplied: 

| Qd - Qs | = | 10 - 6 | = 4

At the price level of P = 2, there is an excess demand of 4 chocolate bars