When the supply and demand curves intersect, the market is in equilibrium.

  This is where the

quantity demanded and quantities supplied are equal. The corresponding price is the
equilibrium price or market-clearing price, the quantity is the equilibrium quantity.

In economics, economic equilibrium is a state of the world where economic forces are balanced
and in the absence of external influences the (equilibrium) values of economic variables will not
change. For example, in the standard text-book model of perfect competition, equilibrium
occurs at the point at which quantity demanded and quantity supplied is equal. Market
equilibrium in this case refers to a condition where a market price is established through
competition such that the amount of goods or services sought by buyers is equal to the amount
of goods or services produced by sellers. This price is often called the competitive price or
market clearing price and will tend not to change unless demand or supply changes.

   
Putting the supply and demand
curves from the previous
sections together. These two
curves will intersect at Price =
$6, and Quantity = 20. 

In this market, the equilibrium

price is $6 per unit, and
equilibrium quantity is 20 units.

At this price level, market is in

equilibrium. Quantity supplied is
equal to quantity demanded (Qs
= Qd). 

Market is clear.
Surplus and shortage:
If the market price is above the equilibrium price, quantity supplied is greater than quantity
demanded, creating a surplus.  Market price will fall.

Example: if you are the producer, you have a lot of excess inventory that cannot sell. Will you
put them on sale? It is most likely yes. Once you lower the price of your product, your product’s
quantity demanded will rise until equilibrium is reached. Therefore, surplus drives price down.

If the market price is below the equilibrium price, quantity supplied is less than quantity
demanded, creating a shortage. The market is not clear. It is in shortage. Market price will rise
because of this shortage.

Example: if you are the producer, your product is always out of stock. Will you raise the price to
make more profit? Most for-profit firms will say yes. Once you raise the price of your product,
your product’s quantity demanded will drop until equilibrium is reached.  Therefore, shortage
drives price up.

If a surplus exists, price must fall in order to entice additional quantity demanded and reduce
quantity supplied until the surplus is eliminated.  If a shortage exists, price must rise in order to
entice additional supply and reduce quantity demanded until the shortage is eliminated.

If the market price (P) is higher than $6 (where Qd = Qs),

For example, P=8, Qs=30, and Qd=10.
Since  Qs>Qd, there are excess quantity supplied  in the
Market, the market is not clear. Market is in surplus.

THE PRICE WILL DROP BECAUSE OF THIS SURPLUS.

If the market price is lower than equilibrium price,  $6,

for example,  P=4, Qs=10, and Qd=30.
Since Qs<Qd, There are excess quantity demanded in the
Market. Market is not clear. Market is in shortage.

THE PRICE WILL RISE DUE TO THIS SHORTAGE.

 

Government regulations will create surpluses and shortages in the market.  When a price
ceiling is set, there will be a shortage. When there is a price floor, there will be a surplus.

Price Floor: is legally imposed minimum price on the market. Transactions below this price are
prohibited.

 Policy makers set floor price above the market equilibrium price which they believed is
too low.
 Price floors are most often placed on markets for goods that are an important source of
income for the sellers, such as labor market.
 Price floor generate surpluses on the market.

Example: minimum wage.

 
Price Ceiling: is legally imposed maximum price on the market. Transactions above this price is
prohibited:-

 Policy makers set ceiling price below the market equilibrium price which they believed is
too high.
 Intention of price ceiling is keeping stuff affordable for poor people.
 Price ceiling generates shortages on the market.

Example: Rent control.

Changes in equilibrium price and quantity:

Equilibrium price and quantity are determined by the intersection of supply and demand. A
change in supply, or demand, or both, will necessarily change the equilibrium price, quantity or
both. It is highly unlikely that the change in supply and demand perfectly offset one another so
that equilibrium remains the same.

Example: This example is based on the assumption of Ceteris Paribus.

I. If there is an exporter who is willing to export oranges from Florida to Asia, he

will increase the demand for Florida’s oranges. An increase in demand will create
a shortage, which increases the equilibrium price and equilibrium quantity.    
   
II. If there is an importer who is willing to import oranges from Mexico to Florida,
he will increase the supply for Florida’s oranges. An increase in supply will create
a surplus, which lowers the equilibrium price and increase the equilibrium
 quantity.       

III. What will happen if the exporter and importer enter the Florida’s orange market
at the same time? From the above analysis, we can tell that equilibrium quantity
will be higher. But the import and exporter’s impact on price is opposite.
Therefore, the change in equilibrium price cannot be determined unless more
details are provided. Detail information should include the exact quantity the
exporter and importer is engaged in. By comparing the quantity between
importer and exporter, we can determine who has more impact on the market.

In the following table, an example of demand and supply increase is illustrated. 

In this graph, supply is constant, demand

increases. As the new demand curve (Demand 2)
has shown, the new curve is located on the right
hand side of the original demand curve.

The new curve intersects the original supply curve

at a new point. At this point, the equilibrium price
(market price) is higher, and equilibrium quantity
is higher also.

In this graph, demand is constant, and supply

increases. As the new supply curve (SUPPLY 2) has
shown, the new curve is located on the right side
of the original supply curve.

The new curve intersects the original demand

curve at a new point. At this point, the equilibrium
price (market price) is lower, and the equilibrium
quantity is higher.
 In this graph, the increased demand curve and
increased supply were drawn together.  The new
intersection point is located on the right hand side
of the original intersection point.

This new equilibrium point indicated an

equilibrium quantity which is higher than the
original equilibrium quantity. The equilibrium
price is also higher. It is because demand has
increased relatively more than supply in this case.

Example of Market Equilibrium:

Now we put together the behavior of buyers (part one) and the behavior of sellers (part two) to
have a model of the whole market for pizza.

Recall the demand and supply schedules for pizza delivered in Oswego in a week:
 

Price of pizza Quantity of pizza demanded Quantity of pizza supplied

(per week in Oswego) (per week in Oswego)

$25 100 800

$20 210 700
$15 300 625
$10 500 500
$5 650 300

Note that at a price of $10, the quantity supplied = the quantity demanded = 500.
If we plot the supply and demand curves on the same set of axes, we get the following
illustration of the pizza market:
The supply and demand curves intersect at the point where quantity supplied = quantity
demanded. This intersection is what we call an equilibrium price. This is the price where the
intentions of both the buyer and seller are compatible: Buyers want to buy the exact amount
the sellers want to sell.

Why is (500, $10) an equilibrium? To understand why, let's think about what would happen if
the price was greater than or less than $10.

 If the price is greater than $10, say $20, the quantity demanded = 210 and the quantity
supplied = 700. The result would be a huge surplus of 490 pizzas produced, with no one
willing to buy them for $20. This surplus would force prices to fall, causing pizza supplies
to cut back production and pizza buyers would be willing to buy more pizzas as the price
falls, until the price reaches $10.
 If the price is less than $10, say $5, the quantity demanded = 650 and the quantity
supplied = 300. The result would be a shortage of 350 pizzas. This shortage would force
prices up, causing pizza suppliers to produce more and consumers to buy less, until the
price reaches $10.

So an equilibrium point is a point of rest, where there is no incentive for buyers or sellers to
change their decisions. However, if one of the other factors affecting demand and supply
change, then the demand and/or supply curves will shift, and a new equilibrium will result. Let's
consider a few examples
Changes in Equilibrium:
Let's consider a few examples.

Example 1: Suppose that the price of Chinese food delivery rises. What happens to the market
for pizza? Let's figure this out with a 3 step approach:

 Step 1: Will this affect the demand or supply curve? Chinese food is a substitute for
pizza, so the price of Chinese food affects the demand curve
 Step 2: In what direction will the affected curve moves? The price of Chinese food, a
substitute, INCREASES, so the demand for pizza INCREASES, or the demand curve shifts
right.
 Step 3: What is the resulting impact on the equilibrium price and quantity? This is
easiest to answer with a graph. If you look at the graph below you will see that the new
equilibrium has a higher price and larger quantity. An increase in demand results in an
increase in price and quantity.

Example 2: Suppose instead that the Chinese food business is incredibly popular and profitable.
What happens to the market for pizza? Again, we use the same three step approach:

 Step 1: Will this affect the demand or supply curve? The Chinese food business is an
alternative to the pizza business, affecting the supply curve
 Step 2: In what direction will the affected curve moves? The profitability of Chinese
food means that some pizza places will switch to Chinese food places, so the supply of
pizza DECREASES, or the supply curve shifts left.
  Step 3: What is the resulting impact on the equilibrium price and quantity? This is
easiest to answer with a graph. If you look at the graph below you will see that the new
equilibrium has a higher price and smaller quantity. An decrease in supply results in an
increase in price and a decrease in quantity.

Example 3: Now let’s combine examples 1 and 2 so that the demand for pizza increases & the
supply of pizza decreases. What happens to the market for pizza?

 We know an increase in demand will increase equilibrium price and increase quantity.
 We know a decrease in supply will increase equilibrium price and decrease quantity.
 Put both together the equilibrium price will increase but the affect on quantity is
uncertain, and depends on whether the shift in demand is smaller or larger than the
shift in supply. As I have drawn the graph below, there is no change in quantity.
The table below summarizes how changes in demand and supply affect equilibrium price (P)
and quantity (Q).
 

no change in demand increase in demand decrease in demand

(no shift) (shift right) (shift left)

no change in supply no change in P P increases P decreases

(no shift) no change in Q Q increases Q decreases

increase in supply P decreases P? P decreases

(shift right) Q increases Q increases Q?

decrease in supply P increases P increases P?

(shift left) Q decreases Q? Q decreases

Want to test your understanding? The links below will allow you to test your understanding of
supply and demand. Your CD ROM also has self-quizzes on chapter 3.
References:
I. Hal R. Varian, Microeconomic Analysis, Third edn. Norton, New York 1992

II. Dixon, H. Equilibrium and Explanation, in Creedy (ed) The Foundations of

Economic Thought, Blackwells, 1990, chapter 13, pp.356-394. (reprinted in
Surfing Economics).
III. Augustin Cournot (1838), Theorie mathematique de la richesse sociale and of
recherches sur les principles mathematiques de la theorie des richesses, Paris
IV. Dixon (1990), page 369.
V. Paul A. Samuelson (1947; Expanded ed. 1983), Foundations of Economic Analysis,
Harvard University Press. ISBN 0-674-31301-1
VI. Smith, Adam (1776), Wealth of Nations, Penn State Electronic Classics edition,
republished 2005, Chapter 7: p.51-58
VII. Turnovsky, Stephen J. (2000), Methods of Macroeconomic Dynamics, MIT Press.
ISBN 0-262-20123-2

****