Market equilibrium occurs when demand equals supply.
At market equilibrium, the market-clearing (or equilibrium) price P* is charged and output Q* produced and consumed. Markets clear at P* because all the goods on sale by producers are bought by consumers. At equilibrium, no producer or consumer has an incentive to change their behaviour.
Disequilibrium Markets could also be in disequilibrium, but market forces will move markets back towards equilibrium. The time it takes to move from disequilibrium to equilibrium depends upon how long it takes for demand and/or supply to adjust to the equilibrium level.
Markets are in disequilibrium if there is excess demand or excess supply.
Excess Demand Excess demand occurs when demand is greater than supply.
At price P’ there is excess demand because quantity demanded Qd is greater than quantity supplied Qs. Excess demand is . As there is excess demand, consumers bid up prices from P’ to P*, quantity demanded falls and quantity supplied rises until the equilibrium price P* and quantity Q*.
Excess Supply Excess supply occurs when supply is greater than demand.
At price P’ there is excess supply because quantity supplied Qs is greater than quantity demanded Qd. Excess supply is . As there is excess supply, producers reduce prices from P’ to P*, quantity supplied falls and quantity demanded rises until the equilibrium price P* and quantity Q*.
Changes in Market Equilibrium Market equilibrium price and quantity will change if the demand curve and/or supply curve shifts.
A Change in Demand An increase (decrease) in demand causes the demand curve to shift right (left), equilibrium price to rise (fall) and quantity to rise (fall), ceteris paribus.
Assume there is an increase in demand that causes the demand curve to shift right from D to D’.
At the original equilibrium price P* there is now excess demand, so prices are bid up by consumers, price rises to P’ and there is a movement along the supply curve as quantity supplied increases from Q* to Q’. Markets clear at the new equilibrium price P’ and output Q’.
The extent of the change in equilibrium price and output depends on the magnitude of the increase in demand, how far the demand curve shifts. A larger (smaller) increase in demand causes a larger (smaller) price rise and larger (smaller) increase in quantity demanded.
Additionally, the extent of the rise in price and output depends upon the elasticity of supply. The more elastic (inelastic) is supply, the smaller (larger) the increase in price and the larger (smaller) the rise in output.
If supply is elastic, an increase in demand causes an increase in the equilibrium price but a more than proportionate increase in output.
If supply is inelastic, an increase in demand causes an increase in the equilibrium price but a less than proportionate increase in output.
If supply is perfectly inelastic, an increase in demand causes an increase in equilibrium price but no change in output.
If supply is perfectly elastic, an increase in demand causes no change in equilibrium price but an increase in output.
A Change in Supply An increase (decrease) in supply causes the supply curve to shift right (left), equilibrium price to fall (rise) and output to rise (fall), ceteris paribus.
Assume there is an increase in supply that causes the supply curve to shift right from S to S’.
At the original equilibrium price P* there is now excess supply, so prices are reduced by producers, price falls to P’ and there is a movement along the demand curve as quantity demanded falls from Q* to Q’. Markets clear at the new equilibrium price P’ and output Q’.
The extent of the change in equilibrium price and output depends on the magnitude of the increase in supply, how far the supply curve shifts. A larger (smaller) increase in supply causes a larger (smaller) price fall and larger (smaller) increase in quantity demanded.
Additionally, the extent of the fall in price and rise in output depends upon the elasticity of demand. The more elastic (inelastic) is demand, the smaller (larger) the fall in price and the larger (smaller) the rise in output.
If demand is elastic, an increase in supply causes a fall in the equilibrium price but a more than proportionate increase in output.
If demand is inelastic, an increase in supply causes a fall in the equilibrium price but a less than proportionate increase in output.
If demand is perfectly elastic, an increase in supply causes no change in the equilibrium price but an increase in output.
If demand is perfectly inelastic, an increase in supply causes a change in the equilibrium price but no change in output.
A Change in Both Demand and Supply Markets can experience increases/decreases in demand and increases/decreases in supply at the same time. Any combination of demand curve and supply curve shifts can occur, for simplicity only increases are illustrated here.
An increase in demand and supply may cause equilibrium price to rise or fall but the equilibrium level of output rises, ceteris paribus. A rightward shift of the demand curve from D to D’ and supply curve from S to S’ causes equilibrium price to remain constant at P* but equilibrium output to rise from Q* to Q’. Again the extent of the change in price and output depends upon the degree to which demand and supply increase. If demand shifts more in proportion than supply shifts, equilibrium price and output both rise. If supply shifts more in proportion than demand shifts, equilibrium price falls but output rises. Additionally, the extent of the change in equilibrium price and output depends on the elasticities of demand and supply.