Market equilibrium

Price discovery

Economic theory states that there will be a single price at which demand equals supply – called ‘equilibrium price’.

Consumers would prefer to pay as little as possible, and producers would like to sell for as much as possible. However, if there is no flexibility in how price is arrived at, transactions will not take place.

This means that consumer demand is unsatisfied, and the seller earns no revenue. Hence, both parties have a strong incentive to modify their position and adjust the price they will accept.

In order to satisfy a want or a need and gain utility, rational consumers will readjust their assessment of what they are prepared to pay, and will increase the price they will accept - without doing this, their demand will go unsatisfied.

In contrast, rational producers must sell goods and services gain revenue, and to derive a profit. If they fail to sell the goods or services they offer, and 'take to market' they will not satisfy their need to make a profit. Like consumers, they will readjust their expectations, and will be prepared to reduce price to make a sale.

Economic theory predicts that slowly, through incremental adjustment, or 'price discovery' price will slowly converge and eventually reach a level both parties will accept. When this price is reached the market is in equilibrium.

At equilibrium the market ‘clears’ - there are no shortages or surpluses and marginal utility equals marginal cost.

Also at equilibrium, economic welfare is maximised. (see equilibrium and welfare video)

Example

Consider the following information for demand and supply at various prices.

Market equilibrium
Market equilibrium

There is only one price at which the market clears - all that is brought to market by producers is bought by consumers - namely, a price of 4. This is equilibrium price.

Assuming the market is 'free' and consumers and producers are free to enter and have perfect knowledge, then only a price of 4 will prevail.

Non-equilibrium prices of more than 4, and less than 4 will result in excess supply or excess demand.

Market equilibrium

Non-equilibrium prices are inefficient

So what will happen if consumers and producers do not adjust what they are willing to pay, or willing to accept? Or, what will happen if the government fixes a price that is not the market equilibrium price?

If the price is set too high, demand will contract and supply extend as the price signaling system starts to operate. This will lead to a surplus, and stocks will build up, requiring extra storage, distribution to warehouses, additional insurance and staffing costs.

If the price is set too low, there will be excess demand, with a shortage - queues will form, waiting lists may be needed, and consumers may waste considerable time queuing and waiting for the good or service. In addition, 'unofficial markets' may emerge and a 'shadow economy' may form.

In the above example, if price is set below 4, demand exceeds supply, and queues will build up. The incentive is now for producers to raise price towards a stable (market-clearing) equilibrium price.

For all these reasons, non-equilibrium prices are considered inefficient and, if free to do so, both consumers and producers will changes their behaviour.

Of course, if producers and consumers are not free to adjust their behaviour, permanent market disequilibrium can arise. In Cuba, where prices are fixed by the state, considerable shortages exist, with widespread rationing of essential goods.

Non-equilibrium price is also an opportunity cost as resources could have been better used elsewhere.

video on equilibrium
Video on equilibrium

Equilibrium


Externalities

Why are externalities a market failure?

Externalities
Demerit goods

What are the remedies for demerit goods?

Demerit goods
Welfare

How does equilibrium create welfare?

Welfare

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