Market equilibrium

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

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

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

These non-equilibrium prices are inefficient and will result in changes in the behaviour of both consumers and producers. At a higher price, demand will contract and supply extend as the price signalling system starts to operate.

However, stocks will build up, and this is ineffficient and a waste of scarce resources. It is also an opportunity cost as resources could have been better used elswhere. The incentive now is for the firm to raise price and cut back output (towards the stable equilibrium).

Video on market equilibrium

If price is set below 4, then demand exceeds supply, and queues will build up. Firms will sell all their goods quickly, and yet are likely to have to pay labour for a whole day's work. The incentive is now for producers to raise price towards a stable (market-clearing) equilibrium price.

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