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. So both parties have an incentive to modify their position and change the price they will accept.

In order to consume and gain utility, consumers will readjust their expectations, and will increase the price they are prepared to pay. In contrast, producers must sell goods and services to derive a profit, and will be prepared to reduce price to make a sale. Economic theory predicts that slowly, through adjustment, or 'price discovery' price will 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

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 signaling system starts to operate.

However, stocks will build up, and this is inefficient and a waste of scarce resources. It is also an opportunity cost as resources could have been better used elsewhere. 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.


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

facebook link logo twitter link logo email link logo whatsapp link logo gmail link logo google classroom link logo