Equilibrium
Supply and demand come together in the marketplace. With a downward-sloping demand curve and an upward-sloping supply curve, there will ordinarily be a point of intersection of the two curves. That point shows the price at which the quantity demanded in the market equals the quantity supplied. This is called an equilibrium point, and the corresponding price is the equilibrium price while the corresponding quantity is the equilibrium quantity. At equilibrium, there is no tendency for price or quantity to change.
Consider now prices below the equilibrium price. The quantity demanded will be greater than the quantity supplied. This is referred to as excess demand, or a shortage. In the face of a shortage, consumers will compete with one another for the limited supply, and this will result in an increase in the price of the product. The increase in price will stimulate a reduction in quantity demanded and an increase in quantity supplied (movements up along the demand curve and the supply curve) until the equilibrium point is reached. Conversely, at prices above the equilibrium price, quantity demanded will be smaller than the quantity supplied, and there will be excess supply (a surplus) in the market. With a surplus, firms will compete to sell their products, and this will result in downward pressure on the price of the product. As with a shortage, there will be movements along the supply and demand curves as price changes, until the equilibrium point is reached.
Changes in Supply and Demand
When supply and demand curves shift, this results in changes to the equilibrium price and quantity. For example, if there is an increase in demand (a shift to the right of the demand curve, as might occur with higher incomes, higher prices for a substitute good, or stronger tastes for the product in question), both the equilibrium price and equilibrium quantity will increase. A decrease in demand will entail reductions in the equilibrium price and quantity. If there is an increase in supply (a shift to the right of the supply curve, as might occur with improved technology or reduction in the prices of inputs), this will result in a decline in the equilibrium price and an increase in the equilibrium quantity. Conversely, a decrease in supply will raise the equilibrium price and lower the equilibrium quantity.
You can see these changes by starting with a simple supply and demand graph showing an initial equilibrium, and then drawing the new demand or supply curve and observing the new equilibrium point. In order to do well in this course, you will need to become proficient at drawing supply and demand graphs and using them to determine the consequences of changes in demand, supply, or both.
The four basic changes (increase in demand, decline in demand, increase in supply, reduction in supply) are illustrated in the diagrams below. Note that in each case, there is a movement along the curve for the aspect that does not change. That is, when demand increases, there is an increase in the quantity supplied (movement along the supply curve) as the market moves from the initial equilibrium price to the new equilibrium price. Likewise, when there is an increase in supply, there is an increase in the quantity demanded (downward movement along the demand curve).
1. An increase in demand | 2. A decline in demand |
3. An increase in supply | 4. A decline in supply |
Price Ceilings and Floors
We noted above that shortages and surpluses are not equilibrium situations, and that markets allowed to adjust to shortages or surpluses will move to equilibrium. But sometimes markets are subject to regulations that prevent them from adjusting to shortages or surpluses. This is especially the case with price ceilings and price floors. The video at right illustrates how Germany instituted price controls after World War II.
A price ceiling is a maximum price that sellers may charge for a good or service. Normally this maximum price is established by some governmental authority. A classic example of price ceilings is provided by rent controls, where cities establish maximum rents in an effort to keep housing “affordable.” If this ceiling keeps the market price below the equilibrium price, it creates a shortage that persists (since the market price is prevented from rising to its equilibrium level).
Think like an Economist...
Examples of price ceilings and floors in the news:
Florida insurance premiums
Penn State student football tickets
Examples of price ceilings and floors in the news:
Florida insurance premiums
Penn State student football tickets
When price ceilings are in effect and the ceiling price is below the equilibrium price, it is no longer the case that supply, demand, and price alone can serve to allocate the product to different consumers. The product must be rationed via nonprice mechanisms as well. Allocation in these circumstances may be based on queuing (lining up to wait for distribution of the good or service), rationing coupons, or black markets (where illegal trading takes place at market-determined prices).
A price floor is a minimum price that must be paid in a market – i.e., exchange at a lower price is prohibited. Governmental bodies typically establish price floors. Two examples are the minimum wage and support prices for agricultural products. If a price floor keeps the market price above the equilibrium price, it creates a surplus that persists (since the market price is prevented from falling to its equilibrium level). This surplus typically will create some problems. In the minimum wage example, it may contribute to higher unemployment than would exist in the absence of a minimum wage, and in the farm price support example it will translate into a need to cope with growing surpluses of agricultural products. Again, nonprice rationing will be utilized.
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