Illustrated Guide to the Supply and Demand Equilibrium

IN ONE HAND, OUT THE OTHER
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In terms of economics, the forces of supply and demand determine our everyday lives as they set the prices of the goods and services we purchase daily. These illustrations and examples will help you understand how the prices of products are determined via market equilibrium.

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Supply and Demand Equilibrium

Even though the concepts of supply and demand are introduced separately, it's the combination of these forces that determine how much of a good or service is produced and consumed in an economy and at what price. These steady-state levels are referred to as the equilibrium price and quantity in a market.

In the supply and demand model, the equilibrium price and quantity in a market is located at the intersection of the market supply and market demand curves. Note that the equilibrium price is generally referred to as P* and the market quantity is generally referred to as Q*.

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Market Forces Result in Economic Equilibrium: Example of Low Prices

Even though there is no central authority governing the behavior of markets, the individual incentives of consumers and producers drive markets toward their equilibrium prices and quantities. To see this, consider what happens if the price in a market is something other than the equilibrium price P*.

If the price in a market is lower than P*, the quantity demanded by consumers will be larger than the quantity supplied by producers. A shortage will therefore result, and the size of the shortage is given by the quantity demanded at that price minus the quantity supplied at that price.

Producers will notice this shortage, and the next time they have the opportunity to make production decisions they will increase their output quantity and set a higher price for their products.

As long as a shortage remains, producers will continue to adjust in this way, bringing the market to the equilibrium price and quantity at the intersection of supply and demand.

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Market Forces Result in Economic Equilibrium: Example of High Prices

Conversely, consider a situation where the price in a market is higher than the equilibrium price. If the price is higher than P*, the quantity supplied in that market will be higher than the quantity demanded at the prevailing price, and a surplus will result. This time, the size of the surplus is given by the quantity supplied minus the quantity demanded.

When a surplus occurs, firms either accumulate inventory (which costs money to store and hold) or they have to discard their extra output. This is clearly not optimal from a profit perspective, so firms will respond by cutting prices and production quantities when they have the opportunity to do so.

This behavior will continue as long as a surplus remains, again bringing the market back to the intersection of supply and demand.

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Only One Price in a Market Is Sustainable

Since any price below the equilibrium price P* results in upward pressure on prices and any price above the equilibrium price P* results in downward pressure on prices, it should not be surprising that the only sustainable price in a market is the P* at the intersection of supply and demand.

This price is sustainable because, at P*, the quantity demanded by consumers is equal to the quantity supplied by producers, so everyone who wants to buy the good at the prevailing market price can do so and there is none of the good left over.

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The Condition for Market Equilibrium

In general, the condition for equilibrium in a market is that the quantity supplied is equal to the quantity demanded. This equilibrium identity determines the market price P*, since quantity supplied and quantity demanded are both functions of price.

See here for more on how to calculate equilibrium algebraically.

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Markets Are Not Always in Equilibrium

It is important to keep in mind that markets are not necessarily in equilibrium at all points in time. This is because there are various shocks that can result in supply and demand being temporarily out of balance.

That said, markets trend toward the equilibrium described here over time and then remain there until there is a shock to either supply or demand. How long it takes a market to reach equilibrium depends on the specific characteristics of the market, most importantly how often firms have the chance to change prices and production quantities.

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Beggs, Jodi. "Illustrated Guide to the Supply and Demand Equilibrium." ThoughtCo, Oct. 31, 2017, thoughtco.com/supply-and-demand-equilibrium-1147700. Beggs, Jodi. (2017, October 31). Illustrated Guide to the Supply and Demand Equilibrium. Retrieved from https://www.thoughtco.com/supply-and-demand-equilibrium-1147700 Beggs, Jodi. "Illustrated Guide to the Supply and Demand Equilibrium." ThoughtCo. https://www.thoughtco.com/supply-and-demand-equilibrium-1147700 (accessed January 22, 2018).