Market Equilibrium

The graph of market equilibrium

The graph of market equilibrium provides useful insights into the dynamics of a market. Why do some economists argue that a market is destined to reach the equilibrium point in a free market setting?

To understand how and why the market reaches the equilibrium point consider Figure 1 below. Imagine that the free market equilibrium is at the intersection of supply and demand at the price of £4.

Imagine that transactions currently occur at a price of £3, which is £1 below the equilibrium price. At this point, you would have a firm willing to supply 300 units of goods, but consumers are willing to buy 500 units. In other words, there is excess demand for the good of 200 units.

The excess demand will push the price up to £4. At £4, firms are willing to sell 400 units, and buyers are ready to buy 400 units. Both sides are happy!

Fig 1. - Price below market equilibrium

But what if the price at which transactions currently occur is £5? Figure 2 illustrates this scenario. In such a case, you would have the opposite. This time, you have buyers willing to buy only 300 units at £5, but sellers are willing to supply 500 units of goods at this price. In other words, there is an excess supply of 200 units on the market.

The excess supply will push the price down to £4. The equilibrium output occurs at 400 units where everyone is happy again.

Fig 2. - Price above market equilibrium

Due to the incentive provided by the dynamics of prices being above or below the equilibrium, the market will always have the tendency to move towards the equilibrium point. Figure 3 shows the market equilibrium graph. At the equilibrium point both the demand curve and the supply curve intersect, creating what is known as equilibrium price P and equilibrium quantity Q.

Fig 3. - Market equilibrium graph

Changes in market equilibrium

One important thing to consider is that the equilibrium point is not static but subject to change. The equilibrium point can change when external factors cause a shift either in the supply or demand curve.

Fig 4. - A change in market equilibrium as a result of a demand shift

As Figure 4 shows, an outward shift in the demand curve would cause the market equilibrium to move from point 1 to point 2 at a higher price (P2) and quantity (Q2). The demand could shift either inwards or outwards. There are many reasons why the demand could shift:

• A change in income. If an individual’s income increases, the demand for goods and services will also increase.
• Taste change. If someone didn’t like sushi but started liking it, the demand for sushi would increase.
• Price of substitute goods. Whenever there is an increase in a price of a substitute good, the demand for that good will fall.
• Price of complementary goods. As these goods are significantly linked, a price drop in one of the complementary goods would increase the demand for the other good.

To learn more about the determinants of demand check our explanation on Demand.

Fig 5. - A change in market equilibrium as a result of a shift in supply

In addition to demand shifts, you also have supply shifts that cause the market equilibrium to change. Figure 5 shows what happens to the equilibrium price and quantity when there’s a supply shift to the left. This would cause the equilibrium price to increase from P1 to P2, and the equilibrium quantity to decrease from Q1 to Q2. The market equilibrium will move from point 1 to point 2.

Many factors cause the supply curve to shift:

• The number of sellers. If the number of sellers in the market increases, this would cause the supply to shift to the right, where you have lower prices and higher quantities.
• Cost of input. If the cost of production inputs were to increase, it would cause the supply curve to shift leftwards. As a result, the equilibrium would occur at higher prices and lower quantities.
• Technology. New technologies that would make the production process more efficient could increase supply, which would cause the equilibrium price to drop and the equilibrium quantity to increase.
• The environment. Nature plays a vital role in many industries, especially agriculture. If there are no favourable weather conditions, the supply in agriculture would fall, causing an increase in equilibrium price and a decrease in equilibrium quantity.

To learn more about the determinants of supply check our explanation on Supply.

The market equilibrium formula and equations

If you are looking at how to estimate the market equilibrium demand and supply, the main formula to consider is Qs=Qd.

Assume that the demand function for the apple market is Qd=7-P, and the supply function is Qs= -2+2P.

How to estimate equilibrium price and quantity?

The first step is to calculate the equilibrium price by equalizing the quantity demanded and quantity supplied.

$Qs=Qd$

The price equilibrium, in this case, is P*=3 and the equilibrium quantity is Q*=4.

Keep in mind that the market equilibrium will always occur when the Qd=Qs.

A market is in equilibrium for as long as the planned supply and planned demand intersect. That is when they are equal to each other.

What would happen if there’s a change in the market equilibrium for some reason? That’s when disequilibrium occurs.

When situations like this emerge, you would expect to see an imbalance between the quantity supplied, and the quantity demanded.

Consider the case of a fish market. Figure 6 below illustrates the market for fish that is initially in equilibrium. At point 1, the supply curve for fish intersects the demand curve, which provides the equilibrium price and quantity in the market.

Fig 6. - Excess demand and excess supply

What would happen if the price was P1 instead of Pe? In that case, you would have fishermen wishing to supply much more than the number of people who want to buy fish. This is a market disequilibrium known as excess supply: sellers wanting to sell more than the demand for the good.

On the other hand, you would have less fish supplied when the price is below the equilibrium price but significantly more fish demanded. This is a market disequilibrium known as excess demand. Excess demand happens when the demand for the good or service is much higher than the supply.