Now that we have the basic tools to understand
how supply and demand work, let’s analyze
how the two market forces interact with each
other.
Market equilibrium is a situation in which
the quantity supplied equals the quantity
demanded.
Buyers are willing to buy what sellers are
willing to sell, and sellers are willing to
sell what buyers are willing to buy.
There are two aspects to market equilibrium:
the equilibrium price, and the equilibrium
quantity.
Equilibrium price is the price at which the
quantity demanded is equal to the quantity
supplied.
The equilibrium quantity is the quantity that
is bought and sold at the equilibrium price.
Graphically speaking, this quantity and price
occur at the point at which the supply and
demand curves intersect each other.
This is where the quantity demanded equals
the quantity supplied at a single price.
At this point you might be wondering: what
happens if the price isn’t at the equilibrium
price?
Well, if the price isn’t at the equilibrium
price, it can either be higher or lower.
If market price is higher than the equilibrium
price, on the graph we will see this as price
“P”, producers are supplying more of the
good to the market than buyers are willing
to buy.
This is a situation in which we have a surplus
of the good in the market.
On the graph, firms produce “Qs” amount
of the good whereas buyers only buy “Qd”
amount of the good.
Sellers, who are unable to sell their extra
quantity at this price begin lowering their
selling prices in order to get rid of their
excess inventories.
This induces buyers to buy more of the good.
Eventually, prices will keep falling due to
this mechanism until we reach equilibrium,
where the amount that sellers are selling
is equal to the amount that buyers are buying.
On the graph, this corresponds to Pe and Qe,
or the equilibrium price and equilibrium quantity.
The second possibility, if market price is
not equal to the equilibrium price, is that
the price is lower than the equilibrium price,
such as price “P” on the graph.
In this situation, the quantity demanded exceeds
the quantity supplied.
On the graph, “Qd” units are demanded
and “Qs” units are supplied.
We have a shortage.
What happens in this situation is that buyers
begin to offer sellers more money for the
good so that they can buy it.
Sellers accept this higher price, and in turn,
because the price has risen, produce more.
Buyers keep bidding up the price and sellers
keep accepting these higher prices until we
reach the equilibrium price, at which buyers
and sellers are happy with the amount of the
good that is being traded.
