Economics (9214) | Equilibrium price

💰 How Prices Are Determined: Understanding Equilibrium Price

Welcome to one of the most important chapters in all of Economics! Have you ever wondered how the price of your favourite snack or the latest video game is actually decided? It’s not magic—it's determined by the forces of demand and supply interacting in the market.

In this chapter, we will learn about the Equilibrium Price: the crucial point where buyers and sellers agree, and the market achieves perfect balance. Mastering this concept is key to understanding how real-world markets function!

⭐ The Core Concept: Market Equilibrium

The Balancing Act: What is Equilibrium?

Imagine a set of scales perfectly balanced. This is exactly what we mean by equilibrium in Economics.

Equilibrium occurs when the amount of a product that consumers want to buy is exactly equal to the amount that producers want to sell.

• Key Term: Equilibrium Price (P_e)
  This is the price where Demand equals Supply (D = S). There is no pressure for the price to change.
• Key Term: Equilibrium Quantity (Q_e)
  This is the specific amount of goods bought and sold at the equilibrium price.

Analogy: Think of a crowded dance floor. Equilibrium is the point where every person who wants to dance has a partner, and there are no unhappy people waiting on the sidelines or looking for a second partner!

Visualizing Equilibrium on the Graph

Don't worry if graphs seem tricky—the concept is simple!

When we draw a standard demand curve (sloping down) and a supply curve (sloping up) on the same graph, the Equilibrium Point is where the two lines cross.

At this intersection:

1. The price on the vertical axis is the Equilibrium Price.
2. The quantity on the horizontal axis is the Equilibrium Quantity.

Quick Review: Remember that the Demand curve shows consumer behaviour, and the Supply curve shows producer behaviour. Equilibrium is the point of agreement!

📉 Market Disequilibrium Part 1: Excess Supply (Surplus)

What happens if the price is set too high?

If the market price is set above the equilibrium price, suppliers are thrilled—they want to sell lots of products because they get a high return. However, consumers won't buy much because the price is too expensive.

What is a Surplus?

A Surplus (or Excess Supply) occurs when the quantity supplied (Q_S) is greater than the quantity demanded (Q_D).
(Q_S > Q_D)

Real-World Example: Imagine a farmer grows 1,000 apples and tries to sell them for $3 each. Consumers only want to buy 400 apples at that high price. The farmer has 600 unsold apples—that’s the surplus!

Step-by-Step Adjustment Back to Equilibrium

When there is a surplus, the market naturally fixes itself:

1. Problem: Producers have too much stock sitting around (Surplus).
2. Action: To get rid of the unsold goods, producers must lower the price.
3. Consequence: As the price falls, two things happen:
   • Demand rises (consumers like the lower price).
   • Supply falls (producers are less willing to sell at the lower price).
4. Result: The market moves back down along the curves until D = S, and the equilibrium is restored.

Key Takeaway: A surplus always puts downward pressure on price.

📈 Market Disequilibrium Part 2: Excess Demand (Shortage)

What happens if the price is set too low?

If the market price is set below the equilibrium price, consumers are delighted—they want to buy huge quantities! However, producers are unhappy because they make very little profit, so they only want to supply a small amount.

What is a Shortage?

A Shortage (or Excess Demand) occurs when the quantity demanded (Q_D) is greater than the quantity supplied (Q_S).
(Q_D > Q_S)

Real-World Example: A hot new video game console is released for only $100 (a price far below the equilibrium). Thousands of people want one, but the company only made 100 consoles. There is a massive queue and many disappointed customers—that’s the shortage!

Step-by-Step Adjustment Back to Equilibrium

When there is a shortage, the market fixes itself in the opposite direction:

1. Problem: Goods are selling out instantly, and many potential customers are left wanting (Shortage).
2. Action: Producers realize they can raise the price because consumers are desperate and willing to pay more.
3. Consequence: As the price rises, two things happen:
   • Demand falls (only the most willing buyers remain).
   • Supply rises (producers are now motivated by the higher profit).
4. Result: The market moves back up along the curves until D = S, and the equilibrium is restored.

Key Takeaway: A shortage always puts upward pressure on price.

🌪️ Changes in Equilibrium: When Demand or Supply Shifts

Equilibrium is stable, but not permanent! Real-world events (like changes in income, fashion, or production costs) can cause the entire Demand or Supply curve to shift, leading to a new equilibrium price and quantity.

Don't worry if this seems tricky at first. We just follow three simple steps every time a curve shifts:

1. Identify which curve shifts (D or S).
2. Determine the direction of the shift (Left or Right).
3. Analyze the resulting temporary disequilibrium (Shortage or Surplus) and the final price/quantity change.

Scenario 1: Increase in Demand (D Shifts Right)

Example: A celebrity promotes a new brand of running shoe (Demand increases).

Process:

1. Demand shifts right (D to D1).
2. At the original price, Quantity Demanded is now higher than Quantity Supplied. This creates a temporary Shortage.
3. The shortage puts upward pressure on price (P rises).
4. The result is a Higher Equilibrium Price (P↑) and a Higher Equilibrium Quantity (Q↑).

Scenario 2: Decrease in Supply (S Shifts Left)

Example: A factory fire destroys the equipment needed to make the running shoes (Supply decreases).

Process:

1. Supply shifts left (S to S1).
2. At the original price, Quantity Demanded is now higher than Quantity Supplied. This creates a temporary Shortage.
3. The shortage puts upward pressure on price (P rises).
4. The result is a Higher Equilibrium Price (P↑) and a Lower Equilibrium Quantity (Q↓).

Quick Review Summary of Shifts:

Understanding these four outcomes is essential for the exam:

Change	Curve Shift	Effect on Price (P)	Effect on Quantity (Q)
Demand Increases	D → Right	↑ Rise	↑ Rise
Demand Decreases	D → Left	↓ Fall	↓ Fall
Supply Increases	S → Right	↓ Fall	↑ Rise
Supply Decreases	S → Left	↑ Rise	↓ Fall

Memory Aid: If Demand shifts, Price (P) and Quantity (Q) move together. If Supply shifts, Price (P) and Quantity (Q) move in opposite directions!

Did you know? Economists call the mechanism where prices change to signal shortages or surpluses the Rationing Function of Price. Price rations the scarce goods to those who value them most highly (and can afford them).

Common Mistake to Avoid

A common error is confusing the cause and effect. Remember:

• A shift in the curve (D or S) is the cause.
• The resulting change in equilibrium price (P_e) is the effect.

Price changes never cause a shift; they are the result of the shift!

🧠 Final Key Takeaway

The market price is constantly moving towards equilibrium. If the price is too high (surplus), it falls. If the price is too low (shortage), it rises. This constant adjustment is what makes free markets efficient and dynamic.