In a competitive market, demand for and supply of a good or service determine the equilibrium price.

Equilibrium

MARKETS: Equilibrium is achieved at the price at which quantities demanded and supplied are equal. We can represent a market in equilibrium in a graph by showing the combined price and quantity at which the supply and demand curves intersect.
For example, imagine that sellers of squirrel repellant are willing to sell 500 units of squirrel repellant at a price of dollar sign, 5 per can. If buyers are willing to buy 500 units of squirrel repellent at that price, this market would be in equilibrium at the price of dollar sign, 5 and at the quantity of 500 cans.

Disequilibrium

Whenever markets experience imbalances—creating disequilibrium prices, surpluses, and shortages—market forces drive prices toward equilibrium.
A surplus exists when the price is above equilibrium, which encourages sellers to lower their prices to eliminate the surplus.
A shortage will exist at any price below equilibrium, which leads to the price of the good increasing.
For example, imagine the price of dragon repellent is currently dollar sign, 6 per can. People only want to buy 400 cans of dragon repellent, but the sellers are willing to sell 600 cans at that price. This creates a surplus because there are unsold units. Sellers will lower their prices to attract buyers for their unsold cans of dragon repellant.

Changes in equilibrium

Changes in the determinants of supply and/or demand result in a new equilibrium price and quantity. When there is a change in supply or demand, the old price will no longer be an equilibrium. Instead, there will be a shortage or surplus, and price will subsequently adjust until there is a new equilibrium.
For example, suppose there is a sudden invasion of aggressive unicorns. There will be more people who want to buy unicorn repellent at all possible prices, causing demand to increase. At the original price, there will be a shortage of unicorn repellant, signaling sellers to increase the price until the quantity supplied and quantity demanded are once again equal.
We can summarize the changes in equilibrium with the following table:
Change Change in P, start superscript, times, end superscript Change in Q, start superscript, times, end superscript
Supply increases \uparrow (shifts right) P \downarrow Q \uparrow
Supply decreases \downarrow (shifts left) P \uparrow Q \downarrow
Demand increases \uparrow (shifts right) P \uparrow Q \uparrow
Demand decreases \downarrow (shifts left) P \downarrow Q \downarrow
Demand Increases, Supply increases P \updownarrow (indeterminate) Q \uparrow
Demand Increases, Supply decreases P \uparrow Q \updownarrow (indeterminate)
Demand decreases, Supply increases P \downarrow Q \updownarrow (indeterminate)
Demand decreases, Supply decreases P \updownarrow (indeterminate) Q \downarrow

Key Terms

Term Definition
market an interaction of buyers and sellers where goods, services, or resources are exchanged
shortage when the quantity demanded of a good, service, or resource is greater than the quantity supplied
surplus when the quantity supplied of a good, service, or resource is greater than the quantity demanded
equilibrium in a market setting, an equilibrium occurs when price has adjusted until quantity supplied is equal to quantity demanded
disequilibrium in a market setting, disequilibrium occurs when quantity supplied is not equal to the quantity demanded; when a market is experiencing a disequilibrium, there will be either a shortage or a surplus.
equilibrium price the price in a market at which the quantity demanded and the quantity supplied of a good are equal to one another; this is also called the “market clearing price.”
equilibrium quantity the quantity that will be sold and purchased at the equilibrium price

Key Graphical Models - The market model

Consider the market for giant shiny salamander stickers, given in Figure 1. Currently, the equilibrium price of these stickers is dollar sign, 5, and the equilibrium quantity is 3.
 
 
Figure 1: The market for salamander stickers
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Changes in Supply

Suppose the price of glitter, which is used to make giant shiny salamander stickers, increases so that it now costs the seller dollar sign, 2 more per sticker to produce them. This will cause the supply of this good to decrease. To see the impact a decrease in supply will have on the equilibrium price and quantity, grab the interactive supply curve and shift it to the left until the price is dollar sign, 2 higher at every level of output (the new supply curve should start at dollar sign, 4).
What change did you notice? If you adjusted the graph correctly, you should see the equilibrium price increases to dollar sign, 6, and the equilibrium quantity in this market decreases to 2 stickers.
Now instead, suppose someone invents a new way to produce shiny salamander stickers so there is less waste and fewer resources are needed to produce them. This would result in an increase in the supply of shiny salamander stickers. To see the impact an increase in supply will have on the equilibrium price and quantity, grab the interactive supply curve and drag it to the right so that at every quantity the price is dollar sign, 2 lower (the new supply curve should start at dollar sign, 0).
How did you do? If you adjusted the graph correctly, you should see the equilibrium price decreases to dollar sign, 4 and equilibrium quantity increases to 4 stickers.

Changes in demand

Suppose a famous, trendsetting actress starts wearing giant shiny salamander stickers, which makes them instantly the must-have accessory. This would cause the demand for this good to increase. To see the impact on equilibrium price and quantity in the market from an increase in demand, grab the demand curve Figure 2 and shift it to the right to represent an increase in demand.
 
 
Figure 2: The market for salamander stickers
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Changes in both demand and supply

When both supply and demand change at the same time, the impact on equilibrium price and quantity cannot be determined for certain without knowing which changed by a greater amount.
Suppose shiny salamander stickers fall out of popularity, and therefore the demand for them decreases. At the same time, the price of glitter goes up, which leads to a decrease in supply.
On the one hand, the decrease in demand should make price decrease and quantity demanded decrease.On the other hand, the decrease in supply should also make price __increase and quantity demanded decrease. That means we know for certain that the quantity of giant shiny salamander stickers will decrease. But what will happen to price?
In Figure 3, we see a decrease in supply and a decrease in demand. The effect on quantity is easy to determine (quantity will definitely decrease). On the other hand, it is hard to tell if the equilibrium price has increased, decreased, or stays the same. Because we cannot say which of these has happened with certainty, we say that the price change is indeterminate or ambiguous.
Figure 3: The market for giant shiny salamander stickers
Of course, when modeling changes in a graph it is possible to see changes in both equilibrium price and quantity when shifting both demand and supply (depending on how much each curve shifts). In the interactive graph below, move both demand and supply in different directions. Each time, move the equilibrium point to the new intersection of demand and supply. Try to create new equilibria at which:
  • Price is higher and quantity is higher
  • Price is higher and quantity is lower
  • Price is lower and quantity is higher
  • Price is lower and quantity is lower
 
 
 
 
 
 
 
 
 
 
123456789123456789���1�1��Figure 4: The market for salamander stickers

Common Misperceptions

  • When showing an equilibrium price and quantity, it is important to clearly label these on the appropriate axis, not just the interior of the graph. Remember that the point on either axis represents the market price and the market quantity, not a point in the middle of the graph.
  • When both supply and demand change at the same time, we will not be able to make a statement about what happens to both price and quantity, one of these will be uncertain.