The Equilibrium Price

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The Equilibrium Price

The last two Learns-Its looked at the demand and supply curves in some detail. Now we need to bring these two things together to find the equilibrium price. After all, the market for any good or service needs buyers and sellers. The demand curve represents the actions, at any price level, of the buyers (or consumers). The supply curve represents the actions, at any price level, of the sellers (or firms, or producers). To find out what the price level will actually be, we need to see what happens when we combine the demand and supply curves.

Some of the textbooks you have read may have referred to the price mechanism. This is the mechanism through which the price is determined in a market system. Basically, the price will adjust until supply equals demand, at which point we have the equilibrium price.

The dictionary definition of 'equilibrium' is 'a state of physical balance', or put more simply, 'a state of rest'. As you will see in the following diagrams, any given market is only 'at rest' when supply equals demand, which is where the two curves cross.

The price mechanism

In the diagram above, let us assume that the price is P2 temporarily. At this price, demand is quite low (Q3) but firms wish to supply quite a lot (Q2). We have excess supply equal to Q2 - Q3. Firms find that they have a glut of unsold goods. This is not a 'state of rest'. If you were one of those firms, what would you do? I would probably reduce the price a little (have a sale, maybe?) until I could sell off all my excess stock. Applying this to the diagram, the price would fall until firms reached a position where they no longer experienced excess supply. This occurs where supply equals demand, price P1, quantity Q1. You may have heard of the 'invisible hand', Adam Smith's famous metaphor that tries to explain what is going on here. Nothing physically forces the price down; it just happens naturally, or 'invisibly'!

The price mechanism

Now let us assume that the price is P3 temporarily. Now we have a situation when the price is relatively low, so the demand for the product (Q4) is much higher than the amount firms wish to supply (Q5). We have excess demand equal to Q4 - Q5. Now firms find that they sell their stock very easily and there are customers queuing at the door wanting more! What would you do this time if you were one of those firms? I would be thinking that I could get away with raising my price given the popularity of the good. I would keep doing this until there were no longer queues outside my door and the demand for my product matched the amount I supplied. Again, this will occur where supply equals demand, price P1, quantity Q1. The invisible hand is at work again!

In the last two Learn-Its, we looked at why supply and demand curves might shift. We can now look at how these shifts can affect the equilibrium price.

Shifts in supply and demand

The original equilibrium price is P1, quantity Q1. We are at a 'state of rest'. Now assume that one of the determinants of demand changes. For instance, there may have been an increase in advertising in the industry. This will shift the demand curve to the right, ceteris paribus (D2). The price will not stay at P1 for much longer. We have an excess demand situation (A to C). As stated above, this will cause the price to be bid up, and this will keep going until we reach the new equilibrium price where the new demand curve crosses the supply curve (at point B). Note that there has been a shift in the demand curve, but only a movement along the supply curve. None of the determinants of supply have changed.

Earlier, we called this process the 'price mechanism'. From the analysis above, we can see that the price itself has the most important role. The rising price has acted as a signal to possible new firms who might want to join this expanding industry. It acted as an incentive, encouraging existing firms to produce more (the movement along the supply curve). It also acted as a sort of rationing device in the sense that it put off some existing buyers and helped make sure that demand matched supply.

You can probably see that there are three other diagrams that I could draw: a shift to the left of the demand curve; a shift to the right of the supply curve and a shift to the left of the supply curve, all assuming ceteris paribus. You should be able to think of reasons why any one of those curves might shift (ceteris paribus) and then draw the appropriate diagram yourself. Try this now, but if you do have problems then look at the diagrams below.

Demand curve shifts to the left

Demand curve shifts to the left

  • Initial equilibrium: P1, Q1 (A)
  • New equilibrium: P3, Q4 (E)
  • Why might the demand curve shift to the left?
  • Fall in real incomes
  • Reduced preferences for the good
  • Fall in the price of a substitute
  • Rise in the price of a complement
  • Fall in population numbers
  • Reduced advertising and marketing

Supply curve shifts to the right

Supply curve shifts to the right

  • Initial equilibrium: P1, Q1 (A)
  • New equilibrium: P4, Q6 (G)
  • Why might the supply curve shift to the right?
  • Fall in wage costs
  • Fall in raw material costs
  • Improved labour productivity
  • Reduced indirect taxes
  • Increased subsidies
  • Improved technology
  • Entry of new firms into the industry

Supply curve shifts to the left

  • Initial equilibrium: P1, Q1 (A)
  • New equilibrium: P5, Q8 (J)
  • Why might the supply curve shift to the left?
  • Rise in wage costs
  • Rise in raw material costs
  • Reduced labour productivity
  • An increase in indirect taxes
  • Reduced, or elimination of, subsidies
  • The exit of existing firms from the industry

When both curves shift

It is not unreasonable to think of a situation where both the demand and supply curves shift. Think of the market for computers over the last decade or so.

When both curves shift

The demand curve for computers has definitely shifted to the right for several reasons. Real incomes have risen, there has been a rise in their preferences and the marketing of computers has increased, to name just three factors. But there has also been a huge shift to the right in the supply curve for computers. There have been immense leaps in technology so that any given computer can be produced at a fraction of the cost compared with a decade ago. This can be seen in the diagram above. The equilibrium price has fallen from P1 to P2, a fairly large relative drop, and the quantity supplied and demanded has also risen hugely, from Q1 to Q2. What actually happens in the market for computers at the moment is that the price remains fairly constant, but for the same price, a given computer gets technically better and better as the months go by.

Consumer surplus is officially defined as the welfare, or benefit, a consumer derives from the purchase of a good or service. It is a 'surplus' because it measures, in a sense, the extra 'benefit' they receive because the price they actually pay is less than the price they were willing to pay.

Consumer surplus

In the diagram above, the equilibrium price is P1 and the equilibrium quantity is Q1. The demand curve shows the value that consumers place on the product in question. If the price is high then there are not many consumers who value the product so highly. When the price is low numerous consumers are prepared to buy the product. Imagine that you are a consumer that is prepared to pay P2 for the product in question. Luckily for you, the market price is only P1, so the difference between the two prices (P2 - P1, or A minus B) is, in a sense, an intangible benefit that you receive. If you went to a newsagent, fully prepared to pay 80p for an ice cream, but for whatever reason the price was only 50p, then, in a way, you have received a benefit of 30p.

If you extend this analysis over all prices, then the total consumer surplus in this market is represented by the triangle P1EC (under the demand curve, above the equilibrium price and to the right of the y-axis). It can be seen; therefore, that if the price rises, for whatever reason, then total consumer surplus will fall, and if the price falls then total consumer surplus will rise.

This concept is similar but refers to producer welfare rather than consumer welfare. Producer surplus is, effectively, producer profit (much more detail in the 'Costs and revenues' topic).

Producer surplus

As we know, the supply curve represents what the producers are willing and able to supply. It is also their marginal cost curve. If a producer is just prepared to supply the Q2th unit, then the cost of producing that unit must be the distance CQ2. But the market price is P1, so the revenue he gains from selling that unit is represented by the distance BQ2. Profit is revenue minus cost, so the producer profit (or producer surplus) is the distance BC.

Again, if one extends this analysis to all units supplied, the total producer surplus is represented by the triangle P1AE (Above the supply curve, below the market price and to the left of the y-axis.)