Price determination in a market
In a competitive market, the price of a good or service is mainly determined by the interaction of demand and supply. Demand shows how much consumers are willing and able to buy at different prices. Supply shows how much producers are willing and able to sell at different prices.
Equilibrium means balance. In a market, equilibrium happens when the quantity demanded by consumers is equal to the quantity supplied by producers.
1. Market equilibrium
The equilibrium price is the price where demand and supply meet. The equilibrium quantity is the quantity bought and sold at that price. At equilibrium, there is no shortage and no surplus, so the market is stable.
In the diagram above, the downward-sloping demand curve and the upward-sloping supply curve cross at one point. This point gives the market equilibrium. At this price, consumers want to buy exactly the same quantity that producers want to sell.
2. Excess demand: shortage
Excess demand happens when the market price is below the equilibrium price. At this lower price, consumers want to buy more, but producers are not willing to supply enough. This creates a shortage.
When a shortage occurs, some consumers cannot get the product. Because demand is greater than supply, producers may raise the price. As price rises, quantity demanded falls and quantity supplied rises. The market moves back towards equilibrium.
Easy rule: If the price is too low, there will be a shortage. Demand is greater than supply, so price tends to rise.
3. Excess supply: surplus
Excess supply happens when the market price is above the equilibrium price. At this higher price, producers want to sell more, but consumers are not willing to buy as much. This creates a surplus.
When a surplus occurs, firms may have unsold stock. To sell this stock, producers may lower the price. As price falls, quantity demanded rises and quantity supplied falls. The market again moves back towards equilibrium.
Easy rule: If the price is too high, there will be a surplus. Supply is greater than demand, so price tends to fall.
4. Changes in equilibrium
Equilibrium can change if demand or supply shifts. A shift means that consumers or producers are now willing to buy or sell different quantities at each price. This can happen because of changes in income, tastes, population, technology, production costs, taxes, subsidies or weather conditions.
| Scenario | Effect on equilibrium price (Pe) | Effect on equilibrium quantity (Qe) |
|---|---|---|
| Demand increases while supply stays the same | Price rises | Quantity rises |
| Demand decreases while supply stays the same | Price falls | Quantity falls |
| Supply increases while demand stays the same | Price falls | Quantity rises |
| Supply decreases while demand stays the same | Price rises | Quantity falls |
5. Simple exam explanation
When answering a question on price determination, start by identifying whether the price is at equilibrium, below equilibrium or above equilibrium. Then explain what happens to demand and supply. If there is excess demand, price rises. If there is excess supply, price falls. In both cases, the market moves towards equilibrium.
Quick check
- Equilibrium: quantity demanded = quantity supplied.
- Shortage: price is below equilibrium, so quantity demanded is greater than quantity supplied.
- Surplus: price is above equilibrium, so quantity supplied is greater than quantity demanded.
- Price signal: shortages push prices up; surpluses push prices down.
