Finding an equilibrium price

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Introduction

What do we mean by the concept of a market equilibrium?

Equilibrium means a state of equality or balance between market demand and supply

Without a shift in demand and/or supply there will be no change in price. In the diagram above, the quantity demanded and supplied at price P1 are equal. At price P3, supply exceeds demand and at P2, demand exceeds supply.

Prices where demand and supply are out of balance are termed points of disequilibrium.

Changes in the conditions of demand or supply will cause changes in the equilibrium price and quantity in the market.

Demand and supply schedules can be represented in a table. The weekly demand and supply schedules for T-shirts (in thousands) in a city are shown in the next table:

• The equilibrium price is £5 where demand and supply are equal at 12,000 units
• If the current market price was £3 – there would be excess demand for 8,000 units
• If the current market price was £8 – there would be excess supply of 12,000 units
• A rise in income causes demand to rise by 4,000 at each price. The next row of the table shows the higher level of demand. Assuming that the supply schedule remains unchanged, the new equilibrium price is £6 per tee shirt with an equilibrium quantity of 14,000 units
• The entry of new producers into the market causes a rise in supply of 8,000 T-shirts at each price. The new equilibrium price becomes £4 with 18,000 units bought and sold

• The outward shift in the demand curve causes an expansion along the supply curve and a rise in the equilibrium price and quantity.  Firms in the market will sell more at a higher price and therefore receive more total revenue
• The reverse effects will occur when there is an inward shift of demand
• A shift in the demand curve does not cause a shift in the supply curve! 
• Demand and supply factors are usually assumed to be independent of each other although some economists claim this assumption is no longer valid!
• Equilibrium price represents a trade-off for buyer and seller – higher prices are good for the producer (higher revenues and profits) but they make the product more expensive for the buyer

Changes in Market Supply and Equilibrium Price

The equilibrium price and quantity in a market will change when there shifts in both market supply and demand. Two examples of this are shown in the next diagram:

In the left-hand diagram above, we see an inward shift of supply together with a fall in demand. Both factors lead to a fall in quantity traded, but the rise in costs forces up the market price.

The second example on the right shows a rise in demand from D1 to D3 but a much bigger increase in supply from S1 to S2. The net result is a fall in equilibrium price (from P1 to P3) and an increase in the equilibrium quantity traded in the market from Q1 to Q3.

Moving from one market equilibrium to another

• Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand outlined in the diagrams before are reflective of changes in conditions in the market.
• So an outward shift of demand (depending upon supply conditions) leads to a short term rise in price and a fall in available stocks.
• The higher price is an incentive for suppliers to raise their output (termed as an expansion of supply) causing a movement up the short term supply curve towards the new equilibrium point.

Diagrams are a simplification of reality!

• We tend to use supply and demand diagrams to illustrate movements in market prices and quantities – this is known as comparative static analysis
• The reality in most markets and industries is more complex. For a start, many businesses have imperfect knowledge about their demand curves – they do not know precisely how consumer demand reacts to changes in price or the true level of demand at each and every price
• Likewise, constructing accurate supply curves requires detailed information on production costs and these may not be readily available.

Regulated prices

Not all prices are set by the free-market forces of supply and demand. In Britain, a number of prices are affected by industry regulators – good examples are rail fares, the cost of postage stamps and water bills.

In the rail market, some of the fares are unregulated allowing train operating companies to set their own prices. But around half of the fares charged for UK rail travellers are determined by the rail regulator

You can see from the chart below that average rail fares in the UK have grown faster than the overall consumer price index. The result is that the real cost or price of travel has increased over recent years.

A Summary of Changes in Market Equilibrium Price

Here is a summary when there is a unique change in one of the conditions of market demand or supply

The possible outcomes for price and quantity are less certain when there is more than one change in demand and supply conditions

• (+) signifies increase in demand / supply
• signifies no change in conditions of demand / supply
• (-) signifies a fall in demand / supply

The outcome for market price is often uncertain because it depends on the size of the relative changes in supply and demand in a given time period.

For example:

• A 20% rise in demand and a 8% rise in supply will cause prices to rise
• A 10% rise in demand and a 30% rise in supply will cause prices to fall
• A 25% rise in demand and a 25% rise in supply will cause prices to remain constant
  

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