4.5 Supply and demand - finding the market equilibrium
We now examine how an industry supply curve and market demand curve interact to produce a market equilibrium. We have already discussed the factors that affect the shape and position of each of these curves: price, income, and consumer preferences in the case of the demand curve; price, costs, and other factors in the case of the supply curve.
- It is important to bear in mind that the supply curve and the demand curve are both independent of each other. The shape and position of the demand curve is not affected by the shape and position of the supply curve, and vice versa.
What the supply and the demand curves have in common is their representation of responses to price.
In a perfectly competitive market an equilibrium is achieved when supply equates to demand.
QS = QD
Thus, price varies until QS = QD. Two key mechanisms are involved in ensuring that if price is not at this clearing level, it will adjust until it reaches that level. These are as follows.
- If the price lies above the clearing price, producers will be left with excess stocks that consumers are not willing to buy at the prevailing price. In this situation the market is characterised by what is called excess supply. In order to clear these stocks, producers will have to accept a lower price for their goods. Price will fall until the market is in equilibrium and supply equates to demand. Remember the assumption of perfect information and consider how this will facilitate this mechanism.
- If the price lies below the clearing price, there will be what is termed excess demand. Many consumers will be unable to purchase the goods they are seeking because suppliers have run out of stock. At the prevailing price, suppliers are unable to meet demand. Market forces will eventually rectify this situation as consumers bid up the price until the equilibrium price is reached.
Remember that, in a perfectly competitive market, producers are price-takers. Individually, none of them can effect a price change. All buyers and sellers have perfect information about the quantities available for sale and the prevailing price. If these conditions did not exist then an equilibrium would not necessarily be established at QS = QD, although it might well be established at another point. For example, if supply was controlled by a monopoly, the latter could set the price wherever it liked. However, a monopoly is still bound by how much the market demands at any given price.
Now consider a situation where the suppliers are price-takers, but information about market conditions is not widely available. In this case excess supply or demand might persist, slowing down, or preventing altogether, the process of reaching an equilibrium at QS = QD.
However, in a competitive environment we have price independently determining where suppliers and consumers position themselves along their respective supply and demand curves.
We also have the equilibrium price being determined by the interaction of supply and demand. At the point of equilibrium there is no reason for the market to move away from this position unless either the supply or the demand curve moves. You should recall from the previous two sections the factors that are likely to bring about a shift in either of these two curves.
The supply and demand model can be represented as a figure as shown in 4.5.1.
4.5.1 Basic supply and demand
Source: unit author
The supply function shows planned responses to differing levels of price.
If either the supply or demand curve shifts, a new equilibrium price will be created. A shift in the demand curve to the right will raise the equilibrium price. A movement of supply to the right will reduce the equilibrium price.
Importantly the analysis presented assumes that movements/shifts of the supply and demand curves are independent of each other. Making this assumption helps us to illustrate clearly what is meant by a market equilibrium, and the way in which a market clearing price is established.
Endogenous and exogenous variables
- Exogenous variables are considered to emanate from outside the market in question. They include all those influences such as consumers' preferences, incomes, technological change, the cost of inputs, climate etc.
- Endogenous variables are those which lie within the market system. There are three of them: the price of a good, the quantity of the good supplied, and the quantity demanded.
Comparative static analysis
Comparative static analysis means comparing two market equilibria before and after a change. Consider the figure in 4.5.2 which illustrates a supply shift and a demand shift. In each case, comparative statics is concerned with comparing the two static equilibria (A, B and C, D) rather than how the market moves from A to B or C to D.
4.5.2 Comparative statics
Source: unit author
In each case, the worst mistake would be to say that a change in the good's own price caused the shift in equilibrium. In moving from A to B, increasing price reduces quantity demanded along the demand curve. However, the new equilibrium was caused by the shift in the supply curve. Note that:
- a shift in the supply curve leads to a movement along the demand curve to a new static equilibrium position (eg at B). This could be caused, for example, by an increase in the costs of production, or for one season by bad weather for an agricultural crop.
- a shift in the demand curve leads to a movement along the supply curve to a new static equilibrium position (at D). This could result from by an increase in consumer incomes, a change in preferences in favour of the good, a decrease in the price of a complementary good, or an increase in the price of a substitute.