assignment 1 market equilibrium analysis

3.1 Demand, Supply, and Equilibrium in Markets for Goods and Services

Learning objectives.

By the end of this section, you will be able to:

• Explain demand, quantity demanded, and the law of demand
• Explain supply, quantity supplied, and the law of supply
• Identify a demand curve and a supply curve
• Explain equilibrium, equilibrium price, and equilibrium quantity

First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.

Demand for Goods and Services

Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won't buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a person who does not have a drivers license has no effective demand for a car.

What a buyer pays for a unit of the specific good or service is called price . The total number of units that consumers would purchase at that price is called the quantity demanded . A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand . The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.

We can show an example from the market for gasoline in a table or a graph. Economists call a table that shows the quantity demanded at each price, such as Table 3.1 , a demand schedule . In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like Figure 3.2 , with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical axis. While economists often use math, they are different disciplines.)

Table 3.1 shows the demand schedule and the graph in Figure 3.2 shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.

Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.

Confused about these different types of demand? Read the next Clear It Up feature.

Clear It Up

Is demand the same as quantity demanded.

In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to a (specific) point on the curve.

Supply of Goods and Services

When economists talk about supply , they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service . A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply . The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.

Still unsure about the different types of supply? See the following Clear It Up feature.

Is supply the same as quantity supplied?

In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to a (specific) point on the curve.

Figure 3.3 illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like Table 3.2 , that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.

The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.

Equilibrium—Where Demand and Supply Intersect

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.

Figure 3.4 illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to Figure 3.2 . The supply curve (S) is identical to Figure 3.3 . Table 3.3 contains the same information in tabular form.

Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in Figure 3.4 , is called the equilibrium . The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity . At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.

In Figure 3.4 , the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.

The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.

Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in Figure 3.4 illustrates this above-equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.

Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus .

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.

Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in Figure 3.4 shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.

When the price is below equilibrium, there is excess demand , or a shortage —that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which has been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read Demand, Supply, and Efficiency for more discussion on the importance of the demand and supply model.

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10 Market Equilibrium: Supply and Demand

Supply and Demand

The Policy Question Should the Government Provide Public Marketplaces?

In the Capitol Hill neighborhood of Washington, DC, the Eastern Market is a large building and grounds owned and operated by the city government. Farmers, bakers, cheese makers, and other merchants of food, arts, and crafts assemble there to sell their wares. Marketplaces like it were once a common feature of cities in the United States and Europe but are now a relative rarity. Many have disappeared due to citizens questioning whether the government should be supporting these marketplaces.

So why does the government play a role in providing some markets? The answer is found in the way markets create benefits for the citizens they serve. In this chapter, we explore how prices and quantities are set in market equilibrium, how changes in supply and demand factors cause market equilibrium to adjust, and how we measure the benefit of markets to society.

Markets are often private in the sense that the government is not involved in their creation or presence; instead, they are generated by the desire of private individuals to engage in an exchange for a particular good. Sometimes, however, the government plays an active role in establishing and managing markets. At the end of the chapter, we will study why this occurs, using the Eastern Market as an example.

Exploring the Policy Question

• Is public investment in marketplaces justified and if so why?

Learning Objectives

10.1 what is a market.

Learning Objective 10.1 : Identify the characteristics of a market.

10.2 Market Equilibrium: The Supply and Demand Curves Together

Learning Objective 10.2 : Determine the equilibrium price and quantity for a market, both graphically and mathematically.

10.3 Excess Supply and Demand

Learning Objective 10.3 : Calculate and graph excess supply and excess demand.

10.4 Measuring Welfare and Pareto Efficiency

Learning Objective 10.4 : Calculate consumer surplus, producer surplus, and deadweight loss for a market.

10.5 Policy Example Should the Government Provide Public Marketplaces?

Learning Objective 10.5 : Apply the concept of economic welfare to the policy of publicly supported marketplaces.

10.1 What Is a Market?

In chapter 9 , we found out that the market supply curve comes from the cost structure of individual firms, which in turn comes from their technology, as we discovered in chapter 7 . In chapter 5 , we found out where the demand curve comes from—the individual utility maximization problems of individual consumers. In both cases, we assumed the demand for and supply of a specific good or service. In other words, we were describing a particular market.

A market is characterized as a particular location where a specific good or service is being sold at a defined time. So, for example, we might talk about

• the market for eggs in Nashville, Tennessee, in April 2016;
• the market for rolled aluminum in the United States in 2015; or
• the market for radiological diagnostic services worldwide in the last decade.

In addition, for whatever item, time, and place we describe, there must be both buyers and sellers in order for a market to exist. A market is where buyers and sellers exchange or where there is both demand and supply.

We tend to talk about markets somewhat loosely when studying economics. For example, we might discuss the market for orange juice and leave the time and place undefined in order to keep things simple. Or we might just say that we are looking at the market for denim jeans in the United States. The difficulty with these simplifications is that we can lose sight of the basic assumptions about markets that are necessary for our analysis of them.

The six necessary assumptions for markets are the following:

• A market is for a single good or service.
• All goods or services bought and sold in a market are identical.
• The good or service sells for a single price.
• All consumers know everything about the product, including how much they value it.
• There are many buyers and sellers, and they are known to each other and can interact.
• All the costs and benefits of a transaction accrue only to the buyers and sellers who engage in them.

These assumptions are actually pretty easy to understand. They guarantee that the buyers who value the good more than it costs sellers to produce it will find a seller willing to sell to them. In other words, there are no transactions that don’t happen because the buyer doesn’t know how much they like the product or because a buyer can’t find a seller, or vice versa.

Of course, the assumptions describe an ideal market. In reality, many markets are not exactly like this, and later, in chapters 20 , 21 , and 22 , we will examine what happens when these assumptions fail to hold.

Market equilibrium is the point where the quantity supplied by producers and the quantity demanded by consumers are equal. When we put the demand and supply curves together, we can determine the equilibrium price : the price at which the quantity demanded equals the quantity supplied. In figure 10.1 , the equilibrium price is shown as [latex]P^*[/latex], and it is precisely where the demand curve and supply curve cross. This makes sense—the demand curve gives the quantity demanded at every price and the supply curve gives the quantity supplied at every price so there is one price that they have in common, which is at the intersection of the two curves.

Graphing the supply and demand curves to locate their intersection is one way to find the equilibrium price. We can also find this quantity mathematically. Consider a demand curve for stereo headphones that is described by the following function:

[latex]Q^D = 1,800 − 20P[/latex]

Note that in general, we draw graphs of functions with the independent variable on the horizontal axis and the dependent variable on the vertical axis. In the case of supply and demand curves, however, we draw them with quantity on the horizontal axis and price on the vertical. Because of this, it is sometimes easier to express the demand relationship as an inverse demand curve : the demand curve expressed as price as a function of quantity. In our example, this would be

[latex]P = 90 − 0.05Q^D[/latex].

This is just the original demand curve solved for [latex]P[/latex] instead of [latex]Q^D[/latex]. In the inverse demand curve, the vertical intercept is easy to see from the equation: demand for headphones stops at the price of $90. No consumer is willing to pay $90 or more for headphones.

Similarly, the supply curve can be represented as a mathematical function. For example, consider a supply curve described by the following function:

[latex]Q^S = 50P—1,000[/latex]

Similar to the demand curve, we can express this as an inverse supply curve : the supply curve expressed as price as a function of quantity. In this case, the inverse supply curve would be

[latex]P = 0.02Q^S + 20[/latex].

Here the vertical intercept, $20, gives us the minimum price to get a seller to sell headphones. At prices of $20 or less, there will be no supply. So we know that the equilibrium price should be between $20 and $90.

Solving for the equilibrium price and quantity is simply a matter of setting [latex]Q^D=Q^S[/latex] and solving for the price that makes this equality happen. In our example, setting [latex]Q^D=Q^S[/latex] yields

[latex]1,800 − 20P = 50P—1,000[/latex]

[latex]70P = 2,800[/latex]

[latex]P = $40[/latex]

At [latex]P = $40[/latex], the quantity demanded and supplied can be found from the demand and supply curves:

[latex]Q^D = 1,800 − 20(40) = 1,000[/latex]

[latex]Q^S = 50(40)—1,000 = 1,000[/latex]

That these two quantities match is no accident; this was the condition we set at the outset—that quantity supplied equals quantity demanded. So we know that a price of $40 per unit is the equilibrium price.

These supply and demand curves for headphones are graphed in figure 10.2 below, and their intersection confirms the equilibrium price we calculated mathematically.

Note that we have also identified the equilibrium quantity , [latex]Q^*[/latex]—the quantity at which supply equals demand. At $40 per unit, one thousand headphones are demanded, and exactly one thousand headphones are supplied. The equilibrium quantity has nothing to do with any kind of coordination or communication among the buyers and sellers; it has only to do with the price in the market. Seeing a unit price of $40, consumers demand one thousand units. Independently, sellers who see that price will choose to supply exactly one thousand units.

It makes sense that the equilibrium price is the one that equates quantity demanded with quantity supplied, but how does the market get to this equilibrium? Is this just an accident? No. The market price will automatically adjust to a point where supply matches demand. Excess supply or demand in a market will trigger such an adjustment.

To understand this equilibrating feature of the market price, let’s return to our headphones example. Suppose the price is $50 instead of $40. At this price, we know from the supply curve that fifteen hundred units will be supplied to the market. Also, from the demand curve, we know that eight hundred units will be demanded. Thus there will be an excess supply of seven hundred units, as shown in figure 10.3 .

Excess supply occurs when, at a given price, firms supply more of a good than what consumers demand. These are goods that have been produced by the firms that supply the market and have not found any willing buyers. Firms will want to sell these goods and know that by lowering the price, more buyers will appear. So this excess supply of goods will lead to a price decrease. The price will continue to fall as long as the excess supply conditions exist. In other words, price will continue to fall until it reaches $40.

The same logic applies to situations where the price is below the intersection of supply and demand. Suppose the price of headphones is $30. We know from the demand curve that at this price, consumers will demand twelve hundred units. We also know from the supply curve that at this price, suppliers will supply five hundred units. So at $30, there will be excess demand of seven hundred units, as shown in figure 10.4 .

Excess demand occurs when, at a given price, consumers demand more of a good than firms supply. Consumers who are not able to find goods to purchase will offer more money in an effort to entice suppliers to supply more. Suppliers who are offered more money will increase supply, and this will continue to happen as long as the price is below $40 and there is excess demand.

Only at a price of $40 is the pressure for prices to rise or fall relieved and will the price remain constant.

From our study of markets so far, it is clear that they can contribute to the economic well-being of both buyers and sellers. The term welfare , as it is used in economics, refers to the economic well-being of society as a whole, including producers and consumers. We can measure welfare for particular market situations.

To understand the economic concept of welfare—and how to quantify it—it is useful to think about the weekly farmers’ market in Ithaca, New York. The market is a place where local growers can sell their produce directly to consumers throughout the summer. It is very successful, and many local residents go to the market to buy produce. Now consider the specific example of tomatoes. What is this market worth to the tomato sellers and buyers that transact in the market?

Suppose a farmer has a minimum willingness-to-accept price of $1 for an heirloom tomato. This price could be based on the farmer’s cost of production or the value she places on consuming the tomato herself. Suppose also that there is a consumer who really wants an heirloom tomato to add to his salad that evening and is willing to pay up to $3 for one. If these two people meet each other at the market and agree on a price of $2, how much benefit do they each get?

The seller receives $2, and it cost her $1 to provide the tomato, so she is $1 better off, the difference between what she received and what she would have accepted for the tomato. Likewise, the buyer pays $2 but receives $3 in benefit from the tomato, since that was his willingness to pay; his net benefit is the difference, or $1. The seller and buyer are both $1 better off because they had the opportunity to meet and transact. Without this opportunity, the seller would have stayed at home with the tomato and been no better or worse off, and the buyer would not have a tomato for his salad but would be no better or worse off.

The difference between the price received and the willingness-to-accept price is called the producer surplus [latex](PS)[/latex]. The difference between the willingness-to-pay price and the price paid is called the consumer surplus [latex](CS)[/latex]. The sum of these two surpluses is called total surplus [latex](TS)[/latex]. So the producer surplus in the tomato example is $1, the consumer surplus is $1, and the total surplus is $2. This is the surplus generated by one transaction; if we add up all such transactions in the market, we get a measure of the consumer and producer surplus from the market.

Quantifying surplus for an entire market is easy to do with a graph. Let’s return to our previous example of headphones and find the consumer and producer surplus.

Figure 10.5 shows that the consumer surplus is the area above the equilibrium price and below the demand curve—the green triangle in the figure. Similarly, the producer surplus is the area below the equilibrium price and above the supply curve—the red triangle in the figure. The area of each surplus triangle is easy to calculate using the formula for the area of a triangle: [latex]\frac{1}{2}bh[/latex], where [latex]b[/latex] is base and [latex]h[/latex] is height.

In the case of consumer surplus, the triangle has a base of one thousand, the distance from the origin to [latex]Q^*[/latex], and a height of $50, the difference between $90, the vertical intercept, and [latex]P^*[/latex], which is $40.

[latex]\text{Consumer surplus} = \frac{1}{2}(1,000)($50) = $25,000[/latex]

[latex]\text{Producer surplus} = \frac{1}{2}(1,000)($20)= $10,000[/latex].

Total surplus created by this market is the sum of the two, or $35,000. This is the measure of how much value the market creates through its enabling of these transactions. Without the ability to come together in this market, the buyers and sellers would miss out on the opportunity to capture this surplus.

We say that a market is efficient when the entire potential surplus has been created. Such a market is an example of Pareto efficiency —an allocation of goods and services in which no redistribution can occur without making someone worse off. Think about the distribution of goods in the headphones example. All the buyers and sellers that transact are made better off by the transaction because they gain some surplus from it. If they didn’t, they would not voluntarily trade. None of the trades that shouldn’t happen do. For example, if there were more than one thousand units exchanged, it would mean sellers were selling to buyers who valued the good less than the sellers’ cost of production, where the supply curve is above the demand curve, and one or both of the parties would be worse off because of the exchange.

Another way to see that the market equilibrium outcome is efficient is if we arbitrarily limit the number of goods exchanged to nine hundred. Let’s call this maximum quantity restriction [latex]\overline Q[/latex], where the bar above the Q indicates that it is fixed at that quantity. There are one hundred surplus-creating transactions that don’t occur; this cannot be an efficient outcome because the entire potential surplus has not been created. The lost potential surplus has a name, deadweight loss [latex](DWL)[/latex]: the loss of total surplus that occurs when there is an inefficient allocation of resources. The blue triangle in figure 10.6 represents this deadweight loss.

We can calculate the value of the deadweight loss precisely, again using the formula for the area of a triangle. Since the demand function is [latex]Q^D=1,800 − 20P[/latex], the point on the demand curve that results in a demand of nine hundred is a price of $45. Similarly, if the supply function is given as [latex]Q^S=50P-1,000[/latex], the point on the supply curve that results in a quantity supplied of nine hundred is a price of $38. Thus the base of the triangle is $45 − $38, or $7, and the height is the difference between the one thousand units that are sold in the absence of a restriction and the nine-hundred-unit restricted quantity, or one hundred. So

[latex]DWL=\frac{1}{2}($7)(100)=$350[/latex].

The first question in determining whether a case can be made for the public provision of marketplaces, such as the Eastern Market in Washington, DC, is what would occur in the absence of such a market. If the buyers and sellers in these markets could easily access other markets, then it would be hard to argue that the marketplace is providing a net benefit. Similarly, if the commercial activity that takes place in this market is simply a diversion of similar activity that would have taken place elsewhere, then it is likely that there is little to no net benefit. So for the sake of this exercise, we will assume that the marketplace is providing an opportunity to these buyers and sellers that they would not otherwise have.

So given this assumption, are these marketplaces valuable? The simple answer, as long as transactions are occurring, is yes. We can see this from a simple diagram of a market for an individual good, let’s say fresh apples, that exists within the Eastern Market ( figure 10.7 ).

There is clearly a surplus being created by the apple transactions that take place within the market. This in itself is the primary argument for the marketplace. Buyers and sellers are able to transact and become better off for it. The value to those individuals is measured by surplus.

But a complete answer must compare the value to society of the markets to the cost to society of the marketplace itself. Does the total surplus created by the marketplace justify the cost?

Let’s return now to the key assumption—that a market for fresh apples would not exist without government support. Is this a reasonable assumption?

In the nineteenth and early twentieth centuries, when many public markets were founded, transportation was difficult, and bringing fresh food to support urban population centers was something local governments commonly did. Today, transportation is not nearly as difficult or costly. But although many areas are well served by grocery stores, where it is reasonable to expect customers will find fresh fruits and vegetables, other locations are characterized by food deserts . Food deserts are defined as urban neighborhoods and rural towns without ready access to fresh, healthy, and affordable food. Instead of supermarkets and grocery stores, these communities may have no food access or are served only by fast-food restaurants and convenience stores that offer few healthy, affordable food options. The lack of access contributes to a poor diet and can lead to higher levels of obesity and other diet-related diseases, such as diabetes and heart disease (US Department of Agriculture [USDA]).

The USDA estimates that 23.5 million people in the United States live in food deserts.

Although the Capitol Hill neighborhood experienced some hard times in the past, today it is prosperous and well served by grocery stores. So the need for government support of the Eastern Market there is less clear. In chapter 21 , we will explore public goods and externalities in detail and become better equipped to fully explore this issue.

• What other kinds of marketplaces can you think of that the government aids by providing infrastructure?
• Airports allow the market for airline travel to exist in a functional way. Most airports in the United States are run by local governments. Using the topics explored in this chapter, give a justification for government expenditures on airports.
• Should the District of Columbia government spend money on a market that primarily serves one neighborhood? Give reasons for and against.

REVIEW: TOPICS AND LEARNING OBJECTIVES

Learn: key topics.

The point where the quantity supplied by producers and the quantity demanded by consumers are equal.

The demand curve expressed as price as a function of quantity:

[latex]P = 90 − 0.05Q^D[/latex]

The supply curve expressed as price as a function of quantity:

[latex]P = 20 - 0.03Q^S[/latex]

The price at which the quantity demanded equals the quantity supplied.

[latex]Q^*[/latex]—the quantity at which supply equals demand.

When, at a given price, consumers demand more of a good than firms supply, i.e., the latest video game consoles.

When, at a given price, firms supply more of a good than what consumers demand, i.e., the sales of holiday merchandise once it has passed.

In economics, refers to the economic well-being of society as a whole, including producers and consumers.

The difference between the price received and the willingness-to-accept price.

The difference between the willingness-to-pay price and the price paid.

The sum of the consumer surplus and the producer surplus.

an allocation of goods and services in which no redistribution can occur without making someone worse off, i.e., both seller and buyer are gaining from the exchange–sellers are selling an amount that is equal to the demand curve and buyers are paying prices that indicate close to equilibrium price.

The loss of total surplus that occurs when there is an inefficient allocation of resources, i.e., a firm produces exactly 900 limited edition headphones worth $200 each. The demand tests out at 1000. There are 100 surplus-creating transactions that don’t occur–resources should have been allocated to make the 1000.

[latex]Q^S = 50P - 1000[/latex]

Determining Q* and P*

The above equation utilizes the relationship between quantity and price to determine a starting algorithm for drafting a supply curve. Review this relationship in chapter 9 .

Inverse supply curve

[latex]P = 20 − 0.03Q^S[/latex]

Derived from max production and minimum price to cover costs with profit.

Inverse demand curve

The original equation set to solve for P. In this inverse curve, the vertical intercept is very clear: demand for this product stops at $90. No one is willing to pay more than $90 for the product.

Solving for equilibrium price [latex](P^*)[/latex] and equilibrium quantity [latex]Q^*[/latex]

Solving for the equilibrium price and quantity is simply a matter of setting

[latex]Q^D=Q^S[/latex]

and solving for the price that makes this equality happen. In our example, setting [latex]Q^D=Q^S[/latex] yields

[latex]Q^D = 1,800 − 20(40) = 1,000[/latex] [latex]Q^S = 50(40)—1,000 = 1,000[/latex]

If the proper [latex]P^*[/latex] and [latex]Q^*[/latex] have been found, the two equations should be equal.

Issues of excess and deadweight loss [latex](DWL)[/latex]

Quantifying surplus is easy to do with a graph, see figure 10.5 in full-size via link or half-size below:

the consumer surplus is the area above the equilibrium price and below the demand curve—the green triangle in the figure. Similarly, the producer surplus is the area below the equilibrium price and above the supply curve—the red triangle in the figure. The area of each surplus triangle is easy to calculate using the formula for the area of a triangle, where [latex]b[/latex] is base and [latex]h[/latex] is height:

[latex]\frac{1}{2}bh[/latex]

Utilizing figures from the graph, the following formulas can be derived:

Consumer surplus

[latex]\text{Consumer surplus} = \frac{1}{2}(b)(h)[/latex]

where the area equals the total dollar amount of producer surplus, the base [latex](b)[/latex] is the distance from the origin to [latex]Q^*[/latex], and the height [latex](h)[/latex] is the difference between the maximum willing to pay price [latex]P_{max}[/latex], or the y-intercept, and [latex]P^*[/latex]. This can also be written thusly:

[latex]CS = \frac{1}{2}(Q^*-(O)((P_{max}-P^*))[/latex]

where [latex]O[/latex] is the origin of the supply curve and [latex]P_{max}[/latex] is the vertical intercept of the y-axis, and also the maximum price that anyone is willing to pay for the product.

Producer surplus

[latex]\text{Producer surplus} = \frac{1}{2}(1,000)($20)= $10,000[/latex]

[latex]\text{Producer surplus} = \frac{1}{2}(b)(h) = area[/latex]

where the area equals the total dollar amount of producer surplus, the base [latex](b)[/latex] is the distance from the origin to [latex]Q^*[/latex], and the height [latex](h)[/latex] is minimum price. This can also be written thusly:

[latex]PS = \frac{1}{2}(Q^*-O)(P_{min}) = area[/latex]

where [latex]O[/latex] is the origin of the supply curve and [latex]P_{min}[/latex] is the minimum willingness-to-accept price.

Total surplus

The sum of [latex]CS[/latex] and [latex]PS[/latex]

[latex]TS=CS+PS[/latex]

Deadweight loss [latex](DWL)[/latex]

The loss of total surplus that occurs when there is an inefficient allocation of resources.

[latex]DWL=\frac{1}{2}(P*^-P_Q)(Q*^-Q)[/latex]

Where [latex]P_Q[/latex] is the price determined by the supply/demand curves to be viable at the current output, [latex]Q[/latex]. See Figure 10.6 for full-size or see half-size below. Figure 10.6 illustrates utilizing a graph to develop a [latex]DWL[/latex] equation:

If a firm produces 900 headphones, but the [latex]Q^*[/latex] satates that 1000 is the optimum output, the lost surplus price would then equate to the difference between the price for 900 units [latex](P_Q, \text{in this case} P_900)[/latex], or $38, and the [latex]P^*[/latex], or $45. Thus the denominator would be 100 (1000-900) and the numerator $7 ($45-$38). The equation would look thus:

[latex]DWL=\frac{1}{2}($7)(100)=$350[/latex]

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What Is Equilibrium?

Understanding equilibrium, special considerations, equilibrium vs. disequilibrium.

• Equilibrium FAQs
• Guide to Microeconomics

Equilibrium Price: Definition, Types, Example, and How to Calculate

James Chen, CMT is an expert trader, investment adviser, and global market strategist.

Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest.

Equilibrium is the state in which market supply and demand balance each other, and as a result prices become stable. Generally, an over-supply of goods or services causes prices to go down, which results in higher demand—while an under-supply or shortage causes prices to go up resulting in less demand.

The balancing effect of supply and demand results in a state of equilibrium.

Key Takeaways

• A market is said to have reached equilibrium price when the supply of goods matches demand.
• A market in equilibrium demonstrates three characteristics: the behavior of agents is consistent, there are no incentives for agents to change behavior, and a dynamic process governs equilibrium outcomes.
• There are several types of equilibrium used in economics.
• Disequilibrium is the opposite of equilibrium and it is characterized by changes in conditions that affect market equilibrium.
• In reality, markets are never in perfect equilibrium, although prices do tend toward it.

Investopedia / Paige McLaughlin

The equilibrium price is where the supply of goods matches demand. When a major index experiences a period of consolidation or sideways momentum, it can be said that the forces of supply and demand are relatively equal and the market is in a state of equilibrium.

Economists find that prices tend to fluctuate around the equilibrium levels . If the price rises too high, market forces will incentivize sellers to come in and produce more. If the price is too low, additional buyers will bid up the price. These activities keep the equilibrium level in relative balance over time.

Economists like Adam Smith believed that a free market would tend toward equilibrium. For example, a dearth of any one good would create a higher price generally, which would reduce demand, leading to an increase in supply provided the right incentive. The same would occur in reverse order provided there was excess in any one market.

Modern economists point out that cartels or monopolistic companies can artificially hold prices higher and keep them there in order to reap higher profits. The diamond industry is a classic example of a market where demand is high, but supply is made artificially scarce by companies selling fewer diamonds in order to keep prices high.

As noted by Paul Samuelson in his 1983 work  Foundations of Economic Analysis,  the term equilibrium with respect to a market is not necessarily a good thing from a normative perspective, and making that value judgment could be a misstep.

Markets can be in equilibrium, but it may not mean that all is well. For example, the food markets in Ireland were at equilibrium during the great potato famine in the mid-1800s. Higher profits from selling to the British made it so the Irish and British market was at an equilibrium price that was higher than what consumers could pay, and consequently, many people starved.

When markets aren't in a state of equilibrium, they are said to be in disequilibrium . Disequilibrium can happen in a flash in a more stable market or can be a systematic characteristic of certain markets.

At times disequilibrium can spill over from one market to another—for instance, if there aren’t enough transport companies or resources available to ship coffee internationally then the coffee supply for certain regions could be reduced, affecting the equilibrium of coffee markets. Economists view many labor markets as being in disequilibrium due to how legislation and public policy protect people and their jobs, or the amount they are compensated for their labor.

Types of Equilibrium

Economic equilibrium.

Economic equilibrium refers broadly to any state in the economy where forces are balanced. This can be related to prices in a market where supply is equal to demand, but can also represent the level of employment, interest rates, and so on.

Competitive Equilbrium

The process by which equilibrium prices are reached is through a process of competition . Among sellers to be the low-cost producer to grab the largest market share, and also among buyers to snatch up the best deals.

General Equilibrium

General equilibrium considers the aggregation of forces occurring at the macro-economic level, and not the micro forces of individual markets. It is a cornerstone of Walrasian economics.

Underemployment Equilibrium

Economists have found that there is a level of persistent unemployment that is observed when there is general equilibrium in an economy. This is known as underemployment equilibrium , and is predicted by Keynesian economic theory .

Lindahl Equilibrium

Lindahl equilibrium is a special case where, in theory, the optimal amount of public goods is produced and the cost of public goods is fairly shared among everyone. It describes an ideal state rarely, if ever, achieved in reality, but is used to help craft tax policy and is an important concept in welfare economics .

 Intertemporal Equilibrium

Because prices may swing above or below the equilibrium level due to proximate changes in supply or demand at a given moment, it is best to look at this effect over time, known as intertemporal equilibrium . The concept is also used in understanding how firms and households budget and smooth spending over longer time horizons.

Nash Equilibrium

In game theory , Nash equilibrium is a state of play whereby the optimal strategy involves considering the optimal strategy of the other player or opponent.

The  prisoner's dilemma  is a common situation in game theory that exemplifies the Nash equilibrium.

Example of Equilibrium

A store manufactures 1,000 spinning tops and retails them at $10 per piece. But no one is willing to buy them at that price. To pump up demand, the store reduces its price to $8. There are 250 buyers at that price point. In response, the store further slashes the retail cost to $5 and garners five hundred buyers in total. Upon further reduction of the price to $2, one thousand buyers of the spinning top materialize. At this price point, supply equals demand. Hence $2 is the equilibrium price for the spinning tops.

What Happens During Market Equilibrium?

When a market is in equilibrium, prices reflect an exact balance between buyers (demand) and sellers (supply). While elegant in theory, markets are rarely in equilibrium at a given moment. Rather, equilibrium should be thought of as a long-term average level.

How Do You Calculate Equilibrium Price?

In economics, the equilibrium price is calculated by setting the supply function and demand function equal to one another and solving for the price.

What Is Equilibrium Quantity?

The amount supplied that exactly equals demand is the equilibrium quantity . In such a case, there will neither be an oversupply nor a shortage.

Paul A. Samuelson. "Foundations of Economic Analysis." Harvard University Press, 1983.

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