You will remember that the law of demand states that when price decreases, quantity demanded increases, and when price increases, quantity demanded decreases. And the law of supply states that when price increases, quantity supplied increases, and when price decreases, quantity supplied decreases.
It seems that consumers and producers are at odds with one another. If consumers are willing and able to buy more when prices are low but suppliers are only willing to supply at lower quantities, then isn't this situation will create a mismatch between what consumers demand and what producers supply? Since producers are only willing to produce in smaller amounts (Remember law of supply?) while consumers are willing to buy greater quantities (Remember law of demand?), wouldn't there be a problem of consumers not getting the quantity they desire? And what happens if prices go up? Well, consumers will demand lower quantities but producers will supply higher quantities. Again this will create a mismatch between demand and supply. More will be supplied than demanded.
There certainly is a mismatch between supply and demand. If demand is greater than supply, then a shortage of goods or services will result. If demand is less than supply, then a surplus of goods or services will result. Both conditions are undesirable because they show inefficiency in the handling of scarce resources. But, there is a point along the demand and supply curve that both supply and demand matches each other. If you place both demand and supply curve on the same graph, you will notice that there is a point where the demand curve and the supply curve intersect one another. At the point of intersection, demand is equal to supply. The intersection is called market equilibrium. The market equilibrium comes at that price and quantity where the forces of supply and demand are in balance. At the equilibrium price, the amount that buyers want to buy is just equal to the amount that sellers want to sell. At market equilibrium, there is no shortages or surpluses. Remember that market equilibrium is dependent upon equilibrium price. It is the interplay between consumers and suppliers that sets the equilibrium price.
What happen if suppliers try to raise price above equilibrium? We know that when price increases, consumers will buy less quantity while suppliers are willing to produce more. This condition will result in consumers demanding less than what is available in the market and a surplus of goods results. To rid of surpluses, suppliers have no choice but to allow price to drop back to its original equilibrium price. In a competitive market, suppliers cannot simply raise prices because the price of goods cannot be determined by them but by market forces.
What happens if price of goods are sold below equilibrium? A shortage will result because more will be demanded than supplied. This situation will automatically push prices up back to equilibrium.
What is important to remember is that equilibrium price cannot be simply set by suppliers or by consumers. It is automatically set by the interplay of hundreds or millions buying and selling decisions.
Can equilibrium price change? Definitely, if the conditions are right. Equilibrium price goes up or down depending on the changes in supply and/or demand. Let's look at an example. Let's say the equilibrium price of pencils is RM1.00 per unit. At this price the quantity demanded and the quantity supplied is equal. What happen if demand for pencils increase while the supply of pencils remained unchanged? First, we know that an increase in demand will shift the demand curve to the right. When the demand curve shifts to the right, it intersects the supply curve at a new position. At the new equilibrium point, there is a new equilibrium price, which is above the previous equilibrium price of RM1.00 per unit. In this example, the equilibrium price increases when demand increases while supply remained unchanged.
What will happen if supply changes while demand remained unchanged? A supply change will cause the supply curve to shift either to the left or right of its original position. If supply is reduced, the supply curve will shift to the left. Observe what happen to the equilibrium price. There is a new point of intersection between the demand and supply curve. Youll notice that that the new equilibrium price is higher than previously.
The following conclusions can be made:
- If supply increases while demand remained unchanged, lower equilibrium price results.
- If supply decreases while demand remained unchanged, higher equilibrium price results.
- If demand increases while supply remained unchanged, higher equilibrium price results.
- If demand decreases while supply remained unchanged, lower equilibrium price results.
- If goods are sold at prices lower than equilibrium, shortages will result.
- If goods are sold at prices higher than equilibrium, surpluses will result.
- At equilibrium price, both demand and supply is equal. There is no shortages or surpluses.
Experiment with the following on your demand/supply curve graphs. See what happen to equilibrium price.
- Demand decreases and supply decreases at the same time.
- Demand decreases but supply increases.
- Demand increases and supply increases at the same time.
- Demand increases but supply decreases.