Equilibrium in a market

Equilibrium means there is a balance in the market, with no tendency for price or output to change. The equilibrium price and quantity of a good are obtained from the points of intersection between the demand and supply curves. In the table and figure below, the equilibrium price per unit is £80, and the quantity is 30 units per week.

[diagram on page 30]

Excess supply and excess demand

In a free market, price cannot remain above or below the equilibrium position for long. For example, at a price of £100 there is an excess supply of 40 units. In order to sell the surplus, producers tend to reduce price and this encourages consumers to buy more. Demand extends and supply contract until the equilibrium price of £80 is reached.

At a price of £60 there is an excess demand of 40 units. Consumers tend to bid up the price in order to obtain the good, and this encourages producers to supply more.  Supply extends and demand contracts until the equilibrium price of £80 is reached. Thus, the pricing mechanism eliminates surpluses and shortages of a good, something that Adam Smith referred to as the ‘invisible hand’ of the market.

Consumer and producer surplus

Consumer surplus is the extra amount of money consumers are prepared to pay for a good or service, above what they actually pay for it. It is the utility or satisfaction gained from a good or service in excess of that paid for it.

Producer surplus is the extra amount of money paid to producers above what they are willing to accept to supply a good or service. It is the extra earnings obtained by a producer above the  minimum required to supply the good or service.

The areas of consumer and producer surplus are shown in the diagram. Consumer surplus is the area above the equilibrium price but below the demand curve; producer surplus is the area below the equilibrium price and above the supply curve.

Note that a shift in the demand or supply curve, leading to a new market price, will cause the amount of both consumer and producer surplus to change.

Functions of the price mechanism

Price is the exchange value of a good or service. This price mechanism refers to the way price responds to changes in demand or supply for a product or factor input, so that a new equilibrium position is reached in a market.  The price mechanism has several functions.

  • A rationing device. Resources are scarce, which means that the goods and services produced from them are in limited supply. The price mechanism allocates these goods and services to those who are prepared to pay the most for them. In effect, price will rise or fall until equilibrium is reached between the quantity demanded and the quantity supplied.
  • An incentive device. Rising prices tend to act as an incentive for forms to produce more of a good or service, since higher profits can be earned. Rising prices also mean firms are able to cover the extra costs involved with increasing output.
  • A signalling device. The price mechanism indicated changes in the condition of demand or supply. For example, an increase in demand for a good or service raises its price and encourages forms to expand their supply, while a decrease in demand lowers the price and cause firm to contract their supply. Consequently, more or fewer resources are allocated to the production of a particular good or service.

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