Market equilibrium and how markets clear

Overview

What excess demand is and how the market removes it, what excess supply is and how the market removes it and equilibrium price sometimes called the market-clearing price.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define market equilibrium and explain why it is described as a position of rest.

   Model answer

   Market equilibrium is the price at which the quantity consumers wish to buy exactly equals the quantity producers wish to sell, so the market clears with no unsold stock and no unsatisfied buyers. It is a position of rest because at that price no participant has any reason to change their behaviour: sellers can sell all they want and buyers can buy all they want. Any other price sets in motion forces that push the market back towards it.

2. 2

   Describe how the equilibrium price and quantity are found on a demand and supply diagram, naming the axes.

   Model answer

   Put price per unit on the vertical axis and quantity per period on the horizontal axis. Draw the demand curve sloping downwards and the supply curve sloping upwards. The equilibrium is where the two curves intersect: reading horizontally from that point to the vertical axis gives the equilibrium price, and reading vertically down to the horizontal axis gives the equilibrium quantity.

3. 3

   Explain what excess demand is and how the market removes it.

   Model answer

   Excess demand, or a shortage, exists when the price is below equilibrium so that the quantity demanded exceeds the quantity supplied. Buyers compete for the limited quantity available and are willing to pay more, while sellers find their stocks running down and raise prices. As the price rises, quantity demanded contracts along the demand curve and quantity supplied extends along the supply curve, and the gap closes until the market clears.

4. 4

   Explain what excess supply is and how the market removes it.

   Model answer

   Excess supply, or a surplus, exists when the price is above equilibrium so that the quantity supplied exceeds the quantity demanded. Unsold stock accumulates, so sellers cut prices to shift it and some producers reduce output. As the price falls, quantity supplied contracts along the supply curve and quantity demanded extends along the demand curve, and the gap closes until the market clears.

5. 5

   In a market, quantity demanded is Qd = 120 − 2P and quantity supplied is Qs = −30 + 3P, with P in pounds and Q in thousands of units. Calculate the equilibrium price and quantity.

   Model answer

   In equilibrium Qd = Qs, so 120 − 2P = −30 + 3P. Adding 2P to both sides and adding 30 gives 150 = 5P, so P = £30. Substituting into demand gives Qd = 120 − 2 × 30 = 60 thousand units, and into supply gives Qs = −30 + 3 × 30 = 60 thousand units. The two agree, confirming equilibrium at a price of £30 and a quantity of 60 thousand units.

6. 6

   For the market Qd = 120 − 2P and Qs = −30 + 3P, with P in pounds and Q in thousands, calculate the excess demand or supply at a price of £20.

   Model answer

   At P = £20, quantity demanded is 120 − 2 × 20 = 80 thousand units and quantity supplied is −30 + 3 × 20 = 30 thousand units. Quantity demanded exceeds quantity supplied by 80 − 30 = 50 thousand units, so there is excess demand of 50 thousand units. The price will be bid upwards towards the equilibrium of £30.

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