3.7: Equilibrium

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Page ID: 210831

Martin Medeiros
Chabot College

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So far, it has been demonstrated that both suppliers and demands respond to price changes. Whenever a supplier and demander cannot agree upon a price, there is miscommunication. Think of price as a language. When two people speak to each other in different languages, then there is no communication. Without communication there is waste.

Every price has a quantity supplied and quantity demanded associated with it. At a price of $100, based on the table below, suppliers are willing and able to supply 120 units. On the other hand, demanders are willing and able to demand only 1 unit (one price ($100) → two quantities (120, 1)). This surplus of 119 units (120-1) is a wasteful situation.

As inventories build suppliers will lower their asking price. Lower prices lead to higher demand (see law of demand) and lower supply (see law of supply).

Look when the price falls to $80. Quantity supplied is 70 and quantity demanded is 12. When price fell, the surplus shrank to 58 units (70-12). This is still a wasteful situation, but it is less wasteful than the situation when the price was $100. If there is a surplus, there will be downward pressure on prices. As prices continue to fall, the surplus shrinks due to the laws of supply and demand.

Finally, when prices fall to $50, the supplier and demander speak the same language. At $50 both supply and demand equal 40 units. This situation still obeys the rule of one price →two quantities. It just so happens that at $50, the two quantities happen to be equal. Now, the waste due to over production has been eliminated.

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Table 1

Let’s examine, graphically, the data in figure 9.

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Figure 9

Equilibrium and Allocative Efficiency

An equilibrium price of $50 resulting in a quantity demand and supply of 40 units is allocatively efficient because it means that the social benefit of producing and consuming the good is equal to the social cost. In other words, the price reflects the marginal value that consumers place on the good, and the marginal cost that producers incur to produce the good. At this point, there is no deadweight loss, and the total surplus of the market is maximized. This is the optimal outcome for society, as there is no way to improve the welfare of one party without making the other party worse off.

In other words, allocative efficiency occurs when the market produces the right amount of the right goods and services for the consumers, and there is no waste or excess.

A price above equilibrium price (let’s say $70) results in a surplus (allocatively inefficient) and a price below (let’s say $20) results in a shortage (allocatively inefficient). See figure 10.

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Figure 10

What creates a shortage or surplus? The equilibrium price and quantity will not change if the supply and demand curves remain in place. A shortage or surplus arises when one of the two curves shift (either to the left or right). For example, if consumers suddenly feel more optimistic about their current situation (maybe due to positive economic news) this could cause an increase in overall demand and a rightward shift in the demand curve. See figure 11.

Figure 11

It is important to know that the old equilibrium price of $50 has not changed and this lag in the change in price is what causes the shortage. It becomes clear when the old demand curve is deleted from the graph. See figure 12.

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Figure 12

The shortage puts upward pressure on prices. The increase in price causes the quantity supplied to increase (due to the law of supply) and the quantity demanded to decrease (due to the law of demand). The price increase will end when supply and demand reach a new equilibrium quantity. See figure 13.

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Figure 13

News Alert

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“The Federal Highway Administration reported that over the last eight years the price of gasoline has more than doubled (see left side of chart). During the same period the number of miles driven also increased (see right side of chart). We were taught in our college economics class that whenever the price of a good increases the quantity demand falls. Well, it looks like someone should correct all those economics’ textbooks.”

What could explain this violation of the law of demand and prevent the recall of millions of very expensive textbooks? Use a piece of paper and draw a supply and demand curve for gasoline. Have an equilibrium price of $1.50 gal. and equilibrium quantity of 135 billion gallons (I arrived at this number by 2.7 trillion miles driven by 20 MPG for an average car). What could explain the equilibrium quantity increasing in the face of rising prices?

If the supply curve shifts a lot to the left due to disasters like Hurricane Katrina disrupting oil refining and demand curve shifts a little to the right due to rising incomes, then you should see an increase in both the equilibrium price and quantity
If the supply curve remains unchanged during the last seven years and the demand curve shifts a little to the right due to rising incomes, then you should see an increase in both the equilibrium price and quantity.
If the demand curve shifts to the left a lot due to changes in driving habits and the supply curve remains unchanged then you should see an increase in both the equilibrium price and quantity.
If the demand curve remains unchanged and the supply curve shifts to the left due to new discoveries of oil reserves, then you should see an increase in both the equilibrium price and quantity.

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