3.6 Equilibrium and Market Surplus
Learning Objectives
By the end of this section, you will be able to:
- Explain equilibrium, equilibrium price, and equilibrium quantity
- Understand how supply and demand bring markets back to equilibrium
- Analyze the effect of supply and demand shocks to market price and quantity
- Calculate market surplus given supply and demand curves
Who Sets the Price?
Have you ever been to a busy street corner and seen a row of fast food vendors lined up beside each other? Oftentimes, the vendors have little to no branding, so the stands are relatively homogeneous. How do you decide where to buy? Assuming the quality looks about the same, you might go for the cheapest option.
What about the vendors? Knowing that consumers will purchase the cheapest option, they will avoid setting their price above their competitors, and may lower prices to sell more. As long as the price is above thier costs there is still an opportunity to undercut the competition. This will cause a race to the bottom until the price is at the equilibrium level.
Who sets the price? With many different firms and consumers, no individual has the power to influence price. But collectively, their actions determine it. This brings us to the core conclusion of this chapter: market price is determined by the interactions between supply and demand.
Equilibrium
Equilibrium is formally defined as a state of rest or balance due to the equal action of opposing forces. In economics, these forces are supply and demand. As we will see, when supply and demand are not in balance, economic forces will work until the balance is restored.
Figure 3.6a shows the competitive market for hot dogs, with aggregate demand in blue and aggregate supply in yellow. As price rises, quantity demand for hot dog falls, and quantity supplied rises. There are two important points on this diagram. First is equilibrium quantity (QE). QE is where the quantity supplied is equal to the quantity demanded. It is important to recognize this value and the mechanism that leads us there. There is only one price that corresponds with equilibrium quantity, and that is equilibrium price (PE). The question remains, how do we arrive at equilibrium? Let’s first consider what occurs when the price is too high.
When Price is Higher than Equilibrium
What if the price is above our equilibrium value? How will the equal and opposite forces bring it back to equilibrium? There are a number of reasons why the price may be too high. One common example that we will explore in greater depth in Topic 4 is the price floor. Regardless of the cause, we see in Figure 3.6b that a price above equilibrium will result in quantity supplied being greater than quantity demanded. This excess supply is also known as a surplus. There are too many sellers who are enticed by the high price, and not enough buyers. Consider a hot dog vendor, Paul, in this situation. Though Paul would be happy to receive the high price of $5 from the custo