Price Equilibrium

Our next level of study that comprehends our understanding of demand as well as supply curves, is an equilibrium of price. The demand curve represents the actions, at any price level, of the consumers. The supply curve represents the actions, at any price level, of the producers. To find out what the price level will actually be, we need to see what happens when we combine the demand and supply curves.

As the market price decreases, the quantity demanded will increase and the quantity supplied will decrease until the quantity demanded equals the quantity supplied, at which point the surplus is eliminated and a market equilibrium is established.

In the supply and demand model, the equilibrium price and quantity in a market is located at the intersection of the market supply and market demand curves. Note that the equilibrium price is generally referred to as P* and the market quantity is generally referred to as Q*.

If the price in a market is lower than P*, the quantity demanded by consumers will be larger than the quantity supplied by producers. A shortage will therefore result, and the size of the shortage is given by the quantity demanded at that price minus the quantity supplied at that price. Producers will notice this shortage, and the next time they have the opportunity to make production decisions they will increase their output quantity and set a higher price for their products. As long as a shortage remains, producers will continue to adjust in this way, bringing the market to the equilibrium price and quantity at the intersection of supply and demand.

Conversely, consider a situation where the price in a market is higher than the equilibrium price. If the price is higher than P*, the quantity supplied in that market will be higher than the quantity demanded at the prevailing price, and a surplus will result. (This time, the size of the surplus is given by the quantity supplied minus the quantity demanded.) When a surplus occurs, firms either accumulate inventory (which costs money to store and hold) or they have to discard their extra output. This is clearly not optimal from a profit perspective, so firms will respond by cutting prices and production quantities when they have the opportunity to do so. This behavior will continue as long as a surplus remains, again bringing the market back to the intersection of supply and demand.

Since any price below the equilibrium price P* results in upward pressure on prices and any price above the equilibrium price P* results in downward pressure on prices, it should not be surprising that the only sustainable price in a market is the P* at the intersection of supply and demand. This price is sustainable because, at P*, the quantity demanded by consumers is equal to the quantity supplied by producers, so everyone who wants to buy the good at the prevailing market price can do so and there is none of the good left over.

In general, the condition for equilibrium in a market is that the quantity supplied is equal to the quantity demanded. This equilibrium identity determines the market price P*, since quantity supplied and quantity demanded are both functions of price.

Functionality of supply and demand intersects with price level. Hope, you have understood the different aspects of law of demand, supply and price.