Equilibrium Levels in Economics 1

Before reading this, you should be familiar with the concepts of market demand and market supply. This will have introduced you to how the supply and demand for a good work. Using these fundamental concepts, we can see how the prices of goods and services are set in the real world. You may have often heard people say that the prices and quantities produced of goods are determined by the ‘forces of supply and demand’ – now you will learn what that means. (And when you do, you may well wonder what the point of writing an article about this was).

Equilibrium

The best way to show this is graphically. The above articles both describe the shape of a demand curve and a supply curve – but what happens when both are drawn on the same set of axes?

As you can see, the supply and demand curves have intersected at a point. This point is the point where the quantity supplied of the good equals the quantity demanded of the good: thus, it is at this point that there is an equilibrium in the market. If the price is set higher, say at P1, then the demand of the good will decrease and the supply will increase, leading to the situation of a surplus of this good. The suppliers will then lower the price to a level where they can sell everything they produce. Similarly, if the price is set lower, say at P2, then there will be more demanded of the good than there will be supplied: thus the price will increase back up to Pe. As you can see, the price of the good will tend towards Pe, an equilibrium price.

This point of intersection, as a graphical co-ordinate, has both a y-value and an x-value: the former is its price, and the latter is the quantity of it on the market. Thus are the prices and quantities of goods determined by the forces of supply and demand. Once you know the fundamental workings, it is quite easy to grasp this idea.

Changes in Equilibrium

In the introductions to supply and demand, we discussed the conditions under which either one of them might increase or decrease. This is a graphical change in the demand/supply curve: let us see how this would affect the equilibrium situation.

In the above situation, say the price of conventional electricity usage has increased, and so many of the more rural areas of the population have turned to using charcoal for fuel instead, leading to an increase in the demand for charcoal. (Charcoal and electricity here are substitute goods, and these types of situations were covered in the introduction to demand). As you can see, the shift out of the demand curve has resulted in a new equilibrium price: the price must increase from P1 to P2 in order to avoid the situation of a shortage. This then leads to an extension in supply, as is brought on by the increase in price. Both the price and the quantity of the good have increased. Similar effects will occur with a decrease in demand, and any changes in the supply curve.

Relationships between Markets

As you might have guessed, changes in one market can result in changes in another market. For example, advances in technology might lead to cheaper costs of production when making cameras: this would increase the supply of cameras (which would shift outwards – that is, downwards and to the right graphically). Thus, if you compare the old and new equilibriums, the price of cameras would have decreased. The quantity demanded of cameras has also increased – this would have a knock on effect in the market for camera films, as the demand for camera film would increase with more people buying cameras. Such relationships between markets can be seen with the concept of cross-elasticity, which will be covered later.

Having met the concept of equilibrium, you may be wondering whether markets are always in equilibrium. The answere here is – not always. Government-imposed controls can result in disequilibrium in markets, and this is covered in the next part of this two part series – click here to read it.