Equilibrium

References: Koutsoyiannis, Pindyck & Rubinfeld

 Equilibrium

• Equilibrium is a concept in which

counter acting forces cancel each other
out.

• In a free market, the forces of supply

and demand interact to determine
equilibrium quantity and equilibrium
price.
Graphical Representation
• Equilibrium price – the price at which
the market clears itself.

• Equilibrium quantity – the amount

bought and sold at the equilibrium
price.
• Equilibrium isn’t inherently good or bad,
it is simply a state in which dynamic
pressures offset each other.

• When the market is not in equilibrium,

you get either excess supply or excess
demand, and a tendency for price to
change.
 Excess Demand

• Excess Demand – a shortage, when

quantity demanded is greater than
quantity supplied

i.e. Demand > Supply

• Effect: Prices tend to rise.

 Excess Supply

• Excess Supply – a surplus, when

quantity supplied is greater than
quantity demanded

i.e. Supply > Demand

• Effect: Prices tend to fall.

 Price Adjustment

• The greater the difference between

quantity supplied and quantity
demanded, the more pressure there is
for prices to rise or fall.

• When quantity demanded equals

quantity supplied, prices have no
tendency to change.
Diagrammatic Representation

Per Unit Supply Demand Excess

Price (Rs.)

3.50 7 3 +4

2.50 5 5 0

1.50 3 7 -4
Contd…

5.00
S
4.00 Excess supply
3.50 A
3.00
2.50 E
Price

2.00 C

1.50
Excess demand D
1.00

1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Contd…

• When price is Rs. 3.50 each, quantity

supplied equals 7 and quantity
demanded equals 3.

• The excess supply of 4 pushes price

down.
Contd…
• When price is Rs. 1.50 each,
quantity supplied equals 3 and
quantity demanded equals 7.

• The excess demand of 4 pushes price

up.
Contd…

• When price is Rs. 2.50 each, quantity

supplied equals 5 and quantity
demanded equals 5.

• There is no excess supply or excess

demand, so price will not rise or fall.
Shifts in Supply and/or Demand

• Shifts in either supply or demand

change equilibrium price and quantity.
 Increase in Demand

• An increase in demand creates

excess demand at the original
equilibrium price.
• The excess demand pushes price
upward until a new higher price and
quantity are reached.
Increase in Demand

S0

B
2.50 Excess demand
A
2.25
Price

D0 D1

0 8 9 10
Quantity
 Decrease in Supply

• A decrease in supply creates excess

demand at the original equilibrium
price.
• The excess demand pushes price
upward until a new higher price and
lower quantity are reached.
Decrease in Supply

S1
S0
Price

C
2.50
B Excess demand
2.25 A

D0

0 8 9 10
Quantity