1.2.6 - Price determination

Equilibrium and Market Clearing

The equilibrium point is where the demand curve and supply curve intersect. At this price, the quantity consumers want to buy exactly matches the quantity producers want to sell.

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Where D1 and S1 intersect, the market reaches equilibrium at P1 and Q1. Economists often call this the market-clearing price. There is no unsold stock caused by overproduction and no shortage caused by underpricing, so there is no automatic pressure for price to change.

A simple example shows how the equilibrium is found. In a town's Saturday market for strawberries, suppose quantity demanded is $Q_d = 350 - 50P$ and quantity supplied is $Q_s = 50 + 50P$, where $P$ is the price of a punnet in pounds.

Only at £3 do the two quantities match, so £3 is the equilibrium price and 200 punnets is the equilibrium quantity. To find it with algebra, set quantity demanded equal to quantity supplied and solve for price, then substitute back to find quantity:

When price is away from equilibrium, market forces push it back, as the next two parts show. This self-correcting process is part of the price mechanism. Prices act as signals and incentives: they tell buyers and sellers when a good is relatively scarce or relatively plentiful.

Below Equilibrium: Excess Demand

If price is set below equilibrium, the product looks cheap to buyers, so quantity demanded is high. Producers, however, may not be willing or able to supply much at that low price. Quantity demanded becomes greater than quantity supplied.

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At the below-equilibrium price P1, consumers want to buy Qd but firms supply only Qs, so the gap Qd - Qs is excess demand. As price is bid up toward Pe, the market moves along the same curves: quantity demanded contracts and quantity supplied extends until equilibrium Qe is restored.

That gap is a shortage. In the strawberry market, at £2 buyers want 250 punnets but growers offer only 150, a shortage of 100. Buyers compete for the limited output available, and some are willing to pay more rather than go without. Sellers notice this stronger competition and raise price.

As price rises, two movements happen at the same time:

• quantity demanded contracts
• quantity supplied extends

Those movements continue until the market returns to equilibrium.

In the European gas market in 2022, supply became tight when Russia cut pipeline deliveries (from late July, Nord Stream 1 ran at only about 20% of its capacity), while demand for heating and power remained strong. At the old price, buyers wanted far more gas than was available, so they competed for scarce supply: the Dutch TTF benchmark price peaked above €300 per megawatt-hour in August 2022, more than twenty times its 2019 average. Both movements followed. Quantity demanded contracted, as some energy-intensive firms cut their gas use; CF Fertilisers, for example, halted ammonia production at Billingham on Teesside. Quantity supplied extended, as high European prices drew record shipments of liquefied natural gas (LNG), much of it from the United States.

Above Equilibrium: Excess Supply

If price is above equilibrium, firms want to sell more than consumers want to buy. At that high price, production looks profitable, but buyers are less willing to purchase the product. Quantity supplied becomes greater than quantity demanded.

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At the above-equilibrium price P2, firms want to sell Qs but consumers demand only Qd, so the gap Qs - Qd is excess supply. As sellers cut price back toward Pe, quantity demanded extends and quantity supplied contracts until the market returns to equilibrium Qe.

The result is a surplus of unsold goods. In the strawberry market, at £4 growers offer 250 punnets but buyers want only 150, leaving a surplus of 100. Firms may have stock building up in warehouses or on shop shelves, and holding that stock is costly. To attract more buyers and clear the surplus, sellers cut price.

As price falls:

• quantity demanded extends
• quantity supplied contracts

Again, the market moves back toward equilibrium. This kind of decentralised adjustment is often summed up with Adam Smith's idea of the invisible hand: individuals respond to incentives, and the market moves toward a clearing price without a planner directing every decision.

Shifts and a New Equilibrium

Markets rarely stay unchanged. If demand shifts or supply shifts, the old equilibrium is no longer the market outcome. A new intersection between demand and supply creates a new equilibrium price and quantity.

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The shift from S1 to S2 moves the market from the original equilibrium at P1, Q1 to the new equilibrium at P2, Q2, so price rises and quantity falls. The adjustment works through the same market forces as before. At the old price P1, firms now offer less than consumers want, so there is excess demand. Price is bid up: quantity demanded contracts along D1 and quantity supplied extends along S2 until the market clears at P2, Q2.

The most useful exam pattern is:

Demand shifts move price and quantity in the same direction. Supply shifts move them in opposite directions.

A slightly harder exam version is when demand and supply shift at the same time. Then one part of the answer may be definite while the other depends on which shift is larger.

If both curves shift together, do not overclaim. If the two shifts push price or quantity in opposite directions, the final outcome depends on the relative size of the shifts and on the price elasticities of demand and supply.

A quick exam method is to work in steps:

1. identify the market
2. identify the shock
3. decide whether demand or supply shifts
4. decide whether the shift is left or right
5. trace the effect on equilibrium price and quantity

A compact worked example makes the logic clearer. Suppose disease reduces cattle herds in the UK beef market. This is a fall in supply, so the supply curve shifts left. At the old price there is now excess demand, which pushes price up: quantity demanded contracts and quantity supplied extends along the new supply curve until the market clears. The new equilibrium has a higher price and a lower quantity. How large these changes are depends on how far supply falls, on the price elasticity of demand for beef and on whether imports fill part of the gap.

You can apply the same logic to demand. In the UK market for holiday flights, demand often rises during school-holiday periods. If airlines cannot expand capacity much in the short run, that rightward shift in demand tends to raise equilibrium prices and increase the quantity sold. Because supply is price inelastic in the short run, most of the adjustment comes through higher fares: price rises by a large percentage, while the number of seats sold rises only a little.

Quick Recap

• Equilibrium is where quantity demanded equals quantity supplied.
• A price below equilibrium creates excess demand and pushes price up.
• A price above equilibrium creates excess supply and pushes price down.
• When demand or supply shifts, the market moves to a new equilibrium price and quantity.
• In exam questions, identify the curve, direction of shift, and then the new equilibrium.