Determining Price through Demand and Supply
Part of the Managerial Economics For Dummies Cheat Sheet
Markets move to a price that equates the quantity of a good consumers are willing and able to purchase (the quantity demanded) with the quantity of the good firms are willing to provide (the quantity supplied). When markets reach the point where quantity demanded equals quantity supplied, they’re in equilibrium.
At this point, all buyers and sellers are satisfied: Everyone who wants to buy the good at the equilibrium price can buy it, and everyone who wants to sell the good at the equilibrium price can sell it. Equilibrium corresponds to the intersection of the demand and supply curves. At that point, the equilibrium price corresponds to PE, and the equilibrium quantity corresponds to QE as illustrated in the figure.
If the market initially has a price below the equilibrium price, such as PM in the following figure, the market has a shortage. Consumers want to buy a greater quantity of the good than businesses are willing to provide. In other words, quantity demanded, QD, is greater than quantity supplied, QS. The shortage equals the difference between the quantity demanded and the quantity supplied. When a shortage exists, consumers who want the good but can’t buy it offer a higher price, so the market price rises toward equilibrium. When the market price finally reaches equilibrium, the shortage entirely disappears.
Similarly, if the market initially has a price that is above the equilibrium price, the market has a surplus. Businesses want to sell a greater quantity of the good than consumers want to buy, so the quantity supplied, QS, is greater than the quantity demanded, QD. The surplus is the difference between the quantity supplied and the quantity demanded. When a surplus exists, businesses lower the price to sell their accumulating inventory — the items they can’t sell at the high price. The market price falls toward equilibrium, and when it finally reaches equilibrium, the surplus disappears.