Why is Market Equilibrium important?
The response required for a perfect mark on the general Market Equilibrium question has increased throughout the years. A much more complete answer is now required. Before wee look at what is required, we should probably take a quick look at what Market Equilibrium is.
Market Equilibrium is a situation where Quantity Demanded equals Quantity Supplied and there is no tendency for price to change. Equilibrium occurs when the price is such that the quantity that consumers wish to buy is exactly balanced by the quantity that firms wish to supply, again there is no tendency for price to change.
So, it is price that brings a market into equilibrium. A market will never start in equilibrium but price changes will cause it to move towards equilibrium.
What Happens when Price is above the Equilibrium Price?
Suppose the price being charged for the good in question is above the market price. This is represented in the diagram above, where the price being charged, PHIGH , is above the market equilibrium price PEq . At the price PHIGH, the quantity demanded, QD, is far less than the quantity supplied, QS.
This results in a surplus of goods on the market. More has been supplied than was demanded. When there is a surplus or excess supply for a good, suppliers are unable to sell all they want at the going price. Sellers find stocks increasing so, in order to reduce their excess amount of stock taking up valuable space in their stock rooms, they respond to the surplus by cutting their prices. Another way to look at this is that the suppliers have to lower their price in order to get rid of the excess stock. This fall in price has two separate effects.
Firstly, falling prices increases the amount of the good that consumers wish to buy as the price of the good itself is now cheaper. Therefore Quantity Demanded increases following the fall in price.
Secondly, as the price of the good itself is now cheaper, sellers do not receive the same financial reward they did from selling the good and now, they reduce the amount they are willing to offer for sale. Therefore, quantity supplied decreases following the fall in price.
As long as a Surplus exists, the price will continue to fall until it reaches the equilibrium price of PEq, where Quantity Demanded equals Quantity Supplied. (QD = QS).
It is important to understand that if the market is not in equilibrium, as a result of the price being above the market price (above), there are natural forces at work (Price Changes) to bring the market back into the desired situation of Market Equilibrium.
At this new equilibrium price, consumers are purchasing all that is being supplied and there is no tendency for price to change as all that is being supplied is being bought, at the existing price.
What Happens when Price is below the Equilibrium Price?
Suppose the price being charged for the good in question is below the market clearing price (PEq). This is represented in the diagram above where the consumer is being charged the price PLOW. At the price PLOW, the quantity demanded, QD, is far greater than the quantity supplied, QS.
This results in a shortage of goods on the market. More has been supplied than demanded and as such, consumers are unable to buy all that they want at the current price. With too many buyers chasing too few goods, sellers find that they cannot satisfy all their customers needs at this price so they respond to the shortage by raising their prices without losing sales. This rise in price has two separate effects.
Firstly, rising prices reduce the amount of the good that consumers wish to buy as the price of the good itself is now more expensive. Therefore Quantity Demanded falls following the rise in price.
Secondly, as the price of the good itself is now more expensive, sellers receive a greater financial reward for selling the good now than they did before. As a result of this greater financial reward, sellers increase the amount they are willing to offer for sale. Therefore, quantity supplied increases following the rise in price.
As the price rises, quantity demanded falls, quantity supplied rises and the market reaches equilibrium.
It is important to understand that when the market is not in equilibrium, as a result of the price being below the market price (above), there are natural forces at work (Price Changes) to bring the market back into the desired situation of Market Equilibrium.
Thus the activities of many buyers and many sellers always push market price towards the equilibrium price. Once the market reaches its equilibrium, all buyers and sellers are satisfied and there is no upward or downward pressure on the price.
Why is Market Equilibrium a Desired Outcome?
The above question has the potential to be one of the most important questions in economics. And, over the years, economists have written at length about it. It is very important for you to understand why Market Equilibrium matters if you wish to go on to study economics but I think a simple analogy will suffice in order to help you understand.
One simple question that you need to ask is, “What is an economy?”. For me at least, an economy is simply the way we organise how peoples material desires are met. I want a phone that receives calls, takes photos, has internet and maybe even plays games. Apple releases the iPhone. I want to spend my free time relaxing, Netflix produces shows for me to watch. I want to spend large portions of my summer in hot weather, going on rollercoasters and eating too much fatty food. The Orlando economy creates Disneyland and Busch Gardens.
Thats what an economy is, a way to meet peoples material wants and needs. So again, why is market equilibrium important? Well, in order to produce the things that we want, entrepreneurs use Factors of Production which have alternative uses. A single factor of production can produce many things and entrepreneurs have to try to figure out what the right amount of each good they should produce is. What is the right amount? The right amount is the Equilibrium Quantity. Which can change on a daily basis. The equilibrium quantity today might be 100 units, tomorrow it might be 50 and the next day 200. If entrepreneurs produce too much or too little of a good, price changes to the level that makes Quantity Demanded equal to Quantity Supplied. Where the amount that people want to buy is exactly equal to the amount that people want to sell.
Its relatively obvious why a market shortage is a bad situation as people are just not getting as much of a good that they want at a price they are willing to pay. But why is a market surplus a bad situation? We are producing more than people want to buy at that price. The reason why a market surplus is also undesired is that the extra goods that are not bought at that price go to waste and are not used (unless of course price is allowed to fall). These extra goods required factors of production to make them which could have been used to make something else that people wanted instead of being wasted making things that are not being used.
Lets look at an example. Lets say you go to your friends house and he asks you do you want some sandwiches. You are hungry and you say yes please I will have two. Your friend brings you out half a sandwich (market shortage). The question you have to ask is “Is this a desirable outcome?”. I think you would agree that answer is no. You wanted two sandwiches as you felt that would satiate your hunger and a half is too little.
The next week you go back to your friends house and he says do you want some sandwiches and you say yes, you will have two. This time he brings you out five (market surplus). Again, the question you have too ask is “Is this a desirable outcome?”. I think, again, you would agree that the answer is no. You wanted two as you felt that two would satiate your hunger and five is too many. The extra three will go to waste. Instead of spending all their money on extra bread, meat and other accoutrements, save this money and buy something else that makes you happy (factors of production have alternative uses).
The above analogy is just a taster into why Market Equilibrium is imperative to a wealthy society.