Equilibrium occurs when demand equals supply, i.e. the quantity consumers are willing and able to buy is the same as the quantity suppliers are willing and able to offer for sale. The point at which demand and supply are the same is the equilibrium point. The price and quantity that correspond to the equilibrium point are the equilibrium price and equilibrium quantity respectively. The market is cleared at the equilibrium price, hence the equilibrium price is also called market-clearing price.
Figure 1: Demand and supply of apple
In Figure 1 above, E is the equilibrium point, $10 is the equilibrium price and 110 apples is the equilibrium quantity.
There is no tendency for the price to change when there is equilibrium
Equilibrium, when established, will be restored after there is a disequilibrium. The market is in disequilibrium when the quantity demanded is not equivalent to the quantity supplied. There is a disequilibrium at any price above the equilibrium price because supply is more than demand (surplus). Due to excess of supply over demand, downward pressure is exerted on price until the equilibrium is restored. There is a surplus of 110 apples (160-50) at $15 in Figure 1 above. The price will be reduced from $15 to $10 (the equilibrium price) due to the excess supply of apples. In other words, suppliers will cut the price when there are too many apples available but few people want to buy them.
Likewise, upward pressure builds up as a result of the shortage of the product that occurs below the equilibrium price until the equilibrium is reestablished. That is to say, the price will increase from $3 to $10 because of excess demand for the good. Sellers would increase the price when the number of people who want to buy apples is more than the number of apples available.
Calculation of equilibrium
Suppose we have the following equations calculate the equilibrium quantity and equilibrium price.
D = 40 – 2P
S = -20 + 10P
At equilibrium demand and supply are equal (D = S)
Therefore, 40 – 2P = -20 + 10P
Collecting like terms
40 + 20 = 10P + 2P
60 = 12P
Dividing both sides by 12
60/12 = 12P/12
5 = P
P = 5
Substituting P = 5 into demand or supply function
D = 40- 2P
S = -20 + 10P
S = -20 + 10(5)
S = -20+ 50
Therefore, the equilibrium price is 5 while the equilibrium quantity is 30.
Changes in equilibrium
Change in demand
A change in demand means an increase or decrease in demand as a result of any other factor apart from the price of the product under consideration, such as advertising, taste, income or population. This leads to a shift of the demand curve to the right or left.
An increase in income, for instance, will lead to a rise in demand since there is more money available for purchasing a good or service. It may be the purchasing power that has increased because of reduction in income tax. The demand curve shifts from D1 to D2 in Figure 2 below. Equilibrium price increases from P1 to P2 while equilibrium quantity rises from Q1 to Q2.
Figure 2: Increase in income
In Figure 3 below, a decrease in demand as a result of change in the taste of consumers will shift the demand curve from D1 to D2. Equilibrium price decreases from P1 to P2 and equilibrium quantity decreases from Q1 to Q2.
Figure 3: Change in taste
Change in supply
The factors that can increase or decrease supply include the cost of raw materials, wages, fuel cost, transport cost, subsidies and taxes. When the government gives a subsidy (grant to cover part of the cost of a product) to a firm (producer) it enables it to produce and supply more, thereby shifting the supply curve from S1 to S2 as shown in Figure 4 below. Consequently, the equilibrium price falls to P2 from P1 and equilibrium quantity increases from Q1 to Q2.
Figure 4: Subsidy to the producer
Labour cost will rise when a trade union negotiates a wage increase for the workers. This is an additional cost to firms that will force them to reduce their output and the amount supplied to the market. Supply will reduce from S1 to S2, equilibrium price will increase from P1 to P2 and the equilibrium quantity will decline from Q1 to Q2 (see the figure below).
Figure 5: A rise in labour cost
Simultaneous change in demand and supply
When both demand and supply change concurrently as a result of different factors, the equilibrium quantity and equilibrium price will change. Let us assume that improvement in technology and a decline in the price of a substitute good occur at the same time. Technological advancement will increase the productivity of the firm’s machinery, hence supply expands from S1 to S2 as illustrated in the figure below (Figure 6). Demand, however, shrinks due to a fall in the price of a substitute because consumers will switch to the cheaper alternative. The demand curve moves downward to D2 from D1. The new equilibrium as a result of the two events is E2. In the diagram, the equilibrium price drops to P2 from P1 and the equilibrium quantity decreases to Q2 from Q1.
Figure 6: Change in both demand and supply
Note that what happens to the equilibrium quantity is determined by the magnitude of the change in demand and supply. So the magnitude of the change is important when both demand and supply change simultaneously. The above diagram could be drawn differently to show a bigger change in supply. This means that the equilibrium quantity will increase instead of the decrease shown earlier. (see Figure 7 below).
Figure 7: A bigger change in supply