Equilibrium Price

Equilibrium Price

The demand curve reflects the price-quantity relationship and exhibits the different pairs of price-quantity preferred by the consumers. Similarly the supply curve exhibits the preferences of firms for different pairs of price-quantity. The preferences of consumers (buyers) and firms (sellers) are opposed to each other. It is also evident enough from the shape of demand and supply curves. What will be the actual price charged and quantity sold in a particular market?

There is only one price at which the preferences of sellers and buyers meet together. At that point the quantity demanded of a commodity by the buyer is equivalent to the quantity the seller is willing to sell. This price is called as the equilibrium price and it occurs at the point of intersection of the supply curve and the demand curve. In other words, equilibrium refers to a particular pair of prices and quantity. The supply and the demand will be in balance in equilibrium.

Equilibrium in general is defined as the state of rest or balance from which there is no tendency for change. In economics, equilibrium normally refers to equilibrium in a market. Even if there is any change, the original equilibrium position will be restored by market forces. The concept of equilibrium is also applied to describe and understand other sub-systems of the economy like agriculture, industry, growth and distribution.

P - price

Q - quantity of good S - supply

D - demand

PE - equilibrium price ( or price of market balance) D>S - Excess of demand - when P< PE

S>D - Excess of supply - when P> PE

Market equilibrium can also be illustrated with help of Figure. Equilibrium price is PE. At price PE, the quantity demanded is equal to quantity supplied, D=S. At other prices, there is no equality between quantity demanded and quantity supplied. In both the cases either the consumer or the firms are dissatisfied and tend to change the price.

At any price above the equilibrium price (PE), supply is greater than demand(S>D). Thus there is excess supply. When price is high, buyers prefer to reduce their purchase. But sellers prefer to sell more as price is high. These contrasting behaviours of buyers and sellers result in excess supply in the market which is the difference between the quantities demanded and quantity supplied. As sellers cannot sell all of the quantity at the high price, some of them may reduce price to sell the excess stocks.

For instance, price 'discounts' are advertised by sellers in the name of 'annual stock clearance' sales. When one seller offers discount, the other sellers also follow suit by cutting their prices. As a result, the market price as a whole will decline till the excess supply is sold and equilibrium is (D=S) restored.

Similarly, if the price is below the equilibrium price PE, there will be excess demand, D>S. In this case some of the buyers may try to bid up the price to buy some more quantity when supply is less. This may also encourage sellers to supply more. For instance, buying cinema tickets off the counter (called as tickets in black) by paying a higher price than the actual price.

Thus, in both cases, the actions of buyers and sellers will move the price either upwards or downwards and eliminate the excess demand or excess supply. Such actions also restore the demand-supply balance to attain the market equilibrium. At equilibrium price, there is no force to change the price or quantity demanded of a commodity.

Figure  illustrates the market in equilibrium at the equality between demand and supply. In case of any deviation from the equilibrium price, the direction of price movement is shown by the arrow marks. When there is excess supply, price has a downward tendency. In the case of excess demand, price has an upward tendency. At equilibrium, price is stable because there is no tendency for change as D=S.

Shift in Demand and Supply

The market equilibrium attained above is temporary. It cannot be retained for a long period. It is because demand and supply conditions keep changing frequently. Such changes occur due to many variables other than price. These changes occur independently of price. We will see the causes and nature of such changes that influence demand and supply.

We have already seen that price is the main factor affecting demand and supply keeping 'other things' constant. What are the 'other things'? Suppose, those 'other things' are not constant but changing, what will happen to demand and supply? Note that any change in these determinants of demand and supply will shift the demand curve and supply curve. These shifts will also bring new equilibrium.

Shift in Demand

The 'other things' that affect demand are also called as the determinants of demand. They include income of the consumer, tastes, prices of substitutes and many more. Changes in these determinants will change demand independently of price. If income of the consumer increases, they will buy more irrespective of the price. Similarly a fall in income will bring a fall in demand even if there is no change in price.

In Figure, D is the original demand curve with equilibrium price P and quantity Q. Any change in the determinants of demand like income and tastes will shift the demand curve. For instance, a fall in the income of consumer shifts the demand curve D to D1 and the new equilibrium would be at point E1. Similarly, any increase in income shifts the demand curve from D to D2 . The equilibrium also moves from point E1 to E2 .

Note the distinction between changes in quantity demanded and change in demand. Changes in quantity demanded occur only when there is change in the price. Thus the change in the price-quantity schedule brings movements on the demand curve whereas the changes in the other determinants (namely income, tastes, prices of substitutes, etc) shift the demand curve as a whole.

Shifts in Supply

As seen earlier, the supply curve shows the relationship between the price and quantity supplied keeping the 'other things' constant. The 'other things' which affect supply include number of sellers in the market, factor prices, etc. These factors affect quantity supplied independently of price.

Price is the major determinant of supply. However, a fall in the price of factor (s) of production (land and labour) will reduce the cost of production. This in turn will encourage the firms to supply more. This will cause the shift of supply curve from its original level of S to new level of S1. On the other hand, an increase in factor price will increase the cost of production and the supply curve will shift from S to S2. In these two situations S1 and S2 , equilibrium point also moves from E to E1 or E2 respectively.

Just like demand, the distinction between the change in quantity supplied and change in supply needs to be noted. A change in the quantity supplied occurs only due to change in price whereas the change in the 'determinants' of supply such as factor price will shift the entire supply curve and a new equilibrium will be attained. Such shifts will take place independently of price.

Time Periods and Price Fixation

Time Element

Time element plays an important role in economics. Modern economists divide time periods into short period and long period. The equilibrium price acquired above is valid only for a particular time period. Any change in demand and supply over a period of time will shift the demand and supply curves and different equilibrium will be obtained.

For instance, the flexibility of a firm in adjusting its production to meet the change in demand depends on the nature of its inputs. There are two types of inputs namely fixed inputs and variable inputs.

The fixed input is one whose quantity cannot be adjusted in a limited time period. Heavy machinery, buildings and capital equipments are such fixed inputs and they may need more time for installation or replacement.

However, variable inputs like labour, raw materials and electricity can be changed quickly to change the supply until the full plant capacity is reached. Now it is possible to distinguish between short period and long period. The short period for a firm is the time period during which at least one of the inputs is fixed input. The long period is the time period during which all the inputs are variable inputs.

The specific duration of the short period and long period will vary from firm to firm. A small Bonda stall on the roadside pavements can  change all the inputs even within a single day, because all inputs are easily variable. The seller can install one more stove, use more oil and other ingredients of Bonda within a day to meet any sudden increase in demand. Hence, for him the duration of long period can even be a single day. On the other hand, installation of a specialized machinery for the Ariyalur cement plant may take years, because the production, transportation, installation require a long period of time.

Price Fixation in the Short Period

Alfred Marshall introduced time element in the determination of equilibrium and divided them into market period, short period and long period.

Market Period

Market period is the period during which the ability of the firms to affect any changes in supply in response to any change in demand is extremely limited or almost nil. Thus supply is more or less fixed in the market period without any change. However, the demand may vary during this period.

The equilibrium price will be determined according to the changes in demand, given the fixed supply. Figure  explains the equilibrium price in market period.

As the supply is fixed in the market period, it is shown as a vertical line SMP. It is also called as inelastic supply curve. When demand increases from DD to D1D1, price increases from P to P1. Similarly, a fall in demand from DD to D2D2 pull the price down from P to P2. The market for perishables can be a good illustration. The demand for plantain fruits increases during the festival season, so the prices will naturally go up as the supply cannot be increased immediately to meet the demand. Thus, demand determines the equilibrium price in the market period.

Short period

As mentioned earlier short period is the one during which at least one of the factors will be a fixed input and the supply will be adjusted by changing the variable inputs. The equilibrium price will be determined by adjusting supply (within the plant capacity) according to the changes in demand (Figure)

SSP is elastic implying that supply can be increased by changing the variable input. Note that the corresponding increase in price from P to P1 for a given increase in demand from D to D1 is less than that of the market period. It is because, increase in demand is partially met by the increase in supply from q to q1. Thus during the short period both demand and supply exert their influence on price and the equilibrium price is determined accordingly.

Long Period

In the long period supply can be changed by changing all the inputs (both the fixed and variable inputs). Any amount of change in demand will be met by changing the supply, to the extent of changing the plant, machinery and the quantum of technology. In figure, the long period supply curve SLP is more elastic and flatter than that of the SSP. This implies the greater extent of flexibility of the firms to change the supply. The price increases from P to P2 in response to an increase in demand from D to D1 and it is less than that of the market period (P1) and short period (P2). It is because the increase in demand is fully met by the required increase in supply. Hence, supply plays a significant role in determining the lower equilibrium price in the long run.