Question

Explain the dynamics of equilibrium price. That means to say, teach me step-by-step how the laws of supply and demand combine with basic assumptions about shortages and surpluses to lead to a concept of market equilibrium. In this essay, be sure to include definitions and examples.

Answer 1

Equilibrium in an economy is attained at a point where Demand = Supply.

Diagrammatically, the demand curve is given by DD, the supply curve by SS and equilibrium is point E with equilibrium price P and quantity Q.

Assuming that the economy is to the left of point E, where demand is greater than supply. At any point to the left of equilibrium point E, the quantity demanded is greater than the quantity supplied and there is a shortage in the economy. This means that too many people are chasing too few goods. This will lead to a competition among the people and thus will drive prices upwards. As a result of an increase in price, more sellers will enter the market and/or the existing sellers will increase supply. These dynamics will stop at the point where the economy has reached back to point E.

On the other hand, at any point to the right of point E, there are too many commodities in the market and too less demand. As a result, there will be surplus. The sellers will employ fewer people and reduce production in order to run down the inventories. A few firms may even exit the industry, resulting in a fall in selling price and hence restoration of the equilibrium at point E.