Market equilibrium is the price at which demand equals supply. An equilibrium price exists if there is a perfectly competitive market without any form of government intervention. The quantity demanded and supplied at the equilibrium price are equal. However, shifts in any one of these three market elements -- price, demand and supply -- may result in a change in the other two.
Supply and Demand Curves
Supply and demand curves are two-dimensional plots, with price on the vertical y-axis and quantity on the horizontal x-axis. Aggregate supply-demand curves show the relationship between price and quantity for all consumers and suppliers in the market. A demand curve slopes downward because demand falls as the price increases. A supply curve slopes upward because supply increases with price. The intersection of the supply and demand curves represents the market equilibrium price and quantity.
Price
Consumers and businesses tend to purchase more when the market price is less than the equilibrium price. This increases demand, which may cause shortages if suppliers are not willing to manufacture additional quantities at the new lower price. Conversely, if the market price is higher than the equilibrium price, more producers may be willing to supply at the higher price. However, fewer buyers might be willing to buy at this higher price, thus resulting in a surplus.
Demand
If demand exceeds supply, businesses may increase prices and production to take advantage of the shortage. Some consumers may not buy at the new price and look for other products, but others may take advantage of the increased availability. Over time, this leads to a reestablishment of the market equilibrium between price and quantity.
Demand shocks affect the market equilibrium price and quantity. Issues of product safety could lead to a negative demand shock, as most consumers stop buying the affected products while others do so only at reduced prices. A positive demand shock means greater demand even at higher prices, such as the price of gold in the aftermath of the 2008 financial crisis as investors bought gold to hedge against market volatility.
Supply
If supply exceeds demand, warehouses and store shelves might fill up with products that nobody wants to buy. For example, during a recession, job layoffs and limited hiring reduce disposable income and consumer demand. Retailers may offer discounts to attract customers, which puts pressure on suppliers to reduce prices. Consequently, the market equilibrium quantity, price or both may move lower. Conversely, when economic conditions improve, demand may outstrip supply, and the market equilibrium price and quantity may move higher.
Considerations: Price Floors and Ceilings
Price floors and ceilings are minimum and maximum prices, respectively. They are forms of government price control, such as setting maximum electricity rate increases or minimum agricultural prices. If the price floor is above the market equilibrium price, there might be a surplus because there might not be enough consumers at the higher prices. If the price ceiling is below the market equilibrium price, there might be a shortage because suppliers might not be willing to supply at the lower prices.
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