Equilibrium and the Adjustment Process
Imagine that demand and supply were as in Figure 4.1, but the price was above the equilibrium price of $30, say at $50—we would then have the situation depicted in the left panel of Figure 4.2.
A Shortage Drives Prices Up At a price of $15 there is a shortage of oil. When there is a shortage, sellers have an incentive to increase the price and buyers have an incentive to offer higher prices. The price increases until at $30 the quantity supplied equals the quantity demanded and there is no longer an incentive for the price to rise.
A surplus is a situation in which the quantity supplied is greater than the quantity demanded.
At a price of $50, suppliers want to supply 100, but at that price the quantity demanded by buyers is just 32, which creates an excess supply, or surplus, of 68. What will suppliers do if they cannot sell all of their output at a price of $50? Hold a sale! Each seller will reason that by pricing just a little bit below his or her competitors, he or she will be able to sell much more. Competition will push prices down whenever there is a surplus. As competition pushes prices down, the quantity demanded will increase and the quantity supplied will decrease. Only at a price of $30 will equilibrium be restored because only at that price does the quantity demanded (65) equal the quantity supplied (65).
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A shortage is a situation in which the quantity demanded is greater than the quantity supplied.
What if price is below the equilibrium price? The right panel of Figure 4.2 shows that at a price of $15 demanders want 95 but suppliers are only willing to sell 24, which creates an excess demand, or shortage, of 71. What will sellers do if they discover that at a price of $15, they can easily sell all of their output and still have buyers asking for more? Raise prices! Buyers also have an incentive to offer higher prices when there is a shortage because when they can’t buy as much as they want at the going price, they will try to outbid other buyers by offering sellers a higher price. Competition will push prices up whenever there is a shortage. As prices are pushed up, the quantity supplied increases and the quantity demanded decreases until at a price of $30 there is no longer an incentive for prices to rise and equilibrium is restored.
The equilibrium price is the price at which the quantity demanded is equal to the quantity supplied.
If competition pushes the price down whenever it is above the equilibrium price and it pushes the price up whenever it is below the equilibrium price, what happens at the equilibrium price? The equilibrium price is stable because at the equilibrium price the quantity demanded is exactly equal to the quantity supplied. Because every buyer can buy as much as he or she wants at the equilibrium price, buyers don’t have an incentive to push prices up. Since every seller can sell as much as he or she wants at the equilibrium price, sellers don’t have an incentive to push prices down. Of course, buyers would like lower prices, but any buyer who offers sellers a lower price will be scorned. Similarly, sellers would like higher prices, but any seller who tries to raise his or her asking price will quickly lose customers.
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Who Competes with Whom?
CHECK YOURSELF
Question 4.1
If high gasoline prices lead to a decrease in the demand for large trucks and SUVs, what will automobile companies do to sell the trucks and SUVs already manufactured?
Question 4.2
Consider clothes sold at outlet malls. Have sellers produced too few or too many of the items based on demand? What actions are sellers taking to move their goods out the door?
Sellers want higher prices and buyers want lower prices so the person in the street often thinks that sellers compete against buyers.
But economists understand that regardless of what sellers want, what they do when they compete is lower prices. Sellers compete with other sellers. Similarly, buyers may want lower prices but what they do when they compete is raise prices. Buyers compete with other buyers.
If the price of a good that you want is high, should you blame the seller? Not if the market is competitive. Instead, you should “blame” other buyers for outbidding you.