We have now covered the first three key elements in the supply and demand model: the demand curve, the supply curve, and the set of factors that shift each curve. The next step is to put these elements together to show how they can be used to predict the actual price at which the good is bought and sold, as well as the actual quantity transacted.

In the basic model of a competitive market we normally assume that all buyers and sellers have full information about the product and its price. In addition, it is usually assumed that the good being sold is standardized (i.e., all units are identical).

What determines the price at which a good or service is bought and sold? What determines the quantity transacted of the good or service? In Chapter 1 we learned the general principle that markets move toward equilibrium, a situation in which no individual would be better off taking a different action. In the case of a competitive market, we can be more specific: a competitive market is in equilibrium when the price has moved to a level at which the quantity of a good demanded equals the quantity of that good supplied. At that price, no individual seller could make herself better off by offering to sell either more or less of the good and no individual buyer could make himself better off by offering to buy more or less of the good. In other words, at the competitive market equilibrium, price has moved to a level that exactly matches the quantity demanded by consumers to the quantity supplied by sellers.

The price that matches the quantity supplied and the quantity demanded is the equilibrium price; the quantity bought and sold at that price is the equilibrium quantity. The equilibrium price is also known as the market-clearing price: it is the price that “clears the market” by ensuring that every buyer willing to pay that price finds a seller willing to sell at that price, and vice versa. So how do we find the equilibrium price and quantity?

The easiest way to determine the equilibrium price and quantity in a market is by putting the supply curve and the demand curve on the same diagram. Since the supply curve shows the quantity supplied at any given price and the demand curve shows the quantity demanded at any given price, the price at which the two curves cross is the equilibrium price: the price at which quantity supplied equals quantity demanded.

Figure 3-11 combines the demand curve from Figure 3-1 and the supply curve from Figure 3-6. They intersect at point E, which is the equilibrium of this market; $1 is the equilibrium price and 10 billion pounds is the equilibrium quantity.

Let’s confirm that point E fits our definition of equilibrium. At a price of $1 per pound, cotton farmers are willing to sell 10 billion pounds a year and cotton consumers want to buy 10 billion pounds a year. So at the price of $1 a pound, the quantity of cotton supplied equals the quantity demanded. Notice that at any other price the market would not clear: every willing buyer would not be able to find a willing seller, or vice versa. More specifically, if the price were more than $1, the quantity supplied would exceed the quantity demanded; if the price were less than $1, the quantity demanded would exceed the quantity supplied.

The model of supply and demand, then, predicts that given the demand and supply curves shown in Figure 3-11, 10 billion pounds of cotton would change hands at a price of $1 per pound. But how can we be sure that the market will arrive at the equilibrium price? We begin by answering three simple questions:

Question 3.3

Question 3.4

Question 3.5

There are some markets where the same good can sell for many different prices, depending on who is selling or who is buying. For example, have you ever bought a souvenir in a “tourist trap” and then seen the same item on sale somewhere else (perhaps even in the shop next door) for a lower price? Because tourists don’t know which shops offer the best deals and don’t have time for comparison shopping, sellers in tourist areas can charge different prices for the same good.

But in any market where the buyers and sellers have both been around for some time, sales and purchases tend to converge at a generally uniform price, so we can safely talk about the market price. It’s easy to see why. Suppose a seller offered a potential buyer a price noticeably above what the buyer knew other people to be paying. The buyer would clearly be better off shopping elsewhere—unless the seller were prepared to offer a better deal. Conversely, a seller would not be willing to sell for significantly less than the amount he knew most buyers were paying; he would be better off waiting to get a more reasonable customer. So in any well-established, ongoing market, all sellers receive and all buyers pay approximately the same price. This is what we call the market price.

Suppose the supply and demand curves are as shown in Figure 3-11 but the market price is above the equilibrium level of $1—say, $1.50. This situation is illustrated in Figure 3-12. Why can’t the price stay there?

As the figure shows, at a price of $1.50 there would be more pounds of cotton available than consumers wanted to buy: 11.2 billion pounds versus 8.1 billion pounds. The difference of 3.1 billion pounds is the surplus—also known as the excess supply—of cotton at $1.50.

This surplus means that some cotton farmers are frustrated: at the current price, they cannot find consumers who want to buy their cotton. The surplus offers an incentive for those frustrated would-be sellers to offer a lower price in order to poach business from other producers and entice more consumers to buy. Similarly, in this situation, as buyers become aware of the surplus, they will offer less than the prevailing price in order to buy this output. Either way, the result of this price cutting will be to push the prevailing price down until it reaches the equilibrium price. So the price of a good will fall whenever there is a surplus—that is, whenever the market price is above its equilibrium level.

Now suppose the market price is below its equilibrium level—say, at $0.75 per pound, as shown in Figure 3-13. In this case, the quantity demanded, 11.5 billion pounds, exceeds the quantity supplied, 9.1 billion pounds, implying that there are would-be buyers who cannot find cotton: there is a shortage, also known as an excess demand, of 2.4 billion pounds.

When there is a shortage, there are frustrated would-be buyers—people who want to purchase cotton but cannot find willing sellers at the current price. In this situation, either buyers will offer more than the prevailing price or sellers will realize that they can charge higher prices. Either way, the result is to drive up the prevailing price. This bidding up of prices happens whenever there are shortages—and there will be shortages whenever the price is below its equilibrium level. So the market price will always rise if it is below the equilibrium level.

We have now seen that a market tends to have a single price, the equilibrium price. If the market price is above the equilibrium level, the ensuing surplus leads buyers and sellers to take actions that lower the price. And if the market price is below the equilibrium level, the ensuing shortage leads buyers and sellers to take actions that raise the price. So the market price always moves toward the equilibrium price, the price at which there is neither surplus nor shortage.