Competitive market equilibrium

• Define a market, competitive market equilibrium, the equilibrium price and the equilibrium quantity, and identify them on a diagram or in a schedule.
• Explain how excess demand and excess supply return a market to equilibrium.
• Construct and explain diagrams in which a shift of demand or of supply produces a new equilibrium.
• Explain how prices allocate resources through signalling and incentives, and how they ration goods among buyers.
• Draw and explain consumer, producer and social surplus, and explain why a competitive equilibrium is allocatively efficient.

A Market is any arrangement through which buyers and sellers exchange a good, a service or a resource. In a competitive market there are many buyers and many sellers, and none of them is large enough to set the price. The price is the outcome of all their decisions taken together.

The demand curve shows how much buyers plan to purchase at each price, and the supply curve shows how much sellers plan to offer. A Competitive market equilibrium is the one price and quantity at which these plans agree: quantity demanded equals quantity supplied. That price is the Equilibrium price, also called the market-clearing price, and the amount bought and sold at it is the Equilibrium quantity.

Equilibrium means a position of rest. At the equilibrium price every buyer who is willing and able to pay it finds a seller, and every seller who is willing to accept it finds a buyer, so nobody has a reason to offer or ask a different price. The price stays there until a non-price determinant of demand or of supply changes and shifts one of the curves. Equilibrium describes where a competitive market settles. It does not mean that the price is low, fair or desirable.

In the schedule, quantity demanded equals quantity supplied only at a price of $3, where both are 60 units. The equilibrium price is therefore $3 and the equilibrium quantity is 60 units per week. At every lower price buyers want more than sellers offer, and at every higher price sellers offer more than buyers want. On a diagram the same information appears as the point where the demand curve crosses the supply curve.

At any price other than the equilibrium price the plans of buyers and sellers do not match, and the mismatch itself moves the price.

Excess demand (a shortage) exists when the price is below equilibrium, so that quantity demanded is greater than quantity supplied. Some buyers who are willing to pay the current price cannot find the good. Sellers see that they could sell everything at a higher price, and buyers who value the good highly offer more to obtain it, so the price is bid up. As it rises, quantity demanded contracts (a movement up along the demand curve) and quantity supplied extends (a movement up along the supply curve). The shortage shrinks with each rise in the price and disappears at the equilibrium price.

Excess supply (a surplus) exists when the price is above equilibrium, so that quantity supplied is greater than quantity demanded. Sellers are left with unsold stock, which is costly to hold, and they cut the price to clear it. As the price falls, quantity demanded extends and quantity supplied contracts, until the surplus is eliminated at the equilibrium price. This surplus of unsold goods is a different idea from consumer surplus and producer surplus, which are measures of benefit and are explained later in this lesson.

An equilibrium lasts only while the conditions behind the two curves stay the same. When a non-price determinant of demand or supply changes, one curve shifts. The old price no longer clears the market, and the shortage or surplus that appears at that price pushes the market to a new equilibrium. The analysis of any such change follows the same four steps.

1. Start at the original equilibrium E1, with price P1 and quantity Q1.
2. Decide which curve the change affects, demand or supply, and whether that curve shifts to the right (an increase) or to the left (a decrease). A change in the price of the good itself never shifts either curve.
3. Find the excess demand or excess supply that the shift creates at the old price P1.
4. Follow the price to the new equilibrium E2, and compare P2 and Q2 with P1 and Q1.

A shift of demand moves price and quantity in the same direction, because the market moves along an upward-sloping supply curve. A shift of supply moves them in opposite directions, because the market moves along a downward-sloping demand curve. The drawing guide below constructs the first case in full; the other three are drawn in the same way, and a decrease in supply is constructed in the next section.

Adjustment takes time, and the time differs between markets. Prices on commodity exchanges change within seconds. Prices fixed by long contracts or printed price lists change slowly, and in those markets a shortage or surplus can last for some time before the price moves. A price held away from equilibrium by law cannot adjust at all; price controls of that kind are covered in topic 2.7.

Every economy has to decide what to produce, how to produce it and who receives it. In a market economy no central authority takes these decisions. They are the result of the Price mechanism: changes in prices, caused by changes in demand and supply, move resources from one use to another. Resource allocation means the assignment of scarce factors of production to the production of particular goods and services. Price carries out this task through three functions, which follow one another each time a price changes.

Signalling. A price carries information. A rising price tells every buyer and seller that the good has become scarcer relative to the demand for it, whether the cause is higher demand or lower supply, and a falling price tells them the opposite. Nobody needs to know why the change happened. The price change alone passes the information to producers, consumers and the owners of resources, many of whom are far from the original event. This is the Signalling function of price. Without the signal, producers would not know that consumers' wants or the conditions of production had changed, and resources would stay where they were.

Incentive. A price change also alters what it pays people to do. For producers, a higher price raises the revenue and the profit from each unit, so existing firms extend the quantity they supply and, given time, new firms and additional resources move into the industry. A lower price does the reverse: profit falls, and resources leave for uses that now pay better. For consumers, a higher price is an incentive to economise on the good and to look for substitutes. The signal supplies the information and the Incentive function of price supplies the motive to act on it. Together they allocate resources: factors of production move towards goods whose relative price has risen and away from goods whose relative price has fallen.

Rationing. Because resources are scarce, there is never enough of a good to give everyone all that they would like, so the quantity available has to be shared out in some way. In a market it is shared out by price. The good goes to the buyers who are willing and able to pay the market price; those who are not buy less or go without. When a good becomes scarcer its price rises until quantity demanded has contracted to the quantity available, which removes the shortage. This is the Rationing function of price. Rationing by price means that each unit goes to a buyer who values it at least at its price, but it distributes goods by ability to pay as well as by need, so the result is not necessarily one that people consider fair.

The three functions can be followed on one diagram. Suppose that the supply of a good falls, for example because of a poor harvest. At the old price there is a shortage, and the price rises. The rise is the signal. It is an incentive for growers to bring more to market than they otherwise would, by harvesting more carefully, releasing stocks or, by the next season, planting more land; this is the extension along the new supply curve. It also rations the smaller crop, as buyers who are not willing or able to pay the higher price reduce their purchases; this is the contraction along the demand curve. Some of those buyers turn to substitutes, whose prices rise in turn and draw resources into producing them.

Consumer surplus is the benefit consumers gain from buying a good at a price below the highest price they would have been willing to pay. The demand curve shows that willingness to pay: its height at each quantity is the most that some consumer would pay for that unit. Every unit up to the equilibrium quantity is bought at the one market price, so each buyer except the last gains the difference between what the unit is worth to them and what they pay. Added over all the units bought, this is the area below the demand curve and above the price, out to the quantity traded.

Producer surplus is the benefit producers gain from selling a good at a price above the lowest price they would have been willing to accept. The supply curve shows that minimum: its height at each quantity is the lowest price at which that unit would be supplied, which is the extra cost of producing it. Every unit is sold at the one market price, so each seller except the last receives more than the minimum they required. Added over all the units sold, this is the area above the supply curve and below the price, out to the quantity traded.

Social surplus, also called community surplus, is consumer surplus plus producer surplus. It measures the total net benefit that buyers and sellers gain from trading in the market: the value of the good to those who consume it minus the cost of the resources used to produce it.

The link between surplus and efficiency comes from reading the two curves at the margin. The height of the demand curve at any quantity is the marginal benefit (MB) of that unit: the extra benefit consumers receive from one more unit, measured by what they are willing to pay for it. The height of the supply curve is the marginal cost (MC): the extra cost of producing one more unit. A unit adds to social surplus when its marginal benefit is greater than its marginal cost.

At every quantity below the equilibrium quantity, MB is greater than MC, so producing one more unit adds more benefit than cost and social surplus rises. At every quantity above it, MC is greater than MB, so the last units cost more to make than they are worth to anyone and social surplus falls. Social surplus is therefore at its maximum at the competitive equilibrium quantity, where MB = MC. This is Allocative efficiency: resources are allocated so that every unit worth at least its cost is produced and no other unit is. Too few resources go to the good if output stops short of this quantity, and too many if output goes beyond it.

Two conditions lie behind this result. First, the demand curve must include all the benefits of the good and the supply curve all its costs. Where consumption or production affects third parties, the market quantity is no longer the efficient one (topic 2.8). Second, the market must be competitive, so that no buyer or seller can hold the price away from the level at which MB = MC. Allocative efficiency is also not the same as fairness. Social surplus counts a dollar of benefit equally whoever receives it, so an efficient market can still leave some people unable to afford the good.

• Equilibrium is the price at which quantity demanded equals quantity supplied. It is where a competitive market settles, not a price chosen by anyone and not necessarily a fair one.
• Below the equilibrium price there is excess demand and the price rises; above it there is excess supply and the price falls.
• A change in a non-price determinant shifts one curve and creates a new equilibrium. A change in price alone is a movement along both curves.
• A shift of demand moves price and quantity in the same direction; a shift of supply moves them in opposite directions.
• Prices signal changes in scarcity, give producers and consumers an incentive to respond, and ration the quantity available among buyers.
• Consumer surplus lies below demand and above the price; producer surplus lies above supply and below the price; social surplus is their sum.
• Social surplus is greatest at the competitive equilibrium, where MB = MC. This is allocative efficiency.