Market Equilibrium and Welfare Analysis for AP Economics
The review questions for this study guide can be found at:
Main Topics: Equilibrium, Shortages, Surpluses, Changes in Demand, Changes in Supply, Simultaneous Changes
Demanders and suppliers are both motivated by prices, but from opposite camps. The consumer is a big fan of low prices; the supplier applauds high prices. If a good were available, consumers would be willing to buy more of it, but only if the price is right. Suppliers would love to accommodate more consumption by increasing production, but only if justly compensated. Is there a price and a compatible quantity where both groups are content? Amazingly enough, the answer is a resounding "maybe." Discouraged? Don't be. For now we assume that the good is exchanged in a free and competitive market, and if this is the case, the answer is "yes." We explore the "maybes" in a later chapter.
The market is in a state of equilibrium when the quantity supplied equals the quantity demanded at a given price. Another way of thinking about equilibrium is that it occurs at the quantity where the price expected by consumers is equal to the price required by suppliers. So if suppliers and demanders are, for a given quantity, content with the price, the market is in a state of equilibrium. If there is pressure on the price to change, the market has not yet reached equilibrium. Let's combine our lemonade tables from the earlier sections in Table 6.4.
At a price of 75 cents, the daily quantity demanded and quantity supplied are both equal to 80 cups of lemonade. The equilibrium (or market clearing) price is therefore 75 cents per cup. In Figure 6.7 the equilibrium price and quantity are located where the demand curve intersects the supply curve. Holding all other demand and supply variables constant, there exists no other price where Qd = Qs.
A shortage exists at a market price when the quantity demanded exceeds the quantity supplied. This is why a shortage is also known as excess demand. At prices of 25 cents and 50 cents per cup, you can see the shortage in Figure 6.7. Remember that consumers love low prices so the quantity demanded is going to be high. However, suppliers are not thrilled to see low prices and therefore decrease their quantity supplied. At prices below 75 cents per cup, lemonade buyers and sellers are in a state of disequilibrium. The disparity between what the buyers want at 50 cents per cup and what the suppliers want at that price should remedy itself. Thirsty demanders offer lemonade stand owners prices slightly higher than 50 cents and, receiving higher prices, suppliers accommodate them by squeezing lemons. With competition, the shortage is eliminated at a price of 75 cents per cup.
A surplus exists at a market price when the quantity supplied exceeds the quantity demanded. This is why a surplus is also known as excess supply. At prices of $1 and $1.25 per cup, you can see the surplus in Figure. 6.7. Consumers are reluctant to purchase as much lemonade as suppliers are willing to supply and, once again, the market is in disequilibrium. To entice more consumers to buy lemonade, lemonade stand owners offer slightly discounted cups of lemonade and buyers respond by increasing their quantity demanded. Again, with competition, the surplus would be eliminated at a price of 75 cents per cup.
- Shortages and surpluses are relatively short-lived in a free market as prices rise or fall until the quantity demanded again equals the quantity supplied.
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