Market equilibrium
Previous discussion considered how a manufacturer would react to changes in the price of inputs. We usually expect manufacturers to demand a lesser quantity of an input if its price goes up (relative to the price of other inputs). This is the demand side of a market.
But price affects the other side of the market too. If the price of the input goes up (relative to the price of other inputs), suppliers of that input will tend to supply more of that input. This is the supply side of a market.
These supply and demand relationships are often depicted in graphical form as shown below:
The diagram shows the relationship between Quantity and Price for a hypothetical product from both a supply and demand perspective. The supply and demand curves cross at Price P0 and Quantity Q0. At this point, the price is high enough for suppliers of the product to produce quantity Q0 while being low enough for consumers of the product to demand quantity Q0. This price level is termed the equilibrium price.
Consider what would happen if the price were actually at level P1. Suppliers of the product would supply quantity QS1 while consumers of the product would demand quantity QD1. Therefore, the quantity being supplied to the market is greater than the quantity demanded by consumers, which means that stocks of the product in the marketplace will increase. Eventually, excess stocks in the marketplace will force suppliers to lower their price to encourage greater use of the product and clear the stocks in the market. Indeed, to clear the stocks, the price will probably have to fall below the equilibrium price. At the same time, manufacturers will produce less of the product because the price they are receiving is lower. Once the stocks in the market have been exhausted then the market price will rise again – as will production.
There are two key points to take from this:
- market prices are set by the interaction of the supply and demand for a given product
- market prices often fluctuate around their equilibrium level.
