Equilibrium occurs where quantity supplied equals quantity demanded.
What does it mean?
Basically, your market price will be stable, that is, it won't tend to change, when you
reach the point at which willingness to buy coincides with willingness to sell in the
market.
Here’s a numerical example.
Note that I could pick any numbers for my demand, as long as they follow one simple
rule: as price goes up, quantity demanded must go down.
That's the Law of Demand.
Similarly, for supply, as price goes up quantity supplied must go up as well, to follow the
Law of Supply.
Without even looking at a diagram, where is equilibrium?
Equilibrium occurs at a price of three dollars, where the quantity demanded equals the quantity
supplied, at three units (please note that the fact that price and quantity are both
three is just coincidence; they will not always be the same).
If I plot out these numbers -- first the demand figures, then supply – I reach the same
conclusion with the diagram: equilibrium occurs at a price of three dollars where the quantity
supplied equals the quantity demanded at three units.
Why is this the equilibrium?
Because no other price would be stable.
All other prices would have a tendency to change.
At a dollar, for instance, the buyers are happy (they’d love to buy five units); but
the sellers are unhappy -- they're only willing to provide one unit to the market.
A situation like this, where the quantity demanded is greater than the quantity supplied,
is referred to as a shortage, and will result in upward pressure on price.
Why?
Well, those buyers all want to purchase, but there's only one unit available, so the buyers
start to compete to get the one available unit -- by offering more money.
Price goes up, and consequently quantity demanded drops, and quantity supplied rises until we
get to equilibrium.
What about a higher price, like five dollars?
At five dollars, sellers are happy providing five units, but buyers are unhappy: they only
want one unit.
When the quantity demanded is less than the quantity supplied, we have a surplus, and
price will drop.
OK, let's go back to the housing market example.
Price P1 is the stable market equilibrium price for this market.
What if it's not the price?
Start by taking a look at the Phoenix housing market in 2005 as an example.
At that time the price was below the equilibrium price.
What happens at price 2005?
There are lots of buyers at this price (the quantity demanded); not so many sellers (quantity
supplied).
This was characterized by homes being snatched up off the market, often sight unseen, often
within hours of being listed (sometimes as the for sale sign was going up); new-home
developments were holding lotteries to determine which buyers would be allowed to purchase!
Shortages result in increasing market prices, leading to an increase in the quantity supplied,
and a decrease in the quantity demanded.
When will the prices stop rising?
When there's no more pressure -- no more shortage.
In short, the market stabilizes at P1.
Now, fast-forward three years to observe the Phoenix housing market in 2008.
In 2008, prices were greater than the market equilibrium prices.
What happens at P2008?
There are lots of sellers (quantity supplied); not so many buyers (quantity demanded).
This was characterized by homes sitting on the market for months -- some for over year
-- even with remodeling, and upgrades, and in pristine condition!
Some sat for so long that the owners simply abandoned them.
This is a signal that the prices need to come down in order to increase the quantity demanded,
and decrease the quantity supplied.
When will the price stop falling?
When the surplus goes away, the downward pressure eases.
This means that when the quantity supplied equals the quantity demanded, at P1, the market
stabilizes.
So P1, Q1 must be the market equilibrium price and quantity.
If that's so, how do we ever see sustained, stable price changes?
P1 and Q1 are the equilibrium price and quantity for this particular set of market conditions,
but supply and demand can change, and if they do, you’ll get a new equilibrium for the
new set of market conditions.
TIME TO THINK: What happens to the equilibrium price and quantity if: demand increases?
What if demand decreases?
What if your supply increases?
What if your supply decreases?
While you're thinking about these questions, try to come up with specific examples -- what
is the market, and why would demand increase?
NEXT TIME: Price floors and price ceilings TRANSCRIPT00EPISODE 14: EQUILIBRIUM