Market equilibrium, how price is determined by demand and supply, surpluses and shortages, and how shifts in demand or supply change price and quantity.

What this dot point is asking

OCR wants you to explain how demand and supply together set the equilibrium price and quantity, what happens in surplus and shortage, and how a shift in either curve moves the equilibrium. You must be able to draw the diagram and solve for equilibrium from equations.

Market equilibrium

On the demand and supply diagram, equilibrium is where the two curves cross. The price there is the equilibrium (market clearing) price and the quantity is the equilibrium quantity.

Surpluses and shortages

When the price is not at equilibrium, market forces push it back:

• Above the equilibrium price, quantity supplied exceeds quantity demanded, creating a surplus (excess supply). Unsold stock forces firms to cut the price.
• Below the equilibrium price, quantity demanded exceeds quantity supplied, creating a shortage (excess demand). Competition among buyers pushes the price up.

Calculating equilibrium

When demand and supply are given as equations, equilibrium is found by setting them equal.

For example, if $Q_d = 200 - 5P$ and $Q_s = 50 + 5P$, then $200 - 5P = 50 + 5P$, so $150 = 10P$ and $P = \pounds 15$, giving $Q = 50 + 5 \times 15 = 125$.

How shifts change the equilibrium

A shift in either curve creates a new equilibrium. The four basic cases are worth memorising:

• Demand rises (shifts right): price up, quantity up.
• Demand falls (shifts left): price down, quantity down.
• Supply rises (shifts right): price down, quantity up.
• Supply falls (shifts left): price up, quantity down.

When both curves shift, one of price or quantity is determinate and the other depends on the relative size of the shifts.

The price mechanism at work

These adjustments are the signalling, incentive and rationing functions of price doing their job. A shortage signals scarcity and rewards firms that supply more; a surplus signals over-supply and pushes firms to cut prices or output. Through these pressures the market reallocates resources without any central direction.

Try this

Q1. A market has a price above equilibrium. State whether there is a surplus or a shortage and what happens to price. [2 marks]

• Cue. A surplus (excess supply), which pushes the price down towards equilibrium.

Q2. Demand for a good rises. Explain the effect on equilibrium price and quantity. [3 marks]

• Cue. The demand curve shifts right, creating excess demand at the old price, so both equilibrium price and quantity rise.