This chapter brings consumers’ demand and firms’ supply together to determine the equilibrium price and quantity in a perfectly competitive market. Equilibrium is the price at which the quantity demanded equals the quantity supplied, so the market clears. If the price is above equilibrium there is excess supply (a surplus), which pushes the price down; if it is below equilibrium there is excess demand (a shortage), which pushes the price up. These automatic forces of competition restore equilibrium. The chapter then studies how shifts in demand and supply curves change the equilibrium. An increase in demand raises both equilibrium price and quantity, while an increase in supply lowers price but raises quantity. When both curves shift simultaneously, the effect on price or quantity may be determinate or ambiguous depending on the relative sizes of the shifts. The model is extended to a market with a fixed number of firms and to free entry and exit, where in the long run firms earn only normal profit. Finally, applications of demand-supply analysis are examined, including government price controls — a price ceiling (a maximum price below equilibrium, as in rationing of essentials, leading to shortages and possible black markets) and a price floor (a minimum price above equilibrium, such as a minimum support price for farm products or a minimum wage, leading to surpluses).
Key terms
Market equilibrium
The price at which quantity demanded equals quantity supplied and the market clears.
Excess demand
The amount by which quantity demanded exceeds quantity supplied at a price below equilibrium.
Excess supply
The amount by which quantity supplied exceeds quantity demanded at a price above equilibrium.
Price ceiling
A government-imposed maximum price set below the equilibrium price.
Price floor
A government-imposed minimum price set above the equilibrium price.
Minimum support price
A price floor at which the government guarantees to buy farmers’ produce.
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Market equilibrium occurs at the price where:
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