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In the diagram below, the equilibrium price is P1. The equilibrium quantity is Q1.
If price is below the equilibrium
In the above diagram, price (P2) is below the equilibrium. At this price, demand would be
greater than the supply. Therefore there is a shortage of (Q2 – Q1)
If there is a shortage, firms will put up prices and supply more. As price rises, there will be a
movement along the demand curve and less will be demanded.
Therefore the price will rise to P1 until there is no shortage and supply = demand.
If price is above the equilibrium
If price was at P2, this is above the equilibrium of P1. At the price of P2, then supply (Q2)
would be greater than demand (Q1) and therefore there is too much supply. There is a
surplus. (Q2-Q1)
Therefore firms would reduce price and supply less. This would encourage more demand
and therefore the surplus will be eliminated. The new market equilibrium will be at Q3 and
P1.
Movements to a new equilibrium
1. Increase in demand
If there was an increase in income the demand curve would shift to the right (D1 to D2). Initially,
there would be a shortage of the good. Therefore the price and quantity supplied will increase
leading to a new equilibrium at Q2, P2.
2. Increase in supply
An increase in supply would lead to a lower price and more quantity sold.