1

Surpluses and Shortages

In order to understand market equilibrium, we need to start with the laws of demand and supply. Recall that the law
of demand says that as price decreases, consumers demand a higher quantity. Similarly, the law of supply says
that when price decreases, producers supply a lower quantity.

Consumer - Demand
Producer – Supply

Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the
demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply
determine the price and the quantity that will be bought and sold in a market. These relationships are shown as the demand
and supply curves in Figure 7.16.17.16.1, which is based on the data in Table 1, below.
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Figure 7.16.17.16.1: The supply and demand curves for gasoline.

Table 7.16.17.16.1. Price, Quantity Demanded, and Quantity Supplied

Price (per gallon) Quantity demanded (millions of gallons) Quantity supplied (millions of gallons)

$1.00 800 500

$1.20 700 550

$1.40 600 600

$1.60 550 640

$1.80 500 680

$2.00 460 700

$2.20 420 720

If you look at either Figure 7.16.17.16.1 or Table 7.16.17.16.1, you’ll see that at most prices the amount that consumers
want to buy (which we call the quantity demanded) is different from the amount that producers want to sell (which we call the
quantity supplied).

What does it mean when the quantity demanded and the quantity supplied aren’t the same?

The answer is: a surplus or a shortage. (Artıqlıqlar və çatışmazlıqlar)

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Surplus or Excess Supply (Artıq və ya artıq təklif)

Let’s consider one scenario in which the amount that producers want to sell doesn’t match the amount that consumers
want to buy. Consider our gasoline market example. Imagine that the price of a gallon of gasoline were $1.80 per gallon. This
price is illustrated by the dashed horizontal line at the price of $1.80 per gallon in Figure 7.16.27.16.2, below.

Figure 7.16.17.16.1: A price above equilibrium creates a surplus.

At this price, the quantity demanded is 500 gallons, and the quantity of gasoline supplied is 680 gallons. You can also find
these numbers in Table 1, above. Now, compare the quantity demanded and quantity supplied at this price. Quantity
supplied (680) is greater than quantity demanded (500). Or, to put it in words, the amount that producers want to
sell is greater than the amount that consumers want to buy. We call this a situation of excess supply (since Qs > Qd)
or a surplus.
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* Note that whenever we compare supply and demand, it’s in the context of a specific price—in this case, $1.80
per gallon.

With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts
pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are
not receiving enough cash to pay their workers and cover their expenses. In this situation, some firms will want to
cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices; others will
follow to avoid losing sales. These price reductions will, in turn, stimulate a higher quantity demanded.

How far will the price fall?

Whenever there is a surplus, the price will drop until the surplus goes away. When the surplus is eliminated, the quantity
supplied just equals the quantity demanded—that is, the amount that producers want to sell exactly equals the amount
that consumers want to buy. We call this equilibrium, which means “balance.” In this case, the equilibrium occurs at a price
of $1.40 per gallon and at a quantity of 600 gallons. You can see this in Figure 2 (and Figure 1) where the supply and demand
curves cross. You can also find it in Table 1 (the numbers in bold).

Shortage or Excess Demand (Çatışmazlıq və ya Həddindən artıq tələb)

Let’s return to our gasoline problem. Suppose that the price is $1.20 per gallon, as the dashed horizontal line at this price in
Figure 3, below, shows. At this price, the quantity demanded is 700 gallons, and the quantity supplied is 550 gallons.
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Figure 7.16.37.16.3: A price below equilibrium creates a shortage.

Quantity supplied (550) is less than quantity demanded (700). Or, to put it in words, the amount that producers
want to sell is less than the amount that consumers want to buy. We call this a situation of excess demand

(since Qd > Qs) or a shortage.

In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies
and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher
price. These price increases will stimulate the quantity supplied and reduce the quantity demanded. As this
occurs, the shortage will decrease.
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How far will the price rise? The price will rise until the shortage is eliminated and the quantity supplied equals quantity
demanded. In other words, the market will be in equilibrium again. As before, the equilibrium occurs at a price of $1.40 per
gallon and at a quantity of 600 gallons.

Generally, any time the price for a good is below the equilibrium level, incentives built into the structure of
demand and supply will create pressures for the price to rise.

Similarly, any time the price for a good is above the equilibrium level, similar pressures will generally cause the
price to fall.

As you can see, the quantity supplied or quantity demanded in a free market will correct over time to restore balance, or
equilibrium.
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Equilibrium and Market Surplus

Learning Objectives
By the end of this section, you will be able to:

 Explain equilibrium, equilibrium price, and equilibrium quantity

 Understand how supply and demand bring markets back to equilibrium
 Analyze the effect of supply and demand shocks to market price and quantity
 Calculate market surplus given supply and demand curves

Who Sets the Price?

Have you ever been to a busy street corner and seen a row of fast food vendors lined up beside each other?
Oftentimes, the vendors have little to no branding, so the stands are relatively homogeneous. How do you
decide where to buy? Assuming the quality looks about the same, you might go for the cheapest option.

What about the vendors? Knowing that consumers will purchase the cheapest option, they will avoid setting
their price above their competitors, and may lower prices to sell more. As long as the price is above thier
costs there is still an opportunity to undercut the competition. This will cause a race to the bottom until the
price is at the equilibrium level.

Who sets the price? With many different firms and consumers, no individual has the power to influence
price. But collectively, their actions determine it. This brings us to the core conclusion of this chapter:
market price is determined by the interactions between supply and demand.

Equilibrium

Equilibrium is formally defined as a state of rest or balance due to the equal action of opposing forces.
In economics, these forces are supply and demand.
Figure 3.6a shows the competitive market for hot dogs, with aggregate demand in blue and aggregate
supply in yellow. As price rises, quantity demand for hot dog falls, and quantity supplied rises. There
are two important points on this diagram. First is equilibrium quantity (QE). QE is where the quantity
supplied is equal to the quantity demanded.
Let’s first consider what occurs when the price is too high.
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F
igure 3.6 a

When Price is Higher than Equilibrium

What if the price is above our equilibrium value? Regardless of the cause, we see in Figure 3.6 b
that a price above equilibrium will result in quantity supplied being greater than quantity demanded.
This excess supply is also known as a surplus. There are too many sellers who are enticed by the high
price, and not enough buyers. Consider a hot dog vendor, Paul, in this situation. Though Paul would be
happy to receive the high price of $5 from the customers who buy the good, he will find that he will be
unable to sell all the hot dogs he cooks, since 500 hotdogs are being made, and only 100 sold. This will
result in wasted product, and a surplus of 400 hotdogs in the market. If vendors were forced to stay in
this market, the quantity supplied would fall to 100, as vendors would quickly reduce production to
what customers are willing to purchase.
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Figure 3.6b

As price falls, two things occur:

 There is a decrease in quantity supplied (a movement along the supply curve)

 There is an increase in quantity demanded (a movement along the demand curve)

Notice that both supply and demand are forces that bring the market back to equilibrium. When price is
at equilibrium of $3, no vendor has the incentive to decrease their price, since this would result in them
selling hotdogs at a loss.
When Price is Lower than Equilibrium

What if price is lower than equilibrium? This is depicted in Figure 3.6c with a market price of
$1.0. When price is too low, the quantity demanded is greater than quantity supplied. This excess
demand is known as a shortage. In this situation, the low price causes an excess of buyers. When we
have a shortage, the consumers who are able to buy the good are happy, but due to the low price, not
enough will be produced and not every consumer will get their hands on a hotdog.
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Figur
e 3.6c

At $1.0, 500 hot dogs are demanded, but only 100 are being produced. This means there are many
consumers who are willing to pay more than the $1 for a hotdog, but are unable to find one. So, how do
the 100 hot dogs get allocated? Perhaps it will be on a first come first serve basis, but frustrated
consumers will likely start to offer a higher price to the hot dog stands and outbid other consumers.
This will drive price back to the equilibrium level. As a price rises, two things occur:

 There is an increase in quantity supplied (a movement along the supply curve)

 There is a decrease in quantity demanded (a movement along the demand curve)

Again, both supply and demand are forces that bring the market back to equilibrium.

External Market Shocks & Equilibrium

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How will these shocks affect equilibrium? Suppose the price of a hamburger, a substitute for hot dogs,
rises. In Figure 3.4d below, we see the initial effects of the demand shift. (recall that a demand shift
changes the relationship between quantity demanded and quantity supplied at every point!)

Figure 3.6d

Whereas supply and demand were in equilibrium at QE1 at the initial price of $3, the demand
shift has caused QD > QS. As discussed, this causes a shortage (see left side of Figure 3.6e). Like
before, the equal and opposite effects of supply and demand will cause a movement along both the
supply and demand curve until we return to our equilibrium at QE2 (right side of Figure 3.6e).
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Fig
ure 3.6e

Notice the effects of the demand shift on our overall equilibrium. Both equilibrium price and quantity
are now higher. Understanding these final effects is extremely important to understanding the supply
and demand model.

What if two curves shift?

We have viewed the separate effects of demand and supply shifts, but what happens if both shift at
once? Assume that in addition to an increase in the price of hamburgers, there is a decrease in
the number of hot dog stands in the market, causing a decrease in supply. How do these two
shocks change our equilibrium? The effects are depicted in Figure 3.6f.
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Figure 3.6f

Our two effects, an increase in demand and a decrease in supply, each have thier own effects. The
increase in demand causes both the price and quantity to increase, whereas the decrease in
supply causes the price to increase and quantity to decrease. What does this mean for our equilibrium?
Summarizing these effects:

Price: Demand causes increase, Supply causes increase.

Quantity: Demand causes increase, Supply causes decrease.

If both the supply and demand shifts are causing the price to rise, our prices will clearly rise; however,
the change in quantity is not so simple. If one shift causes quantity to rise and another causes it to fall,
what is the overall effect? In Figure 3.6f, there appears to be no change in quantity, but this is because
the two shifts are depicted as equal and opposite. In reality, unless we know the magnitude of the curve
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shifts, we cannot say much about the change in quantity. In other words, the resulting quantity change
is inconclusive. Figure 3.6g summarizes the results from different combinations of curve shifts.

Figure 3.6g

Remember, the best way to understand these impacts is through practice not memorization.
Market Surplus

In this topic, we have outlined the importance of using consumer surplus and producer surplus to
measure net benefits for consumers and producers. Recall consumer surplus is the difference
between what consumers are willing to pay and what they actually pay, whereas producer
surplus is the difference between what the producer is paid and the marginal costs of production.
Oftentimes, we want to look holistically at the market and calculate market/private surplus, a
measure of the net benefits accruing to all participants in the market. This includes our consumer
surplus, producer surplus, and, as we will explore in Topic 4, government revenue/expenditure.

For our hot dog market, using our market surplus definition of consumer surplus + producer surplus +
government, we can see in Figure 3.6g that the market surplus is equal to the green and yellow areas.
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Figure 3.6h

To calculate market surplus, simply find the area of the shaded regions.

The area of a triangle is (base x height)/2.

Consumer surplus (green)= (300 x 3)/2 = $450

Producer surplus (yellow) = (300 x 3)/2 = $450

Market Surplus = $450 + $450 = $900

While adding up the surplus of every party is simple with just consumers and producers, it gets more
complicated as more players enter the market. In Figure 3.6i, a different process is outlined. Since
the demand curve is the marginal benefit curve, it represents the marginal benefits at each quantity
level. (We know that this is distributed between consumers and producers) Therefore, the area under
our marginal benefit curve represents our total market benefits. Likewise, the supply curve is the
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marginal cost curve and represents the marginal costs at each quantity level. The area under the
marginal cost curve represents our total market costs.

F
igure 3.6i

With our total benefits (blue) and our total costs (red), we can easily determine our total market surplus
is the green area in Figure 3.6j below. To calculate:

Total Benefits: $1350

Total benefits correspond to the blue area in Figure 3.6i. This area is made up of a rectangle with
dimensions 300 x $3 and a triangle with base 300 and height of $3. The area is (300 x $3) + (300 x
$3)/2.

Total Costs: $400

Total costs correspond to the red area in Figure 3.6i. This area is made up of a triangle with a base of
300 and height of $3. The area is (300 x $3)/2.

Total Market Surplus: $900

Total market surplus can be calculated as total benefits – total costs. Alternatively, we can calculate the
area between our marginal benefit and marginal cost, constrained by quantity. This is the equivalent of
finding the difference between the marginal benefits and the marginal costs at each level of production.
In Figure 3.6j, this is the green area, with base of $6 and height of 300.
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Figure 3.6j

Market Surplus and Efficiency

Market surplus is certainly a useful way to measure the net benefits to players in the market, but it can
also be used to measure efficiency. By comparing market surplus in different situations, we can
confirm whether an equilibrium is efficient. (Recall efficiency is a situation where we cannot make one
person better off without making another worse off.) With this in mind, we can infer that
an equilibrium is efficient if it maximizes market surplus.

In Figure 3.6k, we have a market that is producing 200 hot dogs – 100 less than our equilibrium. Is this
efficient? Well, if we calculate the green shaded region below, we find that it is $800, which is $100
less than before. By simply increasing production back to our original level, we make both consumers
and producers better off without making anyone worse off. The difference in green regions from Figure
3.6j and Figure 3.6k is called Deadweight Loss, because it is cost to society made by an inefficiency.
As a whole, the market could be made better off by increasing quantity.
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Figure 3.6k

Summary
In this section we completed the construction of our competitive market model, bringing together
supply and demand. The equal and opposite forces of supply and demand lead the market to a single
equilibrium price and quantity, which is generally self-sustaining. Looking at shocks introduced in
earlier sections, we saw that external events can change our equilibrium, and combinations of shocks
can sometimes lead to ambiguous effects. Using consumer and producer surplus, we developed a
criterion for efficiency – market surplus – that can be used to calculate deadweight loss. Market surplus
and deadweight loss will be a key focus of Topic 4, where we look at the impact of government
intervention in the market.
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Glossary
Deadweight Loss

A cost to society created by a market inefficiency, occurs when quantity is different from equilibrium
quantity

Equilibrium Price

the price where quantity demanded is equal to quantity supplied

Equilibrium Quantity

the quantity at which quantity demanded and quantity supplied are equal for a certain price level

Equilibrium

the situation where quantity demanded is equal to the quantity supplied; the combination of price and
quantity where there is no economic pressure from surpluses or shortages that would cause price or
quantity to change

Excess Demand

at the existing price, the quantity demanded exceeds the quantity supplied; also called a shortage

Excess Supply

at the existing price, quantity supplied exceeds the quantity demanded; also called a surplus

Market Surplus

the total welfare to society, includes producer surplus, consumer surplus, and government expenditure

Shortage

at the existing price, the quantity demanded exceeds the quantity supplied; also called excess demand

Surplus

at the existing price, quantity supplied exceeds the quantity demanded; also called excess supply

Understanding Market Equilibrium

Let us recall “demand curve” and “supply curve”.

The following table shows the price of gasoline versus the average quantity of
gasoline demanded by a person in Region A.
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Price of gasoline (per gallon in USD) Quantity demanded per week

15 1

12 2

10 3

7 4

When the prices per gallon is high, the quantity demanded is less; as the price of
the product decreases, the demand increases.

The supply curve indicates how the supply of a product changes with price change.
Let us look at the same gasoline example. When the price per gallon is high, oil
suppliers bring more supply into the market because they can make higher profits.
This is called the law of supply.

The following table shows the price of gasoline versus the quantity of gasoline
supplied into the market of Region B. This is referred to as supply schedule.

Price of gasoline (per gallon) (in USD) Quantity supplied per week

5 100

8 125

10 150

12 200

The parameters of the x-axis and y-axis remain the same for both demand and
supply curves, we can plot both the curves on the same graph.

Let’s look at this graph. While plotting price versus quantity of a Good X, you can
find the point where the demand curve and supply curve intersect.
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The point where the demand and supply curves meet is called the equilibrium
point. That is the price where the quantity demanded is equal to the quantity
supplied. This point indicates equilibrium price and equilibrium quantity. In other
words, equilibrium quantity is the amount bought and sold at the equilibrium price.
When the market is not in equilibrium, market surplus and market shortage occur.

In the image shown above, the region that is above the price equilibrium indicates
market surplus and the region below the price equilibrium indicates market
shortage.

Consider the following graph:

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Now, do you notice the area between the equilibrium price and the demand curve?
Also, do you notice the area between the equilibrium price and the supply curve?
These areas indicate "consumer surplus" and "producer surplus".

Examples to Explain Consumer Surplus and Producer Surplus

Let’s assume that you are willing to pay $30 for a ticket to your favorite movie;
however, you are able to get a ticket for $25. The difference between what the
consumer pays for a product ($25) and what he would have been willing to pay
($30) is called the consumer surplus. Here, the consumer surplus is $5. In the
graph, consumer surplus is the area between the demand curve and the market
price.

In another scenario, the market price of a large pizza is $7 but the pizza company
sells it at $4. The price difference between what the pizza company receives ($4)
and the price it would want to sell ($7) is called the producer surplus. The producer
surplus here is $3. In the graph, producer surplus is the area between the supply
curve and the market price.

Producer Surplus Example

Say that there are 20 companies that make widgets, each producing them at
slightly different costs. ranging from $2.50 to $3.50 per widget. In the market, there
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is an equilibrium point where the amount of widgets supplied meets demand at

$3.00.

The producer surplus would define those producers who can make widgets for
less than $3.00 (down to $2.50), while those whose costs are up to $3.50 will
experience a loss instead. For the lowest-cost producer, they would enjoy a
surplus of $0.50 per widget.

Causes of Deadweight Loss

 Price floors: The government sets a limit on how low a price can be charged
for a good or service. An example of a price floor would be minimum wage.
 Price ceilings: The government sets a limit on how high a price can be
charged for a good or service. An example of a price ceiling would be rent
control – setting a maximum amount of money that a landlord can collect for
rent.
 Taxation: The government charges above the selling price for a good or
service. An example of taxation would be a cigarette tax.
Imperfect Competition and Deadweight Loss

Deadweight loss also arises from imperfect competition such as oligopolies

and monopolies. In imperfect markets, companies restrict supply to increase prices
above their average total cost. Higher prices restrict consumers from enjoying the
goods and, therefore, create a deadweight loss.

Example of Deadweight Loss

Imagine that you want to go on a trip to Vancouver. A bus ticket to Vancouver

costs $20, and you value the trip at $35. In this situation, the value of the trip ($35)
exceeds the cost ($20) and you would, therefore, take this trip. The net value that
you get from this trip is $35 – $20 (benefit – cost) = $15.

Before buying a bus ticket to Vancouver, the government suddenly decides to

impose a 100% tax on bus tickets. Therefore, this would drive the price of bus
tickets from $20 to $40. Now, the cost exceeds the benefit; you are paying $40 for a
bus ticket, from which you only derive $35 of value.
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In such a scenario, the trip would not happen, and the government would not
receive any tax revenue from you. The deadweight loss is the value of the trips to
Vancouver that do not happen because of the tax imposed by the government.

Graphically Representing Deadweight Loss

Consider the graph below:

At equilibrium, the price would be $5 with a quantity demand of 500.

 Equilibrium price = $5
 Equilibrium demand = 500

In addition, regarding consumer and producer surplus:

 Consumer surplus is the consumer’s gain from an exchange. The consumer

surplus is the area below the demand curve but above the equilibrium price
and up to the quantity demand.
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 Producer surplus is the producer’s gain from exchange. The producer

surplus is the area above the supply curve but below the equilibrium price
and up to the quantity demand.

Let us consider the effect of a new after-tax selling price of $7.50:

The price would be $7.50 with a quantity demand of 450. Taxes reduce both
consumer and producer surplus. However, taxes create a new section called “tax
revenue.” It is the revenue collected by governments at the new tax price.

With this new tax price, there would be a deadweight loss:

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As illustrated in the graph, deadweight loss is the value of the trades that are not
made due to the tax. The blue area does not occur because of the new tax price.
Therefore, no exchanges take place in that region, and deadweight loss is created.

Calculating Deadweight Loss

To figure out how to calculate deadweight loss from taxation, refer to the graph
shown below:
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Notes:

 The equilibrium price and quantity before the imposition of tax are Q0 and P0.
 With the tax, the supply curve shifts by the tax amount from Supply0 to
Supply1. Producers would want to supply less due to the imposition of a tax.
 The buyer’s price would increase from P0 to P1, and the seller would receive a
lower price for the good from P0 to P2.
 Due to the tax, producers supply less from Q0 to Q1.

The deadweight loss is represented by the blue triangle and can be calculated as
follows: