_Price and output determination

Tags: #cb2/03/03

This section includes:

Equilibrium price and output

Movement to a new equilibrium
Identifying the position of demand and supply curves
Incentives in markets

Equilibrium price and output:

In a free and competitive market, the actual price of the product and the quantity bought and
sold are determined by the interaction of demand and supply. The total market demand and
supply of potatoes at different price level is given in the following table

We want to answer the question : What will be the price and output that actually prevail

initial price is 20p

Here, demand will exceed supply by 600,000 tonnes (A - a)

This will lead to a shortage which will lead to increase in price
But as the price rises, the quantity demanded falls and the quantity supplied rises.
Hence, the shortage is progressively eliminated

Note: Same situation will persist if the initial price is 40p

Initial price is 100p

Here, supply will exceed demand by 600,000 tonnes (e - E)

This will lead to a surplus which will lead to decrease in price
 But as the price falls, the quantity demanded rises and the quantity supplied falls
Hence, the surplus is progressively eliminated

Note: Same situation will persist if the initial price is 80p

Initial price is 60p

Here, demand and supply are equal (C - c = 0)

This is the only price point which is sustainable (i.e. demand and supply are equal at
this price point)
When supply matches demand the market is said to clear (i.e. there is no shortage and
no surplus)

Market clearing: A market clears when supply matches demand, leaving no shortages
or surplus

In Price Mechanism , we saw that the price where demand and supply are equal is
known as equilibrium price

Interpretation:

In the above table, if the price starts at other than 60p per kg, it will tend to move
towards 60p.
The equilibrium price is where producers' and consumers' plans align (i.e. where the
producers' plan to supply exactly match the consumers' plan to buy), ensuring a
balanced market.

Demand and supply curves

The determination of equilibrium price and output can be shown using demand and supply
curves. Equilibrium is the point where both the curves intersect

The following figure shows the demand supply curves of potatoes corresponding to the data
in the above table.
Equilibrium price is P (60p) and the equilibrium quantity is Q (350,000 tonnes)
e e

Surplus above 60p:

At any price above 60p, there's a surplus. For example, at 80p, a surplus of 330,000
tonnes (D-d) is there
Here, more is supplied than consumers are willing and able to purchase at that price
Thus price of 80p fails to clear the market
Price will fall to the equilibrium price of 60p
When the price falls, there will be a movement from point D to point C on demand curve
and a movement from point d to c in the supply curve

Shortage below 60p:

At any price below 60p, there's a shortage. For example, at 40p, a shortage of 300,000
tonnes (B-b) is there.
Price will rise to the equilibrium price of 60p
When the price rises, there will be a movement from point B to point C on demand
curve and a movement from point b to c in the supply curve

Point Cc is the equilibrium: where demand equals supply