Question

Market for a good is in equilibrium. Explain the chain of reactions in the market if the price is (i) higher than equilibrium price and (ii) lower than equilibrium price. 

Answer 1

(i) When the market price is higher than the equilibrium price then it results in a situation of excess supply. That is, under such a situation the market demand falls short of the market supply. 

In the diagram, the initial equilibrium is established at point E, where the market demand curve and the market supply curve intersect. Correspondingly, the equilibrium price is OP^e at Rs 8 and the equilibrium quantity is Oq^e at 4 units.

Let price rise above the equilibrium price to Rs 12. At this price, the market demand is 2 units, whereas the market supply is 6 units. As the market supply exceeds the market demand, so there exists excess supply of 4 units (6 - 2). As a result of this excess supply, the competition among the sellers to sell their output increases and they are ready to reduce the price in order to sell more units of output. The fall in the price continues until it becomes equal to OP^e, where the market demand equals the market supply.

(ii) On the other hand, when the market price is lower than the equilibrium price then it results in a situation of excess demand. Excess demand refers to a situation where market demand exceeds market supply at a particular market price.

In the diagram, the initial equilibrium is established at point E, where the market demand curve and the market supply curve intersect. Correspondingly, the equilibrium price is OP^e at Rs 8 and the equilibrium quantity is Oq^e at 4 units.

Let the market price be below the equilibrium price, say Rs 2. At this price, the market demand equal to 7 units and the market supply is 1 unit. Thus, there exists excess demand as the market demand exceeds the market supply. As a result, the competition among the buyers to purchase the output rises and they are ready to pay higher prices for the output. The rise in the market price continues until it reaches the equilibrium price OP^e, where the market demand equals the market supply.