4.2 Equilibrium

You may have encountered the term equilibrium in your science classes. Scientists refer to equilibrium as a stable situation with no tendency to change; this occurs when competing forces balance each other. The same idea applies in economics. A market is in equilibrium when the quantity supplied is equal to the quantity demanded. In equilibrium, every seller who wants to sell an item can find a buyer, and every buyer can find a willing seller. Because of this balancing, there’s no tendency for the market price to change when a market is in supply-equals-demand equilibrium. There’s only one price at which the quantity supplied equals the quantity demanded. This is referred to as the equilibrium price. The resulting quantity is called the equilibrium quantity.

Supply Equals Demand

The building blocks of our analysis will be market demand and supply curves. As you know, market demand and supply curves summarize the purchasing and producing decisions of all the participants in the market. The equilibrium occurs at the point at which the market supply and demand curves cross, because this is the point at which the quantity supplied equals the quantity demanded. You will see this most clearly by working through an example, and Figure 2 reintroduces the data on the market demand for gasoline (which should be familiar from Chapter 2) and data on the market supply (from Chapter 3). The table lists both the quantity demanded at each price and the quantity supplied at each price. Graphing the price against the quantity demanded yields the downward-sloping market demand curve shown on the right. Likewise, graphing the price against the quantity supplied yields the upward-sloping market supply curve.

A graph and a table explain supply and demand in regard to the market for gas in the United States.

Figure 2 | Supply and Demand

Now that we’ve graphed the relevant data, it’s time to figure out the equilibrium. Equilibrium occurs at the point where the quantity demanded is equal to the quantity supplied, and this occurs where the curves cross. Check both the graph and the table, and you’ll see that when the price is $3 per gallon, then 2 billion gallons of gas are demanded each week, and 2 billion gallons are supplied. Consequently, the equilibrium price of gas is $3 per gallon, and at that price, the equilibrium quantity of gas produced each week is 2 billion gallons. Markets have a tendency to move toward equilibrium, and once they find it, prices and quantities stop changing—at least until something disturbs the market.

Recap: Equilibrium reflects both supply and demand.

You’ve covered a lot of ground since you started studying economics, so let’s review how we got here. In the chapter on demand, we discovered how to summarize the behavior of many individual buyers with a downward-sloping market demand curve. Likewise, the actions of many individual sellers lead to an upward-sloping market supply curve. Markets tend to move toward equilibrium, which occurs at the point where the supply and demand curves cross.

When you stop to think about it, it’s pretty amazing. The seemingly chaotic actions of many buyers and sellers in competitive markets can be summarized neatly into demand and supply curves. And the resulting market outcomes can be predicted by calculating the supply-equals-demand equilibrium. Your graphical analysis also makes it clear that market equilibrium is determined in equal measure by both supply and demand. Any analysis that omits either side of the market will be incomplete. While this might sound obvious right now, you’ll be surprised at how often you hear even so-called experts talk about supply (and marginal costs) but forget demand (and marginal benefits), or vice-versa.

EVERYDAY Economics

Why is water cheap, while diamonds are expensive?

Water is essential for human survival. Not only is it delicious and refreshing, but it also sustains all life. If you don’t drink enough water, you’ll die. And yet water is extremely cheap. Contrast this with diamonds, which sparkle beautifully, but are inessential for human survival and yet incredibly expensive. What gives? Your analysis of supply and demand yields two important lessons that are at the core of resolving this paradox.

A photo shows a piece of diamond held in a tweezer and another photo shows a sprinkler watering a field.

Diamonds or water: Which is more valuable?

Prices are determined by both supply and demand: If you think it’s surprising that water can be both essential and cheap, you’re probably only thinking about the demand (or marginal benefit) side. For instance, you figure that if something is essential, people must be willing to pay a lot for it. But prices are determined by both supply and demand. And when you think about the supply (or marginal cost) side, you’ll notice that water is also plentiful and costs little to produce, while diamonds are scarce and expensive to mine.

Prices are determined at the margin: Okay, so prices are determined by both supply and demand; so far so good. Now recall that your demand curve is your marginal benefit curve, while the supply curve is your marginal cost curve. That is, when you think about your demand for water, you need to think about your marginal benefit, not total benefit. The total benefit of all your water consumption is extraordinarily high—it sustains your life. But if the price of water rose, you probably wouldn’t reduce the amount of water you drink. Instead, you might take shorter showers or water your lawn less often. Thus, the “marginal” gallon of water you buy is quite inessential. And so your willingness to pay for a gallon of water is low, because the marginal gallon brings little marginal benefit. But if water ever were to become so scarce that the marginal gallon would save you from dehydration, your willingness to pay for one more gallon of water may be so high as to make water more valuable than diamonds.

Getting to Equilibrium

So far, we’ve described equilibrium as the point at which there’s no tendency for change. It’s also important because markets tend to move toward the point of supply-equals-demand equilibrium. As a result, you can use your analysis of equilibrium to predict whether prices are likely to rise or fall.

Shortages lead the price to rise.

Let’s begin by thinking about what happens when the price is below the equilibrium level. Figure 2 demonstrates that when gas is only $2 per gallon, a shortage will result: The quantity of gas demanded (2.4 billion gallons per week) far exceeds the quantity supplied (1.5 billion gallons). There are too many people chasing too little gas, leading to shortages. As a result, individual gas stations find themselves selling out of gas, or facing long queues of desperate customers. How will suppliers and demanders respond to this shortage?

Start by putting yourself in the shoes of your local gas station owner. You know that at a price of $2, you will sell out of gas. You also know that if you raise your price to $2.10, you’ll still sell all your gas (check Figure 3; there’s still a shortage), and so raising your price means raising your profits. Raising your price to $2.20 will raise your profits even further, and you will still sell all your gas. As long as the shortage persists, you’ll keep marking up your price.

A graph depicts how markets approach equilibrium.

Figure 3 | How Markets Approach Equilibrium

Gas customers are also a critical part of the process of pushing the price toward equilibrium. If you’re a customer who’s worried about a gas shortage, you might tell a gas station owner that you’re willing to pay 10 cents per gallon above her posted price of $2.20 to avoid missing out, and so the price rises to $2.30. As this process continues, the price will keep rising until the gas shortage is eliminated, which occurs when the price is $3.

Surpluses lead the price to fall.

A similar process operates in the reverse direction when the price is above its equilibrium. Figure 2 shows that when gas is $4 per gallon, a surplus results as the quantity of gas supplied far exceeds the quantity demanded. Gas station owners, trying to sell off their unsold gas, will charge lower prices in the hopes of attracting more customers. With enough competition, repeated rounds of discounting will push the price down to $3 per gallon, eliminating this surplus.

Figure 3 illustrates that when supply and demand are out of step, the forces of competition push markets toward the equilibrium price, thereby eliminating any shortages or surpluses. Economists emphasize this equilibrium point because it can help you figure out whether prices are headed up or down. And it’s only when a market reaches equilibrium that supply and demand will be in balance, and so there will be no tendency for the price to change.

Figuring Out Whether Markets Are in Equilibrium

How can you tell whether a market is in a supply-equals-demand equilibrium? A simple diagnostic is to check whether prices are changing. Whenever the price is rising, that’s a sign that at the current price, the quantity demanded exceeds the quantity supplied. And if the price is falling, it’s likely that the quantity supplied exceeds the quantity demanded. If prices are free to adjust, then eventually these markets will be drawn to their equilibrium.

But sometimes, this process of price adjustment might be slow, or the price isn’t free to change. And so this excess demand or supply will spill over into other domains. The next case study examines what happens when a market is not in equilibrium.

EVERYDAY Economics

Smart parking meters

Have you ever driven around for what seemed like hours, looking for a place to park? The problem is that the number of parking spaces is relatively fixed, and during busy times, the quantity of spots demanded exceeds this fixed supply. What you’re experiencing is a parking market that’s stuck out of equilibrium. And the price can’t rise to eliminate this shortage, because that would require reprogramming all the parking meters.

People respond in different ways to this problem. You might keep circling the block, effectively queuing for the next spot that comes up. Another possibility is to alter your plans for the evening by starting your night with dinner at a restaurant that offers valet parking. Yet another alternative—one that’s quite common in the neighborhood of big concerts or sporting events—is that you’ll find someone who will let you park in their driveway for $20. But each of these are pretty costly fixes—mere Band-Aids for the problem. When the price can’t change, the shortage of parking spots can persist.

Is there a better solution? The city of San Francisco thinks so, and it has experimented with one possibility: charging higher prices to park in the most overcrowded areas during busy times, and lower prices during less popular times. The program seems to have worked: Since it began, the number of people “cruising” for a spot fell by about 30%.

The problem of insufficient parking spaces highlights the three symptoms of a market out of equilibrium, which is also known as disequilibrium:

Each of these symptoms serves to raise the “effective price,” even when the price charged by sellers can’t directly rise. These three symptoms of disequilibrium are not just about parking spaces—they occur in many markets. For instance, when a new videogame console is released, you’ll often see gamers queuing to snag a scarce console. You’ll find videogame stores that’ll only sell you a console if you also buy a bunch of extra games that they bundle with it. And you’ll find people reselling their consoles at a hefty markup on secondary markets like eBay or Craigslist.

If the problem is a surplus instead of a shortage, you’ll observe similar symptoms, although in reverse—in a way that lowers the “effective price.” For instance, sellers may queue to meet buyers—such as when the unemployed, who are potential sellers of labor queue for a chance at a job interview. Buyers may demand “extras” be bundled for free, such as when savvy car buyers can get the dealership to throw in an upgrade. And prices will be lower on the secondary market, such as when tickets to unpopular sporting events sell below face value on StubHub.