Note that there is just one price where this is true! The equilibrium price is the price that will generally prevail in a perfectly competitive market that is not subject to governmental intervention. As you might remember from your chemistry classes, a system is in equilibrium when there is no tendency for it to change under existing conditions. When a market is in equilibrium, there is no tendency for the market price to change. In other words, the equilibrium price is stable under the existing market conditions.
Consider, for example, the soybean market depicted in the following figure:
Under the existing conditions of supply and demand (the existing incomes for consumers, prices of related goods, state of technology, input prices, and other conditions), the market price of soybeans will be $2.50 per bushel. When farmers hear the farm report on the radio in the morning, the price of soybeans will be quoted as being $2.50 per bushel. Agricultural products such as apples, bread, or other items, are generally about their equilibrium prices.
If the equilibrium price is the price that is stable under existing conditions, that must mean other prices will tend to be unstable. That is exactly the case. Consider what happens when the market price is below the equilibrium price. At low prices, producers supply less and consumers want to buy more than at the equilibrium price. This creates an excess demand, and causes a shortage of the product. Imagine the situation at your local market if the minute supplies of the product came in, frantic consumers immediately would scoop them up! What is the manager of the store likely to do in such a situation? The manager would most likely raise prices. When the market price is below the equilibrium price, consumers compete with each other in order to grab the good deals. This puts upward pressure on the market price. Such pressure will cease when the market price reaches the equilibrium price.
The shortage resulting from the price being below the equilibrium level is shown in the following figure at the price of $1.75. The amount of the shortage is the difference between quantity demanded and quantity supplied at that price. In this case, there is a shortage of 25,000 bushels (50,000 - 25,000).
Now consider what happens when the market price is above the equilibrium level. In this case there is an excess supply, or surplus, of the product. At high prices, producers are willing to produce more of the product, but consumers are willing to buy less than at the equilibrium price. Excess supply, the condition where quantity supplied exceeds quantity demanded at the current price, will result. Now imagine what happens at your local store. As inventories pile up on the back shelves, managers will put the product on sale in order to unload some of it.
As a result, market forces will pull the price down toward the equilibrium price. The surplus resulting from the price being above the equilibrium level is shown below:
To more fully understand equilibrium, try the following Active Graph exercise:
For more practice in understanding market equilibrium, try the following Active Graph exercise: