Now that you understand the basics of demand and supply, let’s put them together and see what sort of magical things happen.

Earlier, I told you that by themselves, demand and supply cannot tell you what the market price for a product will be. It is only when we put the two together that we can see how buyers and sellers will interact to determine how much of a product will be put on the market and what price it will be sold for.

Market Equilibrium for Bacon Example

Taking a look at the demand and supply table, we can see that there is one price that stands out from the rest. At $6, the amount of bacon consumers are willing and able to purchase matches the amount of bacon firms are willing and able to supply. In other words, at this point and this point only, the quantity demanded matches the quantity supplied, so we say that the market is in a state of equilibrium. $6 is the equilibrium price and 10 pounds of bacon per week is the equilibrium quantity. The equilibrium point can easily be observed in the graph as well; it’s where the demand and supply curves intersect.

When we are at the equilibrium price, suppliers are producing and selling the exact amount that consumers are purchasing. Since there are neither too many goods nor too few goods in the market, economists sometimes call the equilibrium price the market clearing price. Let’s see what happens when we deviate away from this price.
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Shortages
Let’s say we’re at some price below the equilibrium price, PE. We’ll call this number P* (it can be any number as long as it’s below the equilibrium price). At every price below PE, consumers are willing and able to purchase more than producers are supplying, resulting in a shortage. The lower the price is below equilibrium, the greater the shortage. You can easily see this on a graph.

Shortage Example
At P*, consumers are demanding QD, but producers are only supplying QS. The difference between QD and QS is the shortage amount (highlighted in orange).

When a shortage occurs, there will be consumers who want the product, but are unable to get it. Some of these consumers will want the product more than others and are willing to pay a premium for the product, a price higher than the current market price to ensure that they get their hands on it (some people really love their bacon). In doing so, they’ll bid up the market price. As the market price goes up, some consumers will deem bacon too expensive and will no longer want to buy it while others simply will not be able to afford it, causing the quantity demanded to go down.

As the consumers bid up the market prices, suppliers are going to find that this product is becoming more and more profitable so they’re going to increase production, increasing the quantity supplied.

These two things will happen in conjunction with one another, driving the market price up, decreasing quantity demanded and increasing quantity supplied until we hit our equilibrium price and quantity.
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Surpluses
At every price greater than the equilibrium price PE, producers are willing and able to sell more than consumers are buying, leading to a surplus of goods. The higher the price is above equilibrium, the greater the surplus. Again, you can easily see this on a graph.

Surplus Example
At P*, consumers are only demanding QD, but producers are supplying QS. The difference between QS and QD is the surplus amount (highlighted in orange).

When there’s a surplus, suppliers will have an excess amount of goods on their hands. They’re going to need to find a place to store these extra goods. While some businesses tend to keep some extra inventory on hand, most businesses in general do not like to carry an excess surplus of goods. That’s because it costs them money to store their surpluses. They’ll need to rent out additional warehouse space, someone has to keep track of the extra inventory, security needs to be hired to so the goods don’t get stolen, so on and so forth. It’s too much of a hassle and too costly to maintain a surplus, so suppliers want to get rid of it. They’ll do so by lowering their prices. As the market price falls, producers will have less incentive to produce as much as they used to, so the quantity supplied will also fall.

As the suppliers drive down the market price, consumers are going to be more and more inclined to purchase more of the product, increasing the quantity demanded. This will continue to happen until we reach the equilibrium price, where the quantity demanded equals the quantity supplied and there is neither a shortage nor a surplus.
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Rationing Function of Prices
The ability for the market to regulate itself to find the market clearing price is known as the rationing function of prices. In a capitalistic economy, the market will revert to the equilibrium price without any assistance and will remain at equilibrium unless it’s influenced by some outside factor, like a change in demand and/or supply or through government intervention.
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Reference
McConnell, Campbell R., Stanley L. Brue, and Sean Masaki. Flynn. Macroeconomics: Principles, Problems, and Policies. Boston: McGraw-Hill Irwin, 2009. Print.
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Next economics post: Market Equilibrium: Shifting Demand and Supply
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