Equilibrium price and quantity occur where the demand and supply curves intersect. At this point, the quantity demanded equals the quantity supplied. If price is above or below the equilibrium, there will be excess supply or demand which pushes prices back to equilibrium. The equilibrium can shift due to changes in demand or supply. Government policies like price floors or ceilings can prevent the price mechanism from restoring equilibrium if set too high or too low.

1. Price determination
Equilibrium (Demand and Supply)

2. • Assume that we have a free market,
i.e. one in which demand and
supply alone determine the price.
Since our demand and supply
curves have the same axes, i.e. price
and quantity, we can put them on
the same diagram.
• From the Figure shown; at price
P1 the demand and supply curves
intersect at the same quantity, Q1.
• We call this price P1 and quantity
Q1 the equilibrium price and
• quantity. Equilibrium means ‘at
rest’, with ‘no tendency to change’.

3. Restoring equilibrium price
• At any price other than P1 there will clearly be a tendency
for change.
• Excess supply
• If Price is higher than P1, then supply will exceed demand.
• At price P2, there is an excess supply.
• ■ As price falls consumers find the product more attractive
than substitutes in consumption
• and some will switch away from those substitutes so that we
move rightwardsalong the demand curve D (expansion of
demand).
• ■ As price falls producers find the product less attractive
than any substitutes in production and may switch resources
to these alternatives so that we move leftwards
• along the supply curve (contraction of supply).

4. Equilibrium price and quantity
Note: Price will
continue to fall until
we reach price P1,
where sellers and
buyers are in
harmony, with all that
is offered for sale
being purchased, i.e.
we have equilibrium in
the market.

5. Excess demand
• If price is lower than P1, then demand exceeds supply.
• At price P3 there is an excess demand. In a free market
excess demand will cause prices to be bid up, as at an
auction, since there are more buyers than units of the
product available.
■ As price rises, consumers find the product less attractive
than the substitutes in consumption and some will switch
into those substitutes so that we move leftwards along the
demand curve D (contraction of demand).
■ As price rises, producers find the product more attractive
than any substitutes in production and may switch resources
to this product so that we move rightwards along the supply
curve S (expansion of supply).
• Prices will continue to rise until we reach price P1

6. Changes in market price and quantity
■ Increase in demand
• Demand increases from D to D,,
so that the original equilibrium
price quantity P1–Q1 can no
longer continue.
• At price P1 we now have a
situation of excess demand.
• In a free market, price will be bid
up.
• As price rises, supply expands along
S and demand contracts along D,
until we reach the higher price P2
at which demand and supply are
again equal at Q2.
• We call P2–Q2 the new price and
quantity equilibrium.

7. ■ Decrease in demand
• In the opposite case, where
demand shifts leftwards from D to
D-, we find
the new price-quantity equilibrium to
be P2–Q2.
• At price P1 we now have a
situation of excess supply.
• In a free market price will fall. As
price falls, demand expands along
the new demand curve D- and
supply contracts along S until we
reach the lower price P2 at which
demand and supply are again equal
at Q2.

8. ■ Increase in supply
• Supply shifts from S to S, so that the
original equilibrium price quantity P1–
Q1 can no longer continue.
• At price P1 we now have a situation of
excess supply.
• In a free market, price will fall as
producers try to dispose of surplus
stock.
• As price falls, supply contracts along
S, and demand expands along D until
we reach the lower price P2, at which
demand and supply are again equal at
Q2.

9. Decrease in supply
• In the opposite case, where
supply shifts leftwards from S
to S-, we find the new price-
quantity equilibrium to be P2–
Q2.
• At price P1 we now have a
situation of excess demand.
• In a free market price will be
bid upwards. As price rises,
supply expands along the new
supply curve S- and demand
contracts along D until we
reach the higher price P2 at
which demand and supply are
again equal at Q2.

10. ■ Maximum and minimum prices
• Maximum price
• The government or agency may seek to
establish a maximum price in the market, i.e.
a ceiling above which price will not be allowed
to rise.

11. Maximum price – cont.
• If the maximum price were set above the equilibrium price P1,
then the market would still be able to reach the equilibrium
outcome of price P1 and quantity Q1.
• However, the market mechanisms would not be able to reach
this equilibrium outcome if the maximum price (P*) was set
below the equilibrium price P1.
• At price P* there is an excess demand and price would have
risen in a free market to P1, encouraging producers to expand
supply from Q2 to Q1 and discouraging consumers so that
demand contracts from Q3 to Q1, until the equilibrium P1–
Q1 was established.
• Here, however, price is prevented from providing such
signals to sellers and buyers to bring their decisions into
harmony, and we may be left with the disequilibrium
outcome P* in which excess demand persists.

12. Minimum price
The government or agency may seek to establish a
minimum price in the market, i.e. a floor below which the
price will not be allowed to fall.

13. • Suppose now that the government imposes a minimum price, P*,
below which the price will not be allowed to fall.
• If that minimum price is set below the equilibrium price P1 then
there will be no problem. The market will already have reached its
equilibrium at price P1, and there will be no reason for P1 to
change.
• If, however, the minimum price is set above the equilibrium price
P1, then price will have to rise from P1 to the new minimum, P*.
• There will then be an excess supply at P* of Q3–Q2 units. If the
market had remained free, the excess supply would have been
removed by the price system.
• However, the important point here is that the market is not free!
Price cannot fall below the minimum that has been set, P*.
• The excess supply will therefore remain and the price system will
not be able to remove it. Sellers will be unable to dispose of their
surplus stocks, which will have to be stored, destroyed or disposed
of in less orthodox ways which prevent the price falling below P*.