Equilibrium: Determination of Price and Quantity

What price should the seller set and how many videos will be rented per month? The seller could legally set any price she wished; however, market forces penalize her for making poor choices. Suppose, for example, that the seller prices each video at $20. Odds are good that few videos will be rented. On the other hand, the seller may set a price of $1 per video. Consumers will certainly rent more videos with this low price, so much so that the store is likely to run out of videos. Through trial and error or good judgement, the store owner will eventually settle on a price that equates the forces of supply and demand.

In economics, an equilibrium is a situation in which:

there is no inherent tendency to change,
quantity demanded equals quantity supplied, and
the market just clears.

At the market equilibrium, every consumer who wishes to purchase the product at the market price is able to do so, and the supplier is not left with any unwanted inventory. As Table 3 and the figure titled "Equilibrium" demonstrate, equilibrium in the video example occurs at a price of $3 and a quantity of 30 videos.

At the equilibrium price desired quantity demanded and supplied are equal

At the equilibrium price desired quantity demanded and supplied are equal

TABLE 3 Video Market Equilibrium
Price	Quantity Demanded	Quantity Supplied
$5	10	50
$4	20	40
$3	30	30
$2	40	20
$1	50	10

Suppose that the video store owner charges $2 per video rental. The result is a shortage. A shortage occurs when quantity demanded exceeds quantity supplied. At a price of $2, quantity supplied is 20 videos but quantity demanded is 40 videos. Some consumers who wish to rent videos are unable to do so. A shortage implies the market price is too low. Shortages are common in socialist economies because low prices for common staples such as food and energy are set by the government. Rather than pay higher prices, people are forced to wait in long lines to purchase the desired goods and services.

A surplus occurs when quantity supplied exceeds quantity demanded. With a rental price of $4, quantity supplied is 40 videos but quantity demanded is only 20 videos. A surplus of 20 videos exists. A surplus implies the market price is too high.

Perhaps more often than not, markets are not exactly in equilibrium. Minor surpluses and shortages are common in a market economy. A stroll through most malls at the end of the clothing season reveals the excess clothing inventory that many stores carry. How do they manage this situation? By lowering prices. Lower prices reduce the incentive for stores to carry the clothes while simultaneously increasing the incentive for consumers to purchase the clothes. The important point is that even though a market may not be in perfect equilibrium, it tends to gravitate towards equilibrium over time. This fact makes markets stable most of the time such that persistent surpluses and shortages are uncommon and self-correcting.

Persistent and severe shortages and surpluses do occur in the U.S. economy every now and then. At the end of 1998, for example, the supply of hogs in the U.S. markets was so much greater than demand that the price of hogs fell from about $50 per hundredweight to $13 per hundredweight. Many farmers were so badly hurt by that experience that they left the hog market completely--a painful but self-correcting force. In the late 1970s the relative shortage of gasoline resulted in long lines at the gas pumps. The shortages lasted for a couple years until oil producers stepped up production and consumers learned to use fuel more efficiently.

Equilibrium: Determination of Price and Quantity