Price determination | IGCSE Class 10 Economics Notes

This note covers price determination in a market economy: how demand and supply schedules and curves establish market equilibrium, the meaning of equilibrium price and equilibrium quantity, how a price away from equilibrium creates a shortage (excess demand) or a surplus (excess supply), how the price mechanism removes a shortage or surplus, and how a shift in demand or in supply moves the market to a new equilibrium.

What is meant by market equilibrium?

A market demand curve shows the total quantity of a good that all buyers in a market are willing to buy at each possible price, holding everything else constant.

A market supply curve shows the total quantity that all sellers are willing to offer for sale at each possible price.

Both curves can also be shown as a demand schedule and a supply schedule: a table listing the quantity demanded and the quantity supplied at a series of prices.

Market equilibrium is the situation in which the plans of buyers and sellers match exactly: the quantity that all firms wish to sell at a given price equals the quantity that all consumers wish to buy at that price.

The market is said to "clear" because nothing is left unsold and no buyer is left unsatisfied. Graphically, equilibrium occurs where the market demand curve and the market supply curve intersect.

The price at which this happens is the equilibrium price, and the quantity bought and sold at that price is the equilibrium quantity.

Definition: market equilibrium. The price and quantity at which the quantity that firms wish to sell equals the quantity that consumers wish to buy, so that the market clears with no shortage and no surplus.

At any price other than the equilibrium price, the plans of buyers and sellers do not match: either there is more demanded than supplied, or more supplied than demanded. The next sections look at each of these cases.

How is equilibrium price and quantity read from a demand and supply schedule?

A demand and supply schedule lists, for each price, the quantity consumers are willing to buy (qD) and the quantity firms are willing to sell (qS).

The equilibrium price is the price at which the two quantities are equal; the equilibrium quantity is that common quantity.

The table below sets out a demand and supply schedule for a single good, built from the demand relation qD = 200 - p and the supply relation qS = 120 + p, where p is the price per unit in a generic currency.

Reading down the table, as price rises the quantity demanded falls and the quantity supplied rises; the two columns become equal only at a price of $40, where both quantities equal 160 units.

This is the equilibrium price and equilibrium quantity for this market. Plotting the schedule gives the familiar downward-sloping demand curve and upward-sloping supply curve crossing at a single point.

The horizontal axis measures quantity and the vertical axis measures price. A downward-sloping demand curve (DD) and an upward-sloping supply curve (SS) are drawn on the same diagram.

They intersect at a single point where the equilibrium price (p*) is read off the vertical axis and the equilibrium quantity (q*) is read off the horizontal axis.

At any price above p*, the supply curve lies to the right of the demand curve, meaning quantity supplied exceeds quantity demanded. At any price below p*, the demand curve lies to the right of the supply curve, meaning quantity demanded exceeds quantity supplied. These two situations are examined next.

What is excess demand and why does it cause a shortage?

Excess demand exists at a given price when the quantity that consumers wish to buy is greater than the quantity that firms wish to sell at that price. This gap is often called a shortage.

From the schedule above, at a price of $25 the quantity demanded is 175 units but the quantity supplied is only 145 units, so there is excess demand of 30 units.

Definition: excess demand (shortage). The amount by which quantity demanded exceeds quantity supplied at a price below the equilibrium price.

When a shortage exists, some consumers who want the good cannot obtain it, or cannot obtain enough of it, at the prevailing price.

Disappointed buyers are willing to pay more rather than go without the good, so the price tends to rise. As price rises, the law of demand means quantity demanded falls, and the law of supply means quantity supplied rises.

Both movements narrow the gap between the two quantities. This process continues until price reaches the equilibrium price, at which point quantity demanded again equals quantity supplied and the shortage has disappeared.

This self-correcting tendency of price to rise when there is excess demand and to fall when there is excess supply is sometimes called the price mechanism, or (in classical economic writing going back to Adam Smith) the "invisible hand": a process by which price movements, driven by self-interested buyers and sellers, remove shortages and surpluses without any outside direction.

The strength of this adjustment depends on how sensitive quantity demanded and quantity supplied are to price, but the direction is always the same: a price below equilibrium produces excess demand, and excess demand pushes price upward towards equilibrium.

What is excess supply and why does it cause a surplus?

Excess supply exists at a given price when the quantity that firms wish to sell is greater than the quantity that consumers wish to buy at that price. This gap is often called a surplus.

From the schedule above, at a price of $45 the quantity supplied is 165 units but the quantity demanded is only 155 units, giving an excess supply of 10 units.

Definition: excess supply (surplus). The amount by which quantity supplied exceeds quantity demanded at a price above the equilibrium price.

When a surplus exists, some firms cannot sell as much as they would like at the prevailing price. Unsold stock builds up, so firms are willing to accept a lower price rather than hold unsold goods.

As price falls, quantity demanded rises and quantity supplied falls, again narrowing the gap. This continues until price falls back to the equilibrium price, where the surplus is eliminated.

A surplus at a price above equilibrium therefore pushes price downward, just as a shortage at a price below equilibrium pushes price upward: both forces move the market towards equilibrium.

On the same demand and supply diagram as before, a horizontal price line is drawn above p*.

Between this line and the two curves, the gap measured on the demand curve is smaller than the gap measured on the supply curve, showing a surplus (quantity supplied minus quantity demanded).

A second horizontal price line drawn below p* shows the opposite case: the gap on the demand curve is larger than on the supply curve, showing a shortage (quantity demanded minus quantity supplied).

A market is therefore in market disequilibrium whenever the prevailing price differs from the equilibrium price, producing either a shortage or a surplus, together with a tendency for price to move back towards equilibrium.

What happens when the government sets price away from equilibrium?

A shortage or surplus can also be deliberately created when a price is fixed away from its equilibrium level rather than left to adjust. A price ceiling is an upper limit set below the equilibrium price, often used for necessities.

Because the fixed price is below equilibrium, quantity demanded at that price exceeds quantity supplied, so the result is a shortage rather than the intended help for buyers; the quantity actually available then has to be shared out in some other way, for example by rationing, and consumers unable to obtain enough at the controlled price may be willing to pay more elsewhere.

A price floor is a lower limit set above the equilibrium price, for example a minimum price guaranteed to producers or a minimum wage set for workers.

Because the fixed price is above equilibrium, quantity supplied at that price exceeds quantity demanded, so the result is a surplus of unsold goods or of labour willing to work but unable to find employment at that wage.

Both cases illustrate the general rule of market disequilibrium: any price fixed below the equilibrium price produces a shortage, and any price fixed above the equilibrium price produces a surplus, whatever the reason the price is prevented from reaching equilibrium.

How does a shift in demand change equilibrium?

The equilibrium price and quantity were derived assuming that incomes, tastes, prices of related goods, and other influences on demand stay constant.

If one of these changes, the whole demand curve shifts to a new position, and a new equilibrium is found where the new demand curve crosses the unchanged supply curve.

If demand increases (the demand curve shifts to the right, for example because consumer income rises for a good consumers buy more of as income rises), then at the old equilibrium price there is now excess demand.

Price rises in response, and the market settles at a new equilibrium with both a higher equilibrium price and a higher equilibrium quantity than before.

If demand decreases (the demand curve shifts to the left), then at the old equilibrium price there is now excess supply.

Price falls in response, and the new equilibrium has both a lower equilibrium price and a lower equilibrium quantity than before.

In both cases, equilibrium price and equilibrium quantity move in the same direction as the shift in demand, because the supply curve has not moved.

How does a shift in supply change equilibrium?

A shift in the supply curve, with demand held constant, has the opposite pattern of effects.

If supply increases (the supply curve shifts to the right, for example because an input used in production becomes cheaper or more firms enter the market), then at the old equilibrium price there is now excess supply.

Price falls, and the new equilibrium has a lower equilibrium price but a higher equilibrium quantity than before.

If supply decreases (the supply curve shifts to the left, for example because the price of an input rises), then at the old equilibrium price there is now excess demand.

Price rises, and the new equilibrium has a higher equilibrium price but a lower equilibrium quantity than before. Equilibrium price and equilibrium quantity therefore move in opposite directions whenever supply shifts and demand does not.

Going beyond the syllabus

Where both demand and supply shift at the same time, the direction of change in equilibrium quantity is clear whenever the two shifts are in the same direction (quantity rises if both shift right, falls if both shift left), but the direction of change in equilibrium price then depends on the relative size of the two shifts and cannot be predicted from direction alone.

Conversely, where demand and supply shift in opposite directions, the direction of change in price is clear, but the change in quantity depends on the relative size of the shifts.

This is useful background for understanding why real markets sometimes show a price rise alongside a quantity fall, which looks puzzling if only one curve is assumed to move.

Glossary

• Market demand curve — a curve showing the total quantity of a good all buyers are willing to buy at each price, other things equal.
• Market supply curve — a curve showing the total quantity of a good all firms are willing to sell at each price, other things equal.
• Demand schedule — a table listing the quantity demanded of a good at a series of different prices.
• Supply schedule — a table listing the quantity supplied of a good at a series of different prices.
• Market equilibrium — the price and quantity at which quantity demanded equals quantity supplied, so the market clears.
• Equilibrium price — the price at which quantity demanded equals quantity supplied.
• Equilibrium quantity — the quantity bought and sold at the equilibrium price.
• Market disequilibrium — any situation where the prevailing price differs from the equilibrium price, so quantity demanded and quantity supplied are unequal.
• Excess demand — the amount by which quantity demanded exceeds quantity supplied at a given price.
• Excess supply — the amount by which quantity supplied exceeds quantity demanded at a given price.
• Shortage — a situation where the quantity of a good demanded exceeds the quantity available at the prevailing price.
• Surplus — a situation where the quantity of a good supplied exceeds the quantity consumers wish to buy at the prevailing price.
• Price mechanism — the process by which changes in price, caused by shortages and surpluses, bring a market back towards equilibrium.
• Price ceiling — a government-imposed maximum price, fixed below the equilibrium price, which creates a shortage.
• Price floor — a government-imposed minimum price, fixed above the equilibrium price, which creates a surplus.

Common errors and misconceptions

• Misconception: equilibrium means prices never change again once reached. Correct: equilibrium holds only as long as the demand and supply curves themselves do not shift; a change in any underlying factor moves the curves and creates a new equilibrium.
• Misconception: a shortage means the good has run out completely. Correct: a shortage simply means quantity demanded exceeds quantity supplied at that price; some of the good is usually still available, just not enough to satisfy everyone willing to buy at that price.
• Misconception: excess supply and excess demand are the same thing viewed from different sides. Correct: they occur at opposite ends of the price scale, excess demand below the equilibrium price and excess supply above it, and they push price in opposite directions.
• Misconception: a rightward shift of demand always raises price by a large amount. Correct: a rightward demand shift always raises equilibrium quantity, but how much price rises depends on the shape and position of the supply curve.
• Misconception: a price ceiling always helps consumers because it keeps prices low. Correct: because the ceiling is set below equilibrium, it also reduces the quantity firms are willing to supply, creating a shortage that may leave some consumers unable to buy the good at all.
• Misconception: movement along a demand curve and a shift of the demand curve are the same thing. Correct: a change in the good's own price causes movement along the existing demand curve; a change in income, tastes or the price of a related good shifts the whole curve to a new position.
• Misconception: disequilibrium is a rare or unusual event. Correct: any price away from the equilibrium price produces disequilibrium, and the market mechanism is constantly adjusting prices towards equilibrium whenever any underlying factor changes.

Exam-style questions with model answers

Q1. Define 'market equilibrium'. [2 marks]

1. Market equilibrium is the price and quantity at which the quantity consumers wish to buy equals the quantity firms wish to sell, so the market clears with neither a shortage nor a surplus.

Q2. At a price of $8 in a market for notebooks, quantity demanded is 500 units and quantity supplied is 350 units. State whether this is a shortage or a surplus, and explain your answer. [2 marks]

1. This is a shortage, because quantity demanded (500) exceeds quantity supplied (350) at this price, so there is excess demand of 150 units which the market cannot satisfy at $8.

Q3. Explain, using a demand and supply diagram, how a market moves from a shortage back to equilibrium. [4 marks]

1. At a price below the equilibrium price, the demand curve lies above (to the right of) the supply curve at that price, showing quantity demanded greater than quantity supplied, which is a shortage.
2. Disappointed buyers who cannot obtain the good are willing to pay a higher price, so price begins to rise.
3. As price rises, quantity demanded falls along the demand curve and quantity supplied rises along the supply curve.
4. This continues until the two quantities become equal at the equilibrium price, where the demand and supply curves intersect and the shortage disappears.

Q4. A government sets a minimum price for milk above the market equilibrium price. Explain two consequences of this policy for the milk market. [4 marks]

1. Because the minimum price is set above equilibrium, quantity supplied by dairy farmers at that price will exceed quantity demanded by consumers, creating a surplus of milk.
2. The surplus means that some milk produced cannot be sold to consumers at the controlled price, so the surplus milk may have to be bought up or stored by the government, or dumped, at a cost.
3. Consumers end up paying a higher price for milk than the equilibrium price, and buy a smaller quantity than they would have bought at the market equilibrium.

Q5. Analyse the effect on the equilibrium price and quantity of coffee of a sharp increase in consumer incomes, assuming coffee is a good that consumers buy more of as income rises. [5 marks]

1. An increase in income raises consumers' ability to buy goods, and for a good bought more as income rises, this increases demand at every price, shifting the whole demand curve to the right.
2. With the supply curve for coffee unchanged, at the old equilibrium price there will now be excess demand, because quantity demanded at that price has risen while quantity supplied has not.
3. This excess demand puts upward pressure on price, since disappointed buyers are willing to pay more.
4. As price rises, quantity demanded falls back along the new demand curve and quantity supplied rises along the supply curve, until a new equilibrium is reached.
5. The new equilibrium has both a higher equilibrium price and a higher equilibrium quantity than the original equilibrium, because the demand curve shifted right while the supply curve stayed fixed.

Q6. Discuss whether imposing a price ceiling on bread is an effective way to make bread more affordable for low-income consumers. [6 marks]

1. A price ceiling fixes the maximum price of bread below the market equilibrium price, so in principle low-income consumers pay a lower price per loaf than they would without the ceiling.
2. However, because the ceiling is below the equilibrium price, quantity supplied by bakers at that price falls below quantity demanded, creating a shortage of bread in the market.
3. The shortage means some consumers, possibly including the low-income consumers the policy is meant to help, cannot obtain bread at all, or must queue for limited stock, so the policy may not succeed in its aim.
4. Rationing schemes can be used to share out the limited bread more fairly among consumers, but this adds administrative cost and inconvenience such as long queues.
5. A shortage can also encourage a black market in which bread is resold above the official ceiling price, undermining the policy and potentially harming the very consumers it was designed to protect.
6. On balance, while a price ceiling lowers the official price, its effect on affordability depends on whether consumers can actually obtain the good at that price; without additional measures such as rationing or increased supply, the resulting shortage may offset the intended benefit.

Key takeaways

• Market equilibrium is the price and quantity at which quantity demanded equals quantity supplied, so the market clears.
• A demand and supply schedule or diagram identifies equilibrium price and quantity at the point where the two curves, or columns, meet.
• A price below equilibrium creates excess demand, called a shortage, because quantity demanded exceeds quantity supplied.
• A price above equilibrium creates excess supply, called a surplus, because quantity supplied exceeds quantity demanded.
• Shortages push price up and surpluses push price down, moving the market back towards equilibrium.
• A price ceiling fixed below equilibrium causes a shortage; a price floor fixed above equilibrium causes a surplus.
• A rightward shift of demand raises both equilibrium price and equilibrium quantity if supply is unchanged.
• A rightward shift of supply lowers equilibrium price but raises equilibrium quantity if demand is unchanged.

Test yourself

What condition must hold for a market to be in equilibrium?

Quantity demanded must equal quantity supplied at the prevailing price, so that the market clears with no shortage and no surplus.

What is the difference between a shortage and a surplus?

A shortage is excess demand, where quantity demanded exceeds quantity supplied, usually at a price below equilibrium; a surplus is excess supply, where quantity supplied exceeds quantity demanded, usually at a price above equilibrium.

If price is above the equilibrium price, what happens to price over time?

There is excess supply, so unsold stock builds up and sellers lower price, which continues until price falls back to the equilibrium price.

If demand for a good increases and supply stays the same, what happens to equilibrium price and quantity?

Both equilibrium price and equilibrium quantity rise, because the demand curve shifts right while the unchanged supply curve is met at a higher point.

If supply of a good increases and demand stays the same, what happens to equilibrium price and quantity?

Equilibrium price falls and equilibrium quantity rises, because the supply curve shifts right while the unchanged demand curve is met at a lower price.

Why does a price ceiling set below equilibrium cause a shortage?

At the ceiling price, quantity demanded is higher than at equilibrium and quantity supplied is lower than at equilibrium, so quantity demanded exceeds quantity supplied.

Why does a price floor set above equilibrium cause a surplus?

At the floor price, quantity supplied is higher than at equilibrium and quantity demanded is lower than at equilibrium, so quantity supplied exceeds quantity demanded.