Markets do not always begin in equilibrium, but when there is a surplus or shortage, natural price adjustments help bring the market back into balance.
Market disequilibrium and the role of prices
In a perfectly competitive market, equilibrium is reached when the quantity demanded equals the quantity supplied at a certain market price. However, markets frequently move away from this equilibrium due to changes in conditions such as income, preferences, production costs, or external shocks. When this happens, a market enters a state of disequilibrium, where either a surplus or a shortage exists.
Price serves as the primary mechanism that guides markets back toward equilibrium. It functions as a signal and incentive for both buyers and sellers. When the market is in disequilibrium:
A surplus puts downward pressure on price.
A shortage puts upward pressure on price.
Through these price adjustments, the forces of supply and demand interact until the market settles at a new equilibrium where quantity demanded equals quantity supplied once again.
Surplus and downward pressure on price
A surplus occurs when the price is set above the equilibrium level, leading to a situation where quantity supplied exceeds quantity demanded. At this higher price, producers are willing to supply more of the good, but consumers are unwilling or unable to purchase as much.
Causes and characteristics of surplus
The surplus reflects inefficiency, with more goods produced than consumers want to buy at that price.
Unsold goods accumulate, especially in industries with perishable items (e.g., agriculture) or inventory-heavy sectors (e.g., retail).
This excess supply leads to competitive pressure among sellers, who begin lowering their prices to clear their unsold stock.
The adjustment process in response to surplus
The price adjustment process can be broken down into a predictable pattern:
Sellers notice they are unable to sell all their goods.
In response, they reduce the price to attract more buyers.
As the price decreases:
Quantity demanded increases (movement along the demand curve).
Quantity supplied decreases (movement along the supply curve).
This continues until the surplus is eliminated and quantity demanded equals quantity supplied—restoring equilibrium.
This is an example of the law of demand and the law of supply working simultaneously. Buyers respond to lower prices by increasing their purchases, and sellers respond to lower prices by cutting back on production.
Graphical representation of surplus
On a standard demand and supply graph:
The vertical axis represents price, and the horizontal axis shows quantity.
The equilibrium point is where the supply and demand curves intersect.
A price above equilibrium creates a horizontal gap between the quantity supplied (Qs) and quantity demanded (Qd) at that price.
The difference Qs - Qd represents the size of the surplus.
As the price falls, this gap narrows until equilibrium is reached.
Key insight: Surpluses create an incentive for sellers to reduce prices, which pushes the market back toward equilibrium.
Shortage and upward pressure on price
A shortage arises when the market price is set below the equilibrium level, causing the quantity demanded to exceed the quantity supplied. Consumers want to buy more of the good than producers are willing to supply at the current price.
Causes and characteristics of shortage
Shortages are common in markets with price controls (such as rent ceilings) or in cases of sudden demand spikes (e.g., panic buying).
Long lines, rationing, and waitlists often indicate a shortage.
In a free market, sellers recognize they can raise prices because of strong consumer demand and limited availability.
The adjustment process in response to shortage
At the low price, buyers compete for the limited supply.
Sellers respond by increasing prices to capture more revenue.
As the price rises:
Quantity demanded decreases (movement along the demand curve).
Quantity supplied increases (movement along the supply curve).
This continues until the shortage disappears and the market reaches a new equilibrium.
This process reflects both the law of demand (higher prices reduce quantity demanded) and the law of supply (higher prices encourage more supply).
Graphical representation of shortage
On a demand and supply graph:
A price below equilibrium creates a horizontal gap where Qd > Qs.
This gap indicates the shortage, calculated as Qd - Qs.
As the price increases, the demand curve shows fewer units desired, and the supply curve shows more units offered.
The market returns to equilibrium once the curves meet again.
Key insight: Shortages result in upward pressure on prices, encouraging sellers to supply more and buyers to demand less.
Price as a signaling and incentive mechanism
Price performs two critical roles in market adjustment:
1. Signaling function
Prices signal information about relative scarcity or abundance. A high price tells buyers to conserve or seek substitutes, while telling producers to increase output. A low price signals buyers to consume more and producers to cut back.
2. Incentive function
Prices provide incentives to change behavior:
Buyers react to higher prices by cutting consumption.
Sellers react to higher prices by boosting supply.
This process ensures resources are allocated to their most valued uses, even as market conditions change.
Factors influencing speed of market adjustment
The speed at which a market returns to equilibrium depends on several factors:
Price elasticity of demand and supply:
If demand is inelastic, buyers do not reduce quantity demanded quickly in response to price increases.
If supply is elastic, producers can adjust production rapidly.
Information and communication:
Informed consumers and sellers can respond more quickly to price changes.
Storage capabilities and perishability:
Goods that can be stored allow for more flexible responses (e.g., canned goods).
Perishable goods (e.g., fruits) often lead to quicker price cuts to avoid losses.
Time frame:
In the short run, supply may be less flexible.
In the long run, firms can adjust production capacity or enter/exit the market.
Real-world example: agricultural markets
Agricultural markets are often used to illustrate how price mechanisms restore equilibrium after a disruption.
Example: surplus in wheat markets
Suppose there is a bumper harvest due to favorable weather conditions:
The supply of wheat increases significantly.
At the existing market price, farmers find they cannot sell all of their crop.
This leads to a surplus of wheat.
To clear the excess stock, prices begin to fall.
As wheat becomes cheaper:
Consumers purchase more wheat-based products.
Some farmers reduce future planting, as the lower price makes production less profitable.
Eventually, the surplus disappears and the market returns to equilibrium.
This adjustment may take several months due to the time it takes to plant and harvest new crops, but the process is driven by price changes.
Example: shortage in wheat markets
Now imagine a drought reduces the wheat harvest:
The supply of wheat falls sharply.
At the current price, consumers want more wheat than is available, creating a shortage.
Prices begin to rise, reflecting the scarcity.
As the price increases:
Consumers buy less, switch to alternatives, or ration usage.
Farmers are incentivized to grow more wheat in future seasons.
These changes reduce the shortage over time, restoring equilibrium.
Agricultural markets highlight how external shocks create disequilibrium and how price adjustments guide market correction.
Real-world example: housing markets
The housing market also experiences surpluses and shortages, often due to changes in population, construction, or regulation.
Surplus in rental housing
Consider a city that builds too many apartment complexes:
The number of rental units exceeds the number of people looking to rent.
This leads to a surplus in the rental market.
Property owners compete for tenants, offering discounted rent or incentives.
As rents fall:
More people may choose to rent.
Developers may pause new construction, reducing future supply.
Over time, the market rebalances and rents stabilize.
Shortage in rental housing
In contrast, a city might face a housing shortage due to population growth, zoning restrictions, or construction delays:
Demand for housing rises, but supply remains limited.
A shortage develops, leading to rising rents.
As prices climb:
Some renters leave the market or live with roommates.
Builders are incentivized to increase construction.
These adjustments eventually eliminate the shortage and restore market balance.
Note: Government-imposed rent controls can prevent this adjustment process, leading to persistent shortages—a topic covered elsewhere in the syllabus.
FAQ
In most competitive markets, surpluses and shortages are temporary because price mechanisms naturally drive markets back to equilibrium. However, in some exceptional cases, markets can remain in disequilibrium for extended periods if price signals are distorted or blocked. For example, if a price floor is imposed above the equilibrium price (like a minimum wage), a persistent surplus of labor, or unemployment, can result because prices are not allowed to adjust downward. Similarly, a price ceiling below equilibrium (such as rent control) can lead to persistent shortages, as prices are prevented from rising to reflect true demand. Even without government interference, adjustment may be slow if producers or consumers lack complete information, or if there are long production timelines, such as in housing or agriculture. While permanent disequilibrium is rare in free markets, the adjustment process can take time and may be delayed by external factors like regulation, market rigidities, or behavioral influences.
“Sticky prices” refer to situations where prices are slow to change in response to market conditions. This can occur due to contracts, menu costs, wage agreements, or reluctance to lower prices for fear of damaging brand perception. In such markets, when a surplus or shortage arises, the normal price adjustment process is delayed or weakened. For example, in a surplus with sticky prices, firms may accumulate excess inventory and may resort to non-price competition—such as offering promotions, bundling, or improving product features—to increase demand instead of lowering prices directly. On the flip side, in a shortage, rather than raising prices, firms may ration goods, limit purchases per customer, or create waitlists. Sticky prices prevent immediate movement along the supply and demand curves and slow the return to equilibrium. Over time, if the market imbalance persists, businesses may eventually adjust prices, but the delay can create inefficiencies and extended periods of disequilibrium.
Expectations about future prices can significantly influence how buyers and sellers behave during periods of surplus or shortage, potentially delaying or even reversing the usual path toward equilibrium. For instance, if there is a current surplus of a product, but producers expect higher prices in the future, they may withhold supply instead of lowering prices, hoping to sell at a better price later. This behavior can keep the market in surplus longer than usual. Conversely, during a shortage, if consumers believe that prices will rise even more in the future, they may accelerate their purchases or stockpile goods, increasing current demand and intensifying the shortage. Similarly, sellers expecting rising prices may be reluctant to sell inventory now, reducing current supply. These forward-looking behaviors create a feedback loop that can exaggerate disequilibrium rather than resolving it. Expectations, especially when widely held, can therefore complicate the normal equilibrium adjustment process and lead to short-term instability.
No, not all markets adjust to equilibrium at the same pace. The speed of market adjustment depends on several key factors. First, the price elasticity of supply and demand is critical—markets with more elastic supply or demand adjust faster because quantity responds more sensitively to price changes. Second, the nature of the good matters. In markets for perishable goods like fresh produce, sellers are more motivated to cut prices quickly to avoid losses, leading to faster adjustment. In contrast, markets like real estate, where production and transaction times are longer, adjust more slowly. Third, information availability plays a role; if buyers and sellers have accurate, real-time data about prices and quantities, they can respond more efficiently. Additionally, institutional factors such as government policies, regulations, or price controls can speed up or delay adjustments. Market structure also matters—more competitive markets tend to correct disequilibria more quickly due to the pressure on firms to react promptly to price signals.
The adjustment process can vary notably between goods markets and services markets due to differences in storability, production flexibility, and consumer behavior. In goods markets, especially with physical products, producers can store inventory during a surplus or ramp up production to respond to a shortage, assuming production can be scaled. Price reductions can be implemented easily to clear a surplus, and sales promotions can quickly boost demand. In services markets, however, surplus capacity (like unbooked hotel rooms or unused doctor appointments) cannot be stored. Once time passes, the opportunity is lost, which makes the cost of surplus capacity especially high. During a shortage of services, such as medical care or skilled labor, adjusting supply is harder because it often requires training new personnel or increasing labor hours, which may not be immediately feasible. Additionally, service prices are often more regulated or contracted, leading to slower adjustments. Thus, services markets often experience more rigid responses to disequilibrium.
Practice Questions
A sudden increase in consumer demand causes a shortage in the market for smartphones. Using the concepts of supply and demand, explain how the market will adjust to restore equilibrium. Illustrate the process with changes in quantity demanded and quantity supplied.
When consumer demand increases suddenly, quantity demanded exceeds quantity supplied at the original price, creating a shortage. This shortage puts upward pressure on the price of smartphones. As the price rises, consumers buy fewer smartphones, reducing quantity demanded, while producers are incentivized to increase production, raising quantity supplied. These simultaneous movements along the demand and supply curves continue until the shortage is eliminated and quantity demanded equals quantity supplied. The market returns to a new equilibrium with a higher price and quantity than before. This self-correcting process is driven entirely by price adjustments in a competitive market.
At a price of $10, a surplus exists in the market for oranges. Describe what will happen to price and quantities in the market over time. Use economic reasoning to explain how the surplus is eliminated.
A surplus means the quantity of oranges supplied at $10 exceeds the quantity demanded. Sellers will notice excess inventory and begin lowering the price to attract more buyers. As the price falls, consumers purchase more oranges (increasing quantity demanded), and some producers reduce the quantity they supply (decreasing quantity supplied). These movements along the supply and demand curves reduce the surplus. Eventually, the price falls to a level where quantity demanded equals quantity supplied, eliminating the surplus. The market returns to equilibrium through this price-driven adjustment process, ensuring efficient resource allocation without the need for government intervention.
