Price determination explains how demand and supply interact in markets to set prices and allocate resources, leading to market equilibrium and responses to disequilibrium.
Market equilibrium
Defining market equilibrium
Market equilibrium is a key concept in economics that describes the point at which the quantity of a good or service demanded by consumers equals the quantity supplied by producers. This occurs at a specific price level, known as the equilibrium price, and a corresponding quantity, known as the equilibrium quantity.
At this price, there is no excess demand (shortage) or excess supply (surplus).
Both consumers and producers are satisfied: consumers can purchase the amount they desire at a price they are willing to pay, and producers can sell their goods at a price that covers costs and provides a profit.
The market is said to be cleared, meaning there is no tendency for change in price or quantity—unless disrupted by external factors.
This concept lies at the heart of market economies, where prices are determined by the free interaction of supply and demand without government intervention.
Interaction of demand and supply
The interaction of demand and supply forms the foundation of market equilibrium:
Demand represents how much of a good or service consumers are willing and able to buy at various prices.
Supply represents how much producers are willing and able to offer at different prices.
A demand curve typically slopes downwards from left to right, showing an inverse relationship between price and quantity demanded.
A supply curve usually slopes upwards, reflecting a direct relationship between price and quantity supplied.
The equilibrium occurs where these two curves intersect. This point determines the price and quantity exchanged in the market.
If any factor shifts either the demand or supply curve, a new equilibrium is formed.
Diagrammatic illustration
Market equilibrium diagram
To visually understand price determination, a basic supply and demand diagram is used:
Vertical axis (Y-axis): Represents price.
Horizontal axis (X-axis): Represents quantity.
Demand curve (D): Slopes downward from left to right.
Supply curve (S): Slopes upward from left to right.
The point where D intersects S is the equilibrium point (E).
The price at E is the equilibrium price (Pₑ).
The quantity at E is the equilibrium quantity (Qₑ).
At this point, the market clears—buyers and sellers are both satisfied with the outcome. No unsold stock remains and no consumer demand goes unmet at the given price.
Excess demand (shortage)
When the price is set below the equilibrium, a situation of excess demand arises:
Consumers want to buy more because the price is low.
Producers supply less because the lower price is less profitable.
This creates a shortage, where quantity demanded exceeds quantity supplied.
For example:
At price P1 (below Pₑ), consumers demand Q1, but producers only supply Q2 (Q1 > Q2).
This gap creates pressure in the market.
As a result:
Some consumers are unable to purchase the good.
They may bid up the price, leading to upward price movement.
Excess supply (surplus)
Conversely, if the price is set above the equilibrium, there is excess supply:
Producers supply more than consumers want to buy at the higher price.
The quantity supplied exceeds quantity demanded, resulting in a surplus.
For instance:
At price P2 (above Pₑ), producers supply Q3, but consumers only demand Q4 (Q3 > Q4).
This imbalance puts downward pressure on the price:
Producers may reduce prices to sell their excess inventory.
Price continues to fall until the market reaches a new equilibrium.
These two conditions demonstrate how disequilibrium creates pressure for price to change, thereby restoring balance in the market.
Elimination of disequilibrium
Markets are self-correcting in nature. When disequilibrium occurs, price mechanisms act to restore balance. These adjustments ensure efficient allocation of resources and prevent persistent shortages or surpluses.
Prices rise with excess demand
In a situation of excess demand:
A large number of buyers compete for a limited quantity of goods.
Sellers respond by raising prices due to increased willingness to pay.
This higher price discourages some buyers, causing a contraction in quantity demanded.
At the same time, producers are encouraged to supply more due to higher potential profits.
This dual effect continues until the gap between quantity demanded and quantity supplied is closed, restoring equilibrium.
Prices fall with excess supply
In a scenario of excess supply:
Goods remain unsold, increasing inventory costs for firms.
Sellers are motivated to lower prices to attract buyers.
Lower prices encourage more consumers to purchase, expanding demand.
Simultaneously, lower prices reduce producers' willingness to supply, leading to a contraction in supply.
This process continues until supply and demand are once again in balance.
These mechanisms showcase the dynamic responsiveness of prices in a free market system, driven by changes in buying and selling behaviour.
Real-world examples of price determination
Concert tickets
A well-known example of price determination occurs in the market for concert tickets:
Popular concerts often have fixed venue capacity, meaning supply is perfectly inelastic in the short term.
If tickets are priced too low, excess demand occurs—tickets sell out quickly and many fans are left empty-handed.
A secondary market emerges where tickets are resold at higher prices, closer to the true equilibrium.
Organisers may use this information to adjust prices for future events, aiming for equilibrium.
If tickets are priced too high:
They may remain unsold, resulting in excess supply.
Promoters may offer last-minute discounts to encourage demand, again shifting toward equilibrium.
Housing markets
Housing is a classic example of how supply and demand interact over time:
In cities like London, demand for housing is high due to population growth, income levels, and job opportunities.
However, housing supply is slow to adjust due to land use regulations and construction times.
The result is often rising house prices, showing persistent excess demand.
Over time:
Rising prices incentivise developers to build more homes, increasing supply.
If supply eventually overtakes demand, prices stabilise or even fall, creating a new equilibrium.
If economic conditions change and demand falls (e.g. due to interest rate rises):
Sellers may struggle to find buyers.
Excess supply leads to falling prices, and eventually equilibrium is re-established.
Supermarket promotions
Temporary sales or promotional offers also highlight price determination:
For example, a supermarket offering a “buy one get one free” (BOGOF) deal on soft drinks might experience a spike in demand.
This could lead to shortages if stock runs out, indicating the price is below equilibrium.
Supermarkets might restock or end the promotion, allowing prices to return to normal levels.
Alternatively:
A new product launch with a high price might lead to unsold stock.
Price reductions follow to stimulate demand and eliminate the surplus.
Seasonal produce
Agricultural markets show how supply can shift significantly due to seasonal factors:
During harvest periods, supply of certain fruits and vegetables increases rapidly.
If demand does not rise in parallel, excess supply can lead to falling prices.
This encourages more consumption or export and reduces production incentives next season.
In contrast, during the off-season:
Limited supply leads to higher prices, reflecting the scarcity of the good.
These fluctuations are an example of how markets adjust prices based on supply changes, maintaining balance over time.
Dynamic equilibrium adjustments
Market equilibrium is not a fixed point—it changes as external factors influence supply or demand. These changes cause the entire curve to shift, resulting in a new intersection point and new equilibrium price and quantity.
Demand curve shifts
If the demand curve shifts to the right (an increase in demand):
At the original price, there is now excess demand.
This puts upward pressure on price.
As price rises, quantity supplied expands and quantity demanded contracts, until a new higher equilibrium is reached.
Causes of increased demand:
Increase in consumer incomes (for normal goods)
Positive media coverage or trends
Increase in population
Fall in price of complementary goods
Rise in price of substitute goods
If the demand curve shifts to the left (a fall in demand):
A surplus forms at the original price.
Price falls, quantity demanded increases, and quantity supplied decreases.
A new lower equilibrium is reached.
Supply curve shifts
If the supply curve shifts to the right (an increase in supply):
At the original price, there is now a surplus.
Price falls, quantity demanded increases, and quantity supplied contracts.
A new equilibrium forms at a lower price and higher quantity.
Causes of increased supply:
Technological improvements
Decrease in cost of raw materials or labour
Favourable weather (for agricultural goods)
Reduction in business taxes
Government subsidies
If the supply curve shifts to the left (a decrease in supply):
A shortage forms at the old price.
Price rises, demand contracts, and supply expands.
New equilibrium forms at a higher price and lower quantity.
Summary of adjustment mechanism
To understand how markets continually adjust to maintain equilibrium, it is helpful to follow this step-by-step outline:
Initial change: A shift in either the demand or supply curve due to external factors.
Imbalance: At the old price, there is either excess demand or excess supply.
Price adjustment: Prices respond to this imbalance—rising with shortages or falling with surpluses.
Quantity response: Buyers and sellers alter their behaviour as prices change.
New equilibrium: A new market-clearing price and quantity are established.
This adjustment process is the essence of how markets function efficiently, using price as a signal and an incentive to coordinate economic activity.
FAQ
Market equilibrium may not be reached instantly due to time lags, imperfect information, and market frictions. In many real-world markets, especially for complex or durable goods like housing or machinery, producers cannot instantly increase or decrease supply in response to price signals. Building new homes, for example, takes time and is constrained by planning laws and resource availability. Additionally, consumers and producers may not have perfect information about prices, quality, or availability, which delays decision-making. There can also be menu costs, where firms delay price changes due to administrative or strategic reasons. Labour markets show another example: wage rigidity caused by long-term contracts, union negotiations, or social expectations can prevent quick adjustments to new equilibrium levels. These frictions mean that even though supply and demand may push toward equilibrium, it may take time for actual prices and quantities to fully adjust. In the meantime, markets may operate in a state of persistent disequilibrium.
Yes, in certain markets, multiple equilibria can exist. This occurs when different combinations of price and quantity satisfy the condition where demand equals supply, especially in non-linear or discontinuous markets. For instance, in the case of network goods (such as social media platforms or video game consoles), consumer demand increases as more people adopt the product. This creates a situation where low demand leads to one low-level equilibrium, while higher adoption leads to a different, higher equilibrium. Additionally, in financial markets, investor expectations can influence demand for assets like stocks or bonds. Optimism may lead to high demand and prices (a bullish equilibrium), while pessimism results in lower demand and prices (a bearish equilibrium). Similarly, markets affected by government interventions—such as guaranteed minimum prices or subsidies—might result in an artificial equilibrium different from the free market one. In these scenarios, initial conditions, expectations, or interventions can result in multiple possible market outcomes.
Speculation plays a major role in influencing price determination, especially in commodity and financial markets. Speculators buy or sell goods and assets not for direct consumption or production, but to benefit from expected future price changes. Their activity can distort current demand or supply, shifting equilibrium away from fundamentals. For example, if traders expect the price of oil to rise, they may increase demand now by purchasing futures contracts or physical oil. This artificial boost in demand can push prices up, even if current supply conditions haven’t changed. Similarly, if speculators expect falling prices, they may withhold demand or short-sell assets, depressing current prices. This creates price volatility, leading to unstable or shifting equilibria. In the short term, speculation can exacerbate imbalances, but over time, it may also provide liquidity and help markets adjust quicker to new information. However, excessive speculation can lead to bubbles or crashes, deviating significantly from true market-clearing prices.
Government-imposed price controls, such as price ceilings and price floors, interfere directly with market equilibrium by restricting the free movement of prices. A price ceiling is a maximum legal price (e.g. rent control) set below the equilibrium, leading to excess demand or shortages. At this lower price, consumers demand more, but producers supply less, causing long queues, black markets, or allocation by non-price means. A price floor is a minimum legal price (e.g. minimum wage or agricultural price supports) set above the equilibrium, leading to excess supply or surpluses. Producers are willing to supply more at the higher price, but demand falls, leading to unsold stock or underemployment. These policies can prevent the market from clearing, distorting incentives and leading to inefficiency. While they may achieve social or political objectives (e.g. protecting low-income groups), they typically result in disequilibrium conditions unless supplemented by additional policies like subsidies, rationing, or government procurement schemes.
Expectations about future prices, incomes, or availability can significantly influence current demand and supply, shifting equilibrium in advance of actual changes. If consumers expect prices to rise in the future (e.g. due to inflation or supply shocks), they may increase their current demand. This shifts the demand curve to the right, raising the current equilibrium price and quantity. Similarly, if producers anticipate higher future costs or believe that goods will fetch better prices later, they might withhold current supply, shifting the supply curve leftward and raising prices now. In both cases, expectations drive present behaviour, even in the absence of current changes in fundamentals. The reverse also holds: expectations of falling prices or income may reduce current demand, depressing the equilibrium price. In financial markets, forward-looking behaviour based on expectations is particularly influential, often creating cycles of volatility. Therefore, expectations act as a powerful, anticipatory force in determining price and quantity adjustments in many types of markets.
Practice Questions
Explain how excess demand leads to a new market equilibrium.
When excess demand exists, the quantity demanded exceeds the quantity supplied at the current price. This creates a shortage, causing upward pressure on price. As price rises, producers are incentivised to supply more, while consumers demand less. The higher price contracts demand and expands supply until quantity demanded equals quantity supplied. The market then settles at a new, higher equilibrium price and quantity. This self-correcting mechanism ensures that resources are efficiently allocated, and market disequilibrium is eliminated through the interaction of supply and demand forces, restoring balance in the market without government intervention.
Using a real-world example, analyse how a shift in demand can affect equilibrium price and quantity.
In the housing market, an increase in population or incomes can shift the demand curve to the right. At the original price, this leads to excess demand, driving prices upward. As prices rise, the quantity supplied increases over time—developers are more willing to build new homes. However, supply may be slow to adjust due to planning constraints, so prices may remain high in the short term. Eventually, a new equilibrium is reached with a higher price and higher quantity. This demonstrates how changes in demand affect both market-clearing price and output in real-world markets.
