Market Supply &
Demand
For exchange to take place, a market supply curve and a
market demand curve must exist and there must be at least one common price at
which suppliers are willing to sell some quantity of the good and at which
buyers are willing to buy some quantity of the good.
If at all
positive prices in a market the quantity of a good supplied exceeds the
quantity supplied, the price of the good will be zero (“free good”). Fresh air
is an example. A certain amount of fresh air exists at a price of zero. For
more than this quantity to be produced, the price has to be greater than zero.
However, there is a certain maximum demand that exists even at a price of zero:
If everyone has as much fresh air as they need, they do not want any more even
if there is no cost. If the quantity of fresh air that can be supplied at a
price of zero exceeds the maximum amount demanded, then fresh air is a free
good. If the supply curve shifts to the left due to air pollution, fresh air
may cease to be a free good.
Excess
supply exists when, at a given price, the quantity of a good firms are prepared
to supply exceeds the quantity consumers are prepared to buy. Excess demand
exists when the quantity consumers are prepared to buy exceeds the quantity
firms are prepared to supply. The price where the quantity firms are prepaded
supply equals the quantity consumers are prepared to buy, or in other words the
price at which neither excess supply nor excess demand exists, is called the
equilibrium price. At the equilibrium price, every supplier willing to sell at
that price is able to and every consumer willint to buy at that price is able
to.
The Operation of Markets
If a price
causes excess demand or excess supply in a market, forces in the market will
change the price of the good and the quantity bought and sold. These forces
will eventually eliminate any excess demand or excess supply.
If excess
supply exists in a market, suppliers desire to sell more than they are able to
at the prevailing price. It is to their advantage to offer to sell more goods
at a lower price. Therefore competition among suppliers will force down the
price of the good. These price reductions will also decrease the quantity of
goods sold, reducing and eventually eliminating the excess supply.
If excess
demand exists in a market, buyers desire to purchase more than suppliers are
willing to provide at the prevailing price. Buyers will therefore offer to pay
a higher price to induce suppliers to produce more of the good. The increased
price will result in less and eventually zero excess demand.
Producer and Consumer Surplus
In a market
at equilibrium, all consumers who wish to purchase at the prevailing price are
able to do so and all suppliers who wish to sell at the prevailing price are
also able to do so. However, most of the consumers and suppliers would have
been willing to trade at less favorable prices. For a consumer who purchases a
good at the equilibrium price of $40 but would have been willing to pay up to
$70, a consumer surplus of $30 exists. For a supplier who sells a good at $40
but would have been willing to sell at $20, a producer surplus of $20 exists.
The market consumer and producer surpluses are the sum of all individual
surpluses and are graphically represented by the area measured between the
supply or demand curve, a horizontal line at the equilibrium price, and the
price axis (ie a vertical line at zero quantity). These surpluses provide the
motivation for the market to achieve equlibrium.