5.1. Equilibrium, Excess Demand, Excess Supply

A perfectly competitive market consists of buyers and sellers who are driven by their self-interested objectives. Recall from Chapters 2 and 4 that objectives of the consumers are to maximise their respective preference and that of the firms are to maximise their respective profits. Both the consumers’ and firms’ objectives are compatible in the equilibrium.

In a perfectly competitive market, individuals act out of self-interest — consumers want to buy at the lowest price possible, while firms want to sell at the highest price possible. This self-interested behavior leads to a situation known as market equilibrium, where the supply of goods matches demand. At this point, both consumers and firms are satisfied as they achieve their objectives without any excess supply or demand.

Imagine a busy marketplace where many people are trying to buy fresh fruits. Sellers want to maximize their prices while buyers want to get the best deals. When sellers set a price that allows all fruits to be sold without leftovers, and all buyers have found what they want, the market reaches equilibrium. It signifies balance — no one wants to change their price because they are satisfied with the exchange.

An equilibrium is defined as a situation where the plans of all consumers and firms in the market match and the market clears. In equilibrium, the aggregate quantity that all firms wish to sell equals the quantity that all the consumers in the market wish to buy; in other words, market supply equals market demand. The price at which equilibrium is reached is called equilibrium price and the quantity bought and sold at this price is called equilibrium quantity.

Equilibrium occurs when the amount of goods that firms are prepared to sell is equal to the amount that consumers want to buy. This is reflected in two key terms: the equilibrium price, which is the price at which this balance occurs, and the equilibrium quantity, which is the quantity of goods exchanged at that price. When either of these conditions isn’t met, adjustments will occur in the market until a new equilibrium is established.

Consider a popular concert where tickets are priced at $50. If 1,000 people want to buy tickets, but only 800 are available, that leads to excess demand. The concert organizers may raise the ticket price until the new quantity demanded matches the supply — perhaps to$60 — achieving a new equilibrium where 800 people are willing to buy at this price.

If at a price, market supply is greater than market demand, we say that there is an excess supply in the market at that price and if market demand exceeds market supply at a price, it is said that excess demand exists in the market at that price. Therefore, equilibrium in a perfectly competitive market can be defined alternatively as zero excess demand-zero excess supply situation.

Excess demand occurs when the quantity demanded by consumers at a given price exceeds the quantity supplied by producers. Conversely, excess supply occurs when producers supply more than what consumers are willing to buy. These situations prompt natural market adjustments — with excess demand causing prices to rise and excess supply leading to price drops until the market reaches a new equilibrium.

Think of a situation in a bakery where fresh bread is sold. If on a certain day they bake 200 loaves but 300 people are queued up to buy them, there’s excess demand. The bakery might raise prices for the next batch to balance supply and demand. If they bake 300 loaves the following day and only 200 people come, that creates excess supply, prompting the bakery to lower prices to attract more customers.

Whenever market supply is not equal to market demand, and hence the market is not in equilibrium, there will be a tendency for the price to change. In a perfectly competitive market, an ‘Invisible Hand’ is at play which changes price whenever there is imbalance in the market.

The concept of the ‘Invisible Hand,’ proposed by economist Adam Smith, suggests that individuals’ self-interested actions inadvertently promote the welfare of society as a whole. In the context of market equilibrium, when there is a mismatch between supply and demand, market forces will adjust prices — raising them in the case of excess demand and lowering them in cases of excess supply — leading to a new equilibrium. This process reflects how markets naturally respond to changes.

Picture yourself buying avocados at a supermarket. If a sudden trend makes avocados very popular, the demand skyrockets. Initially, the price might jump sharply as people are willing to pay more. Over time, as a result of higher prices, more suppliers start stocking avocados until the prices stabilize at a new equilibrium, balancing supply with the new level of demand.

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