Market equilibrium and the price mechanism
Equilibrium is where quantity demanded equals quantity supplied. Surpluses push price down and shortages push it up until the market clears.
Worked example: finding equilibrium price and quantity
In a town market, daily demand for coconuts is Qd = 6,000 − 20P and supply is Qs = 30P − 1,500, where P is the price in rupees. Find the equilibrium price and quantity. What happens at Rs. 180 and at Rs. 120?
- At equilibrium, Qd = Qs: 6,000 − 20P = 30P − 1,500.
- Collect terms: 6,000 + 1,500 = 30P + 20P, so 7,500 = 50P.
- P = 7,500 ÷ 50 = Rs. 150.
- Q = 6,000 − 20 × 150 = 6,000 − 3,000 = 3,000. Check with supply: 30 × 150 − 1,500 = 4,500 − 1,500 = 3,000. ✓
- At Rs. 180: Qd = 6,000 − 3,600 = 2,400; Qs = 5,400 − 1,500 = 3,900. Surplus = 3,900 − 2,400 = 1,500.
- At Rs. 120: Qd = 6,000 − 2,400 = 3,600; Qs = 3,600 − 1,500 = 2,100. Shortage = 3,600 − 2,100 = 1,500.
Equilibrium: Rs. 150 and 3,000 coconuts a day. At Rs. 180 there is a surplus of 1,500; at Rs. 120 a shortage of 1,500.
How a surplus is removed
How a shortage is removed
Worked example: a shift in demand and a shift in supply
Using the coconut market above (equilibrium Rs. 150, 3,000 nuts): (a) Before a festival, demand rises to Qd = 6,500 − 20P. (b) Separately, a drought cuts supply to Qs = 30P − 2,500. Find the new equilibrium in each case.
- (a) 6,500 − 20P = 30P − 1,500, so 8,000 = 50P and P = Rs. 160.
- Q = 6,500 − 20 × 160 = 6,500 − 3,200 = 3,300. Check: 30 × 160 − 1,500 = 3,300. ✓
- (b) 6,000 − 20P = 30P − 2,500, so 8,500 = 50P and P = Rs. 170.
- Q = 6,000 − 20 × 170 = 6,000 − 3,400 = 2,600. Check: 30 × 170 − 2,500 = 2,600. ✓
(a) Demand up: price rises to Rs. 160 and quantity rises to 3,300. (b) Supply down: price rises to Rs. 170 but quantity falls to 2,600.
Effects of shifts on equilibrium
| Change | Equilibrium price | Equilibrium quantity |
|---|---|---|
| Demand increases (shifts right) | Rises | Rises |
| Demand decreases (shifts left) | Falls | Falls |
| Supply increases (shifts right) | Falls | Rises |
| Supply decreases (shifts left) | Rises | Falls |
Role of the price mechanism
- Signalling: a rising price tells producers that buyers want more; a falling price tells them to produce less.
- Rationing: when goods are scarce, a higher price cuts quantity demanded, so the good goes to those most willing and able to pay.
- Incentive: higher prices and profits attract resources and new firms into the industry.
- Allocation: resources move from goods people want less to goods people want more, without central planning.
- Limits: it ignores public goods and pollution (externalities), can leave the poor unable to buy essentials, and can be distorted by monopolies.
Before the Sinhala and Tamil New Year, demand for rice, oil and sweets rises and prices climb, signalling traders such as Cargills to stock more. After the season, demand falls back and prices ease. This is the price mechanism at work.
Structured question: “Given Qd = 6,000 − 20P and Qs = 30P − 1,500, find the equilibrium price and quantity, and the shortage at Rs. 120.” Set Qd = Qs: P = Rs. 150, Q = 3,000. At Rs. 120, Qd = 3,600 and Qs = 2,100, so the shortage is 1,500.
Essay: “Explain how market equilibrium is determined and discuss the role of the price mechanism.” Draw D and S, explain surplus and shortage adjustment, show effects of shifts, then the signalling, rationing and incentive roles of price and their limits.
Short answer: “What is equilibrium price?” The price at which quantity demanded equals quantity supplied, so there is no shortage or surplus.
Surplus → Slash price. Shortage → Shoot price up. Demand shifts move P and Q the same way; supply shifts move them opposite ways.