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Market Equilibrium

Market Equilibrium

Author: Kate Eskra

This lesson will explain the basics of market equilibriums.

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Source: Image of Equilibrium Graph by Kate Eskra, Image of Consumer and Producer Surplus Graph by Kate Eskra, Image of DWL Graph by Kate Eskra

Video Transcription

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Hi. Welcome to Economics. This is Kate. This tutorial is Market Equilibrium. As always, my key terms are in red and my examples are in green.

So in this tutorial, we'll be at defining equilibrium. You'll be able to find it given a supply and demand schedule, as well as on a supply and demand graph. We'll talk about why equilibrium results in the absolute best outcome for society. And we'll also talk about what happens when there's interference of equilibrium and it can't be reached.

OK. So I want you to keep in mind that as consumers-- this is pretty common sense-- we're always searching for what we want at a price that we're willing to pay. Producers want to provide us with goods at prices we'll pay, because that's the only way they're going to make money. So equilibrium is where we, as buyers, converge with sellers, or suppliers, in the marketplace.

We, as consumers, obviously want low prices. Producers would love to sell at high prices. So how is it that we agree on a price? Let's use an example. Here's an apples example for you.

If this is the price of apples, this is the quantity of apples that producers are willing to supply. This is the quantity of apples that buyers are willing to demand at those prices. Notice, with the quantity supplied, that at a high price-- that's an expensive apple, right? $2 for one apple-- suppliers are willing to produce a whole lot because it's worth their time. They can make a big profit if they're able to sell them at that high price.

Notice that as the price falls, their willingness to produce the apples drops. There's that positive relationship between price and quantity supplied. Whereas there's an opposite relationship with price and quantity demanded. No one's willing to buy when each apple costs $2. But as the price drops, the quantity demanded rises, and rises, and rises.

Let's look at the graph. Price is on the y-axis, quantity of apples is on the x-axis. Here's that positive relationship between price and quantity supplied. And here's the inverse relationship between price and quantity demanded.

OK. So have you figured it out yet-- where's equilibrium? Well, on the graph, it's where supply and demand-- aha-- are equal. You can see that right here on the graph, or on the chart, it's the same thing. It's where quantity supplied equals quantity demanded.

All right. Let's talk about when the market's not in equilibrium. So let's say at a price higher than $1. I've indicated that in red here. At prices above $1, the quantity supplied is greater than the quantity demanded. You can see that on the graph up here. The quantity supplied is to the right of the quantity demanded.

So what would happen if that were the case? If the price were too high, and producers certainly wanted to sell a lot but no one was buying them, what would producers have an incentive to do? Wouldn't they have an incentive to lower the price? And that's exactly what would happen.

Let's look at the opposite situation. What if they lowered price so much that it were down here, under $1. Now it's the opposite situation. The quantity demanded exceeds the quantity supplied. You can see that on the graph. The quantity demanded would be greater than the quantity supplied.

If a lot of people wanted the apples, but they weren't out there to purchase because producers weren't willing to produce them, producers would notice how many people wanted to buy them, and they would have an incentive to raise price. So the market itself can establish equilibrium. And it does so once there's no tendency for price to go up or down any longer.

And that's what equilibrium is. $1 is the equilibrium price, because it's the only price where the two are equal-- quantity supplied equals quantity demanded. And so there's no need for price to go up or down any longer.

OK. So why is this so great? Well, demand represents our, consumer, marginal benefits. Supply represents the producers' marginal costs. When we equate the two, that means society is best off, because we're equating marginal benefit with marginal cost to society.

What this is going to do is maximize something we call consumer and producer surplus. Let's talk about that now. So consumer surplus is the difference between what you actually pay for a good and the highest amount you would have been willing to pay for it. Have you ever gotten a better deal on something than you expected?

Let's say that you were willing to actually pay $100 to see a concert. But you were able to buy a ticket from someone for $60. You just enjoyed what we would call a consumer surplus of $40.

A producer surplus is the difference between actually what a producer receives for a good and the lowest amount they would have agreed to receive for it. So my husband right now is selling baseball cards on eBay. And last night he told me that he was willing to accept as little as $25 for one that he put up there. But last night, someone offered him $40 for it. So he enjoyed a producer surplus of $15.

OK. Hopefully you understand that concept now. So let's look at it on my graph and on my chart. If this is the graph that we were just looking at, and here's the equilibrium, consumer surplus would be all of these people up here on the demand curve, above $1. They're all willing to pay more than $1. But $1 is the market price, so they enjoy some consumer surplus.

If we add all of these people up and their consumer surpluses, that gives us the green triangle. It's everything above the price up to the demand curve. These are all the producers on the supply curve who are actually willing to sell those apple for less than $1. They enjoy some producer surplus.

When we add them all up, we get the red triangle. If we allow the market to establish equilibrium, consumer surplus plus producer surplus represents the overall benefit to society. And that triangle could not get any bigger.

So like I just showed you, overall welfare will be maximized whenever people can trade freely in the market and equilibrium can be established. What the market is allowing us to do is to trade for the things we want. So it provides opportunities for purchases and sales.

Consumers and producers are both better off when they can freely trade with one another. And there will not be any dead weight loss, which is the next term that we need to talk about. So when the market can't establish equilibrium, there's going to be some sort of dead weight loss. I'll be defining that on the next slide.

But let's look at the labor market, because it's going to offer us a good example of this. So in this example that I made up, I'm showing you the supply of labor, people willing to supply their labor, and our employers who are demanding our labor. If we let the market come to equilibrium, apparently in this example the market would clear-- meaning there would be as many people who want jobs as are going to be hired for those jobs. The market would clear at a market wage rate of $6.

Three million workers would want jobs, three million workers would get jobs if $6 was the wage rate. But does the government allow companies to pay workers $6 per hour? No, we have minimum wage law that prevents that from happening. So instead, this is what the graph looks like.

Here's that minimum wage that they come in and impose, up above where the market would clear. So at the minimum wage, now the quantity supplied of workers surely would be greater. A lot more people are willing to supply their labor as wages go up. But do all those people get hired?

Here we have-- looks like about four million or more workers willing to work. But where does it hit the demand curve? Under two million employers are willing to hire people at that wage. So there's a gap between the quantity supplied and the quantity demanded. What that's going to do is really reduce our consumer surplus. As you can see, that green arrow really shrunk. And producer surplus will grow a little bit.

But this grey area right here, that's what we call dead weight loss. Because this whole big triangle used to be realized. Now, because this amount of workers are the only ones getting jobs, we lose out on this that used to be both consumer and producer surplus. It's what we call a dead weight loss to society. So that's a dead weight loss is when we see this decrease in producer and consumer surplus.

OK. One other thing that I need to mention, and that's this idea of ceteris paribus. Ceteris paribus is the idea that we hold all other variables constant. In any supply and demand analysis, what we're doing is we're really simplifying things.

OK. There's always a lot going on in the world. I'm sure you are well aware of that. So many, many factors can change. If we were talking about my apples example, there are a lot of things other than apples that could be going on in the world, right? But what we're doing when we're looking at that apple demand and supply and equilibrium price graph is we're just looking at those two factors-- the supply of apples and the demand for apples.

And that's what we're looking at to come up with our equilibrium price and our equilibrium quantity. We are isolating outside factors and we're just looking at one situation at a time. We will take into account that other things can change, but we will look at those changes one change at a time.

So in this tutorial, you learned that equilibrium is where supply and demand meet, and there is an equilibrium price that clears the market. You learned that equilibrium results in the best outcome because consumer and producer surplus are maximized. And when the markets can't reach equilibrium, there's a dead weight loss that results Thanks so much for listening. Have a great day.

Terms to Know
Ceteris Paribus

Holding all other variables constant.

Consumer Surplus

Determined by the difference between actual price paid for a good and the highest amount the consumer would have paid for the good.

Deadweight Loss

A variable that decreases the producer and consumer surplus due to a section of incapacitated resource, such as tax.

Producer Surplus

The difference between actual payment for a good and the least amount a producer would have agreed to receive for the good.