Source: Image of Demand Graph created by Kate Eskra, Image of Supply Graph created by Kate Eskra, Image of Equilibrium Graph created by Kate Eskra
Hi. Welcome to Macroeconomics. This is Kate. This tutorial is on Prevailing Price. As always, my key terms are in red and my examples are in green.
In this tutorial, we will be talking about equilibrium, or what's known as the prevailing price. You'll be able to find equilibrium on a supply and demand schedule as well as on a supply and demand graph.
So I want you to keep in mind that we as consumers are always searching for what we want at a price we are willing to pay. And that's what demand is all about.
At the same time, producers want to provide us with goods at prices we will pay. Because that is the only way that they will make money. So producers is all about supply.
So let's review the laws of supply and demand quickly. The law of demand is the inverse correlation between price and quantity with all other variables fixed. So I've been giving you the example along the way here of Granny Smith apples and my demand for that. And this is what's called a demand schedule. So at various prices, this is how many apples I would purchase at those prices.
When we plot the points, we can see this inverse relationship between price and quantity. As the price of apples goes down, I buy more. And as the price of apples goes up, we move along the curve to see that I buy fewer apples. So there's a negative relationship between price and quantity with demand.
The law of supply says if the price of a good decreases, the quantity supply decreases. And the opposite would be the case. As prices go up, the quantity supplied would also increase.
So here, with those same prices of apples, now there's a different relationship between price and quantity. You can see that as price goes down, the quantity these farmers are willing to produce falls. And as price goes up, the quantity that they're willing and able to produce rises. So that's a positive relationship between price and quantity for supply.
So equilibrium is all about putting these two things together. Buyers and sellers, or demand and supply, are now going to come together in the market. We know that consumers want low prices. And we know that producers would love to sell at high prices. So how do they agree on a price? How do we figure out what price we will see in the market?
So let's look at both the schedule of supply and demand and the graph. Notice that I've put demand here in green, and the numbers I have indicated in green. And the supply I drew in red, which these numbers are in red because they're the quantity supplied.
I'm sure that you're smart enough and you have figured out that where these two meet is, in fact, equilibrium. Because it's equal. But let's talk about how we get there.
Notice that at any price above $1, so all of these prices up here, the red numbers, the quantity supplied, exceeds the green numbers, the quantity demanded.
So what's going on at prices above $1 are that many farmers want to grow apples. But people don't want to buy that many apples for those prices. So there are many more apples available for sale in the grocery stores than people willing to purchase them.
So at all of these price-- and at the higher prices, the quantity supplied really exceeds the quantity demanded. Then as price falls, we're getting closer. But we're still seeing quantity supplied greater than the quantity demanded.
So what will grocers do? Well, the people running the grocery stores, seeing that their apples are not selling, will respond by lowering the price to get consumers to buy them. Because the apples will spoil otherwise.
Now that the apples are being sold at a lower price, how are some of these farmers going to react? Well maybe next month, some of the farmers who have the ability to produce something else decide to produce something else. Because they don't want to produce something that is lowering in price. Their incentive has been taken away.
Farmers have an incentive to produce more as price goes up and less as price goes down, our law of supply tells us. So as the price falls, we know that quantity demanded rises, and we know that quantity supplied falls. So as the price comes down, these two will converge until equilibrium is reached.
Let's look at the opposite situation, though, at prices below $1. So now, if price fell too much or of price started out too low, the figures in green, or the quantity demanded, would now exceed the quantity supplied. These figures in red. That would be on this bottom portion of the graph here. So you would see that the quantity demanded would be greater than the quantity supplied.
Now all of a sudden that apples are really cheap, more consumers want to purchase them. But now that they are cheap, there aren't as many available for sale. Because farmers haven't produce them at those low prices. So grocers are selling out like crazy.
Seeing that they're selling out, grocer's will have the incentive to raise the prices. Because they see that people really, really want these and they don't have enough to meet the current supply. With the higher price, now some farmers have the incentive to get back into the market. Or more people will enter this market and the quantity supplied will rise. At the same time, as prices are on the rise, we know that the quantity demanded will fall. And again, the two will converge until we meet at equilibrium, or the prevailing price.
So you can see here that the only price for the quantity supplied and the quantity demanded are equal is at $1. Because 3,000 equals 3,000. And that on the graph is right here. So the price of $1 clears the market.
When we say "clears the market", we mean that every buyer has a seller, and every seller has a buyer. And with that, there is no tendency for change. There's no incentive to raise price. There's no incentive to lower price. Because it is clearing the market.
So equilibrium then is defined as the price and quantity pair at which supply and demand intersect. The price and quantity at which the market clears.
So in this tutorial, we talked about how equilibrium is where supply and demand meet. This is where consumers and producers meet in the market. And the price clears the market. That's why it's called the prevailing price. And here there is no tendency for change. At any other price, there is tendency for price to change.
Thank you so much for listening. Have a great day.
Law of Supply
If the price of a good decreases, the quantity supplied decreases.
Law of Demand
The inverse correlation between price and quantity with all other variables fixed.
The price and quantity pair at which supply and demand intersect; price and quantity at which the market clears.