Problem 3 What happens in a market if the ... [FREE SOLUTION]

Chapter 3: Problem 3

What happens in a market if the current price is above the equilibrium price? What happens if the current price is below the equilibrium price?

Short Answer

Expert verified

If the current price is above the equilibrium price, there will be a surplus (excess supply) and prices will decrease. If the current price is below the equilibrium price, there will be a shortage (excess demand) causing prices to rise.

Step by step solution

Understand The Effect Of A Price Higher Than Equilibrium

When the current price in a market is above the equilibrium price, which is also known as a surplus, there will be an excess supply. This happens because at a higher price, consumers demand less of the product, while producers are willing to supply more.

Impact Of Surplus On Market

This surplus of goods will force suppliers to lower their prices in order to sell their products. Also, competition among suppliers may increase, potentially driving down the price further. As the price decreases, consumers will start to demand more of the product, which will gradually reduce the excess supply.

Analyze The Effect Of A Price Lower Than Equilibrium

When the current price in a market is below the equilibrium price, which is referred to as a shortage, there is excess demand. At a lower price level, consumers demand more of a product, while producers are less willing to supply it.

Impact Of Shortage On Market

The excess demand or shortage pressures suppliers to increase their prices. As the price increases, the quantity demanded by consumers will decrease, and suppliers will be more willing to produce and supply the product, gradually reducing the excess demand. The price will continue to rise until it reaches the equilibrium level where supply equals demand.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

market equilibrium

In economics, market equilibrium is a state where the supply of goods matches the demand for them. This means that the quantity of goods that producers are willing to sell exactly equals the quantity that consumers are ready to purchase. At this point, the market price becomes stable due to no existing pressure for it to change.

When supply equals demand, resources are allocated efficiently.
Firms sell as much of the product as they are producing, and consumers get all the products they desire at the equilibrium price.

Understanding equilibrium is crucial because it is the ideal spot where markets naturally gravitate over time. In reality, markets are dynamic, and prices fluctuate due to different factors, but they tend to adjust back to the equilibrium eventually.

excess supply

Excess supply occurs when the price of a product is set above its equilibrium. This situation is often referred to as a surplus. At a higher price:

Producers are eager to supply more as it seems more profitable.
Consumers demand less since the product is more expensive.

This mismatch means there are more products than people are willing to buy, leading to excess supply. Producers, therefore, have to reduce prices to encourage consumers to purchase the extra goods. As prices lower, demand usually increases, which helps clear the surplus.
Excess supply signals that prices need to adjust to achieve balance again.

excess demand

When the market price falls below the equilibrium price, it leads to a situation of excess demand, also called a shortage. This occurs because:

Consumers want to buy more because the product is cheaper.
Producers supply less as it's less profitable at lower prices.

The imbalance creates a deficit where there are more buyers than there are goods available for sale. This situation typically compels producers to raise prices, which discourages some consumers from buying excessive quantities and encourages producers to increase production.
Through this price adjustment, the market can work its way back to equilibrium.

price adjustment

Price adjustment is the natural mechanism that markets use to eliminate excess supply or excess demand. When there's an imbalance:

If there's excess supply, prices will decrease.
If there's excess demand, prices will increase.

As prices adjust, supply and demand will gradually align once more. For instance, in cases of excess supply, reducing prices makes the product more attractive to consumers and less appealing for further production unless needed.
During excess demand, higher prices encourage producers to create more while dissuading consumers from over-purchasing.
These adjustments continue until prices are in harmony with both supply and demand, restoring equilibrium.

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