Market equilibrium is one of the most important concepts in the study of economics. In this lesson, you’ll learn what market equilibrium is and how it is established, and you’ll also be provided some examples. A short quiz follows the lesson.
Definition of Market Equilibrium
Market equilibrium is a market state where the supply in the market is equal to the demand in the market. The equilibrium price is the price of a good or service when the supply of it is equal to the demand for it in the market. If a market is at equilibrium, the price will not change unless an external factor changes the supply or demand, which results in a disruption of the equilibrium.
Supply, Demand & Equilibrium
If a market is not at equilibrium, market forces tend to move it to equilibrium. Let’s break this concept down.
If the market price is above the equilibrium value, there is an excess supply in the market (a surplus), which means there is more supply than demand. In this situation, sellers will tend to reduce the price of their good or service to clear their inventories. They probably will also slow down their production or stop ordering new inventory. The lower price entices more people to buy, which will reduce the supply further. This process will result in demand increasing and supply decreasing until the market price equals the equilibrium price.
If the market price is below the equilibrium value, then there is excess in demand (supply shortage). In this case, buyers will bid up the price of the good or service in order to obtain the good or service in short supply. As the price goes up, some buyers will quit trying because they don’t want to, or can’t, pay the higher price. Additionally, sellers, more than happy to see the demand, will start to supply more of it. Eventually, the upward pressure on price and supply will stabilize at market equilibrium.
Examples of Market Equilibrium
Flat Screen TVs
Imagine that you make flat screen televisions. Your flagship model is a 72-inch plasma that currently wholesales to your retailers at $2,500. Unfortunately, your warehouse has recently been filling a bit too quickly with 72-inch plasmas. This is probably because each of your three largest competitors has finally gotten around to introducing their own 72-inch televisions, which means that there are a bunch more 72-inch televisions on the market. You decide to lower your wholesale price to $2,250 and see what happens. You also decide to cut production down by 25% for the next month to clear out existing inventory.
When you reviewed the numbers at the end of the month, the price reduction did work, but not quite well enough. So you decide to reduce the wholesale price once again to $2,100 and keep production at the same level. When you reviewed the numbers at the end of the month, you see that you barely have any inventory and the purchase orders from your retailers have started to go up a bit. In the following months, orders have kept up with production and inventory is where it is suppose to be. It appears that the price for your television has reached market equilibrium.
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