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Definition: Market Equilibrium
Market Equilibrium is a market state when the economic forces such as supply and demand are in balance, i.e. supply of an item is equal to its demand. The price of the commodity at this stage is called the equilibrium price and it remains stable in the absence of external forces. This price is also called the competitive price or the market clearing price.
Here, Px is the equilibrium price and the quantity of good supplied at this price is Qx, D is the demand curve and S is the supply curve.
If a market is not at equilibrium, then market forces try to bring it back to equilibrium:
• When the market price is higher than the equilibrium price, it means the supply is greater than the demand. This is called a surplus. In this case, the suppliers try to reduce the price of their goods in order to clear their inventories. They will also stop ordering new inventory, so the production process slows down. Since the prices are now low, consumers buy more of the products and demand increases. In this way, demand increases and supply decreases till it reaches equilibrium.
• When the market price is lower than the equilibrium price, then the demand is higher than supply. This situation is called a supply shortage. In such a case, buyers bid the pric4 higher in order to obtain the product or good during the short supply period. As the price increases, some buyers quit trying because they don’t want to or might not be able to pay such a high price. Because of the increased demand, suppliers start supplying more than before. In this way, supply increases till it reaches the equilibrium level.
For example, there is a company ABC which manufactures televisions of different sizes, of which the 40 inch plasma is their flagship product. They found that the inventory of their 40 inch plasmas has been not clearing like normally last month. On further research they found that competitors also started introducing 40 inch plasmas. Now company ABC decreases the price of their 40 inch plasmas by 20%. After a month they find that the purchases have increased but not as much as they expected. Now they decrease the prices further by 7.5%. After another month they find that their inventories are clearing effectively. Now the price for 40 inch televisions has reached a price equilibrium.