Equilibrium

Explain how the equilibrium price and quantity in a market is determined and how governments can change the equilibrium outcome by influencing supply and demand In a market economy the main goal aimed to be achieved in the market is the Equilibrium level. Equilibrium price and quantity is the one and only price and quantity where there is no tendency to change as long as the supply and demand curve stays in their current position (ceteris paribus). Basically this means it is the price and quantity, the buyers and sellers both agree on without considering the other variables (ceteris paribus). Hence in this situation there is no excess supply or a situation of excess demand. Therefore the prices will move until it obtains the equilibrium level. Using a diagram the Equilibrium level is essentially the point of intersection of the supply and demand curve. This is the point where the quantity demanded is exactly equal to the quantity supplied. Shown in the diagram below Figure 1.1 it illustrates to us the equilibrium. It shows that at Price p* and Quantity q* the buyers demand exactly the amount the seller produce. [pic]Figure 1.1 The equilibrium price and quantity in a market is basically determined by the fundamentals of supply and demand. Demand is the quantity of a particular good or service that consumers are willing and able to purchase at various price levels at a given point in time. There are factors that influence this market demand such as the price of the good itself, the price of the substitutes, changes in taste and preferences and the level of income. Only a change of price can influence the movements along the existing demand curve by way of expansions and contractions in demand. Any other factors that influence the market demand will lead to a shift of the curve, these shifts are referred to as either increase or decrease in demand. As shown in Figure 1.2 where D1 to D2 is the increase in demand causing an expansion of supply. The law of demand is the lower the price the more consumers will demand and the greater the price the less consumers will demand. [pic]Figure 1.2 Supply is the quantity of the product that suppliers are willing to sell at a certain price. The factors that influence this market supply include changes in the cost of factors of production, other cost changes, changes in technology, expected future prices and changes in the number of suppliers. Once again only the change of price influences the movement along the existing supply curve and all the other factors influences the shift of the actual curve. As shown in Figure 1.3 the supply curve has shifted to the right indicating an increase in supply causing an expansion of demand. The law of supply is the lower the price of goods the less firms will supply, but the greater the amount of goods the more they will supply, this occurs because firms are assumed to maximize profit. [pic]Figure 1.3 There are 2 situations where the current price is under the equilibrium and above the equilibrium. When the price is under the equilibrium there is a situation of excess demand. In this situation the quantity demanded exceeds the quantity supplied. As mentioned the aim of a market economy is to achieve the Equilibrium price and quantity. With this limited quantity supplied the buyers would start to become more competitive raising the price. The rise in price means the contraction of demand and the expansion of supply hence moving along each of the curves. This movement along each curve would continue until the desired point of equilibrium price and quantity is achieved. The diagram Figure 1.4 illustrates the excess demand situation heading towards equilibrium. [pic]Figure 1.4 The alternative situation is when the price lies above the equilibrium price and quantity. This situation is called the excess supply situation where the quantity supplied exceeds the quantity demanded. In this situation for the equilibrium level to be achieved the suppliers have to lower their prices. As the suppliers lower their prices there would be an expansion in demand and a contraction in supply, heading towards the equilibrium price and quantity. This lowering of price would have to continue until it reaches the equilibrium level where the suppliers supply exactly the amount the consumers demand. Figure 1.5 shows the situation of excess supply heading for the equilibrium level. [pic]Figure 1.5 The governments take a big part in changing the equilibrium outcome by influencing the mechanisms of supply and demand. In Australia the 2 main policies the government uses is The Fiscal Policy and The Monetary Policy. The fiscal policy could be handing out stimulus packages (handouts) to increase the consumer spending and stimulate the economy. Injecting these packages into the economy increases consumer demand and expands supply. At this current situation the government is handing out stimulus packages of $900 per person to everyone that earns an income below $80,000. This is an attempt to increase the consumer demand. Once the demand increases the supply would expand creating more jobs. This would lead to a decrease of unemployment improving the greater economy and becoming closer and closer the equilibrium price and quantity. In a situation where the government is attempting to increase supply the government would give out subsidies to the firms where the firms could now spend money on their production but still earn enough money. Governments could also could intervene and influence the fundamentals of supply and demand by fixing prices, where setting the maximum prices which may be charged (called the price ceilings) or the minimum prices (called the price floors). Taxation is another major method government’s take part in changing the equilibrium using supply and demand. Governments have the power to impose heavy taxes on what they want to reduce the demand of. For e.g. to discourage people from smoking the government could impose heavy taxes on cigarettes. This in sense wouldn’t be affecting the cost of production for the suppliers but would be affecting the consumers that would now have to pay an increased price for each cigarette bought. This is an attempt decrease the demand of cigarettes. In a market economy the fundamentals of supply and demand influence the equilibrium price and quantity. All this influences of supply and demand is to achieve this “equilibrium level.” Due to so many factors affecting this mechanism of supply and demand achieving this equilibrium is extremely difficult and virtually impossible. Governments make an attempt to achieve this equilibrium through the fiscal policy such as stimulus packages and taxation but even through all this achieving the equilibrium level is very difficult.