The Equilibrium Price and Quantity

How are prices set in a market? The interactions of buyers (demand) and sellers (supply) determine the price of a good or service. The equilibrium price is the price where the quantity demanded is equal to the quantity supplied. That quantity is known as the equilibrium quantity.

You can visualize the equilibrium price as a ball in bowl. The bowl can can be tipped and the ball will move, but it will find its way back to a stable place. The equilibrium price works that same way. At any other price, forces are put into play that will push the price back towards equilibrium.

The first thing you need to understand about this process is how the competition works. Buyers are competing against other buyers and sellers are competing against other sellers. Buyers are not competing sellers.

Let’s examine how this works with oil. If oil is $50 per barrel, but the equilibrium price is $30 per barrel, what happens? Well, the quantity demanded is lower than the quantity supplied – there’s a surplus. Sellers can’t sell as much as they’d like at $50 per barrel, so they lower the price. And what happens to demand? It goes up! Eventually, the price reaches equilibrium and the quantity demanded equals the quantity supplied.

When the price of oil is too low and the quantity demanded is higher than the quantity supplied, there’s a shortage. The correction process in this case works much the same way. Buyers compete by bidding up the price so that they can get more oil. Sellers have an incentive to raise the price so that, once again, price and quantity reaches equilibrium.

To recap, the only stable price is the equilibrium price. If the price is not at equilibrium, the actions of buyers and sellers will push the price back towards equilibrium.