To understand the market equilibrium concept, we need to learn the demand and supply as the conceptual framework. These two components can describe how the market equilibrium formed. The first is the demand which is the quantities (Q) of the good or service that consumer willing to buy as their reference and their capability refers to their income at various prices (P) within some given periods (t) and for this concept, the other factors beside prices held constant. The relationship between price and the quantity of demanded is inverse with each other or called a Law of demand.
There is the other condition that the customer behaves in an “irrational” manner which results in the linear relationship between price and demand due to the level of product quality preference. But in the business economics analysis of demand, the assumption is not applied.
Factors can cause the shifting of demand (nonprice determinants of demand) :
- Taste and Preference. These factors are related to the reason for people to buy things, the likes and dislikes about products. The external cause that may affect these factors is the marketing strategies (advertising and promotions) and the government report.
- Income. The people’s income rise tend to increase their demand for consumption product.
- Price of related products. Subtitle or complementary products.
- Future expectations. These factors related to speculation of demand (needs) in the future.
- Several buyers.
The second component is supplied which is the quantities (Q) of the good or service that seller ready to sell at various prices (P) withing some given period and for this concept, the other factors besides price held constant. In contrast, the law of supply states that the quantity supplied is related directly to price. The increase in price will increase the number of supplies. Some factors can cause supplies to change (nonprice determinants) :Cost and Technology. These two factor is closely related, it refer to cost of production and ureduction of nit cost of production.
- Cost and Technology. These two factors are closely related, they refer to the cost of production and reduction of nit cost of production.
- Prices of other goods or services offered by the seller. It related to complementary or substitute products or services offered in the market so the producer can reallocate the resources toward the more profitable product.
- Future expectations. Different from buyers, the supplier has linear anticipation on a rise in price by hold back the current supply to take advantage of the higher future price. So when the price increase the quantity of supply will decrease.
- The number of sellers. The more seller, the greater the market supply.
- Weather conditions. Bad weather will reduce the supply of an agricultural commodity for example. (vice versa)
The Correlation Between Demand and Supply in The Market Equilibrium
There is a correlation between demand and supply mechanism in terms of market equilibrium formation. When the supply equal to the demand on the market, it will form a market equilibrium and result in the equilibrium price. There are two conditions if the supply and demand quantity not equal on the market, the first is surplus. If the quantity of supply is more than the quantity of demand, there will be an excess supply or called a surplus and the price will decrease. The supplier tends to reduce the price to averse the overstock. The lower price will attract more people to buy and this process will result in an increasing quantity of demand until the market form the equilibrium again.
The second condition is a shortage, if the quantity of demand is more than the quantity of supply, there will be an excess of demand or called a shortage. In these conditions, higher demand to obtain the product or service will increase the price due to short in supply. Some buyers will quit obtaining the products or services because of the higher price (discouraging buying) and the supplier will increase the supply due to higher demand. The price and supply movement will stabilize the market to equilibrium again.
To analyze the market, we can use the model of market supply, demand, and equilibrium price and quantity as a comparative statics analysis method. This method is a form of sensitivity analysis or what-if analysis Here is the step to use this method :
- State the assumption needed to construct the model.
- Begin by assuming the model is in equilibrium.
- Introduce a change in the model.
- Find the new point at which equilibrium is restored.
- Compare the new equilibrium point with the original one.
Changes in supply and demand
The first step of the comparative statics analysis method is to assume to construct the model. For the example is short-run market changes or the rationing function of price. This function does not affect supply shifting.
Changes in Supply and Demand and their short-run impact on market equilibrium
Here is the explanation of the short-run impact curve above:
- The increase in demand will create a new higher price equilibrium follow by the increase of quantity supply and make shortage condition due to lower quantity supply than the demand.
- The decrease in demand will create a new lower price equilibrium follow by the decrease in the quantity of supply and make surplus condition due to a higher quantity of supply than the demand.
- The increase in the quantity of supply will create a new lower price equilibrium follow by the increase in the quantity of supply.
- The decrease in the quantity of supply will create a new higher price equilibrium follow by the decrease in the quantity of supply.
In the short run sellers already in the market respond to a change in equilibrium price by adjusting the number of certain resources (variable inputs). The buyers already in the market respond to changes in the equilibrium price by adjusting the quantity demanded a particular good or service.
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Long-run Market Analysis : The guiding or allocating function of price
On the long-run adjustment, equilibrium price and quantity return to the levels at which they were before initial changes in demand took place. The resources shifted out of the one market to another market in response to a change in the equilibrium price of the goods and service or it called the guiding or allocating function of price.
Short-run and Long-Run Changes in Supply (in response to an initial change in demand)
In the long run, the new sellers may enter a market or the original seller may exit from the market. This period is long enough for existing sellers to either increase or decrease their fixed factors productions. The buyers may react to a change in equilibrium price by changing their tastes and preferences or buying patterns. This action makes a given demand curve shifted. In the long-term, price fulfills its guiding function by causing sellers and potential sellers to respond by increasing capacity or entering one market by decreasing capacity or leaving the initial market.