Equilibrium in Economics: How a Supply and Demand Graph Dot Explains Producer and Consumer Surplus

Welcome back.

Every supply and demand graph features a humble little dot in the middle. Let's call it "equilibrium." And in this video, we're going to explore equilibrium, and how a free market maximizes the gains from trade.

We showed in an earlier video that at any price above the equilibrium price, there's a surplus, and the incentives of sellers pushes the price down. And at any price below the equilibrium price, there's a shortage, and the incentives of buyers pushes the price up. As a result, the equilibrium price is the only stable price.

We're now going to use a similar exercise to show how the equilibrium quantity is the only stable quantity, and this will help us to understand how a free market maximizes the gains from trade.

Suppose that the market quantity was less than the equilibrium quantity, say here, at 10 million barrels of oil per day. At that quantity, notice that buyers are willing to pay about $41 for one more barrel of oil. But at that quantity, sellers are willing to sell the next barrel of oil for just $6.

So these buyers and sellers -- they've got a strong incentive to make a trade, as the gains from trade is approximately $35. In fact, so long as the price the buyers are willing to pay for the next barrel -- which is right off the demand curve -- exceeds the price the suppliers are willing to sell the next barrel of oil for -- right off the supply curve -- there are gains to be had from trade, and thus incentives to trade more.

In fact, buyers and sellers will continue trading until there are no more gains from trade, which means the buyers and sellers will continue to trade more units until the price at which buyers are willing to buy just equals the price at which sellers are willing to sell. The quantity at that price is the equilibrium quantity.

What about if the market quantity was more than the equilibrium quantity, say here, at 40 million barrels of oil per day? Notice now that suppliers are willing to sell that last barrel of oil -- the 40 millionth barrel -- for $40! That means they require at least $40 to stay in business and cover their costs from producing that barrel of oil. On the other hand, that last barrel of oil -- it's only worth $7 to the buyers.

So in other words, at a quantity greater than the equilibrium quantity -- it's costing sellers more to produce the good than buyers value the good. Resources are being wasted. There are negative gains from trade.

But naturally, suppliers -- they don't want to sell goods at a price less than their cost. And buyers -- they don't want to buy goods for more than they're worth. So, of course, the quantity traded will fall. And the quantity traded will fall so long as the cost to sellers -- right off the supply curve -- exceeds the value of the good to the buyers -- right off the demand curve.

So the quantity will fall till the value to buyers of the last unit sold is just equal to the cost to the sellers. And that's the equilibrium quantity.

One final thing. Notice that the equilibrium price splits the demand curve into two parts: the buyers and the non-buyers. And the oil is bought by the buyers who value it the most. In the same way, the supply curve is split into sellers and non-sellers, and the oil is sold by the sellers with the lowest costs.

Let's put it all together. What this means is that at the equilibrium quantity, the gains from trade are maximized, and the gains from trade are the sum of the consumer surplus and the producer surplus. So the equilibrium maximizes the sum of consumer surplus and producer surplus.

What an amazing little dot!

If you're a teacher, you should check out our Supply and Demand unit plan that incorporates this video. If you're a learner, make sure this video sticks by answering a few quick practice questions. Or if you're ready for more microeconomics, click for the next video.