Equilibrium (Price)

We know from previous lessons that the demand curve and the supply curve show how buyers and sellers respectively respond to changes in the price of a good. In this lesson, we'll show you how the interactions of buyers and sellers determine the price.

Let's start with the punch line. The equilibrium price is the price where the quantity demanded is equal to the quantity supplied, right here, and this is the equilibrium quantity. Why is this the equilibrium price? At any other price, forces are put into play that will push the price towards the equilibrium price. It's kind of like a ball in a bowl, where the ball always returns to one stable position. The equilibrium price is the only place where the price is stable.

To see why, the first thing to understand is that buyers don't compete against sellers. Buyers compete against other buyers. A buyer obtains goods by bidding higher than other buyers. And sellers compete against other sellers by offering to sell at lower prices. Think about it -- at an auction, the buyer with the highest bid gets the item, and the seller with the lowest price makes the sale.

So let's say the price of oil is currently 50 bucks a barrel -- that's above the equilibrium price of $30 a barrel. At $50, the quantity supplied is more than the quantity demanded so we say there is a surplus. So what happens? It's sale time! When there's a surplus, sellers can't sell as much as they would like to at the going price so sellers have an incentive to lower their price a little bit so they could outcompete other sellers and sell more. The price will continue to fall until the quantity demanded is equal to the quantity supplied, and equilibrium is reached.

Now let's say the price is less than the equilibrium price, say 15 bucks a barrel. At 15 bucks a barrel, the quantity demanded exceeds the quantity supplied, a shortage. And what happens now? When there's a shortage, buyers can't get as much of the good as they want at the going price so they compete to buy more by bidding up the price. Now since buyers are easy to find, sellers also have an incentive to raise the price. The price will continue to rise until quantity demanded is equal to the quantity supplied and equilibrium is reached. At any price other than the equilibrium price, the incentives of the buyers and sellers push the price towards the equilibrium price. Only the equilibrium price is stable.

Now let's take a deeper look at the market equilibrium and some of its properties. Remember that there are many different users of oil and many different uses for oil, each with substitutes, alternatives, and values. At any specific price of oil, there's a group of buyers who value oil enough to demand it at that price. And as the price changes, so do the buyers and their uses.

On the supply side, at each price on the supply curve, we're looking at a group of suppliers whose cost of extraction is low enough to be profitable at that price. At the equilibrium price, these higher value groups are the buyers, and these lower value groups are the non-buyers. Also notice that every seller has lower cost than any of the non-sellers.

Since the buyers with the highest values buy, and the sellers with the lowest cost sell, the gain from trade -- the difference between the value a good creates and its cost -- is maximized. In addition, at the equilibrium quantity, every trade that can generate value does generate value up until the very last trade where the value to buyers is just equal to the cost to sellers.

In a free market, there are no unexploited gains from trade, and there are no wasteful trades. If the quantity exchanged were greater than the equilibrium quantity, for example, we would be drilling deep and expensive oil wells just to produce more rubber duckies, and that would be wasteful. In a free market, buyers and sellers acting in their own self interest end up at a price and quantity that allocates oil to the highest value buyers produced by the lowest cost sellers in a way that maximizes the gains from trade -- the sum of the benefits to buyers and sellers. This is one of the reasons Adam Smith said that the market process works like an invisible hand to promote the social good.