Behavior and Choice: EC 102

With a foundation for the origins of supply and demand, we turn to how buyers and sellers interact in markets. We have been introduced to the variety of market structures, each endowed with a different set of defining characteristics. For now, though, we begin with market outcomes in perfect competition.

We define a market outcome as a combination of price and quantity that prevail in a market, denoted by \((P, Q)\text{.}\) For example, if today, the price for a watermelon is $3.50, and the number of watermelons exchanged in the market is 2500, then the market outcome would be \(P = 3.50\) and \(Q = 2500\text{;}\) or, \((P, Q) = (3.50, 2500)\text{.}\)

If the price is $8, then sellers are willing to sell 240 bags of potatoes, while buyers are only willing to buy 140 bags of potatoes. Ok, so what happens? Since the quantity supplied exceeds the quantity demanded, not all sellers will have a buyer to sell to. This results in a surplus: an excess quantity of bags that go unsold in the market. All 140 buyers will be able to buy from 140 sellers, and 100 units will be left unsold. This is the amount of the surplus: \(Q_S - Q_D = 240 - 140 = 100\text{.}\) Finally, in this scenario, since at a price of $8, exactly 140 units are exchanged, the market outcome is \((P, Q) = (8, 140)\text{.}\)¹

Importantly, consider why this happens here. The price of $8 in the market incentivizes sellers to sell more units than buyers are willing to buy. Or, conversely, the price of $8 underincentivizes buyers relative to sellers: the price is too high to attract enough buyers to match the quantity supplied. This makes some intuitive sense, since high prices are good for sellers and unwelcome for buyers.

What if instead, the price in the market is \(P = 5\text{?}\) In this case, \(Q_D = 300 - (20)(5) = 200\text{,}\) while \(Q_S = (30)(5) = 150\text{.}\) Now, more consumer are willing to buy (200) than there are units available. This results in a shortage: an excess quantity of units demanded in the market. All 150 of the sellers who were willing to sell at a price of 5 will be able to, and 150 of the 200 buyers will be able to buy. However, 50 of the buyers represent the excess demand for potatoes in the market at that price: the size of the shortage is \(Q_D - Q_S = 200 - 150 = 50\) units. The market outcome here is \((5, 150)\text{,}\) because at a price of 5, the number of units exchanged in the market is 150.

Once again, we can consider the intuition for the shortage. The price of 5 is low enough to incentivize more buyers to enter the market than there are units available. Sellers are unwilling to supply as many units to the market at that price, and as a result, some consumers (the shortage) are left without a unit to buy.

In each market outcome above, there is either excess supply (a surplus) or excess demand (a shortage). The quantity demanded and quantity supplied don’t line up and the market does not “clear.” Economists say that a market clears when the number of units sellers want to sell equals the number of units buyers want to buy. In fact, economists will often express this as the market-clearing condition: \(Q_D = Q_S\text{.}\)

In perfect competition, if a market does not clear, the market is in need of a price adjustment. And in perfectly competitive markets, with many buyers and sellers all exchanging identical products, freely entering and exiting, the price is able to freely adjust. In the presence of a surplus, for example, the current price is so high that it incentivizes too much quantity supplied relative to quantity demanded. This puts downward pressure on the price, since a lower price is needed to both attract more buyers (according to the Law of Demand) and to deter a few of the sellers (Law of Supply). Similarly, when there is a shortage, the current price is too low, and buyers overdemand the good relative to the quantity supplied. This suggests the price is too low: for the market to clear, a higher price is needed to draw more sellers and deter several of the buyers.

If the price in the market reaches a point where the quantity supplied equals the quantity demanded, then the market clears. We then say the market is in (perfectly competitive) equilibrium. Formally, equilibrium is a market outcome \((P^*, Q^*)\) where, at the price \(P^*\text{,}\) \(Q_D = Q_S = Q^*\text{.}\) The “starred” notation is used to indicate the specialness of this outcome.² Equilibrium describes a scenario where there at the equilibrium price (or market-clearing price) \(P^*\text{,}\) there is no shortage or surplus: the number of units demanded by buyers is exactly equal to the number of units sellers are willing to sell - typically called the equilibrium quantity.

At the equilibrium price of \(P^* = 6\text{,}\) \(Q_D = 180\) and \(Q_S = 180\text{,}\) which means the equilibrium quantity is \(Q^* = 180\) units. We can then express the equilibrium as \((P^*, Q^*) = (6, 180)\text{.}\) Notice how the intuition for this solution matches our prior analysis. At a price of 8, the market experiences a surplus, and due to the excess supply, there is downward pressure on the price. At a price of 5, the market experiences a shortage, and the excess demand generates upward pressure on the price. The price of 8 is too high, the price of 5 is too low, and the price of 6 is just right to clear the market.

The prevalence of competitive equilibrium in economics cannot be understated. Equilibrium is an attractive concept in the study of perfectly competitive markets because it has some desirable properties. We will look at two of these - dynamic stability and efficiency - in the coming sections.