It explains how the price of a commodity and the quantity traded in the market are determined through the interaction of buyers and sellers. In a competitive market, neither buyers nor sellers decide the price independently. Instead, price is determined at the point where the quantity demanded by consumers equals the quantity supplied by producers.
Demand refers to the quantity of a good or service that consumers are willing and able to buy at different prices during a given period of time. Generally, demand has an inverse relationship with price. When the price of a commodity increases, its demand usually decreases, and when the price falls, demand tends to increase, other factors remaining constant. This inverse relationship is explained by the law of demand and is influenced by factors such as income, tastes and preferences, prices of related goods, and expectations of future prices.
Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at different prices during a given period of time. Supply generally has a direct relationship with price. When the price of a commodity rises, producers are motivated to supply more in order to earn higher profits. When the price falls, supply tends to decrease. This direct relationship between price and quantity supplied is explained by the law of supply and is affected by factors such as cost of production, technology, prices of inputs, government policies, and number of sellers.
Equilibrium occurs at the price level where quantity demanded is exactly equal to quantity supplied. This price is known as the equilibrium price, and the corresponding quantity is called equilibrium quantity. At this point, the market is in balance, and there is no tendency for price to change. Buyers are able to purchase exactly what they want to buy, and sellers are able to sell exactly what they want to sell at that price.
If the market price is above the equilibrium price, the quantity supplied exceeds the quantity demanded. This situation is known as excess supply or surplus. When there is surplus in the market, sellers find it difficult to sell all their goods. To clear unsold stock, they start reducing the price. As the price falls, demand increases and supply decreases, gradually moving the market back towards equilibrium.
On the other hand, if the market price is below the equilibrium price, the quantity demanded exceeds the quantity supplied. This situation is called excess demand or shortage. In case of shortage, consumers compete with each other to buy limited goods, and some are willing to pay a higher price. Sellers respond by increasing the price. As price rises, demand decreases and supply increases, once again pushing the market towards equilibrium.
The equilibrium of supply and demand is not static. It can change when there is a shift in the demand curve or the supply curve. A shift in demand occurs due to changes in factors such as consumer income, tastes, population, or prices of related goods, while the price of the commodity remains unchanged. For example, an increase in income for a normal good leads to an increase in demand, shifting the demand curve to the right and resulting in a higher equilibrium price and quantity. Similarly, a shift in supply occurs due to changes in production costs, technology, taxes, subsidies, or natural conditions.
Government intervention can also affect market equilibrium. Price controls such as price ceilings and price floors disturb the natural equilibrium. A price ceiling set below the equilibrium price may lead to shortages, as demand exceeds supply. A price floor set above the equilibrium price may result in surplus, as supply exceeds demand. Taxes increase the cost of production and reduce supply, leading to a higher equilibrium price, while subsidies reduce production cost and increase supply, lowering the equilibrium price.
It is important to understand that equilibrium of supply and demand explains price determination under free market conditions. It also helps in analysing the impact of changes in economic variables and government policies on prices and quantities in the market. In banking and finance, this concept is useful in understanding interest rates, credit demand and supply, and pricing of financial products.
In conclusion, the equilibrium of supply and demand represents a state of balance in the market where the intentions of buyers and sellers are perfectly matched. It ensures efficient allocation of resources, stable prices, and smooth functioning of the market mechanism.